Basics of How to Read Stock Charts

Charting principles work universally across all markets and all time frames. What works on a five minute chart is applicable to daily, weekly, or monthly charts. Charts allow us to identify areas of supply and demand. Any market that can be charted, can be traded.

Let’s begin with the basic unit of charting, the price bar. Whether you are using western style bar charts or Japanese candlestick charts, there are four common points to be aware of: the open, the high, the low, and the close (OHLC). In the example below, the bar on the left and the candlestick on the right both contain the same information. The only difference is that the candlestick is more visual and because of this quality, it has become popular with active traders who must scan dozens of charts at a time.

You will find it beneficial to make the study of price patterns your number one focus. All other technical indicators, oscillators, and moving averages are based upon price or a combination of price and volume. Price is as close to the truth you will get in trading.

Next, we will look at a few basic price patterns. These patterns can involve one to twenty or more bars. Let’s take a look at a pattern that marks the end of a trend. When prices finally run out of steam and change direction, they typically form an “M” or “W” pattern, also know at top and bottom formations. Here are a couple of examples.

"M" Topping Pattern

In the “M” topping pattern above, the right side makes a lower high. The final candle confirms the pattern when it makes a lower low. Sometimes, the right side of the “M” will make a slightly higher high, before taking out the most recent pivot low.

"W" Bottoming Pattern

Although the “W” Bottoming pattern above doesn’t show the confirmation of a higher high, take notice of the three bottoming tails. These long tails demonstrate strong demand and increases the probability that this is a bottom.

When you combine these patterns with other elements such as previous areas of supply and demand, trend line breaks, topping and bottoming tails, changes in volume, and moving average relationships, your batting average will improve.

"V" Shaped Topping Pattern

Tops and bottoms that do not form “M” or “W” patterns may form a “V” shaped pattern which is typically followed by a pause or shallow pull pack before continuation. These patterns often occur after prices become over bought or over sold to the extent that there are no more buyers or sellers. Prices then move swiftly and steeply in the opposite direction on heavy volume. Traders who wait for a retest of the highs or lows are forced into chasing which adds more fuel to the fire.

Next, let’s review congestion patterns that occur within a trend. They are brief pauses that do not flatten the trend and can be identified by their rectangular shapes. They will typically continue the trend with a break out or break down at or near one of the short term major moving averages (i.e., 20 period simple moving average). Here are some examples:

Congestion in a downtrend followed by a breakdown.

The above congestion pattern occurred within a downtrend and lasted for 15 bars before thrusting downward again. During the 11th period, prices began to break down and an entry would have been valid although it took another five periods before there was follow through. Once prices neared the 20 SMA, the breakdown followed through with increased momentum.

Break out from congestion within an uptrend.

This example is not as clean as the first. It started out as a retracement, but then decided to pause for a few more bars. Those who took the pull back were soon stopped out. Those who waited for the 20 SMA to catch up were rewarded with an explosive break out at the red horizontal line.

Longer and broader congestion patterns will flatten the trend as depicted by flattened moving averages. These are called “Trading Ranges” and can be traded from top and bottom and bottom to top, until key support or resistance levels are breached. These patterns and others will be covered in other articles.