What is chart reading?
Chart reading is a form of analysis seeking patterns in security price movements. The relevant charts display price levels over time. Sometimes these charts will include moving averages. For example, today’s 50-day moving average for stock X would be the average price of stock X over the past 50-days; yesterday’s 50-day moving average would be the average from yesterday on back to the 50th day prior.
Certain features or patterns supposedly predict the future. A “head and shoulders” pattern, featuring a peak surrounded by two level plateaus, hints at near-term collapse. When a stock price crosses its 50-day moving average, a big move in the same direction might be imminent. Double tops and bottoms theoretically signify peaks and troughs.
Figure 39-1 plots daily closing levels of the Standard & Poor’s 500 over a 7-year span. Also shown are the course of the S&P 500’s 50-day and 200-day moving averages. Circles mark a double and triple top. Arrows point to moments of theoretically important line crossings. On a live computer screen these charts look awesome. Some brokers promote their chart analyzing capabilities, citing “pattern recognition” tools as a snazzy, sophisticated benefit within their platforms. Snazzy they are; sophisticated and of benefit they are not.
Why you should avoid reading charts
Past movements indicate nothing
The price of any stock today reflects all publicly known information as of today. If the price of a stock changes tomorrow, it will be due to events or information not known today. It will have nothing to do with the price of the stock yesterday, the price fifty days earlier, or the pattern drawn by connecting the dots of those prices.
For instance, in Figure 39-1 you can spot as many head and shoulders patterns as you want depending on how wide the “head” and “shoulders”. There is no predictable price movement after any of them. If you sold after the “double top” circled in 2008, you saved much; if you sold after the “triple top” in 2011 you lost much. As for the line crossings marked, more was lost than gained should you have traded according to the signals.
Computers will do math-based trades before you blink
As you read this, thousands of computer programs are analyzing the price patterns of every tradable security on the planet, seeking predictive relationships or improper pricing for possible profit. If any opportunities do present themselves, they will be long gone before you’ve read a report or run some broker’s software.
What you should do instead
Discerning future market behavior based on shapes formed by previous prices has as much merit as predicting the course of your life with tea leaves. While charts are handy visual tools providing a quick synopsis of a lot of information, they have no predictive value.
When you invest, always look ahead. If chart reading is one of your investment tools, drop this backward-looking process. You will save time and probably avoid some misfires.
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* Data source:
S&P Dow Jones Indices LLC; Standard & Poor’s 500 Index