How Understanding Charts Can Make You A Better Trader

They say a picture is worth a thousand words.

But I disagree. I believe they’re much more valuable.

You see, I owe a great deal to a special type of picture. They’ve allowed me to see situations that others miss. Learning about these images has been truly life changing.

Do you know the type of picture I mean?

Well let me tell you: I’m talking about charts.

And I’m not just talking about stock charts.

Give me a graph of anything, and I’ll start scanning for patterns.

One of the more unusual examples concerns the birth of our first child. My wife was in the early stages of labour, and I was watching a monitor graphing the baby’s heart rate.

I noticed a pattern on the chart. The pulse was rhythmically rising and falling. I asked a nurse why the baby’s heart rate was fluctuating. She calmly said it was normal.

But things were far from normal.

The room was full of specialists in no time. Minutes later it was off to the emergency room. And twenty minutes after that we had our healthy newborn.

The cycle I’d spotted indicated the cord was around the baby’s neck. The heart rate was slowing as the cord tightened during contractions. It’s a chart pattern I’ll never forget.

I’m going to show you a fascinating chart in a moment. Don’t worry, you won’t need a medical degree to analyse it. The chart relates to stocks, and it’s unique to Quant Trader.

But first, let me tell you how I got started with charts…

Understanding the cycle is key

My introduction to charts was in late 1991. And it was largely by chance.

You see, I had a part-time job in the dealing room at Bankers Trust. I would go in every day after uni to do admin tasks. It was an ideal springboard to a graduate position.

Things went well. By the end of the year, I had two potential full-time offers. One was on the floor of the Sydney Futures Exchange, the other was in the charting department.

My first thoughts were of the futures floor. It was full of noise and activity. This made charts seem a bit dull. At 21 years of age, I didn’t know any better.

But fate had the casting vote…

The head of charting was first to offer me a position. I wasn’t about to tell him I’d think about it. I took the job on the spot.

My new boss — Scotty — had the respect of all the top traders. They’d often stop by our office to discuss the markets. It was a learning experience like no other.

Scotty taught me to see the market in phases — up, down, and sideways. He said understanding the cycle was key. This is what makes successful trading possible.

My year with Scotty was a gift. It put my career on a path I couldn’t imagine. Many of the lessons from that time sit within Quant Trader’s algorithms.

A strategy to stay ahead of the pack

Last week’s focus was on the ‘wall of worry’. I told you about the chorus of voices predicting a market collapse, and I explained why following them is often a huge mistake.

This week, I’m going to take in a different perspective…

I’m going to tell you about the rhythm of the market. I want you to see how stocks have an ebb and flow. Understanding this could help you stay ahead of the pack.

OK, let’s get started with a chart:

MoneyMorning 05-10-18

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Now, you may have seen this before. It’s my proprietary indicator — the ‘Quant 300’.

Here’s how it works…

The indicator calculates the number of top 300 companies in a rising trend. The stocks change over time, but the number remains fixed at 300.

A stock enters an up-phase when its shares:

  1. Hit a 40-day high
  2. Are trading above their 100-day moving average (MA)

The trend stays bullish while the shares are above the MA.

If you don’t know, a MA is simply the average share price over a set period (in this case 100 days). A rising MA is typically a bullish sign.

The indicator mostly ranges between 25 and 225: a low number indicates stocks are generally weak, while high numbers occur when the market has been rising.

I use this indicator to help identify market tops and bottoms. Major lows tend to occur when the indicator trades below 50, and then rebounds. Tops are most likely when it’s above 150.

You’ll see the indicator is currently mid-range. It’s most recent reading is 103 — well below the levels typically associated with major market highs.

Yes, stocks could consolidate further. But I believe a big downturn is unlikely.

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This strategy in practice…

OK, it’s time to look at the image I told you about earlier.

Check this out:

MoneyMorning 05-10-18

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Let me explain what’s happening…

The image aligns the Quant 300 with Quant Trader’s hypothetical gains. It assumes $1,000 on every signal 1 (buys only). There’s also no company cap, and it doesn’t account for costs or dividends.

To be clear, the performance graph is from back-testing. The chart goes back further than Quant Trader’s live signals. This is so you can see several market cycles.

Now, I want you to focus on the bottom graph first…

Notice how it rises and falls in an almost rhythmic way. A number of bullish stocks increase to above 150, then falls to below 50. This cycle repeats over and over.

You’ll see several shaded areas on the chart. They cover the periods when the indicator peaks, to when it bottoms. This is when the number of bullish stocks are declining.

Now, follow those shaded areas up to the performance chart. Pay close attention to what happens during those periods. You’ll see these coincide with a lull in performance.

Some people get upset when Quant Trader’s stocks aren’t rising. I typically get these complaints during the down phase of the cycle. This is when stocks are generally falling or flat.

But here’s the thing. The market is like a living organism — it inhales and exhales. You can’t have one without the other. Down periods will always be part of the picture.

The best time to make money is during the upswings. This is when an increasing number of stocks are trending higher, and corrections are likely to be relatively shallow.

Understanding this cycle could give you an edge. It can help you stick to your system when others give up. And it could help you push forward when the doomsayers say to run away.

Study the charts in this update carefully. They give you an insight into the market’s rhythm. I believe these could be some of the most valuable pictures you ever see.

Until next week,

Jason McIntosh
Editor, Quant Trader

PS: If you want to lay down a little money on the hottest corner of the ASX right now…but you don’t know your way around the small-cap sector…this report is for you. Get access now (free).

Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

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