By Sylvain Vervoort – Technical analysis starts with the graphical representation of stock prices in a chart. Although there are many chart types, the ones used most often are the line chart, the bar chart and the candle chart which is the preferred one because it provides the most information.
A line chart is not used that much anymore. It was the basic chart used prior to the advent of the personal computer. Stock price data was registered manually, and only closing prices were registered. The line chart was created connecting the closing prices.
For a bar chart, the highest and the lowest prices in a given period (minutes, hours, days, weeks, or months) are connected with a vertical bar. The opening price is represented by a tick mark at the left side; the closing price is represented by the tick mark at the right side. The bottom and the top of the vertical bar represent the lowest and highest prices of the period, respectively. The bar chart is used mostly in Western technical analysis.
The candle chart has its roots in the Far East. Steve Nison introduced the candle chart to the Western world in his book, Japanese Candlestick Charting Techniques (Nison, 1991).
Candle charts clearly depict price development in a trading period. The body of the candle represents the move between the opening and closing price. If the price closes above the opening price, the candle body is blank (white). If the stock price closes below the opening price, the candle body is filled (black). A candle can be either a body or a body with long or short wicks, called shadows that reach to the highest and lowest prices in the trading period. The recognition of candle-chart patterns is a study unto itself.
Looking at price moves of 100% and more it may be a good idea to use a logarithmic scaling on the vertical price axis of the chart. If you are using a division of five points on a linear scale, a price change from $20 to $40 comprises four divisions, whereas a price change from $40 to $80 comprises eight divisions. This means that the distance on the vertical axis from $40 to $80 is twice as large as the one from $20 to $40. On the other hand, a price change from $20 to $40 or from $40 to $80 equals the same 100% price increase. A price moving from $5 to $10 or from $100 to $105 is the same distance on a linear scale. Clearly, this does not provide a good visual impression of what the price movement really represents.
Moving from $5 to $10 equals a 100% price increase, but moving from $100 to $105 equals only a 5% increase. To have the same distance on the vertical scale representing equal percent changes, you can use logarithmic scaling. This means that the distance on the vertical axis from $40 to $80 is now the same as the one from $20 to $40, namely a 100% price increase. This gives a much better visual impression on charts with large price moves.
When there are large price moves, applying a linear scale can be a disadvantage. It may simply not be possible to draw a linear trend line under an up or down-moving trend. However using a logarithmic trend line probably will give you the support levels you need to see. Nevertheless, most people will use linear scaling on daily price charts, which is fine as long as the price moves within limits. More often, logarithmic scaling is applied to longer-term charts, such as weekly or monthly charts, mainly because the price moves are much more significant. The right solution is to use logarithmic price charts with logarithmic trend lines all the time.
About the Author
Interested in technical analysis? You can find a lot of learning material about basic technical analysis techniques for free at my website: http://stocata.org under the Technical Analysis Menu item. Sylvain Vervoort is a regular contributer of technical analysis articles in Stocks & Commodities magazine.