The Importance of Stock Market Charts

If you are a beginner to stock trading you may think that stock charts are just so much mumbo jumbo, akin to dowsing, feng shui, palmistry etc… and just another way for people to get paid for blinding the gullible with pseudo science. How can dots and lines on a piece of graph paper that represent past events possibly predict future events? If this is what you think then I would urge you to think again before committing any money to the financial markets.

Stock market charts may appear to have no rhyme or reason to them but in fact what they are is a representation in graphic form of human behaviour. They represent what is sometimes referred to as the ‘wisdom of crowds’.

The reason that stock charts are important is because professionals, analysts and assorted experts use them ! This may seem like an odd statement to make and a bit like putting the cart before the horse, but what I am saying is that stock charts are in fact a self-fulfilling prophecy. Rather like towards the end of a football match when some people start moving towards the exit. Why do they do that ? Because they know what’s coming next i.e. an almighty rush to get out. This rush clogs up the exits and the carparks and the smart ones are the ones that got out first and are already on their way home.

Charts are similar to this. Professionals look at the charts and decide that if such and such an event takes place i.e. if a certain price is reached, then it is a good time to sell. If that price is reached then they sell, but because there are so many professionals looking at the same charts and coming to the same conclusion then they all sell at the same time. As a result of this concentrated selling, the price of that particular stock goes down, thus confirming that they were right to sell in the first place. This is how stock charts act as a self-fulfilling prophecy.

One particularly flagrant example of this is the “200 day moving average”. The 200 day moving average is the price of a stock plotted every day for 200 days then averaged out. This is seen on graphs as a curved line. If the price of a stock is above this line, then this is considered to be positive, if the price is below this line then it is considered to be negative. The most important period, however, is when the stock price crosses above or below the 200 day moving average. If a stock price crosses below the 200 day moving average then this is generally seen as an indication that the stock price will be headed even lower and so it is time to sell.

RBS 3 Year Chart with 200 Day MA in Red – the time to sell was back in 2007 when the red line crossed below the blu (stock price) line

The fact that so many people believe this to be the case means that if it happens then they will sell. This selling forces the price lower, thus confirming that it was the correct decision to sell and the charts are therefore proved right.

This is why it is important for beginners to study stock market charts. Professionals study charts all the time and their combined ‘wisdom’ and decisions will drive a stock in a particular direction. If you don’ t know what signs to look out for you are at a distinct disadvantage.