Technical Analysis (TA) is the art of predicting price movements for a financial market, based on historical charting, previous patterns, and statistical data. This analysis helps traders to make decisions based on what is most likely to happen given the data and patterns available. In this article we look at the basics of charting and candlesticks, followed by a short introduction into the most popular trading strategies used today.
Terminology:
Bullish - Buy signal, market sentiment shows there is upside potential for the market.
Bearish - Sell signal, market sentiment shows there is downside potential for the market.
Before we get into the do's and do not's, it's imperative to realise that nobody can be spot on 100% of the time. Technical analysis should provide only a small percentage of your overall analysis, but can be effective if utilised correctly.
There are several "rules" to remember when conducting technical analysis.
Fundamentals - The main idea is that you should never base trading decisions solely on the technicals; they must be backed up by the macro fundamentals and general sentiment of the market.
Timeframes - The longer the timeframe used, the more significant the pattern. This is logical, a bullish signal based on a 30 second timeframe will not be as important as a bearish signal based on a 4 hour timeframe.
Simplicity - Keep things simple and don't over analyse. It's key to remember that you shouldn't be actively trying to find signals and patterns which aren't there. If you're desperately trying to support your analysis with patterns, you're doing it wrong. Let the patterns dictate the analysis and sentiment.
Consistency - Perform fresh analysis everyday. If you're a regular trader, or looking to trade most days, it's crucial that you reset your analysis and start from scratch. A bullish signal yesterday may have turned into a bearish signal today.
Candlesticks
Reference
The picture above shows the basics of a candlestick, which will become second nature when you start trading and doing TA.
For a candlestick to be bullish, the candle (green) starts at the open price, and ends up at the close price at the end of the timeframe. This timeframe could be 30 seconds, 1 minute, 30 minutes, 4 hours, or even 1 day. After starting at the open price, the price of the market has dropped down to it's lowest price at some point during the timeframe, conveniently called the low price. However, due to the bullish sentiment, the price has recovered to reach a highest price during the timeframe, i.e the high price. The important thing to note is that the price started at a certain point, and in the end, the price has finished at a higher point than when the candle began its journey. This logic works similarly for the bearish red candlestick, except the open and close price are swapped around, because the price is lower than when the timeframe first started.
In order to learn more about the different types of candlesticks, please check out this great article done by IG.com on 16 candlestick patterns every trader should know!
Conclusions:
Candlesticks are the most common charting method for TA.
Single patterns and movements are used to gauge the behaviour of a market.
Recommended to use in conjunction with other tools and strategies to further confirm the signal.
Support and Resistance
Support - Price levels at which demand from buyers becomes high enough to prevent the price from falling further. Buy.
Resistance - Price levels at which demand from sellers becomes high enough to prevent the price from rising further. Sell.
When a resistance level breaks, it then becomes the support level. And vice-versa, when a support level breaks, it becomes a resistance level.
Common Errors during Analysis
Weak Levels
First retest of a support level will usually be the strongest.
What if it's already been broken?
Ignored/Missed Fundamentals
Will supersede any technical analysis.
Is there any incoming news/data?
Counter Trending
Market sentiment is opposite to the signal, against the direction of the majority.
Multiple Tests
Level may break if tested several times.
Bullish signal may turn into bearish.
Timeframe
Focusing on patterns which aren't necessarily there.
The closer a level is to the current price, the more relevance it has.
Popular Strategies
Trendlines
The pictures below show the trendline for a buy and sell signal.
Buy Signal:
Sell Signal:
Trendlines, or otherwise known as wave patterns, act as support and resistance levels based on the type of signal. For a bullish or bearish signal, you should buy or sell respectively when the price hits the trendline.
The examples above are basic, however they illustrate the point very well!
Channels
A channel is a set of parallel trendlines showing a clear uptrend or downtrend. This type of analysis is very common, as it gives a clear picture of the way the market is moving! The picture above shows a downtrend, with the upper line being the resistance level, and lower line being the support level.
For the example above, a trader would sell at the top of the channel, and buy back in at the bottom of the channel, over and over again until the channel is broken.
Pivot Points
This type of analysis uses the previous day's volatility in order to map areas of support and resistance for today's market.
H - High price from yesterday
L - Low price from yesterday
C - Close price from yesterday
Most investment sites/apps have this tool built in, so all you have to do is turn it essentially.
Now for the maths:
P = ( H + L + C ) / 3
S1 = ( P * 2 ) - H
R1 = ( P * 2 ) - L
S2 = P - ( H - L ) = P - ( R1 - S1 )
R2 = P + ( H - L ) = P + ( R1 - S1 )
Pivot points can also be considered an average of yesterday's volatility.
How to use them:
Trend Observations
Trading above pivot may indicate a bullish sentiment.
Entry and Exit Identification
Execute trades using support and resistance levels.
Technical Confirmation
Determine high probability trades using natural support levels.
Caution:
Only useful for the short term.
High volatility days lead to very wide pivot points and ranges which can be deemed inaccurate.
Moving Averages
Probably the most commonly used technique, moving averages (MA) are used to calculate the trend direction of a market, also known as a lagging indicator. The length of the time period used for the MA is correlated with the degree of lag. A 200 day MA will have a larger lag than that of a 20 day MA. The most common time periods used are 15, 20, 30, 50, 100, and 200 days.
When the plotted moving average crosses with the trading price, it results in a strong bullish or bearish signal depending on which direction the price goes. Crossing upwards is a bullish signal, and a downwards cross is a bearish signal.
There are 2 main types of moving averages, simple and exponential.
Simple Moving Average:
SMA = ( A1 + A2 + A3 + ... ) / n
A - average in period n.
n - number of time periods.
The SMA is calculated by taking the mean of a given set of prices.
Exponential Moving Average:
EMA (t) = ( V * (s/1+d) ) + EMA (y) * ( 1 - (s/1+d) )
EMA (t) - EMA value today.
V - value today.
s - smoothing.
d - number of days.
EMA (y) - EMA value yesterday.
The EMA is a bit more complicated, as we first calculate the SMA, followed by combining it with a smoothing factor to arrive at the value.
The picture shows the SMA and EMA side by side on a chart.
Pros and Cons:
EMA reacts faster when the price is changing direction, susceptible to giving wrong signals.
SMA moves much slower and can keep you in trades you shouldn't be in, which can lead to losses.
If price action becomes erratic, it may generate multiple trend reversals and trade signals which are false.
Final Word
There are several other important strategies which can be used, such as:
RSI Indicator:
Momentum Oscillator which measures velocity and magnitude of directional price movement.
Indicator lies between 0 and 100.
Below 30 = oversold (buy signal), Above 70 = overbought (sell signal).
Opposite to MA as it is a leading indicator.
Fibonacci Retracement:
Golden ratio = 1.618, Inverse = 61.8%.
Levels at 0%, 23.6%, 38.2%, 50%, 61.8%, 76.4%, 100%.
Each level represent support/resistance levels.
Highly subjective tool.
Positive correlation between timeframe and reliability.
Bollinger Bands:
Developed by John Bollinger.
Set of lines + and - 2 standard deviations from SMA.
Overbought and oversold market as price reaches top or bottom of band.
75.4% probability that price remains within 2 standard deviations.
MACD:
Relationship between 2 separate EMAs of an asset's price.
Line is calculated by subtracting 26 day EMA from 12 day EMA.
9 day EMA is called signal line, used as trigger point for buys and sells.
Crossovers with centre line indicates bullish and bearish sentiments.
Timeframes super important for this strategy.
The important thing is that although these techniques may seem nice and fancy, they should only form part of your analysis when trading. Market fundamentals should play a much larger part in recognising market sentiment.
Trading is not easy. As with most things though, practicing improves your knowledge and gives vital experience.
Please consider starting off with a demo account where you can master the art!
Finally, if you are thinking about going into the deep end, only invest what you can afford to lose.
