Have you ever really looked at a stock chart?

Technical analysis uses stock chart patterns to make money in the market. Technical charts can be hard to decipher for the uninitiated… with trend lines, candle sticks, and trading channels, understanding charts requires a solid foundation in the anatomy of a stock chart. Are you ready to get "chart smart"?

What is Charting?

Charting is the process of looking at a stock chart to glean information about where it’s going in the future. Just like someone who follows fundamental analysis uses a company’s income statement, balance sheet, and a slew of other financial data to figure out what a company’s prospects are, a stock chart can give a technical trader some hints too.

The distinction between technical investors and fundamental investors is an important one – investors who look at charts think more in the short-term (traders), whereas fundamental analysis (investors) usually takes longer to bear fruit. Technicals usually yield smaller individual gains than a longer-term investor might get from a well-picked fundamental stock, but the frequency of trades is where traders really make their money.

Only around 10% of Wall Streeters are technicians, people who use technical analysis to make their investment decisions. But those ranks are growing.

Even fundamental hedge and mutual funds typically employ traders who are responsible for looking at technicals to follow a portfolio manager’s strategy at the best possible price. That’s largely because experienced traders make money on 90% of their trades.

Finding Charts

Finding good charts is one of the first challenges for investors who are new to technical analysis. While the charts you can find on sites like Yahoo! or Google Finance are useful, they simply don’t provide the shear amount of information that a traders needs to get out of a chart.

If you’re looking for really good real-time charts, lots of services require a subscription fee – but not all.

Your best bet is to turn to your discount online broker. Chances are they provide a real-time charting tool that’s free to use if you’re a client. Otherwise, sites like StockCharts.com and INO.com offer a number of free interactive charts that you can cut your teeth on while you get the hang of charting.

Anatomy of a Stock Chart

The first thing you’ll notice is the fact that it’s not a line like most traditional charts – the chart’s made up of a series of boxes called candlesticks. Why the boxes?

Well, unlike a line chart, which only gives you one data point (like daily closing price), a candlestick chart gives you five data points in the same amount of space. In other words, candlestick charts give traders five times as much information as a line chart would.

Candlesticks are especially useful in looking at trends… and after all, trends are an integral part of technical analysis. We’ll take a look at trends next time; for now, let’s look at the rest of this stock chart.

Support and Resistance

Take a look at that support line – it’s a pretty important element of the chart. A stock’s support level is the price that the stock doesn’t want to fall below. It’s like the "floor" for the stock.

On the other end of the spectrum is resistance, the stock’s "ceiling" price. As you can see on the chart above, the price bounced off resistance twice. Bouncing off resistance and support is pretty common because it takes a big catalyst – like an earnings release or a change in market sentiment – to make a stock breakout above resistance or below support.

Profitable Patterns

Now that you’ve got the basics under your belt, here’s a look at the next step…

In technical analysis, stock chart patterns are used as tools to determine where a stock’s price is going. Even if you’re a fundamental investor – someone who invests based on a company’s business and financials instead of stock charts alone – taking a look at technicals can be incredibly useful… and profitable.

After all, even when you find a stellar fundamental play, the technicals can help you get in at the best price.

So, what patterns should you be watching for?

Double Top and Double Bottom

The double top (and its bullish cousin, the double bottom) is one of the easiest technical patterns to pick out. It happens when a stock’s price bounces off the same resistance line twice in a short period of time (or in the case of a double bottom, it bounces off support), and gives strong evidence that the stock is having serious trouble breaking through that barrier.

The double top is usually not a good sign, because it represents a limit on a stock’s upside potential – at least in the short term. A double bottom, on the other hand, is a good thing because it means that there’s a strong support level that the stock’s price will have trouble falling below.

Trading Channel

Another simple pattern to pick out is a trading channel. While a trading channel is any range in which a stock’s price is fluctuating, a horizontal trading channel is a lot more interesting. It could mean that the stock is consolidating – trying to regain its footing after a big drop-off, for instance – and gearing up for a breakout either up or down.

When you see horizontal consolidation, especially on lower-than-normal volume, keep your eyes peeled.

Head and Shoulders Pattern

The head and shoulders pattern is a bearish trend that usually means that a stock is headed downward. When you see two "shoulders" with a taller "head" in between, watch out, a head and shoulders pattern may be forming. Take note, though, that within the head and shoulders pattern itself you’ll find a strong support level (called the neckline).

Like most patterns, the head and shoulders has an opposite – in this case, the inverse head and shoulders. This bullish pattern looks the same as the regular head and shoulders, except it’s flipped upside down. When an inverse head and shoulders is on your chart, it could mean a rally is coming up.

Descending Triangle

The descending triangle isn’t a pattern you’ll want to find on a stock chart in your portfolio. It’s a bearish signal that usually results in price movement downward.

A descending triangle occurs when a stock’s downward trend intersects with a strong level of support. Again, its opposite, the ascending triangle is a bullish signal.

Hammer and Hanging Man

A hammer is a single candlestick that might mean a bottom is in sight. It’s formed when a stock trades in a wide range downward during the day, but closes near the open. It’s opposite, the hanging man, happens at the end of an uptrend, and signals that the trend is likely to resolve downward in the near future.

Start to Chart

While this is by no means an exhaustive list of the types of charting patterns you’ll see when you enter the wild world of technical analysis and technical trading, it is a starting point that can help you set off in the right direction. Here at the Penny Sleuth, we’ll keep filling you in on technical analysis tips to make sure that you can make the most of your investment dollar.

Cheers,

Jonas Elmerraji