Don't let your charts deceive you. Remember, scale is everything

One risk of chart-based trading strategies is misinterpreting, or overinterpreting, the visual data presented by a chart and concluding that a new trend is emerging when nothing could be further from the truth. We humans are visually-oriented creatures, and are inclined to see patterns even when they aren't there. The risk of jumping to false conclusions based on a chart increases when you're looking at a time scale much shorter than you're used to, displaying pip ranges much smaller than you're accustomed to.

For example, I recently switched from an hour chart to a five minute candlestick chart and was amazed at the exciting trends that were suddenly jumping out at me from the screen. I quickly realized that what looked like major movements were in fact just upticks of a few pips, and that the shorter time scale gave the illusion of faster, more dramatic market activity. When I switched back to my hour chart, it became clear that all the movement was actually happening within a very narrow range.

When I first got started trading, I would often be staring at a 5 minute CCI (Commodity Channel Index) chart for hours, even during the low-volume doldrums of the afternoon, since I didn't know any better. One of the problems I had with the CCI as a newbie trader was that what often looked like an important trend on the chart, as the CCI shot upward or plunged downward, was often just a movement of 7 or 8 pips. The CCI is like that: it can swing widely up and down regardless of whether the price is moving 10 pips or 100 pips. If you don't keep a careful eye on the price and just watch the CCI, you might end up making a trade that looks big on the chart and ends up so small it's hardly worth your while. I found this was especially true during those afternoons, when the CCI would continue to spike up and down based on the smallest price movements. I eventually found it helpful to have a candlestick chart running alongside my CCI chart to give me some more perspective on what the price was actually doing.

Remember, a chart signal or indicator will work with whatever prices are fed into it, keeping up a constant visual chatter even when there's not much to talk about. Many charts and signals will also shift their scale to fit whatever the current range is, which can create an illusion of market activity even when volumes are low. A CCI or Bollinger Band or ADX or MACD won't just turn itself off and say, Hey, charting these prices isn't worth my while, and it's likely it lose you money as well. They'll just chart what's there, and it's up to you to decide whether they're saying anything meaningful. Often they aren't, and there are many times when the best strategy is to just leave your charts for a while, go get lunch, watch the Simpsons, have a beer, go swimming, walk the dog, and come back to them when the market's really moving.

Related topics:
The Perils of Chart Burnout
Common Errors When Designing a Trading Strategy