Introduction to Technical Analysis
Technical analysis is the study of past price and activity history from charts in order to predict future price movements. The art of technical analysis is to identify patterns in price movements that will then dictate where that market is moving to in the future.
It must be remembered and more importantly understood that the market is not just a number of shares of different companies moving in one direction or another. The market is a number of human beings moving the price of those shares in one direction or another. People make the market change, when they demand more of one share or less of another. This is what moves the price. One may feel that a share price in an individual company has gone up because it has posted a large gain in profits that year. It hasnt. The price of the share has gone up because based on that profit news more people wanted to buy that share. The human beings demanding that share have forced the price up. This concept is crucial to your understanding of technical analysis.
Human nature remains more or less constant and tends to react to similar situations in consistent ways. By studying the nature of previous market turning points, it is possible to identify certain patterns to develop an understanding of where the market is going to move in the future. Technical analysis therefore is based on the assumption that people will continue to make the same mistakes that they made in the past. Human relationships are extremely complex and never repeat in identical combinations. The markets, which as explained are a reflection of people in action, never duplicate their performance exactly, but the recurrence of similar characteristics is sufficient to enable market watchers to identify major junction, or turning points.
Philosophy/Rational behind technical analysis
There are three premises on which technical analysis is based:
- History Repeats Itself
- Prices Move In Trends
- Market Action Discounts Everything
History repeats itself
Much of the body of technical analysis and the study of market action has to do with the study of human psychology. Chart patterns, for example, which have been identified and categorised over the past 100 years, reflect certain standard pictures that appear on price charts. These pictures reveal the bullish or bearish psychology of the market. Since these patterns have worked well in the past, it is assumed that they will continue to work well in the future.
Another way of expressing this premise is that the key to understanding the future lies in the study of the past, or that future is just a repetition of the past.
Prices move in trends
The concept of a trend is absolutely essential to the technical approach. Here again, unless one accepts the premise that markets do in fact trend, there is no point in reading any further. The whole purpose of charting the price action of a market is to identify trends in the early stages of their development and ride on that trend. Furthermore, it is important to realise that a trend in motion is more likely to continue than reverse. A trend will continue until it changes course. This sounds a very obvious concept, but then this is what we are trying to achieve. We are looking for the most probable movement of a market. If the market is going up, it will continue going up until it reverses. If we can identify that market is going up, then we will buy the product until this identification tells us otherwise.
Market action discounts everything
This statement forms what is probably the cornerstone of technical analysis. Unless this premise is understood and accepted then nothing else really makes sense. The technical analyst believes that everything that could affect the price, fundamental, political, psychological or otherwise, is already reflected in the price of that product. It follows therefore, that analysing companies’ profit forecasts is useless, as the market has already priced that into the value of the share. All that is needed therefore, is a study of the price action. While this claim appears at first hand to be rather fantastical and unbelievable, it is hard to disagree with if one takes time to consider its true meaning.
As a rule, chartists do not concern themselves with the reasons why prices rise or fall. Very often, in the early stages of a price trend or at critical turning points, no one seems to know exactly why a market is performing in a certain way. This doesnt matter to a chartist, as he will just look to follow this trend. He knows there are reasons why the market has gone up or down, but he just doesnt believe that knowing what those reasons are is necessary to the forecasting of that price.
It follows then that if everything that affects the market price is ultimately reflected in the market place, then all that is necessary is the study of the price action, not why it moved. By studying price charts and a host of other technical indicators, the chartist in effect lets the market tell him which way it is most likely to go.
Another very important thing that must be borne in mind when discussing technical analysis is that the practice of it is self-fulfilling. There are many millions of traders that treat technical analysis as a religion. When the chart pattern indicates they should buy, they will buy. If it indicates that they should sell, they will sell. If many millions are following the same pattern, the price will do exactly what they thought it would because they are all doing it. If everyone looked at a chart and decided at some point the market would go up, they would all buy it at this point. As they are all buying it at this point, the market will go up, as demand factors on that product will be greater than supply. There are a million technical analysts all buying at this level. We may as well join them.
Charts are primary tools of technical analysis. There are a lot of different types of charts. Usually, the x-axis measures time, while the y-axis measures price level. Charts can be constructed using different intervals; i.e. monthly, weekly, daily and also intra-day charts (e.g. 30 minutes, 5 minutes, tick)
Line charts are usually based on the closing price, which some traders regard as the most important indicator, as its value reflects the whole information made available and digested during the trading day. Line charts contain more data in a compact space than the other types of charts do. They should be used when a large number of points are to be plotted, or when several series are being compared.
Each bar on a bar chart represents price performance for a specific period. These periods could be as long as a month or as short as one minute, depending on the purpose for which the chart is to be used. Daily bar charts are the most popular.
The closing price is indicated by a horizontal protrusion to the right of the bar, while the opening price is indicated by a horizontal protrusion to the left of the bar.
In the 1600s, the Japanese developed a method of technical analysis to analyse the price of rice contracts. This technique is called candlestick charting. Candlestick charts display the open, high, low, and closing prices in a format similar to a modern-day bar-chart, but in a manner that makes it easier to observe the relationship between the opening and closing prices. Each candlestick represents one period (e.g., day) of data.
Candlesticks display the opening and closing prices as a solid body with the highs and lows as additional vertical lines. A clear distinction is made between up and down price moves. The body of an up move is shown as white and a down move as black.
A candlestick showing a DOWNWARD MOVE - the closing price lower than the opening price.
A candlestick showing an UPWARD MOVE - the closing price higher than the opening price.
Candlestick charts dramatically illustrate changes in the underlying supply/demand lines. It is obvious for example, that if a stock price moved far below its open but then rallied back into positive territory by the close of market, there is strong support for that stock. You would not obtain this information from looking at a simple line graph. A candlestick shows the movement during the day, and so at what price people were willing to buy or sell. As with all technical analysis, the interpretation of candlestick charts is based primarily on patterns, which have been observed over many centuries as to how they can be used to predict the price movement of a product. The most popular patterns are explained below.
Long white (empty) line. This is a bullish line. It occurs when prices open near the low and close significantly higher near the period's high.
Hammer. This is a bullish line if it occurs after a significant downtrend. If the line occurs after a significant up-trend, it is called a Hanging Man. A Hammer is identified by a small real body (i.e., a small range between the open and closing prices) and a long lower shadow (i.e., the low is significantly lower than the open, high, and close). The body can be empty or filled-in.
Piercing line. This is a bullish pattern and the opposite of a dark cloud cover. The first line is a long black line and the second line is a long white line. The second line opens lower than the first line's low, but it closes more than halfway above the first line's real body.
Bullish engulfing lines. This pattern is strongly bullish if it occurs after a significant downtrend (i.e., it acts as a reversal pattern). It occurs when a small bearish (filled-in) line is engulfed by a large bullish (empty) line.
Morning star. This is a bullish pattern signifying a potential bottom. The "star" indicates a possible reversal and the bullish (empty) line confirms this. The star can be empty or filled-in.
Long black (filled-in) line. This is a bearish line. It occurs when prices open near the high and close significantly lower near the period's low.
Hanging Man. These lines are bearish if they occur after a significant uptrend. If this pattern occurs after a significant downtrend, it is called a Hammer. They are identified by small real bodies (i.e., a small range between the open and closing prices) and a long lower shadow (i.e., the low was significantly lower than the open, high, and close). The bodies can be empty or filled-in.
Dark cloud cover. This is a bearish pattern. The pattern is more significant if the second line's body is below the center of the previous line's body (as illustrated).
Bearish engulfing lines. This pattern is strongly bearish if it occurs after a significant up-trend (i.e., it acts as a reversal pattern). It occurs when a small bullish (empty) line is engulfed by a large bearish (filled-in) line.
Evening star. This is a bearish pattern signifying a potential top. The "star" indicates a possible reversal and the bearish (filled-in) line confirms this. The star can be empty or filled-in.
Doji star. A star indicates a reversal and a doji indicates indecision. Thus, this pattern usually indicates a reversal following an indecisive period. You should wait for a confirmation (e.g., as in the evening star illustration) before trading a doji star.
Shooting star. This pattern suggests a minor reversal when it appears after a rally. The star's body must appear near the low price and the line should have a long upper shadow.
Long-legged doji. This line often signifies a turning point. It occurs when the open and close are the same, and the range between the high and low is relatively large.
Dragon-fly doji. This line also signifies a turning point. It occurs when the open and close are the same, and the low is significantly lower than the open, high, and closing prices.
Gravestone doji. This line also signifies a turning point. It occurs when the open, close, and low are the same, and the high is significantly higher than the open, low, and closing prices.
Star. Stars indicate reversals. A star is a line with a small real body that occurs after a line with a much larger real body, where the real bodies do not overlap. The shadows may overlap.
Spinning tops. These are neutral lines. They occur when the distance between the high and low, and the distance between the open and close, are relatively small.
Doji. This line implies indecision. The security opened and closed at the same price. These lines can appear in several different patterns. Double doji lines (two adjacent doji lines) imply that a forceful move will follow a breakout from the current indecision.
Harami ("pregnant" in english). This pattern indicates a decrease in momentum. It occurs when a line with a small body falls within the area of a larger body. In this example, a bullish (empty) line with a long body is followed by a weak bearish (filled-in) line. This implies a decrease in the bullish momentum.
The basic trend line is one of the simplest of the technical tools employed by the chartist, but by any standard the most powerful and valuable tool in trading. The trend line is constructed when there are three higher or lower points to be connected. This forms a channel which the price action can be monitored.
As discussed, one of the obvious presumptions derived from chart studies is that prices have a prevailing tendency to move in a particular direction. This trend frequently assumes a definition pattern which evolves along a straight line. This ability of prices to adhere extremely close to an imaginary straight line is one of the most extraordinary characteristics of chart movements.
Drawing a Trend line
The correct drawing of trend lines is an art like every other aspect of charting and some experimenting with different lines is usually necessary to find the right one. Sometimes a trend line which appears to be correct may have to be redrawn. With practice, the art of drawing trend lines becomes easier, but initially there are some useful guidelines in the search for the correct one.
There must be evidence of a trend. This means that, for an up trend line to be drawn there must be at least two reaction lows with the second low higher than the first. Once two ascending lows have been identified, a straight line is drawn connecting the lows and projected up and to the right.
Once the third point has been confirmed and the trend proceeds in its original direction, the trend line becomes very useful in a variety of ways. One of the basic concepts of technical analysis is that a trend in motion will tend to stay in motion. Therefore, once a trend assumes a particular slope or a rate of speed, as identified by the trend line, then it usually maintains the same slope. The trend line then helps not only to determine the extremities of the corrective phases but also importantly, when that trend is changing. Very often the breaking of the trend line is one of the best early warnings of a change in trend.
The Significance of the Trend line
It is very important to discuss how to determine the significance of a trend line. In every market and on every chart you see there are many trends in motions, short term, mid term, long terms, hourly and so on. However, not all these trends will be significantly strong. If they are not, a trader runs the risk of entering or exiting the market at the wrong time. The more significant a trend line, the more confidence it inspires and the more important its penetration. There are two factors that determine the significance of a trend line. Firstly, the length of time it has been intact, and secondly how many times it has been tested. A trend line that the market has tested 8 times for example, but keeps pushing the price away, is obviously a more significant trend line than one that has only been tested twice. As a rough estimate after the third bounce off the trend line will be when the market will start to offer trading signals. Similarly, a trend line that has been intact for the last 9 months is of more importance than one that has been intact for 9 weeks. There is no standard as to what duration one needs to wait before relying on the trend, as some trends will only stay in motion for short periods of time. To catch these, you have to use the time in conjunction with the testing of the line. Upward trend An up trend line is a straight line drawn up to the right of the chart along successive higher highs and lows.
Downward trend A down trend line is a straight line drawn down to the left of the chart along successive lower highs and lows.
Range trading The prices move up and down in a horizontal trading channel for an extended period of time.
Support and Resistance
Support and resistance levels are ones of the most basic but essential components of technical analysis. Support and resistance are price areas where an abundance of trading has taken place and where considerable buying or selling pressure exists. Underlying support (buying pressure) keeps a market in an uptrend, and overhead resistance (selling pressure) keeps a market trending lower. Once a trader can accurately determine where these levels are, they can be used very effectively to manage risk, and identify profit opportunities. By entering trades at price levels at which a significant move is likely, the probability or reward over risk is improved. There are support and resistance levels that are applicable to every traders time frame. Observing how the market reacts when encountering these levels is a very good barometer to measure the strength of the underlying trend. They are also key points for breakout moves. Large quantities of stop loss orders will usually accumulate at key support and resistance areas and will often contribute to a dramatic surge in the market in the direction of the breakout once these areas have been penetrated.
A support level is a price area at which there should be an increase in the demand for that product. A support area is not difficult to find in a chart. When the market is in an uptrend, any previously established congestion area is the uptrend is usually an area of support. To draw a support line you need to find at least 2 points on the chart that adhere to this criteria. This then forms a line that can be extended across the chart.
When a support area is penetrated on the downside, it then may become the nearest resistance area to a subsequent advance.
A resistance level is a price area characterised by increased selling pressure or increased supply of a particular investment product which tends to level off advances. If the market is in an uptrend, any point at which new highs are reached or any congestion on the upside will act as resistance. To draw a resistance line you need to find at least 2 points on the chart which adhere to this criterion. This then forms a line which can be extended across the chart.
When a resistance area is penetrated on the upside, it may become then the nearest support area to any subsequent decline.
Probably more money is being traded today using moving averages than with all other technical indicators combined. They are very simple to calculate, and can be used for everything from finding very long term monthly trends to setting stops for day trading, and also for determining solid entry and exit points in the market.
Moving averages smooth out market fluctuations and short-term volatility to give the trader some idea of which way the market is going. That in itself is a useful tool for any trader, but they offer much more information.
A moving average is an indicator that shows the average value of a security's price over a period of time. When calculating a moving average, a mathematical analysis of the security's average value over a predetermined time period is made. When calculating a moving average, you specify the time span to calculate the average price (e.g., 25 days). As the security's price changes, its average price moves up or down.
A "simple" moving average is calculated by adding the security's prices for the most recent "n" time periods and then dividing by "n." For example, adding the closing prices of a security for most recent 25 days and then dividing by 25. The result is the security's average price over the last 25 days. This calculation is done for each period in the chart.
The most popular method of interpreting a moving average is to compare the relationship between a moving average of the security's price with the security's price itself. A buy signal is generated when the security's price rises above its moving average and a sell signal is generated when the security's price falls below its moving average.
This signal is generated because it is considered that the moving average line is a strong level of support or resistance for the price. The price should bounce off the moving average. If it does not, and breaks through, then it should continue in that direction until it finds a new level to rest at.
Short term moving averages tend to generate more buying/selling signals. However, some of them are false.
Long term moving averages tend to be more reliable and generate fewer entry signals. However, as the move may be well under way, before the signal is generated, a substantial part of the move may be missed.
Multiple Moving Average
Multiple Moving Averages
Moving averages can become more powerful when more than one is plotted on the same chart. We would use one long term average (for example 40 day) and one short term average (for example 20 day). These are used separately from the actual price action of the product we are charting. A buy signal would be generated when the short-term average moves above the long-term average line if both lines are directed upwards. A sell signal would be generated when the short-term average moves below the long-term average line if both lines are directed downwards.
Moving averages only work well in trending markets. When a market fluctuates in a narrow trading channel, moving average generate only false signals.
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