Optimize Your Charts!
Keep things streamlined, simple and powerful, using the "anatomy" of technical analysis.
Background
Investopedia.com defines technical analysis as “a method of evaluating statistical trends in trading activity involving price movement and volume”. Ok, that’s a method, but why the method? What are we trying to accomplish with technical analysis anyway?
To answer this question, consider the gamblers’ edge in a game like poker. How will the game play out if I know the cards in the other players’ hands? What if I both know the cards and have an idea on how the player will play his hand. This would lead to two outcomes relative to my poker game. 1) I would make a lot of money on winning hands and 2) I would play a lot fewer hands. This is called “perfect information”.
The next few sections I support the components of my base chart build. I think it is important that we understand what we do, why we chose to do it that way and what each indicator means with respect to market action. At the end of this piece, I synthesize all of this in my description of my own personal setup. If you would like to skip straight there skip to the bottom of this page.
What is in the market’s “hand”?
The markets “poker hand” and how it will act, is the future order block yet to be played out. The market orders, in terms of buyers and sellers, will not be uniform across all price levels. Orders will form at higher density at certain places. These places are called liquidity pools because of the presence of buyers and sellers.
To further fully understand an order block, it’s best to have an idea of the characteristics of orders and how they are placed at the institutional level. This is very different that the way most orders are placed at the retail level. Consider the most common type of orders:
Market orders - In other words, the latest price on the screen. This is how most retail traders execute orders on popular vehicles. The market buy order will fill at the best price of the next sell order. It will continue down the sell order block until the full quantity until the order is filled. For small orders this is an inconsequential detail that has almost no material impact to the investor.
Limit orders – Limit order is an auction bid in the case of a buyer and the actual ask in the case of the seller. The moment bids and asks overlap on the order book, an exchange is executed.
Stop Limit orders – A stop limit order tells the broker to initiate the sell below a certain price or the buy above a certain price. This is a popular order technique for technical traders who are looking to open or close positions when certain levels are breached, and the market is signally a change in its dynamic. Put simply, the trader has confirmation to enter or exit the trade. It’s important to recognize that there can be a high volume of these above or below the current price that will accelerate the breakout or breakdown.
Dark pools and high-volume institutional orders – I summarize institutional behavior in this fourth category as… large volume, you don’t know about, but the seller and the broker does. A dark pool is a term for a large private buy or sell order that is issued over a longer period or enough time to provide adequate liquidity for the order. The key word is liquidity pool. It is impossible for outsiders to know when large buying or selling pressure will end at certain levels, but large breakouts typically confirm these things. That’s what break of price structure is indicating probabilistically!
How can we paint a more complete picture of the market order block that will be executed in the future?
1) Volume Profiles
Some of the order block we can see in terms of the Depth of Market (DOM). This is but a small fraction of the future orders to be executed. We use historic price data to fill in the gaps of where the market is likely to place it buys and sells. Imagine a liquidity histogram that overlays the price scale. This is called volume profiling.
2) Price Pivot Points
Swing highs and swing lows identify places in the price chart where the market issued a price rejection or price reversal. Generally, there were some preceding indicators and confirming indicators. The further in history we look (left) the clearer these pivot locations become. These indicate a shift between buyers and sellers. Perhaps buyers became exhausted, and sellers took over or vice versa.
3) Global maximums and minimums
Bigger is better, higher time frames and global maximums in pivot and volume always dominate the smaller signals in terms of significance and probability.
4) Recent history bias
As time moves forward the effect of signals in price and volume tend to fade slightly. All things being equal when considering number 3, prioritize the more recent historic data when judging the more imminent future.
Astrology for men? Or market luminary?
We should think of the future market order block as the hidden thing. While it will mostly play out in plain sight (much like weather) it’s not intuitive without the proper toolkit and analysis. Suppose the market were a dark cave and our charts the flashlight to illuminate our journey forward. What properties would we need to build into the flashlight?
1) Breadth – the light would need to shine broadly enough to see both what is in front of us and the periphery.
2) Balance – the brightness should not overwhelm what we can interpret such that we miss what isn’t in our main field of view.
3) Flexibility – One man’s vision doesn’t work the same as another. Start with some factory settings and adjust as you build experience.
4) Unburdened – Remove more than you can reasonably carry. Don’t make the flashlight heavy or burdensome. Less is usually more.
The remainder of this piece will focus on how to build your own market flashlight. It will focus on 6 main categories:
Candles
Time Frames
Price Structure
Econometrics and Times Series
Volumetrics and Liquidity
Trends
Why Candles?
Candles display 6 things in a single symbol. The charting method was invented in Japan in the 18th century, but since has become the standard for charting price because of its information density. Open, session low, session high, close and whether the candle was up or down on net (color). The most important part of a candle is its close, however, what happened in the session is also very important.
Close is very important because institutional traders are often given buy or sell criteria to complete before the close of a particular unit of time. Daily close is the most common and critical of these, but large funds often set rebalance criteria at the complete of monthly and quarterly time periods. It is for these reasons that you may see a large uptick in volume very close to a major close period.
Wick length, type of consecutive candle (engulfing, hammer, topping tail, dojis) can add additional visual clues to the significance of support, resistance or the strength of a reverse. Candle pattern trading is its own discipline. Tradingview has provided an article on how to add pattern recognition out of the box here: https://www.tradingview.com/support/solutions/43000584462-candlestick-patterns/
For a deep dive into various flavors, I recommend Ross Cameron’s course on youtube:
If you are an interested trader, you’ll most likely find the information exciting and even actionable. Remember, back testing and experience are key to implementing any trading strategy.
Time Frames
What kind of trader or investor are you? The answer to this question will determine what 3 time frames you are going to be looking at. There isn’t really a reason to venture from these time frames for the purpose of making an entry or exit decision.
What kind of market participant are you?
1. Day trader – you plan to close positions at the end of the day and open at the beginning. You have no risk of slippage at market open in this scenario, but the market will move quickly as there are only 7.5 bars of hourly trading open in each day (for US markets). Your chart setups will be on the 60, 15 and 5 minute timeframe.
2. Short Term trader – you plan to hold beyond market daily close but often will close positions at the end of the week. Your chart timeframe will consist of 240, 60 and 15 minute timeframes
3. Swing Trader – You intend to hold positions for a period of months or perhaps quarters. You will need to be looking at Weekly, Daily and 4 hour charts.
4. Investor/Long Term Trader – You intend to hold positions often for more than a year. You may be supplementing value investing with technical analysis to improve entries and exits, position sizing and so on (as I do). You will be setting up Monthly, Weekly and Daily charts. Keep in mind, in this time frame you can responsibly check your charts as little as once a week if you are using alerts.
I only use daily charts for options or entries and exists for a stock or investment that has given me a positive entry signal on weekly or monthly timeframes. The 3 time frames selected here are an example of the rule of 3. This is a rule of thumb that keeps information that isn’t relevant to my own investment strategy at bay. Its generally best to ignore timeframes outside of the rule of 3. (Rule of 3 gets used again with MAs, trend lines and competing chart indicators just to keep the information noise and redundancy to a minimum)
Price Structure
Components of price structure:
· Horizontal levels
· Swing highs and lows
· Higher highs, lower lows
· Higher lows and lower highs
Horizontal price levels are generally the most powerful forms of support and resistance (especially round numbers). Almost everyone can recall some items from the grocery store like bananas for $1.99. In the retail sense, these types of recall usually mean the price is either the common low sale price (support) or the common retain price (resistance). Once what was a retain price becomes the new sale price, you intuitively understand that we are in a period of higher prices than before. Resistance has become support. An annotated chart of price structure looks like the following
Price structure is a wide field of technical study. Many traders operate exclusively on it alone. The most in depth of these is likely the SMC (smart money concepts) framework. They have a youtube channel for a much deeper dive below. As a long term trader and investor, I rely on more than structure alone.
Econometrics, Time Series and Momentum Indicators
Econometrics and momentum indicators are an integral part of the market psyche due to a concept called reversion to the mean. This simply means that at a high enough viewpoint the chart is moving up and to the left when fully smoothed out (obviously, there will be individual company failure, and this will not be the case with every ticker). Because the calculation of these indicators have the same basic mathematical DNA, they can be thought of as a signal group. However, I split the group into leading indicators and lagging indicators, based on how they are used for analysis and display on the charts. For moving averages, I suggest applying the rule of 3 here. 50 DMA, 200DMA or 30WMA and 3YMA as popular examples for an investor. A day trader will obviously choose much shorter periods. Likewise, RSI (relative strength index), ATR (average true range), MACD (moving average convergence/divergence), DMA (distance from the moving average) all detect momentum convergence and divergence to one degree or another.
Lagging Indicators: Moving Averages
Leading Indicators: RSI, MACD, ATR, DMA
Given the choice of only one leading indicator, I prefer the distance from the moving average. As you can see below divergence is depicted like other similar indicators. However, DMA gives the user the ability to set price targets based on the historic price elasticity relative to the first order moving average. This sets DMA apart from the others as a target setting tool.
There are many youtube videos on moving averages, rsi and other indicators on youtube. Most are targeted at shorter term traders. For longer term buying and selling look for topics and bullish/bearish divergence and hidden bullish/bearish divergence.
Volumetric Indicators
Volume - Volume is an indicator of money flow and liquidity. It’s generally presented at the bottom of the chart, green bars representing up candles and red down. Blocks of green and red together combined with high volume can indicate strong push to a bull or bear move. If a breakout to the bullish side is supported with volume, there is much greater trust in its ability to establish a bull run. Only the largest market players have any hope of creating a high-volume market move artificially. On the other hand, be very skeptical of low volume breaks of structure and trend.
Visible Range Volume Profile – VRVP is a vertical histogram that illustrates the most popular prices that a market ticker traded hands. You can infer future price will not linger very long at locations where there aren’t previous historic transactions.
Tradingview has a video to explain VRVP. Getting the indicator on the chart is the most difficult part. Using it is intuitive since it’s just a visualization of the volume data behind the price.
Trends & Patterns
Trend Lines
Flags, Channels and Broadening Structures
Trend lines (non-horizontal) are used to help us identify changes in the market dynamics. Let’s be clear, drawing trend lines is an art and will take some practice. Often times break of a long-term trend is a signal for an entry or an exit on a particular investment. Pennant flags, parallel channels and broadening structures often suggest a break of the structure will offer a long continuation in the direction of the break. In addition, it is believed the rising structures will break down with higher probability and the descending structures will break up. I try to observe the rule of 3 here. Keep your charts clean by removing anything that could possibly be redundant or less significant to your time preference.
Note: Use logarithmic scale to draw trends!!!
The best literature on this subtopic of classical TA can be found in Technical Analysis of the Financial Markets by John Murphy: https://a.co/d/7QdPoAV
Chart Settings
Time Frames:
Monthly – apply any drawings to the monthly chart first, these are the “prevailing winds”. Use a different color for monthly drawings.
Weekly – main area of focus. There isn’t a reason to zoom farther in unless you are executing and entry or an exit
Daily – lowest timeframe used to determine an entry or exit where the investment choice has already been triggered by the higher timeframe.
Candles: Red/Green
Econometric Indicators:
Primary: 50DMA, 200DMA and 3YMA
Second Order: Distance from the 200 DMA (There is no built in tradingview indicator, simple code example is provided below)
//@version=3
study("Percentage Distance From Moving Average")
MALength = input(50)
price = close
ma = sma(price, MALength)
PercentageDifference = (price - ma) / ma * 100
//plot(strategy.equity, title="equity", color=red, linewidth=2, style=areabr)
plot(PercentageDifference)Volumetric Indicators:
Primary: Volume
Second Order: VRVP
Trends
Monthly - draw 2 monthly trend lines first
Weekly – draw 3 (max) weekly trendlines second
Draw from the candle close (body)
Keep maximum of 3 triangles, pennants, channels and megaphones
Don’t overdraw!
