Reading a chart without fooling yourself

In short

A friend of mine once showed me a chart that went up and to the right, and he was sure he had found a sure thing. You have probably felt that same tug when a line seems to tell you exactly what comes next. A chart is a picture of what already happened, and the picture can flatter you or fool you depending on how you look at it. Check the scale on the side before you trust the slope. Ask how much time the chart covers and what was left out. Write down what would prove you wrong before you start, so your mind cannot move the goalposts later. Treat every pattern as a guess, not a promise. And remember that a good look at a chart costs you nothing, while a hasty one can cost a great deal.

The whole of it

What it is

I once watched a fellow at the county fair study the weather vane for a full ten minutes, certain it could tell him about next week. It could only tell him about the wind right then. A price chart works much the same way. It takes the prices that traded over some stretch of time and draws them as a line or a set of bars. Each bar or point shows where a price started, where it ended, and often how high and low it went. You have probably seen the green and red candles that show up on trading screens. They are just a tidy way to pack four prices into one small shape.

Here is the plain truth about that picture. It records the past and nothing more. It does not know why prices moved, and it cannot see tomorrow. When you read a chart, you are reading a diary, not a forecast. That may sound like a letdown, but it is really a kindness. Once you accept it, you stop asking the chart for something it cannot give and start using it for what it can do well, which is to show you what actually happened.

How it works

If you are holding a chart in front of you right now, start with the two lines that frame it. The bottom edge is time. The side edge is price. Both can be stretched or squeezed, and the stretching changes how the whole thing feels. A price that moves a little can look like a cliff if the side scale is zoomed in tight. A price that moves a lot can look like a lazy hill if the scale is zoomed out wide. Neither picture is a lie, yet each can leave a wrong impression in a hurry.

Many charts also let you pick a scale that is linear or one that is logarithmic. On a linear scale, equal dollar moves look equal. On a log scale, equal percent moves look equal. This matters over long stretches, because a jump from 10 dollars to 20 dollars is the same doubling as 100 dollars to 200 dollars, even though the second is ten times larger in dollars. A log scale shows those two doublings as the same height. Choose the scale that matches the question you are asking.

Then there is the stretch of time you choose. Zoom in on one afternoon and you will see a jagged mess. Zoom out to ten years and the mess smooths into a shape. Both views are true. But each one tells a different story, and it is easy to pick the window that agrees with what you already hoped. I have done it myself, and I was not proud of it afterward.

Many charts also draw lines on top of the price, like a moving average. That is simply the average of recent prices, recalculated as time passes, so it smooths out the noise. It always lags behind the price, since it is built from old numbers. Volume bars along the bottom show how many shares changed hands. They tell you how busy the market was, not which way it will go.

The numbers, and where to find yours

You do not need many numbers to read a chart honestly, but a few are worth knowing. The first is your own time frame, meaning how long you plan to hold a position. A chart for a person who trades within a day looks nothing like a chart for a person who saves for twenty years. Pick the chart that fits your plan, and not the other way around.

The second is what it costs you to act. Every trade can carry a commission, and there is often a gap between the price to buy and the price to sell. That gap is called the spread, and it is a real cost even when no fee is listed. Your broker shows its fees on its own pricing page, so look there for yours. The tax rules for gains also depend on how long you held and on rules set by law. The Internal Revenue Service explains these in Publication 550, Investment Income and Expenses, and the current rates and thresholds sit at the current figure, which the official source publishes each year. Read the official page, not a forum post, for that figure.

A worked example

Let me tell you about a woman named Dolores. She took a chart of a stock that had risen from 40 dollars to 60 dollars over three months. She felt sure it would keep climbing. So she asked herself the questions in the order that protects a person.

First she checked the scale. The side of her chart ran only from 38 dollars to 62 dollars, so the climb looked steep. She switched to a wider view that ran from 0 dollars to 100 dollars, and the same climb looked gentle. Nothing had changed but the picture.

Next she did the math. The stock rose from 40 to 60. That is a gain of 60 minus 40, or 20 dollars. She divided 20 by 40 and got 0.5, which is 50 percent. Fifty percent in three months sounded wonderful. Then she zoomed out to two years and saw the price had been 90 dollars before it fell to 40. A rise from 40 to 60 was only a partial climb back from a deep drop. The drop from 90 to 40 was a loss of 50 dollars, and 50 divided by 90 is about 0.56, or 56 percent. So the recent gain had not even erased the earlier loss.

Dolores then wrote down her exit before she did anything. She decided that if the price fell to 52 dollars, she would admit her guess was wrong and step aside. That is a drop of 8 dollars from 60, which is 8 divided by 60, or about 13 percent. She also counted costs. If a round trip cost her 10 dollars in fees on a 1,000 dollar position, that is 10 divided by 1,000, or 1 percent, before any move in the price. She did not buy anything that day. She simply learned to see what the chart was and was not telling her. That was a fine afternoon's work.

Where it goes wrong

We all want to be right, and that wish is the trouble. When you stare at a chart hoping for a certain answer, your eyes will find it. Two lines cross, and you call it a signal. A bump appears, and you call it a pattern. Give a hopeful mind enough squiggles and it will draw a face in the clouds. That is a human habit, and there is no shame in it. Still, it is a habit worth catching.

Another slip is looking only at the winners. A chart of a company that survived tells you nothing about the many that quietly vanished. When you see a beautiful climb, ask what you are not being shown. A third slip is fitting a story to the line after the fact. Anyone can explain why a price went up once it has gone up. Explaining it beforehand is the hard part.

Then there is the pull of recent events. What just happened feels like what will keep happening. Three green days in a row start to feel like a rule, and they are not one. Be gentle with yourself here. Being fooled now and then is part of learning, and the fix is a few small habits, not a great deal of cleverness.

Finally, watch out for charts that come with a sales pitch. If someone shows you a chart to sell you a course or a service, ask what they gain when you agree. That question is polite, and it is fair.

Questions to answer before you leave this page

What is the scale on the side of the chart in front of you, and would the story change if you widened it? How much time does the picture cover, and did you pick that window because it agrees with what you hoped? What would have to happen for you to say your guess was wrong, and have you written that down where you cannot quietly change it? What does it cost you in fees and in the spread to act, and what share of your money is that? What might this chart be leaving out, such as the companies that failed or the years before the picture began? And if a stranger handed you this same chart with no story attached, what would you honestly see?