Tuesday, December 9, 2008

Basic chartology: Linear vs Log scales & other useful tips

Several of my close friends in the investment field have recently admitted to me in whispered tones that they have suffered significant losses this year not only in their personal portfolios but their professionally managed ones as well. These are serious people who make stock selections based on fundamentals and hold on to them through thick and thin, provided the reasons that they bought them in the first place don't change. Whenever I happen to toss in a polite comment such as "Your favorite stock just broke major support and I strongly recommend dumping that stinker," I receive reactions that range from rolling eyes to actual nose scrunching, as if I just presented them with a plate of Limburger.

The financial field is divided into two camps, much like the Republicans and Democrats--the technicians who see the world as it is and the fundamentalists, like my friends, who insist on viewing the world through rose-colored glasses. In general, the fundamentalist camp lumps technical analysis in with voodoo and elven runes and therefore since they don't know anything about it, it must be evil. Frankly, we technicians don't give a damn what they think as long as they leave us alone.

But sometimes miracles do happen.

It's amazing how a contraction in one's financial security can change a person's point of view, for in fact, a couple of my friends have recently admitted that they wished they had understood the basics of technical analysis. I accept their hidden apologies and in the spirit of their recent enlightenment, today's article is dedicated to them and all other beginning chartologists.

Note: Seasoned technicians need not proceed any further.

What am I looking at?
Before one can even begin to dissect a stock chart, one needs to understand the difference between a linear and a logarithmic scale. On a linear scale, all whole numbers are equidistant from each other. In other words, the distance between, say, one and two is the same as the distance between one hundred and fifty-nine and one hundred and sixty. Simple, right?

A logarithmic, or log, scale is very different. Here, the numbers are not equally spaced distance-wise; rather, they are equally spaced percentage-wise. For example, the distance between 5 and 10 is the same as the distance between 10 and 20. What this means on a stock chart is that a price bar representing a 50% gain will be the same size no matter where it appears. In this case, a picture is probably worth a thousand words. Below are two charts of Excel Maritime, EXM—one linear and one log.

Comparing these two charts, you can see that the log scale puts an equal weight on each price bar making today's 42% move that much more dramatic. Most technicians prefer a log price scale for this very reason, but it's okay if a linear scale makes more sense to you. Just know the difference.

A few other technical tips
You might notice a few things from examining the above charts. For one, you can see that the price tends to “bunch up” at the decade intervals, i.e. 10, 20, 30, etc., and to a lesser extent, at the 5-levels, i.e. 5, 15, 25, etc. These are called support and resistance levels. For EXM, you can see that it spent a good month bouncing off the $10 level in October which became a level of support because it was, in fact, “supporting” the price.

You'll see this support was violated on November 11th followed by another down day. This was a strong indication that the buyers had thrown in the towel and the sellers were now in charge. The price plunged. Its recent $3.50 low could be the bottom as evidenced by two factors: 1. The past two days of strong price movement have been accompanied by much heavier than normal volume (not shown on the charts above), meaning that the shorts are probably covering and the bulls are regaining power; and 2. Today's price bar has filled the gap set on November 20th. Once a price gap is filled, chances are good that it will continue moving in the direction of the fill.

Notice that the previous $10 support level is now a resistance level. This is a psychological barrier for traders and will be the stock's next hurdle to upward progression. If it manages to break through it on heavy volume, further upside movement is highly probable.

Well, that's the long and the short of log and linear scales. I hope this mini-chartology lesson has whetted your appetite for further study into the beauty of technical analysis. Tomorrow, I'll continue our education with a few other interesting and useful chart-reading tips.

Note: All of the major web-based financial sites--MSN Money, Google, Yahoo!--offer both linear and log charts. MSN Money also offers a log base 2 scale, not that I'm sure how to use it.

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