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Technical Analysis

TECHNICAL ANALYSIS

Dear colleagues! This page helps you to quickly refresh your knowledge.

Technical market analysis is the first of the two basic market analysis types.

It allows forecasting of price directions, trading volume and the amount of open positions through the study of past market data, such as price movements, index changes and functioning of the trading market.

TECHNICAL ANALYSIS IS BASED ON TWO TENETS:

Forex Market considers everything

Everything is cyclical and repetitive

It means that this analysis is based on historical backgrounds. It exempts a trader from the researching of many macroeconomic factors which are strongly needed for fundamental analysis.

Using technical analysis, a player can track the history of the complete transactions and the cyclic occasions which have made those transactions successful. If technical analysis is used in a combination with fundamental analysis, it can show the more detailed view for the calculation of potential profits.

HERE ARE THE PRIMARY TECHNICAL ANALYSIS CONCEPTS:

Dow Theory

The main technical indicators

Graphical methods for analysis and types of charts

Lines of support and resistance

Trend continuation patterns

Species of mathematical trading methods

Fibonacci price movement analysis and Elliott Wave Theory

DOW THEORY

A far-famed theory by Charles Dow, first outlined in “Wall Street Journal” in early 20th century, performs the basic technical analysis elements. It has three primary tenets:

The price shows market dynamics at any time

Price changes are shown in trends which can be set to determine the possibility of profits

Price change dynamics periodically repeat

Thereby, the main advantage of technical analysis is that it needs much less information than fundamental analysis for the final positive results. Knowing the price and trading volume only, a technical trader can get a maximum of the required information. As the attention focuses on rating the trend reversal direction, it easy to predict when opening a position is more profitable.

However, there are some shortcomings of technical analysis can appear. As most investors changing positions for supply and demand using the same methods and following the same principles, the prices always change the same way.

THE MAIN TECHNICAL INDICATORS

The most important goal in technical analysis is determining of market movement direction that is called a trend. Trading without using trend is unlikely and precarious, so it is very important to set the line.

TREND CAN BE:

Rally – increasing trades

Downtrend – descending trend

Sideways – lack of trading movements, also known as “flat market” or “trendless”.

WITHOUT REFERENCE TO THE DIRECTIONS, TRENDS ARE CLASSIFIED BY ITS TERMS:

Short-term trend; usually lasts up to three weeks

Intermediate-term trend; usually lasts from three weeks to a few months

Long-term trend; usually lasts more than a year. It consists of several intermediate-term trends directed to the opposite side

As it said above, to analyze the information it is important to set trend lines – this is a simple graphic technique consisting in the connection of the local maximum peaks with the local minimums. These lines are to set trend in trading movements.

TREND LINES ARE:

Upward line

Downward line

Sideways line

The chart below shows short-term upward trend line for EUR/USD couple, along with upward long-term trend line.

Price channel is the two additional parallel lines; they represent the clear lines of support and resistance. One trend line connects several price maximums; the other one connects the minimums series. This channel can diverge up, down and sideways. Until support and resistance lines breakout, traders expect the trade will be going on within these. They use price channels to determine the moment of closing position and setting stop-loss order.

Below there is upward channel chart for S&P 500 index.

GRAPHICAL METHODS FOR ANALYSIS AND TYPES OF CHARTS

Change of price for a certain period is shown on the chart. The vertical line marks quote rates, the horizontal one marks time.

There are two factors in graphical analysis which have an influence on the results: time frames and price range.

TIME FRAMES

Every line, candlestick or dot contains information for a certain period. Duration of that period is a chart length.

Chart length depends on your trading strategy and on investment period. Ephemeral traders can choose a very short chart length, even about a minute; the more active investors (usually making transactions longing from several days to several weeks) prefer chart length of several hours or several days.

PRICE RANGE

There are two methods of displaying information on the horizontal line: arithmetic and logarithmic.

On arithmetic range, all dots placed on the equal distance from each other independently from price level. It has a single unit of measurement for all range. If shares rise from 10 to 100 in a half of year, the changing from 10 to 20 (100% deviation) will be shown on the chart through the same interval as the changing from 90 to 100 (11% deviation). Those intervals are equal numerically, but their percentages are not equal.

On logarithmic range, all dots placed on the equal percentage vertical distance. 10-20 progression signifies 100% increase, same as 20-40 and 40-80 progressions. On logarithmic range they will be shown as the equal intervals.

TYPES OF CHARTS

There are three main types of charts:

Linear;

Bar;

Japanese candlestick.

Linear chart is the most common type. The graphic line shows prices plotted over a specific time frame. Daily chart is the most popular linear chart. For many traders, the most important price, independently from day period, is the closing price. But there is a problem arises in this case – daily linear chart doesn’t show price change over entire day.

Although, the privilege is that the trader gets the full vision of what was going on with the price of his instruments for this time frame.

In bar chart every vertical bar shows price change in a specific time frame. This period may denote 1 minute on intraday charts and even several years on historical charts. On daily chart one bar is one trading day, where:

Top of bar is the highest market price

Bottom is the lowest one

Left stick is the opening price

Right stick is the closing price

Bar chart informs about the highest and the lowest prices, as well as opening-closing prices, so it allows making a more detailed analysis than linear chart.

Candlestick charts are fairly similar to bar charts as they show the same four price types. Every candlestick means chosen time frame. The different programs suggest build candlesticks differ by time: 1 min., 15 min., 30 min., 1 h., 2 hrs., 4 hrs., 8 hrs. and also daily, weekly and monthly charts.

On daily chart each candlestick performs one-day trade range as “open position” and “closed position”:

Open position candlestick (blue) shows that opening price is higher than closing one.

Closed position candlestick (red) shows that closing price is lower than opening one.

Candlestick consists of two components – body and shadow:

The candlestick body borders perform opening and closing prices

Upper and bottom lines – “shadows” – perform maximal and minimal prices in this period, respectively.

Candlestick chart is a widely spread method in technical analysis. Many trading strategies are based on this kind of diagram.

LINES OF SUPPORT AND RESISTANCE

The point of these lines is in the continuous cooperation between trades who trading upwards (bulls) and ones who trading downwards (bears).

It needs to be mentioned that line of support depicts price which, as the most of investors guess, should go up. When price starts to fall and tends to line of support, buyers intend to buy and sellers intend to sell.

Conversely, line of support depicts price which, as the most of investors guess, should go down. When price tends to line of resistance, buyers are ready to sell and sellers are inclined to buy.

This chart shows lines of support and resistance for EUR/JPY.

 

When share price ranges between support and resistance lines, most likely that trend won’t break. When price breaks through these lines, it could mean:

Trend acceleration

Trend reversal

When the level of support breaks, it becomes the level of resistance and backwards.

On the chart this process looks this way:

 

The support and resistance lines analysis is used by technical traders for making trading decisions and determining the moment of trend acceleration and reversal. Such information is necessary for your trading strategy and helps to improve it.

TREND CONTINUATION PATTERNS

In technical analysis graphical patterns can be introduced to confirm the current trend. They’re called continuation patterns and denote a fairly short term of consolidation. The breakthroughs in these patterns are appearing in the direction of the previous trend movement.

THE MOST IMPORTANT PATTERNS ARE:

Price channel

Symmetrical triangle

Flags and pennants

TAKE A CLOSER LOOK ON THESE PATTERNS:

Price channel is a continuation pattern bounded by lines of trend and return. Price channel can go up (ascending), down (descending) or make no movements (horizontal). Depending on those directions, every line can provide support or resistance.

On the chart below you can see ascending price channel, it is called “bull channel”. Traders will be buying when prices reach support trend line and they’ll make a profit when prices reach resistance return line.

 

The second chart shows descending price channel which is called “bear channel”. Traders will be selling when prices reach a resistance trend line and they will make a profit when prices reach support return line.

 

On the last chart, there is a rectangular pattern which shows neither bull nor bear channel, this is just trend in pause.

 

Despite the fact that price channels are considered to be continuation patterns, there is an exception for the changing of trend itself. In such occurrences prices are falling without reaching return line, which could mean an impendent trend reversal.

Price channels also carry quantitative characteristics. As soon as price breaks channel line, it usually changes at least in range of channel width.

Symmetrical triangle consists of symmetrically converging lines of support and resistance which are drawn at least through four dots. The symmetrical convergence of these lines reflects a balance between demand and supply that exists in money market. It means that the breakthrough is possible for any direction. In case of bull symmetrical triangle it will appear at the direction to the previous trend reaffirming the status of triangle as a continuation pattern.

The classic example of symmetrical triangle is in the chart below

 

“Flags and pennants” are frequently found in  the charts. According to their similarity, these models  are traditionally considered together. They appear on certain levels of trend progress, they have the same indications of trading volume as well as the measurement methods. Before the formation of “flags and pennants” there should be quite sharp and nearly straight price movement line. Those patterns depict markets outstripping themselves by ascends or descends which force them to take a break before continuing the foregoing movement.

“Flag and pennant” is one of the very reliable patterns denoting continuation of the previous trend and turning point comes rarely.

Here is an example of ascending flag on the market: during the breakthrough minimal price movement equals the length of the flagpole.

KINDS OF MATHEMATICAL TRADING METHODS

Mathematical trading methods give a presentment about price activity. It helps you to get a view of price changes directions in a specific time frame, to minimize risks and to make trades in the sufficient volume. These methods also aim on the recognition of price fluctuations signals before the situation appears in financial market.

The indicators that used in mathematical trading methods are: a moving (dynamic) average and an oscillator (the indicators developed for the effective recognition of overbought and oversold situations).

There is an uncountable amount of mathematical indicators, here are the most important:

Moving (dynamic) average – simple and exponential (SMA, EMA)

MACD – moving average convergence/divergence

Bollinger bands

Parabolic SAR

RSI (relative strength index)

And more details about each of them.

Moving average (MA) shows average price of instrument in a specific time frame. As the price changes, this indicator either goes up or down.

There are several types of MA, let’s have a look on two primary ones:

1. SIMPLE MOVING AVERAGE (SMA)

A simple, or arithmetical moving average is calculated by summing the instrument closing prices in a certain number of unit periods (e.g. 12 hours) with a following dividing the sum by the number of periods:

SMA = SUM (CLOSE (i), N) / N

The advantages: this indicator is the best way to check the strength of long-term trend and probability of its reverse. In its turn, the MA descend can be accepted as a start signal of downtrend.

The disadvantage of this indicator is that it is more like a lagging indicator than a leading one. It signals about certain events only after they have happened and not before. It may become a cause of your delayed market entry.

The example with two simple moving averages (red – 5 days, blue – 20 days) is in the chart below

 

2. EXPONENTIAL MOVING AVERAGE (EMA)

It is calculated by adding a certain share of the current closing price to the previous moving average value. In case of exponential moving averages, the last closing prices have a prevalent value.  P-percentage exponential moving average is calculated this way:

EMA = (CLOSE (i) * P) + (EMA (i - 1) * (1 - P))

 

Keys:

CLOSE (i) – closing price for the current period

EMA (i - 1) – moving average value for the previous period

P – the using share of closing price

As EMA gives a meaning to the last outlooks and remarks, technical traders are able to determine price change quicker. Unlike SMA, EMA is calculated by considering every following price in complex record. The impact of the previous records in short-term EMA weakens faster than in a long-term one, but does not disappear completely. It really does take place despite the EMA’s calculating period.

The difference between SMA (blue) and EMA (green) is in the chart below

 

MACD (moving average convergence/divergence) is a dynamic indicator following the tendency. It shows the ratio between two price moving averages. It’s calculated by subtracting 26-perioded EMA from 12-perioded one. Then 9-perioded SAM is to be put in the chart as a dotted signal line.

MACD = EMA (CLOSE, 12) - EMA (CLOSE, 26)

SIGNAL = SMA (MACD, 9)

Using exponential smoothing, MACD allows determining price changes faster than signal line.

When MACD crosses signal line, short-term MA (12 days) will be higher than changes in long-term MA (26 days). This is the typical bull market signal, telling that price is going in ascending trend direction. On the other hand, when MACD appears below signal line, it’s the signal for bear market telling that trend may come to reverse.

In the chart below there is an example of MACD (green) with signal line (blue).

 

John Bollinger bands is an indicator in the form of the stripes characterizing the market reliability (the less it fluctuates – the more stable the market quotation). These bands – another trend indicator – are used to fix market price volatility. It refers to a group of “channel” indicators.

BOLLINGER BANDS PERFORM AS THREE LINES:

1. Middle line (ML) – moving average, calculating by a formula:

ML = SUM (CLOSE, N) / N = SMA (CLOSE, N)

Keys:

SUM (…, N) – sum for several periods

CLOSE – closing price

N – number of periods

2. Top line (TL) – middle line shifted up to the number D of standard deviations (StdDev):

TL = ML + (D * StdDev)

3. Bottom line (BL) – middle line shifted down to the number D of standard deviations (StdDev):

BL = ML - (D * StdDev)

Standard deviation calculating by formula:

StdDev = SQRT (SUM ((CLOSE - SMA (CLOSE, N))^2, N)/N)

It is recommended to use 20-perioded SAM with two StdDevs for calculating Bollinger bands borders.

The possibility of price breakthrough accurate determination is growing when the intervals are narrow. When the prices cross top line repeatedly, it’s assumed that they’re going to be unusually high; it’s a signal to selling, and backwards.

There are Bollinger bands for S&P 500 index (green)

 

PARABOLIC STOP-AND-REVERSE SYSTEM (SAR) is a trading system calculating moving stop-loss orders. The chart of these dots moves according price changes in an extension of dotted line which usually goes parabolic trajectory.

LET’S TAKE A CLOSURE LOOK ON THIS INDICATOR:

When parabola goes above the price, it is a signal to buy.

When parabola goes below the price, it is a signal to sell.

Stop-loss dots set the level for moving stop-loss, according which it is recommended to open a position. In “bull trend” a long position should to be set with moving stop which will be getting ahead every day until the activation by the price going down to stop level. In “bear trend” a short position should to be set with moving stop which will be decreasing every day until the activation by the price going up to stop level.

Parabolic system is the best choice for working with trends. It helps traders to catch trend direction at the very beginning. If new trend breaks, parabola immediately switches to the other side making stop-and-reverse signal. It means for the trader that he should close his position or open the opposite one.

Parabolic system for USD/JPY (green)

 

Relative strength index (RSI) is a system determining sell/buy signals in rapidly changing market dynamics. RSI based on the difference between average rates of price coefficient in days of positive or negative market dynamics (counting a 14-days period). This information is brought to value from 0 to 100.

When average profit value is situated above an average loss value, RSI increases, and vice versa.

RSI calculated by a formula:

RSI = 100 - (100 / (1 + U / D))

Keys:

U – average positive changes

D – average negative changes

The relative strength for GBP/USD is painted red in the chart below.

FIBONACCI PRICE MOVEMENT ANALYSIS AND ELLIOT’S THEORY

There is Elliot’s wave theory. The base of his reasoning was market psychology, and the waves display crowd’s psychic climate. Elliot distinguished “bull” and “bear” markets. He was convinced that the complete market cycle has eight waves: five of them are moving in one side, three others are moving in opposite.

Elliot also thought that each wave consists of several smaller waves. Thereby, it all looked like a constructor.

In its simplest form, this theory proves that market dynamics following the cyclic recurrence of five waves in the main trend direction, before which there are three corrective waves (a “5-3 movement”).

Progressive waves are marked: 1-2-3-4-5; retrograde waves: a-b-c. Progressive waves 1, 3 and 5 belong to impulsive phase and move the trend direction; waves 2 and 4 are corrective. After impulsive five-wave phase, corrective three-wave phase (a-b-c) comes, in which a and c move in retrograde direction, b moves in opposite.

 

Note: in the chart above, there is an example with ascending trend, though this model matches for descending trend, too. Progressive and retrograde waves will be moving on the contrary.

After three-wave retrograde phase, progressive five-wave phase comes again, and it goes round until trend reversal. Then in every five-wave movement a particular progressive wave can be distinguished, and every wave can be divided by smaller waves.

Elliot’s wave theory classifies waves according the length of cycle placing them in one main super-cycle which joins decades (up to subminuette level including no more than a couple of hours). As it were, the eight-wave cycle remains constant.

 

Note: two biggest waves (1 and 2) can be divided by 8 smaller waves, which can be also divided by 34 waves even smaller. Wave 3 (going higher) is a start for another couple. 34 waves can be divided by smaller waves in their turn, and so on.

Fibonacci numbers

Initially, Fibonacci theory has not been related to analysis of Forex market dynamics, but today it has got wide recognition among analysts and became an object of study. Fibonacci had revealed it during the contemplation of Pyramid of Cheops in Giza. This is Fibonacci numerical sequence, where every following number is a sum of two previous numbers:

1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89,…

THESE NUMBERS HAVE SOME INTERESTING CORRELATIONS:

Every number is about 1,618 greater than previous one.

Every previous number is about 0,618 of the next one.

Such significant Fibonacci numbers feature is reflected in several technical methods using in market analysis. The common principle is when the price approaching to the lines built using these methods, it is expected that some changes in trend progression may follow.

Some numbers of Fibonacci sequence can be spot in several merchandise prices dynamics; the Fibonacci levels are used in Forex technical analysis. Ratio fluctuations of 1,615 are seen in Elliot’s wave theory, where they are presented in rule of alternation.

Fibonacci numbers sequence is a mathematical golden section basis – 0,618. If you split a segment according this 0,618 coefficient, the ratio between its bigger and smaller parts will be equal to the ratio between the whole segment and its bigger part.

Price correction is a change in prices which counting the previous changes. Usually, the market is to be tracked in one of these Fibonacci levels: 38,2%, 50% and 61,8%. Fibonacci price correction is determined by the main maximal and minimal fluctuations, which set support level once the market digresses from maximum (or in case of market digressing from minimum, it’s determined in opposite direction by resistance level).

 

Traders use Fibonacci price extension to determine the chart ranges which allows entering the market during the forthcoming stable price movement, whether trend is ascending or descending. Percentage level prolongation on the chart builds horizontal lines above or under previous trend change. The most common prolongation levels are: 61,8%, 100%, 138,2% and 161,8%.

 

Notice: on the practice, it’s not always so easy to find an appropriate model for Elliott wave and price actions not always accord to this model. So it’s not recommended to rely entirely on Fibonacci correlations, but to combine them with other technical analysis methods.