Get to know the basics of using charts for technical analysis
Chart analysis is the projection of future price movements via the analysis of historical price movements, where historical price movements can be presented in various ways.
The bar chart, also called the Western chart, is a demonstration of price development in which for each period the highest and lowest prices and the opening and closing prices are recorded using bars. The highest and lowest prices are represented by the ends of the vertical bar, the closing price is represented by a horizontal dash on the left of the vertical bar, and the closing price is represented by a horizontal dash on the right of the vertical bar.
The individual bar gives an indication of the market movement for a given day, when talking about a daily chart. For example, the bars in Figure 1 show that the opening price on day 2 was higher than the opening price on day 1, while the closing price on day 2 was lower than it was on day 1. The bars also indicate that the price movement on day 1 was greater than on day 2. Furthermore, the price increased on day 1, while it fell on day 2.
The candlestick, also called the Japanese candlestick and widely used in all trading rooms, uses a match-like shape to represent price movement. The candlestick reveals the difference between the opening price and the closing price of a trading day using a rectangle. If this rectangle is dashed (or coloured green), this indicates that the closing price on a trading day was higher than the opening price. If it’s empty (or coloured red), the closing price on that day was lower than the opening price.
The difference between the lowest and highest price on a given trading day is represented by a vertical line running through the body. Figure 2 shows the Japanese candlesticks for the same price movements that were used in Figure 1.
In a line chart, prices are shown as points on a graph. The frequency with which the prices are recorded depends on the total period presented on the chart. For example, if the chart covers a period of several months, the closing prices for all trading days are included. However, if the chart shows the price development for a period of several years, only weekly prices or even only monthly prices are shown. The horizontal axis of a line chart represents the time, while the vertical axis shows the price.
In addition, weekly and monthly charts compress the price action to allow for much longer-range trend analysis. A weekly chart can go back as much as five years and a monthly chart up to 20 years. It’s a simple technique that can help you study the markets from a longer-range perspective – a valuable perspective that is often lost when relying solely on daily charts.
A chart can become an extremely useful tool in the art or skill of market forecasting once the rules are understood.
Support and resistance
Support and resistance are fundamental concepts in technical analysis. A support level is a price below the current price that, in the case of a downward movement, is not easily broken. A resistance level is a price above the current price that, in the case of an upward movement, is not easily broken.
The support and resistance levels are determined by drawing help-lines on a price chart. A support line is often drawn by connecting a number of previous lowest points (lows) on the price chart. On the chart below, the line that runs through points 1 and 2 acts as a form of support.
Technical analysts assume that the price in the downward movement from the high that has been formed after point 2 will continue to fall until it reaches the support level. The most likely scenario is, after having reached that level, the price will climb again (remember one of the main premises that history repeats itself). However, that’s not the case presented in the chart above.
A resistance line is often drawn by connecting a number of previous peak points on the price chart. The chart above presents the resistance line as the line that runs through points 3 and 4. Technicians assume that the price in the upward movement from the lowest point reached before point 3 will continue to climb until it reaches the resistance level. The most likely scenario is that, after having reached that level, the price will fall again (which is actually the case).
Support becomes resistance
A support level that is broken often becomes a resistance level and vice-versa. The market tests this by means of a pullback movement. A pullback is a brief reversal of the prevailing upward momentum and is considered a buying opportunity after a large upward price movement. A pullback is a test by the market to see if there has been a valid breakout. After breaking through a support level, the market often shows an upward movement to test if the old support level now acts as a resistance level. If the price does not rise above this level, the price is expected to continue to fall. This phenomenon is shown is the chart above. The old support line is now seen as resistance.
Got all that? Great! Then you’re well on your way to becoming a forex investor. If you’re ready for the next lesson on technical analysis, head on over by clicking here. Not yet ready to proceed? Re-read this section and do your research so you fully understand how support, resistance, and other technical analysis factors can play a role in your investing success.