Basics of Chart Analysis for Trading Options
Chart analysis is the aspect of technical analysis that focuses on visual analysis to ferret out price and volume data that will let you discover the dominant trends in the market. There are a variety of chart types and data displays, providing you with an extremely large list of tools for analysis.
By focusing here on a handful of technical tools and techniques geared toward sector and option trading, traders new to chart analysis should get up to speed quickly while those more familiar with it will get a bit of review.
Charts are pictures that are built by plotting price data to provide you with a view of trading activity during a given period. A short list of common chart types include the following:
Line chart: Documents price movement versus time. A single price data point for each period is connected using a line. Line charts typically plot closing values, which are generally considered the most important value for the period (day, week, and so on). Line charts provide great “big picture” information for price movement and trends by filtering out noise from more minor moves during the period.
Disadvantages to line charts include the fact that they provide no information about the strength of trading during the day or whether price gaps occurred from one period to the next. A price gap is created when trading for one period is completely above or below trading for the previous period. This happens when significant news impacting the company comes out when the markets are closed. Doesn’t that seem like good information for you to have when you’re trading?
Open-high-low-close (OHLC) bar chart: Pictures price versus time. The period’s trading range (low to high) is displayed as a vertical line with opening prices displayed as a horizontal tab on the left side of the range bar and closing prices as a horizontal tab on the right side of the range bar. A total of four price points are used to construct each bar.
OHLC charts are more complete and useful over different periods of time because they provide information about both trading period strength and price gaps. Using a daily chart as a point of reference, a relatively long vertical bar tells you the price range was pretty big for the day. Another way to look at it is to say the stock was volatile that day — good information for option traders. It also hints at strength in the stock when the stock closes near the high of the day and weakness when it closes near the low for the day.
Candlestick chart: These are the most commonly used charts by professional traders. They also plot price versus time and are similar to an OHLC chart with the price range between the open and the close for the period highlighted by a thickened bar. Patterns unique to this chart can enhance daily analysis.
Candlestick charts have distinct pattern interpretations describing the battle between bulls and bears. These are best applied to a daily chart. Candlesticks also display price ranges and gaps.
View charts using both:
Longer-term line charts noting price trends
OHLC or candlestick charts for better understanding of price action during the period, including security strength and volatility
Many technical charting packages are available as independent software programs or web-based applications. The cost ranges from free to thousands of dollars, depending on the package features. When first using technical analysis, consider starting with a free web-based package and then identify your specific needs and expand from there.
Your online broker will often have a “home” charting program available. Sometimes these packages are available at some cost, whereas at other times, they may be free of charge, especially if you are an active trader. It’s a good idea to research this aspect of your broker’s services.