How to read a stock chart without fooling yourself

Charts are the most seductive object in this entire subject. They are visual, they look precise, and they produce a strong feeling of understanding within about two seconds. That feeling is the problem, because a chart contains far less information than it appears to, and most of what it does contain is about the past.

What a chart is, and is not

A price chart plots one thing: the price at which transactions took place, over a chosen period. Each point is a record of an agreement between a buyer and a seller, which is the idea developed in stock market basics.

It is not a picture of value, of company quality, or of anything that has not happened yet. A rising line means people paid more recently than they used to. That is the entire content of the statement.

The two axes, and the choices hidden in them

The horizontal axis is time, and whoever drew the chart chose how much of it to show. The vertical axis is price, and they chose where it starts and how it is spaced. Neither choice is dishonest, and both change the impression enormously.

The vertical axis does not have to start at zero

Take a price that moved from 100 to 110 over a year, a rise of 10 percent. Draw that on an axis running from 0 to 120 and it is a gentle slope. Draw the same data on an axis running from 99 to 111 and it is a cliff face. Same numbers, same year, completely different feeling.

This is the single most common way a reader misleads themselves, and it costs nothing to defend against: before reacting to a shape, read the numbers at the ends of the vertical axis.

Linear and logarithmic spacing

On an ordinary linear axis, equal distances represent equal amounts of money. A move from 10 to 20 doubles your money and occupies ten units of height. A move from 100 to 150 gains half as much in percentage terms and occupies fifty units. So a long term chart on a linear axis makes the early years look flat and the recent years look dramatic, even when the percentage changes were larger at the start.

A logarithmic axis spaces equal percentage moves equally, which makes it the honest choice for any chart covering many years. When a decade long chart looks like a hockey stick, checking which spacing is in use is worth doing before drawing any conclusion.

The period is a choice too

The same holding can be shown falling over five days, rising over five years, and flat over ten. All three charts are accurate. Whoever selected the period selected the conclusion, and a chart that begins at a conveniently low point is making an argument rather than reporting a fact.

Three ways an honest chart misleads

1. It omits income. A price chart shows price. If the holding paid dividends, that money is not in the line, so the chart understates what a holder actually received. Comparing two holdings on price charts alone is comparing incomplete figures.
2. It survives. Charts exist for things that still exist. Companies that failed do not appear in most retrospective pictures, which quietly flatters any impression you form about how things generally turn out.
3. It invites pattern finding. Human vision is superb at finding shapes in noise, and a price series contains a great deal of noise. The shape you notice is real in the sense that it is in the data, and it does not follow that it means anything about tomorrow.

Moving averages, worked by hand

A moving average is the most common line drawn on top of a price, and it sounds more sophisticated than it is. A five day moving average is the average of the last five closing prices, recalculated each day.

What it is genuinely useful for is removing visual noise so that a longer shape is easier to see. What it cannot do is predict, and every claim built on averages crossing one another should be read with that limitation in mind. An average of past prices contains no information that the past prices did not already contain.

Volume, and what it adds

Volume is the number of shares that changed hands in a period, usually drawn as bars along the bottom. It is the one additional piece of real information on most charts.

Its value is as a measure of how tested a price is. A price move on very light volume was agreed by few participants; the same move on heavy volume was agreed by many. It is context rather than a signal, and it is worth exactly that much and no more.

You may also meet candlesticks, which pack four numbers into each shape: the opening price, the closing price, and the highest and lowest points reached in the period. They contain more detail than a simple line, and no additional predictive content.

What no chart can tell you

The honest list is short and worth keeping.

• Whether something is expensive. Price alone cannot answer that, because expensive is a relationship between price and what the company earns or owns. The nearest simple measure is discussed in value and growth investing.
• Why anything moved. Explanations attached to charts are written after the fact, fitted to a movement that had already occurred.
• What happens next. Every point on the line is a completed transaction. The chart ends where the known information ends.
• Whether it suits you. That depends on your horizon and the size of fall you can sit through, which is a question about your household rather than about the line, as set out in how much risk can you actually live with.

Read this way, charts become genuinely useful and much less exciting. They are a compact record of what happened and a good way to see the scale of past falls, which is worth knowing before you own something. They are not a source of instructions.

This page explains how price charts are constructed and how to read them carefully. It refers to no real company or security, teaches no trading method, and is not a recommendation to buy or sell anything.