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Regardless of the type of chart you look at, regardless of the time frame or the scaling, in the final analysis a price chart gives you a shorthand analysis of what the marketplace thinks of the fundamentals of the company, index, or sector - plus much more.
How do you read a chart? Each of us will bring our own biases as we look at the graph, but try to put them aside and be objective.
This is not English. Read the chart from right to left. The most recent data is the most important. The market has a memory but like everything else, the most recent price action is freshest in our mind.
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What is the right chart to use? If you are day trading you should probably be looking at one-minute charts. If you are a more traditional trader from the days before point and click, you are focused on days to weeks and should be using a daily chart.
Otherwise I suggest you start with the longest time frame available and drill down or scale up from a short-term chart. In this way you can get perspective. This is how you will find out - if the short-term move down is a test of support and a buying opportunity, or if it is a break of a key uptrendline and more declines are expected.
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Reading a chart is all about answering questions before you enter a trade.
- What is the direction of the overall market, industry, and sector?
- What are the major, intermediate and minor trends?
- Where are the key support or resistance zones?
- Does volume show you anything? Confirming the price action? A blowoff? Exhaustion?
- Do you see any patterns on the chart?
- Have we reached the price objectives from any of these patterns?
- What phase is the stock in? Neutral/Bottoming? Rallying/Uptrend? Neutral/Topping? Or Declining/Downtrend?
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The next major tool to add to your simple chart is one or more moving averages. Moving averages can be simple averages of the closing prices or they can be weighted or smoothed in various ways. Moving averages can be combined to smooth out signals, but keep you with the major trend.
There are many, many moving averages to use but many traders combine the 50-day and 200-day moving averages. They can also be used separately. The moving average is just what it sounds like - you add up the closing prices for the stock or average and divide by the number of days you have selected. The 200-day moving average is a trending tool that can be used to confirm a bull market as well as major moves in stocks.
When a shorter moving average like the 50-day crosses above a longer one like the 200-day it is a major buy signal. In Japan this signal is called a "Golden Cross." The reverse is called a "Dead Cross" and it is a sell signal. Using moving average crossovers takes the subjective part of chart reading, as this is just pure math in determining the trend. When the 50-day crosses above the 200-day it's a signal to go long.
Besides trend following tools like moving averages, there are a host of indicators that are aimed at telling us when markets are oversold and overbought. If we are in a long-term bull market why should we care about being overbought? The reason is that the markets only trend about 30 percent of the time, the other 70 percent the markets are consolidating usually in sideways price action. This group of indicators can be effective in trading sideways markets.
There are many, many tools and indicators out there. What you need to do is some homework. Read about these tools and indicators, find the ones that complement your trading style and see how they have performed. A few well-chosen tools that you understand will probably yield you better results than jumping around looking at everything under the sun.
Contributed by Bruce Kamich, Chartered Market Technician and author of the book How Technical Analysis Works.
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