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New to FX - Technical Analysis

Technical Analysis

» BASIC TECHNICAL ANALYSES

With Technical Analysis, investors usually look for chart patterns that have a high chance of reoccurring, in an attempt to determine the direction of the market. These patterns usually have names that represent their look, like Cup and Handle, Head and Shoulders or Double Top or simply a channel. You can find examples of these patterns later in this section with screenshots from our LOYEX MT4 platform to visualize i this better.

There are also Technical Indicators, which are drawings on the given chart that are derived from generic price activity in a stock or asset. Usually these indicators are used by active traders for short term entry or exit signals to enhance their trading. Some of these indicators are: MACD, Bollinger Band, Relative Strength Index (RSI).

Technical Analysis is based on three assumptions:

    1. The market discounts everything
    2. Price moves in trends
    3. History repeats itself

The assumptions are:

    1. The market discounts everything.

    Some people who claim TA is useless or ineffective support their opinion with the argument that it ignores fundamental factors of the given company or currency pair. This is not true however, because the assumption is that at any given time the stocks or currency pairs price reflects everything that has or could affect it, including fundamental analysis factors

    2. Price moves in trends

    In technical analysis it is believed that once the price follows a trend, it is more likely to go with it than against it. Therefore the future price movement can be anticipated in the trend direction, whether it is up or down.

    3. History repeats itself

    This is another important idea, since without it the chart patterns would not hold any value and mean nothing, is that the repetitive nature of price movements is attributed to market psychology; in other words, market participants tend to provide a consistent reaction to similar market stimuli over time. Although it is true that markets have changed over the past 100 years, human psychology remains mainly the same.

» CHARTS

What is a chart? A chart is simply a graphical representation of data. It allows us to visually process a price action of an underlying and find patterns on it that might repeat themselves therefore allowing us to predict future price movements with a greater accuracy for a more profitable trading. A chart can be drawn in many different ways but the most widely used are:

  • Line charts
  • Bar or OCHL charts
  • Candlestick charts

Most of the technical analysis is done on the candlestick charts, since it is the most informative of the three.

The candlestick chart consists usually of a body and two shadows, the upper one for the daily high, and the bottom one for the daily low. In some cases there are no visible shadows. Filled charts represent bearish or days on which prices fall while hollow ones represent bullish days where the price movement was upwards.

Let's see some chart pattern examples:

1. The Trend

As you can see (depicted by yellow circles) whenever the price touched or came close to the red line drawn, there was a price movement in an upward direction. Since a line can only be drawn if there are already two existing points, the first possible entry was at circle number three, and the next at circle number four. This way a trader could anticipate an upward price movement and simply had to wait for the price to touch the trendline (also called support in this case since it supports the price, and lifts it upwards) and take a long position. Usually a trend is valid until it gets broken through by price action and it remains under or above the trendline.

2. The head and shoulders

The head and shoulders is a so called reversion pattern, meaning that more often than not it predicts a change in price movement. The simple head and shoulders could be found at a top of an upwards trend, just as the inverted head and shoulders should be found at the bottom of a downwards trend. If we could categorize chart patterns based on how "strong" they are, the head and shoulders would be between the first ones, since it is usually very reliable.

3. Double Top and Cup and Handle

As you can see on the example picture, these two patterns got their name from their appearance. The first one is called double top. It consists of two tops that reached resistance at around the same price level, therefore indicating, that the price will not be able to break through that level. The yellow line is called the neckline (This was the first lowest point of the double top) and once the price broke through that line (at the white circle) one can enter a short position since there is a high probability that the price action will continue downwards. This pattern should be looked for after the price had a major upwards movement, since this is a reversion pattern. The opposite of the double top is the double bottom.

The Cup and Handle got its name because with a little imagination one can see how it forms a cup and then a smaller "handle" afterwards. This can be either a reversal or continuation pattern, but either way it predicts bullish price action. Once the price broke through the neckline (yellow line) one could enter a long position with a high propability of success. Usually the price goes up as much as the cup was deep, counted from the breakout point. A cup and handle should not be too steep, it should have a nice round bottom.

Naturally, there are several more patterns, and generally the topic of technical analysis is too deep to go into in brief however many traders have had great success with applying only a few simple rules and strong money management skills.

» BULLISH CONTINUATION CHART PATTERNS

Ascending Triangle

The ascending Triangle is a trading strategy defined by an upward slant support and a flat resistance line. Traders should look for these patterns after a trend has been established. It is the most reliable indicator if found at the top of an uptrend. The entry point is usually after a confirmed breakout from the resistance level.

Bull Flag Patterns

The Bull flag pattern usually follows a steep rise in price, and consists of two parallel lines (one support and one resistance). Usually these have a slight downtrend, but they are also considered valid if the lines are horizontal. The entry point is usually once a confirmed breakout has been made.

Bullish Pennant Patterns

The Bullish Pennant pattern is very similar to the Flag, however the two lines (support and resistance) converge to form a narrow flag shape, which lies horizontally. After breakout to the upside, a long position can be opened.

Cup with Handle

The cup and handle is one of the most powerful trading patterns in terms of reliability. The price action resembles what seems like a cup with a handle. The cup should have a round bottom and steep or V formed cups are usually not valid. The price should break above the neckline for a safe entry.

Symmetrical Triangle

The symmetrical Triangle behaves like the regular ascending triangle but looks similar to the Pennant, since two lines tend to converge. It can signal market movement in both directions, meaning it is very important to wait for a valid and confirmed breakout to enter a position.

Price channel Patterns

Although this is not really a pattern, it's easy to recognize features and greater reliability allows the trader to use this formation to his advantage. A channel is basically a range, in which the price moves and thus creates a trend.

Entry points can usually be found at the support.

» BEARISH CONTINUATION CHART PATTERNS

Bear Flag Patterns

The bear flag works the same way as the bull flag, and has the same appearance. The difference is that the trader should look for bear flags in a downtrend. Entry point is once the price has a confirmed breakdown below the support line.

Bearish Pennant Chart

After a steep decline in price there is a high chance that a Bearish Pennant will form. It has the same characteristics as the bullish pennant, except this one is a downward continuation pattern, meaning that the price action will most likely be bearish after breakdown.

Descending Triangle

The descending triangle is formed by a horizontal support and a downwards pointing resistance. The price breakdown is valid and confirmed if the price drops below the support line with a high volume and stays there.

Rectangle Chart Patterns

A rectangle pattern is a continuation pattern that is defined by two parallel lines, one support and one resistance. Once the price has a confirmed breakout or breakdown, a position can be entered accordingly.

Rising Wedge Patterns

Rising wedge formations are bearish continuation patterns. They look very similar to triangle patterns, because of the narrowing price range and due to converging trendlines. A rising wedge pattern can usually be found in a down-trending chart, with a short entry point defined once the price breaks down below the support.

» REVERSAL CHART PATTERNS

Double or Triple Bottom Chart

A double or triple bottom formation refers to a lower rate that was hit by the price two or three times in a row, but could not break through it. Usually the currency drops and bottoms out with high volume, after which a small rally ensues, but after a while (sometimes it takes weeks) the price will re-test this low. Once it has bounced back successfully it can break through the neckline and continue its way upwards. Sometimes the price will re-test the lows a third time after which we refer to the pattern as a triple bottom.

Falling Wedge Patterns

The falling wedge begins wide at the top and contracts as price moves lower. Falling wedges always slope down and have a bullish bias, meaning that they can be found at the end of downtrends.

Head and Shoulder Bottom

A head and shoulder bottom (also called inverted head and shoulders pattern) is a favoured chart pattern with investors due to its reliability. Rarely does a confirmed entry point in this pattern fool the investor, and therefore good results can be achieved with it if traded correctly. Entry point is once the neckline is broken through by the price action with high volume.

Rounding Bottom Chart

A rounding bottom chart can be thought of as a head and shoulders pattern without the readily identifiable shoulders. The lowest point can be referenced as a head, and while a nice, symmetrical shape is always preferred, a difference in time or sloping of the left or right side is not a problem. The point is to capture the essence of the pattern as a whole. Breakout has to be confirmed with high volume.

Broadening Top Chart

The broadening top pattern is a very rare one to be found on charts. It looks like an inverted triangle, because the broadening swings are caused by price swings that are increasingly widening. Entry point is defined once the price breaks down below the support line with high volume.

Diamond Top Patterns

The diamond top pattern signals a reversal to a downtrend. Volume is usually high during the entire forming of the pattern, and the pattern usually occurs only in very active markets. The price creates higher highs and lower lows in a broadening pattern, then the price range tightens until the breakout to one direction happens.

Double Top and Triple Top

The double and triple top patterns are one of the most commonly found patterns in currency markets. It indicates a reversal in the trend and can be found at the top of uptrends. It has an M shape (for double tops) and volume tends to peak at the tops. The triple top looks like the double top, but with one more top. Entry point is after the neckline has been broken with high volume.

Head and Shoulders Top

The Head and Shoulders marks a top in the price trend and is extremely popular among traders due to its reliability. A key element of this pattern is the neckline. It can be horizontal, sloped upwards or sloped downwards. Once this neckline is broken through a position can be entered.

Rising wedge pattern

Although usually a rising wedge pattern is a bearish continuation pattern, it can mark a reversal of the trend if found at the bottom of a downtrend and price action does break out above the resistance instead of breaking down from the support.

Rounding Top

The rounding top pattern works just like the rounding bottom, but can be found at the end of an uptrend. Entry point is once the price breaks down below the neckline with high volume.