TECHNICAL ANALYSIS BASICS

By Haresh Motiani

Reviewed by: Indrajit Mukherjee www.stockmaniacs.net

(1) Hammer and Hanging Man (Candlestick Reversal Pattern) In a Hammer, during a downtrend, there is an initial sharp sell off to new lows. However, by the end of the day, the market rallies to close at or near its high for the day. :

The sharp recovery suggests that the bearish sentiment may be beginning to wane and if a move above the high of the Hammer days occurs during the next day's trading there is a stronger risk of complete trend reversal. In a Hanging man, during an uptrend there is a sharp sell off after the market. By the end of the day, the market rallies to close at or near the high for the day. This pattern definitely requires confirmation. The recovery in price over the day could mean the bulls are still in control. However, a break to new highs on the next trading day is required to confirm. Alternately, a decline to test the low of the Hanging Man day will suggest a trend reversal. (2)The engulfing-bullish and bearish A bullish engulfing candle occurs after a significant downtrend. Note that the engulfing candle must encompass the real body of the previous candle, but need not surround the shadows. Below you will find an illustration of a bullish engulfing candle

A bearish engulfing candle occurs after a significant uptrend. Again, the shadows need not be surrounded. Below you will find an illustration of a bearish engulfing candle: The power of the engulfing candle is increased by two factors -- the size of the candle and the volume on the day it occurs. The bigger the engulfing candle, the more

significant it is likely to be. A large bullish engulfing candle says the bulls have seized control of the market after a downtrend. Meanwhile, a large bearish engulfing says the bears have taken command after an uptrend. Also, if volume is above normal on the day when the signal is given, this increases the power of the message. (3)Bearish Harami Bearish Harami Pattern is a two-candlestick pattern composed of a small black real body contained within a prior relatively long white real body. “Harami” is an old Japanese word for “pregnant”. The long white candlestick is “the mother” and the small candlestick is “the baby”. Recognition Criteria: 1. Market is characterized by an uptrend. 2. We see a long white candlestick on the first day. 3. Then we see a black candlestick on the second day whose real body is completely engulfed by the real body of the first day. The shadows (high/low) of the second candlestick do not have to be contained within the first body, though it's preferable if they are.

Explanation: The Bearish Harami Pattern is a sign of a disparity about the market’s health. Bull market continues further confirmed by the long white real body’s vitality but then we see the small black real body which shows some uncertainty. This shows the bulls’ upward drive has weakened and now a trend reversal is possible. Important Factors: It is important that the second day black candlestick has a minute real body relative to the prior candlestick and that this small body is inside the larger one. The Bearish Harami Pattern does not necessarily mean a market reversal. It rather predicts that the market may not continue with its previous uptrend. There are however some instances in which the Bearish Harami Pattern can warn of a significant trend change - especially at market tops. A confirmation of the reversal on the third day is required to be sure that the uptrend has reversed. This confirmation may be in the form of a black candlestick, a large gap down or a lower close on the next trading day (the third day).

(4) Bullish Harami Cross

Bullish Harami Cross Pattern is a doji preceded by a long black real body. The Bullish Harami Cross Pattern is a major bullish reversal pattern. It is more significant than a regular Bullish Harami Pattern. Recognition Criteria: 1. Market is characterized by downtrend. 2. Then we see a long black candlestick. 3. Long black candlestick is followed by a doji completely engulfed by the real body of the first day. The shadows (high/low) of the doji may not be necessarily contained within the first black body, though it's preferable if they are. Explanation: The Bullish Harami Cross Pattern is a strong signal of disparity about the market’s health. During a downtrend, the heavy selling reflected by a long, black real body; is followed by a doji next day. This shows that the market is starting to severe itself from the prior downtrend. Important Factors: The Bullish Harami Pattern is not a major reversal pattern, however the Bullish Harami Cross Pattern is a major upside reversal pattern. Short traders will not be wise to ignore the significance of a harami cross just after a long black candlestick. Harami crosses point out to the bottoms.

A third day confirmation of the reversal is recommended (though not required) to judge that the downtrend has reversed. The confirmation may be in the form of a white candlestick, a large gap up or a higher close on the next trading day.

(5) Inverted Hammer

If you are a regular Swing Trader reader, then the inverted hammer should seem very familiar. However, you may not be able to put your finger on exactly why it looks so familiar. The reason is that the inverted hammer is identical in appearance to the shooting star, which we discussed in our December 8th, 2003 Swing Trader issue. The difference is that the shooting star occurs at the end of a long uptrend. The inverted hammer, on the other hand, occurs after a significant decline has taken place. If you examine the inverted hammer carefully, it hardly looks like a bullish candle. Prices opened low and then rallied strongly. By the close of trading, however, the stock has given back almost all of the day's gains. That leaves a small real body and a very large upper shadow. If anything, the candle looks bearish. The bulls could not sustain a rally, so the bears took the stock back toward its lows for the day. So, why should this candle potentially set up an important reversal? My theory is that the inverted hammer is a signal that shorts are beginning to cover their positions. Here is my reasoning. Since the inverted hammer can only occur after a sustained downtrend, the stock is in all probability already oversold. Therefore, the inverted hammer may signify that shorts are beginning to cover. In addition, traders who have held long positions in the security, most of whom are now showing large losses, are often quick to dump their shares by selling into strength. This will also serve to drive the stock back down. With this candle, it is imperative to watch the next day's trading action. If the stock opens strongly and remains strong during the day, then a key reversal is likely in progress.

(6) Piercing lines

In a downtrend the market gaps open, but rallies strong to close above the previous days midpoint. This pattern suggests an opportunity for the bulls to enter the market and support the trend reversal. The Piercing Line pattern is the opposite of the Dark Cloud

Cover. A long black body followed by a white body. The white body pierces the midpoint of the prior white body. Occurs in a downtrend. (7) Dark cloud cover

Recognition The market is in uptrend 1st day is a long white body 2nd day is a black body which opens above the previous day’s high 2nd day closes within, but below the midpoint of the 1st day's body

(8) Doji Star

Bullish

Bearish

A Doji Star is a trend reversal pattern which is composed of a long black body fol owed by a doji(a pattern with the same opening and closing price). Recognition Criteria: Long black day fol owed by a doji. The doji gaps down from the prior black body. (Confirmation is suggested.)

(9) Evening Star

Evening Star (Bearish)--a top reversal pattern where the first is a tall real body, the second is a small real body (green or red) which gaps high to form a star. The third is a red candlestick which closes well into the first session's green real body. (10) Morning Doji Star

When a downtrend market is in place, fol owing by a Doji Star. Like the regular Morning Star, the third day will support the reversal of the trend. It is more significant than the regular Morning Star pattern. Recognition Criteria: The first day is a black day which indicates the trend of the market. The second day must be a Doji day. The third day is a white day and supports the reversal of the trend. (Confirmation is suggested.)

(11) Evening Doji Star

An Evening Doji Star is when a Doji Star is in an uptrend fol owed by a long black body. Like the regular Evening Star, the third day will support the reversal of the trend. It is more significant than the regular Evening Star pattern. Recognition Criteria: The first day is a white day which indicates the trend of the market.

The second day is a Doji day. The third day is black day which supports the reversal of the trend. (Confirmation is suggested.) (12) Abandoned Baby

Bullish Abandoned Baby

Bearish Abandoned Baby

Abandoned Baby pattern is similar to the family of Morning Star and Evening Star patterns. It is almost the same as Morning Doji and Evening Doji Star. The difference is the shadows on the Doji must gap below the shadows of the first and third days for the Abandoned Baby bottom. Recognition Criteria: The first day shal indicates the prior trend. The second day is a Doji which gaps above or below the previous day's range. The third day is the opposite color of the first day and gaps in the opposite direction. There is no shadows overlapping between the Doji and other two days. (Confirmation is suggested.) (13) Trading the Upside Gap Two Crows Pattern

Description The Upside Gap Two Crows is a three-day pattern. The upside-gap is created between the long white candle at the top of an uptrend and the small black candle of the second day. The black candle gaps open and pulls back before the end of the day. Even though it has pulled back, it did not fill the gap. The third day opens above where the first black candle opened. It can not hold at these evels and pulls back before the end of the day. Closing

lower than the previous ay, it has engulfed the small black candle's body. However, it still did not close the gap from the white candle. Criteria 1. A long white candle continues the uptrend. 2. The real body of the next day is black while gapping up and not filling the gap. 3. The third day opens higher than the second day's open and closes below the second day's close. This produces a black candle that completelyengulfs the small black candle. 4. The close of the third day is stil above the close of the last white candle

(14) MEETING LINES

Meeting Lines (or Counterattack Lines) are formed when opposite colored bodies have the same closing price. The first Candlestick body is the same color as the current trend. The second body is formed by a gap open in the same direction as he trend. However, by the close, it has come back to the previous day's close. The Bullish Meeting Line has the same criteria as the Piercing Line except that is closes the same close as the previous day and not up into the body. Likewise, he Bearish Meeting Line is the same as the Dark Cloud pattern, but it does not close down into the body of the previous day. Criteria 1. The first candlestick body should continue the prevailing trend. 2. The second candlestick gaps open continuing the trend. 3. The real body of the second day closes at the close of the first day. 4. The body of the second day is opposite color of the first day 5. Both days should be long candle days.

15) Trading the Unique Three River Bottom Pattern

The Unique Three River Bottom is a bullish pattern, somewhat characteristic of the Morning Star Pattern. It is formed with three candles. At the end of a downtrend, a long black body is produced. The second day opens higher, drops down to new lows, then closes near the top of the trading range. This is a hammer-type formation. The third day opens lower but not below the low of the previous day. It closes higher, producing a white candle. But it doesn’t close higher than the previous day’s close. This pattern is a rare pattern. Criteria 1. The candlestick body of the first day is a long black candle, consistent with the prevailing trend. 2. The second day does a harami/hammer. It also has a black body. 3. The second day’s shadow has set a new low. 4. The third day opens lower, but not below the lowest point of the previous day. It closes higher but below yesterday’s close.

Signal Enhancements 1. The longer the shadow of the second day, the probability of a successful reversal becomes greater. Broadening Formation A pattern used in technical analysis to predict the likelihood of a reversal in the direction of the current trend. It is identified by finding diverging trendlines that connect a series of widening peaks and troughs. The most common type of broadening formation is found at the end of a prolonged uptrend and is used to predict a move lower.

As the two trendlines diverge from the apex, the pattern resembles a reversed version of a symmetrical triangle. This pattern is considered quite rare, but the signal it generates is deemed to be very reliable. As shown by the last candle on the chart above, many technical traders will use candle stic patterns such as a doji to confirm the reversal predicted by the broadening formation.

Broadening Top is a rally to a new high, weakness to an intermediate support level, a second rally to a higher high on increased volume and decline through the intermediate support level, a third rally to a higher high on strong volume followed by a eventual collapse Because Broadening Tops are very large reversal patterns, the technical implications are usually extreme. The measured target is derived by subtracting the height of the pattern from the eventual breakout level. ·Unlike most consolidation patterns, broadening tops feature increasing wide ranges and greater volatility as time passes. ·Volume increases as the share prices rises. Normally this is bullish but rallies prove very short-lived and declines "take-out" previous support levels. ·Broadening formations are only found in topping formations because they are the product of unrealistic expectations on the part of bullish investors. Downside breakouts often lead to small 2-3% declines followed by an immediate test of the breakout level. If the stock closes above this level (now resistance) for any reason the pattern becomes invalid. Whereas some technical patterns are characterized by consensus and a general lack of volatility, the same cannot be said about the broadening top. These patterns always feature indecision and extreme volatility. When one looks at the pattern the resemblance to a megaphone is striking. The stock makes a series of higher highs and lower lows. Normally as time passes and more information is disseminated, investors come to consensus and volatility slows but just the opposite is true of broadening tops. There are distinct parts of every broadening top formation. The first of three small tops (top #1) occurs after a spectacular run to new high on increasing volume. Generally, this advance will be the result of better than expected earnings, a new product and/or a barrage of Wall Street recommendations. However, as the stock surges to new highs sellers also step-up selling efforts and it is not long before the stock settles back to a prior support level (a).

After several sessions of slower trade more positive news pushes the stock to yet another new high on increased volume (top #2). The increased volume should be a sign that bullish consensus is building but once again the stock falters, falling to a relative new low (b) just days after making a new high. Although the news flow is still very positive, rumors begin to circulate that some institutions and insiders are beginning to liquidate positions. It is at this time that there is a full scale defense of the stock by bullish investors. Wall Street firms make new recommendations with lofty price targets and once again, the stock begins to move higher. Although volume is strong, it is noticeably less than the prior rallies. The stock moves to third new high (top #3) in as many attempts. All of the news is positive. The company may be raising guidance, setting a stock split or talking about the outlook for new products. The prospects seem bright but even as the stock is making a new high, there is skepticism among some investors. Days later the stock begins to falter on increased volume but no specific news. Several days later the stock is collapsing and support at the most recent low is in jeopardy. There is news that a large shareholder has filed to sell stock, bullish investors panic. Weeks later the stock sinks back to the longer-term support level. Channel Line What It Is ? While the trendline is the primary tool of technical analysis, the channel line is an important secondary one. Many times, I have questioned the channel lines drawn by other technical analysts -- even those whose insights I admire. Often, channel lines are inserted where I do not believe they belong. For example, a channel line sloping at one angle, while the trendline is sloping at another, is incorrect and can lead to misleading conclusions. When constructing a channel line, it should be drawn absolutely parallel to the basic trendline or at minimum very close to parallel.

Why it Matters A channel line is a secondary tool to the trendline. When drawn properly, however, it can assist the trader in identifying areas of support or resistance. It can also help gauge whether when the trend is losing steam or accelerating. Construct channel lines effectively, and you will discover that they can be an important part of your technical

analysis toolkit.

Diamond Formation The diamond formation reversal pattern is found relatively infrequently. When it does form, however, it usually does so at market tops rather than at bottoms. This is consistent with its appearance, which suggests a confused, active market found at a top more often than at a bottom. As Figure 1 show, the diamond starts off as a broadening formation and then consolidates, usually forming a symmetrical triangle. The combination of price patterns first broadening and then consolidating gives the geometry for which the diamond is named. This shape becomes more apparent when trend lines, like those shown, are drawn connecting successive peaks and valleys. The shape has also been described as a complex head and shoulders with an odd center movement Volume activity can help distinguish a diamond from an ordinary head-and-shoulders formation. The tendency might be to see a formation and interpret it as a diamond, when in reality it is only a head-and-shoulders pattern. This bias toward the diamond might be because an up sloping neckline would allow an earlier entry of the position and therefore more potential profit. A genuine diamond pattern is signified by a decrease in volume during the second half of the price pattern.

This volume pattern is similar to the one found in a standalone symmetrical triangle. When a diamond forms at a top, the following down move is usually significant. A minimum expectation of the move can be estimated by measuring the distance in points at the widest part of the diamond. Prices usually move from the breakout price to a low, giving a net change at least equal to this measurement, typically further. An uncommon but recognizable reversal pattern that begins as a broadening formation and reverts to a symmetrical triangle after several swings to make a four-cornered pattern. Normally occurs only in very active stocks, and shows up more often during tops. Double Top A double top occurs when prices form two distinct peaks on a chart. A double top is only complete, however, when prices decline below the lowest low - the "valley floor" - of the pattern. The double top is a reversal pattern of an upward trend in a stock's price. The double top marks an uptrend in the process of becoming a downtrend. Sometimes called an "M" formation because of the pattern it creates on the chart, the double top is one of the most frequently seen and common of the patterns. Because they seem to be so easy to identify, the double top should be approached with caution by the investor. According to Schabacker, the double top is a "much misunderstood formation." Many investors assume that, because the double top is such a common pattern, it is consistently reliable. This is not the case. Schabacker estimates that probably not more than a third of them signal reversal and that most patterns which an investor might call a double top are not in fact that formation.2 Bulkowski estimates the double top has a failure rate of 65%. If an investor waits for the breakout, however, the failure rate declines to 17%. The double top is a pattern, therefore, that requires close study for correct identification. What does a double top look like? As illustrated below, a double top consists of two well-defined, sharp peaks at approximately the same price level. A double top occurs when prices are in an uptrend. Prices rise to a resistance level, retreat, return to the resistance level again before declining. The two tops should be distinct and sharp. The pattern is complete when prices decline below the lowest low in the formation. The lowest low is called the confirmation point. Analysts vary in their specific definitions of a double top. According to some, after the first top is formed, a reaction of at least 10% should follow. That decline is measured from high to low.

According to Edwards and Magee, there should be at least a 15% decline between the two tops, on diminishing activity. The second rally back to the previous high (plus or minus 3%) should be on lower volume than the first. Other analysts maintain that the decline registered between the two tops should be at least 20% and the peaks should be spaced at least a month apart. There are a few points of agreement, however. Investors should ensure that the pattern is in fact comprised of two distinct tops and that they should appear near the same price level. Tops should have a significant amount of time between them -ranging from a few weeks to a year. Investors should not confuse a consolidation pattern with a double top. Finally, it is crucial to the completion of the reversal pattern that prices close below the confirmation point.

Double Bottom The double bottom is a major reversal pattern that forms after an extended downtrend. As its name implies, the pattern is made up of two consecutive troughs that are roughly equal, with a moderate peak in-between.

Although there can be variations, the classic double bottom usually marks an intermediate or long-term change in trend. Many potential double bottoms can form along the way down, but until key resistance is broken, a reversal cannot be confirmed. To help clarify, we will look at the key points in the formation and then walk through an example.

Prior Trend: With any reversal pattern, there must be an existing trend to reverse. In the case of the double bottom, a significant downtrend of several months should be in place. First Trough: The first trough should mark the lowest point of the current trend. As such, the first trough is fairly normal in appearance and the downtrend remains firmly in place. Peak: After the first trough, an advance takes place that typically ranges from 10 to 20%. Volume on the advance from the first trough is usually inconsequential, but an increase could signal early accumulation. The high of the peak is sometimes rounded or drawn out a bit from the hesitation to go back down. This hesitation indicates that demand is increasing, but still not strong enough for a breakout. Second Trough: The decline off the reaction high usually occurs with low volume and meets support from the previous low. Support from the previous low should be expected. Even after establishing support, only the possibility of a double bottom exists, it still needs to be confirmed. The time period between troughs can vary from a few weeks to many months, with the norm being 1-3 months. While exact troughs are preferable, there is some room to maneuver and usually a trough within 3% of the previous is considered valid. Advance from Trough: Volume is more important for the double bottom than the double top. There should clear evidence that volume and buying pressure are accelerating during the advance off of the second trough. An accelerated ascent, perhaps marked with a gap or two, also indicates a potential change in sentiment. Resistance Break: Even after trading up to resistance, the double top and trend reversal are still not complete. Breaking resistance from the highest point between the troughs completes the double bottom. This too should occur with an increase in volume and/or an accelerated ascent. Resistance Turned Support: Broken resistance becomes potential support and there is sometimes a test of this newfound support level with the first correction. Such a test can offer a second chance to close a short position or initiate a long. Price Target: The distance from the resistance breakout to trough lows can be added on top of the resistance break to estimate a target. This would imply that the bigger the

formation is, the larger the potential advance.

FLAG When a stock has a strong run up over a short period of time, where it gains 30% or 40% or more, there is a tendency for either a correction or a continued advance with even larger gains expected. One chart pattern that sometimes precedes a second large advance is called the "high tight flag". This is a pattern that starts with a flag pole, or price that rises sharply in a short period of time. This is followed by a tight consolidation period that can last between 2 to 6 weeks. The consolidation period creates the formation of a "flag", a break out of such a consolidation period is usually to the upside and can produce gains similar to the percentage increase of the initial gains made during the creation of the flagpole. During the formation of the flag in the consolidating period volume generally declines. A breakout from the flag pattern is usually accompanied by increased volumes. Price projections that are estimations based on the range of price during the formation of the flagpole are projected upwards from the flag formation on a breakout give a rough idea of what to expect near term for prices. What price projections do not do is tell you whether prices will reach that level or stay at that level. A projection is simply an estimation based on the increased demand for the stock and a potential for a short term continuation

of price surge following a consolidation of prices.

Stocks and Stock Market Gaps A "Gap" is a term used to describe the condition when a stock opens at a higher price than it closed the prior day. The word gap refers to the space that is left in the daily chart. It is the "empty space" from yesterday's close to today's open. Gaps can be either up or down and they can happen to all stocks and in all stock markets. Gaps are measured from the prior day's closing price to the current day's opening price. The post market activity and pre market activity do not affect the gap. Stocks can trade after market hours, and at pre market starting, but these are not considered "normal"

market hours.

Head and Shoulders Top A Head and Shoulders reversal pattern forms after an uptrend, 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 reaction lows of each peak can be connected to form support, or a neckline. As its name implies, the Head and Shoulders reversal pattern is made up of a left shoulder, a head, a right shoulder, and a neckline. Other parts playing a role in the pattern are volume, the breakout, price target and support turned resistance.

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