Just what is charting all about?

By Deputy Editor Tim Bennett Sep 04, 2007

Tim Bennett

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Many investors, including Warren Buffett and Hargreaves Lansdowne’s Mark Dampier, dismiss technical analysis (charting) as “mystic Meg philosophy”. With its odd jargon and arcane diagrams, charting can seem to have more in common with astrology than financial analysis. But chartists argue that, in a volatile market like today’s, reading investor sentiment correctly and acting on it matters more than dissecting sets of accounts. Many successful investors use technical analysis to help with market timing. So, what are the secrets of successful charting?

The building blocks: price charts

A price chart is just a sequence of prices – anything from exchange rates to share prices – plotted over time. A popular type of chart is made up of vertical bars with the top and bottom showing the highest and lowest prices for that particular day, week, or month, with the closing price shown as a short horizontal dash across it. The height of the bar shows its volatility – or how much the share price moved over a particular period. A variation of this, the candlestick chart – first used in Japan over 300 years ago – is also popular:

candlestick chart of ftse 100

So what is charting?

A lot of jargon surrounds charting and dozens of trading strategies have been built up around odd-sounding price patterns, such as double tops, rounding bottoms and triangles. But the basic concepts are simple and also tend to be the most reliable. Chartists believe the past is a guide to the future and that you can project past behaviour to predict future prices. They assume that all available information about a stock is already reflected in share prices, so there’s no point trying to identify “fundamental” mispricing using ratios; but you might make money if you spot the direction a share is heading in early and buy or sell it before everyone else does.

Spotting trends – the moving average 

At the heart of technical analysis is the observation that share prices follow one of three underlying trends: up, down or sideways. The trick is spotting the right one and sticking with it until you get a signal that things have changed. One way to spot a trend and test whether it’s intact is to follow moving averages. One of the most widely used is based on closing prices. To work out a five-day moving average you would take the total of a given share’s closing prices for the last five days and divide by five. So from prices of 10, 10, 12, 13, and 15, the moving average is 60/5 = 12. If the next day the price closes at 15, the five-day moving average is 65/5 =13, and so on. 

By itself, a rising average can indicate an uptrend, a falling one a downtrend. You can also gauge the trend by looking at whether the latest stock price is above or below the moving average. Finally, if the moving average of 13 for a short period exceeds the average taken over a longer period, you get a buy signal, whereas if it “crosses below”, you have a sell signal. All of these are particularly powerful when supported by increasing trading volumes, which can indicate that big, institutional buyers or sellers may be buying or selling to reinforce the trend.   

Unfortunately, trends don’t last forever. Anthony Bolton warned in the spring that a four year, almost unbroken, upward run for the FTSE 100 was unprecedented and for that reason alone, a correction was due regardless of what the latest short-term moving averages may suggest.

Buying the dips – resistance points

Rather than heading up or down in a straight line, share prices tend to zigzag above and below the overall trend line. So a short-term trader will try to maximise profits from a rising trend by buying on all the dips on the way up. How often you do this depends on your enthusiasm for trading and your dealing costs; but the golden rule is to use the longer-term chart to monitor the overall trend, and shorter-term charts (hourly or daily for traders) to spot individual buying/selling opportunities. Resistance points occur at the top of each mini-rally, as traders cash in that day’s profits; and at the bottom of each mini-dip, as scavengers pick up cheap shares. By linking together past prices and previous resistance points on a share-price chart and then extending the line forward, chartists hope to anticipate the price trend and where the next resistance points will occur, then buy or sell accordingly. 

Charting, like ‘fundamental’ investing, can provide some useful tools – but they’re only as good as the person using them. A bullish or bearish chartist can always find a trend line/moving average to suit their views. And the fact that a stock is in a rising trend won’t help if it suddenly has to issue a profit warning. So while we wouldn’t entirely dismiss charting, it’s just a small part of a successful investing strategy. Although ‘fundamental’ analysis can take a long time to show results, at least if you buy a stock when it’s cheap, the market will hopefully wake up to that eventually. Following the herd movements of the market as chartists do can make you profits in the short-term, but it can also leave you exposed to sudden switches in sentiment, as many traders have learned to their cost in recent weeks.

For more articles on technical analysis, see MoneyWeek.com/charting

Published in How to invest | More articles by Tim Bennett

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