Technical analysis is not concerned with reasons why the price changes its direction; instead it only considers current price movement direction.
3 Postulates of technical analysis
Market movement is influenced by all factors
According to this axiom all information affecting price of a commodity is already reflected in the price itself and trade volume, so there is no need to additionally examine price dependence on political, economic and other factors.
Market moves in accordance to trends
Instead of changing randomly prices follow certain trends (tendencies). That is, price time series can be divided into intervals, within the duration of which the market mostly moves in certain directions.
The history repeats itself
It makes sense to use graphic models (patterns) of price change developed on the basis of retrospective analysis, for price change reflect quite persistent psychology of the market crowd, i.e. market players react similarly to similar situations. It’s well known that mostly price rises relatively smoothly, and falls by leaps and bounds.
Although many technical analysis devotees believe their technique gives them an advantage over other market players, by no means all researchers share this belief. There are quite a lot successful investors criticizing technical analysis.
– I realized technical analysis doesn’t work, when I turned price charts «upside down» and got the same result.
Warren Edward Buffet
One of the world’s largest and best known investors, whose capital as of 2010 amounted to 47 billion USD.
– Charts are brilliant tool for predicting the past.
American financial expert and investor. During the period from 1977 to 1990 he managed investment fund named Fidelity Magellan Fund.
Actually, if an analyst devoted exclusively to technical analysis is compared to another one relying on fundamental data only, both of them are equally vulnerable.
Despite all the criticism, technical analysis used as a complementary tool is still essential method for a trade open price determination.
In the framework of financial markets price charts look quite uncommon. The fact is that in the beginning of stock markets development everyday trading results were published in newspapers in the form of a table reflecting four prices:
Open price (Open)
A trading day’s opening price. That is, the first quote after beginning of a trading session.
Maximum price (High)
I.e. the highest point the price reaches within a trading day.
Minimum price (Low)
I.e. the lowest point the price reaches within a trading day.
Closing price (Close)
The market’s closing price, i.e. execution price of the last trade prior to the market closure.
Recording and publishing of all the data mentioned are matters of complexity and expensiveness, thus, new forms of charts were developed basing on these four key prices reflecting vital information on trading session results.
Today two chart types are most commonly used.
Notably, almost 200 years before computers were invented charts were drawn manually, and in most cases a chart itself was the only source of information and subject for analysis for traders. While examining charts they noticed that sometimes price levels form shapes or patterns. Once a pattern is formed, prices typically move in a certain direction. This was the beginning of the technical analysis and its first type – graphical analysis.
«The trend is your friend!»
Trend — a currency exchange rate movement directed upwards or downwards. The task for many market players is to recognize the direction the market moves to.
Depending on duration trends are divided into following categories:
(1 month – 2.5 years; chart timeframe: Месяц (MN), Неделя (W1), День (D1))
(from one to several weeks; chart timeframe: Н4, Н1)
(from one to several trading sessions; chart timeframe: М15-М5)
According to direction trends are identified as:
- Upwards – “bullish”
- Downwards – “bearish”
- Sideways – “Flat”
Within the frame of upwards trend every subsequent high and low must be higher than the previous ones, while in case of downwards trend the values must be lower than the previous ones. Flat trend is characterized by absence of directional movement up or down. Long lasting sideways movement might lead to sudden and dramatic price movement upwards or downwards.
Resistance and support lines
All trend lines and patterns of graphical analysis are, virtually, combinations of resistance and support lines.
Resistance line connects critical maximums (peaks, highs) of the market. It appears when buyers either cannot or do not want to buy a certain currency at a higher price anymore. Simultaneously, as price moves upwards, resistance of sellers start to increase and boost of sales occurs as well that also puts decreasing pressure on the price. An upwards trend gets stopped by and, so to say, bump into a kind of invisible ceiling, which it is unable to break through right now. If “bulls” come together or “bears” weaken their grip, the price would most probably break through a previously set resistance level. Otherwise, opposite price movement is inevitable (so called “retracement”).
Support line connects critical minimums (lows, bottoms) of the market. Support lines emerge and exist in situations opposite to resistance lines situations, and this is where “bulls” change places with “bears”. Sellers are active market players that push the price downwards and buyers are defenders here. High activity of sellers and low activity of buyers increase the chances that support line will be broken through and the price will go further downwards.
Trend indicators were designed for general recognition of market movement direction. Generally, every indicator is based in a mathematic formula, with the help of which it is computed.
Trend indicators include the following:
- Average Directional Movement Index
- Bollinger Bands
- Moving Average
- Parabolic SAR
- Standart Deviation
These are the most common indicators available in MetaTrader trading terminal: menu “Insert” – “Indicators” – “Trend”.
All other indicators are derivatives based exactly on these ones.
Generally, if you use a trend indicator, classical point to open a trade is crossing of a price chart and an indicator chart.
Moving averages are indicators designed as averaged price value. Visually, you might see that the moving average chart is smoother as compared to the price chart. This is because statistical noise present on a price chart due to random price fluctuations is eliminated.
As moving average is plotted, you should take some specific characteristics of this indicator into account:
– In case of flat trend and if price fluctuates within a narrow range, larger indicator period should be set.
– In case of a strong trend moving averages with large period settings will always be delayed.
– A moving average with a small period quite often will provide false signals, which is due to large losses.
– As we mentioned before, the larger period settings we choose for a moving average, the less sensitive it will be to price changes.
Moving average analysis rules
1. Search for intersection points of a moving average and a price chart. If the moving average crosses the price chart from the bottom upwards, it’s a signal to buy. And if the moving average crosses the price chart from top downwards, it’s a signal to sell.
2. Indicator’s direction indicates direction of a major trend.
3. Search for price points following high and low of the moving average. Probability of trend change.
4. Search for points of maximum divergence of the average and the price.
5. The main rule! In no case it’s allowed to open trades against direction of a moving average, unless additional confirmation signals are provided by other indicators.
6. Moving average works properly in a trend market and is inappropriate in flat trend, for severe lag will generate a lot of false signals.
All patterns are formed by support and resistance levels. The understanding that patterns are formed by a trend line and horizontal support and resistance lines will help you to trade and recognize any patterns with precision. The first step to this is to recognize lines and levels of a pattern. Knowing exactly what to look for simplifies the task. One of the most common reasons many traders use chart patterns is that they are recognizable to a certain degree and have long become a part of our life. We all know what a triangle or a rectangle is. These shapes are familiar to us, so we can easily recognize them on a trend line. We also have aesthetic perception allowing us to distinguish “good” shapes. The use of this knowledge in financial markets seems convenient. And operation within such an area of convenience gives a trader confidence to make decisions basing on the shapes he saw.
However, there is a higher level of chart pattern analysis. In case a trader realizes that symmetrical triangle is upwards and downwards trend lines converging in one point, he can use this knowledge to predict breakouts.
Confirmed trend line breakout is the simplest signal to enter the market.
This is what traders using triangles do.
It’s much easier to figure out support and resistance levels forming a rectangle, than to recognize a wedge, a ascending or descending channel. However, it’s not complicated as well, if a trader knows, which lines and levels should be paid attention to, and what kind of market allows the pattern formation: trend or flat. You will be able to recognize patterns even more precisely, if you know market cycles, within which this or that pattern usually appears.
On this rectangle pattern you may notice a double bottom formed by two tangency points. It shows us horizontal support line. Determining tangency points for a descending wedge pattern (below) is much different from the example above. The wedge is formed within trend market, therefore descending trend line for descending wedge and ascending trend line for ascending wedge should be paid close attention, for they form the basis for the pattern.
Trend market indicates a continuation pattern, nevertheless, opening trades at reversal points of ascending and descending wedges, as well as ascending and descending channels, might be extremely advantageous if properly prepared for. Therefore, recognition of wedges and ascending/descending channels formed within the frame of ascending/descending markets is as important as recognition of symmetrical triangles and rectangles within the flat market.
The difference between trend reversal and continuation patterns
There are historical currents indicating whether a pattern is a continuation or reversal pattern. Let’s discuss, what reversal patterns and continuation patterns are.
Trend reversal and continuation patterns correspond exactly to their titles. Important factor that should be considered to determine a pattern type is a trend it’s preceded by. No matter whether it’s bullish or bearish, but persistence and duration of preceding trend partially determine the type and formation quality of a pattern.
Remember, the title only indicates what usually happens to a pattern, but not what will actually happen. Mostly, whether a pattern will be of continuation or reversal type depends on a preceding trend.
It’s formed the following way:
Within ascending market at a certain point of time two tops are formed located at the same level, as well as two bottoms that together form ascending perspective. If they are connected by lines as shown on the picture, we get the ascending triangle.
In most cases, once this pattern is formed the market keeps moving further. At that, importantly for traders, this pattern allows determining a so called target, i.e. a point the market will get to after breakout of the pattern. Distance to the target equals to length of the triangle’s base, drawn up from the breakout point.
It’s formed the following way:
Classical reversal patterns is a shape called “Head&Shoulders”. Within ascending trend it look the following way:
In case the market moves up, at a certain point of time several tops occur together forming a shape resembling head and shoulders of a man. The line called “neck line” comes through the head’s base points. The “neck line” is crucial for recognizing this pattern. The case is that if this line is broken through in opposite direction, most probably soon the market will reverse, and, as in the case with the triangle, it’s possible to predict a target the market will most probably get to. Distance to the most probable target equals to line drawn from the head’s top to the neck line. Thus, graphical analysis helps to find moments suitable to make a trade and predict probable market movement.