Trends & chart patterns
Technical analysis is about making money from trend-following, using charts. Chartists identify trends and try to ride them. A trend is easily identifiable with the naked eye. An up-trend consists of a series of higher lows and highs, while a downtrend consists of falling highs and lows.
Drawing a straight line through the low points of an uptrend or the high points of a downtrend produces a trend-line. The longer a trend-line and the more points it encompasses, the greater its significance. Once the price moves decisively beyond a trend-line, there is a strong chance that the trend may have reversed.
Moving averages also help to define trends. A moving average is an average of a recent period’s trading prices. So, a 20-day moving average is the average of the most recent 20 days’ prices. Each day it is recalculated to encompass the latest price at the expense of the oldest price in the series. This produces a smoothed rising or falling line on a chart. An exponential moving average gives greater weight to recent periods’ data.
The direction and interaction of moving averages with each other also tells us whether a trend is still intact. Financial markets do not always have a trend: they can trade sideways within a range for some time.
Price patterns hint at an imminent change in trend or that a trend is likely to continue. They also provide targets of where a price might end up after the trend reverses. When a price fails two or three times to get beyond a particular level after trending strongly, this is often signals a top or bottom has occurred. The pattern’s height gives us a measured objective of how far it may subsequently fall or rise.
Support & resistance
Even in strong trends, asset prices face obstacles. Support levels can halt or delay a price’s decline, whereas resistance levels do the same during an ascent. Support and resistance levels are often points where the price has stopped in the past.
Put another way, support is the area where buyers have gained the upper hand over sellers, whereas resistance is where sellers have overcome buyers. Once these levels are decisively broken, supports become resistance and vice versa.
Moving averages often act as support and resistance. Slower averages – such as the 200-day average – can act as long-term support or resistance, whereas faster ones – such as the 20-day average – might be more relevant for day-to-day trading.
Ichimoku clouds are a Japanese technique, where moving averages are combined to create a band or ”cloud” of support or resistance, which is projected into the future. The tops and bottoms of these clouds patterns present barriers to price action.
Momentum
The rate of change of a price is almost as important as its direction. Changes in momentum can indicate that a trend is running out of steam, if only temporarily. To gauge momentum, there is a wide range of tools known as oscillators, so called because they ”oscillate” either side of a horizontal line.
In an uptrend, we expect to see oscillators rising with the price – and vice versa – thereby confirming the price trend. When a price hits a new high or low but the oscillator does not, it is called ”divergence.” Although not a signal to buy or sell in itself, it is a warning that a pause or reversal may be imminent.
When oscillators reach extreme levels, it can be a clue that the trend has gone too far too fast. In this situation, a market is said to be ”overbought” or ”oversold.” As a result, the share price may snap back towards one of its averages before resuming its upward or downward course.
The relative strength index (RSI), moving average convergence/divergence (MACD) and stochastic oscillators are three of the most widely-used momentum oscillators. However, there are many more indicators that do the same job.
Breadth & sentiment
An index may be going up or down, but it is important to know how many of its individual members are doing the same. This is the concept of breadth and it is a test of the market’s health. For example, the FTSE may rise strongly because a few of its biggest members are doing very well, even though many of the rest are not.
Breadth indicators look how many index members are hitting new highs or lows, or trading above or below a certain moving average, or have positive charts. When an index is at new highs or lows, many of its members should be as well. If not, that is a warning that the market may be on the turn. Likewise, an index’s bull market should be confirmed by plenty of index members having giving positive chart signals.
Sentiment is hugely important in markets. The key principle here is that when the vast majority of investors hold the same opinion - whether bullish or bearish - there is a strong chance the next major move will be in the opposite direction. So, when an overwhelming majority of investors are optimistic about the market, the market is usually ripe for a sell-off. Sentiment surveys are few and far between, but Investors Intelligence publishes an excellent and long-standing one for the US market. Levels of open interest on futures contracts can be interpreted in this way too.
Price & time targets
Chartists believe that significant highs and lows in financial markets are mathematically related. The Elliott Wave Principle says that markets move in recurring sequences of waves, whose dimensions are often determined by ratios drawn from the Fibonacci series of numbers. This mathematical series occurs repeatedly in the living world, in the dimensions of plants, shells, and even the human body. By applying these ratios to price movements, chartists derive targets for expected moves up and down.
Gann Theory applies halves, quarters and thirds and subdivisions of these fractions to price ranges and to highs and lows – to determine potential reversal points in the market. It also draws angles inspired by these fractions from highs and lows, with the aim of identifying points in time where turning points may occur. The Fibonacci series is also used to project significant trading dates in the future.
