Technical Chart Analysis: Meaning & Trading Strategies

Introduction

Technical Chart analysis has to do with forecasting future financial price movements based on past price movements which helps investors anticipate what is likely to happen to prices over time. It can be applied to stocks , indexes, commodities, futures or any tradable instrument where the price is influenced by the forces of supply and demand.

What are technical chart analysis?

Technical analysis is a tool, or method, which is used to predict the probable future price movement of a security-such as stock or currency pair-based on market data. Technical analysis is a theory which has the notion that collective actions of buying and selling of all the participants in the market accurately reflect the relevant information pertaining to a traded security.

Understanding Technical Analysis or Technical Chart Analysis

Technical analysis are tools which are used to scrutinize the ways supply and demand for a security effects changes in price, volume and implied volatility. It operates from the assumption that past trading activity and price changes of a security can be good indicators of the security’s future price movements when paired with appropriate investing and trading rules. It is often used to generate short term trading signals from various charting tools, but can also help improve the evaluation of a security’s strength or weakness relative to the border market. Technical analysis was first introduced by Charles Dow and the Dow Theory in the late 1800s.

List of Technical Charts in Stock Market

A. Multi-Bar Patterns Horizontal Congestion

Double and Triple Tops/Bottoms
Rectangles Triangles
Symmetrical
Ascending and Descending
Wedges Other
Head and Shoulders
Cup and Handle

B. Candlestick Patterns

Doji
Harami
Hanging Man/Hammer
Shooting Star/Inverted Hammer
Engulfing
Dark Cloud/Piercing

C. Short-Term Patterns

Pennant/Flag
Gaps
Pipe Bottom
Narrow Range

Overview of Technical Charts & Analysis

A. Multi-Bar Patterns Horizontal Congestion

Double and Triple Tops/Bottoms

a. Double Top

Characteristics:

Two successive peaks separated by an opposite reversal point
Either rounded or pointed peaks that are usually at roughly the same price (resistance level)
Price must break out of middle reversal point

b. Double Bottom

Characteristics:

Two successive troughs separated by a peak
Either rounded or pointed troughs that are usually at roughly the same price (support level)
Price must break out of middle peak

c. Triple Top

Characteristics:

Three distinct peaks at roughly the same price level separated by two intermittent troughs
Breakout occurs when price exceeds the extreme of the intermittent trough or a trend line connecting those points

d. Triple Bottom

Characteristics:

Three distinct troughs at roughly the same price level separated by two intermittent peaks at any level
Breakout occurs when price exceeds the extreme of the intermittent peaks or a trend line connecting those points
Best performance may be after a sustained decline
An average performance, but watch for failures

2. Rectangles

Characteristics:

Trading range with support and resistance levels bounding price action
Slight tilt, similar to horizontal channel
Often has many false breakouts
Things to consider: ‐ Confirm a breakout ‐ “Shortfall” often indicator of eventual breakout direction
Best occurrence may be bottom breaking upward

3. Symmetrical

Characteristics:

Bounded by a downward sloping upper trend line and an upward sloping lower trend line. Each bound is a straight trend line
Prices must touch each bound at least twice. Many false breakouts. Moderately successful in performance
Things to consider: ‐ Confirm a breakout
Best occurrence may be upward breaking out – above average for all patterns

4. Ascending

Characteristics:

Bounded by a horizontal upper trend line and an upward sloping lower trend line. Each bound is a straight trend line.
Prices can break in either direction, but more commonly upward.
Breakout usually occurs in pattern. About average failure rates but many small false breakouts.
Post breakout performance average on upside but above average on downside.

5. Descending

Characteristics:

Bounded by two trend lines; the lower is horizontal and the upper slopes downward
Prices can break in either direction but most commonly downward
Above-average performance on upside break; retracements occur often.

6. Wedge

Characteristics:

Bounded by two trend lines, each headed in the same direction; Price must touch a trend line at least five times before a breakout
Often occur following a panic or bubble
Performance in both types is below average, and retracements are very common

7. Head and Shoulder

a. Top

Characteristics:

Three peaks with center peak higher than the other two
Shoulders should be at approximately the same level and the head higher
Line connecting the two through between the peaks is called the “neckline”
Pattern is only complete on breaking the neckline
Target is the distance from the head to the neckline projected from the neckline
This is a standard pattern for tops and has one of the lowest failure rates

b. Bottom

Characteristics:

Inverted but otherwise identical to a top pattern except not as profitable

8. Cup and Handle

Characteristics:

Pattern consists of a rounded bottom (not a “V” bottom), two “lips” at each end, and a “handle” from the handle
Pattern is complete with breakout above both lips
Often have a throwback
The pattern’s performance ranks about average for bottom patterns

B. Candlestick

Doji

Characteristics:

A one-candle pattern formed when the open and close are the same price, and the high and low are roughly equidistant from the open and close
Extremely common
Indicates indecision in the marketplace and thus is a possible warning of price change

Harami

Characteristics:

A two-candle pattern of a large body of either color followed by a small body of the opposite color; The second body is completely within the body of the large body and is called a “spinning top”
Although common belief is that the Harami is a reversal pattern, many report that is has the potential of breaking either way
A variation that has a Doji instead of a spinning top as the second candle has equally average performance and random breakout

3. Hanging Man and Hammer

Characteristics:

One-candle patterns differentiated by the color of the body. Each pattern has a high that coincides with either the opening or closing price
Hanging man, thought to be a continuation pattern, actually breaks in either direction randomly with a slight upward bias. Its overall performance is below average
Hammers occur relatively frequently but have below-average performance

4. Shooting Star and Inverted Hammer

Characteristics:

A one-candle inverted hanging man or hammer pattern. Hammers by themselves have white bodies and shooting stars have black bodies
As a one-candle pattern, the shooting star has average performance. The same is true for the single inverted hammer

5. Engulfing

Characteristics:

A two-bar pattern in which the second bar body completely engulfs the first bar body
A bottom engulfing pattern, with a short black body followed by a tall white body, is thought to be an upward reversal pattern and actually has very good performance on a downward breakout in a downward trend

6. Dark Cloud Cover and Piercing Line

Characteristics:

The dark cloud cover is a two-bar pattern where the second bar closes higher than the first and is black versus white in the first bar
The piercing line is the opposite of the dark cloud cover in that the second bar is white and lower than the first bar which is black
The dark cloud is thought to be a downward reversing pattern
The piercing line pattern is thought to be an upward reversing pattern

C. Short Term Patterns

Penant/Flag

Characteristics:

Pennant and flag patterns are variations of the same pattern
These patterns are often preceded by a steep, sharp price change, up or down, and form a short consolidation that appears like a triangle or flag. Generally, the pattern slopes slightly in the direction opposite from the trend
The breakout in either direction is often followed by a move that equals the earlier steep, sharp price change into the pattern

Gaps

Characteristics

Definition – no trading (gap) at specific prices
Gaps can be considered “up” or “down”
Gaps are caused by appreciable changes in supply and demand from one close to the following open
Gaps are generally profitable on breakouts from patterns, trends, support or resistance
A method of trading a gap is the “explosion gap pivot.” It assures that the gap is valid
After the gap, wait for “throwback.” If throwback “covers” the gap, no action. If the throwback stops, this is called the “pivot low.” Place buy entry above high of the gap bar
“Pivot” is the lowest level of the post-gap breakout
Protective stops initially placed at gap low and then below pivot low

Two-Bar Reversal Button or Pipe Bottom

Characteristics:

Two bars and occurs at the end of a large trend, up or down trend. Ideally, the first bar, in a bottom pattern, closes at the low, and the second bar closes in the upper half of the range. It is more reliable in weekly data
Bar ranges are larger than preceding bar ranges
Action occurs on breakout through second bar

Volatility Pattern

Characteristics:

Dull activity is known as “low volatility.” New trends often begin from periods of low volatility
One way to look at volatility is to observe the relationship between price bars
“Range” is the spread between high and low in a price bar
If a bar is followed by a bar with less range, volatility is declining; the second bar is called a “narrow range” bar
When this second bar’s range is contained within the range of its preceding bar, it is called an “inside bar.”

Narrow Range

Characteristics:

One low volatility pattern is called a “Narrow Range” pattern and consists of a bar with a range narrower than its preceding bars
The graph shows a four-bar, Narrow Range pattern (NR4) with four bars, the fourth bar having a narrower range than the preceding three bars
The breakout occurs on a break above or below the high or low of the narrow range

Identifying Trends and Support/Resistance Levels

Support level is the level where the price regularly stops falling and bounces back up while the resistance level is where the price normally stops rising and dips back down. The levels exist as a product of supply and demand. If there are more buyers than sellers, the price could rise, and if there are more sellers than buyers the price tends to fall.

The more often a price hits either level, the more reliable that level is likely to be in predicting the future movements. If a price touches or breaks through a support or resistance level but jumps back fairly it is only testing that level. But if price breaks through any given level for a longer period of time, it is likely to keep rising or falling until a new support or resistance level is established.

Technical Patterns and Trading Strategies in stock market

A trading strategy is a plan for buying and selling stocks designed to generate a good return on investments. A good trading strategy should be consistent. Trading indicators are mathematical calculations which are plotted as lines on a price chart and can help traders identify certain signals and trends within the market.

Risk Management and Position Sizing

Position Sizing refers to the number of units invested in a particular security by an investor or trader. An investors account size and risk tolerance should be considered when determining the position sizing. While position sizing is an important concept in most every investment type the term is most closely associated with faster moving investors like day traders and currency traders. Even with correct position sizing investors may lose more than their specified risk limits if a stock gaps below their stop loss order.

Back testing and Performance Evaluation

Back Testing is applying a trading system to historical data to verify how that system would have performed during a specified period. Trading platforms generally support back testing through which the traders test ideas and gain knowledge without risking funds. Common back testing measures include net profit/loss, return, risk-adjusted return, market exposure and volatility. Analysts use back testing as a way to test and compare various trading techniques without risking money. A successful back test will show traders a strategy that’s proven to show positive results historically. While the market never moves the same, back testing relies on the assumption that stocks move in similar patterns as they did historically.

Evaluating stock performance is very individual to each investor. Just as every person has different appetites for risk, plans for diversification, and investing strategies, so too does every investor have different standards for evaluating stock performance. Evaluating the performance of a stock requires more than simply looking at the change in price over time. Returns can only be properly compared against an appropriate benchmark that reflects the investment style and risk level of the stock you’re looking at.

Trading Psychology and Discipline

Trading Psychology is the way you approach or think about and feel about the stock market and your trades. The traders psychology affects your trades performance. If the traders emotions cloud up decision making then the trader ends up making loss. To be a successful trader , one need to recognize their emotional biases like greed, fear, hope, panic and then keep a check of them. The tips include to avoid overconfidence, learn from mistakes, Balance trading risks, have a trading process and follow it, Follow effective trading habits. Thus trading psychology and discipline is very important to succeed as a trader.

Conclusion

Thus technical analyst can add value to an investment team by providing trading/investment ideas depending on the nature of the fund. In addition technical analysis can add value to a fundamental portfolio approach by adding input on the timing of the purchase or sale of a security.