Technical analysis is one of the best available means in an investors toolkit for timing trades in assets across the spectrum. While practitioners of fundamental analysis may not necessary always agree with the use of technical analysis is their strategies, it is undeniable that charts provide a lot of crucial information when it comes to making effective trading decisions does not matter whether you're a ‘wolf from Wall Street’ or one of the binary options trader. Besides helping determine entry points and exit strategies, reading the rice action on charts is especially useful when it comes to setting up the risk and reward parameters of a trade. The most important thing to remember when reviewing charts is that despite the fact that there are many different ways to read and interpret price action, past performance is not necessarily indicative of future price behavior.
An Overview of Charts
When it comes to reviewing charts and price action, the first, and most important convention to remember is how prices are plotted versus time. The vertical scale (or y-axis) is always used to represent the price scale, or how prices are either rising or falling. The horizontal scale (or x-axis) is used to represent time. Together, they give us an idea of how prices are trending over time. The four major types of price action we most commonly see are upward trends, downward trends, horizontal (sideways) trend or price action that is trendless. However, the way that prices are plotted on the graph can also provide valuable information that is helpful when it comes to making trading decisions. While there are many different ways to plot price action, the three most popular amongst investors are line charts, OHLC charts, and candlestick charts.
The basic idea behind line charts is to strip away much of the intraday noise when it comes to trading, and is especially useful for traders that are taking a longer-term view of investing. Typically, the line is used to connect closing prices over the period measured. Closing prices in this case typically refer to the closing price of the trading session, however, the line can be fitted to shorter time frames as well depending on the trading time horizon of the investor.
This is a commonly applied charting technique that involves mapping the open, high, low, and closing (OHLC) price during a specific period of time being measured by the OHLC bar. One of the benefits of using OHLC lines is that they give more information than line charts which can then be used to help structure trades over shorter periods of time.
The last, and among the most popular charting techniques is the Japanese candlesticks. Originally used as a means to track price changes in rice, Japanese candlesticks are helpful because similar to OHLC charts, they give an idea not only of the strength of the trend and a good indication of volatility during the time period measured in comparison to other periods, but they additionally provide meaningful signals of assets when prices are on the verge of reversals, helping traders to structure trades that are anticipating a change in moment.
What The Charts Tell Us
Charts tell us more than how prices are changing over a specified period of time. They are valuable in that they provide an easy way for investors to judge how market participants are feeling about a particular asset. If sentiment is positive, meaning that investors are bullish, price action would typically reflect these indications by traveling higher over a period of time. Conversely, if investor sentiment is negative, price action would probably be reflected by momentum lower in an assets price over time.
Visually, the charts represent the intersection of supply and demand for a particular asset. If buyers outnumber the amount of sellers in a particular instrument, an asset will see prices rise over time. On the other hand, if the sellers outnumber the buyers during a particular point in time, it would be reflected by the price of an asset declining over time. When the amount of buying pressure is equivalent to the amount of selling pressure, an assets price would trend sideways over time with limited directional momentum.
Aside from just representing sentiment and whether the buyers or sellers are more active, charts give us good information about the strength or weakness of a trend and when it may be approaching a pullback or a directional reversal. Strong directional momentum is typically indicated by a steeper incline in prices whereas weaker momentum would be reflected by flatter price action over time. Candlesticks in particular are useful as described above because they offer a visual representation of when price action is more and less volatile depending on the length of the body of the candle and the wicks. Moreover, the more volume and volatility, the more likely the asset is at a turning point that could signal and trigger a reversal.
Technical Analysis Basics
Technical analysis starts with some very simple analysis of horizontal levels typically referred to as support and resistance. As the name would imply, support represents a level at which prices have difficulty falling below that be thought of as a price floor. Resistance is a horizontal level that an asset’s price has difficulty rising above, comparable to a price ceiling. Support and resistance tell us valuable information about important pockets of buying and selling activity and where an assets price runs into problems rising or falling. One very important idea to remember is that important levels remain relevant once broken. In the case of support, when broken to the downside, it turns into resistance. The opposite is also true, with broken resistance turning into support for prices.
Aside from helping traders to go ahead and understand potential points to enter and exit trades, these levels can be important for longer-term analysis of important areas to watch for changes in directional price momentum. However, psychology can also play a role, and this where major levels come into play. Unlike halves (e.g. 2.50, 10.50, 50.50), whole numbers (e.g. 2.00, 10.00, 50.00) are typically areas that see an increased level of trading activity as they are popular areas for trades to set pending orders or stop-losses and take profits. As a result, they can often be meaningful for sentiment a signal a shift in sentiment once broken.
The natural progression from horizontal lines is diagonal lines which represent an asset and how its price is trending. As was mentioned above, there are four major types, including upward trends, downward trends, sideways trend, and an asset which has no trend which is also referred to as trendless. As the old adage says, “the trend is your friend.” One of the most valuable ways to use trends is to establish positions in the direction of the trend once the price action hits the trend line.
In the event of an uptrend, a trend line which would connect the valleys of price action over a period of time would be used as a location to establish bullish positions. During a downward trend, a trend line would connect the peaks of the price action over a period and be the location where a trader would establish bearish positions. Finally, during a horizontal trend, typically implying a range between two horizontal levels, a trader would traditionally establish bullish positions at the bottom of the range targeting the top of the range and initiate bearish positions at the top of the range targeting the bottom of the range.
Commonly Recurring Chart Patterns
While there are many types of reversal patterns, which basically indicate a change in an assets trend, the three main patterns that standout are trend reversals, double and triple bottoms and tops, and Doji reversals.
A trend reversal indicates a scenario in which a trend line which is connecting the lows or the highs is broken. While the typical trend trading strategy is to go ahead and trade with the trend, when the trend line itself is broken, this could be an early indication that the trend higher or lower is reversing. In the event of a bullish upward trend line being broken with a candlestick close below the diagonal level, it is a good idea to start considering establishing bearish positions. Conversely, when a downward trend line is broken to the upside with a candlestick close above the trend line, it is a good time to consider establishing bullish positions anticipating a new upwards trend.
Double/Triple Bottoms and Tops
Building off of horizontal levels such as support and resistance are the double bottoms and tops which can occasionally find themselves being triple bottoms and tops. A double top is indicative of a situation in which an asset’s price has difficulty rising above a resistance level which remains firmly in the way of further appreciation. After two bounces off of the resistance level with no cross to the upside, a double top is formed with the expectation that prices will reverse lower. A triple top is an even stronger signal that the bullish price action is on the verge of reversal lower. A double or triple bottom is identical in nature expect that instead of prices trying to rise above resistance, they have difficulty falling below support, indicating that a trend may be changing and the time is ripe to establish bullish positions.
Japanese candlesticks are extremely useful for identifying potential reversals. In particular, a Doji is a candlestick that suggests a reversal in the price action is imminent. They typically resemble a plus (+) or a cross (t) or a “t” (^ or T) and occur when opening prices and closing prices during a time period are equivalent. While there are numerous forms of Doji reversal patterns, they require confirmation from subsequent candlesticks that a trend is changing. Although, as in all reversals, Doji are traditionally accompanied by higher volatility which is indicated by longer candlestick wicks and higher than average trading volumes.
Some of the best reward conditions that present themselves in trading opportunities are not necessarily trend following, but breakout trades which have the benefit of added directional momentum that traditionally occurs very quickly. Breakouts normally occur after a sustained period of range bound price action or consolidation, which is another name for price action that is narrowing over time. The key is not to trade the consolidation, but instead wait for the directional breakout to reap the rewards of this particular type of recurring chart pattern. Three common recurring breakout patterns are range breakouts, triangle breakouts, and equidistant channel breakouts.
A range breakout is formed by price action that is trending between a horizontal support and horizontal resistance level. While there are two strategies, one being trading the range by establishing bullish positions near support and bearish positions near resistance, the second strategy of waiting for a breakout can occasionally provide better reward conditions. A breakout would be defined as a candlestick close outside of the range, meaning a candlestick close above resistance or below support. It is good to use a measure of 60-75% of the horizontal range when determining when to take profit after a breakout move. However, if price action moves back into the range, it is a signal that the breakout is a fake directional move intended to shake out traders.
Triangle breakouts are typically defined by a period of consolidation between two trend lines or horizontal line and a trend line. The three main forms of these recurring patterns are symmetrical triangle breakouts, ascending triangle breakouts, and descending triangle breakouts. Unlike range-based breakouts, which are more low-risk, triangle-based breakouts are more medium risk, but present better reward conditions.
As its name would imply, a symmetrical triangle is formed by a upward trending line converging with a downward trending line. Over time, the trading range of prices narrows as the trend lines approach one another, meaning that potential reward is shrinking over time. Instead of getting caught in a situation where reward is not optimal, traders should use consolidations as an opportunity to spot a breakout trading opportunity. Once a candlestick closes above the downward trending line or below the upward trending line, this is a breakout sign. After the candlestick close, one would establish bullish or bearish positions if prices close above or below the triangle formation.
An ascending triangle is first formed by a consolidation between a horizontal resistance level and an upward trend line. Over time, the ranges prices trade within narrow, making it increasingly difficult to trade. Instead, it is best to wait for a candlestick close above resistance, indicating an upside breakout and usually accompanied with higher trading volumes and increased directional momentum. However, if the price action falls below the trend line, this is defined as a breakdown in the pattern. A descending triangle is identical to an ascending triangle in terms of the idea, except is instead a bearish pattern formed by a horizontal support level and downward trend line. The strategy is the reverse of the ascending triangle.
Equidistant channels are the final breakout trading strategy, and while more high risk than triangle breakouts, they provide the greatest reward potential of any of the recurring breakout patterns. An equidistant channel is formed by two parallel trend lines that keep the price action contained over time. Unlike a range, the parallel lines which are equidistant form a channel that is trending either higher or lower over time. A channel is typically confirmed by three points of contact on both the lower and upper channel lines.
Like ranges, there are two strategies for trading channels. In the event of an upward trending channel, one would establish bullish positions at the lower channel line targeting the upper channel line. However, bearish positions should not be established from the upper channel line because it fights the trend and offers poorer reward than bullish positions. The opposite is true for downward trending channels, with bearish positions more favorable when trading the channel itself and bullish positions not advised due to worsening reward characteristics.
While channels are very popular to trade, the better reward conditions occur when the parameters for a breakout have been met. A channel-based breakout is signaled when a candlestick closes outside of a channel and is accompanied by higher trading volumes and increased directional momentum. Once a confirmed breakout, the strategy is to trade in the direction of the breakout. However, be warned that these are typically very volatile moves that happen quickly, so while it requires patience to identify, these breakouts must be taken advantage of quickly.
Things to Remember
toolkit.tradersOne of the first rules of technical analysis is that past performance is not necessarily indicative of future price behavior. While it is a strong way to identify the potential of price action, it should be used as a guide and not an absolute rule. Just because a recurring pattern appears, it does not mean that the pattern itself will complete and come to fruition. As a result, it is essential to always set reward and risk parameters before entering a bullish or bearish position. Furthermore, because technical analysis is more an art than a science, it is important to recognize that everyone might not interpret charts the same way. However, while chart analysis is not perfect, it is still especially useful for timing trades and helping to identify important levels when it comes to setting risk and reward and a great part of every