Happy New Year! May 2019, be your best year yet!
As mentioned in the last blog, I planned to discuss “How we should go about deciding entry into a trend”? However, during my preps, I realized that it would be incredibly short-sighted of me to go there without explaining different kinds of charts which we use for our analysis.
So, that is where we are heading today!
There are a lot of charting techniques, which maps the price movement of a script or an instrument. Bar, Lines, and Candlestick are the primary ones. Within these, the most widely used one is Candle Sticks, which will hog the limelight in this post.
As is the case with any statistical representation, it is the underlying data that decides upon form and shape of the chart. Underlying parameters for a stock chart consists of the price and time frame.
There are four key price aspects a trader looks for while trying to read a stock or an index:
- Open Price – Price at which the script opened in the market during a chosen timeframe
- Close Price – Price at which the script closed in the market during a selected timeframe
- High – The maximum price of the script during the timeframe
- Low – The minimum price of the script during the time frame
The timeframe is the period for which a single price point visually represented. Selection of timeframe is entirely dependent on the objective of the trader from the market.
Broadly, traders are of two type – Intraday and Positional Traders.
An intraday trader buys and sells on the same day, whereas a positional trader carries over the holding to next day/days.
An intraday trader analyzes stocks over 1 minute, 5 minutes, 10 minutes, 15 minutes, 30 minutes, and 1-hour timeframe. Anything over this will be too big for them to make an informed decision. Whereas, a positional trader uses hourly, 4 hours, daily or weekly timeframe. It is because a shorter timeframe throws up a lot of noise, which doesn’t aid in decision making.
#BonusInfo# You get an option to choose the timeframe on popular DMAT platforms. While a DMAT account is essential to trade, if you are starting and are looking to gauge your interest in technical analysis, you can head to www.investing.com to fiddle around with TA tools.
Types of Charts
Line Charts – Line charts are the most basic price chart, which takes into consideration only one among the four price aspects into consideration. In general, it is the closing price that most of the folks go with earning it the name – close-only chart.
A line chart helps in understanding the broader trends but doesn’t give further insight that may be important to decision making, which makes it less favorable to traders.
Bar Charts – Unlike the line chart, a bar incorporates all the four pricing parameters into consideration to provide a more holistic view to the trader.
In a bar chart, a vertical line indicates the highest and the lowest price point within the selected timeframe. The distance between the two called the price range. Small horizontal lines called ‘tick’ indicate opening and closing prices. Tick representing the opening price is on the left side of the price range, and the tick representing the closing price is on the right side of the price range.
In our previous posts, we have already established that the price movement of a stock, in its entirety is a tug of war between the buyers and seller.
Hence, irrespective of the timeframe in question, there will be three kinds of moves.
- “Bulls win over Bears” – In this situation, the price of the stock in question will go up from its opening price and close above the starting point. In the above image, illustration A denotes a ‘Bullish Bar,’’ where the price opened at 200 and went up to close at 500. Between the open and close, the stock saw a low of 100and a high of 600, which forms the price range.
- “Bears win over Bulls” – This is the exact opposite situation, where the price of the stock goes down from the opening point to close in below the starting point. In the above image, illustration B denotes a ‘Bearish Bar,’ where the price opened at 500 and went down to close at 200. Between the open and close, the stock saw a high of 600 and low of 100, which formed the price range.
- “Bulls = Bears” – This is a situation where the bulls and bears pulled the stock with equal strength resulting in a tie. No matter what price range the stock makes, open and close end up being the same.
As mentioned earlier, Bar Charts have fallen out of favor for technical traders only because Japanese Candlesticks are much easier to comprehend, without compromising on the inference one makes from it.
Let us dwell into its details of Candle Stick Charts!
Japanese Candle Stick charts and patterns have been around for over 400 years. The best parts about candlesticks are that it visually depicts the sentiments running in the market, which neither the bar or line charts provides with ease.
That is exactly why traders prefer candlestick charts!
Even when you see the stock market as a tug of war between the bulls and bears, it is crucial to understand that bulls and bears are people with raw emotions! Of course, some institutional investors and traders use complex algorithms and automation to execute. However, there are a lot of retail investors like us, who get involved in it, reacting solely on emotions of fear and greed.
Make of a Candlestick
A candle stick will have two parts to it – A body and Shadows
Candle Body – It is the rectangular box that forms between the open and close of a candle for the chosen timeframe.
Candle Shadow – A shadow denotes the price range formed between the high and low of the stock for the chosen time frame.
What is a Bullish Candle?
Here is an illustration of a bullish candle:
A bullish candle is when the Bulls win over the Bears. As shown in the illustration, the stock opens up at 200 and closes at 500 to form the body of the candle. During the same period, the share saw a low of 100 (which creates the lower shadow) and a high of 600 (which forms the upper shadow).
What is a Bearish Candle?
Here is an illustration of the Bearish Candle:
A bearish candle is when the bears win over bulls. As shown in the illustration, the stock opens up at 500 and closes at 200 to form the body of the candle. During the same period, the share saw a low of 100 (which creates the lower shadow) and a high of 600 (which forms the upper shadow).
The psychology behind candles
Now this is the fascinating part!
In the illustration, after opening at 200, people who were holding it were pessimistic about the stock, probably due to a fall in the previous timeframe. They feared it was going to continue the nose dive and started selling off their holdings, bringing the price down to 100.
However, at 100, the sentiments turned. Bulls believed there was potential for the stock to stage a reversal and go up. They started placing buy orders, and the demand started increasing steadily. Seeing this, more and more buyers joined the queue, taking the price to 600.
At that point, many sellers started to take profit and exit. Initial orders trapped buyers who were still optimistic about the price going up. However, what happened was that the buying orders reduced, which means the demand reduced. With that, the price dropped to 500, where it closed.
Again, referring back to the illustration of the bearish candle, after opening at 500, the bulls may have been extremely optimistic about the stock. Many orders came in, which pushed the price up to 600, essentially trapping them there. Bears started taking control of the market since bulls felt it was too high a price to enter and those who were holding it started selling off. Suddenly the price started free falling to 100.
Buyers started feeling that 100 was a fair price to pick up the stock. They started placing buy orders. Emotions began shifting. Suddenly, there is optimism. Buyers overpower sellers. Demand overtakes supply, pushing the stock price up to 200.
Please note that these are just one way of representing the illustrations for your understanding. There might be more explanations, which can be arrived at by looking at the larger
So what do traders do?
As traders, our job is to understand this tug of war. Understand the underlying story. It helps us decide on where the journey is going. Sometimes we hop on and ride with it. Occasionally, we let it pass. Occasionally, we hop on to realize it is going in the opposite direction and get off-board.
This is what we do!
In the next blog, I will take a few examples of actual scripts and try and define this journey further.
Until Then, Cheers,
N.B – Below are the resources I referred to for this post:
- The usual suspect – “Technical Analysis of the Financial Markets” by John J Murphy
- I found this really useful website – http://www.chart-formations.com/stock-charts/default.aspx. This has almost all the major patterns with examples
- One of the first books I invested in, which also turned out to be quiet handy is “How to Make Money Trading with Candle Charts” by Balkrishna Sadekar