Charting market movements is one of the most popular means investors use to identify share market trends. But  are they as good as some say they are?  What are the common traps and pitfalls of using charts?

What is charting? This is a simple question with so many possible answers. In some ways it is easier to start the answer by defining what charting is not. A chart of price information is not a way to predict the future behaviour of the market, or of a stock. A chart of traded prices for a stock tells us very little about the financial health of a company, or the value of a company as it is related to its financial position. Although price is used in some fundamental calculations like the PE ratio, this has nothing to do with the way a price chart is used.

The single most misleading and false idea about charting is that somehow it is able to predict the future. It is an idea repeated endlessly by those who know little about charting. People new to the market who accept this idea are sent off on a fruitless, and sometimes very expensive, chase in search of the method that allows them to predict the future.

So what is charting? It is simply a graphical record of the traded price for a stock during the day. The simplest display is a line chart which usually shows the closing price for each day. This is useful as a way of seeing how price has behaved over the previous weeks or months. The display gives a broad outline of the direction of the trend because we can see if price is generally moving up or down.

Stocks have four significant trading or price points during the day. First is the opening price and last is the closing price. In-between times we are interested in the absolute high price for the day and the absolute low price for the day. The basic chart display uses either a bar chart or a candlestick chart to display these four price elements open, high, low and close.

The bar chart starts with a small horizontal mark, or bar, for the open. The vertical line connects the high and the low for the day. The horizontal bar on the right of the vertical line shows the closing price for the day.


Which you decide to use is a matter of personal preference. Candlesticks are particularly useful when used with certain types of pattern trading approaches. When they are combined with many other analysis techniques, there is no significant difference between candlesticks and bar charts.

These four elements of the day's trading are very useful because they capture the essence of what a chart tells us about the market. Although the chart records the accurate and objective prices paid for the stock, it also captures the emotion of the crowd of people who traded on that day. It also captures the emotions of those who did not trade because their inactivity tells us something about how high or low prices must go before they become active.

Every price has an emotional content. If we buy a stock for $1.00 and it rises to $1.30 we feel very smart. If later in the day it falls back to $1.00 we feel rather silly because we have missed a 30% return. We may believe we are rational when we buy the stock, but we become emotional as price moves and delivers a profit, or a loss.

The movement of share prices tells us something about the emotions of the crowd of people who have traded the stock during the day. Those who believe the stock has a very bright future help set the high for the day. Their bullish enthusiasm means they simply want to buy the stock – at almost any price. A trading day where the close is the same value as the high for the day tells us the crowd is very bullish. A day when the close is the same as the low tells us the crowd is bearish. Sellers are worried about the future, so they sell stock at lower prices just so they can get rid of it.

The price chart tells us first about the emotions of the crowd. It does not tell us about the health of the company, its true value (however that may be calculated), the quality of its management, or the importance of its product line or services. The price chart does tell us what other traders and investors think about these aspects of company behaviour.

It is this feature of charting that captures the difference between price – what we pay for a stock – and value – what we think a stock is worth. The price chart helps us understand the emotions of a crowd and when we get a crowd of people together they start to behave in particular ways. This gives us the most important step in understanding a chart of price activity and making it work for us. The chart illustrates the probability of future price activity. When crowds start to behave in particular way then we know that they are most likely to continue behaving in one way rather than another.

The difference between probability and prediction is very important. A chart is used effectively as a probability tool.

We know how a crowd of supporters will behave at a sporting match. They will shout and roar when a winning point is scored. We cannot tell when the winning point will be scored – prediction – but when do know how the crowd is most likely to behave when this happens – probability.

The price chart of Fleetwood Corp can be understood as a graphical representation of the most likely course of price action. If we buy Fleetwood in July we are joining an established trend. It is most likely – most probable – that this rising trend will continue for the next few days, or weeks, or months. We cannot predict this for this tells us that something must happen in the future. We can say that the trend is most likely to continue to rise. Probability allows for mistakes, in this case a trend collapse. If we know there is the possibility our analysis is wrong then we can plan for this eventuality. This is the first step in effective risk management and this underpins every successful trade or investment.