Rule 1 – If you cannot see trends and patterns almost instantly when you look at a chart then they are not there. The longer you stare, the more your brain will try to apply order where there is none.
If you have to justify exceptions, stray data points and conflicting evidence then it is safe to say the market is not showing you what you think it is.
Rule 2 – You can torture a chart to say anything you want. Don’t do it.
This is very similar to Rule 2 but it there is an important point to drive home. You can cherry pick indicators to justify whatever biases you bring to the table and that attempts to impose your will on the market. You cannot tell the market what to do – ever.
Rule 3 – Be sure you check out one time frame larger than the one in which you are operating (a weekly chart for a swing trader, a monthly chart for a position trader).
It is very easy to get caught up in your own world and miss the bigger picture getting ready to smack you. It can mean the difference between buying the dip in a rising trend and selling a breakdown in a falling trend.
Rule 4 – Look at both bars (or candles) and close-only line charts to see if they agree. And look at both linear and semi-logarithmic scaled charts when price movements are large.
Short-term traders can ignore the latter since prices are not usually moving 30% in a day. But position traders must compare movements at different price levels.
As for bars and lines, sometimes important highs and lows are set by intraday or intra-week movements. And sometimes intrday or intra-week highs and lows are anomalies that can safely be ignored. Why not look at both?
Rule 5 – Patterns must be in proportion to the trends they are attempting to correct or reverse. I like the trend to be at least three times as long as the pattern. (more…)