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

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