8. Chart Patterns
•v Distinct formation on a stock chart that creates a trading signal, or a sign of future price movements that are used to identify current trends and trend reversals and to trigger buy and sell signals.
•v Theory behind chart patterns is that history repeats itself, and that certain patterns are seen many times, signaling a certain high probability move in a stock
•v Chartists look for these patterns to identify trading opportunities, though there are no chart patterns that will tell you with 100% certainty where a security is headed.
•v There are two types of patterns within this area of technical analysis, reversal and continuation.
•v A reversal pattern signals that a prior trend will reverse upon completion of the pattern.
•v A continuation pattern, on the other hand, signals that a trend will continue once the pattern is complete. These patterns can be found over charts of any timeframe.
8.1 Head and Shoulders
•v One of the most popular and reliable chart patterns in technical analysis.
•v A reversal chart pattern that when formed, signals that the security is likely to move against the previous trend.
•v Head and shoulders top is a chart pattern that is formed at the high of an upward movement and signals that the upward trend is about to end.
•v Head and shoulders bottom, also known as inverse head and shoulders, is the lesser known of the two, but is used to signal a reversal in a downtrend.
Charting Test - Identify the inverse Head and Shoulders found below:
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Chart 10: Inverse Head and Shoulders
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The head and shoulders chart pattern illustrates a weakening in a trend by showing the deterioration in the successive movements of the highs and lows.
8.2 Cup and Handle
•v A cup and handle chart is a bullish continuation pattern in which the upward trend has paused but will continue in an upward direction once the pattern is confirmed.
•v As you can see above, this price pattern forms what looks like a cup, which is preceded by an upward trend. The handle follows the cup formation and is formed by a generally downward/sideways movement in the security's price.
•v Once price movement pushes above the resistance lines formed in the handle, the upward trend can continue. There is a wide ranging time frame for this type of pattern, with the span ranging from several months to more than a year.
8.3 Double Tops and Bottoms
•v This chart pattern signals a trend reversal
•v It is considered to be one of the most reliable and is commonly used. These patterns are formed after a sustained trend and signal to chartists that the trend is about to reverse. The pattern is created when a price movement tests support or resistance levels twice and is unable to break through. This pattern is often used to signal intermediate and long-term trend reversals.
Charting Test - Identify the double bottom and double top below:
Chart 11: Double top and double bottom
•v In the case of the double top pattern, the price movement has twice tried to move above a certain price level. After two unsuccessful attempts at pushing the price higher, the trend reverses and the price heads lower. In the case of a double bottom, the price movement has tried to go lower twice, but has found support each time. After the second bounce off of the support, the security enters a new trend and heads upward.
8.4 Triangles
There are 3 types of triangles, which vary in construct and implication, the symmetrical triangle, ascending and descending triangle. These chart patterns are considered to last anywhere from a couple of weeks to several months.
Charting Test - Identify the triangle
Chart 12: Triangle
•v The symmetrical triangle in chart 12 is a pattern in which two trendlines converge toward each other. This pattern is neutral in that a breakout to the upside or downside is a confirmation of a trend in that direction.
•v In an ascending triangle, the upper trendline is flat, while the bottom trendline is upward sloping. This is generally thought of as a bullish pattern in which chartists look for an upside breakout.
•v In a descending triangle, the lower trendline is flat and the upper trendline is descending. This is generally seen as a bearish pattern where chartists look for a downside breakout.
8.5 Flag and Pennant
•v These two short-term chart patterns are continuation patterns that are formed when there is a sharp price movement followed by a generally sideways price movement.
•v It is then completed upon another sharp price movement in the same direction as the move that started the trend. The patterns are generally thought to last from one to three weeks.
Charting Test - Identify the flags
Chart 13: Flags
•v In a pennant, the middle section is characterized by converging trendlines, much like what is seen in a symmetrical triangle. The middle section on the flag pattern, on the other hand, shows a channel pattern, with no convergence between the trendlines. In both cases, the trend is expected to continue when the price moves above the upper trendline.
8.6 Wedge
•v Can be either a continuation or reversal pattern. Similar to a symmetrical triangle except that the wedge pattern slants in an upward or downward direction, while the symmetrical triangle generally shows a sideways movement. The other difference is that wedges tend to form over longer periods, usually between three and six months.
Charting Test: Identify the wedge
Chart 14: Wedge
The fact that wedges are classified as both continuation and reversal patterns can make reading signals confusing. However, at the most basic level, a falling wedge is bullish and a rising wedge is bearish.
8.7 Gaps
•v A gap in a chart is an empty space between a trading period and the following trading period.
•v Occurs when there is a large difference in prices between two sequential trading periods. For example, if the trading range in one period is between $25 and $30 and the next trading period opens at $40, there will be a large gap on the chart between these two periods.
•v Gap price movements can be found on bar charts and candlestick charts but will not be found on point and figure or basic line charts.
•v Show that something of significance has happened in the security, such as a better-than-expected earnings announcement.
•v 3 main types of gaps, breakaway, runaway (measuring) and exhaustion. A breakaway gap forms at the start of a trend, a runaway gap forms during the middle of a trend and an exhaustion gap forms near the end of a trend.
8.8 Triple Tops and Bottoms
•v Another type of reversal chart pattern in chart analysis.
•v Not as prevalent in charts as head and shoulders and double tops and bottoms, but act in a similar fashion. These two chart patterns are formed when the price movement tests a level of support or resistance three times and is unable to break through; this signals a reversal of the prior trend.
•v Confusion can form with triple tops and bottoms during the formation of the pattern because they can look similar to other chart patterns. After the first two support/resistance tests are formed in the price movement, the pattern will look like a double top or bottom, which could lead a chartist to enter a reversal position too soon.
8.9 Rounding Bottom
•v A rounding bottom, also referred to as a saucer bottom, is a long-term reversal pattern that signals a shift from a downward trend to an upward trend. This pattern is traditionally thought to last anywhere from several months to several years.
•v A rounding bottom chart pattern looks similar to a cup and handle pattern but without the handle.
•v The long-term nature of this pattern and the lack of a confirmation trigger, such as the handle in the cup and handle, makes it a difficult pattern to trade.
9. Moving Averages
•v Most chart patterns show a lot of variation in price movement. This can make it difficult for traders to get an idea of a security's overall trend.
•v One simple method traders use to combat this is to apply moving averages:the average price of a security over a set amount of time.
•v By plotting a security's average price, the price movement is smoothed out. Once the day-to-day fluctuations are removed, traders are better able to identify the true trend and increase the probability that it will work in their favor.
9.1 Types of Moving Averages
•v There are a number of different types of moving averages that vary in the way they are calculated, but how each average is interpreted remains the same.
•v Calculations only differ in regards to the weighting that they place on the price data, shifting from equal weighting of each price point to more weight being placed on recent data.
•v The three most common types of moving averages are simple, linear and exponential.
Simple Moving Average (SMA)
•v Most common method used to calculate the moving average of prices: take the sum of all of the past closing prices over the time period and divides the result by the number of prices used in the calculation.
•v For example, in a 10-day moving average, the last 10 closing prices are added together and then divided by 10. A trader is able to make the average less responsive to changing prices by increasing the number of periods used in the calculation. Increasing the number of time periods in the calculation is one of the best ways to gauge the strength of the long-term trend and the likelihood that it will reverse.
Linear Weighted Average
•v least common out of the three and is used to address the problem of the equal weighting.
•v Calculated by taking the sum of all the closing prices over a certain time period and multiplying them by the position of the data point and then dividing by the sum of the number of periods.
•v For example, in a five-day linear weighted average, today's closing price is multiplied by five, yesterday's by four and so on until the first day in the period range is reached. These numbers are then added together and divided by the sum of the multipliers.
Exponential Moving Average (EMA)
•v uses a smoothing factor to place a higher weight on recent data points and is regarded as much more efficient than the linear weighted average
•v The most important thing to remember about the exponential moving average is that it is more responsive to new information relative to the simple moving average. This responsiveness is one of the key factors of why this is the moving average of choice among many technical traders.
•v A 10-period EMA rises and falls faster than a 10-period SMA. This slight difference doesn't seem like much, but it is an important factor to be aware of since it can affect returns.
9.2 Major Uses of Moving Averages
•v Used to identify current trends and trend reversals as well as to set up support and resistance levels. Moving averages can be used to quickly identify whether a security is moving in an uptrend or a downtrend depending on the direction of the moving average.
•v 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.
•v Another method to determine momentum is to look at the order of a pair of moving averages. When a short-term average is above a longer-term average, the trend is up.A long-term average above a shorter-term average signals a downward movement in the trend.
•v Moving average trend reversals are formed in two main ways:
•v The first common signal is when the price moves through an important moving average. For example, when the price of a security that was in an uptrend falls below a 10-period moving average, like in the figure above, it is a sign that the uptrend may be reversing.
•v The other signal of a trend reversal is when one moving average crosses through another. For example, if the 5-day moving average crosses above the 20-day moving average, it is a positive sign that the price will start to increase.
•v If periods used in the calculation are relatively short, for example 15 and 35, this could signal as short-term trend reversal.
•v On the other hand, when two averages with relatively long time frames cross over (50 and 200, for example), this is used to suggest a long-term shift in trend. Another major way moving averages are used is to identify support and resistance levels.
•v It is not uncommon to see a stock that has been falling stop its decline and reverse direction once it hits the support of a major moving average. A move through a major moving average is often used as a signal by technical traders that the trend is reversing. For example, if the price breaks through the200-day moving average in a upward direction, it is a signal that the downtrend is reversing.
•v Moving averages are a powerful tool for analyzing the trend in a security. They provide useful support and resistance points and are very easy to use.
•v The most common time frames that are used when creating moving averages are the 200-day, 100-day, 50-day, 20-day and 10-day. The 200-day average is thought to be a good measure of a trading year, a 100-day average of a half a year, a 50-day average of a quarter of a year, a 20-day average of a month and 10-day average of two weeks.
•v Moving averages help technical traders smooth out some of the noise that is found in day-to-day price movements, giving traders a clearer view of the price trend.
10. Indicators And Oscillators
•v Indicators are calculations based on the price and the volume of a security that measure such things as money flow, trends, volatility and momentum.
•v Used as a secondary measure to the actual price movements and add additional information to the analysis of securities.
•v Used in two main ways: to confirm price movement and the quality of chart patterns, and to form buy and sell signals.
•v Two main types of indicators: leading and lagging. A leading indicator precedes price movements, giving them a predictive quality, while a lagging indicator is a confirmation tool because it follows price movement. A leading indicator is thought to be the strongest during periods of sideways or non-trending trading ranges.
•v The line measures money flows in a security. This indicator attempts to measure the ratio of buying to selling by comparing the price movement of a period to the volume of that period. trending periods.
•v There are also two types of indicator constructions: those that fall in a bounded range and those that do not. The ones that are bound within a range are called oscillators - these are the most common type of indicators. Oscillator indicators have a range, for example between zero and 100, and signal periods where the security is overbought (near 100) or oversold (near zero).
•v Non-bounded indicators still form buy and sell signals along with displaying strength or weakness, but they vary in the way they do this. The two main ways that indicators are used to form buy and sell signals in technical analysis is through crossovers and divergence.
•v Crossovers are the most popular and are reflected when either the price moves through the moving average, or when two different moving averages cross over each other.
•v The second way indicators are used is through divergence, which happens when the direction of the price trend and the direction of the indicator trend are moving in the opposite direction.
•v This signals to indicator users that the direction of the price trend is weakening. Indicators that are used in technical analysis provide an extremely useful source of additional information. These indicators help identify momentum, trends, volatility and various other aspects in a security to aid in the technical analysis of trends. It is important to note that while some traders use a single indicator solely for buy and sell signals, they are best used in conjunction with price movement, chart patterns and other indicators.
Accumulation/Distribution Line
accumulation/distribution Calculated:
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Acc/Dist = ((Close - Low) - (High - Close)) / (High - Low) * Period's Volume
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•v This is a non-bounded indicator to help traders look for trends to gain insight on the amount of purchasing compared to selling of a security. If a security has an accumulation/distribution line that is trending upward, it is a sign that there is more buying than selling.
Average Directional Index (ADX)
•v Trend indicator that is used to measure the strength of a current trend.
•v Seldom used to identify the direction of the current trend, but can identify the momentum behind trends. The ADX is a combination of two price movement measures: the positive directional indicator (+DI) and the negative directional indicator (-DI).
•v The ADX measures the strength of a trend but not the direction. The +DI measures the strength of the upward trend while the -DI measures the strength of the downward trend. These two measures are also plotted along with the ADX line. Measured on a scale between zero and 100, readings below 20 signal a weak trend while readings above 40 signal a strong trend.
Aroon
•v A trending indicator used to measure whether a security is in an uptrend or downtrend and the magnitude of that trend.
•v The indicator is also used to predict when a new trend is beginning. The indicator is comprised of two lines, an "Aroon up" line (blue line) and an "Aroon down" line (red dotted line). The Aroon up line measures the amount of time it has been since the highest price during the time period. The Aroon down line, on the other hand, measures the amount of time since the lowest price during the time period. The number of periods that are used in the calculation is dependent on the time frame that the user wants to analyze.
Aroon Oscillator
•v Plots the difference between the Aroon up and down lines by subtracting the two lines. This line is then plotted between a range of -100 and 100. The centerline at zero in the oscillator is considered to be a major signal line determining the trend.
•v The higher the value of the oscillator from the centerline point, the more upward strength there is in the security; the lower the oscillator's value is from the centerline, the more downward pressure.
•v A trend reversal is signaled when the oscillator crosses through the centerline. For example, when the oscillator goes from positive to negative, a downward trend is confirmed.
•v Divergence is also used in the oscillator to predict trend reversals. A reversal warning is formed when the oscillator and the price trend are moving in an opposite direction. The Aroon lines and Aroon oscillators are fairly simple concepts to understand but yield powerful information about trends.
Moving Average Convergence Divergence (MACD)
•v This indicator comprises of two exponential moving averages, which helps to measure momentum in the security.
•v Difference between these two moving averages plotted against a centerline. The centerline is the point at which the two moving averages are equal. Along with the MACD and the centerline, an exponential moving average of the MACD itself is plotted on the chart. The idea behind this momentum indicator is to measure short-term momentum compared to longer term momentum to help signal the current direction of momentum.
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MACD= shorter term moving average - longer term moving average
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•v When the MACD is positive, it signals that the shorter term moving average is above the longer term moving average and suggests upward momentum. The opposite holds true when the MACD is negative - this signals that the shorter term is below the longer and suggest downward momentum.
•v When the MACD line crosses over the centerline, it signals a crossing in the moving averages. The most common moving average values used in the calculation are the 26-day and 12-day exponential moving averages. The signal line is commonly created by using a nine-day exponential moving average of the MACD values. These values can be adjusted to meet the needs of the technician and the security. For more volatile securities, shorter term averages are used while less volatile securities should have longer averages.
•v Another aspect to the MACD indicator that is often found on charts is the MACD histogram. The histogram is plotted on the centerline and represented by bars. Each bar is the difference between the MACD and the signal line or, in most cases, the nine-day exponential moving average. The higher the bars are in either direction, the more momentum behind the direction in which the bars point. As you can see in the chart below, one of the most common buy signals is generated when the MACD crosses above the signal line, while sell signals often occur when the MACD crosses below the signal.
Relative Strength Index (RSI)
•v RSI helps to signal overbought and oversold conditions in a security. The indicator is plotted in a range between zero and 100. A reading above 70 is used to suggest that a security is overbought, while a reading below 30 is used to suggest that it is oversold. This indicator helps traders to identify whether a security's price has been unreasonably pushed to current levels and whether a reversal may be on the way.
•v The standard calculation for RSI uses 14 trading days as the basis, which can be adjusted to meet the needs of the user. If the trading period is adjusted to use fewer days, the RSI will be more volatile and will be used for shorter term trades.
On-Balance Volume
•v Well-known technical indicator that reflect movements in volume, and is one of the simplest to compute and understand.
•v Calculated by taking the total volume for the trading period and assigning it a positive or negative value depending on whether the price is up or down during the trading period.
•v When price is up during the trading period, the volume is assigned a positive value, while a negative value is assigned when the price is down for the period. The positive or negative volume total for the period is then added to a total that is accumulated from the start of the measure. It is important to focus on the trend in the OBV - this is more important than the actual value of the OBV measure. This measure expands on the basic volume measure by combining volume and price movement.
Stochastic Oscillator
•v One of the most recognized momentum indicators used in technical analysis.
•v The idea behind this indicator is that in an uptrend, the price should be closing near the highs of the trading range, signaling upward momentum in the security. In downtrends, the price should be closing near the lows of the trading range, signaling downward momentum.
•v Plotted within a range of zero and 100 and signals overbought conditions above 80 and oversold conditions below 20. The stochastic oscillator contains two lines. The first line is the %K, which is essentially the raw measure used to formulate the idea of momentum behind the oscillator. The second line is the %D, which is simply a moving average of the %K. The %D line is considered to be the more important of the two lines as it is seen to produce better signals. The stochastic oscillator generally uses the past 14 trading periods in its calculation but can be adjusted to meet the needs of the user.
11. Strengths of Technical Analysis
Focus on Price
•v If the objective is to predict the future price, price movements usually precede fundamental developments. By focusing on price action, technicians are automatically focusing on the future.
•v The market is thought of as a leading indicator and generally leads the economy by 6 to 9 months. To keep pace with the market, it makes sense to look directly at the price movements. More often than not, change is a subtle beast.
•v Even though the market is prone to sudden knee-jerk reactions, hints usually develop before significant moves. A technician will refer to periods of accumulation as evidence of an impending advance and periods of distribution as evidence of an impending decline.
Supply, Demand, and Price Action
•v Many technicians use the open, high, low and close when analyzing the price action of a security. Separately, these will not be able to tell much. However, taken together, the open, high, low and close reflect forces of supply and demand.
•v The annotated example above shows a stock that opened with a gap up.
•v Before the open, the number of sell orders exceeded the number of buy orders and the price was dropped to attract more buyers. The intraday high reflects the strength of demand (buyers). The intraday low reflects the availability of supply (sellers). The close represents the final price agreed upon by the buyers and the sellers.
•v By looking at price action over an extended period of time, we can see the battle between supply and demand unfold. In its most basic form, higher prices reflect increased demand and lower prices reflect increased supply.
Support/Resistance
•v Simple chart analysis can help identify support and resistance levels that are usually marked by periods of congestion (trading range) where the prices move within a confined range for an extended period, telling us that the forces of supply and demand are deadlocked.
•v When prices move out of the trading range, it signals that either supply or demand has started to get the upper hand. If prices move above the upper band of the trading range, then demand is winning. If prices move below the lower band, then supply is winning.
Pictorial Price History
•v Price chart can offer plenty of valuable information. The price chart is an easy to read historical account of a security's price movement over a period of time.
•v Charts are much easier to read than a table of numbers. On most stock charts, volume bars are displayed at the bottom. With this historical picture, it is easy to identify the following:
•v Reactions prior to and after important events.
•v Past and present volatility.
•v Historical volume or trading levels.
•v Relative strength of a stock versus the overall market.
Assist with Entry Point
•v Technical analysis can help with timing a proper entry point.
•v Some analysts use fundamental analysis to decide what to buy and technical analysis to decide when to buy.
•v Technical analysis can help spot demand (support) and supply (resistance) levels as well as breakouts. Simply waiting for a breakout above resistance or buying near support levels can improve returns.
•v Important to know a stock's price history. If a stock you thought was great for the last 2 years has traded flat for those two years, it would appear that Wall Street has a different opinion. If a stock has already advanced significantly, it may be prudent to wait for a pullback. Or, if the stock is trending lower, it might pay to wait for buying interest and a trend reversal.
12. Weaknesses of Technical Analysis
Analyst Bias
•v Technical analysis is subjective and personal biases can be reflected in the analysis.
•v Important to be aware of the biases when analyzing a chart.
•v If the analyst is a perpetual bull, then a bullish bias will overshadow the analysis. On the other hand, if the analyst is a disgruntled eternal bear, then the analysis will probably have a bearish tilt.
Open to Interpretation
•v Technical analysis is open to interpretation.
•v Even though standards are present, many times two technicians will look at the same chart and paint two different scenarios or see different patterns. Both will be able to come up with logical support and resistance levels as well as key breaks to justify their position.
•v Technical analysis is more like an art than a science, somewhat like economics.
Too Late
•v Technical analysis has been criticized that by the time the trend is identified, a substantial portion of the move has taken place, so much so that the reward to risk ratio is not great.
Trader's Remorse
•v Not all technical signals and patterns work.
•v For instance: A sell signal is given when the neckline of a head and shoulders pattern is broken. Even though this is a rule, it is not steadfast and can be subject to other factors such as volume and momentum.
•v What works for one particular stock may not work for another.
•v A 50-day moving average may work great to identify support and resistance for IBM, but a 70-day moving average may work better for Yahoo.
•v Even though many principles of technical analysis are universal, each security will have its own idiosyncrasies.
