Technical analysis

 
Technical analysis definition:
Technical analysis is the examination of past price movements to forecast future price
movements. Technical analysts are sometimes referred to as chartists because they rely
almost exclusively on charts for their analysis.
 
Technical analysis is applicable to stocks, indices, commodities, futures or any tradable
instrument where the price is influenced by the forces of supply and demand. Price refers
to any combination of the open, high, low or close for a given security over a specific
timeframe. The time frame can be based on intraday (tick, 5-minute, 15-minute or
hourly), daily, weekly or monthly price data and lasts for few hours or many years.
In other words technical analysis is defined as the art of identifying a trend reversal at a
relatively early stage and riding on that trend until the weight of the evidence shows or
proves that the trend has reversed. 
 
Technical basics:
 
Price Discounts Everything: This theorem is similar to the strong and semi-strong forms
of market efficiency. Technical analysts believe that the current price fully reflects all
available information. Because all information is already reflected in the price, it
represents the fair value and should form the basis for analysis. After all, the market
price reflects the sum knowledge of all participants, including traders, investors, portfolio
managers, buy-side analysts, sell-side analysts, market strategist, technical analysts,
fundamental analysts and many others. It would be folly to disagree with the price set by
such an impressive array of people with impeccable credentials. Technical analysis
utilizes the information captured by the price to interpret what the market is saying with
the purpose of forming a view on the future.
 
Prices Movements are not Totally Random: Most technicians agree that prices trend.
However, most technicians also acknowledge that there are periods when prices do not
trend. If prices were always random, it would be extremely difficult to make money using
technical analysis.
 
A technician believes that it is possible to identify a trend, invest or trade based on the
trend and make money as the trend unfolds. Because technical analysis can be applied to
many different timeframes, it is possible to spot both short-term and long-term trends.
 
What is more Important than Why: A technical analyst knows the price of everything,
but the value of nothing". Technicians, as technical analysts are called, are only
concerned with two things:
1. What is the current price?
2. What is the history of the price movement?
The price is the end result of the battle between the forces of supply and demand for the
company's stock. The objective of analysis is to forecast the direction of the future price.
By focusing on price and only price, technical analysis represents a direct approach.
Fundamentalists are concerned with why the price is what it is. For technicians, the why
portion of the equation is too broad and many times the fundamental reasons given are
highly suspected. Technicians believe it is best to concentrate on what and never mind
why. Why did the price go up? It is simple, more buyers (demand) than sellers (supply).
After all, the value of any asset is only worth what someone is willing to pay for it. Who
needs to know why?
 
Conclusion
The markets move in trends caused by the changing attitudes and expectations of
investors with regard to the business cycle, an understanding of the historical
relationships between certain price averages and market indicators can be used to identify
turning points. No single indicator can ever be expected to signal all trend reversals, so it
is essential to use a number of them together to build up consensus.
 
Chart analysis
The chart represents a price chart and is a sequence of prices plotted over a specific
timeframe. In statistical terms, charts are referred to as time series plots.
On the chart, the y-axis (vertical axis) represents the price scale and the x-axis (horizontal
axis) represents the time scale. Prices are plotted from left to right across the x-axis with
the most recent plot being the furthest right.
Technicians, technical analysts and chartists use charts to analyze a wide array of
securities and forecast future price movements. The word "securities" refers to any
tradable financial instrument or quantifiable index such as stocks, bonds, commodities,
currencies, futures or market indices. Any instrument with price data over a period of
time can be used to form a chart for analysis.
 
Chart types
We will be explaining the construction of line, bar, candlestick and point & figure charts.
Although there are other methods available, these are four of the most popular methods
for displaying price data.
 
Line chart
The line chart is one of the simplest charts. It is formed by plotting one price point,
usually the closing price of a security over a period of time. Connecting the dots or price
points over a period of time creates the line.
Some investors and traders consider the closing level to be more important than the open,
high or low levels. By paying attention to only the closing price, intraday swings can be
ignored. Line charts are also used when open, high and low data points are not available.
 
Bar Chart
Perhaps the most popular charting method is the bar chart. The high, low and close values
are required to form the price plot for each period of a bar chart. The high and low are
represented by the top and bottom of the vertical bar and the close is the short horizontal
line crossing the vertical bar. On a daily chart, each bar represents the high, low and close
for a particular day. Weekly charts would have a bar for each week based on Friday's
close and the high and low for that week.
 
Candle stick chart
Originating in Japan over 300 years ago, candlestick charts have become quite popular in
recent years. For a candlestick chart, the open, high, low and close values are all required.
A daily candlestick is based on the open price, the intraday high and low, and the closing
price. A weekly candlestick is based on Monday's open, the weekly high-low range and
Friday's close.
Many traders and investors believe that candlestick charts are easy to read, especially the
relationship between the open and the close values. White (clear) candlesticks form when
the close is higher than the open and black (solid) candlesticks form when the close is
lower than the open. The white and black portion formed from the open and close values
is called the body (white body or black body). The lines above and below are called
shadows and represent the high and low.
 
Point & Figure Chart:
The charting methods show all plot in one data point for each period of time. No matter
how much prices moved, each day or week is represented by one point, bar or candlestick
along the time scale. Even if the price is unchanged from day to day or week to week, a
dot, bar or candlestick is plotted to mark the price action. Contrary to this methodology,
Point & Figure Charts are based solely on price movements and do not take time into
consideration. There is an x-axis but it does not extend evenly across the chart.
The beauty of Point & Figure Charts is their simplicity. Little or no price movement is
deemed irrelevant and therefore not duplicated on the chart. Only price movements that
exceed specified levels are recorded. This focus on price movements makes it easier to
identify support and resistance levels, bullish breakouts and bearish breakdowns.
 
Market trends
A trend is a time measurement of the direction in price levels covering different time
span. There are many trends, but the three that are most widely followed are:
 
Primary: it is between 9 months and 2 years and is a reflection of investor's attitude
towards unfolding fundamentals in the business cycle. The business cycle extended
statistically from trough to trough approximately 3.6 years, so it follows that rising and
falling primary trends (BULL and BEAR markets) lasts for 1 to 2 years. Since building
up takes longer than tearing down, bull markets generally last longer than bear markets.
The primary trend cycle is operative for bonds, equities and commodities. Primary trends
also apply to currencies, but since currencies reflect investor's attitudes toward
interrelationships among two different economies.
 
Intermediate: Anyone who has looked at a price chart will notice that the prices do not
move in a straight line. A primary upswing is interrupted by several reactions along the
way. These countercyclical trends within the confines of a primary bull market are known
as intermediate price movements. They last anywhere from 6 weeks to as long as 9
months, sometimes even longer, but rarely shorter.
Its important to have an idea of the direction and maturity of the primary trend, but an
analysis of intermediate trend is also helpful for improving success rates in trading, as
well as for determining when the primary movement may have run its course.
 
 
 
Short term: Short-term trends typically last from 2 to 4 weeks, sometimes shorter and
sometimes longer. They interrupt the course of the intermediate cycle, just as the
intermediate-term trend interrupts primary price movements. Short-term trends are shown
in the market cycle model as a dotted line figures, they are usually influenced by random
news events and are far more difficult to identify then their intermediate or primary
counterparts.
Trend lines
 
Technical analysis is built on the assumption that prices trend. Trendlines are an
important tool in technical analysis for both trend identification and confirmation. A
trendline is a straight line that connects two or more price points and then extends into the
future to act as a line of support or resistance. Many of the principles applicable to
support and resistance levels can be applied to trendlines as well.
 
It takes two or more points to draw a trendline. The more points used to draw the
trendline, the more validity attached to the support or resistance level represented by the
trendline. It can sometimes be difficult to find more than 2 points from which to construct
a trendline. Even though trendlines are an important aspect of technical analysis, it is not
always possible to draw trendlines on every price chart. Sometimes the lows or highs just
don't match up and it is best not to force the issue. The general rule in technical analysis
is that it takes two points to draw a trendline and the third point confirms the validity.
 
Ascending trend line
An ascending trend line has a positive slope and is formed by connecting two of more
low points. The second low must be higher than the first for the line to have a positive
slope. Ascending trend lines act as supports and indicate that net-demand (demand less
supply) is increasing even as the price rises. A rising price combined with increasing
demand is very bullish and shows a strong determination from the buyers. As long as
prices remain above the trendline, the upside trend is considered solid and intact. A break
below the upside trend line indicates that net-demand has weakened and a change in
trend.
 
Descending trend line
A descending trend line has a negative slope and is formed by connecting two or more
high points. The second high must be lower than the first for the line to have a negative
slope. Downside trend lines act as resistance and indicate that net-supply (supply less
demand) is increasing even as the price declines. A declining price combined with
increasing supply is very bearish and shows a strong resolve from the sellers. As long as
prices remain below the downside trendline, the downtrend is considered solid and intact.
A break above the downside trend line indicates that net-supply is decreasing and a
change of trend could be imminent.
 
The Support and resistance: represent key junctures where the forces of supply and
demand meet. In the financial markets, prices are driven by excessive supply (down) and
demand (up). Supply is synonymous with bearish, bears and selling. Demand is
synonymous with bullish, bulls and buying. These terms are used interchangeably
throughout this and other articles. As demand increases, prices advance and as supply
increases, prices decline. When supply and demand are equal, prices move sideways as
bulls and bears battle it out for control.
 
The definition of the support
Support is the price level at which demand is thought to be strong enough to prevent the
price from declining further. The logic dictates that as the price declines towards support
and gets lower, buyers become more tempted to buy and sellers become less tempted to
sell. By the time the price reaches the support level, it is believed that demand will
overcome supply and prevent the price from falling below the support level.
 
Support levels do not always hold and a break below support signals that the bears have
won out over the bulls. A decline below the support indicates a new willingness to sell
and/or a lack of incentive to buy. Support breaks and new lows signal that sellers have
reduced their expectations and are willing to sell at even lower prices. In addition, buyers
could not be persuaded into buying until prices declined below the support or below the
previous low. Once a support is broken, another support level will have to be established
at a lower level.
 
The definition of the resistance
Resistance is the price level at which selling is thought to be strong enough to prevent the
price from rising further. The logic dictates that as the price advances towards resistance,
sellers become more tempted to sell and buyers become less tempted to buy. By the time
the price reaches the resistance level, it is believed that supply will overcome demand and
prevent the price from rising above the resistance.
 
Resistance levels do not always hold and a break above a resistance signals that the bulls
have won out over the bears. A break above a resistance shows a new willingness to buy
and/or a lack of incentive to sell. Resistance breaks and new highs indicate buyers have
increased their expectations and are willing to buy at even higher prices. In addition,
sellers could not be persuaded into selling until prices rise above the resistance or above
the previous high. Once a resistance is broken, another resistance level will have to be
established at a higher level.
 
 
  
Candle stick patterns
In the 1600s, the Japanese developed a method of technical analysis to analyze the price
of rice contracts. This technique is called candlestick charting. Candlestick charts are
simply a new way of looking at price; they don't involve any calculations.
 
Candlestick charts are much more visually appealing than a standard two-dimensional bar
chart. As in a standard bar chart, there are four elements necessary to construct a
candlestick chart, the OPEN,HIGH, LOW and CLOSING price for a given time period.
Below are examples of candlesticks and a definition for each candlestick component:
 

The body of the candlestick is called the real body, and represents the range between the
open and closing prices.
A black or filled-in body represents that the closing price during that time period was
lower than the opening price, (normally considered bearish) and when the body is open or
white, that means the closing price was higher than the opening price (normally bullish).
 
The thin vertical line above and/or below the real body is called the upper/lower shadow,
representing the high/low price extremes for the period (one period of time measures the
duration of selling or buying within the market). As a trader, you can use any time period
you want, time intervals may be a tick chart, 1 min, 5min, 10 min, 1 hour, 4 hour, 1 day,
…
 
 
 
 
 
 
 
Technical indicators
 
Relative Strength Index (RSI):
 
This index is a popular indicator for the Forex (FX) market. The RSI measures the ratio
of up-moves to down-moves and normalizes the calculation so that the index is expressed
in a range of 0-100. If the RSI is 70 or greater then the instrument is seen as overbought
(a situation whereby prices have risen more than market expectations). An RSI of 30 or
less is taken as a signal that the instrument may be oversold (a situation whereby prices
have fallen more than market expectations).
 
Stochastic Oscillator:

This is used to indicate overbought/oversold conditions on a scale 0-100%. The indicator

is based on the observation that in a strong upside trend, closing prices for periods tend to
be concentrated in the higher part of the period’s range. Conversely, as prices fall in a
strong downside trend, closing prices tend to be near to the extreme low of the period
range.

Stochastic calculations produce two lines, %K and %D which are used to indicate
overbought/oversold areas of a chart. Divergence between the stochastic lines and the
price action of the underlying instrument gives a powerful trading signal.  
 
 

Moving Average Convergence Divergence (MACD):

This indicator involves plotting two momentum lines. The MACD line is the difference
between two exponential moving averages and the signal or trigger line which is an
exponential moving average of the difference. If the MACD and trigger lines cross, then
this is taken as a signal that a change in trend is likely.
 
 

Number theory
 
Fibonacci numbers:

The Fibonacci number sequence (1, 1, 2, 3, 5, 8, 13, 21, 34…..) is constructed by adding
the first two numbers to determine the third n umber that follows. The ratio of any
number to the next larger number is 62%, which is a popular Fibonacci retracement level.
The inverse of 62%, which is 38%, is also used as a Fibonacci retracement level.
(Combined with the Elliott wave theory, see hereunder)

Gann numbers:

W.D. Gann was a stock and a commodity trader working in the 50’s who reputedly made
over $50 million in the markets. He made his fortune using methods which he developed
for trading instruments based on relationships between price movement and time, known
as time/price equivalents. There is no easy explanation for Gann’s methods, but in
essence he used angles in charts to determine support and resistance areas and predict the
times of future trend changes. He also used lines in charts to predict support and
resistance areas.
 
  

 
Waves
 
Elliott wave theory:

The Elliott wave theory is an approach to market analysis that is based on repetitive wave
patterns and the Fibonacci sequence. An ideal Elliott wave patterns shows five advancing
waves followed by three waves of decline.
 
 
Gaps:
 
Gaps are spaces left on the bar chart where no trading has taken place.
An ascending gap is formed when the lowest price on a trading day is higher than the
highest price of the previous day.
A descending gap is formed when the highest price of the day is lower than the lowest
price of the prior day. An ascending gap is usually a sign of market's strength, while a
descending gap is a sign of market's weakness.
A breakaway gap is a price gap that forms on the completion of an important price
pattern. It signals usually the beginning of an important price move.
A runaway gap is a price gap that usually occurs around the mid-point of an important
market trend. For that reason, it is also called a measuring gap.
An exhaustion gap is a price gap that occurs at the end of an important trend and signals
that the trend is ending.
 
Trends:
 
A trend refers to the direction of prices. Rising peaks and troughs constitute an upside
trend; falling peaks and troughs constitute a downside trend, that determines the
steepness of the current trend. The breaking of a trend line usually signals a trend
reversal. A trading range is characterized by horizontal peaks and troughs.

Moving averages are used to smooth price information in order to confirm trends and
support and resistance levels. They are also useful in deciding on a trading strategy
particularly in futures trading or a market with a strong upside or a downside trend.

For simple moving averages, the price is averaged over a number of days. On each
successive day, the oldest price drops out of the average and is replaced by the current
price. Hence, it calculates the average for the daily moves. Exponential and weighted
moving averages use the same technique but weight the figures-least weight to the oldest
price, most to the current.
 
 
 
 
 
 
Chart formations
 
Head and shoulders pattern:
 
A technical analysis term used to describe a chart formation in which represented by an
instrument's price:

1. Rises to a peak and subsequently declines.

2. Then, the price rises above the former peak and again declines.
3. And finally, rises again, but not to the second peak, and declines once more.
The first and third peaks are shoulders, and the second peak forms the head.
 
 

A head and shoulders reversal pattern forms after an upside trend, and its completion
marks a trend reversal. The pattern contains three successive peaks with the middle peak
(head) being the highest and the two outside peaks (shoulders) being low and roughly
equal. The lows of each peak can be connected to form support, or a neckline.
 
Head and Shoulders Bottom (Reversal):

A chart pattern used in technical analysis to predict the reversal of a current downside
trend, this pattern is identified when the price of a security meets the following
characteristics:

1. The price falls to a trough and then rises.

2. The price falls below the former trough and then rises again.
3. Finally, the price falls again, but not as far as the second trough.

Once the final trough is made, the price heads upward toward the resistance found near
the top of the previous troughs. Investors typically enter into a long position when the
price rises above the resistance of the neckline. The first and third troughs are considered
shoulders, and the second peak forms the head.
 
The head and shoulders bottom is sometimes referred to as an inverse head and
shoulders. The pattern shares many common characteristics with its comparable partner,
but relies more on volume patterns for confirmation.
As a major reversal pattern, the head and shoulders bottom forms after a downside trend,
and its completion marks a change in trends. The pattern contains three successive
troughs with the middle trough (head) being the deepest and the two outside troughs
(shoulders) being shallower. Ideally, the two shoulders would be equal in height and
width. The highs in the middle of the pattern can be connected to form a resistance.
 
Double tops reversal:
 
A term used in technical analysis to describe the rise of a stock, a drop, another rise to the
same level as the original rise, and finally another drop.
 
The double top is a major reversal pattern that forms after an extended uptrend. As its
name implies, the pattern is made up of two consecutive peaks that are roughly equal,
with a moderate trough in between.
 
Double Bottom:
 
A charting pattern used in technical analysis. It describes the drop of a stock (or index), a
rebound, another drop to the same (or similar) level as the original drop, and finally
another rebound.
 

 
The double bottom is a major reversal pattern that forms after an extended downside
trend. As its name implies, the pattern is made up of two consecutive troughs that are
roughly equal, with a moderate peak in between.
 
Falling Wedge:
 
A technical chart pattern composed of two converging lines connecting a series of peaks
and troughs.
 
Falling wedges indicate temporary interruptions of upward price rallies. Rising wedges
indicate interruptions of a falling price trend. Technical analysts see a 'breakout' of this
wedge pattern as either bullish (on a breakout above the upper line) or bearish (on a
breakout below the lower line).
 
Triangle
 
A technical analysis pattern created by drawing trendlines along a price range that gets
narrower over time because of lower tops and higher bottoms. Variations of a triangle
include ascending and descending triangles. Triangles are very similar to wedges and
pennants.
 
 

 
The symmetrical triangle, which can also be referred to as a coil, usually forms during a
trend as a continuation pattern. The pattern contains at least two lower highs and two
higher lows. When these points are connected, the lines converge as they are extended
and the symmetrical triangle takes shape. You could also think of it as a contracting
wedge, wide at the beginning and narrowing over time.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Price Channel:
 
When charting the price of an asset, this is the space on the chart between an asset's
support and resistance levels. The price of the asset will stay within the support and
resistance levels until a breakout occurs.
 
Range traders will buy an asset when its price is near the bottom of the trading channel
and sell it when the price gets closer to the top of the trading channel, making a profit
from the price spread. Trading channels may be flat, ascending or descending