One of the basic tools of technical analysis is the bar chart, where the open, close, high, and low prices of stocks or other financial instruments are embedded in bars, plotted as a series of prices over a specific time period. Bar charts are often called OHLC charts (open-high-low-close charts) to distinguish these charts from more traditional bar charts used to depict other types of data. Bar charts allows traders to see patterns more easily. In other words, each bar is actually just a set of 4 prices for a given day, or some other time period, connected by a bar in a specific way — called a price bar.
A price bar shows the opening price of the financial instrument, which is the price at the beginning of the time period, as a left horizontal line, and the closing price, which is the last price for the period, as a right horizontal line. These horizontal lines are also called tick marks. The high price is represented by the top of the bar and the low price is depicted by the bottom of the bar.
If the price bar is a daily price bar of a stock, then the opening and closing prices are the prices of the stock at the open of the market and at the close of the market, respectively. Similarly, the high price is the highest price traded during the day, while the low price is the lowest price of the day.
But note that a day is a rather arbitrary division of time — any time period can be considered, whether the market opens every day or is open continuously, such as the foreign exchange markets on weekdays. As electronic trading becomes more widespread, trading eventually will become a 24/7 activity — hence, the markets will never open or close, but there will still be open and close prices for a specific time period. Bar chart analysis can also be used for periods shorter than a day, such as an hour or even 1 minute.
This ability to extend bar chart analysis to any time period gives more utility to technical analysts as a means to look for patterns in different time periods. These patterns are given a similar interpretation because of the fractal quality of the patterns — that the patterns themselves also have patterns within them.
Bar chart analysis is more useful when the bars over a time period are viewed, allowing patterns to be discerned that may forecast future prices with varying degrees of success. The simplest comparison is between 2 consecutive bars. An up-day is when the close is higher than the day before. A down-day is when the close is lower. The closing price is generally considered the most important price, because traders have reacted to the news for the day. But sometimes the close is down, not because of negative news, but because many traders sell on close to avoid any price declines due to bad news overnight.
Higher closes generally implies a bullish market sentiment whereas lower closes indicates bearish market sentiment. An uptrend is a series of up-days where the highs are mostly higher than the day before and the lows are also higher. Both the higher lows and the higher closes (up-day) confirm the uptrend. A downtrend is the opposite pattern, where highs, lows, and closes are usually lower on successive down-days.
Probably, there will be countervailing bars which contradict the trend or pattern, but if there are only a few, then most technical traders discount them.
Sometimes the significance of the trend is considered, which is commensurate with the difference between successive prices. Significance can be determined by either looking at the bar charts or by using charting software that defines significance as being a difference equal to at least a certain percentage.
Note that when confirming a trend, all 3 factors should support it. So to confirm an uptrend most of the bars should have higher closes, higher highs, and higher lows; for a downtrend, lower closes, lower highs, and lower lows. If 1 of the factors does not support the trend, then there is less confidence that a trend is forming or that it is beginning to end. Hence, a continuation pattern is one where the trend is fully confirmed. A continuation pattern is especially confirmed when a series of prices closes at the high, or its downtrend counterpart, when a series of prices closes at the low. If the pattern does not have an unambiguous interpretation, then prices may trend sideways or a reversal pattern may be forming, when the trend starts moving in the opposite direction.
Another factor considered is the daily trading range, which is measured by the height of the bar. Short bars, with only a small difference between the high and the low, generally indicate indecisiveness of the market. Often, this pattern forms an inside day, where the low is higher than the previous low but the high is lower than the previous high.
Long bars may indicate that sentiment is changing or that important news about the security has been published during the trading period, which may change the trend. Long bars often form an outside day, where the low is higher than the previous high.
An outside day often occurs on important news, creating a larger range of prices, and may very well change the trend. If the security opens low and closes high, then an uptrend may be forming; if the open is at a high and the close is at the low, then a downtrend may be forming due to negative news during the period. Hence, if no trend is present, an outside day may indicate the beginning of a new trend; if a trend was present, then it may be changing or ending.
Another simple pattern of some bars is when the opening and closing ticks are close together, indicating that the opening price was close to the closing price. This often occurs on inside days, and indicates indecisiveness. However, if the ticks are at the top of the bar, then it confirms an uptrend, and indicates a reversal of a downtrend. If the opening and closing prices are at the low of the day, then this confirms a downtrend or indicates a reversal of an uptrend.
Spikes are long bars, indicating a large daily trading range. That means that throughout the day, people were buying and selling at a wide variety of prices. Oftentimes, spikes indicate the dissemination of important news and that a key reversal could be imminent, in which case, the bar is known as a swing bar.
When a spike occurs, a trader should try to find the cause of the spike, then act appropriately. If the cause is not discernable, then the closing price should be given more weight, since it sums up the market sentiment for the day.
Price gaps are prices within a certain time period that is between the high and low of the period, but for which there were no trades. Like spikes, price gaps often result from the dissemination of important news. Most often, the gap appears at the open, when the opening price is not within the daily trading range of the previous day. An upside gap is measured by the price differential of the daily low and the high of the preceding day. Similarly, a downside gap is equal to the difference between the high of the day, and the low of the preceding day.
Often, gaps appear in the prices of thinly traded securities, those for which there is little trading activity. Most of these gaps have little to do with news — hence, they are often called common gaps — and are simply the result of the discontinuity of prices that people are willing to sell and those that are willing to buy. Sometimes a common gap will even appear for a heavily traded security. If the volume of the trading is low, then it is unlikely to be based on news. Often, traders fill the gap in time as the security continues to trade at the same price levels.
Uncommon gaps are usually based on news and the gaps are larger than common gaps. A breakaway gap is a large gap created by important news that starts a new trend, either up or down. The breakaway gap is not only large, but is based on large volume as new traders enter the market spurred by the news.
A runaway gap has all the features of a breakaway gap, except that a runaway gap simply augments a trend rather than starting a new trend and is usually the result of news that supports the trend. In both kinds of gaps, trading is highly emotional and often overshoots what many traders consider to be a reasonable response to the news, and, thus, there is a subsequent pullback to compensate for the emotional trading.
An exhaustion gap occurs at the end of a trend and is characterized by low volume of trading. It may even signal a reversal.
When an exhaustion gap is followed by a breakaway gap in the opposite direction, it may form an island reversal which is graphically portrayed as a single, usually long bar that is well above the bars both preceding it and after it, if the island reversal was a peak, or well below its peers if it was a bottom. Naturally, a trader should sell if the island reversal was a top and buy if it was a bottom.
Bar Chart Analysis is not an Exact Science
Remember, bar chart analysis, like technical analysis, is not foolproof — many times results will differ from what was expected. Furthermore, patterns are rarely as unambiguous as abstract diagrams would show, and signals could be conflicting, depending one's trading horizon. The most you can hope for in using bar patterns, or any form of technical analysis, to predict future prices is that you are more often right than wrong — and you will be wrong!— and that the profits you make are worth the time that you put in analyzing charts.