Technical analysis definition:
Technical analysis is the examination of past price movements to forecast
future price movements. Technical analysts are sometimes referred to as
chartists because they rely almost exclusively on charts for their analysis.
Technical analysis is applicable to stocks, indices, commodities, futures or
any tradable instrument where the price is influenced by the forces of
supply and demand. Price refers to any combination of the open, high, low or
close for a given security over a specific timeframe. The time frame can be
based on intraday (tick, 5-minute, 15-minute or hourly), daily, weekly or
monthly price data and lasts for few hours or many years.
In other words technical analysis is defined as the art of identifying a
trend reversal at a relatively early stage and riding on that trend until
the weight of the evidence shows or proves that the trend has reversed.
Technical basics:
Price Discounts Everything: This theorem is similar to the strong and
semi-strong forms of market efficiency. Technical analysts believe that the
current price fully reflects all available information. Because all
information is already reflected in the price, it represents the fair value
and should form the basis for analysis. After all, the market price reflects
the sum knowledge of all participants, including traders, investors,
portfolio managers, buy-side analysts, sell-side analysts, market
strategist, technical analysts, fundamental analysts and many others. It
would be folly to disagree with the price set by such an impressive array of
people with impeccable credentials. Technical analysis utilizes the
information captured by the price to interpret what the market is saying
with the purpose of forming a view on the future.
Prices Movements are not Totally Random: Most technicians agree that prices
trend. However, most technicians also acknowledge that there are periods
when prices do not trend. If prices were always random, it would be
extremely difficult to make money using technical analysis.
A technician believes that it is possible to identify a trend, invest or
trade based on the trend and make money as the trend unfolds. Because
technical analysis can be applied to many different timeframes, it is
possible to spot both short-term and long-term trends.
What is more Important than Why: A technical analyst knows the price of
everything, but the value of nothing". Technicians, as technical analysts
are called, are only concerned with two things:
1. What is the current price?
2. What is the history of the price movement?
The price is the end result of the battle between the forces of supply and
demand for the company's stock. The objective of analysis is to forecast the
direction of the future price. By focusing on price and only price,
technical analysis represents a direct approach. Fundamentalists are
concerned with why the price is what it is. For technicians, the why portion
of the equation is too broad and many times the fundamental reasons given
are highly suspected. Technicians believe it is best to concentrate on what
and never mind why. Why did the price go up? It is simple, more buyers
(demand) than sellers (supply). After all, the value of any asset is only
worth what someone is willing to pay for it. Who needs to know why?
Conclusion
The markets move in trends caused by the changing attitudes and expectations
of investors with regard to the business cycle, an understanding of the
historical relationships between certain price averages and market
indicators can be used to identify turning points. No single indicator can
ever be expected to signal all trend reversals, so it is essential to use a
number of them together to build up consensus.
Chart analysis
The chart represents a price chart and is a sequence of prices plotted over
a specific timeframe. In statistical terms, charts are referred to as time
series plots.
On the chart, the y-axis (vertical axis) represents the price scale and the
x-axis (horizontal axis) represents the time scale. Prices are plotted from
left to right across the x-axis with the most recent plot being the furthest
right.
Technicians, technical analysts and chartists use charts to analyze a wide
array of securities and forecast future price movements. The word
"securities" refers to any tradable financial instrument or quantifiable
index such as stocks, bonds, commodities, currencies, futures or market
indices. Any instrument with price data over a period of time can be used to
form a chart for analysis.
Chart types
We will be explaining the construction of line, bar, candlestick and point &
figure charts. Although there are other methods available, these are four of
the most popular methods for displaying price data.
Line chart
The line chart is one of the simplest charts. It is formed by plotting one
price point, usually the closing price of a security over a period of time.
Connecting the dots or price points over a period of time creates the line.
Some investors and traders consider the closing level to be more important
than the open, high or low levels. By paying attention to only the closing
price, intraday swings can be ignored. Line charts are also used when open,
high and low data points are not available.
Bar Chart
Perhaps the most popular charting method is the bar chart. The high, low and
close values are required to form the price plot for each period of a bar
chart. The high and low are represented by the top and bottom of the
vertical bar and the close is the short horizontal line crossing the
vertical bar. On a daily chart, each bar represents the high, low and close
for a particular day. Weekly charts would have a bar for each week based on
Friday's close and the high and low for that week.
Candle stick chart
Originating in Japan over 300 years ago, candlestick charts have become
quite popular in recent years. For a candlestick chart, the open, high, low
and close values are all required. A daily candlestick is based on the open
price, the intraday high and low, and the closing price. A weekly
candlestick is based on Monday's open, the weekly high-low range and
Friday's close.
Many traders and investors believe that candlestick charts are easy to read,
especially the relationship between the open and the close values. White
(clear) candlesticks form when the close is higher than the open and black
(solid) candlesticks form when the close is lower than the open. The white
and black portion formed from the open and close values is called the body
(white body or black body). The lines above and below are called shadows and
represent the high and low.
Point & Figure Chart:
The charting methods show all plot in one data point for each period of
time. No matter how much prices moved, each day or week is represented by
one point, bar or candlestick along the time scale. Even if the price is
unchanged from day to day or week to week, a dot, bar or candlestick is
plotted to mark the price action. Contrary to this methodology, Point &
Figure Charts are based solely on price movements and do not take time into
consideration. There is an x-axis but it does not extend evenly across the
chart.
The beauty of Point & Figure Charts is their simplicity. Little or no price
movement is deemed irrelevant and therefore not duplicated on the chart.
Only price movements that exceed specified levels are recorded. This focus
on price movements makes it easier to identify support and resistance
levels, bullish breakouts and bearish breakdowns.
Market trends
A trend is a time measurement of the direction in price levels covering
different time span. There are many trends, but the three that are most
widely followed are:
Primary: it is between 9 months and 2 years and is a reflection of
investor's attitude towards unfolding fundamentals in the business cycle.
The business cycle extended statistically from trough to trough
approximately 3.6 years, so it follows that rising and falling primary
trends (BULL and BEAR markets) lasts for 1 to 2 years. Since building up
takes longer than tearing down, bull markets generally last longer than bear
markets.
The primary trend cycle is operative for bonds, equities and commodities.
Primary trends also apply to currencies, but since currencies reflect
investor's attitudes toward interrelationships among two different
economies.
Intermediate: Anyone who has looked at a price chart will notice that the
prices do not move in a straight line. A primary upswing is interrupted by
several reactions along the way. These countercyclical trends within the
confines of a primary bull market are known as intermediate price movements.
They last anywhere from 6 weeks to as long as 9 months, sometimes even
longer, but rarely shorter.
Its important to have an idea of the direction and maturity of the primary
trend, but an analysis of intermediate trend is also helpful for improving
success rates in trading, as well as for determining when the primary
movement may have run its course.
Short term: Short-term trends typically last from 2 to 4 weeks, sometimes
shorter and sometimes longer. They interrupt the course of the intermediate
cycle, just as the intermediate-term trend interrupts primary price
movements. Short-term trends are shown in the market cycle model as a dotted
line figures, they are usually influenced by random news events and are far
more difficult to identify then their intermediate or primary counterparts.
Trend lines
Technical analysis is built on the assumption that prices trend. Trendlines
are an important tool in technical analysis for both trend identification
and confirmation. A trendline is a straight line that connects two or more
price points and then extends into the future to act as a line of support or
resistance. Many of the principles applicable to support and resistance
levels can be applied to trendlines as well.
It takes two or more points to draw a trendline. The more points used to
draw the trendline, the more validity attached to the support or resistance
level represented by the trendline. It can sometimes be difficult to find
more than 2 points from which to construct a trendline. Even though
trendlines are an important aspect of technical analysis, it is not always
possible to draw trendlines on every price chart. Sometimes the lows or
highs just don't match up and it is best not to force the issue. The general
rule in technical analysis is that it takes two points to draw a trendline
and the third point confirms the validity.
Ascending trend line
An ascending trend line has a positive slope and is formed by connecting two
of more low points. The second low must be higher than the first for the
line to have a positive slope. Ascending trend lines act as supports and
indicate that net-demand (demand less supply) is increasing even as the
price rises. A rising price combined with increasing demand is very bullish
and shows a strong determination from the buyers. As long as prices remain
above the trendline, the upside trend is considered solid and intact. A
break below the upside trend line indicates that net-demand has weakened and
a change in trend.
Descending trend line
A descending trend line has a negative slope and is formed by connecting two
or more high points. The second high must be lower than the first for the
line to have a negative slope. Downside trend lines act as resistance and
indicate that net-supply (supply less demand) is increasing even as the
price declines. A declining price combined with increasing supply is very
bearish and shows a strong resolve from the sellers. As long as prices
remain below the downside trendline, the downtrend is considered solid and
intact. A break above the downside trend line indicates that net-supply is
decreasing and a change of trend could be imminent.
The Support and resistance: represent key junctures where the forces of
supply and demand meet. In the financial markets, prices are driven by
excessive supply (down) and demand (up). Supply is synonymous with bearish,
bears and selling. Demand is synonymous with bullish, bulls and buying.
These terms are used interchangeably throughout this and other articles. As
demand increases, prices advance and as supply increases, prices decline.
When supply and demand are equal, prices move sideways as bulls and bears
battle it out for control.
The definition of the support
Support is the price level at which demand is thought to be strong enough to
prevent the price from declining further. The logic dictates that as the
price declines towards support and gets lower, buyers become more tempted to
buy and sellers become less tempted to sell. By the time the price reaches
the support level, it is believed that demand will overcome supply and
prevent the price from falling below the support level.
Support levels do not always hold and a break below support signals that the
bears have won out over the bulls. A decline below the support indicates a
new willingness to sell and/or a lack of incentive to buy. Support breaks
and new lows signal that sellers have reduced their expectations and are
willing to sell at even lower prices. In addition, buyers could not be
persuaded into buying until prices declined below the support or below the
previous low. Once a support is broken, another support level will have to
be established at a lower level.
The definition of the resistance
Resistance is the price level at which selling is thought to be strong
enough to prevent the price from rising further. The logic dictates that as
the price advances towards resistance, sellers become more tempted to sell
and buyers become less tempted to buy. By the time the price reaches the
resistance level, it is believed that supply will overcome demand and
prevent the price from rising above the resistance.
Resistance levels do not always hold and a break above a resistance signals
that the bulls have won out over the bears. A break above a resistance shows
a new willingness to buy and/or a lack of incentive to sell. Resistance
breaks and new highs indicate buyers have increased their expectations and
are willing to buy at even higher prices. In addition, sellers could not be
persuaded into selling until prices rise above the resistance or above the
previous high. Once a resistance is broken, another resistance level will
have to be established at a higher level.
Candle stick patterns
In the 1600s, the Japanese developed a method of technical analysis to
analyze the price of rice contracts. This technique is called candlestick
charting. Candlestick charts are simply a new way of looking at price; they
don't involve any calculations.
Candlestick charts are much more visually appealing than a standard
two-dimensional bar chart. As in a standard bar chart, there are four
elements necessary to construct a candlestick chart, the OPEN,HIGH, LOW and
CLOSING price for a given time period. Below are examples of candlesticks
and a definition for each candlestick component:
Technical indicators
Relative Strength Index (RSI):
This index is a popular indicator for the Forex (FX) market. The RSI
measures the ratio of up-moves to down-moves and normalizes the calculation
so that the index is expressed in a range of 0-100. If the RSI is 70 or
greater then the instrument is seen as overbought (a situation whereby
prices have risen more than market expectations). An RSI of 30 or less is
taken as a signal that the instrument may be oversold (a situation whereby
prices have fallen more than market expectations).
Stochastic Oscillator:
This is used to indicate overbought/oversold conditions on a scale 0-100%.
The indicator is based on the observation that in a strong upside trend,
closing prices for periods tend to be concentrated in the higher part of the
period’s range. Conversely, as prices fall in a strong downside trend,
closing prices tend to be near to the extreme low of the period range.
Stochastic calculations produce two lines, %K and %D which are used to
indicate overbought/oversold areas of a chart. Divergence between the
stochastic lines and the price action of the underlying instrument gives a
powerful trading signal.
Moving Average Convergence Divergence (MACD):
This indicator involves plotting two momentum lines. The MACD line is the
difference between two exponential moving averages and the signal or trigger
line which is an exponential moving average of the difference. If the MACD
and trigger lines cross, then this is taken as a signal that a change in
trend is likely.
Number theory
Fibonacci numbers:
The Fibonacci number sequence (1, 1, 2, 3, 5, 8, 13, 21, 34…..) is
constructed by adding the first two numbers to determine the third n umber
that follows. The ratio of any number to the next larger number is 62%,
which is a popular Fibonacci retracement level. The inverse of 62%, which is
38%, is also used as a Fibonacci retracement level. (Combined with the
Elliott wave theory, see hereunder)
Gann numbers:
W.D. Gann was a stock and a commodity trader working in the 50’s who
reputedly made over $50 million in the markets. He made his fortune using
methods which he developed for trading instruments based on relationships
between price movement and time, known as time/price equivalents. There is
no easy explanation for Gann’s methods, but in essence he used angles in
charts to determine support and resistance areas and predict the times of
future trend changes. He also used lines in charts to predict support and
resistance areas.
Waves
Elliott wave theory:
The Elliott wave theory is an approach to market analysis that is based on
repetitive wave patterns and the Fibonacci sequence. An ideal Elliott wave
patterns shows five advancing waves followed by three waves of decline.
Gaps:
Gaps are spaces left on the bar chart where no trading has taken place.
An ascending gap is formed when the lowest price on a trading day is higher
than the highest price of the previous day.
A descending gap is formed when the highest price of the day is lower than
the lowest price of the prior day.
An ascending gap is usually a sign of market's strength, while a descending
gap is a sign of market's weakness.
A breakaway gap is a price gap that forms on the completion of an important
price pattern. It signals usually the beginning of an important price move.
A runaway gap is a price gap that usually occurs around the mid-point of an
important market trend. For that reason, it is also called a measuring gap.
An exhaustion gap is a price gap that occurs at the end of an important
trend and signals that the trend is ending.
Trends:
A trend refers to the direction of prices.
Rising peaks and troughs constitute an upside trend; falling peaks and
troughs constitute a downside trend, that determines the steepness of the
current trend. The breaking of a trend line usually signals a trend
reversal. A trading range is characterized by horizontal peaks and troughs.
Moving averages are used to smooth price information in order to confirm
trends and support and resistance levels. They are also useful in deciding
on a trading strategy particularly in futures trading or a market with a
strong upside or a downside trend.
For simple moving averages, the price is averaged over a number of days. On
each successive day, the oldest price drops out of the average and is
replaced by the current price. Hence, it calculates the average for the
daily moves. Exponential and weighted moving averages use the same technique
but weight the figures-least weight to the oldest price, most to the
current.
Chart formations
Head and shoulders pattern:
A technical analysis term used to describe a chart formation in which
represented by an instrument's price:
1. Rises to a peak and subsequently declines.
2. Then, the price rises above the
former peak and again declines.
3. And finally, rises again, but not to the second peak, and declines once
more. The first and third peaks are shoulders, and the second peak forms the
head.
A head and shoulders reversal pattern forms after an upside trend, and its
completion marks a trend reversal. The pattern contains three successive
peaks with the middle peak (head) being the highest and the two outside
peaks (shoulders) being low and roughly equal. The lows of each peak can be
connected to form support, or a neckline.
Head and Shoulders Bottom (Reversal):
A chart pattern used in technical analysis to predict the reversal of a
current downside trend, this pattern is identified when the price of a
security meets the following characteristics:
1. The price falls to a trough and then rises.
2. The price falls below the former trough and then rises again.
3. Finally, the price falls again, but not as far as the second trough.
Once the final trough is made, the price heads upward toward the resistance
found near the top of the previous troughs. Investors typically enter into a
long position when the price rises above the resistance of the neckline. The
first and third troughs are considered shoulders, and the second peak forms
the head.
The head and shoulders bottom is sometimes referred to as an inverse head
and shoulders. The pattern shares many common characteristics with its
comparable partner, but relies more on volume patterns for confirmation. As
a major reversal pattern, the head and shoulders bottom forms after a
downside trend, and its completion marks a change in trends. The pattern
contains three successive troughs with the middle trough (head) being the
deepest and the two outside troughs (shoulders) being shallower. Ideally,
the two shoulders would be equal in height and width. The highs in the
middle of the pattern can be connected to form a resistance.
Double tops reversal:
A term used in technical analysis to describe the rise of a stock, a drop,
another rise to the same level as the original rise, and finally another
drop.
The double top is a major reversal pattern that forms after an extended
uptrend. As its name implies, the pattern is made up of two consecutive
peaks that are roughly equal, with a moderate trough in between.
Double Bottom:
A charting pattern used in technical analysis. It describes the drop of a
stock (or index), a rebound, another drop to the same (or similar) level as
the original drop, and finally another rebound.
The double bottom is a major reversal pattern that forms after an extended
downside trend. As its name implies, the pattern is made up of two
consecutive troughs that are roughly equal, with a moderate peak in between.
Falling Wedge:
A technical chart pattern composed of two converging lines connecting a
series of peaks and troughs.
Falling wedges indicate temporary interruptions of upward price rallies.
Rising wedges indicate interruptions of a falling price trend. Technical
analysts see a 'breakout' of this wedge pattern as either bullish (on a
breakout above the upper line) or bearish (on a breakout below the lower
line).
Triangle
A technical analysis pattern created by drawing trendlines along a price
range that gets narrower over time because of lower tops and higher bottoms.
Variations of a triangle include ascending and descending triangles.
Triangles are very similar to wedges and pennants.
The symmetrical triangle, which can also be referred to as a coil, usually
forms during a trend as a continuation pattern. The pattern contains at
least two lower highs and two higher lows. When these points are connected,
the lines converge as they are extended and the symmetrical triangle takes
shape. You could also think of it as a contracting wedge, wide at the
beginning and narrowing over time.
Price Channel:
When charting the price of an asset, this is the space on the chart between
an asset's support and resistance levels. The price of the asset will stay
within the support and resistance levels until a breakout occurs.
Range traders will buy an asset when its price is near the bottom of the
trading channel and sell it when the price gets closer to the top of the
trading channel, making a profit from the price spread. Trading channels may
be flat, ascending or descending