What is Technical Analysis
Technical analysis is the study of investor behaviour and its effect on the price movement of financial instruments. The main data that we need to perform our studies are the price histories of the instruments, together with time and volume information. These enable us to form our views, based on objective facts.
Technical Analysis versus Fundamental Analysis
Fundamental Analysis concerns itself with determining the value of stocks and other financial instruments. The goal is to anticipate movements based on external events and influences, rather than look at price patterns.
To establish the true value of a share, for example, the fundamental analyst will concern himself with complex inter-relationships of financial statements, revenue forecasts, quality of management, earnings and growth, etc. They will then make a judgement on the share, commodity, or other financial instrument, often relative to its sector or market peers, about whether it is over- or under- valued.
Technical analysis, on the other hand, draws all the information it needs directly from charts. It doesn’t look at what’s going on within the components of a market; rather, it looks only at the movement patterns of the market itself.
By examining the patterns forming on the charts, technical analysts can see how buyers and sellers are behaving. Since certain types of behaviour patterns have been seen repeatedly in the past, it’s possible to identify them as they emerge. This helps with predicting the likely future trend for the market.
Types of Charts
There are many ways to display price charts. Each has its own benefits, but at the end of the day it is up to the individual to decide which provides the clearest visual picture and is likely to be of most in identifying trends at an early stage. We will look at the most popular four types used by traders.
This is the simplest chart format and is generated by using a line to join consecutive data points. The most common use for line charts is for indicators that only have a single daily value (rather than high/low) such as momentum or moving averages.
As their name suggests, bar charts use vertical bars to represent price movement for each day, drawn from the lowest price to the highest price with a short horizontal dash depicting the opening price and closing price.
Candlestick charts provide a more sophisticated visual representation of bar charts. The opening price is included in the chart and a day’s activity would be represented as follows:
Note: an up day is signified by a white (or empty) box. A down day is represented by a black or shaded box. The “box” shows the open to close range. The “wick” displays the full day’s range.
Candlestick charting is one of the oldest methods of technical analysis. Its appeal lies in its ability to give a clear visual representation of the price action during a period, leading to easy-to-recognise pattern recognition.
Here are a few of the key patterns to watch out for:
Doji Lines: from the Japanese meaning simultaneous, or at the same time. The pattern occurs when the opening and closing price are the same. No candle is displayed, merely a horizontal line. Not particularly significant in itself (perhaps a sign of indecision or lack of trend), but sometimes a component in multi-day patterns.
Umbrellas: A short body on a larger intra-day range. Also known as “hammers” when they occur in a downtrend. Considered to be bullish in a downtrend, bearish in an uptrend.
Stars: A concept similar to the “Island Reversal” pattern known to bar chart users. A reversal indicator. Tops are rather charmingly known as “Evening Stars“, bases as “Morning Stars“. The example below shows the latter.
The Bear Engulfing pattern. Basically similar to an “outside day” in bar chart jargon. Another reversal pattern. The bullish counterpart is known as a “bull engulfing” pattern.
Harami patterns: meaning pregnant in Japanese, the Harami pattern is shows a small day’s range occurring entirely within (hence the pregnancy) the previous day’s larger range. These patterns should be viewed as an “early warning” signal for any potential change of trend. The example below shows a bear Harami.
Point & Figure Charts
P&F charts map out the relationship between supply (created by sellers) and demand (created by buyers) at different price levels. When demand outstrips supply (more buyers than sellers), asset prices rise and this is depicted by a column of Xs on the chart. Conversely, when supply outstrips demand, (more sellers than buyers) prices fall and this is depicted by a column of Os on the chart.
The objective of a p&f chart is to identify the points at which established supply/demand relationships change (these are known as “breakouts”). These changes will very probably lead to a future significant move in the asset price.
Point & figure charts are unique in several ways:
a) No time axis – unlike bar or candlestick charts, p&f charts have no horizontal time axis – only price change generates chart action by plotting a column of Xs as the price rises and a column of Os as the price falls.
b) The 3 Box reversal rule – P&F charts will not change direction (i.e. from a column of Xs to a column of Os) unless the price moves more than 3 ‘boxes’ (or unit of price) in the opposite direction. There can therefore be no fewer than three boxes in a column. This reversal technique is one of the key strengths to p&f charting as it effectively filters out minor fluctuations to reveal patterns.
c) Semi log scale – the Y axis scale on a p&f chart is graduated to allow one to view and compare similar signals for different prices.
d) Clear cut signals – what makes p&f charts so popular is the clarity of signal: each asset is either on a buy or on a sell and identifying when this signal changes is well-defined and easy to spot.
e) Support/resistance levels easy to identify due to the almost diagrammatic box format.
f) Stop and target levels are calculated for every breakout signal.
Support and Resistance
Understanding the concepts of support and resistance is vital in developing a disciplined trading strategy. Prces are dynamic, reflecting the continuing change in the balance between supply and demand. When supply exceeds demand prices tend to fall, whereas when there is not enough supply to meet demand prices tend to rise. By identifying the price levels at which these balances change we can plan not only the price level at which to purchase but also the level at which we can subsequently sell (and vice versa for a short trade). Whilst these levels may be created by the markets subconsciously they represent the collective opinions of the participants in the markets.
Support is the level at which a falling price finds some support to halt its decline and potentially rise again. What is happening is that potential buyers are looking at the drop in price and deciding it’s a good time to enter the market. This mops up the excess supply, until supply and demand rebalance and the decline halts. As more buyers decide to join in, the balance tips back towards demand, which pushes the price up again.
It’s worth bearing in mind that if the price does pass a perceived support level, it may well keep falling until it finds another support level.
Resistance is the opposite of support and is the level at which the volume of selling (supply) outweighs the volume of buying (demand). If the price does break through a perceived resistance level, some chartists believe it’s likely to keep rising until it reaches the next resistance level.
These mini-levels can change frequently but over time a clear pattern emerges and firm levels become established.
The conditions for a change from a sideways trend to an uptrend
In a sideways trading range, the market is relatively stable with a limited degree of volatility – as defined by the support and resistance levels. However, market conditions change (it may be due to improvements in the earnings estimates for a stock, a newly released report for a commodity or economic data for a currency).
Let’s say, for example, that market conditions improve. This will alter the balance between supply and demand. The bears (the supply or sellers) will be less keen to sell and will generally become less pessimistic. The bulls (the demand or the buyers) will be more keen to add to positions. The next time the price approaches the previous level of resistance, there will be less bears than before and prices will push above the previous resistance and, possibly, mark the start of a ‘break out’ into a new trend.
Not all the bulls and bears will have changed their opinion, however. This is because most investment related news is open to personal interpretation and of course, not all investors may have noticed it in the first place. It is the reaction of the investors who didn’t change their view at the time that will establish a new trend. Here’s how:
a) Some of the short traders will have set stop losses above the prior resistance level to close out their position if the price rises and limit their losses. These ‘limit orders’ will be triggered and they will have to buy to satisfy their earlier sales contracts creating more demand and more upward price momentum.
b) Other investors who had previously decided not to participate and remain out of the market will notice that the sideways range has been broken and may decide to now take a position – this will create even more demand and push prices higher still.
Conditions for a new level of Support
This is where it gets interesting. The previous level of resistance will now become a new level of support. This is because not everyone got the chance to act immediately that the price broke resistance; some people may have decided to monitor the situation for a while, others may simply have not been watching.
They will have seen the price jump ahead strongly after breaking resistance and many will be buyers if the price retraces to this level: the short sellers who previously opened a position just below resistance (this strategy had worked for them several times before so they may have upped the stakes) will want to cover with a small loss if the price gets back to this level – this exposes market ‘fear’. Traders who had been long but taken profits at resistance will want to re-join the party and purchase as near to where they previously sold as possible – exposing market ‘greed’.
Both of these examples add buying pressure – demand – to the market and drive prices upwards. Apart from a new level of support developing from prior resistance as discussed above, there will also be a new level at which the buyers want to take profits i.e. a new resistance level will develop as earlier buyers reach their targets and start to sell. This action is the first stage in the development of successive higher support and higher resistance levels which brings us to the Concept of Trend.
The concept of trend
Charles Dow is probably best known as the founder of the Dow Jones Industrial Average. However, it was during his time as editor of the Wall Street Journal that he produced a series of articles examining stock market behaviour, and it was from these editorials that “Dow Theory” evolved.
Dow theory provides us with a clear definition of trend. Dow described how prices did not rise or fall in a straight line but moved in a series of zigzags which resembled waves and it was the relative positioning of the peaks and troughs in these waves that defined the trend.For a stock to be in an uptrend, it must make successive higher peaks (highs) and higher troughs (lows). For a stock to be in a downtrend, it must make lower peaks (highs) and lower troughs (lows).
By identifying these peaks and troughs, we can not only describe the current trend and put it in its historic context but, just as importantly, determine when it is changing. We do this by looking at the patterns formed by the peaks and troughs and this is covered in the next section (Major Reversal Patterns).
Trends are fairly easy to identify, but it’s not so obvious how long a trend will continue before going into reverse. However, by looking for certain chart patterns, you can often get a good indication of the likely future movements of the market.
The Double Top and Bottom
Double tops or double bottoms form after a sustained trend, signalling to chartists that the trend may be about to reverse.
These patterns are created when a price movement nudges support or resistance levels twice and fails to break through them. This behaviour is often a signal of an intermediate or long-term trend reversal.
The chart below depicts a double top formation.
The Triple Top and Bottom
The triple top is a bearish reversal pattern, as the price eventually takes a turn downwards.
These patterns form when a security tries and fails to pass a key level of resistance three times. After the three failed attempts, it falls through the support level and is then expected to move in a downward trend.
This pattern can be difficult to spot in the early stages, as it will initially look like a double-top or double-bottom pattern. The key is to wait for the price to move past the level of support or resistance before entering the market, otherwise it could trade sideways within the same range for some time.
The triple bottom is a bullish reversal pattern, as the price eventually takes a turn upwards. It is effectively the opposite of a triple top, as it involves a market trying to drop below a support level three times before giving up and moving above the resistance level.
Another rule to remember is that the more times a price finds support at a particular level, the stronger that level of support is (vice versa for resistance).
Head and Shoulders Formation
Another trend reversal pattern which is widely referred to is the head and shoulders formation. This pattern signals a likely downward move but differs from the double top in that the first evidence of its development is the generation of a lower high rather than an equal high; in other words, sellers are beginning to appear at lower levels than they did previously and the buyers no longer have the same appetite at these higher levels as before.
The diagram below is an example of the head and shoulders top. The high A is referred to as the first “shoulder” and the high B as the “head”. The most recent lower high C is referred to as the second “shoulder”. A trend line can be drawn below the recent lows and this is referred to as the “neckline”. The change of trend is signalled by a decisive break below the “neckline”.
The previous examples use the relative positioning of peaks and troughs (Dow theory) to determine changes in trend and these can take weeks or months to develop. The V reversal is a much more dramatic event and unlike double bottoms, there is no higher low to alert us to a potential signal and generally we cannot identify this signal until the day after the reversal.
Before a bullish reversal, prices will begin to accelerate downwards. This action suggests that there is fast becoming a bearish consensus i.e. the vast majority of investors are bearish and the price drops faster and faster as the few remaining bulls throw in the towel and liquidate their long positions – this phenomenon is also known as “capitulation”.
Analysts who are alert will flag this chart and comment that it is looking “overextended” or oversold. Momentum indicators define this oversold status further (covered later in this tutorial).
The reversal signal culminates when the price makes a new low but then reverses up sharply the same day and actually closes higher than the previous day; this is also known as “a key day reversal”.
Let’s try and look a little closer at what is happening to investor sentiment during a bullish reversal. As discussed above, we know that immediately prior to the reversal, investors have capitulated i.e. the last few bulls have vanished into thin air and that virtually everyone is now bearish. However, the majority of those who want to sell will already have sold on the way down so, eventually, the supply will dry up. All it takes now is for one short trader to take some profits (buy back) or a few bulls to do a bit of bargain hunting and we have an imbalance i.e. the supply (the bears or sellers) have dried up and we have an increase in demand (bulls or buyers). This will create a reversal and the sudden up-move will trigger other short sellers to close out positions and further bargain hunters to step in causing further upward pressure.
The bearish reversal is the inverse of the bullish reversal as discussed above. It is a dramatic top formation and develops when prices have accelerated higher and become overextended on the upward side. It is characterised by a new short term high followed by the price closing the day lower.
It is not uncommon for an instrument to regain composure after a reversal and revisit the level at which the previous reversal took place. However, it is more than likely that this level will have become a powerful level of support or resistance and may generate a further reversal signal.
Momentum indicators are used to monitor the underlying “health” of a particular trend. They do this through a variety measurements and most commonly by assessing the rate at which a stock or financial instrument is advancing or declining.
Changes in the rate of advance/decline are useful in determining the level of investor enthusiasm: for example, an uptrend “losing momentum” suggests investors are no longer prepared to buy as much stock at current prices demand pull had run out of steam and we could reasonably expect a period of consolidation before enthusiasm returns.
The Relative Strength Index (RSI)
Relative Strength Index or “RSI” was developed by J. Welles Wilder in 1978 and was later discussed in his book New Concepts in Technical Trading Systems. The name “Relative Strength Index” compares the strength of a single security to past data.
It is calculated by measuring the ratio of average price gains against average price losses over a specific rolling period.
The RSI is an oscillator that ranges between 0 and 100. There are two main signals that can be generated from this indicator:
When the RSI turns up, developing a trough from below 30, it suggests the price is oversold and likely to rally. Conversely, when the RSI turns down, making a peak above 70, it suggests that the price is overbought and likely to drop.
RSI Divergence signals
Divergence occurs when the price makes a new high (or low) that is not confirmed by a new high (or low) in the RSI.
Prices usually correct and move in the direction of the RSI. In this case, the RSI is acting as a leading rather than a lagging indicator giving early indication of future price movement.
The stochastic indicator was developed by George C. Lane in the 1950’s. It measures the position of a price within its range over a specified time period using the closing price relative to the high and low prices over a period.
It is expressed as an oscillator and signals are somewhat similar to the RSI as one can use both overbought/oversold and divergence. What differentiates the stochastic indicator from the RSI is that the stochastic uses a moving average as a signal trigger.
The main stochastic line is known as %K, and is calculated over a specified number of days (default is 9). A short term moving average (default 3) is applied to %K and this timing line is known as %D. As you will see from the momentum settings screen, there is a third variable which is used to “slow” or smooth the %K line by displaying it as a moving average.
The most reliable buy signal is to look for divergence in oversold territory (below 20) and then trade when %K the green line moves back above %D. The most reliable sell signal is divergence in overbought territory above 80 and the %K moving below %D.
The MACD was developed by Gerald Appel and set out in his book “The Moving Average Convergence Divergence Trading Method“.
The MACD indicator is the difference between two exponential moving averages (12 and 26 as default) and also has a signal trigger or timing line (9 day ema as default).
When values of the MACD indicator move above the zero level, it is similar to a moving average crossover signal described previously to identify uptrends.
However, many investors do not wait for the indicator to move above zero as a buy signal but instead look for divergence i.e. for the price to make a lower low and the MACD to make a higher low.
A signal line in the form of a short term moving average (red line) is applied to the MACD to provide the actual signal.