If we boil it down to the core, price can do one out of three things: it can go up, down or sideways. In the trading jargon, we call these different phases, trends or ranges and the direction is called bullish or bearish.
Trend = A period when price moved mainly in one direction, either up or down
Range = A period when price moved mainly sideways
Bullish = Prices that are rising.
Bearish = Falling prices
Of course, there is much more to it as we will see later, but to learn how to read charts, it is essential to familiarize yourself with these basics.
Up, Down or Sideways – Trend vs Range
The picture below illustrates the three possible, but very broad, scenarios. First price went up(uptrend), then it moved sideways (range) for a while, before it went down (down trend) again. Note that even when price moved sideways, there were shorter periods when price showed signs of smaller trends. Furthermore, even in the downtrend, there were periods of temporary and short-lived uptrends.
Highs and Lows
The most basic way when it comes to identifying the general direction on your charts is through analyzing highs and lows of price. A high can be a temporary or overall price point where price went up before turning down again. On the other hand, a low is a price point where price went down, before going higher again. The screenshot below shows exactly what traders mean when they talk about highs and lows.
An uptrend is characterized by higher highs and higher lows which will translate into price moving upwards.
The swing lows in an uptrend will be higher as well since the dips will be bought and usually do not retrace as deep. Conversely, the lower highs and lower lows indicate a downtrend with declining prices.
The line graph provides much easier to digest information and can be very helpful, especially for new traders who are not very experienced yet. Switching to the line graph from time to time to identify the general market direction can help traders tremendously to make sense out of data.
Support, Resistance and Trend Lines
Horizontal Lines – Support and resistance
Support and resistance is among the most used concepts by all sorts of traders and even the media often picks up when a financial instrument approaches a famous support or resistance level.
Support = A price level where price ‘found support’ and went higher after reaching the support level.
Resistance = A price level that makes price bounce back lower after reaching it.
Often, you can see that a price level that was support before acted as resistance at a later time.
Diagonal lines – channels and trendlines
In contrast to support and resistance lines, trendlines are diagonal lines that also connect highs or lows, but slope upwards or downwards.
By connecting lows in an uptrend, a trader can draw a trendline that signals the direction of the trend. Furthermore, the angle of the trendline can provide information about the strength of the trend – but more to that later.
Channels and trend lines are another way to identify the direction of a trend, although a trader has to be aware of a few limitations and characteristics when it comes to using trend lines. Trend lines might be better suited for long term trends and to get a very broad sense of direction, because a trader needs at least two points, better three, to draw a trendline. The screenshot below shows the first scenario again. This time, we applied trendlines to the chart that help identify the direction of the market.
Moving averages are undoubtedly among the most popular trading tools and they are great to identify the market direction as well. Moving averages take the previous price information and calculate the average price out of it. The screenshot below is the price chart with Daily candlesticks (each candle represents 1 day) and a 21 moving average has been applied to it (blue line). Thus, the moving average represents the average price over the last 21 days.
The angle and the direction
The angle and the direction the moving average points to can be used to identify the direction of a trend. A moving average that moves upwards indicates that over the past x periods, price moved higher. A moving average that points down signals a previous downtrend.
The length of the moving average
The length of the moving average (the amount of past periods it analyzes) highly impacts the way the moving average forms on your charts. If your moving average is too fast (very few periods), your moving average will change direction very frequently. On the other hand, a slow moving average takes longer to turn the direction.
The picture below illustrates these points further: the black line is the faster 10 period moving average and the blue line is the slower 21 period moving average. You can see that the black line changes its direction very often, whereas the blue lines moves smoothly and doesn’t turn often.
(1) The fast moving average reacts much faster to sudden changes, whereas the slow moving average runs smoother. In an established trend, a slow moving can potentially keep you in the trend longer.
(2) However, a fast moving average signals a change in price movement faster.
(3) In a sideways range, the fast moving average changes direction frequently and fast.
Different moving averages for different purposes
As you can see, different moving averages offer different advantages in certain market conditions. In the end it comes down to what you feel comfortable with and what matches your trading style. Furthermore, there are different ways of using moving averages as directional filters. Whereas some traders only look at the slope of the moving average to determine the direction, other traders analyze which side of the moving average price is currently being on. We analyze moving averages in depth in a later chapter.