Pattern Analysis
Note:
This here is the last instalment of technical analysis basics, then after that we can move on to other financial topics :)
Also, thanks to Richard Schabacker (1932 Technical Analysis and Stock Market Profits), Edwards and Magee, and John Murphy.
There are thousands of market participants selling and buying securities for many reasons, motives and positions: love of return, hope of gain, fear of loss, short-covering, hedging, stop-loss triggers, price target triggers, fundamental analysis, technical analysis, broker recommendations, and more. Trying to figure out here why participants are buying and selling can be daunting. Chart patterns place buying and selling into perspective by consolidating supply and demand into a concise picture. As a complete visual record of trading, chart patterns provide a framework to analyze the “bulls and bears”, to analyze prices. Hence chart patterns and technical analysis together can help us determine the true picture. In many ways, chart patterns are more complex trend lines.
Chart pattern analysis can be used to make short-term or long-term forecasts. The data can be intraday, daily, weekly or monthly and the patterns can be, again, as short as one day or as long as many years. Gaps and outside reversals may form in one single trading session, while broadening tops and dormant bottoms may take months to form.
Technical analysis can at times be science and, then again at other times, more art. In addition, price pattern recognition is open to interpretation, which is subject to personal bias. To defend against bias and confirm pattern interpretations, other aspects of technical analysis should be employed to verify or refute the conclusions once again. While many price patterns may seem similar, no two patterns are exactly alike. False breakouts and exceptions are all part of the game here. Hence, careful constant study is required here for successful chart analysis.
Two basic tenets of technical analysis are that prices trend and that history repeats itself. An uptrend indicates that demand is in control here, and a downtrend that supply is in control. As the balance shifts, a pattern emerges. The vast majority of chart patterns fall into two main groups: reversal and continuation.
Reversal patterns indicate a change of trend. Continuation patterns indicate a pause in trend and indicate that the previous direction will resume after a while. However, just because a pattern forms after a significant advance or decline does not mean it is a reversal pattern. Many patterns can be classified as either reversal or continuation. Much depends on the previous price action, volume, and more, as the pattern evolves. This is where the science of technical analysis becomes an art.
In summary, for technical analysis, the keys to successful chart pattern analysis are dedication (learn, learn, learn), focus (limit charts, indicators and methods to those you know well), and consistency (maintain your charts regularly and study them often).
In conclusion, a paragraph from Schabacker:
“The science of chart reading, however, is not as easy as the mere memorizing of certain patterns and pictures and recalling what they generally forecast. Any general stock chart is a combination of countless different patterns and its accurate analysis depends upon constant study, long experience and knowledge of all the fine points, both technical and fundamental, and, above all, the ability to weigh opposing indications against each other, to appraise the entire picture in the light of its most minute and composite details as well as in the recognition of any certain and memorized formula.”
Investment: Technical Analysis basics 6
Investment: Technical Analysis basics 5
Introduction to Trends
Technical analysis is based on the assumption that prices follow a trend. Trend lines are hereby important for trend identification and confirmation. A trend line is a straight line that connects two or more price points and extends into the future to act as a line of support or resistance.
An uptrend line has a positive gradient and is formed by connecting two or more low points. Uptrend lines act as support and indicate that net demand is increasing even as the price rises. A rising price combined with increasing demand is very bullish, and shows strong determination on the part of buyers. As long as prices remain above the trend line, the uptrend is considered intact. A break below the uptrend line indicates that net demand has weakened and a change in trend could be imminent.
A downtrend line has a negative gradient and is formed by connecting two or more high price points. Downtrend lines act as resistance, and indicate that net supply is increasing even as the price declines. A declining price combined with increasing supply is very bearish, and shows strong resolve of sellers. As long as prices remain below the downtrend line, the downtrend is intact. A break above the downtrend line indicates that net supply is decreasing and that a change of trend could be imminent.
Again, it takes two or more points to draw a trend line. The more points used to draw the trend line, the more validity attached to the support or resistance level represented by the trend line. Even though trend lines are important to technical analysis, occasionally it is not always possible to draw trend lines on a given price chart. Sometimes the lows or highs do not match up. The general rule in technical analysis is: it takes two points to draw a trend line and a third to confirm its validity.
As the steepness of a trend line increases, the validity of the support or resistance level decreases. A steep trend line comes from either a sharp advance or decline of price over a short period of time. The angle of a trend line created from such a sharp move is unlikely to offer any meaningful interpretations. Even if the trend line is formed with three seemingly valid points, attempting to play a trend line break or to use the support and resistance level established will often prove difficult.
Sometimes there appears to be the possibility for drawing a trend line, but the exact points do not match up cleanly. The price highs or lows might be “off”, the angle might be too steep, or the points too close. If one or two points could be ignored, then a fitted trend line could be formed. With volatility present in the market, prices can over-react and produce spikes that distort highs and lows. One method for dealing with over-reactions is to draw internal trend lines, as an internal trend line ignores price spikes.
Trend lines can offer insight, but if used improperly may also produce false signals. Then again, other analyses can be employed to validate trend line breaks. While trend lines have become very popular again, they are merely one tool for establishing and confirming a trend. Trend lines should not be final, but should serve merely as a warning for changes in price trends. By using trend line breaks as warnings, investors can pay closer attention to other confirming signals.
Investment: Technical Analysis basics 4
Introduction to Trading ranges
Trading ranges are important in determining support and resistance as either turning points or continuation patterns. A trading range is a period when prices move within a relatively tight range. This signals that supply and demand are evenly balanced. When the price breaks out of the trading range, this signals that a winner has emerged here, where a break above is a victory for the “bulls” and a break below is a victory for the “bears”.
It is sometimes useful to create support and resistance zones. Each security has its own characteristics; analysis should reflect the securities’ intricacies. Sometimes exact support and resistance levels are best, and sometimes zones are better. Again, the tighter the range, the more exact the level. If the trading price range spans less than, say, 2 months and the price range is tight, more exact support and resistance levels are best. If a trading range spans months and the price range is relatively large, it is best to use support and resistance zones.
Identification of key support and resistance levels is essential to technical analysis. It is difficult to establish exact support and resistance levels. However, being aware of their existence and location enhances analysis and forecasting. If a security is approaching a support level, it comes to remind us to look for signs of increased buying pressure and a potential reversal of price. If a security is approaching a resistance level, it can tell us to look for signs of increased selling pressure and potential reversal of the price. If a support or resistance level is broken, the relationship between supply and demand has changed again. A resistance breakout signals that demand has won; conversely, a support break signals that supply has won.
Investment: Technical Analysis basics 3
Introduction to Support and Resistance
Thanks to http://stockcharts.com/
Support and resistance are important parts of technical analysis, where supply and demand meet. Prices are driven by excessive supply and demand. Supply is synonymous with “bears” and selling. Demand is synonymous with “bulls” and buying. As demand increases, prices advance and as supply increases, prices decline. When supply and demand are equal, prices move sideways.
Support is the price level at which demand is strong enough to prevent the price from declining further. As the price declines towards support and gets cheaper, buyers become more inclined to buy and sellers become less inclined to sell. By the time the price reaches support, demand will overcome supply and prevent the price from falling below support.
Support does not always hold and a break below support signals that the bears have won out over the bulls. A decline below support indicates a new willingness to sell and/or a lack of incentive to buy. Support breaks and new lows signal that sellers have reduced their expectations and are willing to sell at even lower prices. Buyers cannot be coerced into buying until prices decline below support or below the previous low. Once support is broken, another support level will have to be established at a lower level.
Support levels are usually below the current price, but it is not uncommon for a security to trade at or near support. In addition, price movements can be volatile and dip below support briefly. For this reason, some traders and investors establish support zones.
Resistance is the price level at which selling is strong enough to prevent the price from rising further. As the price advances towards resistance, sellers want to sell and buyers become disinclined to buy. By the time the price reaches resistance, supply will overcome demand and prevent the price from rising above resistance.
Resistance does not always hold and a break above resistance signals that the bulls have won out over the bears. A break above resistance shows a new willingness to buy and/or a lack of incentive to sell. Resistance breaks and new highs indicate buyers have increased their expectations and are willing to buy at even higher prices. In addition, sellers cannot be forced into selling until prices rise above resistance or above the previous high. Once resistance is broken, another resistance level will have to be established at a higher level.
Resistance levels are usually above the current price, but it is not uncommon for a security to trade at or near resistance. Also, price movements can be volatile and rise above resistance briefly; therefore, some traders establish resistance zones.
It is possible that support can turn into resistance and visa versa. Once the price breaks below a support level, the broken support can turn into resistance. The break of support signals that supply has overcome the demand. Therefore, if the price returns to this level, there is likely to be an increase in supply, and hence resistance. The other situation is resistance turning into support. As the price advances above resistance, the breakout above resistance proves that the demand has overwhelmed the forces of supply. If the price returns to this level, there is an increase in demand and support will be found.
Investment: Technical Analysis basics 2
Introduction to technical analysis (for beginners)
Thanks to http://stockcharts.com/
Introduction to Charts
Technical analysts use charts to analyze securities and forecast price movements. For beginners, “securities” refers to any tradable financial instrument or index such as stocks, bonds, commodities, futures or market indices. Any security with price data over a period of time can be used to form charts for analysis. Because charts provide a graphical representation of a security's price movement over a specific time period, they can also be of great useful benefit to fundamental analysts, not just technical analysts. A graphical historical record makes it easy to hereby spot the effects of key events on a security's price, its performance over a time period and if it is trading near its highs, lows, or in-between. The time frame used depends on the compression of the data: intraday, daily, weekly, monthly, quarterly or annual data are the major time frames.
Daily data is made up of intraday data that has been compressed to show each day as a single data point, or period. Weekly data is made up of daily data that has been compressed to show each week as a single point. Traders usually concentrate on charts made up of daily and intraday data to forecast short-term price movements. The shorter the time frame and the less compressed the data is, the more detail that is available. Short-term charts can thus be volatile and contain a lot of noise. Large sudden price movements, wide high-low ranges and price gaps can affect volatility, which can distort the big picture.
Investors usually focus on weekly and monthly charts to spot long-term trends and forecast long-term price movements. Because long-term charts, typically 1-4 years, cover a longer time frame, price movements do not appear as extreme here and there is often less noise.
Some use a combination of long-term and short-term charts. Long-term charts are good for analyzing the larger big picture to get a broad perspective of historical price action. Once the general picture is analyzed, a daily chart can be used to zoom in on the last few months, and can thus provide perspective.
It seems that the most popular charting method is the bar chart. The high, low and close are required to form the price plot for each period of a bar chart. Bar charts can be displayed using the open, high, low and close. Bar charts can be effective for displaying a large amount of data. For instance, line charts show less clutter, but do not offer as much detail. The individual bars that make up the bar chart are relatively skinny, which allows users the ability to fit more bars. If you are not interested in the opening price, bar charts are an ideal and useful method for analyzing the close, relative to the high and low. In addition, bar charts that include the open will tend to get cluttered quicker.
If you are interested in opening price, candlestick charts offer a better alternative. Candlestick charts are quite popular nowadays. For a candlestick chart, the open, high, low and close are all presented here. Many traders and investors believe that candlestick charts are easy to read, especially the relationship between the open and close.
The beauty of point and figure charts is their simplicity. Little or no price movement is irrelevant and not duplicated. Only price movements that exceed specified levels are recorded here. This focus on price movement makes it easier to identify “support’ and “resistance” levels, “breakouts” and “breakdowns”, which will be dealt with in later posts in this blog on technical analysis.
“There are two methods for displaying the price scale along the y-axis: arithmetic and logarithmic. An arithmetic scale displays 10 points as the same vertical distance no matter the price level. Each unit of measure is the same throughout the entire scale. If a stock advances from 10 to 80 over a 6-month period, the move from 10 to 20 will appear to be the same distance as the move from 70 to 80.”
“A logarithmic scale measures price movements in percentage terms. An advance from 10 to 20 would represent an increase of 100%. An advance from 20 to 40 would also be 100%, as would an advance from 40 to 80. All three of these advances would appear as the same vertical distance on a logarithmic scale.”
Key points on the benefits of arithmetic and semi-log scales here:
Arithmetic scales are useful when the price range is confined within a relatively tight range. Arithmetic scales are useful for short-term trading. Price movements are shown in absolute dollar terms and reflect movements dollar for dollar.
Semi-log scales are useful when the price has moved significantly, be it over a short or extended time frame. Semi-log scales are useful for long-term charts to gauge the percentage movements over a long period of time. Large movements are put into perspective.
Stocks and many other securities are judged in relative terms through the use of ratios such as PE, Price/Revenues and Price/Book, hence it makes sense to analyze price movements in percentage terms.
Conclusions
Even though many different charting techniques are available, one method is not necessarily better than another. The data is the same but you can see that each method will provide its own interpretation, with its own particular benefits and drawbacks. Again, the data is the same and price action is what matters. It is the analysis of the price action that separates successful technical analysts from unsuccessful ones. The choice of which charting method to use will depend again on personal preferences and trading/investing styles. Once you have chosen a particular charting methodology, it is best to stick with it and learn how best to read the signals. Switching back and forth may cause confusion and undermine the focus of your analysis, giving rise to faulty analyses.
Investment: Technical Analysis basics 1
Investment: Technical Analysis basics 1
There are two common approaches when investigating any investment: fundamental and technical analysis. Fundamental analysis focuses on the company, looking at things like balance sheets, book value and price earnings ratios, and is used to determine if the stock being considered is a good long-term investment. Technical analysis focuses almost entirely on the stock price and its concomitant patterns. The fundamental assumption with fundamental analysis is that the stock price will reflect the company’s profitability. The more profitable the company is, the higher the stock price will be. Investors using fundamental analysis are certain that one follows the other.
Technical analysis, on the other hand, also called chart analysis, is based on completely different assumptions. The premise is that the market is made up of a large group of people behaving in predictable patterns. The challenge for technical analysts is to therefore find these patterns in the price movements. The patterns tend to become obscured in the price trends, since outside events tend to influence the movement of the price. These outside events tend to add noise that mask or change the price patterns of the stock. Technical analysis uses many tools or techniques. However, the goal is always to predict the price movement of the stock. If the prediction is correct, then a profit is made.
Fundamental analysis is considered more conservative than a technical analysis approach. There is far less agreement as to the soundness of technical analysis, but the appeal of technical analysis is the perception that one can make a profit more quickly than with a buy-and-hold approach, the typical result of fundamental analysis. The returns and payoffs differ from person to person.
So in short: What is Technical Analysis?
"Technical analysis is the practice of studying a stock’s past prices and trends in an attempt to determine its future prices and trends. People who utilize technical analysis often study charts and graphs of a particular stock, industry, or sector to find patterns."
I think this here is the best and simplest explanation that I've found!
