By Alan Hull, AlanHull.com
The science of technical analysis can be daunting for the newcomer. One of the most intimidating areas is the use of logarithmic charts. Adults who weren’t paying attention in their Math’s classes in High School will find the word ‘Logarithm’ in itself to be somewhat intimidating. The easiest way to explain how and why we use logarithmic charts is to illustrate the difference between a linear price chart and a logarithmic chart. The charts are both of Cochlear…the former with a linear price scale and the latter with a semi-log price scale.
Using a semi-log price scale has had the magical affect of turning a curve into a straight line. It is important however, if we are going to use the semi-log function in our charting programs, to understand at a conceptual level what we are doing. When we look at a conventional chart we are observing the ‘Change in price’ with respect to the ‘Change in time’. When we look at a logarithmic chart we are looking at the ‘Proportional change in price’ with respect to the ‘Change in time’.
We use ‘Proportional change in price’ to observe market sentiment. Market participants move share prices either up or down proportionally depending on how bullish or bearish they feel. Imagine that a group of people were so keen on a share that they bought up the share price from $1 to $2 in one month. Now imagine that the same group of people were just as enthusiastic about the same share when its price was $5. They would move the price from $5 to $10 in one month.
The first price movement is $1 in one month and the second price movement is $5 in one month. But both price movements are proportionally the same at 100% in one month. This equal proportionality tells us that market sentiment is the same in both cases even though the ‘Change in price’ in each case is different. We can also add to this body of evidence the observation that when price moves sideways over time then sentiment is obviously neutral.
When we analyze logarithmic charts our interest is of a qualitative nature and not a quantitative one. We are using the gradient of the curve to observe market sentiment. If price activity curves upwards then market sentiment is improving and when it curves downwards market sentiment is falling.
If price activity moves sideways then market sentiment is neutral and when the price activity moves in a straight line then sentiment is constant. We can therefore conclude that market participants are almost as bullish on Cochlear in early 2001 as they were back in 1998.