An Introduction to Technical Analysis

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Introduction

Technical analysis was invented for the purpose of forecasting future price trends in various markets. It is the backbone of analysis for many traders in today’s rapidly changing markets.

As we have learned in the previous Learn To Trade lesson called “How to get started in trading (Beginners Guide)“, there are two analysis tools that traders and investors use for forecasting future price trends. Technical analysis and Fundamental analysis. Today we are going to take a look at the first one of the two. We will be exploring many different dimensions of technical Analysis, so this is going to be a rather extended article.

In general, many traders use both, Technical and Fundamental analysis combined. However, some believe one is superior to the other and simply works better. Whichever the case, even if you are a hardcore fundamentalist, you cannot disregard the fact that many traders actually do use technical analysis and pay attention to some key price levels. And that can move the market in the opposite direction to that suggested by fundamental analysis alone. That is if enough people believe a certain technical point to be relevant, it is bound to be market-moving and can make or break a trade. For this very point, it pays dividends to be aware of technical analysis in the markets, at least at a basic level.

If you wish to enroll in a more extensive course of Technical Analysis, you may want to check out our FREE Technical Analysis course.

A Brief History of Technical Analysis

Some aspects of technical analysis began to appear in Amsterdam-based merchant Joseph de la Vega’s accounts of the Dutch financial markets in the 17th century. However, many credit technical analysis to Munehisa Homma, (1724-1803), also referred to as Sokyu Homma or Sokyu Honma. He was a wealthy rice merchant and trader from Sakata, Japan who lived during the Tokugawa Shogunate. The reason why he is credited as a pioneer of technical analysis is that he invented Candlestick Charting, which is a backbone of technical analysis to this very day.

Initially, in Japan, only physical rice was traded, but beginning in 1710 a futures market was established where coupons representing future delivery of rice were traded. Homma was a successful trader in this secondary market of trading rice coupons. Renowned for his ability in trading the rice market, Homma became a financial advisor to the government and was even awarded the rank of honorary Samurai. In 1755, he wrote The Fountain of Gold – The Three Monkey Record of Money, a text focused on market psychology. Centuries later, the Candlestick Charting technique has been brought to the western world and is now used by many traders all over the world.

History of technical analysis in the US began quite sometime later, in the late 19th/early 20th century. The most credited work has come from the collected writings of Dow Jones co-founder and editor Charles Dow, who was also the pioneer of the Dow Theory. A theory that has been built on throughout recent decades and now forms the basis of modern technical analysis.

Key Definitions and Philosophy of Technical Analysis

Before we get more in-depth into technical analysis, we do need to clearly define what it is. In this article, we will hold that technical analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends. The term “market action” includes three main sources of information available to technicians: price, volume, and open interest (open interest is only used in futures and options markets).

There are three premises upon which technical analysis is based:

  1. Market action discounts everything
  2. Prices move in trends
  3. History repeats itself

Let’s explore these assumptions in more detail.

Market action discounts everything

The statement “market action discounts everything” forms the basis of technical analysis. Many other principles follow from this idea. What it means is basically that anything that can possibly affect the market price (fundamentally, politically, psychologically and otherwise) is actually reflected in the market price. In other words, for instance, if a price rises, it must mean that demand outweighs supply. Conversely, if the price falls, it must mean that supply outweighs demand. Therefore, a study of price action is all that is required. A technician doesn’t believe that knowing the reasons why the price rises or falls is necessary. That may seem rather extreme and this is the exact reason why many traders prefer to use a combination of technical and fundamental analysis.

Prices move in trends

Another premise that is crucial to technical analysis is that prices move in trends. That is, a price in motion is more likely to persist than to reverse. The entire trend-following approach is predicated on riding an existing trend until it shows signs of reversal. If prices did not move in trends, then there would be no point in studying price patterns at all. That is as all price movements would simply be random and unpredictable.

History repeats itself

Another assumption os technical analysis is that human nature does not change. Therefore, since market action is based on human psychology, history tends to repeat itself. So, there are a lot of things we can learn from market history and analysis.

Chart Construction

This chapter is meant for those who are unfamiliar with chart construction. We will be looking at how 3 types of charts are constructed and compare how they depict the same information. We will also take a basic look at volume and open interest.

The line chart

The most basic chart and one of the most widely used ones is the line chart. Since closing prices are of extreme significance to chartists, the line chart connects closing prices and makes them into a continuous line. The line chart is one of the easiest to read charts.

However, it also lacks a lot of information. We only know where the price has closed, but do not know where it has gone. Two other chart types help us get this information. Those are the bar chart and the candlestick chart.

The bar chart

The bar chart conveys more information than the line chart. However, it is also more difficult to read. The following chart shows the key metrics of a bar chart:

As we can see, the full range of the price movement is the length of the vertical line. The bottom point of the vertical line is the low of the range, while the top is the high of the range. Also, the horizontal left-pointing tick shows the opening price, while the right-pointing tick shows the closing price. The open and closing prices show the daily range without the spikes in prices. These are important characteristics because not all of the time the closing price of the last bar is the opening price of the next bar, as is with the line chart. Sometimes there are gaps in charts and they depict that the price has opened at a different price than the previous closing price. The chart below shows the bar chart within the same time range for the same instrument as in the previous line chart.

Notice how there is a large gap in the chart. That is something you would not see on a line chart since all price points are connected by a line.

The candlestick chart

Candlestick charts are the Japanese version of bar charting and have become very popular in recent years among western chartists. The Japanese candlestick records the same four parameters of price as the bar chart. That is, the open, the close, the high, and the low prices. However, the visual presentation is different.

Similarly to the bar chart, the candlestick chart’s vertical height shows the range in which the price fluctuated throughout the day (we are referring to the daily chart), including all the spikes and price activity. The body (open minus close price or close minus open price) shows where the price fluctuated throughout the day in terms of open and close prices. If the close price is higher than the open price, then the body will be green (positive candle). If the open price is higher then the close price, then the body will be red (negative candle). As with the bar chart, the ends of the vertical shows high and low prices. The upper and lower shadows tell us where the price has been, over or below the open and close prices.

It should be noted, however, that the green/red colors can be changed to white/black or any other combination that feels intuitive for the trader. This can usually be done within the trading or charting software you are using.

Let’s take a look at how the candlestick chart would look at the same timeframe and instrument as shown earlier for the line and bar charts.

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It does probably feel more intuitive than the bar chart for many traders. Hence its popularity. That said, however, it does take some time to adjust to it if you are a new trader.

Chart construction; arithmetic vs logarithmic (log) scale

Most of you already know that charts are constructed by plotting the price on the Y-axis (vertical) versus time on the X-axis (horizontal). However, the Y-axis, that is, the price, can be scaled arithmetically or logarithmically. Let’s see an example of that and compare those scales:

As we can see, on the arithmetic scale, the distance between each incremental price point is equivalent. That is, the distance from 0 to 1 is the same as the distance from 1 to 2. Such a scale is used and is more useful in most cases. However, over longer periods of time, where the price usually quadruples, ten folds, and hundredfolds, it is actually more useful to use a log scale. In a log scale, each point increment is smaller than the previous one. To fully understand how it is constructed, we need to understand the following. On a log scale, the distance from 1 to 2 is the same as the distance from 5 to 10. Why? Because in both cases, the price has doubled.

To see a real-life example, let’s plot the arithmetic vs logarithmic S&P 500 index side by side and see how they look.

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From the first graph, the arithmetically scaled S&P500 index, you would assume that there was an exponential price increase within the last few decades, and almost no price activity prior to that. However, as we can see on a log scale, the growth is much more linear, and we are able to see price changes throughout the whole history of the S&P500 index. The log scale can be particularly useful in visual demonstrations, comparisons, in order to illustrate a trend. That said, however, you will be using the arithmetic scale in your day-to-day trading.

Volume

Another important piece of information that should be included in the chart is volume. Volume represents the total amount of trading activity in that market for that day or a particular time period. It is the number of contracts traded, or that changed hands during that particular time period. Volume is usually recorded below the chart and is represented in bars. Higher bars represent more volume, and lower bars represent less volume. Also, an arithmetic scale is usually present on the right side of the volume chart to help measure it. As shown below in the example chart:

Open interest

In order to understand open interest, we first need to understand how futures and options contracts are created. If a futures contract exists, it must have had a buyer. For every buyer, there must also be a seller, since you cannot buy something that isn’t available for sale. Hence, one contract is created. The contract is considered “open” until the counterparty closes it. Adding open interest where there are a buyer and a seller for each result in open interest.

Whenever a buyer and a seller come together to initiate a new position of one contract, the open interest increases by one contract. If both the buyer and the seller exit a contract position on a trade, then the open interest decreases by one contract. However, if either the buyer or the seller passes their position to a new buyer or seller, then open interest remains unchanged. In such a situation, the only record would be an increase in volume. That is, volume would increase by one contract.

The Concept of Trend

The term “trend” is absolutely key to technical analysis. You often hear phrases such as “a trend is your friend” or, “never go against the trend”. All of the tools of technical analysis have the sole purpose of participating in that trend. So, what do we mean by a trend when we talk about one? In general, a trend is simply the direction of the market, or where it’s going. However, more often than not prices tend to go in zigzags rather than straight lines. And these zigzags tend to resemble waves of peaks and troughs. It is the direction of these peaks and troughs that constitutes a market trend. Here is a good explanation of what we mean by peaks and troughs:

Example of peaks and troughs:

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This could also be an example of an uptrend, as each new peak and trough is higher than the previous one.

A downward trend has descending peaks and troughs:

While a horizontal trend (sometimes referred to as trendless) has horizontal peaks and troughs.

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As we can see, there are three main categories of trends. That is an upward trend, a downward trend, and a sideways trend. In general, most technical analysis tools have been designed for upward or downward markets, rather than sideways-going markets. This is one of the reasons why many technical traders lose most of their equity in sideways markets.

Trends can additionally be broken down into three more categories. They are, major, intermediate, and near term trends. Some prominent books on technical analysis define major trends as lasting more than 6 months, intermediate trends – 3 weeks to 6 months, and near term trends – anything less than 3 weeks. However, there is a lot of disagreement in this realm. Since some traders focus on the very short-term, while others – on the longer term, it depends on the trader’s horizon.

Generally, the intermediate trend is the primary focus of most technical traders, while the near term trend is of interest for timing the entry of the position.

The Concept of Support and Resistance

In the previous paragraph, we’ve stated that prices tend to move in a series of peaks and troughs. It is time to give those peaks and troughs a more clear name and introduce the concept of support and resistance. We call troughs support. The term represents the idea that support is a level on the chart, below the market price, where buying interest is greater than selling pressure. As a result, the price decline halts and prices turn back up again. Resistance, on the other hand, (referring to what we called peaks) represents a price level over the current market price where selling pressure outweighs buying interest. As a result, the price advance halts and the price turns back downwards. We can illustrate support and resistance in an upward trend in the following graph:

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Similarly, we can depict support and resistance in a declining market in the following manner:

In order for a trend to continue, each successive low (support level) must be higher than the one preceding it. Similarly, each rally high (resistance level) must be higher than the one before it. If the corrective dip on an uptrend comes back all the way to the support level, then a shift to a sideways trend is likely. If the support level is violated, then a reversal to a downtrend is likely.

Psychology of support and resistance

Support and resistance can be explained further by traders’ psychology. Let’s assume there are 3 kinds of traders. The longs, the shorts and the uncommitted. Let’s also assume that the market has gone higher from the support level, where the price has been fluctuating for some time. In this situation the longs feel delighted that the market’s going in their direction, however, they wish they had bought more. If the market dipped back to the support level, they would add to their positions even more. The shorts have realized they’re on the wrong side of the trade and wish the market would turn back so that they could close their positions. Finally, those who are uncommitted wish the market would go down and are waiting for the next good buying opportunity.

As we can see, all three groups have a vested interest in that support level and are all ready to buy if the price dipped back to this level. Naturally, this is the theory behind why support levels tend to work and prices tend to bounce off of them.

Significance of support and resistance

The more trading that occurs around that support area we’ve just discussed, the more significance it carries. Generally, the significance of a support or resistance level is influenced by the following three factors:

  1. Amount of time spent there
  2. Volume
  3. How recently the trading took place

That is, the longer the period of time that prices trade in a support or resistance area, the more significant that area becomes. Also, if a support level is formed on heavy volume, this is a good indication that the support level is strong. This point goes back to the psychology of support and resistance we’ve discusses earlier. Finally, naturally, the more recent the trading took place, the more significant the support or resistance level is.

Just to give you a practical example of how some traders look at support and resistance levels, what they do is put on a Volume-by-price indicator, which sums the volume for each price point. This, in turn, lets them see at which price point the most trading took place. They then compare it to the support or resistance levels that are apparent in the graph to confirm that very level. The more trading took place at that support or resistance level, the more significant it is. See the chart below.

Source: school.stockcharts.com

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Support becoming resistance and vice verse

As we’ve previously discussed, the three types of market participants form support and resistance. In the previous example, prices went up and traders were ready to buy the next dip. However, if prices moved past the support level and down, then the opposite would become true. Buyers would now realize they’re on the wrong side of the trade and would be willing to sell the next bounce. Therefore, support has become resistance.

This can be illustrated by the following graph:

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Also, resistance can become support if those resistance levels have been broken down by a significant enough margin.

What constitutes a significant enough margin? How much should prices violate support or resistance levels, in order for such a reversal of roles to take place? It is probably one of the most difficult questions to answer in technical analysis. It depends on the timeframe you’re trading on and each trader has to find what the right level of significance is for him/her in a particular market. Trading is a game of probability and it does take practice and experience. Also, journaling is key here.

The importance of round numbers

Another key characteristic of markets which applies to support and resistance is round numbers. The more “round” the number, the more significance it holds. For instance, in oil futures markets (let’s say, WTI – West Texas Intermediate), the round numbers that traders would look at when determining support and resistance would be in 5’s, 10’s 50′, and 100’s. That is, $50, $55, $60, $100 etc. $60 would be a more important level than $55, and $50 – a more important level than $60 – because it’s more “round”, and hence more “significant” in a way. Traders tend to keep an eye on these levels, and in combination with other components of technical analysis, this can form a very strong level of support or resistance.

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The Concept of Trendline

Now that we understand support and resistance, let’s take a look at the concept of a trendline. An up trendline is a straight line drawn upward to the right along successive rising market lows, as shown in the image below. An up trendline is first drawn under two successfully higher lows (points 1 and 3) but needs a third test to confirm the validity of the trendline (point 5).

A down trendline is drawn downward to the right along successive declining market peaks, as shown in the image below. A down trendline is first drawn under two successfully lower highs (points 1 and 3) but needs a third test to confirm the validity of the trendline (point 5).

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One of the most basic concepts of trend is that a trend in motion will tend to remain in motion. Also, the slope of the trendline tends to remain the same. There will be inevitable dips in an uptrend, and those dips will be used by traders for buying opportunities. Vice verse, corrective rallies can be used for selling purposes. That is, as long as the trend has not been violated. If it has been violated, as shown in the image below, this is one of the best early warnings of a change in trend.

The significance of a trendline

What determines the significance of a trendline? The answer is twofold. First, the time a trendline has been intact for. Second, the number of times it has successfully been tested. So, the longer it has been intact and the more times it has successfully been tested, the more significant the trendline. Hence, the more confidence it inspires.

A note on the significance of the trendline should be made, however. Not all markets are equal. Some are much more speculative than others. Many traders that combine fundamental analysis with technical analysis tend to think that in certain markets that are more speculative in nature if the price rises in an upward trendline without any significant fundamental news announcements or changes in market perception, such a technical move is more likely to reverse than continue, the more significant the trendline has been. You will hear them say “the markets have oversold”, “overdone” or “market has overreacted”. Hence, it is up to the trader to make sense of the market he/she is in.

The art of drawing a trendline

Sometimes drawing the correct trendline can be very subjective. A number of questions can arise in practice, such as: Do you incorporate breaches of support/resistance levels into the trendline? What if the trendline’s steepness changes?

In general, this is rather subjective, and different traders will have different approaches to this. As a general rule of thumb, however, if the trendline goes back into rhythm, and the breach of support was a one-off event, it’s probably best to ignore it and leave the original trendline intact. On the topic of steepness, the general rule of thumb is that most significant trendlines tend to go up or down at a 45-degree angle. If the trendline is steeper than that, then the price rise or decline might be unsustainable. However, if the trendline is flatter than 45 degrees, then it may be too weak and should not be trusted. The steepness of the trend also depends on how much you zoom into or out of the graph/prices and should be taken into consideration.

The channel line

The channel line is another useful technique for traders. Sometimes prices tend to trend between two lines the trendline, and the channel line. In turn, this can be used to a profitable advantage. The drawing of the channel line is very simple. In an upward rising price channel, first draw the trendline, connecting the lows. Then, draw a line, parallel to the trendline, starting at the first high (point 2), as shown in the graph below:

If the price reaches and retracts again, from the channel line (point 4), then a channel may exist. If the price reaches point 5 and bumps into the trendline again (point 5), then a channel probably does exist. It might sound vague using such jargon as might, probably, however, bear in mind that trading is a game of probabilities. You will not guess every move right, however, your goal is to take advantage of higher probability trades. And a channel helps you do just that.

Similar to what we have discussed earlier, usually, the more the channel remains within the trendline and channel line range, the more significant it is. It is easy to see how on an uptrend channel one can take advantage of the low points such as point 5 to go long. More aggressive traders might even go short on channel highs, however, this is a risky and often costly strategy. Remember, the trend is your friend.

Additional channel line observations

There are of course other scenarios when the channel does not hold and one has to redraw it or discard it for the time being. Sometimes the price will go past and above the channel line. Often times, the channel line has to be readjusted to a steeper one, which often works better than the last one. Sometimes the price will not reach the channel line or the trendline. Such a situation is a sign of a weakening channel. That increases the chances that the channel will be broken. If a breakout occurs from an existing price channel, prices usually travel the distance equal to the width of the channel. It should always be kept in mind, however, that the trendline is more important than a channel line. A breakout from a trendline is more significant than a breakout from a channel line.

Percentage retracements

One has probably noticed that in all of the previous examples, after a certain market move, prices tend to retrace back a portion of the original gains before going back into the original direction again. These countertrend moves tend to fall within predictable percentage parameters. The most widely known parameter is the 50% retracement. For instance, say the price has gone up from 10 to 20. Very often the price will retrace back a portion of the original gains, back to around 15, which is just around 50% retracement, before going up again.

Besides the 50% retracement, there are also the minimum and maximum retracements that are also widely recognized – 33% and 66% retracements (one third and two thirds). Usually, you will find that the minimum retracement is around 33%, and the maximum retracement is around 66%. That means prices will usually retrace at least 33% of the original move. If prices retrace more than 66%, this usually means a change in trend. In such a scenario, its common for the price to retrace the full 100% of the initial move. The percentage retracements are usually tools that are available in any trading software. They look something like this:

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There are slight differences in approaches to the exact percentage retracements in different theories. For instance, as we will later see in our next technical analysis articles, Fibonacci and Elliot Wave theory followers use the 38% and 62% retracements.

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Conclusion

In this rather extended article, we have covered the most basic topics of technical analysis. We have gone through chart construction, basic concepts of technical analysis, trends, channels, support and resistance and other important topics that form the basis of technical analysis. There are a lot of rules in technical analysis, and many exceptions, many ifs, and whens. This makes it just as much a science as an art. In fact, some critics of technical analysis say it is too much of an art and too subjective. Many data scientists and researchers come to conclusions that technical analysis does not work at all, and the gains from using it average out to zero at best. While some believe that, others tend to argue that data analysis on such research is too rigid, and does not include and reflect all the rules and complexities of technical analysis.

Also, different people will have different views on which price levels are important or more important than others. This makes technical analysis very much a psychology game, where you are basically trying to predict what the market thinks where the market is going, and which price levels are important. And that often matters more than what you think about where the market should be.

A lot of the credit for this article goes to the book “Technical Analysis of the Financial Markets” by John J. Murphy.