Introduction
A. Technical analysis is the process of forecasting the prices of commodities by studying charts and other tools that depict the past market action.
Technical analysis is a trading strategy that aims at searching for the trading signals based solely on the statistical characteristics of the trading data. While fundamental analysis works in assessing the value of an asset by using economic information, technical analysis mainly focuses on the price chart and volume. The first assumption of technical analysis is that price is the ultimate reflection of all current information and that by analyzing the price movements, we can gain insights into market psychology and future prices.
The role of technical analysis in trade
Technical analysis is one of the widely implemented strategies for analysing a security or stock, as well as for trading and risk management. Technical analysis concerns itself with the belief that the price charts patterns of certain assets can be used to predict what their price movements will be in the future. Technical analysis assists traders to find the right strategy of trading by understanding the nature of the support, resistance, trends, momentum, volatility and investor psycholog
y reflected in the pricing data. The application of technical analysis in trading enhances the overall performance of a trade significantly.
In technical analysis, indicators can be categorized as key indicators or variables.
Moving Averages
A moving average helps reduce the level of volatility by jointly averaging the closing prices within a specific period. They are active ones and used to define both the support and the resistance levels. The three main types of moving averages are:The three main types of moving averages are:
Simple Moving Average (SMA)
The SMA divides the total sum of closing prices over the lookback period by the number of time periods, and thus disseminates the weight uniformly. It shows overall trend and can act as support or resistance that changes with the price action.
Exponential Moving Average (EMA)
An exponential moving average (EMA) gives a higher weight to the most recent price changes in the computation process. This makes it more sensitive to the latest price movement as compared to other forms of technical analysis.
The other technical tool that can be used is the Moving Average Convergence Divergence (MACD).
MACD comprises of two EMAs, which indicate changes in trends, momentum and divergence, by the interaction of the two. Signal: Trade signals can be produced by crossover of the MAC line and the MACD signal line.
Relative Strength Index (RSI),
Relative Strength Index (RSI) is an oscillator which computes the strength and momentum of price patterns to identify whether an asset is overbought or oversold.
Explanation of RSI
The RSI measures the average of gain and loss of price over a specified number of periods or days, usually 14 periods and then provides a value of 100. It is customary that when the reading is above 70, it is indicative of an overbought situation, which could mean that there will be selling pressure soon. When the values are below 30, it means oversold which may suggest that it is the right time to go for the purchase.
Overbought and oversold conditions
If an asset goes above 70, it signals that the buying pressure has hit its peak and there is a high tendency that prices will reverse and start falling as more people rush to the exit. Readings below 30 indicate oversold conditions, and if true, one could expect that panic selling has stopped, and a rebound may be in the offing as accumulation comes back into prominence.
Divergence signals
Price, when reaches its higher high, and RSI makes a lower high is bearish divergence showing possible weakness despite higher price levels. The converse is true in bullish divergence where while price creates lower lows, the RSI creates higher lows suggesting accumulation at higher levels.
Bollinger Bands
In this method, we will first define Bollinger Bands and the elements that make up its structure.
Bollinger Bands is a technical analysis tool which was designed by John Bollinger, it uses two standard deviations above and below a simple moving average line to envelop the prices. The upper and lower bands are moving averages mirroring the volatility and serving as variable support and resistance levels.
Volatility and trend analysis
The direction of the prevailing trend and that narrowing of Bollinger Bands during periods of low volatility indicates that risk is on the decrease. Bollinger Bands with larger space available suggest higher volatility and price fluctuation, thus suggesting that a price reversal could potentially occur.
In terms of technical analysis, the most widely used options are Bollinger Squeeze and breakout strategies.
For instance, when Bollinger Bands narrow, then it indicates that the range is contracting meaning low volatility at a time before or before a period of high volatility and thus quick shifts in prices. Whenever a price bar extends beyond the upper or lower Bollinger Bands, this may mean the beginning of a new trend, making it easy to use Bollinger Bands to make trades on the basis of volatility.
Common Chart Patterns
Charts patterns are special formations that are seen in price charts, which indicate certain buying and selling pressures at some price levels of the stock and help forecast the price trends in the future.
Head and Shoulders
Formation and interpretation
The Head and Shoulders pattern has four main formations which include the left shoulder, the head, the right shoulder and the neckline support. It shows up as price seeks to rally to form the left shoulder and head. A breakdown below the neckline on the right shoulder may indicate a drastic turn in the stock.
Signal and entry points determination when using the Head and Shoulders chart formation
The Head and Shoulders formation is a bearish formation that indicates a possible bear trend and invites traders to short sell. After such breakdowns, below the neckline, traders are encouraged to engage in short selling to further sell the stock. Targets are expressed in centimeters, and they are calculated through measuring a line from the crown of the head till the neck line.
Identifying Double Tops and Double Bottoms
As mentioned earlier, it is easier to identify the double tops and the double bottoms of the stock prices.
Double Top pattern occurs as a result of prolonged bullish run of price which pulls back to similar high level signaling that buyers’ pressure is weakening. This yields a central resistance level from the upside rejection about the double top peak. The Double Bottom pattern formed when the price trend is down for quite some time to form two similar swing lows indicating that demand is greater than supply. Together they suggest the beginning of a reversal of directions.
Entry and exit strategies
Like all types of chart patterns, double tops necessitate taking short positions once the price breaks below the swing low next to the two peaks. Sloping bottoms assist the traders to initiate long buy trades as soon as the asset breaks the middle level between the two valleys. First protective stop levels are set just outside the pattern with targets determined with the use of pattern’s height starting from the breakout price level.
Triangles
However, the ascending triangle and descending triangle are the exact opposite of the symmetrical triangle.
The three triangle patterns show that the trendlines are converging in a fashion that reflects a state of uncertainty when two opposing groups of bulls and bears find themselves in balance. The symmetric triangle has no preference for either direction while the ascending triangle tends to incline in the bullish direction while the descending triangle in the bearish direction. When a decisive continuation occurs, then the dominant trend is back in force.
Escaping methods used in triangle formations
Because triangles provide a state of equilibrium between buying/selling pressures, the trader waits patiently for a breakout before assuming a position in the direction of the move with targets set accordingly depending on the height of the triangle pattern. Appears after major support or resistance levels that formed the triangle sides are violated.
Candlestick Patterns
Candlesticks represent the price of an asset at the opening, highest, lowest and closing the prices within a specific period. There are specific figures in the candlestick patterns that indicate that there may be various trading opportunities.
Bullish Patterns
Hammer and inverted hammer
The Hammer and Inverted Hammer candlestick patterns both represent a small real body with a long lower wick, which indicates that there has been a wide range of intraday trading, but the price closed near the opening price. They point to buying pressure eradicating selling pressure, which is an informative signal of possible bottoms.
Engulfing patterns
Bullish Engulfing patterns form during declining markets in which a wide-range candle engulfs the previous red candle since this shows that buying pressure has surpassed selling pressure which could signify a reversal of the downtrend.
Bearish Patterns
This involves shooting star and hanging man techniques.
The Shooting Star and Hanging Man patterns resemble hammer patterns but appear in an upward trend to symbolize the conflict between bulls and bears that the bears have triumphed at that moment. It becomes worse when the signals are bearish and the confirmation of them is already present.
This evening star along with bearish engulfing was witnessed in the prices of the stocks.
Bearish Engulfing has a reversal signal from bullish to bearish while the Evening Star indicates a potential trend reversal. In the Evening Star pattern, after an upward movement, sellers gain the upper hand while in the Bearish Engulfing pattern the whole of the previous bullish candle is completely ‘engulfed’ by the bearish candle indicating that there is overwhelming selling pressure.
Fibonacci Retracement Levels
Explanation of Fibonacci retracement level
Fibonacci retracement levels are a technical analysis tool that employs horizontal lines at predetermined levels based on Fibonacci numbers to determine likely support/ resistance levels during counter-trend pullback. The levels are normally 23. 6 % , 38. 2 %, 50 %, 61. 8 %, 100 %.
Recognizing the levels of support and resistance
When price after going up is coming back, the Fibonacci levels often create support zones where prices fade up and continue to the down. On the declines, Fibonacci levels act as resistance on bounce-backs in which selling pressure outdoes buying efforts. Among the levels, the 50 percent level is considered more important.
Applying Fibonacci levels in the entry as well as the exit of the trade
One way traders use the Fibonacci levels is to determine how price responds or interacts with the levels to assist in trading. The bounces or breaks affirm the levels for higher confidence and setting of protective stop orders in place. Fib levels can also be used to determine the profit target exits based on the oscillations between the Fib levels.
Putting it All Together: Some examples of case studies and examples that are pertinent to the topic are:
Technical analysis examples of trends and indicators
July 2014 – S&P was near 50-day SMA and the RSI was below 30, which is an oversold level, along with a Bullish Engulfing signal. The index then skyrocketed to 8% over the next month.
January 2016 saw the $30 level in crude oil where it formed a long-tailed Hammer candlestick coupled with oversold RSI line. It then surged more than 150% to $1,225 by the end of 2018.
The first one is the tested divergence of RSI and MACD in Bitcoin which points to weakening upside potential and trend strength before the late 2017 major correction occurred even when the price touched new highs. Bitcoin, for instance, continued free-falling, reducing by more than 70%.
A review of specific price data in the form of charts and graphs with selected basic and advanced parameters
If a person had analyzed the Stock chart of AMD in the year 2016, he or she would have found out that this company had formed a Descending Triangle consolidation pattern which is indicative of a bearish continuation. Just before the decline of nearly 40 percent over the following months, the stock saw a downside breakout along with the Moving Average crossovers and bearish divergence.
In 2017, the pattern of the gold price chart with the study of the pattern, Fibonacci level, and RSI unveiled Double Bottom reversal and Golden Cross plus bullish divergence to the upward trend of the gold price that in which the price hiked over 25 percent in the subsequent year.
Conclusion
Summary of main points raised
Technical analysis can also be of advantage to traders as they look into factors like price and its movement, momentum, formation of patterns and indicators. Major concepts discussed involve the moving averages, RSI, Bollinger bands, chart pattern analysis including Head and Shoulders along with candlestick analysis, Fibonacci analysis, MACD and simple trends/support/resistance.
Relevance of technical analysis for achieving successful trades
Even though it is not perfect, technical analysis when applied hand in hand risk management provide a probabilistic base that assists the trader to take advantage of high probability conditions in the market. Advanced technical analysis enhances the trader’s ways on market timing, trade identification, entry/exit strategies, and position size management based on technical indicators using multi-timeframe and multi-chart view analysis.
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