Divide by Nought

3. Charts

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The chart isn’t always where analysis begins. As often as not I’ll start by looking at an option chain. That said, I will always check various charts before making a trade. The past may not dictate the future, but it certainly can act as an indicator. The follow is my approach to drawing and reading charts.

Channels & Trend Lines

If price is king then price levels are the foot prints in the sand from the king. And the king, it seems likes to make patterns and retrace his steps. The mind is a pattern generating machine. It’s extremely good at finding patterns even in things that truly are random. So when drawing trend lines it’s important to be as objective as possible.

  1. No matter how short term the trade is, it’s a good idea to look for the long term to back it up. If nothing else it’s a good sanity check. I look for long term trend as 5 or 10 year channels because they are normally very strong.
  2. Most good trend lines can be duplicated to make channels. Once that’s done, channels can be broken at 50% as many times as it works (see the charts below for details) to show likely price movements. This is similar to using Fibonacci retracements, but a bit more adaptive in terms of trend following.
  3. Creating long terms channels (5-10 years) is a good first step. This helps to clarity what the trend of the equity is, where it is within its range, and where it’s likely to move next. Taking the long term channels and breaking them into finer granularity for specific (usually more recent) periods. See the charts below for an example of this.
  4. The question of where to draw trend lines is often a very contested discussion. In my mind I want to hit as many points as possible with the line(s). In general, the more opening prices, closing prices and price extremes (candle’s shadows/wicks) that touch the line the better. Passing through areas of heavy congestion is also beneficial. That said, I prefer to touch opening and closing prices more than extremes and congestion areas. Exceptions arise when the shadow includes more information. For example, a monthly candle’s shadow tends to mean a lot more than a weekly or daily shadow. This is because a long shadow on a monthly chart will typically contain many days of movement. Whereas a long shadow on a daily chart may only contain minutes of movement; hardly indicative of the market’s overall mentality. There’s a lot to say about intra-day moments, but that’ll have to come later. Suffice it to say that one of these days I’m going to write some trend line drawing code that will take the amount of activity in a shadow into account.
  5. All of the charts below where captured at Feb 08 expiration. It’s worth noting that these are logarithmic charts; albeit I’m not convinced it makes any difference.
SPY 10 year monthly (10yM)
SPY 2 year weekly (2yW)
SPY 3 month daily (3mD)

Other Indicators

For a Specific Underlying
  1. The RSI is easy to read and in my experience pretty good at showing when something is overbought or oversold.
  2. The aggregate implied volatility for the underlying is as close as most will get to a future indicator, at least when looking at a chart; we can do better…but we’ll get there and it’s nice to see at a glance.

Written by me

Thursday, March 13, 2008 at 2:45 am

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