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The art of the charts

Created:
25 April 2008
Updated:
18 November 2008
Written by:
Dominic Picarda

Technical analysis reigns supreme in the world of short-term trading. While scrutinising company accounts or macroeconomic trends is essential to assess an asset's prospects over a few months or years, looking at recent price movements on the charts is the best way to get an idea of where an asset is headed in the next few minutes or days.

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Despite the off-putting jargon, technical analysis is a very simple skill. It's based on the principle that 'the trend is your friend'. The chartist's job is to identify a trend and to try to ride it for as long as possible. As straightforward as this is, charting still requires effort to learn and apply.

Successful trading isn't just about spotting promising patterns on graphs. Just as important is controlling your risks. This involves knowing when to harvest your profits and when to cut your losses. The charts can also play a vital role in this, alongside some basic rules.

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Go with the flow

Technical analysis isn't a secret system for predicting future price changes, as some investors believe. It's about trying to increase your odds of success. Trading in the same direction as the various trends at work in the market is a good example. That means looking for situations where the daily, weekly and monthly price trends are all heading the same way.

Having identified a situation where a price is heading decisively up or down over several time-frames, the next task is to determine an entry level. Buying or selling on pull-backs is one technique. In any up- or downtrend, an asset tends to move strongly in a particular direction and then consolidate some of its progress, before resuming its course.

Moving averages and trendlines are two of the main tools for defining a trend. During pronounced trends, a price will touch a particular line or moving average repeatedly. The more times a price returns to a moving average or line, the greater its significance to traders. Chart 1 shows the euro versus the pound. Pull-backs to the 34-day exponential moving average have several times proved an excellent opportunity to buy euros and sell pounds.

Chart 1

Using this insight, you could await the next retreat to this level. Assuming it finds support again at the 34-day moving average, you'd place a buy order to exploit its next upwards surge. The average could also inspire placement of a stop-loss. For example, you might place a stop-loss just below the average, perhaps also coinciding with a particular lateral support level.

Using moving averages and trendlines is the simplest and the most effective way of trading trends. But there are more sophisticated techniques at your disposal. The Elliott Wave Principle says that asset prices move in predictable sequences of waves, defined by certain structures and often related by mathematical ratios.

According to Elliott Wave Principle, a market moves in the direction of its main trend – whether up or down – in five waves. Three of those waves are impulsive – ie, carrying the market in the main direction and are separated from each other by two 'corrective' waves against the larger trend. Each wave is made up from smaller waves and also forms part of much bigger waves.

In chart 2, we give an Elliott Wave interpretation of British American Tobacco. Three degrees of waves are shown to be operating here, represented by circled numbers, red numbers and roman numerals. Third waves are usually of greatest interest to traders, as they are typically the longest and strongest of the three 'impulse' waves, and therefore represent the best profit-making opportunities.

Chart 2

In this chart, the share appears to have traced out a clear first, second and third wave and is now in a fourth-wave correction. The triangle pattern is a typical feature of fourth-wave corrections. A short-term trader would wait for a clear breakout above the downward sloping line to establish a long position. After a decisive move upwards out of the triangle and a pull-back, you would then be preparing for a powerful third wave. Buying a breakout above the top of the first wave would be an obvious way to play this.

Reversal plays

Rather than betting on a trend continuing, you can also use technical analysis to spot where that trend is likely to reverse. Where several indicators cluster together and suggest the same thing, traders can have greater confidence in the message. For example, a bearish candle formation after a strong run-up would have more technical significance if it were accompanied by oscillator divergence, and if it took place at an area of historical resistance that coincided with a key Fibonacci level.

In chart 3, AstraZeneca has rallied during a downtrend. However, it forms a bearish 'shooting star' formation at the top of its daily Ichimoku cloud – circled in red. At the same time, its relative strength index is showing bearish divergence: a new price high is unaccompanied by a new high in this indicator. To exploit this, you could open a short position the following morning, placing a stop-loss above the price high of the shooting star.

Chart 3

A clever way to pick out levels where a price may reverse is to use Gann Theory. According to this approach, significant highs and lows in financial markets are related mathematically. For example, with a share that peaked at an all-time high of 1,000p, one would watch for major reversals at 750p, 500p and 333p – being key Gann percentages.

The leading UK practitioner of this branch of technical analysis is Gann Management, which offers a software package and an advisory service to private investors. Free introductory seminars are held regularly. Chart 4, below, was produced with this software and illustrates the methods involved.

Chart 4

Money management

The essence of money management is keeping your losses small and making big profits. Although this sounds obvious, most traders end up achieving exactly the opposite. They cling to losing positions that eat into their account and close winning positions for less than their full potential.

Knowing when to admit you’re wrong is essential. Many novice contract for difference (CFD) traders don't place a stop-loss when they enter a position. When the price moves against them, they simply hang on in the hope of a recovery. The result is larger than necessary losses, which can devastate a modest trading account.

The lesson: always set a stop-loss. Identify on the chart where you will exit your position if things don't go as planned. Support and resistance levels, recent highs and lows, trendlines and moving averages are just some of the reference points you can use to place a stop-loss. For long positions, put it below the reference point, and above for short positions.

Contrary to popular belief, trading is not about being right all of the time or even for most of it. "Your bottom line matters more than your success rate," says Steven Mayne, head of CFDs at Montague Pitman. "As long as your money management is sound, you can have many more losers than winners and still end up making profits."

The risk-reward relationship lies at the heart of this. The numbers will vary but, as a rule of thumb, you should be looking for a minimum reward of three times the risk you are taking. So, when considering going long at 100p with a stop-loss at 95p, you need to believe the price is heading to at least 115p.

Sizing your trades correctly is also vital. "Whatever you happen to be trading, work out an appropriate dealing size for you and stick to it," says Richard Cunningham, head of CFDs at City Index Advisory. "For example, you may be trading equities and have £25,000 in your account. Say you decide £15,000 is the right amount of stock to be trading, you should never exceed that, no matter how confident you are. That way you can lose two or three times in a row and still be in the game."

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