Should I use logarithmic or linear plotted stock charts? This is one of the most common questions asked by traders who use technical analysis. The answer is, it usually doesn’t matter. I prefer to use linear charts in most cases – but I do check stocks I want to trade using both a linear and logarithmic chart. Sometimes it does matter and it’s best to use logarithmic charts. One instance where the need to use logarithmic charts over linear charts is for stocks that have a large price range in a give time frame. This usually does not occur very often on daily charts with a 6 month to 1 year time frame, but occurs regularly with stocks over a long time frame that have large price variations. This is generally encountered with weekly or monthly based charts where the stock or index had a parabolic price movement, either up or down.
Why is this important you ask? Well, in technical analysis, we often use trendlines to identify which way a stock or index is trending. For instance, trendlines tell you if a stock is in an uptrend or downtrend, they also indicate support and resistance zones, as well as identifying important stock patterns such as triangles, flags, pennets, etc. When a stock has had a large price movement in a given period of time (i.e. a parabolic price move) it becomes difficult to draw meaningful trendlines. When a stock’s price goes parabolic, it means that the price moves either up or down in a curve at an ever increasing slope, until eventually it is moving almost straight up or down and forms a pattern much like a half circle or half moon. In other words, the stock price starts at almost a zero degree slope until it reaches almost a 90 degree slope. In science, when data is plotted from an experiment, if often does the same thing. Scientists use logarithmic charts to make the curve a straight line so that they can measure the slope and get an equation. In technical analysis, the log charts do the same thing by taking away the curve in the price movement so that straight lines, or trendlines, can be drawn to connect highs and lows.
Cisco System (CSCO) is perfect example of this phenomenon and illustrates the need to use a logarithmic chart. Below is a multi year linear chart of CSCO. Notice that it is difficult to draw meaningful trend-lines on this chart because of the half-moon shaped curve from the parabolic movement in price over this time frame. Thus, the chart needs to be plotted on a logarithmic scale to give us meaningful data.