Popular in Course
verified elite notetaker
Popular in Finance
This 40 page Document was uploaded by an elite notetaker on Monday December 21, 2015. The Document belongs to a course at a university taught by a professor in Fall. Since its upload, it has received 9 views.
Reviews for Technical-Analysis-Explained-pdf
Report this Material
What is Karma?
Karma is the currency of StudySoup.
You can buy or earn more Karma at anytime and redeem it for class notes, study guides, flashcards, and more!
Date Created: 12/21/15
Explained 1 Contents Introduction 3 Chapter 1 4-7 1.1 Deﬁnition of Technical Analysis 4 1.2 Philosophy of Technical Analysis 4 1.3 Technical Analysis vs. Fundamental Analysis 5 1.4 Technician or Chartist? Is There Any Difference? 6 1.5 Different Theories on Technical Analysis 6 Chapter 2 8-19 2.1 Deﬁnition of Trend 8 2.2 Types of Trends 8 2.3 Support and Resistance Levels 10 2.4 Trend Reversal 11 2.5 Trendline 13 2.6 Channel Line 15 2.7 Percentage Retracements 16 2.8 Price Gaps 17 2.9 Trend Classiﬁcation 18 Chapter 3 20-33 3.1 What is a Chart? 20 3.2 Types of Charts 22 3.3 Chart Patterns 25 3.3.1 Reversal Chart Patterns 25 3.3.2 Continuation Chart Patterns 29 3.4 The Importance of Volume 32 Chapter 4 34-38 4.1 What is a Technical Indicator? 34 4.2 Various Classiﬁcations of Technical Indicators 34 4.3 Major Technical Indicators 34 Conclusion 39 Bibliography 40 Introduction Theﬁnancialmarketisoneofthemostexcitingandfast-pacedmarketsintheworldwhichday by day attracts new traders and investors. Though it provides plenty of opportunity for investors in order to be successful, each investor should understand the basics behind marketmovementsandanalyzesecurities. The methods used for analyzing securities and making investment decisions fall into two categories: fundamental and technical analysiFundamental analysis considers macroeconomic factors to estimate the value of a security, while technical analysis is constrained only to the price movements in the market. Technical analysis attempts to understand the market psychology by studying the market itself. For this reason, some risk/returnanalysisormarketpsychology.the use of such kind of market analysis might be At its core technical analysis is a method of determining if a security or the market is worth buying or selling. If one understands the essence, beneﬁts and limitations of technical analysis, it can give him new skills to become a better trader.And as John Murphy, the father of inter-market technical analysis, states “Technical analysis is a skill that improves with experienceandstudy.Alwaysbeastudentandkeeplearning.” Intheﬁrstchapterofourbook,we'llintroduceyoutothesubjectoftechnicalanalysis-whatitis and why it is used. In the second chapter we are going to discuss the trend with all its and indicators, their major types and how they work to signal the right market direction.Thus, youwillbeintroducedto themaintoolsandtechniquesusedintechnicalanalysis. 3 Chapter I What is Technical Analysis? 1.1DeﬁnitionofTechnicalAnalysis Technical analysis is the study of market action primarily through the use of charts for the purpose of forecasting future price trends. By “market action” the following three main sources of information are implied: price, market volume, and open interest, the latter referring only to options and futures. The terms“priceaction”and“marketaction”areveryoftenusedinterchangeably. The history of technical analysis goes back to 1900s, and its roots can be found in the Dow Theory developed by Charles Dow. The principles that come from this theory are the price trending, convergenceanddivergence,aswellassupportandresistancelevels. Technicalanalysisisacrucialmethodofevaluatingassetsbasedontheanalysisandstatisticsofpast market action, such as past prices and past volume. The main goal of technical analysts is not the measuring of asset's underlying value, they attempt to use charts or other technical analysis tools to determine patters that will help to forecast future market activity. Their ﬁrm belief is that the future performanceofmarketscanbeindicatedbythehistoricalperformance. 1.2.PhilosophyofTechnicalAnalysis Technicalapproachisbasedonthefollowingthreepremises: ·Marketactiondiscountseverything. ·Pricemovesintrends. ·Historyrepeatsitself. Marketactiondiscountseverything This premise is perhaps the most fundamental one, since nothing else coming forth from it can make sense, unless one has completely understood it. Technical analysts believe that each fundamental, political, economic and psychological factor that can possibly affect the price, is reﬂected in the price of the market. All that they claim is that price action should reﬂect changes in supply and demand. Together with the increase of demand the price will rise, and, conversely, if supply exceeds demand, prices will fall. This kind of action is at the base of fundamental forecasting; therefore, all technicians indirectly study fundamentals. The charts themselves do not cause markets to go up or down. These aretheforcesofsupplyanddemand,theeconomicfactorsthatleadtobullishandbearishmarkets. Actually, chartists do not try to ﬁnd out why the prices fall or rise. They can be aware of the trend the market is likely to go by simply studying price charts and technical indicators. They know that there torevealthosereasonsformakingpredictions.or down and meanwhile believe that there is no necessity PriceMovesinTrends There is a corollary to this assumption- a trend in motion is more likely to continue than to reverse. In 4 technical approach once a trend has been established, the future price is accepted to be in the same directionratherthantobeagainstit.Theprimarygoalofchartingthepriceactionistoﬁxtrendsinearly stagesofdevelopmenttolatertradeinthedirectionofthosetrends.Sothattheentireapproachofthis trend-followingpremiseisbasedonthealreadyexistingtrend,untilsignsofreversalareindicated. HistoryRepeatsItself Thispremisebringsforwardtheconceptthatthekeytounderstandingthefutureisbasedonthestudy of the past. The circular nature of price movements is related to the human psychology, meaning that market participants tend to react similarly to identical market events. The analysts use certain chart patternstoanalyzemarketmovements.Mostofthosechartsthatwereidentiﬁedaboutacenturyago, reﬂectcertainpicturesindicatingtherisingorfallingpsychologyofthemarket. Becauseofthesimplereasonthatthosepatternsworkedwellinthepast,theyarestronglybelievedto beasmuchusefulinthefuture.Theyarebasedonthestudyofhumanpsychologywhichisstableand doesnottendtochange. 1.3.TechnicalAnalysisvs.FundamentalAnalysis As it is well known, the two wide spread types of analysis methods to study price trend are technical analysis and fundamental analysis. Comparing technical and fundamental analyses to each other is oneofthebestwaystounderstandthem. While technical analysis is focused on the study and past performance of market action, fundamental analysisconcentratesonthefundamentalreasonsthatmakeanimpactonthemarketdirection. The purpose of both of these methods is an attempt to forecast and determine the future price movements. The difference is based on how they achieve that objective. Fundamentalists study the cause of price movement, whereas the technicians study the result. As we mentioned above, techniciansdonotﬁnditnecessarytoknowthereasonsofmarketchanges,butfundamentaliststryto discover “why”. Therefore, technicians, who are also called chartists are interested in the price movement,theytrytounderstandandstudytheemotioninthemarket. The second distinctive factor for these two types of analyses is the time horizon. Actually technical analysis takes considerably short time to analyze the market, as compared to fundamental analysis. Technical analysts can do their research based on daily, weekly or monthly data. But conversely, fundamentalists may look at data over years. Since each of those approaches takes different time frames,theyareappliedforreachingdifferenttradingorinvestmentgoals. Generally technical analysis is used for a trade, while fundamental analysis is more appropriate for investment purposes.Traders buy an asset in the hope that the latter will rise in value and they will be able to sell it at a higher price. The reason why fundamental analysts use so long timeframe is the following:thedatatheystudyaregeneratedmuchmoreslowlythanthepriceandvolumedatausedby technicalanalysts. Thoughthesetwotypesofanalysesareviewedaspolar,manytradersandinvestors,whohaveactive participation in the market use both. For example, a technician may refer to fundamental analysis to addstrengthandreliabilitytotechnicalsignals,toreafﬁrmhisdecisionwhilebuyingorsellinganasset. And, alternatively, fundamental analysts may use technical analysis tools to identify the best time to enterintoasecurity. Theproblemisthatchartsandfundamentalsareoftenincompetence.Technicalanalystsbelievethat their approach dominates fundamentalists. If a trader or an investor had to make a choice between these two theories, he would give preference to technical analysis. This is because technical approach includes the fundamental. If the fundamentals are reﬂected in the market price, their study alreadybecomesunnecessary.Herein,chartreadingservesasashortcutoffundamentalanalysis. 5 The opposite, however is not possible. Fundamental analysis does not cover the study of price action and it's quite possible to trade using only the technical approach. To trade on ﬁnancial markets one cannotdobuttakeintoconsiderationthemarkets'technicalside. 1.4.TechnicianorChartist?IsThereAnyDifference? Amongvarioustitlesgiventothepractitionersoftechnicalanalysisare:chartist,visualanalyst,market analyst and technical analyst. If once all they meant the same thing, together with the increasing specialization in this ﬁeld there have been made some distinctions in terms. Since till the last decade technical analysis was based on mainly the use of charts, the terms “chartist” and “technician” stood forthesameconcept.Butthisdoesnotholdtrueanylonger. Now in the broad ﬁeld of technical analysis two types of practitioners are distinguished: chartists and statistical technicians. Charts are the primary working tools in technical analysis and the term “art charting” has been given to this approach, since chart reading is really an art. This is largely because thesuccessoftheapproachgreatlydependsontheskillsandexperienceofachartist. Statistical technician considers primary principles, testsand quantiﬁes todevelop mechanical trading systems. These systems are programmed into a computer and generate mechanical “buy” and “sell” signals. That's main purpose is to eliminate human emotional factor in trading. The statisticians may not use charts in their work, and their work can be constrained to the study of market action. From this itfollowsthatallchartistsarealsotechnicians,howevernotalltechniciansarechartists. 1.5.DifferentTheoriesonTechnicalAnalysis The Dow Theory, named after its creator Charles Dow, is the grandfather of technical analysis. While most technicians view the theory as somewhat dated, the approach of many more statistically sophisticated methods are the variants of Dow's approach. The main objective of Dow Theory is to identify long-term trends in stock market prices. The two indicators used are the DJTA (Dow Jones TransportationAverage)andDJIA(DowJonesindustrialAverage).TheDJIAisanimportantindicator ofunderlyingtrends,whiletheDJTAservestoconﬁrmorrejectthesignal. TheDowTheorypositsthreeforcessimultaneouslyaffectingstockprices: 1.Theprimarytrend,whichindicateslong-termmovementofpricesandlastsfromseveralyearsto severalmonths. 2.Secondary(intermediate)trend,whichiscausedbyshort-termdeviationsofprices. 3.Tertiary(Minor)trendwhichindicatesdailyﬂuctuations. Figure 1.1 Three types of trends according to Dow Theory 6 RecentvariationsofDowTheoryaretheElliotWavetheoryandtheKondratieffWavetheory.Theidea ofElliotWavetheoryisthatsecuritypricescanbedescribedbyasetofwavepatterns.Long-termand short-termwavecyclesaresuperimposedandresultinacomplicatedpatternofpricemovements,but by interpreting the cycles one can predict broad movements. Similarly, Kondratieff Wave theory, named after a Russian economist, asserts that stock market moves in broad waves lasting between 48and60years. The Kondratieff waves are, thus, analogous to Dow's primary trend. Kondratieff's assertion is hard to evaluate empirically, because cycles that last about 50 years provide only two full data points per century,whicharehardlyenoughdatatotestthepredictivepowerofthetheory. Conclusion The principles of technical analysis presented in this chapter are widely applied in all markets. How analysts perform all the operations and get the full picture of market action we'll discover in following chapters. 7 Chapter II Trend In Terms of Technical Analysis Trendrepresentsoneofthemostessentialconceptsintechnicalanalysis.Allthetoolsthatananalyst uses have a single purpose: help to identify the market trend. The expressions like “trend is your friend” or “Never buck the trend” are not used accidentally. The meaning they contain is more than differentiate. is worth properly understanding what the trend is and what type of trend is possible to 2.1.DeﬁnitionofTrend The meaning of trend is not so much different from its general meaning- it is nothing more than the direction in which a market moves. But more precisely, market does not move in a straight line, its and troughs or highs and lows, as they are often called.Thus, in technical analysis it is the movement ofthosehighsandlowsthatformatrend. Thus,trendisthedirectionofmarketindicatedbysuccessivepeaksandtroughs. 2.2.TypesofTrends As we mentioned above trend is comprised of a series of highs and lows, and depending on the movementofthosepeaksandtroughsonecanunderstandthetrend'stypeinmarket. Though most people think that market can be either upward or downward, actually there exist not two butthreetypesoftrends: 1.Uptrend 2.Downtrend 3.Sideways Figure 2.1 and lowsle of an uptrend with ascending highs 8 As it is clearly mentioned on the chart, the points stand for identifying highs and lows. The ﬁrst peak represents the point 2 which is determined after the price falls from that point. Herein, point 3 is the trough which is determined after the price falls from the peak. And this should be continuous so that each successive trough must not fall below the previous lowest point. Only in that case the trend can be accepted as an uptrend, otherwise the trend is considered reversal. A downtrend is right the opposite; it is formed of lower peaks and lower troughs Figure 2.2 An example of a downtrend with descending peaks and lows A sideways trend is constituted of many horizontal peaks and troughs, and there is no obvious indicationoftrend.Thedirectioninwhichthesecuritypricemovesisabsolutelyopaque. This type of market direction is sometimes referred as “trendless”. This kind of action reﬂects the period when the forces of supply and demand are in a relative balance. The wide variety of technical analysistoolswhichareprimarilydesignedtofollowthetrendbecomepowerlesswhenmarketenters this “trendless” phase. It is during these periods that traders fail and experience great losses. The failure does not depend on the trend-following system; the system needs a trend to do its work. The reasonishiddeninthetraderwhostrivestoapplythetrend-followingsysteminanon-trendingmarket. Figure 2.3 An example of a sidewise trend with horizontal peaks and troughs Tradersandinvestorsconfrontthreetypesofdecisions:golong,i.e.tobuy,goshort,i.e.tosell,orstay aside, i.e. to do nothing. During any type of trend they should develop a speciﬁc strategy. The buying strategy is preferable when the market goes up and conversely the selling strategy would be right whenthemarketgoesdown.Butwhenthemarketmovessidewaysthethirdoption–tostayaside-will bethewisestdecision. 9 Figure 2.4 An example of a downtrend which gradually turns into an uptrend. The ﬁrst part shows a downtrend, then the market moves sideways and starts to go up. 2.3.SupportandResistanceLevels Troughs and peaks in technical analysis are usually mentioned by their appropriate names which are supportandresistancerespectively. The term support indicates the area on the chart where the buying interest is signiﬁcantly strong and surpassesthesellingpressure.Itisusuallymarkedbyprevioustroughs.Inanuptrendoftheﬁgure2.5 thepoints2and4areconsideredsupportlevels. Resistance level, contrary to the support level, represents an area on the chart where selling interest overcomes buying pressure. It is usually marked by previous peaks. The points 1 and 3 in the ﬁgure identifyresistancelevels. Figure 2.5 Rising support and resistance levels in an uptrend 10 Theimageisdifferentwithadowntrend(seeFigure2.6)whichiscomposedofdescendingpeaksand troughs. In a downtrend the points 1 and 3 indicate support levels and, consequently, the points 2 and 4showresistancelevels. Figure 2.6 Falling support and resistance levels in a downtrend For an uptrend to go on each successive support level should be higher than the preceding one, and each successive resistance level should be higher than the one preceding it. In case this is not so, for instance, if the support level comes down to the previous trough, it may signify that the uptrend is coming to the end or at least it is turning into a sideways trend. It is likely that trend reversal from up to downwilloccur. Theoppositesituationtakesplaceinadowntrend;thefailureofeachsupportleveltomovelowerthan theprevioustroughmayagainsignalchangesintheexistingtrend. 2.4.TrendReversal Another interesting aspect of trend is the reversal of support and resistance levels, which is known as "trendreversal","rally"or"correction". Anuptrendwhichisdeﬁnedbysuccessivehigherhighsandhigherlowscanreverseintoadowntrend bychangingtosuccessivelowerhighsandlowerlows. Figure 2.7 Trend reversal in an uptrend 11 Adowntrend,whichisdeﬁnedbylowerhighsandlowerlows,canreverseintoanuptrendbychanging into successive higher highs and higher lows. To put it more bluntly, a resistance level becomes a supportlevel,andasupportlevelbecomesaresistancelevel. Figure 2.8 Trend reversal in a downtrend A reversal can be either a positive or a negative change against the prevailing trend. This is of high signiﬁcanceformarketparticipantsandanalysts,sincethosepatternsindicatethenecessityoftaking anothertradingstrategyonthesamesecurity. Figure 2.9 Downside trend reversal Asitisclearlyshowninthepicture,point5failstoexceedthepreviouspeak(point3)andisfollowedby a trough which violates the previous low (point 4).This type of pattern is called a double top which we willdiscussinchapter3. Tounderstandthisproperly,let'sgrouptradersandothermarketparticipantsintothreecategories:the longs,theshortsandtheuncommitted. The longs are the ones who have already bought a security, the shorts are those who have already solditandtheuncommittedformthegroupofparticipantswhoeitherremainundecidedorhaveexited the market. Once the market starts moving higher from the support level the longs will be delighted only regretting for not having bought more. But this will create a negative situation for the shorts, who will appear on the wrong side of the market and only hope for a dip back to the area where they went short,sothattheycangetoutofthemarkettheygotin. 12 The group of undecided realizing that prices are increasing will decide to enter the market on the long side. All the mentioned members have a great interest in that support area. The importance of the support and resistance areas is strengthened based on the volume, time spent there and how recently the tradehastakenplace. 2.5.Trendline Another technical tool applied by a chartist is the trendline. Drawing a trendline does not cause any difﬁculty,itisassimpleasdrawingastraightlinewhichfollowsthetrend.Thelineisusedforindicating thetrendandalsoidentifyingtrendreversals. Therecanbedistinguishedtwotypesoftrendlines:uptrendlineanddowntrendline.Anuptrendlineis a straight line drawn upward to the right along successive lows.Adown trendline is drawn downward totherightalongsuccessivehighs. Figure 2.10 An up trendline which is drawn under the rising reaction lows Figure 2.11 A down trendline which is drawn over successively falling highs 13 Drawing a correct trendline, like any other aspect of technical analysis, requires practice and experiment with different lines before ﬁnding the correct one. There are certain factors that are very usefulinthisrespect. Firstly,thetrendshouldbeclearandevident.So,fordrawinganuptrendlinetheremustbeatleasttwo reaction lows where the second low is higher than the ﬁrst. Thus, at least two exact points are necessarytodrawanystraightline.Thisreferstoatentativetrendline.Inordertoconﬁrmthevalidityof thetrendline,thirdpointbecomesnecessary.Thiskindoftrendlineisreferredtoasavalidtrendline. Aslongasthetrendlineisstable,itcanbeusedasadeterminantofbuyingandsellingareas.Butonce itisviolated,itisoneofthebestwarningsofachangeintrend. The signiﬁcance of a trendline is determined by the duration it has been intact and by the number of times it has been tested.Atrendline which has been touched for 10 times is more signiﬁcant than the one which has been tested for only three times. Similarly, a trendline would be of more importance if beingineffectfor7monthsratherthanfor7days. Moresigniﬁcanceofatrendlineindicatesmoreconﬁdenceandmoreimportantpenetration. FanPrinciple There are situations when prices rally back on the level of trendline. In such cases, after the break, a newtrendlineisdrawnandthepreviousonebecomesaresistanceline.Similarly,iftheﬁrsttrendlineis violated, the third one is drawn.And if the price breaks the third line, it is most likely that trend reversal willtakeplace. Inﬁgure2.12itisshownhowpricesralliedtobutfailedtopenetrateline1. Line2,secondtrendline,is also broken. After another rally fails, a third line is drawn. The break of that third trendline usually indicatesthatpricesaremovinglower. Figure 2.12 14 This kind of situation is referred as “Fan principle” whose name derives from the appearance of the linesthatresembleafan.Hereitisimportanttonotethatthebreakingofthethirdlineisasignalofvalid trendreversal. 2.6.ChannelLine Channel lines, or as they are sometimes called return lines, are additions of two parallel trendlines which act as support and resistance levels.As we have already covered, an up trendline connects a seriesofpeaks,whileadowntrendlineconnectsaseriesoftroughs. Drawing a channel line is quite simple. If we want to draw it in an uptrend, ﬁrstly it is important to draw thebasicuptrendlinealongthelowsasshownintheﬁgure2.13(points1,3,5). Thenitfollowstodraw a dotted line parallel to the basic trendline (starting from the ﬁrst peak, point 2). Both the dotted and basic lines move in the right direction forming a channel. If the price increases and the next rally reaches and backs off from the channel line (mentioned by point 4), then a channel may exist.And if the price declines and falls back to the trendline, (shown by point 5), then we can say that a channel exists. Figure 2.13 The same can be said for a downtrend, however in the opposite direction. Figure 2.14 15 Whether a channel is upward or downward, its interpretation is the same. Traders and investors expectaparticularsecuritytotradebetweensupportandresistancelevels,untilitbreaksbeyondone of these levels. Aside from clearly indicating the trend, channels are mainly used to illustrate the important areas of support and resistance. They can be used for short term proﬁt taking. Like a trendline, the longer the channel remains intact and the more often it is successfully tested, the more reliable it becomes. While the breaking of the basic trendline indicates an important change in trend, thebreakingofarisingchannellineindicatesanaccelerationoftheexistingtrend. Itshouldbenotedthatthebasictrendlineismuchmorereliable.Thechannelwhichisoftenincludedin thetoolkitofachartist,isconsideredasecondaryuseoftrendlinetechnique. 2.7.PercentageRetracements While following the market movements one can easily notice that after a particular move, prices retracetheprevioustrendbysomepercentbeforecontinuingintheoriginaldirection.Theamountthat prices retreat from the high to the low can be measured using the technique “percentage retracement”. Let's bring an example. If a market trends high reaching from 100 level to 200, in most cases the price retraces nearly half of the move (at about 150 level). This kind of phenomenon is known as 50% retracementandhappensquiteoften. Besides 50% retracement, there exist the one-third and the two-thirds retracements. Different approachesofferdifferentamountsofminimumandmaximumretracements.Thus,accordingtoDow Theory, there are 3 percentage retracements- 33%, 50% and 66%. But as for Elliot WaveTheory and Fibonacciratios,theminimumandmaximumretracementsare38%and62%. Figure 2.15 Thismeansthatusuallyduringatrendcorrectionthemarketretracesatleastone-thirdoftheprevious move. It is very important for traders to be aware of such information and use the buying and selling opportunities correctly. If the trader wants to ﬁnd a beneﬁcial buying area he can compute a 33-50% area on the chart and use that zone for buying decisions. If the trader wants to ﬁnd a beneﬁcial selling areahecancomputea62-66%areaonthechartandusethatzoneforsellingdecisions. Themaximumretracementusuallycreatesacriticalarea.Ifthecorrectionstopsatthetwo-thirdspoint it becomes a less risky area in an uptrend for buying and in a downtrend for selling. In case prices surpassthemaximumpoint,theconditionfromretracementturnsintotrendreversal. 16 2.8.PriceGaps Price gaps represent such areas on a chart where no kind of trade has been executed.They are open spaces on a chart which mostly appear on daily bar charts but can be seen on weekly and monthly chartsaswell. Gapscanbeofthreetypes:breakaway,runaway/measuringandexhaustion. Figure 2.16 The breakaway gap appears when an important price pattern is completed and usually indicates the beginningofanessentialmarketmove. Itcanalsobeseenwhenamajortrendlinebreaksandsignals areversalpattern.Breakawaygapusuallyisnotﬁlled. The runaway or measuring gap appears somewhere in the middle of the move when prices form a secondtypeofgap.Inanuptrendthiskindofgapindicatesamarketstrength,whileinadowntrendit's asignofmarketweakness. Theexhaustiongapappearsneartheendofthemarketmovewhenthebreakawayandrunawaygaps have already been identiﬁed. Sometimes after the formation of exhaustion gap prices trade in a narrow range for a few days and only then gap to the downside. The exhaustion gap to the upside which is followed by a breakaway gap to the downside completes the island reversal pattern and usuallylookslikean“islandsurroundedbywaterorspace''. 17 2.9.TrendClassiﬁcation Actually, trends can be of different lengths ranging from very short term trends that cover minutes and hours to very long term trends which can last a decade. However, technicians classify trends into threemaingroups:long-term,intermediateandshort-termtrends. Long–termtrend,whichisalsoknownasmajortrend,isconsideredthetrendwhichlastslongerthana year. An intermediate trend is deﬁned as a one-to-three-month trend and a short-term, or so called near- termtrend,isexpectedtolastlessthanamonth. Each trend can become a portion of the next larger trend. For example, a long term trend consists of several intermediate trends which usually move against the long-term trend and are referred as corrections. If a long-term trend is upward and the market pauses to correct itself for some period to resumeitsupwardpath,thecorrectionisconsideredtobeanintermediatetrend. Short–term trends in their turn are components of intermediate and long-term trends. This procedure that each trend is a part of the next larger trend and consists of smaller trends takes place many times (seeﬁgure2.17). Figure 2.17 In the displayed ﬁgure the long term upward trend is shown by peaks and troughs mentioned by the points1,2,3,4.Thepoints2and3representintermediatetrendandshowthecorrectivephasewithin themajortrend.Moreover,thisintermediatetrendconsistsofthreesmallertrends,neartrends(points A,B,C).AtpointCthemajortrendseemstobestillup,whereastheintermediateandneartermtrends are down.At point 4 all the trends are up.Therefore, it becomes very difﬁcult to tell the exact trend in a given market, and analysts usually deﬁne it by different trend classiﬁcations, discussed in our example. How traders perceive a trend may cause a bit of misunderstanding while deﬁning a trend. For a trader of a long-term position a few days' price action may be unimportant, while for a day trader the same time frame may be accepted as a major trend. Thus, it is also important to understand and take into accountdifferentdegreesoftrend. Another important factor in trend analysis is the usage of a right chart which is constructed to best reﬂect the type of trend. So, daily charts are mainly used to analyze intermediate and short-term trends. The longer the trend, the more signiﬁcant it is, e.g. a one-month trend is not considered as muchimportantasatwo-yeartrend. 18 Conclusion In this chapter we presented the core features of chart analysis, including channels and trendlines, supportandresistancelevels,gapsandpercentageretracements.Wealsocoveredthemainclasses oftrendswhoseidentiﬁcationhelpstotradewithandnotagainstthemarket. 19 Chapter III Chart Construction 3.1WhatisaChart? In technical analysis a chart is a graphical representation of price movements over a certain time frame.Itcanshowsecurity'spricemovementoveramonthorayearperiod. Thechartbelowwillhelptounderstandhowchartsreﬂectpricechangesandhowtoreadthem. Figure 3.1 Figure 3.1 represents price movements of a security over a year period. The horizontal x- axis at the bottomofthechartshowsthedateortimescale.Theverticaly-axisshowsthepricescale.Thus,inthe givenexampleitisshownthatinJuly2004(A)thepriceofsecuritywasaround$150,butinDecember 2004 (B) its price reached around $170. This data tells us that the price of the security has risen betweenJuly2004andDecember2004. џ The Time Scale The time scale shows the range of dates which can vary from seconds to decades. Most widely used time scales are intraday, daily, weekly, monthly, quarterly and annually. Intraday charts, as the name implies,plotpricemovementwithinaparticulardayrangingfromseveralminutestothewholetrading day. In the same way, weekly, monthly or yearly time scales cover both intermediate and short–term trendsinpricemovementandaremainlyusedtoanalyzelongertermtrends. џ The Price Scale (Arithmetic and Logarithmic scales) The price scale on the right side of the chart shows security's current price and compares it to past data.Thestructureofthescalecanbeeitherarithmetic(linear)orlogarithmic. Linear scale means that the space between each price point is separated by an equal amount (see ﬁgure3.2). 20 Figure 3.2 Inthisﬁgureitisshownthateachpointonthelinearscaleisequidistant; eachpricepointincreasesby $5.Inthiscasethepricescaledoesnotshowtheeffectsofpercentchangeandmeasuresmovements inabsoluteterms. Logarithmic price scale shows that the distance between points will be equal in terms of percent change(seeﬁgure3.3).Thoughpricechangesfrom10to20andfrom40to50areshownbythesame distance on a linear scale, the percent change is different; a price change from 10 to 20 is a 100% change, while a price change from 40 to 50 is only a 25% increase. Thus, the 100% increase is representedbyalargerspaceonthechart,whilethe25%increaseisshownbyasmallerspace. Figure 3.3 Usually stock market chart analysts use log charts, whereas futures chart analysts give preference to arithmetic charts. The opportunity of using each of them is great since charting software packages allowbothtypesofscaling. 21 3.2. TypesofCharts Depending on what information traders search for and what skills they master, they can use certain typesofcharts.Themaintypesofchartsare:thebarchart,thelinechart,thecandlestickchartandthe pointandﬁgurechart. Linecharts The line chart is considered the most basic chart, since it plots only the closing price over a set period of time. It does not provide such information like high, low and opening prices and is formed by connecting closing prices (see ﬁgure 3.4). Most chartists consider the line chart a valid measure of priceactivitybecausetheybelievethatclosingisthemostessentialpriceintradingdata. Inthefollowingexampleandinotherexamplesaswell(ﬁgures3.4,3.5,3.6) thepricedataofS&P500 IndexbetweenJanuary2006andMay2006arepresented.Whatisimportantheretonoticeisthatthe dataareidenticalonallchartsbutthewaytheyareplottedandrepresentedisquitedifferent. Figure 3.2 A line chart: This type of chart creates a solid line connecting the successive closing prices. BarCharts The bar chart is a more expanded version of the line chart with additional information. It is called bar chart because it consists of a series of vertical bars that show each datum. The bar chart aside from closingpricesalsoplotstheopen,highandlowprices. The closing and opening prices are shown on the bar by a horizontal dash either on its left or right sides. The opening price is represented by the dash on the left of the bar.The closing price, herein, is shown by the dash on the right of the vertical bar. Usually, if the left dash is lower than the right dash thismeansthatthesecurityhasgainedvalue.Iftherightdashislowerthantheleftdash, itmeansthat the security has decreased in value. In such cases bars are colored red once more showing the low valueofsecurityoverthatsettime(seeﬁgure3.5). 22 Figure 3.5 A bar chart: each vertical bar represents one action Candlestick Charts ThecandlestickchartistheJapaneseversionofthebarchartandplotsthesamefourpricesasthebar chart (high, low, opening and closing prices), however the visual presentation differs. The difference mainly lies in the formation of a wide bar on the vertical line which shows the difference between the openingandclosingprices. Onthecandlestickchartthethinline,alsocalledshadow,showsthepricechangefromthehightothe low. A wider portion of the bar, also called real body, shows the distance between the opening and closingprices. The colors as in the bar charts, here also are used to explain the price performance over the trading period.Thoughdifferentsitesusedifferentstandardsforcandlestickcolorconﬁguration,therearetwo colorconstructsforshowingdayswhenpricegoesupandonefordayswhenthepricegoesdown(see ﬁgure 3.6). The candlestick will be white or clear if the security price is up and closes above the opening trade. But if the price is low, the candlestick will usually be red. In other words, if the closing price is higher than the opening price, the real body will be white (positive), and if the closing price is lower thantheopeningprice,therealbodywillbered(negative). 23 Figure 3.6 A Candlestick chart PointandFigureCharts The point and ﬁgure chart though not so well known and widely used by an average investor, has a longhistoryandgoesbacktotheﬁrsttechnicaltraders. Thistypeofchartshowsthesamepriceaction inaquitecompressedformat;itsimplyreﬂectspricemovementsand isnotconcernedabouttimeand volumeandinsigniﬁcantpricemovements.Besidesthis,onthepointandﬁgurechartitismucheasier tospotthebuyandsellsignalsthanonthebarchart. Thenumbersandlettersonthechartrepresentmonthsthroughwhichtraderscanmakeanideaofthe date(seeﬁg.3.7). Figure 3.7 The point and ﬁgure chart: The X column shows rising prices and the O column shows falling prices. 24 Theboxesonthechartrepresentthepricescalebasedonthepriceofthesecurity.Thismeansthatthe higherthesecurityprice,themoreeachboxrepresents. Another important aspect on this chart is its reversal criterion. This indicates how much the price is to moveawayfromthelowtothehightocreateanewtrend.Inotherwords,itshowshowmuchtheprice hastomoveforanXcolumntobecomeanOcolumnandviceversa. 3.3. ChartPatterns Price patterns are certain formations that appear on charts creating a sign of future price movements. Theyhavepredictivevalueandareusedbychartiststoidentifycurrenttrendsandtriggerbuyandsell signals. Thetheoryofchartpatternsisbasedonthebasicassumptionoftechnicalanalysisthathistoryrepeats itself.Themainpremiseisthatcertainpatternsappearmanytimesonthechartandsignalmovements inasecuritybasedonthehistoricaltrendofachartpattern. Though each chart pattern has its own components and shows a certain movement, there is no chart that will tell for 100% how the security is about to move. This always arouses debates as what patternsaregoodandreliable,andthisiswhychartinginmostcasesisreferredtoasratheranartthan ascience. There are two major categories of price chart patterns: reversal and continuation. Reversal patterns indicate that an important reversal in trend will take place upon completion of the pattern. The continuation pattern, conversely, indicates a temporary pause in a market after which the existing trendwillcontinue. 3.3.1. ReversalChartPatterns Reversalchartpatternsareformedafterthepricelevelhasreachedthemaximumvalueinthecurrent trend.Theysignaltheendofthecurrenttrendandthestartofanewone. A pattern which is formed during an uptrend signals that the price will soon decline. Conversely, the patternformedduringadowntrend,signalsthatthepriceisabouttogoup. It is important to know where in the primary trend the pattern is most likely to appear. Patterns that appearatthemarkettoparecalleddistributionpatterns,wheretraderscanselltheinstrument.Onthe other hand, patterns that appear at the market bottom, known as accumulation patterns, indicate the mostefﬁcientperiodofbuyinganinstrument. Whilediscussingreversalchartpatternsitisimportanttoconsidersomecommonandessentialpoints thatformtheirbasis. 1. Existenceofapriortrend Theremustbeapriortrendfortheformationofareversalpattern;ifitisnotprecededbyatrend,there canbenothingtoreverse. 2. Breakingofimportanttrendlines Though the violation of a major trendline does not always indicate a trend reversal, it often signals the beginning of a sideways price pattern, which then can be identiﬁed as a reversal or a continuation type. 3. Greaterpotentialwithlargerpattern Patternswithgreatersizes,thatis,withhighvolatilityandlongdurationofbuilding,aremoreimportant andthepotentialforensuringpricemovebecomesgreater. 25 4. Differencebetweentopandbottompatterns Top patterns usually take less time to build, they are shorter in duration and are more volatile. The volatility within bottom patterns is lower and it takes longer time to build a bottom pattern. In top patterns the prices tend to decline faster than they go up, herein, traders can more quickly make moneybytradingtheshortsideofbearmarket,thanbytradingthelongsideofabullmarket. 5. Volumeismoresigniﬁcantontheupside Being a conﬁrming factor in the completion of all price patterns, volume usually increases in the direction of trend. The completion of each pattern should be accompanied by certain increase in volume.At market tops in the early stages of trend reversal volume is not so important. On the other hand,atbottomsthevolumeincreaseisquiteessential. MajorReversalPatterns The Head and Shoulders Pattern: This pattern, also known as head and shoulders top, is considered the most reliable of all other reversal patterns. Being formed in an uptrend head and shoulderspatternsignalsthatthepriceisgoingtomoveinadownwarddirection. Itisachartformationwherepricemovesinthefollowingway: 1.Risestoapeakanddeclines 2.Rises again, this time higher than the ﬁrst peak,anddeclines 3.Rises but not so high as the second peak, anddeclines. The highest peak is called head and the left and right peaks which are at about the same height are called shoulders. A ﬂatter trendline can be drawn under reaction lows (B and D), called neckline. If the price falls below the neckline a sell signal arises. The pattern is complete if the neckline is broken; only in that case the trend is considered reversed, and the asset can head a newdirection. The Inverse Head and Shoulders: This type of patternisalsocalledheadandshouldersbottom and is exactly the opposite of head and shoulders top, discussed above. It signals that the security is going to make an upward move. Here again there are four steps to form the pattern starting from the left shoulder which is formed when the price declines and rises. Then follows the formation of head, when the price declines lower than the previous low accompanied by a return to the previous high. The third step is the formation of the right shoulder which is higher than the previous low and is followed by a return to the neckline. This pattern is considered complete when the price breaksabovetheneckline. 26 Triple Tops and Bottoms: The triple top and bottom patterns are just slight variations of head and shoulders patterns. The main difference is that three highs or lows in triple tops and bottoms respectivelyareatthesamelevel. Tripletopsarebearishreversalpatternsformed whenthesecuritywhichistrendingupwardtests the same resistance level without breaking it through and each time falls to a similar support area. The pattern is considered complete when after the third decline the security falls through the support level. Thus, the price is expected to move in a downward direction indicating a sell signal. Triplebottomsarebullishreversalpatternsthat share all the features of the triple top, but they only signal a reversal of downward trend. They indicate that a security that is trading in a downtrend and tries to fall through the support level for three times, each time moves back to the resistance level. The pattern is complete whenthepricemovesabovetheresistancelevel andbeginstradinginanupwardtrend. DoubleTopsandBottoms:Thedoubletopsanddoublebottomsareagainwellknownchartpatterns which show a security's attempt to continue an existing trend. After a few attempts to continue the direction, trend is reversed. By their formation these patterns often resemble the letter W (in case of doublebottom)ortheletterM(incaseofdoubletop). The double-top pattern signals the weakening of the preceding upward trend. It has two peaks at about the same level (points A and C). The marketsetsanewhighonincreasedvolume(A), then declines (B) on declining volume. The next high (C) is formed and again begins to fall back. The double – top pattern is formed but it is not complete unless the security breaks down the support level (D) signaling the beginning of a downwardtrend. 27 The double bottom is the opposite pattern of the double top and signals a reversal of the downtrend. It is formed by setting a new low in the price movement (point A). After ﬁnding support the price rises to the resistance level (B) and then declines down to the previous low (C). These two lows (A and C) form the two bottoms on the pattern. But after forming the bottoms the price goes up. It is important to note that the security should break through the support level for trend reversal to take place (here changing fromadowntrendintoanuptrend). Saucer Bottom:Saucer bottom,also called a rounding bottom,is a long termpattern which signals a gradual and very slow shift from a downtrend to an uptrend. It is referred to as a long term pattern, since it can last from several months to several years. It is rather difﬁcult to tell when the pattern has beencompletedandcalculatehowpriceswillmoveintheoppositedirection. The formation of a saucer bottom starts form a downward movement which gradually becomes lower and then is followed by a rise to the initial level of the downward movement creating a pattern which lookslikearoundingbottom. It is not necessary for the pattern to be followed only by a downtrend; it may also proceeded by a sidewaysmovementformedafteradowntrend. The distance from the initial high to the lowest level is considered the half of the distance of the saucer bottom. This helps chartists make an ideawhenthepatternwillbecomplete;iftheﬁrst half of the pattern lasts a year, the signal is not expectedtobeformeduntilayear. 28 V-patterns or Spikes: Spikes are the most difﬁcult patterns to deal with, since they happen very quickly with little or no transition period. They appear when the market has become so overextended in one direction that a sudden event can cause the market change its direction very abruptly. Unfortunately, these sudden turns are difﬁcult to spot in advance. The only way to know what to expect is to use certain technical indicators that help to determine when market have gotten over- extended. 3.3.2 ContinuationChartPatterns Continuation patterns indicate that the sideways price movement on the chart is just a pause in the prior trend and that the next movement will be the continuation of the direction preceding the formation. When these patterns appear on the chart they indicate that the trend is likely to resume afterthecompletionofthepattern.Andthepatternisconsideredcompletewhenafteritsformationthe trend ''breaks out'' of the pattern and continues with the former trend. This is the main feature that distinguishescontinuationpatternsformreversalpatterns. Another factor that differs between these two types of patterns is the time duration. Reversal patterns take longer times to be formed and represent major trend changes. On the other hand, continuation patterns are classiﬁed as intermediate patterns and usually take shorter time to build. They can appearonalltimeframes,fromatickcharttoaweeklychart. MajorContinuationPatterns Triangles: Triangle patterns can be deﬁned as a converging of the price range, with lower highs and higher lows. The converging price action creates a triangle formation. If the price goes on to converge, it will reach the apex of the triangle and the closer the price gets to the apex, the tighter the priceactionbecomes. There are three types of triangles: ascending, descending and symmetrical. Both ascending and descendingtrianglesarevariationsofsymmetricaltriangleanddifferfromitinaveryimportantsense. Theascendingtriangleisbullishandthedescendingtriangleisbearish,whilethesymmetricaltriangle is a neutral pattern. But this does not mean that symmetrical triangle is aimless and has no forecastingvalue.Sinceitisacontinuationpattern,ithelpsanalyststomakepredictionsbasedonthe previoustrendandassumethatthelatterwillcontinue. Symmetrical triangle: The symmetrical triangle, also called coil, shows two converging trendlines, with the lower line ascending and the upper line descending. The dotted line at the left measures the height of the pattern and is called the base. The point where two lines intersect is called the apex. Because of these features, symmetrical triangle is also called a coil. The essential requirements for the formation of this triangle pattern are 4 reversal points (points 1, 2, 3, 4). Thus, while drawing the convergingtrendlines,eachlinemustbetouchedatleasttwice. 29 A symmetrical triangle is usually referred to as a period of consolidation before the price breaks out the trendlines. If the break is above the upper trendline this signals the beginning of an upward movement. On the other hand, a break below the lower trendline signals the beginningofadownwardtrend. Ascendingtriangle: Aswealreadymentionedascendingtriangleisabullishpatternwhichindicates thatthepriceofthesecuritywillgohigheruponthecompletion. The pattern is formed by two trendlines: a ﬂat or a horizontal line and a rising lower line. The price of the security moves between these two trendlines until it breaks out to the upside. The breaking of the upper line indicates the completion of the base and signalsabullishtrend. Thoughtheascendingtriangleusuallyappearsinanuptrendandisconsideredacontinuationpattern, sometimes it may appear in a downtrend. Therefore it is not unexpected to see an ascending pattern todevelopattheendofadowntrend. Descending Triangle: Descending triangle is a bearish pattern and is generally considered the opposite of the ascending pattern. It is formed by a declining upper line and a ﬂat bottom line. Here again, though it is a continuation pattern and is found in a downtrend, sometimesthedescendingtrianglecanbe found in an uptrend. The downside signal is made when the price breaks out the lower trendline and shows the continuationofdownsidetrend. 30 Flags and Pennants:The formations of the ﬂag and pennant patterns are quite common and since they are very similar in appearance they are treated together. They represent brief pauses in the dynamic market move. What is requiredforﬂagsandpennantstobeformedisa sharp and straight line move followed by a brief pauseinthetrend. The ﬂag pattern looks like a rectangle which is formed by two parallel trendlines one of them acting as support and the other resistance (see ﬁgure3.19a) The pennant is constructed by two converging trendlines and looks like a small horizontal symmetrical triangle (see ﬁgure 3.19b). Both patterns are short term; in downtrend they tend to take less time to develop and may last maximumtwoweeks. TheWedge:The wedge signals a reverse ofthe trend which is formed within the wedge. It is similar to a symmetrical triangle and consists of two trendlines (support and resistance). It is, however, a longer-term pattern and usually lasts tillsixmonths. Therearetwotypesofwedges-fallingandrising. A falling wedge slopes downward against the prevailing trend, while a rising wedge slants upward. In other words, a rising wedge is bearish,andafallingwedgeisbullish. The Rectangle Pattern: The rectangle pattern represents a pause in the trend during which prices move sideways between two parallel lines.Itissometimesconsideredaconsolidation zoneoracongestionarea. By its forecasting value it is similar to the symmetrical triangle but with ﬂat trendlines instead of convergingtrendlines. There are two types of rectangle patterns- bullish and bearish. Bullish rectangle (see ﬁgure 3.21) is usually formed in an uptrend and signals trend's upward direction. Bearish rectangle is formed in a downtrendandsignalstrend'sdownwarddirection. 31 3.4 TheImportanceofVolume Volume shows the number of stocks or contracts that trade over a particular time. Higher volume indicates higher degree of intensity or pressure. Being one of the most important factors in trade it is always analyzed and estimated by chartists. In order to determine the upward or downward movement of the volume, they look at the volume bars usually presented at the bottom of the chart. Thesebarsshowthequantityofstocksbeingtradedwithinacertainperiod. Volume plays a very important role in technical analysis since it is used to conﬁrm trends and chart patterns.Any price movement is of more signiﬁcance if accompanied by a relatively high volume than ifaccompaniedbyaweakvolume. Thus,whileconsideringalargepricemovementitisalsoimportant toexaminethevolume. Figure 3.22 VolumeandTrend Volume should correspond to the trend. If the trend is upward and prices are moving up, volume should increase, and conversely, in a downtrend volume should decrease. By viewing the trend and volume together, technicians use two different tools to measure the pressure. If prices are trending higher, it becomes obvious that there is more buying than selling pressure. Technicians think that volume precedes price, which means that the loss of downside pressure in a downtrend or upside pressure in an uptrend show up in the volume ﬁgures before it is manifested in a reversal of the price trend. Volume is used by technicians to make an idea in the upcoming trend reversals. If the volume startstodeceaseduringanuptrend,itsignalsthattheupwardtrendisabouttoend. 32 VolumeandChartPatterns Chart patterns, such as ﬂags, triangles, head and shoulders, can be conﬁrmed with volume. In most patterns there are some pivotal points essential for chartists to see what the chart is able to convey. If the volume lacks and does not conﬁrm the pivotal moments on a chart, the importance of the signal formedbythepatternisweakened. Conclusion Inthischapterwediscussedthemaintypesofcharts-line,bar,candlestick,pointandﬁgure.Aswellas we covered the most commonly used reversal and continuation patterns which signal important trend reversals or trend continuation. There are other technical analysis tools which help to identify the trend.Let'slookatthistypeoftoolsinournextchapter. 33 Chapter IV Technical Indicators 4.1.WhatisaTechnicalIndicator? Technicalindicatorsarecalculationswhicharebasedonthepriceandvolumeofasecurity. Theyareusedbothtoconﬁrmthetrendandthequalityofchartpatterns,andtohelptradersdetermine thebuyandsellsignals. Indicators are used to identify trends, volatility, momentum and other aspects in a security to help in the trend's technical analysis. They can be applied separately to form buy and sell signals, as well as canbeusedtogether,inconjunctionwithchartpatternsandpricemovement. 4.2.VariousClassiﬁcationsofTechnicalIndicators There are two leading groups of indicators: leading indicators and lagging indicators. Leading indicators precede price movement performing a predictive function. They are effective to be used during sideways trend or non-trending treading ranges. Lagging indicators, on the other hand, follow the price movement serving as a conﬁrmation tool. These indicators are mainly used during trending periods(bullishorbearish). By their form indicators either fall in a bounded range or not. Those indicators that are bound within a here means the difference between high and low prices over a set time period. It shows the price volatilityandpricespreadforaspeciﬁcperiod. Oscillators are used in non-trending markets where price ﬂuctuates in a trading range creating a marketsituationwheremosttrend–followingtoolsdon'tworkeffectively. Theyhelptradersproﬁtfrom periodic sideways and trendless market. The oscillator becomes most useful when the price reaches near the upper or lower end of boundaries. The market is overbought when it is near the upper extreme,andoversoldwhenitreachesthelowerextreme. Indicators can form buy and sell signals through crossovers and diCrossovers are reﬂectedwhenpricemovesthroughthemovingaverageorwhentwodifferentmovingaveragescross each other. Divergence happens when the price trend and the indicator trend move in opposite directionsindicatingthatthedirectionofpricetrendisweakening. 4.3.MajorTechnicalIndicators T
Are you sure you want to buy this material for
You're already Subscribed!
Looks like you've already subscribed to StudySoup, you won't need to purchase another subscription to get this material. To access this material simply click 'View Full Document'