Whether you first started charting stocks on paper, software, or a smartphone, you’re likely to make the same charting errors. Here’s how to avoid falling into typical charting traps.
Photo by Dan Saelinger
To err is human. And to do so in your trading platform doesn’t take much. Entering an incorrect stock symbol, adding an extra zero to the order quantity, or interpreting a chart incorrectly—these are all ingredients for impressive trading mistakes.
All errors aren’t created equal; some may have easier fixes than others. Technical analysts have a unique challenge because there’s no right or wrong way to analyze charts and multiple ways to interpret them, leaving the field wide open.
Charting Traps to Avoid
A momentum trader may want to see a strong breakout before jumping into a trade. A trend trader, on the other hand, might look for a breakout confirmation. And a short-term trader may only be interested in volume thrust.
When looking at a price chart, the desire to jump into a trade could surge at the first sign of things going your way. If luck’s on your side, the trade could work out. But fake outs happen. How many times have you succumbed to enter a trade only to find out later that you didn’t read the chart correctly?
Although there’s no right or wrong way to parse a chart, consider five charting mistakes that deserve a place in the Charting Bloopers Hall of Fame.
1. Yikes! You’ve Got it Backward
Say you’ve fired up your thinkorswim® platform and are looking at a stock chart. You see a clear low point, and a few months later, a clear high point. You want to figure out where to enter a trade, so you add Fibonacci retracement levels to help see the support and resistance levels. You bring up your drawing tools, select the % symbol, and drag the tool from the high point to the low point. Oops! There’s a problem. The high point is to the right of the low point. You’re supposed to draw Fibonacci retracements from left to right, and in this case, that would be from low to high (see figure 1).
It may not be the worst thing in the world. The retracement levels would be the same, but the percentages would be reversed. So instead of saying price is at the 23.6% retracement level, you might say price is at the 78.6% level. Why risk sounding like you may not know charts as well as you think you do?
Another common chart error is drawing trendlines on the wrong end of the price bars. The common rule is in an uptrend, draw trendlines that touch the lows, and in a downtrend, draw trendlines that touch the highs. It can be hard to remember because the natural tendency is to think highs when you think of uptrends and lows when you think of downtrends. In a sense, it’s counterintuitive. But do it for a while and it’ll become second nature.
2. Analysis Paralysis: Not Knowing What to Do
Sure, there are tons of indicators, drawing tools, and chart patterns to choose from. You can get dizzy trying to figure out which ones to use. Sometimes, you’d rather procrastinate, which means you miss out on promising trades. Other times, you’re too afraid to trade and would rather not make any decisions. Or perhaps you suffer from “analysis paralysis” and don’t want to hit a buy or sell button. Overcoming these feelings can be tough. But if you’re determined to conquer these behaviors, consider implementing a methodical approach to tackling the markets.
The good news? There are tons of ways to do this. You could set up a system where you scan for stocks that meet specific criteria, analyze those charts, then narrow your choices.
Or, maybe you’re a momentum trader who prefers to trade chart patterns, and you’d rather look for chart patterns that reflect crowd behavior. This might involve setting up a trading plan that focuses on identifying breakouts from consolidation, continuation, or reversal patterns. Above all, find a few approaches that work for you.
3. Indicator Palooza: Resist the Urge
When you look at a chart, do you want it to tell you what you want to hear? If so, you run the risk of placing too many indicators or patterns on a chart. And if you have too many indicators, you may end up misreading the indicators or chart patterns.
One solution could be to create a set of core indicators that look at different types of price action. For example, you could break down the indicators into four categories: price action, trend following, momentum, and an overall indicator.
4. Don’t Get Skimpy: Be Balanced
Maybe minimalism is your schtick, but too few indicators could generate false signals. Because there’s no certainty in signals generated by technical indicators, it’s important to have just enough indicators to get confirmation signals. For example, if you base trading decisions on moving averages, which may have worked well during an extended bull market, there may come a time when the indicator may no longer work well. The trend could slow down, pull back, or even reverse.
Moving averages are lagging indicators; by the time you get a trading signal, the market may have already changed direction. Remember that markets are dynamic, so it’s not a good idea to get comfortable using one or two indicators. A good mix is likely to alert you of a change earlier rather than later.
5. Viva La Volume! Don’t Ignore It
Price movement without volume can be meaningless. When momentum is in vogue, you’re likely considering stocks that have enough volume to move them up or down. Volume bars are a popular way to see how much trading is taking place. But there are some volume-related indicators such as on-balance volume or accumulation/distribution you could also consider. Then ask yourself these questions: When price is moving up or down, is volume also going up? When a price bar breaks out, is it accompanied by high volume? Do you notice any unusual volume spikes?
A good fix for these common charting mistakes is mindful awareness. As you know, markets change, sometimes quickly, which might make you act irrationally. Yet, being aware of errors could help you approach the markets with a calmer, more logical mind—one that’s ultimately wired to make fewer mistakes.
Too Hot, Too Cold. What’s Just Right?
No two chartists will look at charts the same way. What you put on a chart depends on your trading style. The thinkorswim platform has more than 300 indicators to choose from. To browse them, select Studies > Add Study. Browse different categories and try out different indicators. You may find some useful ones you never knew existed. Here’s an example of how you could organize indicators into different categories:
- Price action: Candlestick bars / Support and resistance levels / Fibonacci retracement levels
- Trend following: Trendlines / Moving averages / Moving average convergence divergence (MACD)
- Momentum: Stochastic / Relative Strength Index (RSI)
- Overall market indicator: Bollinger Bands®
On the candlestick chart in figure 2, Fibonacci retracement levels (drawn from a top [left] to a low [right]), volume, and Bollinger Bands are overlaid on the price bars. The RSI, which measures momentum, and MACD, a trend-following indicator, are added as subcharts.
A few observations:
- After hitting the low in mid-March, price started moving up toward the middle Bollinger Band. At the same time, price crossed above the 23.6% and 38.2% Fib retracement levels (and got pretty close to the 50% level). Momentum started moving up, as seen in the upward-trending RSI. The MACD crossover also indicated the trend reversed from down to up. Volume was relatively high during this time.
- A short-term modest pullback followed as prices continued moving along the middle Bollinger Band and prices moved back toward the 23.6% Fib retracement level. The RSI looked to be trending lower, but MACD continued moving up. Volume decreased toward average levels.
- We then see a reversal, with prices moving back toward the upper Bollinger Band and traveling along that upper band for a couple of weeks. Prices moved up to the 61.8% Fib retracement level, and RSI and MACD were trending up. Volume was at average levels.
- In late April, the trend slowed down, with prices pulling back toward the middle Bollinger Band and 50% Fib retracement level. RSI and MACD were relatively flat, and volume was lower with some unusual spikes. The stock was stuck in a trading range.
- It wasn’t until early June that we saw some activity to the downside. Price moved back toward the lower Bollinger Band, which coincided with the 50% Fib retracement level. Volume spiked on the down move, RSI saw a significant drop, and MACD was slowly trending lower.
When all indicators suggest the same action, this might help you make more confident trading decisions.
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