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Technical Analysis Explained

Formations

"History repeats itself" is one of the technical analyst's premises, meaning that a specific price development is not necessarily unique but can occur again and again. The technician is talking about virtual price formations that have predictive value. The literature on the subject differentiates between formations that indicate a trend reversal (reversal formation) or a continuation of the trend (continuation formation).

Double top (reversal formation)

For obvious reasons this is often called an "M-top" (see figure 13). The market is failing twice at a resistance and is reversing then sharply. A break of the support would indicate further losses towards the target that can be evaluated through the following procedure. The vertical width of the "M" (price difference) is projected downwards from the breakpoint of the support. The opposite of this reversal formation occurs on a bottom - W-bottom. (see figure 14)

Figure 13

Figure 14

To better understand the characteristic of the following reversal formation, we should define the parameter "volume" first.

Volume

The volume describes the total amount of trading activity during a certain period of time. The resulting figure represents the number of units, future contracts or stocks traded during the day. The volume is recorded by a vertical bar on the bottom of the chart. The longer the bar the higher the volume for the period. A "healthy" move with a good chance to last, should be confirmed by a high volume. This is true not only for an up-move but for a down-move too.

Head and shoulder (reversal formation)

Figure 15(Compare with figure 15) The market is in an up-trend and sets a new high accompanied by big volume (point a). This peak is called "left shoulder". A correction with light volume follows (point b). A next rally reaches new heights ("head" at point c) and the alert chartist notices that the volume is decreasing in comparison to point a. A subsequent correction falls back to the area of point b (increasing volume at point d) from where the market tries once again to climb higher to form the right shoulder (point e; decreasing volume). Finally, a more impressive sell-off starts and breaks with high volume the neckline (point phi) which is the line drawn through the points b and d. Any rebound should find resistance at the neckline (point phi) so that subsequent further losses can aim for a target evaluated by the heights of the head added vertically to the break point. The same formation, called inverse head and shoulder, can also occur at the bottom.

Rounding bottom and top (reversal formation)

Figure 16The rounding bottom, also called saucer (the inverse formation is the rounding bottom) is a steady flattening of the downtrend (as outlined in figure 16) to such a degree that the market at one moment enters a sideways range. Herein the volume is usually the lightest. It often happens that in the middle of the formation the market shams a surprising outbreak to the upside (accompanied by high volume) but then falls just as quickly back into the range. Slowly the price curve starts to orientate upwards and finally accelerates, all this with an underlying increase of the volume. This rare formation provides no clear price target but usually implies quite a lot of potential in the sense that 50% retracement, or more, of the preceding downtrend can be expected.

Triangle

The triangle formation can be quite difficult to analyse and the fact that a few different types of triangles exist doesn't make this task any easier. Furthermore a triangle is most commonly just a pause in a trend (continuation pattern) but can also terminate a trend (reversal formation).

The most common triangles are the symmetrical- (or horizontal), ascending- and descending triangle. The symmetrical triangle (figure 17) is composed of five legs squeezed between two converging lines. The apex is the point where the two lines cross. The fifth leg usually completes somewhere between the one-half to three-quarters point of the horizontal width of the triangle. An outbreak of the triangle should indicate a follow-through that can take the same price shift as the biggest leg within the formation.

The ascending triangle has basically the same implications as the previously described one. Its shape is a bit different. It consists of a horizontal top-line and an ascending bottom line. The descending triangle, on the other hand, has a horizontal bottom line and a descending top-line. All these triangles are usually continuation formations but in rare cases can also complete a trend.

The pennant (continuation formation)

Figure 18The pennant resembles a small symmetrical triangle. It is interpreted as a brief pause in a strongly trending market. The move after the completion of this formation should duplicate the move proceeding it

 

 

 

 

The flag (continuation formation)

Figure 19The flag and the pennant are quite similar formations. At least the forecasting value is practically the same. However, the top and bottom line are not converging but parallel (figure 19).

 

 

 

 

 

 

Figure 20

The wedge (reversal formation)

The wedge can be considered as a special type of triangle. It consists of two converging lines that meet in an apex. The individual characteristic is that the lines are both pointing in the same direction (figure 20). The slant can either be up or down. A "rising wedge" terminates an up-move, a "falling wedge" unfolds on a bottom. The minimum reaction following the completion of the wedge is a move back to the base of the wedge.

Some continuation or reversal formations are generally not detectable on a bar or line chart but through candle stick charts only. At this stage it seems necessary to define the term "reversal". A reversal formation does not necessarily indicate a sharp turn around followed by a new trend in the opposite direction. This rarely happens! When dealing with candle charts it is prudent to think of a reversal pattern as a trend change pattern. In other words, after the appearance of a reversal pattern the market could shift from an up-trend to a sideways trading range to resume later on the up-trend.

Following are the most important candle stick indicators:

Figure 21 & 22

Hammer (reversal pattern) - characteristic

Bottom formation; shadow at least twice as long as the small body on the top of the candle line. (figure 21)

Hanging man (reversal pattern) - characteristic: same appearance as the hammer but on the top of a move. (figure 22)

Figure 23 & 24

Bullish engulfing pattern (reversal pattern)

It terminates a down-move. The body of the engulfing line envelops the body of the preceding candle (figure 23)

The bearish engulfing pattern is the same formation but at the end of a protracted rally. (figure 24)

Doji (reversal pattern)

Figure 25Characteristic: a doji has a horizontal line instead of a real body. This is because the opening and the closing are at the same level (or almost), expressing in general an indecision of the market participants. The Japanese say that a doji provides " a hint of tops and bottoms". (figure 25)

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Vocabulary

A
Apex
Arithmetic scale
Art-charting
Ascending triangle

B
Bar-chart
Bearish engulfing pattern
Bottom-line
Bullish Consensus
Bullish engulfing pattern

C
Candle Stick /-chart 1, 2
Channel formation
Chart
Chartist
Closing prices
Complete cycle
Consolidation
Continuation formations
Contrarian Opinion
Corrective waves
Cycle lines

D
Descending triangle
Divergence
Daily close
Doji
Double top/bottom
Down-trendline
Dow Theory

E
Edge band analysis
Elliott-Wave
Engulfing pattern
Exponential moving average

F
Fibonacci-numbers
Fibonacci time zones
Five-wave
Four-weekly-rule
Flag
Fundamental Analysis

G
Golden section /ratio (phi)

H
Hammer
Hanging man
Head and Shoulder
High
Horizontal triangle

I
Impulsive waves

L
Larry Williams %R
Line-chart
Logarithmic scale/chart
Long term
Low
Low-risk entry point
Lunar cycle

M
MACD (moving average convergence/divergence)
"Markets Vane"
Medium term
Momentum
Monthly close
Moon cycles
Moving Average
M-Top

N
Negative or bearish divergence
Non-trending indicators

O
Oscillator
Opening

P
Peak
Pennant
"Phi"
Point and figure
Positive or bullish divergence
Price formation
Price objective
Psychological rationale

R
Rate of Change
Ratio
Real Body
Resistance
Rounding bottom/top
Relative Strength Index (RSI)
Reversal criteria/formation 1, 2

S
Saucer
Sentiment
Short term
Sideways trend
Simple Moving Average
Spiral Calendar
Stochastic
Stop-loss/Stop
Stop-profit
Support
Symmetrical triangle

T
Technical Analysis
Technical Analyst
Technical indicators
Three-wave
Time Cycles
Time frame
Timing
Top-line
Trading
Trading signals
Trend
Trending indicators
Trendline
Triangle
Trigger levels
Troughs

U
Up-trendline

V
Volume

W
Weekly close
Wedge
Weighted moving average
Whipsaw

Z
Zero line