Technical analysis is the art and science of predicting future price movement based on its historical movements. This analysis uses charts which consist of price movement and possibly technical indicators to predict where the price is heading on the short, medium, or long term.
Experienced technical analysts usually focus on the price movement as the most important indicator for their analysis. This is a prudent approach as all technical indicators are derived from price action.
There are many ways to visualize price action. It can be visualized using the line chart, or Japanese candlestick, or bars, among many other ways. Each visualization method has its own advantages.
The line method helps smooth extreme market fluctuations and is better for longer term investment decisions. The advantage of using this chart is simplicity. The line chart greatly reduces the noise and is better for seeing trends. On the other hand, you may miss out on some important information related to sentiment with the line chart since it tends to not show extreme peaks and troughs and smooth them out.
Candlesticks, on the other hand, can give a better reading into the sentiment of traders in the market, candles may appear in one of two different colors depending on whether the price increased or declined within the specified time period.
Candlesticks are widely popular and offer many advantages. They help identify trend continuation or trend reversal, and help you make an earlier entry or even exit when the conditions are no longer favorable. They also make it easier to gauge volatility using the length of their bodies. Moreover, you can identify opening and closing price at a glance using candlesticks.
In short, candlesticks tell you the story of the market in a very simple language. In the chart below you can see black candles and white candles. The black candles signify that the price decreased whereas white candles signify that the price increased. The candle consists of the body and shadow.
The body reveals the opening and closing prices. In the white candles, the lower boundary is the opening price, and the upper one is the closing price. In the black candles, the upper boundary is the opening price and the lower one is the closing price.
The shadow shows you the highest price and the lowest price, as indicated by the top and the bottom of the shadow respectively.
Bar charts are rather a more simplistic way of showing trading data within a single period of time (hour, day, week, etc.) without the coloring that can be distracting sometimes.
They offer the same advantages of candlesticks, but they emphasis the closing price in relation to the closing price of the previous period. In candlesticks, the emphasize is more on the difference between the opening price and the closing price of the same period.
To better understand price actions, traders often tend to draw a line at important price levels. The price of a financial asset often turns at certain price points more than once. If the price level proves to be significant (the price tends to reverse at this level more than twice), then this can be used as a valuable piece of information. Those price levels are called support and resistance levels. Support and resistance lines are horizontal lines, as opposed to sloping lines (trend lines), which we shall see later.
Looking at the picture below, you can see a green line and a red line. The green line is considered as a resistance line since obviously, the price could not rise above it on more than two occasions. The red line is considered a support line since the price could not drop below it on more than two occasions.
Financial markets do not work in a uniform fashion. Most support and resistance lines can often be slightly surpassed by the price to only see the price return to them later. For this reason, some traders find support and resistance zones more useful in identifying price levels at which the price reacts.
Technical indicators are mathematical calculations derived from the price action data. Common technical indicators include simple moving averages, exponential moving averages, Bollinger bands, ichimoku kinko hyo, relative strength indicator (RSI), Moving average convergence divergence (MACD), and Average true range (ATR).
Technical indicators can be classified into different categories based on their nature. The most famous categories are trend indicators and oscillators.
Trend indicators such as the simple moving average or the ichimoku indicator give you information about the trend in the market. Those indicators are very useful when the market is trending but are not so useful when the market is moving in sideways and can even be misleading at those times.
Oscillators on the other hand, such as the RSI, MACD have different uses. They oscillate between two values from 0 to 100 and can be useful when the market is moving sideways and can help when you are trying to count market waves.
Traders look at market waves differently, and as a result two traders can identify two different waves on the same chart. For that reason, it may be difficult to define what a market wave is. However, for the sake of simplicity we will define a market wave as a consistent movement of the price in one direction (either upwards or downwards). This is not to say that this movement will not involve smaller movements in the opposite direction.
For example, if you look at the USDJPY chart below, you can see a long wave downwards (between the two violet lines). This can be considered as a one wave, and if you look closely you can see small upward movements of the price inside that big wave.
A trending market is a market that clearly has a bias either to the upside or to the downside. A market is said to be trending up if it is showing higher highs and higher lows, and is said to be trending down if it shows lower highs and lower lows.
When the market is not in a trend, that is, it is not consistently rising on declining, or moving within channels, then it is moving in sideways.
A moving average is simply an average of a certain number of price values, and it moves forward by one period at each period of time.
There are many types of moving averages, the most common of which is the simple moving average (the arithmetic mean). Other types include the linear weighted moving average, where recent price values have a larger effect on the eventual value of the moving average.
Let's take an example:
Say the closing price of a stock was the following:
- Day 1: $10
- Day 2: $11
- Day 3: $9
- Day 4: $8
- Day 5: $12
If we want to calculate a 3 day (the period) moving average, we would have the following values:
- Average of Day 1-3: (10+11+9) / 3 = $10
- Average of Day 2-4: (11+9+8) / 3 = $9.33
- Average of Day 3-5: (9+8+12) / 3 = $9.67
The MACD (moving average convergence divergence) indicator is a famous indicator that was developed by Gerlad Appel. This indicator simply shows whether two moving averages (MA) are converging or diverging. The default moving averages generally used in this indicator to detect divergence or convergence between them are 12MA and 26MA, although the trader can choose different settings.
The idea behind the MACD is that if the two moving averages are going away from one another (diverging) this means that the trend is gaining momentum (either to the upside or the downside), whereas if the two moving averages are getting closer to one another (converging) then this means that the momentum is declining. The MACD makes it simpler for the trader to see whether the two moving averages are converging or diverging by simply looking at its value. If the MACD value is 0 then the two moving averages are at the exact same point and they are crossing over one another. If the value is positive then it indicates the distance to the upside between the two moving averages (the 12MA is higher than the 26MA). If it is negative then it indicates distances to the downside (the 12MA is lower than the 26MA)
It is important to notice that MACD as well as many other oscillators measure the momentum of price movement (the strength of the price movement), and not the price movement itself. As a result, the price may very well be going up whereas the MACD may be going down, in which case this reveals that the momentum of price movement is declining even though the price is still going up, and we can expect an eminent downwards movement soon. The same goes for downward price movement with declining momentum. It means upward reversal may be about to happen. Divergence between the MACD and price direction is often used by traders as an entry signal or at least an indicative signal of slowing momentum.
Another way the MACD can be used is by adding a 9-period moving average to the MACD itself. When the MACD indicator crosses over this moving average below it to the upside, it is a signal that the price is likely to go upwards. On the other hand, if a crossover happens from above it to the downside, then it is a signal that the price may be going downwards. This signal is better used with other supporting signals to confirm a valid entry point.
Unlike other indicators such as the RSI and stochastic oscillator, the MACD does not oscillate between values of 0 and 100, but rather reflects the extent of divergence or convergence between the two moving averages it uses.
The picture below shows the MACD indicator below the chart. The MACD 9-period moving average is shown in red.
*period can be different based on the time frame you are using. If you are looking at the hourly chart, then the period is one hour, whereas if you are looking at the weekly chart, then the period is one week.
Below is an example of a MACD crossover with its 9-period moving to the downside. Notice how the the bars started declining below the red line. The price then continued downwards.
Oscillators like the stochastic oscillator, RSI, and Williams %R, show you where the market is oversold or overbought. For example, the stochastic shows overbought conditions when it goes above the 80 threshold, and shows oversold conditions when it drops below the 20 threshold.
Bollinger bands are simply lines representing a certain number of standard deviations (usually 2 standard deviations), combined with a moving average line between them. When the price goes above the upper band and closes above it with at least 2 candles or more, it shows extreme buying. When the market goes below the lower band and closes below it with at least two candles or more it shows extreme selling.
The Bollinger bands are shown on the chart below with the moving average line in the middle. Notice how the candlesticks to the left side of the chart are mostly closing outside of the upper band. Those candlesticks indicate extreme buying and stretched movement to the upside. In most trends, candles close outside of Bollinger band.
The Fibonacci sequence is a famous sequence in mathematics, and the most important percentages are derived from that sequence. Those percentages are: 23.6%, 38.2%, 50%, 61.8%, 100%. Experienced traders usually use those percentages to identify price level in the market at which the price is expected to resume its trend after a retracement.
For example, after a trend of 1000 points up, the market can reverse by 236 points (23.6%), or 382 points (38.2%), or another important level, then it might resume its trend up.
Most charting software comes equipped with tools to identify those levels easily.
Trend lines are similar to resistance and support lines, however, they are not strictly horizontal in nature. A trader can easily draw a trend line by connecting three market bottoms together (or three tops) together with a straight line that touches those points. Those lines are useful when we want to identify when the price has broken out of a trend and has a started a movement in the opposite direction.
Channels are simply two trend lines that are paralleled with one another. They include a lower trend line and an upper trend line. The price usually oscillates within the channel before it eventually breaks out in a certain direction. The breakout direction is often similar to the direction of the price before entering the channel, as you can see below.
The price often moves in recognizable patterns, and usually, the price tends to have a certain behavior after displaying each of those patterns, which makes it easier to predict its movement.
Among the most well-known chart patterns are Rectangles, Triangles, Flags, Head And Shoulders, and Cup With Handle.
A Rectangle price pattern takes place when the price enters into a channel. The price usually breaks out in the same direction it entered.
A triangle is another price pattern where the price moves in a shape of declining tops and rising bottoms, showing decreased volatility. The price usually then breaks out in the same direction as its previous movement.
The flag pattern happens when the price declines slowly forming a flag shape, then it usually breaks out in the same direction as the previous direction.
The head and shoulders pattern is a reversal pattern. The market first shows one top, then a higher top, then a lower top. The tops look like a head and shoulders shape. If the price then breaks out from the neck line, it is likely to continue downwards. The same can be applied in the opposite direction.
The cup with handle is a trend continuation pattern. The price declines in the form of a cup then it forms a handle. Afterwards, it is likely to continue the pattern.