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Objectives of technical analysis
Should I buy shares now or not? What price will they have in one day or six months?
These questions worry everyone who is going to make transactions in the securities market and get profit from it.
As practice shows, hardly any of the technical analysts can confidently state the unerring use of methods of technical analysis. It can not become a panacea for all unsuccessful transactions on the stock exchange, because the world has not yet figured out how to invest without risking them. However, knowledge of its basic principles will help predict future price movement, expand opportunities and significantly reduce investment risks.
Types of charts and rules for their construction
The basis of technical analysis is graphics. A person perceives information much better graphically than text or numeric, so in this section we’ll look at the main types of charts that traders use and the rules for building them.
The simplest type of chart, which is constructed at closing prices for each subsequent period. It is recommended to apply only on short time intervals (from “ticks” to several minutes).
“Bars” is a very common chart used in the analysis of securities. Its peculiarity is that it is built at maximum prices (the top point of the segment), minimum prices (the bottom point), opening prices (the dash to the left of the vertical bar) and closing prices (the dash to the right of the vertical bar).
This type of chart is recommended for use for periods of five minutes or more.
Currently, “Japanese candles” are the most popular in technical analysis. In the gap between the opening and closing prices, a rectangle is drawn, called the body of a candle. Vertical sticks on the top and bottom of the body are called shadows.
If the body of the candle is black, this means that the prices during the trading period have decreased (the closing price is lower than the opening price).
If the body of the candle is white, then the prices during the trading period have increased.
The volume schedule is mandatory for use. It can be built starting from a few minutes or more. The volume shows the level of market activity.
On the daily chart of the RTS index, we can see all the above-mentioned types of charts. They are built for the same period of time, which will allow them to compare with each other.
Trend, or trend, is a certain price movement in one direction or another. In real life, no one market moves in any direction only in a straight line. Its dynamics is a series of zigzags: rise, fall, temporary consolidation and again the rise. It is the direction of the dynamics of these ups and downs that forms the trend of the market, or the trend.
The main rule, which should always be adhered to, is: Trend is your friend or “Trend is your friend”, so try to avoid making transactions against the trend.
The change in the price of the stock market can be compared to the constant struggle of bulls and bears. “Bulls” are trying to push prices up, and “bears” are down.
Consider the dynamics of the share price on the example of RAO UES of Russia. Every time prices fell to the level of 10.78 rubles, the bulls took the initiative and did not let the stock fall even lower. In practice, this means that investors considered the price of 10.78 rubles to be profitable for the acquisition of shares. This level was the level of support for the shares of RAO UES of Russia. By analogy, you can build a resistance level, where most investors sell assets, believing that they should fall in price.
Quite often in practice, you can find cases when the level of support changes to the level of resistance and vice versa. The example is presented on the schedule of RAO “UES of Russia”. When prices break through the resistance at around 11.05 rubles, it becomes a support level.
Acceleration and slowing down of trends
Acceleration of the trend is expressed in an increase in the angle of price dynamics in the “bull” trend or a decrease in the angle of inclination on the “bearish” trend. Acceleration is a characteristic of a strong trend, at the appearance of which one should expect its continuation.
Acceleration and slowing down of trends is a good confirmation in the analysis of the life cycle of the trend. As a rule, any movement consists of three speeds: from the slowest to the fastest. This kind of analysis is recommended to be applied on any time-freames (time periods).
Classic figures of technical analysis
Breakdown of the price of the “neck” line is a signal of the beginning of a strong market movement against the previous trend. Usually, prices pass from the breakdown point no less than the distance from the top of the “head” to the “neck” line, measured vertically.
“Triple and double top or bottom”
These critical models are very common on the market. With an upward trend, a new maximum is set, then a correction without volume is observed. However, at the next ascent, the bulls can not overcome the previous price level.
Figures confirming the continuation of the trend
“Triangle” is formed with the uncertainty of traders in the direction of movement or waiting for an event that creates again the uncertainty of traders. The fact of a breakout of a “triangle” can be considered to be held if the closing price is fixed outside the corresponding consolidation line (either above or below one of the sides of the “triangle”). A simple crossing of the side with a column of graphics will certainly give a false signal. After the breakout of the “triangle”, the chart usually returns to the broken side (consolidation lines). “Bull triangles” often give a false “bearish” signal, especially if the chart has gone too far to the top of the “triangle”.
“Flag” is formed, as a rule, after a rapid previous trend. It looks like a rectangle directed against the trend direction. The “flag” usually appears in the middle of the movement. The volume decreases as it forms, sharply increasing after the breakthrough.
“Vympel” is similar to a small symmetrical triangle. Volume as the formation of the “pennant” falls, sharply increasing after the breakthrough.
Model of a small triangle that is inclined against the trend direction. If the bias is in the direction of the trend, then the trend is most likely to change. Breakthrough, as a rule, occurs between 2/3 and 1.
Moving average (Moving average)
Moving averages show average values of stock prices for a certain period of time. When calculating them, a mathematical averaging of the price is performed, as the average price either changes or falls. Perhaps this is the simplest, oldest and most popular method of analyzing stock prices.
Simple moving averages of 200 days in length for decades were the most popular and quite effective tool for analyzing the development of market prices. The method of constructing simple moving averages (Simple Moving Average) reduces to the formula of a simple arithmetic mean:
Simple Moving Average
MA = Sum of prices for a period of time / Order of average
Thus, this is the simplest formula of the average, with which a person is familiar. It gives the most approximate, slightly delayed signals. When calculating weighted moving averages (Weighted Moving Average) of each of the prices of the analyzed period of time, a weight is added that increases towards the current day:
Weighted Moving Average
WMA = Sum of product of prices and weights / Sum of weights
It is believed that giving more recent price values to a higher weight gives better information than for a simple average. But it is not recommended to use it for long periods of time (day, week). When building the Exponentially Moving Average, we also assign weights to different prices, the highest weight is assigned to the last values of the price. A distinctive feature of the weighted average is that it includes all the prices of the previous period, and not just the segment specified at the time period setting. Thus, the moving average curve is smoothed against the price chart. The EMA gives more opportunities to open positions on time, without delay, therefore they are recommended as the main ones for application in technical analysis.
Three basic types of moving averages
• simple moving averages
• weighted moving averages
• exponential moving averages
With regard to specific proposals for building averages, we can advise you to use the following orders of means:
- when analyzing the 6-day price schedule – 8, 13, 21-th order of the average
- when analyzing the 1-day price schedule – 8, 13, 21, 55 and 89th orders of the average
- when analyzing the 3-hour price schedule – 8, 34, 55, 89, 144th order of the average
- when analyzing the 1-hour price schedule – 8, 34, 55, 89, 144th order of the average
- when analyzing less than 15-minute price charts – 34, 55, 144-th order of the average
Before considering Bollinger Bands, it should be noted that they do not refer to trend indicators, but represent a completely independent type of analysis.
This indicator characterizes abnormally sharp deviation of the price from the current trend. A trend here is a moving average. Bollinger Bands are built as a band around the middle. The bandwidth is proportional to the standard deviation from the moving average over the analyzed period of time. In this case, the Bollinger lines are not parallel to the average. Graphically Bollinger Bands are two lines that limit the dynamics of prices from the top and bottom. These are original lines of support and resistance, which most of the time are at levels remote from the price.
The decision based on the Bollinger analysis is adopted when the price rises above the upper resistance line or falls below the lower support line. If the price chart fluctuates between these two lines, there are no reliable buy and sell signals based on Bollinger analysis. When going abroad Bollinger can even work against the trend. However, it is necessary to take into account that the transactions against the trend are a game of professionals. And if you do not feel yourself as such, it’s better to refrain.
The main rule in the construction of Bollinger lines is the assertion that about 5% of the prices should be outside these lines, and 95% – inside.
You can select several signals
Convergence of Bollinger lines
The convergence of Bollinger lines is observed when the market calms down and there are no significant fluctuations on it. There is a consolidation to the continuation of the existing or the emergence of a new trend. In such cases they say: “Calm before the storm.”
Bollinger line divergence
The discrepancy of Bollinger lines is observed when the current trend is strengthened or when a new trend begins. The discrepancy with the increased volumes of transactions is a good confirmation of the trend.
The convergence-divergence (MACD) method
The convergence-divergence (MACD) method is the dynamic indicator following the trend. It shows the ratio between two moving average prices.
The MACD indicator is constructed as the difference between two exponential moving averages with periods of 12 and 26 days. The most effective in conditions where the market fluctuates with a large amplitude in the trading corridor. The most commonly used MACD signals are intersections, overbought-oversold conditions and discrepancies.
The basic rule of trade with the help of MACD is built on the intersections of the indicator with its signal line. As signals to purchase and sale are also used intersections MACD zero line up or down.
Buy when the MACD rises above the signal line,
Sell when the MACD falls below the signal line
The MACD indicator was developed by Gerald Appel – publisher of the journal systems and forecasts.
Overbought or oversold
MACD is also very valuable as an indicator of overbought or oversold. When the short moving average rises substantially above the long one (MACD grows), this means that the price of the paper in question is too high and will soon return to a more realistic level. It should be noted that the overbought and oversold conditions determined by MACD will not be the same for different securities.
When there is a discrepancy between the MACD and the price, this means the possibility of an early termination of the current trend.
The parabolic price-time system (Parabolic SAR)
The parabolic price-time system is a unique complete trading system, including the rules of protective stops. It was first described by J. Wells Wilder, Jr. in his 1978 book The New Concepts of Technical Trading Systems. The parabolic system is used to install sliding stop orders. This system is called SAR (stop-and-reversal) – installation and reversal. It perfectly defines the exit points from the market. Long positions should be closed when the price falls below the SAR line, and short – when it rises above the SAR line.
The Relative Strength Index (RSI)
The Relative Strength Index (RSI) is an indicator of the rate of change in prices, described by the same J. Wells Wilder in 1978. It should be noted that Wilder invented several methods of technical analysis of this kind, and almost all of them work well.
The name “index of relative strength” is not entirely successful, since RSI shows not the relative strength of two compared securities, but the internal strength of one paper. Perhaps it would be more accurate to call the “index of internal strength”.
Introducing the RSI, Wilder recommended using its 14-day option. In the future, 9- and 25-day RSIs were also distributed. The number of single periods in the calculation of RSI can vary, so it is recommended that you experiment with them to choose the most suitable option. (The shorter the RSI calculation period, the more sensitive the indicator.)
In his book W. Wilder describes five ways to use RSI for graph analysis
1. Tops and bases. RSI vertices usually form above 70, and bases are lower than 30, and they are usually ahead of the formation of vertices and bases on the price chart.
2. Graphical models. RSI often forms graphic models, such as “head and shoulders” or “triangles”, which on the price chart may not be indicated.
3. Failure (break through the level of support or resistance). Occurs when the RSI rises above the previous high (peak) or falls below the previous low (cavity).
4. Levels of support and resistance. On the RSI chart, support and resistance levels sometimes appear even more clearly than on the price chart.
5. Discrepancies. They are formed when the price reaches a new maximum (minimum), but it is not confirmed by a new maximum (minimum) on the RSI chart. In this case, prices usually adjust in the direction of the RSI movement.
Stochastic Oscillator (Stochastic Oscillator)
A stochastic oscillator is an indicator of the rate of change or price momentum developed by George S. Lane. Like the rate of change, it is computed from the values of three periods, so it can change in a leap as a result of discarding old data. This is its fundamental drawback, because of which the stochastic oscillator is theoretically unstable and can give erroneous signals.
There are several ways to interpret the stochastic oscillator, of which three will be considered:
1. Buy when the oscillator first falls below a certain level (usually 20), and then rises above it. Sell when the oscillator first rises above a certain level (usually 80), and then drops below it.
2. Buy if the main line rises above the second line. Sell if the main line drops below the second line.
3. Watch for discrepancies. For example, prices form a number of new highs, and the stochastic oscillator can not rise above its previous highs.
Combinations of “Japanese candles”. Turning patterns
The signal about the reversal of the trend indicates that the previous move is likely to have ended, and the market has moved either to the outset or in the opposite direction to the previous direction. And after the “flat” (outset), the initial trend may resume, and reversal indicators – a kind of beacons, warning that the trend is in the process of change. The reversal model, of course, does not mean that prices will move in the opposite direction, but only warns about it. Let us consider only some of them.
The appearance of a candle with a small body and a long lower shadow in a downward trend is a signal that its dominance in the market is coming to an end. With this development, the candle is called a “hammer”.
The three main signs of “Hammer” and “Hanged”
1. the body is at the top of the price range
2. the lower shadow is two or more times longer than the body
3. the candle does not have the upper shadow or it is very short and almost imperceptible
The appearance of a candle with a small body and a long lower shadow with an upward trend is a signal that, that its dominance is also coming to an end. With this development of events, the candle is called “hanged”.
The basic rule and peculiarity of any combination of “Japanese candles” is to look at the previous price dynamics. For a “hammer” and a “hanged man” to be true, a story about a descending or ascending trend is necessary. “Hanged” is formed near the high of the previous candle, and “hammer” – near the minimum of the previous candle.
Three criteria for the formation of the “Hammer” and “Hanged”
1. the market should have a pronounced upward or downward tendency
2. the body of the second candle absorbs the body of the first
3. the second body should be of a color contrast and be white in the case of a “bullish” signal, black – a “bearish”
“Dark-cloud cover” (Dark-cloud cover)
This model consists of two candles that appear after an upward trend (or near the upper boundary of the trade corridor). The first candle is white with a strong body. The next day the opening price exceeds the maximum of the previous day. However, the closing price approaches the day’s low and covers a significant part of the white body of the previous candle. The lower the closing price of a black candle, the more likely the formation of a top. Japanese analysts believe that the closing price of a black candle should cover more than 50% of the body of a white candle.
The meaning of this model is as follows. The market is growing all the previous time. The new trading session after the white candle opens with a break up on incredible optimism. It seems that the “bulls” completely control the situation, but then the price rise abruptly stops and sales appear. Moreover, the closing price falls to the daily low (or comes close to it) and closes a significant part of the body of the white candle. “Bears” are beginning to take up the activity, and then the price just falls.
Factors enhancing the model:
• The greater part of the body of a white candle is closed by the body of a black candle, the higher the probability of the formation of a vertex. If a long white candle with a closing price above the highs formed by “dark clouds” appears, you can expect a new increase.
• If a white candle with a long body and no shadows appears during a long upward trend, and the next day a black candle with a long body and no shadows, it is said that a “black day with a cut top and a cut off base” came.
• If the second “veil of dark clouds” candle opens above an important resistance level, and then the price falls – “bulls” can not control the market.
• If the second day is accompanied by a large amount of trade, this indicates a depletion of the upward trend. A large volume of trade with a new maximum opening price can mean that new buyers have appeared. When prices fall, they realize they are on board a sinking ship, and they begin to cover long positions, which, in turn, causes an avalanche reaction in the market.
“Piercing pattern” (piercing pattern)
This model consists of two candles and appears in a falling market, while the first candle has a black body, while the second has a long white one.
The white candle opens considerably below the price of the previous candle. Then the price rises, closing above the middle of the black candle.
The model is determined by the same factors as the “dark clouds” model, but in its mirror image. There are, however, differences, among which the “gleam in the clouds” a white candle should always cover more than half the body of a black candle.
The “veil of dark clouds” has exceptions, since there are three more models that are formed in the same way as the “skylight in the clouds”. The only difference is that the body of the white candle closes the body black less than half. They are called “at the bottom”, “at the bottom” and “push” and are considered “bearish” signals. Three potentially “bearish” models and a “bullish” model “skylight in the clouds” have the same shape. They differ only in the degree of “penetration” of the white body into the body of the black candle. In the model “at the bottom” the white candle closes close to the minimum price of the previous day. In the “in the bottom” model, the white candle closes slightly above the closing price of the previous day. In the “push” model, the body of the white candle is larger in size than in the previous models, but the closing price does not reach the middle of the black candle.
“Star” is a candle with a small body, which forms a price gap with the previous candle, which has a large body. The main condition is the gap between the bodies. Shadows may overlap, and the color of the “star” does not matter much. This model warns of a turn, and a small body indicates that the struggle between “bulls” and “bears” has reached a dead end.
This is a reversal pattern at the bottom, consists of a candle with a long black body, followed by a candle with a small body. On the third day a white candle appears, the body of which covers a significant part of the blackbody of the first day.
When a black candle is seen, the price naturally falls, when a small white candle appears it becomes clear that the forces of the “bears” are running low. In this situation, it would be most logical to buy, as a result, a large white candle of growth appears and the “bulls” are already gaining the upper hand. The determining criterion here is the degree of penetration of the last growth candle into the body of the black candle. Sometimes it happens that there is more than one star in the model, but several.
Factors that enhance the signal of the appearance of the “morning (evening) star”:
• the presence of gaps not only between the first candle and the “star”, but also between the “star” and the third candle;
• the body of the third candle covers a significant part of the body of the first candle;
• a small volume on the first candle and a large volume on the third candle.
“Evening Star” is an inverted “morning star” model.
“Morning and Evening Doji Stars”
Here as a star stands the Dodge, which is the harbinger of the reversal. An obligatory condition in this model should be a break with the previous candle. The description of the principles of the “morning and evening Doji stars” is analogous to the description of a “morning and evening star”, with the only proviso that doji are considered to be more important reversal patterns than ordinary ones.
“Abandoned baby top” and “abandoned baby bottom” are the strongest reversal signals, however, they are extremely rare.
Other reversal models
The previous reversal models are relatively strong signals of trend change. Below are the reversal indicators, which are less strong fracture signals. These include “harami”, the tops and bottoms of “tweezers”, the candle “seizure for the belt”, the models “two taken off crows” and “counterattack”.
The model is harami pattern
The model “harami” (translated from Japanese as “pregnant”) is a candle with a small body that is within the relatively long body of the preceding candle. A long candle is a “mother”, and a short one is a “child”. Candles in absorption patterns, in theory, should differ in color, but in “harami” – this is not necessary. The main thing is that the body of the second candle should be smaller than the body of the first and be inside it. The smaller the body of the second candle, the stronger the signal to turn. It can be seen from practice that the “harami” confirms the end of the previous trend and the transition to “flat”.
Tops and bottoms of “tweezers tops and bottoms”
The “tweezers” model is two or more candles with the same maxima or minima. In the growing market, the “tweezers” peak is formed where two identical price peaks appear, and on a decreasing basis “tweezers” are formed where two price minima coincide. “Tweezers”, as a rule, are not strong signals of a turn. Their significance increases if they appear after a long trend, that is, on long-term charts, where “tweezers” formed during successive trading sessions can serve as important reversal signals.
The name of the model comes from the fact that the candles that form it, in the opinion of the Japanese, resemble the forked tweezers.
Candles “belt-hold lines”
“Capture for the belt” is a candle that can carry both “bullish” and “bearish” character. “Bull capture for the belt” is a long white candle that opens at a daily low, and then moves upwards during the day. It is also called a white candle with a cut base. If the market is in the area of lows and a long white candle “seizure by the belt” appears, then the market is very likely to grow.
“Bear capture” “Bear capture for the belt” is a long black candle with a cut top. If the market is in the area of high prices and there is a “bearish capture for the belt,” then a turn is likely.
The longer the candle “seizure by the belt”, the more importance it has for the subsequent development of the market. These candles are also significant if they did not appear on the chart for a very long time.
“Three black crows” (three black crows)
If three consecutive black candles appear on the chart, a “three black crows” model appears. This model foreshadows the fall in prices if it appears after a long upward trend or in the area of high prices. The closing prices of the three candles should be at or near the minimum prices, and the opening price is inside the body of the previous candle. If the opening prices of the second and third black candles are at the closing price of the previous black candle (or near it), the model is called “three identical black crows” (identical three crows). It is considered a stronger “bearish” signal, but it is extremely rare.
The model of “counterattack lines”
The counter-attack model is formed by two candles of contrasting colors with identical closing prices.
“Bull counterattack” occurs during the fall in prices. The first appears a long black candle. The next trading session opens much lower, the “bears” are confident. But the “bulls” start a counterattack, pushing prices up so that the market returns to the closing price of the previous trading session and even sets a new high. “Bearish” trend is stopped, so the models of “bull counterattack” should be treated with respect. For the “bear counterattack” the conclusions are similar. An important requirement for the “counter-attack” model is that the opening price of the second session should be significantly higher (with a “bear counterattack”) or significantly lower (with a “bullish counter-attack”) of the previous candle.
“Three Mountains” and “Three Buddhas”
The top “three mountains” is formed when the price three times repels from a certain maximum or makes three attempts to reach a new maximum (three rising waves, the third wave must be the highest). The top of the last “mountain” should receive confirmation in the form of a “bearish” model or a candle (for example, “doji” or “veils of dark clouds”). This model is formed for a longer time than all the previous ones. The summit is “three mountains”. If in the “three mountains” model the highest peak is the middle peak, one speaks of the top “three Buddhas” (three Buddha). The top is the “three Buddhas”. The “three Buddhas” model is an analogue of the Western “head-shoulders” model. A signal to buy or sell for “three mountains” and “three Buddhas” occurs when a “neck line” breaks through.