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by Jonathan AnthonyHow to Read Stock Charts
If you want to pick individual stocks, you need to know how to read a stock chart.
For long-term investors, we think investing in broadly diversified exchange-traded and mutual funds is best. This is the best way to take advantage of stock market growth while avoiding the time, hassle, and risk of picking individual stocks.
However, to make the leap and become a real stock trader, you must know how to analyze past stock results and make predictions about future performance. The first thing every stock analyst needs to know is how to read a stock chart.
In this post, we’ll break down the basics of a stock chart and offer a step-by-step method to help you read and analyze these powerful tools.
About Stock Analysis
Before we get exactly to stock charts reading, let’s take a quick look at stock analysis in general. The whole point of what we’re trying to do is figure out which stocks to buy (or sell, short, etc.) and when to do it.
Of course, we can never be certain, but we can use stock analysis to learn all we can and make an informed guess.
Stock analysis can be approached in two basic ways: fundamental analysis, which focuses on the company and business performance (e.g., sales and earnings), and technical analysis, which focuses on historical stock performance (e.g., price and volume).
Stock charts are the primary tool of the technical analyst.
What are Stock Charts?
In the most basic sense, a stock chart is a visual representation of stock prices over time. Many more elements can be added to a chart, such as averages, volume, benchmarks, etc. Still, price over time is the most fundamental component.
Stock Charts Layout
Stock charts are rectangular, with the horizontal axis representing time and the vertical axis indicating price.
The chart period can be adjusted based on the time frame you want to analyze. As the time period changes, the price axis will dynamically adjust. The wavy line on the chart is called the trendline, which indicates the stock’s price over time.
If enabled, trading volume will appear as a bar graph along the bottom. The higher the bar, the greater the trading volume that day. If colored, days with greater sell volume will be colored red, and days with more buy volume will be green or blue.
Stock Chart Types
The three most common chart types are line, bar (OHLC), and candlestick. The line chart only includes close prices, while candlestick and bar charts include open and close prices plus intraday highs and lows.
This extra data provides some insight into volatility, which is helpful for short-term investors. The line chart is most useful for long-term investors as we are more interested in long-term trends, not intraday fluctuations.
Basic Stock Chart Analysis
Now that we know what a stock chart is, we can look at how to read it. Stock charts provide a huge amount of information and opportunities for analysis – far more than can be covered in a single blog post. So, we’ll stick to the basics to get you started.
And remember, despite the name, technical analysis is not an exact science. Ten traders can look at the same chart, and all see something different. Nobody can predict the future, and past results do not guarantee future performance.
Stock chart analysis is just one part of a trader’s overall stock assessment.
1. Analyze the Overall Price Trend
The first step in our analysis is to look at the overall price trend.
Find the trendline and determine whether the price is going up (uptrend), going down (downtrend), or staying the same. Of course, daily fluctuations will always exist, but you can look through the noise to identify the underlying trend.
Make sure to look at the price trend over different time periods. It’s possible that a 1-week downtrend is actually a minor temporary correction in a year-long uptrend.
If you plan to hold the stock for 20 years, the daily and weekly trends are not very useful. Look at the 5- and 10-year charts instead.
2. Analyze Trading Volume
Next, we want to analyze stock trading volume, the other core technical indicator after price. Volume is critical because it helps us see when big institutional traders are buying or selling large chunks of stock, which can significantly affect prices.
If a big bank or mutual fund is buying or selling a lot of shares, we need to pay attention. They have armies of analysts, and there is a good chance they know more than we do.
Don’t follow blindly but always keep an eye on what the big guys are doing.
If the volume is high during a price increase, it may be a sign that the trend is strong and likely to continue. On the other hand, if the volume is low during a price increase, it may indicate that the trend is weak and likely to reverse.
Figure out what normal trading volume looks like and see how the trendline reacts. If trading volume goes up, the price is likely to shift as well. Also, higher volume makes buying and selling easier as more transactions are occurring.
3. Analyze Breakouts and Reversals
Now that we have a handle on price and volume – the two major indicators – it’s time to start digging into why price shifts occurred.
Nobody knows exactly why stocks go up or down, but we can study major price changes to determine what kinds of things affect a particular stock.
As mentioned, volume is a key factor in price changes, both as a cause and an effect. Other factors include dividend payments, earnings reports, stock splits, product launches, geopolitical events, and just plain bad news.
Any of these can cause a significant price shift, so check the effects in the past and be ready for similar effects in the future.
4. Look for Chart Patterns
At this point, we have a good understanding of the history of the stock, so our next step is to start applying technical analysis to help us understand what the chart might tell us about future performance.
Specifically, we want to look for stock chart patterns.
Like so many things about investing, chart patterns are not an exact science, but analysts have figured out that certain patterns show up repeatedly and can provide some insight into what will happen next.
Analysts have discovered and named a wide variety of patterns, but they all fall into two main categories: continuation patterns, which suggest the trend will continue, and reversal patterns, which suggest the trend will reverse.
Some charts are stronger than others. For example, patterns that evolve over weeks and months tend to be more durable and predictive than those developed over hours or days.
5. Identify Support and Resistance
Next, we can identify support and resistance, which are barriers the stock price seems to have difficulty breaking through.
The resistance line represents the price ceiling, and support represents the price floor. High trading volume is often needed to punch through these barriers.
In simple terms, the trendline will seem to “bounce” off the support and resistance lines, like it is hitting an invisible barrier. Chart patterns are often constrained by support or resistance and can help you identify these indicators.
Remember, there are no objective measures to determine support or resistance precisely. The point is to identify where these effects seem to be occurring to gain some insight into the minds of our fellow traders.
Trading volume often indicates how “hard” traders are trying to punch through. If you see particularly high trading volume but the support or resistance persists, you know it’s strong.
The value of support and resistance is to help you time your entry or exit point.
When a stock is “squeezed” between support and/or resistance, a big price move often follows once it “breaks out,” which is a predictable opportunity if you can successfully spot the preconditions.
6. Apply Technical Indicators
Once we’ve spotted everything we can see with our own eyes, it’s time to look for less obvious things. To help us, we can apply more advanced technical indicators.
Moving Average
A moving average calculates the average price over a specific preceding period of time.
Common moving averages include 10-day, 30-day, 50-day, or 200-day. The oldest data point is dropped every trading day, and the newest point is added to recalculate a new average.
Moving averages help you see a “smoother” price trendline by ironing out the noise of daily price fluctuations.
The relationship between the current price and the moving average can tell you if the price is “high” or “low” on any given trading day.
We can also use multiple moving averages together and look for where the lines cross.
For example, if the 100-day moving average crosses above the 200-day, this is known as a golden cross, which suggests prices are trending upward.
In contrast, if the 100-day cross is below the 200-day, this is known as a death cross, and a downturn is underway.
Bollinger Bands
Bollinger Bands are used to figure out if a stock is oversold or overbought.
Using a moving average as a baseline, Bollinger bands are set two standard deviations above and below the moving average, creating a kind of bracket.
If the price goes above the top Bollinger Band, it might be overbought and a good opportunity to sell. If the price goes below the bottom Bollinger Band, it might be oversold and could be a good time to buy.
While none of this is guaranteed, it can be an important part of the overall analytical picture of a stock.
7. Make a Decision
At this point, we have a good understanding of this stock and can make a reasonable estimate about what might happen next. Combined with solid fundamental analysis, we can make an informed buy or sell decision.
Apply Your Stock Charts Reading Knowledge
Stock chart reading and technical analysis can go a long way to helping us make educated stock picks and investing decisions. But will you be right? Probably not – especially if you’re just starting out.
The process of analyzing a stock chart requires intuition built up through years of experience. Don’t expect to get it right on the first try.
Like any skill, it takes time to develop, so don’t be discouraged if your first few trades are a disaster. Just learn from your mistakes and move on – and don’t bet your entire life savings!
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