A short guide to technical analysis

A quick guide to using technical analysis to trade

GLOSSARY OF FORMATIONS AND METHODS

Introduction

Technical analysis has been very widely used in the last 40 years to forecast future price changes in all kinds of markets. There have been long debates as to which one is more useful, fundamental or technical analysis (more on this in our article Fundamentals or Techs? A third view in Forex). Technical analysts are not interested in the cause of a fact but on the fact itself. Mass psychology is believed to be behind any big trend and in this case future changes of such a trend are the result of identical expectations. Hence, if one can quantify expectations he will be able to evaluate and even project these expectations to the future. A tremendous amount of research has been done in this field and besides economics, mathematics and statistics even psychology, sociology and architecture have been studied and applied in this respect. In the following paragraphs we will attempt only to list some of the traditional tools that have been developed in the field without elaborating in analysing each one of them as such an effort would demand hundreds of pages. We will keep to only a brief description in an attempt to assist the new or unsophisticated investor getting more familiar with all these terms. For the sake of an easier search we list these tools in alphabetical order We also keep tight to methods which are more widely applied in the Foreign Exchange market. In order to avoid repetitions we shall describe these tools referring always to an uptrend. It is understood that these also apply to a downtrend by substituting tops with bottoms.

Arcs. A vertical line is placed on an extreme price date in a chart and from the point of intersection with the horizontal axis semicircles are drawn at Fibonacci ratios in an attempt to define trending cycles.

Andrews pitch fork. A line is drawn connecting a major top with a major bottom and on this a vertical is drawn from an intermediate top which provides a middle trendline. From the two original points parallel lines to the trendline define an uptrend channel.

Detrend. An attempt to define cycles in a trend by drawing a moving average as a horizontal straight line and placing prices along the line according to their relation to the moving average.

Diamond. A consolidation formation usually signalling a major top. The tops and bottoms trendlines are initially diverging and then converging looking like a diamond.

Elliott Wave Theory. Very briefly, it is based on the harmony of Fibonacci numbers. A trend usually consists of 5 (sometimes 7) waves. Odd waves show the trend and even waves show the corrections. Ideally odd waves are equal or keep the 1.6 ratio. On the other hand, even waves (corrections) also keep a ratio with odd waves. Ideal levels of correction retracements are 38.2%, 50% and 61.8% of trend waves.

Fan lines. Once a support trendline is broken, a new one is drawn from the same origin and so on, hence the lines formation creates a fan. If the third trendline is broken this usually calls for a trend reversal.

Fibonacci numbers. A series of numbers in which each new number is the sum of the preceding ones. For example 3,5,8,13,21,34 and so on. Also the ratio of each one divided by its preceding one tends to 1.618 and the reverse ratio is 0.618.

Flag. Following a strong move prices correct for some time against the trend forming a channel with parallel lines connecting interim tops and bottoms.

Fourier analysis. An advanced mathematical method that tries to detrend a time-series of prices and define cycles.

Gann’s geometric angles. By drawing two support lines from the same origin and extending them an angle of x degrees is created. Then, this angle is divided into 8ths and correction levels of a trend are expected to reach support lines created by dividing the original angle into proportional sub-angles. In a theoretical right angle e.g. the 1×1 correction is a 45 degrees angle, the 1×2 is a 63 3/4 degrees and so on.

Head and shoulders. Often signalling a trend reversal, this pattern is formed by three tops with the middle one being the highest. Ideally the left and right tops are equal.

Island. A formation in which one single price is extremely isolated from the near by prices and looks out of pattern, It usually signals a trend reversal.

Linear regression. A statistical method where the effect of an independent variable (this is time in time-series) on a dependent variable (price) is measured by an equation that yields a constant coefficient that is the starting point and a slope coefficient that defines the slope of the regression line itself.

Momentum. It measures the rate of change of ascent or descent of a trend for a given period thus providing a measure of an overbought or an oversold situation. The price at the beginning of the period determines the position of the time line.

Moving average. The average value of a given variable for a defined period. For each new value added to the series the oldest value is subtracted so that always the total number of values is the same as defined by the selected period. If all the average values are connected they yield a moving average curve which follows prices in a trend by smoothing them out.

Oscillator. The most common one is the ratio of two moving averages. It is used mainly to measure the relative divergence of prices along a horizontal axis which is used as a basis. Hence, price divergence incorporates the time element and this way different levels are more easily comparable.

Rate of change. It measures the ratio of recent closing prices over an old price which stands at the beginning of the period under observation.

Relative Strength Index (RSI). A ratio line measuring The average of upmove closes against the downmove close over a given period. Its theoretical extreme values are 100 and zero, but it usually fluctuates between 75 and 25.

Saucer. A round top or bottom formation signalling a probable trend reversal.

Spike. A V-shaped formation signalling a probable trend reversal.

Stochastic. Based on that during uptrends the closes are closer to the top rather than the bottom of a range, it compares the most recent closes against the price range for a given period. The two usual lines are %K and %D.

Stop and Reverse parabolic. A parabolic curve following a trend, the breach of which by a daily range signals a change of direction of the trend, triggering an automatic reversal of an existing position in the market.

Support and resistance points. These are the major troughs and the peaks respectively of a given trend

Time zones. A vertical line is placed in a chart on an extreme price date and an attempt is made to define trending cycles by placing similar lines at Fibonacci ratios from the original line.

Trendline. In its simplest form it is a straight line connecting support or resistance points. In more advanced form it is a geometric curve. However, in statistical analysis the term is used for a line or curve that fits better in a group of scattered values i.e. the distance between values and the line is statistically the minimum possible. In this case it is a medium line and channel lines are parallel to it.

Trend reversal. The change of direction of a given trend. Sometimes it is confirmed by a day that provides a new high price but it closes below the closes of the previous two days. On weekly charts this is an even better confirmation.

Triangle. The formation in which a price range becomes more and more narrow with lower tops and higher bottoms. In a perfect triangle all tops can be connected by a straight line and the same is true for the bottoms. There are also ascending and descending triangles as opposed to the common symmetrical one.

Wedge. It resembles both a triangle and a flag but it has a slant.

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