ALGOEXPERT
Trading Intelligence
How to do technical analysis?
1. Introduction
Technical analysis is an analysis method which tries to predict the future prices of the assets by considering their past prices and trading volumes. The future predictions are made by looking over the formations occurred by the price movements and volume. The price movements and the changes in the trading volume are believed the indicators of the future price of the asset.
Technical analysis is built upon the basis that the price of an asset comes into existence only because of the demand and supply. Therefore, it would be enough only to research through the demand and supply of the asset in order to predict its future value. Investigating through demand and supply would cover all the factors which can affect the price of the asset.
2. Underlying Assumptions
There are three main assumptions which the technical analysis based on:
-
The price of an asset is only because of the demand and supply.
-
Price movements always form trends.
-
The past repeats itself.
The price of an asset is only because of the demand and supply
As everybody knows, price of an asset rises as the demand to the asset rises and as the supply of the asset rises price of the asset falls. As a result, price occurs where the supply and demand meets. Demand and supply occurs according to the rational factors like future predictions, expectations, profitability and irrational factors like psychology of the investors. Therefore, analysis of the past prices and volumes covers the analysis of all those factors and for a technical analyst investigation through price and volume is the only thing needed in order to predict future prices.
Price Movements always form trends
The main purpose of a technical analyst is determining if the price of the asset is in downtrend or uptrend. Technical analysts believe that trend will continue and the investment must be made in the direction of the trend. Until the signals which indicate the trend will reverse are received the positions must be hold.
The past repeats itself
The charts of the assets formed in the latest century show us asset prices constitute certain formations under certain conditions. These formations reflect the bearish or bullish psychology of the market. A technical analyst believes that if the conditions which created the past formations reoccur the same formations will appear again and these formations are the reflection of the unchanging human psychology.
3. Types of Charts
Charts are used to easily perceive the price changes and understand why these changes occurred. The X axis is the time and the Y axis can be price, volume or a value of an indicator in the technical analysis charts.
There are 4 main types of charts which are commonly used:
-
Line chart
-
Bar chart
-
Point and Figure chart
-
Candle chart
3.1. Line Chart
X axis is the time and Y axis is the price. Connection of prices through time constitutes a line. Line chart is used to determine the price trends and the price formations.
Bar chart shows the opening, closing, minimum and maximum prices of the asset in the unit time frames. X axis is the time and each dot on x axis is a time frame like 1 minute, 15 minutes, 1 hour or 1 day. The left offset indicates the opening price, right one is the closing. The bottom end is the lowest price and the top is the highest price in the time interval.
3.2. Bar Chart
3.3. Point and Figure Chart
Point and Figure chart is used to analyse the demand and supply of the asset. The X columns on the chart shows the upside trends as the O columns show the downside trends. Every dot on the X axis of this chart indicates a trend. X axis is the axis of successive trends as the Y axis is the axis of price. As the asset price highers in a trend, X's are added upto the maximum price where the asset price reached. As the asset price lowers in a trend, O's are added downto the minimum price where the asset price fell. An X starts just one unit above the latest O and an O starts just one unit below the latest X. In that chart, since the X axis is not a scale of time, time cannot be shown clearly.
3.4. Candle Chart
This type of chart constitutes of the figures like candle. X axis is the time and each dot on x axis is a time frame like 1 minute, 15 minutes, 1 hour or 1 day. The filled candles show the falls as the hollow candles show the rises. The edges of the candle threads show the maximum and minimum values where the asset price reached. The bottom of the hollow candle is the opening price in the time frame and the top is the closing price as it is reverse in the filled candle.
4. Dow Theory
The theory has been named after Charles Dow the founder of Dow Jones and Company. The main aim of the theorem is to determine long term trends of the asset prices. Theory assumes that the prices have three types of movements on their charts. These are:
-
Primary Trend
-
Secondary Trend
-
Daily Volatilities
Primary Trend
Long term movement pattern of an asset price is called the primary trend of the asset. Although an asset price sometimes falls in a year, if its general tendency is a rise then the primary trend of the asset is called uptrend. Vice versa, although an asset price sometimes rise in a year, if its general tendency is a fall then the primary trend of the asset is called downtrend. Primary uptrend is also called bull market as the primary downtrend is called bear market.
Secondary Trend
Price movements longing weeks or couple of months is called secondary trend. If, the primary trend of an asset is a bull market and if the asset price falls for two weeks, this fall is named as secondary trend in the primary uptrend of the asset.
Daily Volatilities
An asset price can rise or fall during a day with or without a fundamental reason. Those kinds of price movements are called daily volatilities.
4.1. Principles of Dow Theory
-
The past price movements of an asset include and reflect all the factors effecting the occurrence of the current price
For example, Dow theorem states that, if a company is believed to increase its profit in the future, all the factors (like the investments or agreements made by the company) which caused the existence of the belief are already reflected to the current price of the asset. Therefore, the research made on the past prices already covers the research to be made on those kinds of fundamental factors.
-
An asset always has three fundamental trends: primary, secondary and daily volatilities. Each trend occurs in the reverse direction of the longer period container trend as a corrective action.
-
A price movement lifecycle of an asset occurs in three periods:
-
Accumulation period
-
Bull market period
-
Bear market period
In the accumulation period, investors who predict the asset will be more valuable in the future accumulate the asset. In the end of accumulation period asset price starts to rise explicitly. After the rise begins asset starts to attract the attention of more and more people and the price starts to rise rapidly. This rapid rise period is called bull market. Bull market ends up with every possible investor invested on the asset and this is the time investors start to sell the asset. This sell and fall period is called bear market.
-
Each and every trend is confirmed with a rise in trading volume
When determining if a trend is real and will continue, trading volume is considered as the most valuable indicator. During a trend, if the trading volume increases then the trend is considered as real and this is the sign that trend will continue.
-
Each and every trend is valid until the signals of the end of the trend are received
5. Determination of Trends
5.1. Trend Lines
There are two types of trend lines: Ascending trend line and descending trend line. The ascending trend line is drawn by connecting two or three deepest points of an uptrend on a chart. The descending trend line is drawn by connecting two or three highest points of a downtrend on a chart.
Ascending trend lines show the price support levels. It is believed that prices will not go down below the ascending trend line unless a negative fundamental factor affecting the asset appears. On the other hand, descending trend lines show the price resistance levels. It is believed that prices will not go up above the descending trend line unless a positive fundamental factor affecting the asset appears.
Existence of a trend on an asset means an informal consensus has been made by the traders that prices will go in the same direction of the trend unless the trend line will be broken.
5.2. Channels
On an existing trend figure, if the top points and the bottom points constitute two parallel horizontal lines then the trend is called a channel.
Through a channel, whenever the price gets closer to the top line, number of sellers increase and they prevent price from going up further. Whenever the price gets closer to the bottom line, number of buyers increase and they prevent the price from falling further.
If one of the channel lines is broken, it can be understood that the channel is over and a new trend will begin. However the volume must be considered carefully on such a break. Only the breaks of high trading volumes are the real indicators of trend change. A break with a low volume is the indicator of bull or bear trap.
5.3. Resistance and Support
The price of an asset is a result of a tough battle between the buyers and sellers. Sometimes a price becomes a consensus between the buyers and they all buy whenever the price falls to that level. This level is called the support level of the asset. Vice a versa, sometimes a price becomes a consensus between the sellers and they all sell whenever the price rises to that level. This level is called the resistance level.
5.3.1. Break of Resistance/Support
Sudden breaks on the trends happen when the expectations of the traders change. A channel trend can be broken upward with high volumes of buys when the price comes to resistance level or can be broken downward with high volumes of sells when the price comes to support level. Volume is the main indicator showing if a break is real. Breaks with low volumes are usually fake and such a break turns out to be a bull or bear trap.
5.3.2. Bear Trap
The support level of an asset is broken downward and the price falls rapidly, however, the trading volume remains low during the break. Traders who understand the break is fake and of a no rational reason start buying and price rise fast and turns back into the channel where it resides usually. The bears who believe the price will go down further with the break sell their assets at the deepest level. In others words bears are trapped.
5.3.3. Bull Trap
The resistance level of an asset is broken upward and the price highers rapidly, however, the trading volume remains low during the break. Traders who understand the break is fake and of a no rational reason start selling and the price falls fast and turns back into the channel where it resides usually. The bulls who believe the price will go up further with the break buy the asset at the highest level. In others words bulls are trapped.
6. Price Formations
6.1. Shoulder Head Shoulder Formation
Shoulder Head Shoulder is observed on a chart as a very highest peak between two lower peaks one on the left one on the right. It is one of the most trustable signs of the end of a uptrend. It is usually seen at the end of long lasting uptrends.
The most important supporter of the shoulder head shoulder formation is the volume. A very big trading volume appears during the constitution of the left shoulder. During the constitution of head and the right shoulder trading volume decreases. Shoulder head shoulder information is an important sign of a rapid fall in the asset price.
Inverse shoulder head shoulder is observed on a chart as a very deepest bottom between two higher bottoms one on the left one on the right. It is one of the most trustable signs of the end of a downtrend. It is usually seen at the end of long lasting downtrends.
6.2. Inverse Shoulder Head Shoulder Formation
The most important supporter of the inverse shoulder head shoulder formation is the volume. A very big trading volume appears during the constitution of the right shoulder. During the constitution of head and the left shoulder trading volume appears less than the volume of the right shoulder. Inverse shoulder head shoulder formation is an important sign of a rapid rise in the asset price.
6.3. Triangle Formations
Sometimes some waves appear on the chart of the asset and those waves look like a fill of an empty triangle. The lines drawn by connecting the peaks and bottoms constitute a triangle. All the triangles constitute because of corrective buys and sells. There are three types of triangle formations:
-
Symmetrical triangle
-
Descending triangle
-
Ascending triangle
6.3.1. Symmetrical Triangle
Symmetrical triangle occurs when the corrective buys and sells happens at the same strength. The direction of the price cannot be predicted during the constitution of the formation. The direction becomes clear when one of the triangle lines is broken. If the upper line breaks, price rises. If the lower line breaks price falls.
6.3.2. Descending Triangle
Hypotenuse of the descending triangle forms in the direction of fall. The strength of the sells is bigger than the strength of the buys. The edge parallel to the X axis is the support line where the tough sell pressure cannot decrease the price more. However the bulls cannot stand with that pressure after a while and the support line breaks. Descending triangle is one of the best signals of the price falls.
6.3.3. Ascending Triangle
Hypotenuse of the ascending triangle forms in the direction of rise. The strength of the buys is bigger than the strength of the sells. The edge parallel to the X axis is the resistance line where the tough buy pressure cannot raise the price more. However the bears cannot stand with that pressure after a while and the resistance line breaks. Ascending triangle is one of the best signals of the price rises.
Double Bottom Formation usually occurs at the end of downtrends. It consists of two dips. After two dips constitute a rapid rise can be seen on the price of the asset. During this rise the trading volume increases.
6.4. Double Bottom Formation
6.5. Double Top Formation
Double Top Formation usually occurs at the end of uptrends. It consists of two peaks. After two peaks constitute a rapid fall can be seen on the price of the asset. During this fall the trading volume increases.
7. Technical Indicators
In addition to the price formations some technical indicators are also used as signals of buy or sell. Most popular indicators are:
-
CCI(Commodity Channel Index)
-
MACD(Moving Average Convergence Divergence)
-
Momentum
-
RSI(Relative Strength Index)
-
Stochastic Oscillator
-
Moving Averages
-
Bollinger Band
7.1. CCI(Commodity Channel Index)
CCI has been developed by Donald Lambert for commodity markets. Determination of prices according to supply and demand in commodity markets is similar to financial markets. Therefore, application of CCI to the financial markets produces very good results.
CCI indicates how much the asset price deviates below or above the statistical average of the stock price. CCI can also be thought of as an oscillator showing overbought and oversold territory. CCI values above +100 indicate that the asset price has risen excessively where the values below -100 indicate that the asset price has fallen excessively.
CCI is calculated with the following formula:
CCI = (Typical Price - nperiod SMA of TP) / (.015 x Mean Deviation)
Typical Price (TP) = (High + Low + Close)/3
Constant = .015
SMA = simple moving average
There are three steps to calculating the Mean Deviation.
1. Subtract the most recent n Period Simple Moving average from each typical price (TP) for the Period.
2. Sum these numbers strictly using absolute values.
3. Divide the value generated in step 3 by the total number of Periods (n in this case).
7.2. MACD (Moving Average Convergence Divergence)
This indicator produces signals that the asset can be bought or sold by looking at the divergence of the asset price from its moving averages. The formula of the moving average is:
MACD = 12 period exponential moving average – 26 period exponential moving average
MACD is an indicator that takes positive and negative values around zero. The big positive MACD values mean 12 period moving average diverged upwards from 26 period moving average a lot and the small negative MACD values mean 12 period moving average diverged downwards from 26 period moving average a lot. The peak and nadir points on the MACD plot indicates diverging moving averages stopped diverging and started to converge. The peak points are the signal of the sell and the nadir points are the signal of the buy.
7.3. Momentum
This indicator show how much profit or loss has been made as percentage in a given time period. The formula of the momentum is:
Momentum = (latest closing value / T period before closing value) * 100
On a momentum plot, rising value of momentum indicates buys get stronger and the falling value of the momentum indicates sells get stronger. Momentum oscillates around 100. The peak points are the signals of sell and the nadir points are the signals of buy.
7.4. RSI (Relative Strength Index)
RSI indicator aims to measure the rising strength of the assets. RSI values range from 0 to 100. RSI is calculated in a predetermined time frame. The default time frame is 14. If the average of the gains versus average of the losses in last 14 periods gets bigger, RSI gets closer to 100. If the average of the losses versus average of the gains in last 14 periods gets bigger, RSI gets closer to 0. The formula of the RSI is:
RSI=100 - ( 100 / ( 1 + (U/D) ) )
Where U is the average of the gains in the last 14 periods and D is the average of the losses.
The RSI values over 70 are considered as the asset is overbought and time gets closer to a fall and the values below 30 indicates asset is oversold and it should rise soon.
7.5. Stochastic Oscillator
Stochastic Oscillator makes its prediction by looking at the last closing price, highest price and a lowest price in a given period of time. It observes how much last closing price is higher than the lowest price in comparison with the highest price. The formula of the stochastic oscillator is:
%K = 100(Cn - Ln)/(Hn - Ln)
K is the value of the stochastic Oscillator. Value is a percentage and ranges between 0 and 100.
Cn is the most recent closing price in the last n period
Ln is the lowest price in the last n period
Hn is the highest price in the last n period
The default value for the n is 14. Usually people like to consider last 14 periods.
The stochastic values above 80 indicate overbought regions and indicate asset price will fall soon. The values below 20 indicate oversold regions and indicate asset price will rise soon.
Stochastic Oscillator(%K) is also usually used with its 3 period moving average(%D). Stochastic Oscillator and its moving average are drawn on the same chart and the intersection points on the graph indicate buy and sell points. If %K crosses %D down, it is the sell signal and if %K crosses %D upwards, it is the buy signal.
7.6. Moving Averages
There are two types of commonly used moving averages: Simple Moving Average and Exponential Moving Average. A moving average is calculated from a predetermined latest period of time. A simple moving average value is the simple arithmetical average of the latest n closing values that n is the predetermined period. Exponential moving average rises and falls more exponential than the simple moving average because more importance is given to the latest closing value in the n periods.
Simple moving average can be calculated by the following formula:
SMA = ( CV(n)th + CV(n-1)th + …. + CV(1)st ) / n
SMA is simple moving average
CV(n)th is n th closing value of the asset in the latest n period
n is the period
Exponential moving average can be calculated by the following formula:
EMA = ( CV(n)th + PEMA*(n-1) ) / n
EMA is the exponential moving average
CV(n)th is n th closing value of the asset in the latest n periods
PEMA previous moving average value
n is the period.
Moving average values are plotted on the same graph of the price. If the price crosses moving average down, it is the sell signal. If the price crosses moving average up, it is the buy signal.
7.7. Bollinger Band
Around a simple moving average plot, the standard deviations in the upward and downward directions constitute a band where the asset price goes through. This band is called Bollinger band. Technical analysts believe that the price remains in the band and if the price goes beyond the band it will return back fast.
