Technical Analysis
Unlike fundamental analysis, technical chartists are not interested in company data, forecasts, currency movements etc. They predict the future movement of price by looking at historical price. All the news and data makes up the price movement which can be seen on charts.
Technical analysis uses chart patterns which are created from the movement of price, and a number of indicators to help the chartists analyze the future movement of the price.
Chart Patterns
Chart patterns are a very important part of technical analysis. They are used to spot possible price reversals and for spotting continuations in current trends. Below are some of the more popular chart patterns.
Reversal Patterns:
Double Tops & bottoms- Double bottoms can be a sign of a possible bottom which could mean the current trend is coming to an end and a reversal is going to take place. The price has been in a downtrend and then pulls back. It then continues rising then stops, and starts it's way back down again. It then stops and works it's way back up again. A double bottom is known as a W as that's the shape it takes. Once the neck of the W is broken this can be a good place to enter long. If the neck doesn't break and then starts a downtrend, this show that particular security is weak and is struggling to find strength. The possibility of a stronger double bottom is when the second low of the W is higher than the first low. Double tops are the inverse of the double bottom.
The line going across where the middle point of the W touches is called the neck. Once the neck line is broken the trader will be looking at the volume to see if this is increasing. If this is increasing whilst the price is rising this is a good sign the bulls are taking control for a reversal.
Double Top
The line going across where the middle point of the W touches is called the neck. Once the neck line is broken the trader will be looking at the volume to see if this is increasing. If this is increasing whilst the price is dropping, this is a good sign the bears are taking control for a reversal.
Rounded Tops & Bottoms- Rounded tops and bottoms are not as common as double tops and bottoms, but when they do happen they should be taken notice of. They are another reversal pattern which indicate a possible top or bottom has been hit.
Rounded Top
The price has been in an uptrend and then slows down. It then starts forming an arched shape where the bulls and the bears are fighting, but neither are taking full control. Once the price breaks the neckline (this is found by drawing a horizontal line across from where the formation started) and volume starts to pick up this is a good sign the bears have taken control and a possible reversal has occurred.
Rounded Bottom
The price has been in an down trend and then slows down. It then starts forming an arched shape where the bulls and the bears are fighting, but neither are taking full control. Once the price breaks the neckline (this is found by drawing a horizontal line across from where the formation started) and volume starts to pick up this is a good sign the bulls have taken control and a possible reversal has occurred.
Head & Shoulders- the head and shoulders is another reversal pattern. The price has been in a downtrend for some time. It then pulls back slightly which is then followed by a drop in price. Suddenly there is some bullish activity and the price rises to a now developed neck line. There is a slight pull back and then the price continues to rise breaking the neck line. By now you should be watching the volume. If it is continuing to increase this is a good sign that the bulls are taking control.
A head and shoulders pattern can occur in an uptrend. The price has been in an uptrend and then pulls back slightly to create the left shoulder. The bulls then continue to push the price up until the bears take over and pull the price back to the new formed neck line. There is a slight pull back from the bulls (forming the right shoulder) and then the bears take full control and break the neck line where the price continues to drop. Once the neck line is broken the trader should be looking at the volume. If this is rising whilst the price is dropping, this is a good indication that the bears have taken control and a reversal may be occurring.
Continuation Patterns:
Cup & Handle- this pattern is a good pattern for spotting a continuation in the current trend. It occurs when price starts to hit new highs or lows. It then fails to break the high or low, and then pulls back between 30-40% of the prior trend. It then starts to form a shape like the rounded top or bottom and tries to test the high or low once again. It fails and then starts to pull back about 20-30% of the 'U' that was created. This pull back creates the handle of the cup. Price then turns and starts heading up to test the current trend line. once it has broken the trend line and volume starts to increase, this is a good sign the price is going to test and possibly break the high or low. The more like a 'U' shape the bowl is, the higher the possibility of the pattern being created. 'V' shape bottoms or tops should be avoided and handles that are too deep should also be avoided.
Pennants & Flags- Pennants happen after a consolidation of price takes place during an trend. The price then moves withing a range that gets smaller and smaller as volume diminishes. There is then a sharp increase of volume with an increase of price which then continues to make new highs or lows.
The flag pattern is another continuation pattern that takes a break after a trend. It pulls back slightly and consolidates in a range. A channel can be drawn, and the channel can be used as support and resistance. Once the resistance is broken and there is an increase in volume, this can be interpreted as a continuation of the trend.
Rectangles- Rectangle patterns are usually used as continuation patterns. The price has been trending and then starts to consolidate. It starts to range where a channel is created. The highs and lows are being tested during the consolidation channel but the bulls and bears are undecided. Eventually the channel is broken in the direction of the previous trend, and the price starts to increase whilst the volume increases.
Triangles- There are symmetrical triangles, ascending and descending triangle patterns. Symmetrical triangles are formed when there is a consolidation period between the bulls and the bears. A side way triangle shape is formed when there is a move to the upside with a sharp pull back of the price and vice-versus. Once the price has broken through the triangle resistance line the price should continue to rise in the direction of the trend.
Ascending triangles have a higher probability if found in an uptrend. The bottom part of it forms a trend line whilst the top of the line can be quite flat. The volume starts to diminish and the range becomes narrow. Once the price breaks the top of the triangle and the volume starts to pick up, this is a good sign of a continuation of the trend.
Descending triangles have a higher possibility once found in a downtrend. The top line forms a trend line and the bottom line is quite flat. The volume starts to diminish and the range become narrow. Once the price breaks the bottom of the triangle and the volume starts to pick up, this is a good sign of a continuation of the trend.
Indicators
Indicators help the chartists confirm the direction of where the price may be heading. It must be realized that there are thousands of indicators as more and more custom indicators are being put together which are being used by traders. A number of the more popular indicators are mentioned below:
Average directional movement (ADX)- this is a trending indicator which shows you the strength of the trend but not the direction of the trend. It has a scale between 0-100. Once the line crosses up above the 30 line this can start to show the beginning of good strength in the trend. When the ADX is at 70 the trend is in full strength. Once it goes around 80 and starts turning south, the trend has lost steam and is coming to the end.
Bollinger Bands- this is a trending indicator and is one of the most popular indicators that is used by traders. They are used to determine a break out by combining a moving average, an upper standard deviation (upper band) and a lower standard deviation (lower band).
Commodity channel index (CCI)- this indicator is used to identify over-brought and over-sold conditions. The price is said to be over-brought once the CCI line goes above 100. If the line then drop back below the 0 line this can be an indication to go short. Conversely, the price is said to be over-sold once it drops below the -100 line. If the CCI line then goes back above the -100 line this can be a signal that the price might rise.
Directional movement indicator (DMI)- this is part of the ADX indicator and can be seen on the chart as %2BDMI and -DMI lines. If the %2BDMI line crosses above the -DMI line this can be seen as the possibility of the start of a trend. If the -DMI line crosses below the %2BDMI this can be part of a sell confirmation.
Exponential moving average (EMA)- this indicator is used to spot reversals and a possible start of a trend. They react quicker than normal moving averages, which can be an advantage if the trade does continue in that direction. The main problem is EMA's can give false signals due to whipsaws.
Fibonacci- the most used Fibonacci tool is the Fibonacci retracement. This is found by taking the high and low of a trend and placing the retracement tool. This will draw percentages of that movement. The key levels being 23.8%, 32.8%, 50%, 61.8% and 100%. The 50% retracement is a popular level that is used. For instance, say the price has been in an uptrend for some time. The price then starts to correct as some traders are starting to take some profit from the trade. The 50% retracement level would then be a key point for traders then to start buying again as the price could start continuing it's trend to the upside.
Gann theory- the Gann theory is based on fans that are drawn from peaks and bottoms, which are then used for support and resistance. Once a major fan is broken it can be an indication the price is going to continue moving in that direction.
Hull moving average- this is an improvement to the standard moving average offering a smoothing which reduces lag. It can be used to spot the start or end of the trend.
Keltner Channel- this indicator is similar to the bollinger bands, but it measures the volatility of the price movement with an upper and lower moving average band. If the price closes above the upper band it could signal a start of an up trend. If the price closes below the lower band this could signal a start of a down trend. The Keltner channel also works well with range trading strategies which can be seen by clicking the link below.
Linear regression channel- the linear regression channel is made up of a linear regression line, an upper channel line and a lower channel line. The channel is used to spot potential reversals of price. If the price drops below the lower channel line, it is said to be in the buy zone area. Other indicators can then be used to confirm the price moving to the upside. If the price moves above the top regression line it is said to be in the sell zone. Other indicators can be used to confirm a reversal in price.
Moving average convergence divergence (MACD)- this is a very popular indicator which is used to detect the beginning of a trend. There are 3 components to this indicator. The first being the MACD which is normally set to a 12 EMA minus a 26 EMA. Next is the signal line which is normally set to a 9 EMA. The third part is the MACD histogram. Sometimes you may find the histogram by itself without the moving averages. A buy signal is in place when the12-26 EMA line crosses above the 9 EMA line. The indicator has a scale and the trend it more likely to be stronger if the cross over happens below the 0 line. A sell signal is in place when the 12-26 EMA crosses below the 9 EMA. This is a stronger if it happens above the 0 line.
On balance volume (OBV)- the on balance volume indicator combines volume with price to determine whether a certain price movement has strength or weakness. It adds or takes away volume at the close of a bar. If the price is rising and the OBV continues to rise, you know there is strength in the price movement as buying volume is increasing. But if the price makes higher highs whilst the OBV makes lower lows, you know there is a possibility of a price reversal. If the price falls and the OBV keeps falling you know there is strength in the downtrend as there is a continuing selling volume. But if the price makes lower lows and the OBV makes higher highs, there is a possibility of a price reversal. Spotting divergences between price and the OBV indicator indicates a good possibility of a reversal.
Parabolic stop and reverse (SAR)- this indicator works by combining time and price to generate buy and sell signals. It is also very useful for placing stop losses and take profit positions. A buy signal is created once price is closed above the upper SAR dot. If you were short, once the price closed below the upper SAR dot this would be a time to close your position. A sell signal is created once price closes below the lower SAR dot. If you were in a long position and the price close below the lower SAR dot, this would be a sign to close your position.
Relative strength index (RSI)- the relative strength index is an oscillating indicator which measures the size of gains and losses which are recentto try and determine whether the price is over brought or oversold. It has a scale ranging from 0-100. 0-30 being the oversold zone and 70-100 being the over brought zone. A buy signal is generated once the RSI goes through the 30 line. A sell signal is generated once the RSI goes below the 70 line.
Stochastic- this is a very popular oscillating indicator. It can also be used to spot the beginning of trends. It is created by comparing the closing price of a security to it's price range over a given time. It contains two lines known as the %D and %K lines. They fluctuate on a scale of 0-100 like the RSI. 20 and below represents the oversold area and 80 above represents the over brought zone. A buy signal is in place when the %D and %K lines crossover above the 20 value. A sell signal is in place when the %D and %K lines crosses below the 80 value. The stochastic indicator works best in a choppy market condition.
Triangular moving average (TMA)- the triangular moving average is a smoothed out simple moving average. It is simply smoothed out twice to reduce lagging and to produce a wave look which is easier to see. When the price crosses and closes above the TMA a buy signal is produced. When price closes below the TMA a sell signla is produced. The TMA can also act as support and resistance.
Ultimate oscillator- this indicator combines 3 different time periods of price action that gives over brought and oversold conditions. 30 being the oversold line and 70 being the over brought line. It is also used to spot divergences between the indicator and price.
Volume- this is a very important indicator. It reflects the amount of people that have placed a trade within that trading session. If the price is rising and volume is increasing this indicates there is good buying power. If the price is falling and the volume is increasing this shows there is good selling power. Volume can also be used to spot reversals by watching the volume bars. If the price has been in a downtrend the bars will be falling. If the volume bars start rising and the price starts rising this might show the bears have backed off and the bulls are starting to take control. The converse for an uptrend. Volume is also very important when buying stocks. If you want to buy a stock but you check it's volume is usually low it is a good sign not to enter. Remember, it is always easy to get into a trade but it isn't always easy to get out. You want to be trading stocks with a high daily volume.
Williams %R- this is another indicator that looks for over brought and oversold conditions. Like nearly all over brought and oversold indicators it has a scale of 0-100. 20 and below being the oversold zone and 80 and above being the over brought zone. It is very similar to the fast stochastic indicator.
Zig Zag indicator- the zig zag indicator is used for determining trends. It is a line that connects the highs and lows of the price movement. It is also very usefull in spotting chart patterns as the connecting line make the patterns more visible. Support and resistance levels also becomes easier to visualize. This can be useful for drawing extra lines to mark out possible break out points.
