Charts are never wrong, analysis is!
Every now and then, we come across someone who doubts the usefulness of the technical analysis. On this, we would like to inform you that technical analysis works wonders and it has been around for decades now. It is one of the best methods used when it comes to studying the trend of the underlying and timing trade but at the same time, one needs to have a proper understanding of what to follow and what not to as the saying goes, ‘charts are never wrong, analysis is’.
Today, we have picked up an interesting topic about which beginners aren’t much aware of and even some of the celebrated technical analysts turn a blind eye to it. This in turn can dramatically affect how you perceive market action.
Linear vs Logarithmic scale
Linear vs Logarithmic scaling are the two primary chart scaling styles and both are available in almost every charting platform.
Let us quickly understand the basic difference between a linear and log scale. On a linear scale, each unit of price change is treated exactly the same. The price move from Rs 10 to Rs 20 would look the same from Rs 90 to Rs 100.
Whereas on a logarithmic chart, we have fixed distances between percentages move on a chart.
This is how a normal chart is constructed, where the price is on the Y-Axis and the time is shown on the X-Axis. The correct selection of the price scale will impact the trend lines that you draw on your price chart.
A good example is the price chart of Tata Motors. The chart on the left-hand side is plotted on a linear scale, while the chart on the right is plotted on a logarithmic scale. The upward sloping trend line broke down earlier on the logarithmic scale when compared with the trend line break on the linear scale price chart.
We would like to share one more example which will give you a much better and clear idea as to which is the best-suited scale to use while analysing the chart.
On the left-hand side is the linear chart of Maruti while on the right hand is the logarithmic chart of the same company. Notice the trendline drawn on the same. The very same trendline which was drawn on a logarithmic scale chart appears like this (no relevance) on a linear chart.
One more example we would like to share:
On the left-hand side is the linear chart of Aarti Drugs Limited while on its right hand is the logarithmic chart of the same company. Which chart gives a clear picture for doing analysis.
When there is a quantum jump in the price of any stock in a short period of time, the logarithmic scale is likely to present a clearer picture for doing analysis as it display price trends in a proportionate way.
To summarise: Scaling is an issue that is often overlooked in technical community, but since it can have an important influence on how trendlines can be interpreted, it should not be ignored at any cost. The difference between a logarithmic price chart and a linear price chart can be very slight when one is analysing a chart in the short-term, where price fluctuations are relatively small. However, as one increase the timeframe i.e. moves from short-term charts to a longer-term charts and where price fluctuations are large, one can spot major differences.