Technical analysis

Technical analysis

Introduction to technical analysis.

Historically, technical analysis was developing the following way. When computers didn't exist, and methods of mathematical analysis were so complicated that nobody tried to use them for analysis of price dynamics, traders, plotted charts with straight lines manually, using just a sliding rule. Later, regular patterns of these lines and charts were revealed. Thus, trend lines, models and figures came into existence. Then it became necessary to depart from linearity of trend lines and models, and traders, also manually, started calculating mean prices, which were successfully used for analysis of Stock Exchange market, and later, for analysis of  financial derivatives and Forex market. With computers, it became possible to calculate and use methods of oscillators and indicators.

General principles of technical analysis.

  • The rate includes everything

It means that any factor influencing the price - economic, political or psychological - has been already accounted by the market and included in the price. Hence, analysis of the price chart is all what required for forecasting.

  • Price is moving directionally

This assumption is the basis of trend analysis and is the backbone of the entire technical analysis.

Three types of trends are distinguished in technical analysis:

    • 'bull trend' - upward movement of price (by analogy with a bull, who pokes up with the horns);
    • 'bear trend' - downward movement of price (by analogy with a bear, who hits down with a paw);
    • 'flat' or 'range' or 'trendless' - price is not moving up or down, but remains within a certain interval.

As a rule, prices are not moving linearly u or down. However, on the bull trend prices grow higher and faster, than they fall. On the bear trend it is vice versa.

Basic principles of price movement can be applied to trends:

    • an active trend will continue with a higher probability, rather than change its direction;
    • a trend will be moving in one direction until it gets weaker.
  • History repeats itself

This statement is based on permanence of effects of laws of physics, economy and psychology in different historical periods. Hence, the rules, which were effective in the past, are effective now and will be effective in the future. This statement enables us to analyze the present and forecast the future.

Types of charts.

  • Line Chart

The line chart represents closing prices (the last price for a specified period), connected by a continuous line.

If the specified period is equal to 1 minute, such a chart is marked M1; if it is equal to 5 minutes - M5; 1 hour - H1; 4 hours - H4; 1 day - D1; 1 week - W1. If all prices are represented on the chart, such a chart is called 'tick'.

The most common charts are D1, H1 and M5.

Technical analysis

  • Bar Chart

The bar chart represents the maximum price for a specified period (upper point of the bar), the minimum price (lower point of the bar), opening price (a line to the left of the vertical bar) and closing price (a line to the right of the vertical bar). It is recommended for time intervals of 5 minutes and more.

Technical analysis / bar

  •  Candle sticks (Japanese Candle Sticks)

The candle sticks chart is plotted by analogy with bars. The difference is that, if closing price is higher than opening price, the 'body' of the stick is colored white, if lower - black. 'Shadows' of the sticks show the maximum and the minimum price levels for the reporting period. Therefore, a white candle means that price has grown for the specified period, and a black candle shows that price has dropped.

Due to its demonstrativeness, this type of charts is the most common in technical analysis. Currently, there is a lot of literature, describing forecasting of price change on the base of Japanese candle sticks.

Technical analysis / Japanese Candle Sticks

Trend as a major instrument of technical analysis.

Trend is a directional tendency of price change, limited by time intervals.

 There three main types of trends:

  • primary;
  • intermediate;
  • short-term;

Primary trend usually lasts from 1 to 2 years and is a reflection of investors' assessment of internal economic process underlying business cycles. According to statistics, the business cycle from one valley to another lasts approximately for 3-6 years; this means that rising and falling trends last from 1 to 2 years. Prices are not moving in a straight line, and movements in the main direction are interrupted by a number of reverse movements - reactions. Such trends, which are in phase opposition to the primary trend, are called intermediate (medium-term) price changes. They last from 3 weeks to 6 and more months. Short-term trends, lasting from 1 to 3-4 weeks, interrupt the movement in the direction of the medium-term trend in the same way, as the latter interrupt the movement toward the primary trend. Usually this is a reaction to accidental events, and they are more difficult to reveal than primary and intermediate trends.

Current computer technologies allow tracking of weekly, daily, hourly, minutely and instant price changes in the market. For analysis of short intervals (less than one hour) methods of technical analysis also can be used. However, it needs to say that reverse moments on such charts have a short-term effect and do not influence much on the long-term tendency. Besides that, trading within ultra-short intervals is exposed to psychological and instant reactions at a greater extent. All this leads to a higher instability of price charts for shorter periods, as compared with charts for longer periods. For technical analysis, the most popular are daily (D1), hourly (H1) and five-minute (M5) charts.

Support and Resistance.

Support and resistance lines are fundamentals of the classic technical analysis (trend analysis) of Stock Exchange market. All trend lines, models and figures are combinations of support and resistance lines.

Support line connects significant maximums of the market. It appears, when buyers are unable or unwilling to buy at higher prices. Simultaneously with each upward movement of price, resistance of sellers increases, and sales grow, which causes price drop. The trend stops as though bearing against an invisible ceiling, and fight of bulls and bears begins here. Depending on who is stronger, the trend continues upward movement (resistance level is broken) or rolls back.

It needs to say, that it is better to draw support/ resistance lines on charts through price concentration zones, but not through maximum peaks. Mass clustering of prices shows behavior of the determinative mass of traders, and peaks reflect just panic actions of the weakest market participants. Also, level values are remembered by traders, and, if some events happen when a certain level is approached, next time, when the same level is approached there is a great probability that traders will make similar actions in the direction, where price was moving in the previous time.

Technical analysis / Support and resistance

Channel - technical analysis instrument.

The channel is a corridor, within which the price chart is moving, limited by the support lien below and the resistance line above. The longer price is moving within the channel, the higher probability that it will leave it. There are three types of channels:

  • bull - ascending channel;
  • bear - descending channel;
  • flat or range (trendless);

The channel is broken, when price breaks through support or resistance. Resistance breaking of the bull channel is a good signal for buying, and it is vice versa for the bear channel. In case of a lateral channel, the signal is weaker. When support on the bull channel and resistance on the bear channel are broken, a weak signal for selling/buying is received (it is better to receive confirmation from other indicators). Besides that, it is possible to play within the channel, observing two rules:

  • The longer price is moving within the channel, the higher probability that it will leave it;
  • It is better to play in the direction of the main trend;

Technical analysis / channels

Computer analysis.

There is a lot of instruments of so-called computer analysis. Computer analysis is analysis of charts with application of mathematical analysis methods. This material is discussed in details at our site, in the section 'Indicators and Oscillators'. In this chapter, as an example, we will perform analysis of price charts with Moving Average.

Moving Average shows an average price value for a certain period of time. Moving Average is placed on the price chart as a continuous line, forming Support or Resistance.

  • Moving Average is divided in 3 types:
    • Simple Moving Average - MA;
    • Weighted Moving Average - WMA;
    • Exponentially Moving Average - EMA;
  • Basic rules of construction:
    • The longer is the period, for which Moving Average is constructed, the lower order of MA should be chosen;
    • The longer MA is, the lower is its sensitivity; MA of a very small order produces many false signals; MA of a very large order is always late;
    • In case of a lateral trend, MA with a higher order should be used.
  • General rules of analysis:
    • to find cross points of MA and the price chart and to track direction of the average;
    • when MA is crossed by the price chart from down upward (in the rising market), a simple signal for buying is received;
    • when it is crossed from top downward (in the declining market), the signal is for selling;

Technical analysis / Moving Average

Fibonacci levels.

Leonardo Fibonacci, a great mathematician, lived in XI century. He established sequence of natural numbers, later named after him. Each number of the sequence is a sum of two preceding numbers: 1+1=2; 1+2=3; 2+3=5, etc. In the result, the sequence is as follows: 1,2,3,5,8,13,21,34,55,89,144, etc. Fibonacci numbers have certain properties:

  • division of the preceding number of the sequence by the subsequent number tends to 0.618 (number of the golden section in Ancient Greek and Ancient Egyptian cultures);
  • division of the subsequent number by the preceding number tends to 1.618;
  • division of a number by the second preceding number tends to 2.618.

Fibonacci numbers are used for analysis of various processes in physics, astronomy and other disciplines. In technical analysis, number 0.618 or 61.8%, as well as 50% and 38.2% are very often used.

On the basis of these coefficients, Fibonacci lines, Fibonacci levels and Fibonacci periods are constructed.

Fibonacci lines are constructed according to significant maximums/minimums and represent support or resistance lines, according to which purchase or sales are made.

Technical analysis

Summary to technical analysis.

Technical analysis is a serious applied discipline, and its methods allow analysis not only of price changes in financial markets (for example, technical analysis of Stock Exchange market or Forex market), but also other nonlinear processes. This article covers only the basics of technical analysis, required for independent study of charts of financial instruments.

*  This article has been prepared and written by the specialists of analytics department of the Company Larson&Holz IT Ltd:  Technical analysis
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