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Chapter 8.1

Technical Charting - Price, Patterns and Indicators


# 1. History repeat itself

A major assumption of technical analysis is that history repeats itself.

Assume today, the 19th Nov 2015 there are few things happening in a particular stock. Let us call this factor:
1. Factor 1 – The stock has been falling for the last 4 consecutive trading sessions
2. Factor 2 –Today (19th Nov 2015) is the 5th session and the stock is falling on relatively lower volumes
3. Factor 3 – The range in which the stock trades today is quite small compared to the last four days.


With these factors are playing in the background, let us assume that on the next day (20th Nov 2015) the fall in stock gets arrested and in fact the stock rallies towards a positive close. So, as an outcome of the 3 factors the stock went up on the 6th day.

Time passes and let’s says after a few months, the same set of factors is observed for 5 consecutive trading sessions. What would you expect for the 6th day? According to the assumption – History tends to repeat itself. However we need to make an supplement to this assumption. When a set of factors that has panned out in the past tends to repeat itself in the future, we expect the same outcome to occur, as was observed in the past, provided the factors are the same. Therefore, based on this assumption even this time round we can expect the stock price to go up on the 6th trading session.

# 2. Support & Resistance

For estimating the target price of a stock we need to look at support & resistance levels for a stock. The support and resistance (S&R) are exact price levels on a chart which are likely to attract higher amount of either buying or selling. Support price is a price at which one may expect higher number of buyers as compared to sellers. Similarly resistance price is a price at which one may expect to see more sellers than buyers.

Resistance area on the chart is that price level beyond which the prices may not move further. At this point we may witness maximum selling (supply) of a stock. The resistance level is always above the current market price. The chance of the stock price rising up to the resistance level, consolidating, absorbing all the supply, and then declining is high. The resistance is one of the critical technical tools which technical analysts look at in a rising market. The resistance levels often acts as a trigger to sell.

Support is the point prevents the price from falling further. At the support level we may witness higher buying (demand) into the stock. Whenever the price falls to the support line, it is likely to bounce back. The support level is always below the current market price. There is a maximum likely hood that the price could fall till the support, consolidate, absorb all the demand, and then start to move upwards. The support is one of the critical technical level market participants look for in a falling market. The support often acts as a trigger to buy.

In technical analysis a green candle represents strength while red candle shows weakness. Thus if you want to sell it should be a green candle day and vice versa when you want to buy red candle day. If you are looking at a bullish pattern, the previous trend should be bearish and similarly if you are looking for a bearish pattern, the prior trend should be bullish.

 

The support and resistance (S&R) are exact price levels on a chart which are likely to attract higher amount of either buying or selling. Support price is a price at which one may expect higher number of buyers as compared to sellers. Similarly resistance price is a price at which one may expect to see more sellers than buyers

 

# 3. Candlestick Patterns

1 - Engulfing - It is a pattern where an opposite trend completely eclipses or engulfs the previous trend.

2 - Doji Pattern - A Doji candlestick forms when a security's open and close are virtually equal for the given time period and generally signals a reversal pattern.

3 - Hammer - A hammer is a price pattern in candlestick charting that occurs when a security trades significantly lower than its opening, but rallies later in the day to close either above or near its opening price.

4 - Hanging Man - A hanging man is a bearish candlestick pattern that forms at the end of an uptrend. It forms when a sell off is near but for that day the buyers are able to push the stock price up near the opening price.

5 - Inverted hammer - An Inverted Hammer pattern forms when the buyers push the stock price higher against the sellers, however, the stock price is pulled back and closes near the open.

6 - Shooting Star - The Shooting Star candlestick pattern forms when buyers push the price higher against the sellers. However, the stock falls and closes near the low.


Trendlines or price patterns

Trendlines help technical analysts identify areas of support and resistance on a chart. Trendlines are straight lines drawn on a chart by connecting a sequence of sliding peaks (highs) or ascending troughs (lows). A trendline that is angled up, known as an up trendline, occurs where prices are experiencing higher highs and higher lows. The up trendline is drawn by connecting the ascending lows. Conversely, a trendline that is angled down, called a down trendline, occurs where prices are experiencing lower highs and lower lows.

• Uptrends occur where prices are making higher highs and higher lows. Up trendlines connect at least two of the lows and show support levels below price.
• Downtrends occur where prices are making lower highs and lower lows. Down trendlines connect at least two of the highs and indicate resistance levels above price.
• Consolidation, or a sideways market, occurs where price is oscillating between an upper and lower range, between two parallel and often horizontal trendlines

Continuation price Patterns

Price pattern that signify a momentary break of an existing trend is known as a continuation pattern. When a price pattern is forming, there is no way to tell if the trend will reverse or continue. So, careful attention should be positioned on the trend lines which are used to draw the price pattern & whether a price pattern breaks below or above this continuation zone. Technical analyst generally recommends that the existing trend will continue till they are confirmed that the reversal will take place.

Reversal Pattern

Price pattern that signify a change in the existing trend is known as a reversal pattern. These patterns signify periods where either the bears or the bulls have lost interest. The established trend will discontinue and then move in a new direction as there is strength from the other side (bull or bear. Reversals that occur at market peaks are called as distribution patterns, here the trading instrument become more willingly sold than bought. On the other hand, reversals that occur at market lows are known as buildup patterns, here the trading instrument become more aggressively bought than sold.

Indicators help in buying, selling, confirming trends, and predicting trends. There are leading & lagging indicators. A leading indicator is ahead of the price i.e it usually signals the happening of a trend in ahead of it. On the other hand a lagging indicator is behind the price i.e it generally signals the happening of a trend after it has taken place.

 

Trendlines are straight lines drawn on a chart by connecting a sequence of sliding peaks (highs) or ascending troughs (lows). A trendline that is angled up, known as an up trendline, occurs where prices are experiencing higher highs and higher lows. The up trendline is drawn by connecting the ascending lows. Conversely, a trendline that is angled down, called a down trendline, occurs where prices are experiencing lower highs and lower lows

 

#4. Relative Strength Index (RSI)

RSI is a leading indicator which helps in spotting reversal trend. This indicator fluctuates between 0 & 100 range and based on the latest indicator reading, the expectations from the markets are set.

To calculate RSI we record points gained/lost with respect to the previous day close.Eg. if today’s close is 104 and yesterday’s close was 100, points gained would be 4 and points lost would be 0. Similarly, if today’s close was 104 and previous day’s close was 107, the points gained would be 0 and points lost would be 3. We have to take 14 points gain loss data as the charting software takes such 14 data points.

RS= average points gained/average points loss

And then put this RS value in the above formula to get RSI The objective of using RSI is to help the trader identify over sold and overbought price areas. Overbought implies that the positive momentum in the stock is so high that it may not be sustainable for long and hence there could be a correction. Likewise, an oversold position indicates that the negative momentum is high leading to a possible reversal.

Suppose a stock which is in a continuous uptrend (remember the uptrend can last from few days to few years) the RSI will remain stuck in the overbought region for a long time, and this is because the RSI is upper bound to 100. It cannot go beyond 100. Invariably the trader would be looking at shorting opportunities but the stock on the other hand will be in a different orbit. While for a stock which is in a continuous downtrend the RSI will be stuck in the oversold region since the RSI is lower bound to 0. It cannot go beyond 0. In this case as well the trader will be looking at buying opportunities but the stock will be going down lower.

# 5. Moving Average Convergence and Divergence (MACD)

The moving average is possibly the most widely used indicator. The Mov Avg 1 line indicator calculates and plots a simple, exponential or weighted average of prices, specified by the input Price, from each of the most recent number of bars specified by the input Length.

A moving average is generally used for trend identification. Attention is given to the direction in which the average is moving and to the relative position of prices and the moving average.

Rising moving average values (direction) and prices above the moving average (position) would indicate an uptrend. Declining moving average values and prices below the moving average would indicate a downtrend. The most commonly used averages are of 5, 13, 20, 50, 100 and 200 days. The longer the time span, the less sensitive the moving average to daily price changes. Moving averages are used to emphasize the direction of a trend and smooth out price and volume fluctuations.

MACD is convergence and divergence of the two moving averages. Convergence occurs when the two moving averages move towards each other, and a divergence occurs when the moving averages move away from each other. A standard MACD is calculated using a 12 day EMA and a 26 day EMA. From the 12 day EMA, the 26 day EMA is subtracted to extract the convergence and divergence (CD) value, also called the ‘MACD Line’. Both the EMA’s are based on the closing prices.

For example if the 12 Day EMA is 7380, and 26 Day EMA is 7220 then the MACD line is +160. The shorter term average will generally be higher than the longer term only when the stock prices are trending upwards. Also the shorter term average will always be more reactive to the current market price than the longer term average. Thus a positive sign tells us that there is positive momentum in the stock, and the stock is drifting upwards. The higher the momentum, the higher is the magnitude. When the MACD line is negative, it means the 12 day EMA is lower than the 26 day EMA. Therefore the momentum is negative. Higher the magnitude of the MACD line, the more strength in the negative drift.

Key Takeaways:

  • Technical analysis helps traders by providing key indicators like Support and Resistance levels to Buy and Sell shares at an appropriate time.
  • Following certain chart patterns will help to understand Bullish or Bearish Trends or Trend reversals.
  • Momentum indicators like Relative Strength Index (RSI) signifies whether it is high time to Buy or Sell certain Stock.

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