A technical analyst should select the chart depending on the investment time-frame
We had already defined and analysed technical analysis, the underlying premises, and a few distinctions between technical and fundamental analysis in our issue dated 28/05/2001.
Now we discuss the different types of charts, their characteristics and applications over different time frames. We also give you an insight into one of the most important indicators in technical analysis -- volume.
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For daily use
Of all the charts utilised by the technical analyst for forecasting and trading, the daily bar chart is the most popular. It usually covers a period of only six to nine months in the life of a stock's trading history.
However, because most traders and analysts confine their interest to relatively short-term market action, the daily bar charts have gained wide acceptance as a primary working tool. It is called a bar chart as each day's action is represented by a vertical bar.
The bar chart usually shows the opening price, the high and low for the day and the closing price. The high and low for the day are represented by the high and low of the vertical bar respectively.
Closing-in
Another chart widely used (though not as much as the daily bar chart) by the technical analysts is the line chart. In this chart, only the closing price for each successive day is plotted.
Many chartists believe that since the closing price is the most critical price of the trading day, a line (or close-only) chart is a more valid measure of price activity.
Depending on what the analyst is looking for, certain techniques used in chart analysis are easier to perform on the line chart than on the bar chart.
Time is money
While the daily charts indicate the open, high, low, and closing prices of the trading day, an enormous amount of trading activity that takes place during the trading session is lost on these charts. But, it is possible to capture that intra-day activity.
Bar charts, for example, can be obtained for time period of five minutes, 15 minutes, one hour etc. For short-term trading purposes (especially for the day trader), this intra-day data becomes extremely useful. With recent improvements in computer technology and reporting capabilities, the intra-day chart is becoming increasingly popular.
For the portfolio investor
The average trader's dependence on the daily charts, and a preoccupation with short-term market behaviour , however, can cause many to overlook a very useful and rewarding area of price charting - the use of weekly and monthly charts for longer-range trend analysis and forecasting.
The purpose of weekly and monthly charts is to compress price action in such a way that its movement can be studied over a much longer time period.
On a weekly chart, one bar represents the price activity during an entire week. On a monthly chart, each bar shows the price action that took place during an entire month.
Importance of long-range
Long-range price charts provide a certain perspective on the market that can be impossible to achieve with the use of daily charts alone.
Readers would remember that in our introduction to technical philosophy (issue dated 28/05/2001) it was pointed out that one of the greatest advantages of chart analysis is the application of its principles to virtually any time frame, including long-range forecasting.
We also mentioned that it was a fallacy to believe that technical analysis should be limited to short-term forecasting with longer-range forecasting left to the fundamental analyst.
The principles of technical analysis -- including trend analysis, support and resistance levels, trendlines and channels, percentage retracements, and price patterns -- lend themselves quiet well to the analysis of long-range price movements.
In fact, most of the charting techniques that are applied to daily bar charts can be applied to weekly and monthly charts as well. Moreover, it can also be stated that long-range forecasting can often be easier than short-term forecasting.
Long-term to short-term
The proper order to follow in chart analysis is to begin with the long-term trends and gradually work to the near-term. If the analyst begins with only the near-term picture, he may be forced to constantly revise his conclusions as more precise data is considered.
A thorough analysis of a daily chart may have to be completely redone after looking at the long-range charts. By starting with the long-range charts, all data to be considered are already included in the chart and a proper perspective is achieved.
Once the analyst knows where the market headed from a long-term perspective, he closes in on the short-term, thus going from 'macro' to 'micro.'
Traders, please excuse
Long-term charts are not meant for trading purposes. A distinction has to be made between analysis for forecasting purposes and the timing of market commitments.
Long-term charts are useful in the analytical process to help determine the major trend and price objectives. They are not suitable, however, for the timing of entry and exit points and should not be used for that purpose. For the more sensitive task of timing, daily and intra-day charts should be utilised.
Importance of volume
Another piece of important information that should be included on the bar chart is volume. Volume represents the total number of shares that changed hands on a given day in the stock market.
The volume for any given stock is recorded by a vertical bar at the bottom of the chart under that day's price bar. A higher volume bar means that volume was heavier for that day while a smaller bar represents lighter volume.
Volume can be plotted for weekly charts as well, in which case, total volume for the week would simply be plotted under the bar representing that week's price action. Volumes are not usually shown, however, on monthly charts.
The level of volume measures the intensity behind a price movement. Heavier volumes reflect a higher degree of intensity or pressure. By monitoring the volume level along with the price action, a technical analyst is better able to gauge buying or selling pressure behind market moves.
This information can be used to confirm price movements. In an uptrend, volumes should be heavier and should decrease on price dips. As long as this pattern continues, volume is said to be confirming the price trend.
The chartist also has to watch for divergence. Divergence occurs if the penetration of a previous high by the price trend takes place on declining volumes. This action alerts the chartist to thinning buying pressure.
If volumes also shows a tendency to pick up on price dips, the analyst begins to worry that the uptrend is in trouble. Besides its use in trend-forecasting, volumes can also play a pivotal role as a conforming indicator. Volume levels indicate different signals depending on the respective tool that it is being used with.