Technical Analysis is the analysis of the movement of prices, volumes and open interests – using historical data – based on the study of past behavior of currency, indices and commodities markets.Technical analysis is a technique used to forecast the future direction of prices through the study of historical market data, primarily price, volume and open interest.Technical traders use trading information (such as previous prices and trading volume) along with mathematical indicators to make their trading decisions. This information is usually displayed on a graphical chart updated in real time that is interpreted in order to determine when to buy and when to sell a specific instrument.
The ideas of Charles Dow, the first editor of the Wall Street Journal, form the basis of modern technical analysis. They are based upon three main premises:
Advantages of Technical Analysis
It requires much less data than fundamental analysis. From price and volume, a technical trader can obtain all the information he needed.As it is focused on identifying trend reversal, the question of timing to enter a trade is easier to address with technical analysis.
Drawbacks of Technical Analysis
Technical analysis can become a self fulfilling prophecy. When many investors, using similar tools and following the same concepts, shift together the supply and demand, this can lead to the prices moving in the predicted direction.
Technical and/or Fundamental Analysis
Technical Analysis is one of the most significant tools available for forecasting financial market behavior. It has been proven to be an effective tool for investors and is constantly becoming more accepted by market participants. When used in conjunction with fundamental analysis, technical analysis can offer a more complete valuation, which can make the difference in executing profitable trades.
Trend is the most important concept in technical analysis. A trend designates the general direction of a market movement. It is important to identify trends so that you can trade with them rather than against them.
Types of Trend
A trend of any direction can be classified according to its length.
A trendline is a simple charting technique that consists of connecting the significant highs (peaks) or the significant lows (troughs) to represent the trend in the market. These lines are used to clearly show the trend and also help in the identification of trend reversals.
A trendline may be classified as:
On the chart below, you can see a representation of a long-term upward trend in the EURUSD, along with a rising trendline.
A price channel is the addition of two parallel trendlines that act as strong areas of support and resistance. One trendline connects a series of price highs while the other connects a series of lows. A channel can slope upward, downward or sideways. Traders expect a given security or currency to trade between the two levels of support and resistance until it breaks beyond one of the levels. They used channel lines to point out where to place “take profit order” and “Stop Loss Order”.
You can see below a chart of an upward channel in the S&P 500 Index.
A price chart is a sequence of prices plotted over a specific time frame. On the chart, the vertical axis represents the price scale while the horizontal axis represents time.
When looking at a chart, there are several factors that you should be aware of as they affect the information that is provided. They include the time frame and the price scale used.
Each bar, candlestick or dot in a chart contains information regarding a defined time interval. The length of this interval is the chart interval.
Deciding on which chart interval to use depends on your trading style and investment horizon. Day traders may use chart intervals as short as 1 minute, while swingers (traders that hold trades between several days to a couple of weeks) usually use intervals varying from several hours to a day.
There are two methods for displaying the price scale along the y-axis: arithmetic and logarithmic.
On an arithmetic price scale, each price point is separated by the same vertical distance no matter what the price level. Each unit of measure is the same throughout the entire scale. If a stock advances from 10 to 100 over a 6-month period, the move from 10 to 20 (+100% variation) will appear to be the same distance as the move from 90 to 100 ( +11% variation). Even though this move is the same in absolute terms, it is not the same in percentage terms.
On a logarithmic scale, each price point is separated by a vertical distance that is equal in percentage terms. An advance from 10 to 20 would represent an increase of 100%. An advance from 20 to 40 would also be 100%, as would an advance from 40 to 80. All three of these advances would appear as the same vertical distance on a logarithmic scale.
Type of Charts
There are three main types of charts that are used by traders depending on the information that they are seeking and their individual skill levels. The chart types are: the line chart, the bar chart and the candlestick chart.
INTERPRETATION: The line chart is the most basic type of chart. The line shown in the chart connects single prices over a selected period of time. The most popular line chart is the daily chart. Although any point in the day could be plotted, most traders focus on the closing price, which they consider the most important. However this presents an immediate problem; using a daily line chart, one cannot see the price activity that occurred during the rest of the day.
BENEFIT: A line chart gives the trader a fairly good idea of where the price of an asset has traveled over a given time frame.
INTERPRETATION: Each vertical bar represents one period of price activity from the chosen periodicity, which could be as short as 1 minute for intraday charts, or as long as several years for historical charts. On a daily chart, the vertical bar represents one day’s trading whereby:
+ the top of the bar represents the market’s high price
+ the bottom of the bar represents the low
+ the left hash mark on the bar indicates the opening price
+ the right hash mark on the bar indicates the closing price
BENEFIT: By including open, high, low and close information, bar charts allow more detailed analysis than standard line charts.
INTERPRETATION: The candlestick chart is closely related to the bar chart, as it also represents the four major prices: high, low, open, and close. Each candle represents a timescale of your choice. The following timescales are offered by different chart software: 1 min, 15 min, 30 min, 1 hour, 2 hour, 4 hour, 8 hour, daily, weekly and monthly.
For a daily chart, each candlestick represents one day’s trading range and is displayed as “open” or “closed”:
+ An open candlestick represents a higher close than open and is shown in blue.
+ A closed candlestick represents a lower close than open and is shown in red.
Each candlestick consists of two components, the real body and the shadows:
+ The real body is the thick part of the candlestick that represents the open and the close
+ The thin lines above and below the real body are the shadows that represent the session’s price extremes. The upper shadow (above the real body) measures the high of the session and the lower shadow (below the real body) measures the low of the session.
BENEFIT: The candlestick chart is the most common chart used for technical analysis. Many trading strategies are based upon patterns in candlestick charting.
SUPPORT AND RESISTANCE
Support and Resistance are lines that illustrate the ongoing battle between the buyers (the bulls) and the sellers (the bears).
See below a graph representing the support and resistance of the EUR/JPY.
As long as the price of a security moves between the support and resistance level, the trend is likely to continue. A break beyond a level of support or resistance can be the sign of:
When a resistance level is broken, its role is reversed and it becomes a support level. Similarly, when a support level is broken, that level becomes a resistance level.You will see below a graph representing a trend acceleration of the AUD/JPY where a resistance becomes a support level.
Support and resistance analysis is used by technical traders to make trading decisions and identify when a trend is accelerating or reversing. Being aware of these important levels should affect the way you trade and help you significantly improve your performance.
Continuation patterns indicate a pause in trend, implying that the previous direction will resume after a period of time. We will look at the following patterns: price channels, symmetrical triangles and flags & pennants.00
A price channel is a continuation pattern that is bound by a trend line and a return line. A price channel may slope up (ascending pattern), down (descending pattern) or not at all (rectangle pattern). Depending on the channel slope, each of the lines can serve as either support or resistance.
+ An ascending price channel is considered bullish. Traders will look to buy when prices reach the trend line support and take profit when it reaches the return line resistance
+ Descending price channel is considered bearish. Traders will look to sell when prices reach the trend line resistance and take profit when it reaches the return line support.
+ Rectangle patterns are neither bullish nor bearish, but simply reflect a pause in the underlying trend.
To draw a bullish price channel it is necessary to have at least two higher-lows and two parallel, or higher-highs. Conversely, to draw a bearish price channel, two lower-highs and parallel, or lower-lows are necessary.
Although channels are usually referred to as continuation patterns, there are exceptions when a reversal trend might occur. In those cases prices usually fail to touch the return line before falling in what can be an early sign for an impending reversal.
Channels also have quantitative implications. Once price action breaks through the channel line, prices usually travel a distance equal to at least the width of the channel.
Because technical analysis is just as much art as it is science, there is room for flexibility. Even though exact trendline touches are ideal it is up to each individual to judge the relevance and placement of both the main trendline and the channel line. By the same token, a channel line that is exactly parallel to the main trendline is ideal.
The symmetrical triangle is a continuation pattern that developed in markets that seems aimless in direction. The pattern contains at least two lower-highs and two higher-lows that seem to come together. When the lines connecting these points are extended, they converge and a symmetrical triangle results.
The symmetrical triangle has both measuring and timing implications. As the pattern is completed, price and volume diminishes before they both react sharply to break out of the triangle’s boundaries. When the breakout occurs, prices tend to travel a distance equal to the triangle’s base or more (see the example below). From the timing perspective, the breach of a triangle should occur somewhere between half-way and two thirds along the distance from base to apex, i.e. the triangle’s height.
The break may occur on either side out of the triangle. In the case of a bullish symmetrical triangle, the breakout occurs in the same direction of the previous bullish trend. In the case of a bearish symmetrical triangle, the breakout occurs in the same direction of the previous bearish trend.
Example of a bullish symmetrical triangle
Flags and Pennants
These two similar continuation patterns usually occur at the midpoint of a large price movement and represent only brief pauses in a dynamic market. They can be identified and distinguished by the shape of their “body;” a rectangle sloping slightly against the trend in the case of the flag, and a triangle in the case of the pennant.
Flags and pennants are similar in both their form and interpretation. Both mark a small consolidation of a price movement, though to be truly considered as continuation patterns there should be evidence of a prior trend.
Flags and pennants are usually preceded by a sharp advance or decline in the direction of the trend, which provides the shape of the “flagpole” on the chart. The breakout from the pattern should show a minimal price move equal to the length of the flagpole.
Example of a Bullish Flag : When a breakout occurs, the minimal price move is equal to the size of the flagpole.
MATHEMATICAL TRADING INDICATORS
The mathematical trading methods provide an objective view of price activity. It helps you to build up a view on price direction and timing, reduce fear and avoid overtrading. Furthermore, these methods tend to provide signals of price movements prior to their occurring in the market.
The tools used by the mathematical trading methods are moving averages and oscillators. (Oscillators are trading tools that offer indications of when a currency is overbought or oversold). Though there are countless mathematical indicators, here we will cover only the most important ones.
A moving average is an average of a shifting body of prices calculated over a given number of days. A moving average makes it easier to visualize market trends as it removes – or at least minimizes – daily statistical noise. It is a common tool in technical analysis and is used either by itself or as an oscillator.
There are several types of moving averages, but we will deal with only two of them: the simple moving average (SMA) and the exponential moving average (EMA).
1.Simple moving average (SMA)
The simple moving average is an arithmetic mean of price data. It is calculated by summing up each interval’s price and dividing the sum by the number of intervals covered by the moving average. For instance, adding the closing prices of an instrument for the most recent 25 days and then dividing it by 25 will get you the 25 day moving average.
Though the daily closing price is the most common price used to calculate simple moving averages, the average may also be based on the midrange level or on a daily average of the high, low, and closing prices.
Moving average is a smoothing tool that shows the basic trend of the market.
It is one of the best ways to gauge the strength a long-term trend and the likelihood that it will reverse. When a moving average is heading upward and the price is above it, the security is in an uptrend. Conversely, a downward sloping moving average with the price below can be used to signal a downtrend.
It is a follower rather than a leader. Its signals occur after the new movement, event, or trend has started, not before. Therefore it could lead you to enter trade some late.
It is criticized for giving equal weight to each interval. Some analysts believe that a heavier weight should be given to the more recent price action.
You can see from the chart below examples of two simple moving averages – 5 days (Red), 20 days (blue).
MACD (Moving Average Convergence-Divergence)
The moving average convergence-divergence indicator (MACD) is used to determine trends in momentum.
It is calculated by subtracting a longer exponential moving average (EMA) from a shorter exponential moving average. The most common values used to calculate MACD are 12-day and 26-day exponential moving average.
Based on this differential, a moving average of 9 periods is calculated, which is named the “signal line”.
MACD = [12-day moving average – 26-day moving average] > Exponential Weighted Indicator
Signal Line = Moving Average (MACD) > Average Weighted Indicator
Due to exponential smoothing, the MACD Indicator will be quicker to track recent price changes than the signal line. Therefore,
When the MACD crossed the SIGNAL LINE: the faster moving average (12-day) is higher than the rate of change for the slower moving average (26-day). It is typically a bullish signal, suggesting the price is likely to experience upward momentum.
Conversely, when the MACD is below the SIGNAL LINE: it is a bearish signal, possibly forecasting a pending reversal.
Example of a MACD
You can see from the chart below example of a MACD. The MACD Indicator is represented in green and the Signal Line in Blue.
Bollinger Bands were developed by John Bollinger in the early 1980s. They are used to identify extreme highs or lows in price. Bollinger recognized a need for dynamic adaptive trading bands, whose spacing varies based on the volatility of the prices. During period of high volatility, Bollinger bands widen to become more forgiving. During periods of low volatility, they narrow to contain prices.
Bollinger Bands consist of a set of three curves drawn in relation to prices:
The middle band reflects an intermediate-term trend. The 20 day – simple moving average (SMA) usually serves this purpose.
The upper band is the same as the middle band, but it is shifted up by two standard deviations, a formula that measures volatility, showing how the price can vary from its true value
The lower band is the same as the middle band, but it is shifted down by two standard deviations to adjust for market volatility.
Bollinger Bands establish a Bandwidth, a relative measure of the width of the bands, and a measure of where the last price is in relation to the bands.
Lower Bollinger Band = SMA – 2 standard deviations
Upper Bollinger Band = SMA + 2 standard deviations.
Middle Bollinger Band = 20 day – simple moving average (SMA).
The probability of a sharp breakout in prices increases when the bandwidth narrows.
When prices continually touch the upper Bollinger band, the prices are thought to be overbought; triggering a sell signal.
Conversely, when they continually touch the lower band, prices are thought to be oversold, triggering a buy signal.
Example of Bollinger Bands
You can see from the chart below the Bollinger Bands of the S&P 500 Index, represented in green.
The Parabolic System, Stop-and-Reverse (SAR)
The parabolic SAR system is an effective investor’s tool that was originally devised by J. Welles Wilder to compensate for the failings of other trend-following systems.
The Parabolic SAR is a trading system that calculates trailing “stop-losses” in a trending market. The chart of these points follows the price movements in the form of a dotted line, which tends to follow a parabolic path.
When the parabola follows along below the price, it is providing buy signals.
When the parabola appears above the price, it suggests selling or going short.
The “stop-losses” dots are setting the levels for the trailing stop-loss that is recommended for the position. In a bullish trend, a long position should be established with a trailing stop that will move up every day until activated by the price falling to the stop level. In a bearish trend, a short position can be established with a trailing stop that will move down every day until activated by the price rising to the stop level.
The parabolic system is considered to work best during trending periods. It helps traders catch new trends relatively early. If the new trend fails, the parabola quickly switches from one side of the price to the other, thus generating the stop and reverse signal, indicating when the trader should close his position or open an opposing position when this switch occurs.
Example of an SAR parabolic study
You can see from the chart below in green the Parabolic System applied to the USDJPY pair.
Relative Strength Index (RSI)
The RSI was developed by J. Welles Wilder as a system for giving actual buy and sell signals in a changing market.
RSI is based on the difference between the average of the closing price on up days vs. the average closing price on the down days, observed over a 14-day period. That information is then converted into a value ranging from 0 to 100.
When the average gain is greater than the average loss, the RSI rises, and when the average loss is greater than the average gain, the RSI declines.
The RSI is usually used to confirm an existing trend. An uptrend is confirmed when RSI is above 50 and a downtrend when it’s below 50.
It also indicates situations where the market is overbought or oversold by monitoring the specific levels (usually “30” and “70”) that warn of coming reversals.
An overbought condition (RSI above 70) means that there are almost no buyers left in the market, and therefore prices are more likely to decline as those who previously bought will now take their profit by selling.
An oversold condition (RSI below 30) is the exact opposite.
Example of RSI
You can see in red from the chart below the Relative Strength Index of the GBPUSD pair.
FIBONACCI ANALYSIS AND ELLIOTT WAVE THEORY
Elliott Wave Theory (EWT)
Ralph Nelson Elliott referred to three important aspects of price movement in his theory: pattern, ratio and time. Pattern usefurefers to the wave patterns or formations, while ratio (the relationship between numbers, particularly the Fibonacci series) is l for measuring waves. To use the theory in everyday trading, the trader determines the main wave, or supercycle, goes long and then sells or shorts the position as the pattern runs out of steam and a reversal is imminent.
The Five-Wave Pattern
In its most basic form the Elliott Wave Theory states that all market action follow a repetitive rhythm of a five waves in the directions of the main trend followed by three corrective waves (a “5-3” move).
The advance waves are denoted 1-2-3-4-5 and the retreat waves are denoted a-b-c. In the advance waves’ phase, waves 1, 3, and 5 are “impulse waves” and move in the direction of the trend, while waves 2 and 4 are called “corrective waves”. After the five-wave advance is completed, a three-wave correction begins denoted a-b-c. In the correction waves’ phase, waves ‘a’ and ‘c’ move in the direction of the retreat, while wave ‘b’ heads in the opposite direction.
Note: In the chart shown here an uptrend is described and therefore the advance waves are moving upwards. In a downtrend the descending waves will be referred to in the form 1-2-3-4-5, with the ascending waves addressed as a-b-c.
When a three-wave retreat is complete, another five-wave advance begins and so on, until a reversal is prompted. It is possible to see then, that each five-wave advance can be identified as a single advance wave. Similarly, when viewed from a larger perspective, and vice versa, each wave can be broken down into smaller waves.
The Elliott Wave Theory classifies waves according to cycle length, ranging from a Grand Supercycle, spanning for decades; to a subminuette degree, covering no more than a few hours. However, the eight-wave cycle remains constant.
Note: The largest two waves, 1 and 2 here, can be subdivided into eight lesser waves that in turn can be subdivided into 34 even lesser waves. The two largest waves, 1 and 2, are only the first two waves in a larger five-wave advance. Wave 3 of that next higher degree is about to begin. The 34 waves that constitute a cycle can be broken down further to the next smallest degree which would result in 144 waves.
Fibonacci numbers provide the mathematical foundation for the Elliott Wave Theory. While the Fibonacci ratios have been adapted to various technical indicators, their utmost use in technical analysis remains the measurement of correction waves.
Fibonacci Series Characteristics
The Fibonacci number sequence is made by simply starting at 1 and adding the previous number to arrive at the new number:
0+1=1, 1+1=2, 2+1=3, 3+2=5, 5+3=8, 8+5=13, 13+8=21, 21+13=34, 34+21=55, 55+34=89,…
This series has very numerous interesting properties:
+ The ratio of any number to the next number in the series approaches 0.618 or 61.8% (the golden ratio) after the first 4 numbers. For example: 34/55 = 0.618
+ The ratio of any number to the number that is found two places to the right approaches 0.382 or 38.2%. For example: 34/89 = 0.382
+ The ratio of any number to the number that is found three places to the right approaches 0.236 or 23.6%. For example: 21/89 = 0.236
These relationships between every number in the series are the foundation of the common ratios used to determine price retracements and price extensions during a trend.
Fibonacci Price Retracements
A retracement is a move in price that “retraces” a portion of the previous move. Usually a stock will retrace at one of 3 common Fibonacci levels – 38.2%, 50%, and 61.8%. Fibonacci price retracements are determined from a prior low-to high swing to identify possible support levels as the market pulls back from a high.
Retracements are also run from a prior high-to-low swing using the same ratios, looking for possible resistance levels as the market bounces from a low.
Fibonacci Price Extensions
Fibonacci price extensions are used by traders to determine areas where they will wish to take profits in the next leg of an up-or downtrend. Percentage extension levels are plotted as horizontal lines above/below the previous trend move. The most popular extension levels are 61.8%, 100.0%, 138.2% and 161.8%.
In reality it is not always so easy to spot the correct Elliott wave pattern, nor do prices always behave exactly according to this pattern. Therefore it is advisable for a trader not to rely solely on Fibonacci ratios, but rather to use them in conjunction with other technical tools.