TECHNICAL ANALYSIS — PART 3
CANDLESTICK ANATOMY
While in a bar chart the open and the close prices are shown by a tick on the left and the right sides of the bar respectively, however in a candlestick the open and close prices are displayed by a rectangular body.
In a candlestick chart, candles can be classified as a bullish or bearish candle usually represented by green/white and red/black candles respectively. If the closing is higher then the opening, it is known as a bullish candle and when the opening is higher then the closing, the candle is known as a bearish candle. Needless to say, the colours can be customised to any colour of your choice, the technical analysis software allows you to do this. Generally, the bullish candle is represented by Green colour and the bearish candle is represented by Red Colour.
Let us look at the candlestick. The candlestick, like a bar chart is made of 3 components.
The Central real body — The real body, rectangular in shape connects the opening and closing price.
Upper shadow — Connects the high point to the close.
Lower Shadow — Connects the low point to the open.
To sum up, candlesticks are easier to interpret in comparison to the bar chart. Candlesticks help you to quickly visualize the relationship between the open and close as well as the high and low price points.
So by now, you will be well versed with the history and definition of Technical Analysis, how it is different to Fundamentals, assumptions that goes into technical analysis and the different types of charts and its plotting on different time frames.
Now, let’s shift our focus on the different concepts in Technical Analysis followed by understanding of different candlesticks pattern, chart patterns and indicators. In this lecture will give you brief about the concepts and introduce you to different names of candlesticks, chart patterns and indicators.
CONCEPTS
Before we delve deeper into the analysis of chart, candlesticks and indicators, it is important to understand the concepts of Technical Analysis and how it influences the decision making. Here are the important concepts we should be aware of:
1) Support and resistance — A price level that may prompt a net increase of selling activity and buying activity.
2) Trend line (technical analysis) — A sloping line described by at least two peaks or two troughs.
3) Breakout (technical analysis) — The concept whereby prices forcefully penetrate an area of prior support or resistance, usually, but not always, accompanied by an increase in volume.
4) Market trend — The phenomenon by which price movement tends to persist in one direction for an extended period of time.
5) Dead cat bounce — The phenomenon whereby a spectacular decline in the price of a stock is immediately followed by a moderate and temporary rise before resuming its downward movement.
6) Elliott wave principle — The principle and the golden ratio to calculate successive price movements and retracements.
7) Fibonacci retracement — Used as a guide to determine support and resistance.
8) Pivot point — Derived by calculating the numerical average of a particular currency’s or stock’s high, low and closing prices.
9) Dow Theory — Dow Theory on stock price movement is a form of technical analysis that includes some aspects of sector rotation.
We will discuss all these concepts in great detail in the upcoming lectures.
CANDLESTICK PATTERNS
As candlesticks are used to identify trading patterns. Patterns, in turn, help the technical analyst to set up a trade.The patterns are formed by grouping two or more candles in a certain sequence. However, sometimes powerful trading signals can be identified by just a single candlestick pattern. Hence, candlesticks can be broken down into single and multiple candlestick pattern.
Under the single candlestick pattern, we will be learning the following…
1) Marubozu(Bullish & Bearish)
2) Doji(Dragon Fly, Gravestone, Long Legged)
3) Spinning Tops
4) Paper umbrella(Hammer, Hanging Man, Shooting Star)
Multiple candlestick patterns are a combination of multiple candles. Under the multiple candlestick patterns we will learn the following:
1) Engulfing pattern(Bullish, Bearish)
2) Harami (Bullish, Bearish)
3) Piercing Pattern
4) Dark cloud cover
5) Morning Star
6) Evening Star
Of course you must be wondering what these names mean. Some of the patterns retain the original Japanese name. Will discuss this in-depth in the upcoming lectures.
Candlestick patterns help the trader develop a complete point of view. Each pattern comes with an in-built risk mechanism. Candlesticks give an insight into both entry and stop loss price.
CHART PATTERNS
A chart pattern is a pattern that is formed within a chart when prices are graphed. In stock and commodity markets trading, chart pattern studies play a large role during technical analysis. When data is plotted there is usually a pattern which naturally occurs and repeats over a period of time. Chart patterns are used as either reversal or continuation signals.
Some people claim that by recognising chart patterns they are able to predict future stock prices and profit by this prediction, other people respond by quoting “past performance is no guarantee of future results.” and argue that chart patterns are merely illusions created by people’s subconscious.
Certain theories of economics hold that if there were a way to predict future stock prices and profit by it then when enough people used these techniques they would become ineffective and cease to be profitable.
On the other hand,if you can predict what other people will predict the market to do then that would be valuable information.
Examples of “classical” chart patterns include:
1) Head and shoulders
2) Trend lines
3) Cup and handle
4) Double top and double bottom
5) Triple top and triple bottom
6) Broadening top
7) Price channels
8) Wedge pattern
9) Triangle (technical analysis)
10)Flag and pennant patterns
11) Elite patterns
INDICATORS
If you look at a stock chart displayed on a trader’s trading terminal, you are most likely to see lines running all over the chart. These lines are called the ‘Technical Indicators’. A technical indicator helps a trader analyze the price movement of a security.
Indicators are independent trading systems introduced to the world by successful traders. Indicators are built on preset logic using which traders can supplement their technical study (candlesticks, volumes, S&R) to arrive at a trading decision. Indicators help in buying, selling, confirming trends, and sometimes predicting trends.
Indicators are of two types namely leading and lagging. A leading indicator leads the price, meaning it usually signals the occurrence of a reversal or a new trend in advance. While this sounds interesting, you should note, not all leading indicators are accurate. Leading indicators are notorious for giving false signals. Therefore, the trader should be highly alert while using leading indicators. In fact the efficiency of using leading indicators increases with trading experience.
Before we proceed further into understanding individual indicators, I think it is a good idea to understand the types of indicators. We have divided the indicators into Trend, Momentum, Volume and Volatility Indicators.
INDICATORS: Trend
1) Average Directional Index
2) Ichimoku Kinkō Hyō
3) MACD
4) Mass index
5) Moving average
6) Parabolic SAR
7) Trix (technical analysis)
8) Vortex Indicator
9) Oscillators
INDICATORS: Momentum
1) Relative Strength Index
2) Stochastic oscillator
3) Williams %R
INDICATORS: Volume
1) Volume (finance)
2) Accumulation/distribution index
3) Money Flow Index
4) On-balance volume
5) Volume Price Trend
6) Force Index
7) Negative volume index
8) Ease of movement
INDICATORS: Volatility
1) Average True Range
2) Bollinger Bands
3) Donchian channel
4) Standard deviation
Of course you must be wondering what these names mean. Don’t worry, for the time being it is good enough to know this names as will go in-depth about it at a later stage.
In the next lecture, will discuss all the concepts related to Technical Analysis mentioned here one by one in detail which will be followed by candlestick and chart pattern and eventually to the different indictors. For the ease of understanding, will take each series categorically as mentioned in this lecture.