Technical Analysis & Charting: Fundamental Concepts & Patterns Flashcards
define the concept
Support and Resistance Levels
Key price levels where a stock/market seldom falls below (support) or surpasses (resistance).
These are key concepts in technical analysis. Support levels are price levels at which a stock or market seldom falls below, while resistance levels are prices that a stock or market seldom surpasses. Identifying these levels can help traders understand potential price movement boundaries.
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Trend Lines
Straight lines on charts connecting a series of prices, identifying market trends (upward, downward, sideways).
These are straight lines drawn on charts to connect a series of prices. They help identify the direction of the market movement, whether it’s an upward, downward, or sideways trend.
define the concept
Moving Averages
Tools like SMA (Simple Moving Average) and EMA (Exponential Moving Average) are used to smooth out price data and identify trend directions.
These are used to smooth out price data to identify the trend direction. Common types include the Simple Moving Average (SMA) and the Exponential Moving Average (EMA). They are often used to determine entry and exit points in trading.
define the concept
Chart Patterns
Patterns in price charts can indicate future price movements. Common patterns include:
- Head and Shoulders: Indicates trend reversal.
- Double Top and Double Bottom: Suggests a potential trend reversal.
- Triangles (Ascending, Descending, and Symmetrical): Used to identify continuation of a trend.
explain the pattern
Head and Shoulders Pattern
A chart pattern indicating trend reversal, characterized by a peak (shoulder), followed by a higher peak (head), and another lower peak (shoulder).
Indicates trend reversal
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Double Top and Double Bottom
Patterns suggesting trend reversal; Double Top appears at market top, Double Bottom at market bottom.
Suggests a potential trend reversal.
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Triangle Patterns (Ascending, Descending, Symmetrical)
Continuation patterns formed during a trend; identified by converging trend lines.
Used to identify continuation of a trend.
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Candlestick Patterns
Specific patterns like Doji, Hammer, Engulfing, Shooting Star, predicting short-term price movements.
These are specific patterns formed by candlestick charts that traders use to predict short-term price movements. Examples include the Doji, Hammer, Engulfing, and Shooting Star.
explain the patterns
Doji & Spinning Top
A doji (plural is also doji) is a candlestick formation where the open and close are identical, or nearly so. A spinning top is very similar to a doji, but with a very small body, in which the open and close are nearly identical.
Both patterns suggest indecision in the market, as the buyers and sellers have effectively fought to a standstill. But these patterns are highly important as an alert that the indecision will eventually evaporate and a new price direction will be forthcoming.
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Bullish/Bearish Engulfing Lines
An engulfing line is a strong indicator of a directional change. A bearish engulfing line is a reversal pattern after an uptrend. The key is that the second candle’s body “engulfs” the prior day’s body in the opposite direction. This suggests that, in the case of an uptrend, the buyers had a brief attempt higher but finished the day well below the close of the prior candle. This suggests that the uptrend is stalling and has begun to reverse lower. Also, note the prior two days’ candles, which showed a double top, or a tweezers top, itself a reversal pattern.
A bullish engulfing line is the corollary pattern to a bearish engulfing line, and it appears after a downtrend. Also, a double bottom, or tweezers bottom, is the corollary formation that suggests a downtrend may be ending and set to reverse higher.
explain the pattern
Hammer
A hammer suggests that a down move is ending (hammering out a bottom). Note the long lower tail, which indicates that sellers made another attempt lower, but were rebuffed and the price erased most or all of the losses on the day. The important interpretation is that this is the first time buyers have surfaced in strength in the current down move, which is suggestive of a change in directional sentiment. The pattern is confirmed by a bullish candle the next day.
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Hanging Man
A hanging man pattern suggests an important potential reversal lower and is the corollary to the bullish hammer formation. The story behind the candle is that, for the first time in many days, selling interest has entered the market, leading to the long tail to the downside. The buyers fought back, and the end result is a small, dark body at the top of the candle. Confirmation of a short signal comes with a dark candle on the following day.
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Abandoned Baby Top/Bottom
An abandoned baby, also called an island reversal, is a significant pattern suggesting a major reversal in the prior directional movement. An abandoned baby top forms after an up move, while an abandoned baby bottom forms after a downtrend.
The pattern includes a gap in the direction of the current trend, leaving a candle with a small body (spinning top/or doji) all alone at the top or bottom, just like an island. Confirmation comes on the next day’s candle, where a gap lower (abandoned baby top) signals that the prior gap higher was erased and that selling interest has emerged as the dominant market force. Confirmation comes with a long, dark candle the next day.
explain the patterns
Long Tails & Small Bodies
Candlesticks that have a small body—a doji, for example—indicate that the buyers and sellers fought to a draw, leaving the close nearly exactly at the open. (Such a candlestick could also have a very small body, effectively forming a spinning top.) Small bodies represent indecision in the marketplace over the current direction of the market.
This suggests that such small bodies are frequently reversal indicators, as the directional movement (up or down) may have run out of steam. Careful note of key indecision candles should be taken, because either the bulls or the bears will win out eventually. This is a time to sit back and watch the price behavior, remaining prepared to act once the market shows its hand.
Another key candlestick signal to watch out for are long tails, especially when they’re combined with small bodies. Long tails represent an unsuccessful effort of buyers or sellers to push the price in their favored direction, only to fail and have the price return to near the open. Just such a pattern is the doji shown below, which signifies an attempt to move higher and lower, only to finish out with no change. This comes after a move higher, suggesting that the next move will be lower.
Which Candlestick Pattern is most reliable?
Many patterns are preferred and deemed the most reliable by different traders. Some of the most popular are: bullish/bearish engulfing lines; bullish/bearish long-legged doji; and bullish/bearish abandoned baby top and bottom. In the meantime, many neutral potential reversal signals—e.g., doji and spinning tops—will appear that should put you on the alert for the next directional move.
Does candlestick pattern analysis really work?
Yes, candlestick analysis can be effective if you follow the rules and wait for confirmation, usually in the next day’s candle. Traders around the world, especially out of Asia, utilize candlestick analysis as a primary means of determining overall market direction, not where prices will be in two to four hours. That’s why daily candles work best instead of shorter-term candlesticks.
How do you read a Candle Pattern?
A candle pattern is best read by analyzing whether it’s bullish, bearish, or neutral (indecision). Watching a candlestick pattern form can be time consuming and irritating. If you recognize a pattern and receive confirmation, then you have a basis for taking a trade. Be careful not to see patterns where there are none. Let the market do its thing, and you will eventually get a high-probability candlestick signal.
explain the difference
Difference Between Foreign Exchange (FX) Candles and Other Markets’ Candles
Because the FX market operates on a 24-hour basis, the daily close from one day is usually the open of the next day. As a result, there are fewer gaps in the price patterns in FX charts. FX candles can only exhibit a gap over a weekend, where the Friday close is different from the Monday open.
Many candlestick patterns rely on price gaps as an integral part of their signaling power, and those gaps should be noted in all cases. As for FX candles, one needs to use a little imagination to spot a potential candlestick signal that may not exactly meet the traditional candlestick pattern. For example, in the figure below taken from an FX chart, the bearish engulfing line’s body does not exactly engulf the previous day’s body, but the upper wick does. With a little imagination, you’ll be able to spot certain patterns, although they might not be textbook in their formation.
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Volume in Trading
Volume indicates the amount of trading in an asset over a period, a key indicator of market interest.
Volume is the amount of trading in an asset over a given period. High volume often indicates strong interest in the asset, which can mean a continuation or change in the market trend.
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Relative Strength Index (RSI)
A momentum oscillator measuring speed and change of price movements; above 70 is overbought, below 30 is oversold.
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How the Relative Strength Index (RSI) Works
As a momentum indicator, the relative strength index compares a security’s strength on days when prices go up to its strength on days when prices go down. Relating the result of this comparison to price action can give traders an idea of how a security may perform. The RSI, used in conjunction with other technical indicators, can help traders make better-informed trading decisions.
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Why Is RSI Important?
- Traders can use RSI to predict the price behavior of a security.
- It can help traders validate trends and trend reversals.
- It can point to overbought and oversold securities.
- It can provide short-term traders with buy and sell signals.
- It’s a technical indicator that can be used with others to support trading strategies.
explain the technical indicator
Bollinger Bands
A volatility indicator with a middle SMA and adjustable upper/lower bands, signaling overbought or oversold conditions.
A volatility indicator that consists of a middle SMA along with upper and lower bands that adjust based on market volatility. They can signal overbought or oversold conditions.
- Bollinger Bands is a technical analysis tool to generate oversold or overbought signals and was developed by John Bollinger.
- Three lines compose Bollinger Bands: A simple moving average, or the middle band, and an upper and lower band.
- The upper and lower bands are typically 2 standard deviations +/- from a 20-day simple moving average and can be modified.
- When the price continually touches the upper Bollinger Band, it can indicate an overbought signal.
- If the price continually touches the lower band it can indicate an oversold signal.
What are the limitations of Bollinger Bands?
Bollinger Bands is not a standalone trading system but just one indicator designed to provide traders with information regarding price volatility. John Bollinger suggests using them with two or three other non-correlated indicators that provide more direct market signals and indicators based on different types of data. Some of his favored technical techniques are moving average divergence/convergence (MACD), on-balance volume, and relative strength index (RSI).
Because Bollinger Bands® are computed from a simple moving average, they weigh older price data the same as the most recent, meaning that new information may be diluted by outdated data. Also, the use of 20-day SMA and 2 standard deviations is a bit arbitrary and may not work for everyone in every situation. Traders should adjust their SMA and standard deviation assumptions accordingly and monitor them.
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Fibonacci Retracement Levels
A tool to identify potential reversal levels, indicated by horizontal lines showing where support and resistance are likely to occur.
- Fibonacci retracement levels connect any two points that the trader views as relevant, typically a high point and a low point.
- The percentage levels provided are areas where the price could stall or reverse.
- The most commonly used ratios include 23.6%, 38.2%, 50%, 61.8%, and 78.6%.
- These levels should not be relied on exclusively, so it is dangerous to assume that the price will reverse after hitting a specific Fibonacci level.
- Fibonacci numbers and sequencing were first used by Indian mathematicians centuries before Leonardo Fibonacci.
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MACD (Moving Average Convergence Divergence)
A trend-following momentum indicator showing the relationship between two moving averages of a security’s price.
- The moving average convergence/divergence (MACD, or MAC-D) line is calculated by subtracting the 26-period exponential moving average (EMA) from the 12-period EMA. The signal line is a nine-period EMA of the MACD line.
- MACD is best used with daily periods, where the traditional settings of 26/12/9 days is the default.
- MACD triggers technical signals when the MACD line crosses above the signal line (to buy) or falls below it (to sell).
- MACD can help gauge whether a security is overbought or oversold, alerting traders to the strength of a directional move, and warning of a potential price reversal.
- MACD can also alert investors to bullish/bearish divergences (e.g., when a new high in price is not confirmed by a new high in MACD, and vice versa), suggesting a potential failure and reversal.
- After a signal line crossover, it is recommended to wait for three or four days to confirm that it is not a false move.
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MACD vs. Relative Strength
The relative strength index (RSI) aims to signal whether a market is considered to be overbought or oversold in relation to recent price levels. The RSI is an oscillator that calculates average price gains and losses over a given period of time. The default time period is 14 periods with values bounded from 0 to 100. A reading above 70 suggests an overbought condition, while a reading below 30 is considered oversold, with both potentially signaling a top is forming, or vice versa (a bottom is forming).
The MACD lines, however, do not have concrete overbought/oversold levels like the RSI and other oscillator studies. Rather, they function on a relative basis. That’s to say an investor or trader should focus on the level and direction of the MACD/signal lines compared with preceding price movements in the security at hand, as shown in the image.
MACD measures the relationship between two EMAs, while the RSI measures price change in relation to recent price highs and lows. These two indicators are often used together to give analysts a more complete technical picture of a market.
These indicators both measure momentum in a market, but because they measure different factors, they sometimes give contrary indications. For example, the RSI may show a reading above 70 (overbought) for a sustained period of time, indicating a market is overextended to the buy side in relation to recent prices, while the MACD indicates that the market is still increasing in buying momentum. Either indicator may signal an upcoming trend change by showing divergence from price (price continues higher while the indicator turns lower, or vice versa).
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Bullish Divergence
When MACD forms highs or lows that that exceed the corresponding highs and lows on the price, it is called a divergence. A bullish divergence appears when MACD forms two rising lows that correspond with two falling lows on the price. This is a valid bullish signal when the long-term trend is still positive.
Some traders will look for bullish divergences even when the long-term trend is negative because they can signal a change in the trend, although this technique is less reliable.
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Bearish Divergence
When MACD forms a series of two falling highs that correspond with two rising highs on the price, a bearish divergence has been formed. A bearish divergence that appears during a long-term bearish trend is considered confirmation that the trend is likely to continue.
Some traders will watch for bearish divergences during long-term bullish trends because they can signal weakness in the trend. However, it is not as reliable as a bearish divergence during a bearish trend.
Explain the chart pattern
Head and Shoulders
Head and shoulders is a chart pattern in which a large peak has a slightly smaller peak on either side of it. Traders look at head and shoulders patterns to predict a bullish-to-bearish reversal.
Typically, the first and third peak will be smaller than the second, but they will all fall back to the same level of support, otherwise known as the ‘neckline’. Once the third peak has fallen back to the level of support, it is likely that it will breakout into a bearish downtrend.
Explain the chart pattern
Double Top
A double top is another pattern that traders use to highlight trend reversals. Typically, an asset’s price will experience a peak, before retracing back to a level of support. It will then climb up once more before reversing back more permanently against the prevailing trend.
Explain the chart pattern
Double Bottom
A double bottom chart pattern indicates a period of selling, causing an asset’s price to drop below a level of support. It will then rise to a level of resistance, before dropping again. Finally, the trend will reverse and begin an upward motion as the market becomes more bullish.
A double bottom is a bullish reversal pattern, because it signifies the end of a downtrend and a shift towards an uptrend.
Explain the chart pattern
Cup and Handle
The cup and handle pattern is a bullish continuation pattern that is used to show a period of bearish market sentiment before the overall trend finally continues in a bullish motion. The cup appears similar to a rounding bottom chart pattern, and the handle is similar to a wedge pattern – which is explained in the next section.
Following the rounding bottom, the price of an asset will likely enter a temporary retracement, which is known as the handle because this retracement is confined to two parallel lines on the price graph. The asset will eventually reverse out of the handle and continue with the overall bullish trend.
Explain the chart pattern
Rising Wedge
Wedges form as an asset’s price movements tighten between two sloping trend lines. There are two types of wedge: rising and falling.
A rising wedge is represented by a trend line caught between two upwardly slanted lines of support and resistance. In this case the line of support is steeper than the resistance line. This pattern generally signals that an asset’s price will eventually decline more permanently – which is demonstrated when it breaks through the support level.
Both rising and falling wedges are reversal patterns, with rising wedges representing a bearish market and falling wedges being more typical of a bullish market.
Explain the chart pattern
Falling Wedge
Wedges form as an asset’s price movements tighten between two sloping trend lines. There are two types of wedge: rising and falling.
A falling wedge occurs between two downwardly sloping levels. In this case the line of resistance is steeper than the support. A falling wedge is usually indicative that an asset’s price will rise and break through the level of resistance, as shown in the example below.
Both rising and falling wedges are reversal patterns, with rising wedges representing a bearish market and falling wedges being more typical of a bullish market.
Explain the chart pattern
Pennants / Flags
Pennant patterns, or flags, are created after an asset experiences a period of upward movement, followed by a consolidation. Generally, there will be a significant increase during the early stages of the trend, before it enters into a series of smaller upward and downward movements.
Pennants can be either bullish or bearish, and they can represent a continuation or a reversal. The above chart is an example of a bullish continuation. In this respect, pennants can be a form of bilateral pattern because they show either continuations or reversals.
While a pennant may seem similar to a wedge pattern or a triangle pattern – explained in the next sections – it is important to note that wedges are narrower than pennants or triangles. Also, wedges differ from pennants because a wedge is always ascending or descending, while a pennant is always horizontal.
Explain the chart pattern
Ascending Triangle
The ascending triangle is a bullish continuation pattern which signifies the continuation of an uptrend. Ascending triangles can be drawn onto charts by placing a horizontal line along the swing highs – the resistance – and then drawing an ascending trend line along the swing lows – the support.
Ascending triangles often have two or more identical peak highs which allow for the horizontal line to be drawn. The trend line signifies the overall uptrend of the pattern, while the horizontal line indicates the historic level of resistance for that particular asset.
Explain the chart pattern
Descending Triangle
In contrast to an Ascending Triangle, a Descending Triangle signifies a bearish continuation of a downtrend. Typically, a trader will enter a short position during a descending triangle in an attempt to profit from a falling market.
Descending triangles generally shift lower and break through the support because they are indicative of a market dominated by sellers, meaning that successively lower peaks are likely to be prevalent and unlikely to reverse.
Descending triangles can be identified from a horizontal line of support and a downward-sloping line of resistance. Eventually, the trend will break through the support and the downtrend will continue.
Explain the chart pattern
Bilateral Symmetrical Triangle
However, if there is no clear trend before the triangle pattern forms, the market could break out in either direction. This makes symmetrical triangles a bilateral pattern – meaning they are best used in volatile markets where there is no clear indication of which way an asset’s price might move. An example of a bilateral symmetrical triangle can be seen below.
Explain
What is a Candlestick?
A candlestick shows an asset’s price movement over a set amount of time. This can be anywhere from a minute to a day, depending on the price chart. They display four different price levels which an asset has reached in the specified time period: the lowest point in an asset’s price, the highest point, and the open and close prices.
Candlesticks are used in all forms of trading, including Forex.
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Color of the Candlestick
The color of a candlestick is used to indicate the way in which a market has previously moved or is currently moving. From the above example, you can see that the chart will be green if the close price is higher than the open price, and will be red if the close price is lower than the open price. As such, the color of a candlestick is a good indicator of whether a market was bullish or bearish during the given period.
When looking at a candlestick chart, the candlestick on the far left will be from the oldest trading period, and the one on the far right will represent the newest or current trading period. The current candlestick can be moving because the current price is used instead of the close price, meaning the candlestick’s color could shift from green to red or vice versa before the trading period is over.
Sometimes, you may find that the candlesticks on a graph are filled and not filled, rather than being green and red. An unfilled or white candlestick is the same as a green candlestick, and a filled or black candlestick is the same as a red candlestick.
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Wick of the Candlestick
The wick or ‘shadow’ of the candlestick shows the highest and lowest prices reached by an asset in the given time period. The top wick, also known as the upper shadow, is the highest price. The bottom wick, or lower shadow, is the lowest price.
A candlestick with a long upper wick and short lower wick shows that buyers were very active during a trading period. However, sellers soon forced prices to fall from their highs, causing the markets to close lower than the level which the upper wick reached. The weak closing price created the long upper shadow.
Conversely, a candlestick with a long lower wick and short upper wick shows us that sellers drove prices lower initially, but then buyers bought cheap and caused prices to recover, with the markets finishing strongly as evidenced by the long lower shadow.
The current candlestick will have dynamic wicks, moving in line with price increases and declines for the given time period.
Explain the candlestick pattern
Hammer candlesticks
One of the bullish candlestick patterns is known as the ‘hammer’ and is formed of a short body with a long lower wick. It is normally found at the end of a downward trend and can be a good indicator of future upward trends.
Explain the candlestick pattern
Doji candlesticks
Another candlestick pattern is the doji, which many believe indicates uncertainty from traders in the market. The doji is comprised of a short or non-existent body and wicks of varying length. Sometimes, a doji can resemble a cross, because a doji’s pattern often has similar open and close positions but varying session high and low positions.
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Candlesticks vs HLOC (OHLC) bar charts
Candlestick graphs are similar to high-low-open-close (HLOC) bar charts. They are both technical analysis indicators, and they both require a certain understanding before traders can use them and learn from them effectively. The main difference is that a HLOC chart lays out the information without the use of the ‘body’ of a candlestick.
Some traders prefer the simplistic nature of bar charts over candlesticks, while others prefer the aesthetic of candlesticks and say that they offer better clarity. They are both, more or less, the same thing. They both indicate market highs and lows, and the open and close prices for an asset in a particular time frame.
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How to use candlesticks when trading
The different parts of a candlestick pattern all tell you something. What they tell you is another question entirely. Sometimes, the shape, color and direction of a candlestick can seem random, but other times a number of candlesticks may form up to make a pattern.
Candlestick patterns are capable of revealing areas of support and resistance, and are also valuable to traders as a means through which they can confirm their predictions about market movements. However, it is worth mentioning that there is a lot that candlesticks cannot tell you. For instance, you can’t use candlesticks to tell you why the open and close are similar or different.
As such, candlestick patterns should be used in conjunction with other forms of technical and fundamental analysis to greater confirm a trader’s suspicions of an overall trend.
