Analisis Teknikal
What is trading?
To understand our role as traders better, we need to ask ourselves – what is trading really about?
The commonly used definition of trading is: a trader tries to make a profit by entering into trades or betting on price movements, by anticipating the future price trend as correctly as possible.
We will now examine the various components of this definition in more detail.
The profit potential
In trading, it is possible to bet on rising as well as on falling prices and thus to make a profit even if the stock market or another financial market falls. If the trader believes, based on the findings of his/her analysis, that the stock of Apple or the exchange rate between the EUR and the USD will appreciate, he/she can buy the shares or the corresponding currencies today and sell them at a higher price later to make a profit. And even if the trader assumes that prices will go down, he/she can take this into account in his/her trading plan and enter a so-called sell (short) trade with which he/she profits when prices on the underlying assets depreciate. Naturally there is always the risk that the price trend will not be as per the trader's expectations and hence he/she has to close the trade with a loss.
Figure 1: Left: EUR-UCD chart. A trader can make profits by betting on rising rates when the exchange rate rises. Right: UCD exchange rate. If a trader enters a sell trade at a right time, he/she can make profits when the rate drops.
Decision-making
To make buying or selling decisions, traders can use various methods and tools to analyse price movements in the price charts and stock prices. A distinction is made between the fundamental data trader, who makes trading decisions based on company or economic data, and the so- called technical trader, who only analyses share prices and focuses on specific patterns and price formations. It is difficult to generalise that a particular type of decision-making or analysis is superior to the other. Rather, it is important that the individual trader chooses the type of trading that suits him/her better. This book exclusively focuses on understanding and applying the concepts of technical analysis.
Short-term vs. long-term trading
The investment horizon is an important topic that fundamentally determines the type of trading. We normally distinguish between two groups: day trading and swing trading. In case of short-term trading, the trader opens and closes his/her individual trades within a few minutes or hours. Since the speculative period is usually limited to one day, these trades are called day trading. If the holding period of a position is a few days to weeks or even months, it is called swing trading. The application possibilities of these two trading types and the respective requirements for traders are fundamentally different. Day trading is often less suitable for employed people due to time constraints, since it is often necessary to keep an eye on price charts throughout the opening hours of the market. When the Frankfurt Stock Exchange opens at 9.00 AM, most people in Germany are probably at work and cannot follow the price movements actively. However, a German day trader could alternatively switch to other stock markets and actively trade on the American or Asian stock exchanges after his/her working hours.
Figure 2: Daily opening times of the most important international finance markets. Timey may change during DCT.
Most people find it far more practical to limit themselves to medium to longer-term swing trading since the time involvement can be considerably less. Swing trading is often the better solution for employed people, since they don’t have to sit in front of a PC for hours and the decision-making process is slower.
What is technical analysis?
Technical analysis is a concept that can be used to analyze the price movements of financial instruments with the objective of identifying profit opportunities. The benefits of technical analysis have been often discussed but it is also important to look at the criticism of this concept at this point to understand all the implications. Scientists,and especially the proponents of the efficient market hypothesis, compare technical analysis with pure speculation, whereby a reference to the popular dart-throwing monkey experiment is often made[1]. On the other hand, a report by Neely and Weller confirms that technical analysis might be superior to fundamental data analysis in the short-term investment horizon[2]. Y. Zhu and G. Zhou recognise that the momentum effect can be a potentially profitable technical strategy based on historical price patterns[3]. A study of over 2,000 Chinese stocks confirmed that the effectiveness of the analysis could be significantly improved with the support of technical tools[4]. Another study of the Russian stock market suggests that trading systems that use technical indicators might outperform a simple “buy-and-hold” strategy
Technical analysis and crowd psychology
Prices on the financial markets move, among other things, because millions of people and institutions interact on the international financial markets every day. Financial market players make buying and selling decisions that influence the pricing of financial instruments and cause upward and downward prices fluctuations.
Technical analysis is so effective because people always follow the same behavioural patterns and often make their trading decisions collectively based on similar emotions.
Most people will already know sayings like “greed is good” or “shares are bought based on expectations and not based on facts”. This indicates that the human psyche and general thinking patterns are an important part of developments on the financial markets. Whether we are looking at a speculator from China 200 years ago, a Wall Street pit trader from New York 80 years ago or a modern-day "Joe Bloggs Trader" – the human components, i.e. emotions and instincts, hardly differ. Greed, fear, uncertainty and the willingness to take risks have determined human actions for millennia and, of course, how people have manoeuvred their money around the world's markets for centuries. When we learn to read the buyer and seller interaction from the charts, we will be able to read and handle any price chart, on any market and for all times going forward.
Another important reason why technical analysis is so effective is because of the principle of the self-fulfilling prophecy. Since millions of people follow the concepts of technical analysis and make decisions based on them, they verify the fact that technical indicators and other concepts work simply because they are widespread. Even the financial media often refer to technical concepts such as past highs and lows, all-time highs and lows, psychologically important price levels and moving averages.
When we delve into the analysis of pricing structures and chart studies during this book, you will soon realise that technical trading is much more than it seems at first glance. We will develop an understanding that will enable us to put ourselves in the shoes of other traders and interpret the thought processes of financial market players, so that we can ultimately benefit from technical analysis through independent strategic thinking.
Most traders carry out technical analysis only at an extremely superficial level since the majority of the literature does not usually deal with the underlying mechanisms in-depth. Here, the criticism by the opponents of technical analysis would even be justified, because such an approach is not effective and trading cannot be reduced to surface level thinking. This book has the goal to explore technical analysis in a new and more effective way.
Figure 3: Whether we follow the UCD-CAD currency pair, the Porsche share price, the C&P 500 or gold, the same patterns are observable everywhere which indicates the importance of technical analysis. Principles of technical analysis are timeless.
Introduction to candlestick analysis
We will start with the fundamentals of technical analysis and then progress step by step to the advanced concepts so that, at the end of this book, we will be able to interpret and trade with any kind of chart.
Even those who have prior experience in trading should not skip the following section. It contains a different approach that is not often addressed in conventional technical analysis and it is a prerequisite for a successful price analysis.
Line charts
For most people, line charts usually provide the first impression of the world of financial markets because we see them frequently when we open the newspaper or turn on the television.
A line chart can describe the price development of a stock, a currency pair, a cryptocurrency, a commodity and any other financial value. The advantage of a line chart is that the information is highly compressed. One glance at the line chart tells you all that you want to know for a first elementary analysis.
If we see a rising line chart, it indicates a rally or a bull market (a bull thrusts its horns in the air). If the line chart shows a falling price, it indicates a bear market (the bear swipes his paws down).
The closing prices for a day are usually plotted and joined together in a line chart. Every day, we move one time unit to the right on the scale. This kind of chart is also called a daily chart.
The disadvantage of a line chart is that the price fluctuations within a day – or any chosen time period - cannot be recorded since the line chart shows only the closing prices. However, we all know that there can be strong price fluctuations in the financial markets and neglecting them can be a disadvantage for the precise technical analysis.
Figure 4: The market snapshot shows the USD and CAD exchange rate. The day period is selected on the left, the 4-hour period in the middle and the 1-hour period on the right. The deeper we go in the chart periods, the more details we can see.
Candlestick charts
Candlestick charts are further developed line charts that serve to compensate for the disadvantage of less information. Candlestick charts have their origin in 17th century Japan. Today, candlestick charts are the preferred tool of analysis for traders and most investors since they provide all the required information at a glance.
The candlestick
As the name suggests, a candlestick chart is made up of so-called (price) candlesticks. These candlesticks are made up of different components to describe the price movements of financial instruments.
Two sample candlesticks are shown in figure 5. A candlestick consists of a solid part, the body, and two thinner lines which are called candle wicks or candlestick shadows.
The candlesticks are color-coded to illustrate the direction of the price movements. A white candlestick represents rising prices, whereas a black candlestick shows that the price fell during the period.
Figure 5: A rising candlestick is shown on the left and a falling candlestick is shown on the right along with the explanations of terms used for individual candlestick components
The length of the shadows shows how much the price has moved up and down with respect to a candlestick within a specific duration. If we set our charts so that one candlestick corresponds to one day, then we can read the daily fluctuations in the financial market using the shadows of a candlestick.
The candlestick body describes the difference between the opening and closing prices for the corresponding time period.
The body of the white, rising candlestick in figure 6 shows that the price opened at $10 and closed at $20 in the selected time interval, but has fluctuated between $25 and $5 in the meantime, as indicated by the shadows.
Figure 6: The trend of candlesticks from the opening price to the closing price is described by the candlestick body. The shadows show the entire fluctuation width.
If we line up several candlesticks, we can reproduce the progression of line charts by following the candlestick bodies as shown in figure 7. The candle shadows also show the severity of price fluctuations in each case. We, thus, get all the information that is essential for an effective price
analysis at a glance. This is why candlestick charts are mostly used for technical analysis these days.
Figure 7: If you follow the path of the candlestick prices, you can reconstruct the line charts.Candlesticks offer more information and are the preferred medium for technical analysts.
The following chapters show how to interpret this information usefully to make actual trading decisions. Anyone who knows how to analyse and interpret the so-called candlestick patterns or candle formations, already understands the actions of the financial market players a little better.
Basics of candlesticks
Candlesticks can be divided into four elements, where each element reveals a different aspect of the current trading behaviour and the prevailing market sentiment.
Intro: The strength ratio – bulls vs. bears
To understand the price and candlestick analysis, it helps if you imagine the price movements in financial markets as a battle between the buyers and the sellers. Buyers speculate that prices will increase and drive the price up through their trades and/or their buying interest. Sellers bet on falling prices and push the price down with their selling interest.
If one side is stronger than the other, the financial markets will see the following trends emerging:
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If there are more buyers than sellers, or more buying interest than selling interest, the buyers do not have anyone they can buy from. The prices then increase until the price becomes so high that the sellers once again find it attractive to get involved. At the same time, the price is eventually too high for the buyers to keep buying.
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However, if there are more sellers than buyers, prices will fall until a balance is restored and more buyers enter the market.
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The greater the imbalance between these two market players, the faster the movement of the market in one direction. However, if there is only a slight overhang, prices tend to change more slowly.
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When the buying and selling interests are in equilibrium, there is no reason for the price to change. Both parties are satisfied with the current price and there is a market balance.
It is always important to keep this in mind because any price analysis aims at comparing the strength ratio of the two sides to evaluate which market players are stronger and in which direction the price is, therefore, more likely to move.
Element 1: Size of the candlestick body
The size of the candlestick body shows the difference between the opening and closing price and it tells us a lot about the strength of buyers or sellers.
Below, the most important characteristics of the analysis of the candlestick body are listed.
A long candlestick body, that leads to quickly rising prices, indicates more buying interest and a strong price move.
If the size of the candlestick bodies increases over a period, then the price trend accelerates and a trend is intensified.
When the size of the bodies shrinks, this can mean that a prevailing trend comes to an end, owing to an increasingly balanced strength ratio between the buyers and the sellers.
Candlestick bodies that remain constant confirm a stable trend.
If the market suddenly shifts from long rising candlesticks to long falling candlesticks, it indicates a sudden change in trend and highlights strong market forces.
Figure 8: Left: Long candlestick bodies during the downward and upward trend phases. Cideways phases are usually characterized by smaller bodies. Right: Rising candlesticks are stronger in the upward trend. At the peak, the ratio tilts and a sideways phase is characterized by smaller candlesticks.
Element 2: Length of candlestick shadows
The length of shadows helps in determining the volatility, i.e. the entire range of price fluctuations.
Characteristics of candlestick-shadow analysis:
- Long shadows can be a sign of uncertainty because it means that the buyers and sellers are strongly competing, but neither side has been able to gain the upper hand so far.
- Short shadows indicate a stable market with little instability. We can often see that the length of the candlestick shadows increases after long trend phases. Increasing fluctuation indicates that the battle between buyers and sellers is intensifying and the strength ratio is no longer as one-sided as it was during the trend.
- Healthy trends, which move quickly in one direction, usually show candlesticks with only small shadows since one side of the market players dominates the proceedings.
Element 3: Body to shadow ratio
For a better understanding of price movements and market behaviour, the first two elements must be correlated in the third element.
Important factors in this context are:
- During a strong trend, the candlestick bodies are often significantly longer than the shadows. The stronger the trend, the faster the price pushes in the trend direction. During a strong upward trend, the candlesticks usually close near the high of the candlestick body and, thus, do not leave a candlestick shadow or have only a small shadow.
- When the trend slows down, the ratio changes and the shadows become longer in comparison to the candlestick bodies.
- Sideways phases and turning points are usually characterised by candlesticks that have a long shadow and only short bodies. This means that there is a relative balance between the buyers and the sellers and there is uncertainty about the direction of the next price movement.
Figure 9: There are almost no shadows during the left rising phase, confirming the strong trend. Cuddenly long candlestick shadows are visible in the sideways phase; these indicate uncertainty and an intensified battle between the buyers and the sellers. When candlestick shadows increase, it can foreshadow the end of a trend.
Element 4: Position of the body
As far as the position of the candlestick body is concerned, we can distinguish between two scenarios in most cases:
If you see only one dominant shadow which sticks out on one side and the candlestick body is on the opposite side, then this scenario is referred to as rejection, a hammer or a pinbar. The third and the seventh example in figure 10 show such candlesticks. The shadow indicates that although
the price has tried to move in a certain direction, the opposition of market players has strongly pushed the price in the other direction. This is an important behaviour pattern which we will analyse in detail later.
Another typical scenario shows a candlestick with two equally long shadows on both sides and a relatively small body. The fifth candlestick in figure 10 shows such an indecision candlestick. On one hand, this pattern can indicate uncertainty, but it can also highlight a balance between the market players. The buyers have tried to move the price up, while the sellers have pushed the price down. However, the price has ultimately returned to the starting point.
Figure 10: From left to right: The size of the candlestick body describes the strength of the price movement. The longer the body, the stronger the impulse. If the candlestick shadows are longer, there is a balance between the sellers and the buyers and the indecision increases.
Mastering candlestick patterns
If you open any trading book about candlestick analysis or do a Google search for candlestick patterns, you will immediately get dozens of different patterns. Conventional technical analysis suggests that a trader should learn all these different patterns and respective meanings to spot them on the price charts during actual trading.
In my opinion, mindless memorisation is not required and it is also not effective since all candlesticks can consist of only the four aforementioned elements. Another risk of pure memorisation is that a trader loses the big picture. Template-thinking should be avoided in trading. Once a trader understands how to interpret the price information in the right context, he/she can immediately understand and trade with any price chart. In addition, the trader is not only restricted to the candlestick patterns learned, but can interpret and correctly classify every possible scenario.
In the technical analysis, we normally differentiate between single candle and multiple candle patterns. As the name suggests, in the single candlestick analysis only a single candlestick is examined for specific characteristics to interpret the prevailing market mood. In the multiple candlestick analysis, up to three consecutive candlesticks are analysed. The most important patterns and the options for their interpretation are illustrated in the next chapter using the four elements from the previous section. The goal is to discard template-thinking to be able to anticipate each scenario correctly.
The most important single candle patterns
Pinbar
The pinbar is probably the most well-known candlestick pattern. A pinbar has only one long shadow, which sticks out to one side. The body of a pinbar is at the opposite end of the shadow. It is not so important whether the candlestick has a large or small body as long as price does not leave a second shadow.
A pinbar after a long uptrend often signifies an imminent sell-off. It is, therefore, also listed under the trend reversal candlesticks because it indicates that an existing trend is coming to an end. If you see a pinbar with a long upstanding shadow, like in figure 11, in an upward trend, it means that although the buyers have tried to push the price up, the interest to sell has suddenly increased and the sellers have reversed the price direction. The body of a candlestick like this should therefore close at the lower end to signal that the sellers have pushed the price below the opening price and the reverse signal has thus been strengthened downwards.
Figure 11: The elements of a pinbar candlestick include a long shadow and one comparatively smaller body. The pinbar shows a price reversal and/or a rejection. After an uptrend, such a pinbar could foreshadow a potential downward trend.
The Hanging Man
The Hanging Man is also one of the trend reversal candlesticks, but it differs from the Pinbar as far as the characteristics and interpretation are concerned.
In an upward trend, a candlestick with a long downward shadow, like in figure 12, means that interest in selling has suddenly increased and sellers have managed to move the price down sharply. This should prick up buyers’ ears, because the price usually moves upwards in a straight line during a healthy upward trend since buying interest absorbs all sellers. The body of the Hanging Man is often relatively small and there is little difference between the opening and closing prices. The Hanging Man can have a small second shadow, which is usually not pronounced. Its main feature is the long shadow against the prevailing trend direction, which shows the newly developed interest of the opposition.
If the buyers withdraw completely, the price can often easily start a new downward trend, because the Hanging Man has already indicated that the sellers have taken their positions.
Figure 12: The Hanging Man indicates that the strength ratio moves slowly. After an uptrend phase, the downward shadow confirms that more sellers are entering the market.
Marubozu
The interpretation of the Marubozu candlestick is clear because the Marubozu candle consists only of a long candlestick body without any
shadows. The Marubozu candlestick is also known as an impulse, momentum or trend continuation candlestick because it indicates that the candle has only moved in one direction from the opening time to the closing time. The longer the Marubozu candlestick is, compared to the previous candlesticks, the stronger the trend signal. A trader can then expect the prevailing trend to continue. During an upward trend, the Marubozu candlestick shows that there is no selling interest and that the buyers can easily drive the price up.
Figure 13: The Marubozu candlestick consists only of a candlestick body and is a strong impulse candle.
The Doji
The Doji is a well-known candlestick pattern, but with a little informative value on its own. The Doji is a neutral candlestick, which consists of two shadows of equal length and only a small body. The two shadows indicate that the buyers as well as the sellers have tried to steer the price in a particular direction, but there was no overweight and the price has eventually returned to the opening price. The Doji thus indicates a temporary pause and indecision by the market players.
If a Doji occurs during a trend phase, it usually has no significance and everything depends on the candlestick that follows as we will see in the following multi-candlestick analysis section.
Figure 14: The Doji candlestick indicates a temporary pause and the equilibrium between the buyers and the sellers.
Multiple candles pattern
Multiple candles patterns are based on the aforementioned four candlestick elements and they are also made of the described single candles from the previous pages. We simply need to follow the price path and then analyse it in the context that we have learnt until now.
Multiple candles patterns have a greater predictive power than single candles, because the simultaneous analysis of multiple candles can make use of double or triple information content. Caginalp and Laurent have shown in their research that certain multiple candles patterns, such as the Three White Soldiers or the Three Black Crows, might have significant short-term predictive power. They confirmed that these patterns could enable correct predictions of up to 75%. [6]
The most well-known multiple candles patterns are presented in this chapter.
The Engulfing candlestick
The Engulfing formation consists of two successive candlesticks, wherein the second candlestick is significantly larger than the first and engulfs it completely.
The second candlestick often resembles the Marubozu candlestick, which consists only of a long body without a shadow.
If the candlesticks initially become smaller during a downward trend, they indicate that the sellers are slowly withdrawing from the market. The following engulfing candlestick then signals that the strength ratio suddenly reverses and more buyers enter the market so rapidly that they explosively reverse the trend direction within a single candlestick. In this context, the Engulfing formation is a reversal signal: the price then has a higher probability of moving further in the direction of the Engulfing candlestick since the strength ratio has shifted on one side.
Figure 15: The Engulfing candlestick is an effective multiple candles pattern that describes the sudden and strong change in direction.
Three Black Crows (3BC)/Three White Soldiers (3WS)
The 3BC formation is a signal for the trend continuation. It shows how the sellers are pushing buyers out of the market. Figure 16 shows that the 3BC formation consists of three consecutive downwards candlesticks,
where each candle starts at a higher opening value than the previous closing value. This is a typical scenario in the stock market, where price gaps/jumps between the closing price of one day and the opening price of the next day are often observed. These upward jumps indicate that the buyers are still trying to push the price upwards, but the sellers are again gaining the upper hand during the candlestick period. Individual candlesticks in the 3BC formation often resemble the Marubozu candlesticks and signal a strong downward impulse. If the buyers finally give up and if prices no longer jump upward, you can often observe a strong downward movement after the 3BC formation when only the sellers remain in the market.
Figure 16: If you notice the 3 Black Crows, they often lead to a strong impulse movement as soon as the buyers withdraw from the market.
Three Inside Up (3IU)
The 3IU formation is another important formation with high information content. The second candlestick of this formation is a small candlestick, which is completely engulfed by the previous one, hence the term inside. This means that the price movement is slowing down.
The third candlestick is a strong impulse candlestick, which is similar to the Marubozu candlestick, with a long candlestick body. It ultimately confirms that the sellers have been completely pushed out of the market and that the market is now dominated by buyers.
The 3IU formation is a good example of how we can combine what we have learnt so far to analyse candlestick sequences effectively: If the candlesticks become smaller, they indicate that a trend is slowing down. Long shadows also signal a rejection and the strong impulse candlestick in the opposite direction of long shadows confirms the final change of direction.
Figure 17: The inside-up candlestick is an effective reversal signal and it indicates the shifting strength ratio.
Evening Star/Abandoned Baby
There are various multiple candles patterns that are based on the Doji candlestick. However, their meaning is often similar, and considering only the most important Doji formation suffices in developing a general understanding of this pattern.
As already mentioned, a Doji is a neutral candlestick and only indicates a temporary pause in the price movement and equilibrium between the buyers and the sellers. But if a single Doji becomes part of a multiple candles pattern, we as traders can see interesting formations on our charts.
The Evening Star is a formation in which a Doji follows an upward trend candlestick. The Doji initially indicates only a temporary pause in the upward trend and has no significance on its own. However, if the Doji is
followed by a strong Marubozu candlestick in the opposite trend direction, this often signals a complete trend reversal.
Figure 18: The Evening Ctar is a pattern based on the Doji candlestick. In this case, the Doji signals the market high during a trend phase and it is followed by a strong impulse into the opposite direction.
The Evening Star information, thus, describes the slowly reversing strength ratio in a trend movement. The Doji marks a turning point at which the price is too high for the buyers to continue buying, but is high enough for sellers to enter the market. The forces of buying and selling interests neutralise each other at the top of the Doji and then start their new trend movement when the sellers enter the market.
The element of “context”
Candlesticks independently offer a good starting point for analysing the prevailing strength ratios between the buyers and the sellers and for identifying possible trend reversal or trend continuation signals.
In my opinion, an effective analysis of candlesticks is, however, not sufficient to become a successful trader in the long run since it only provides an extremely limited cross-section of charts and neglects important chart context.
Based on what we have learnt until now, important concepts such as trend and momentum analyses will be explained below so that even the long-term chart cross-sections can be interpreted correctly.
Candlestick cheat sheets
All graphics have been comprehensibly compiled on www.tradeciety.com/candlesticks/. These can be printed and used in your own trading.
Figure 19: This cheat sheet and other information are available to readers. Use the link to get all details.
Chart anatomy
The next step in understanding technical charts is to explore the different chart formations. Classical chart formations can include dozens of candlesticks and, thus, carry even more information content.
Figure 20 illustrates how an engulfing candlestick formation on the Daily time frame (left) looks like a multi-candle Head-and-shoulder formation on the 1-H time frame (right). We will cover the Head & Shoulder formation in the next sections.
Owing to the larger context and extended information contents, the analysis of broad chart patterns is, therefore, informative for effective technical analysis. The aim of this chapter is to enable attentive readers to correctly interpret any chart in practice and to significantly exceed the analytical ability of most traders.
Figure 20: We can see the daily chart on far left; the marked area in this chart represents an Engulfing candlestick. The 4-hour chart can be seen in the middle and it already contains more information. The Head-and-shoulders formation can be seen at the far right in this pattern on the 1- Hour chart. The more we zoom-in, the more information is visible.
Chart phases
At any given time, the price can either rise, fall, or move sideways. This may sound simple, but as we have already seen during the candlestick analysis, we can quickly acquire comprehensive knowledge when we break down complex facts into its single components.
Figure 21 shows that each chart comprises the following five phases:
Trends
If the price rises over a period, it is called a rally, a bull market or just an upward trend. If the price falls continuously, it is called a bear market, a sell-off or a downward trend.
Different trends can have varied degrees of intensity. In the next section, we will learn the individual facets of trend analysis.
Corrections
Corrections are short price movements against the prevailing trend direction. During an upward trend, corrections are short-term phases in which the price falls. As we will see, the price does not always move in a straight line in one direction during trend phases, but constantly moves up and down in so-called price waves.
Consolidations
Consolidations are sideways phases. During a sideways phase, the price moves sideways in a usually clearly defined price corridor and there are no impulses to start a trend.
Breakouts
The buyers and the sellers are in equilibrium during a sideways phase. If the strength ratio between the buyers and the sellers changes during consolidations and one side of the market players wins the majority, a breakout occurs from such a sideways phase. The price then starts a new trend. Breakouts are, therefore, a link between consolidations and new trends.
Trend reversal
If a correction continues for a long time and if its intensity increases, a correction can also lead to a complete trend reversal and initiate a new trend. Like breakouts, trend reversal scenarios, thus, signal a transition in prices from one market phase to the next.
Figure 21: A classic example of the division of a complete price chart into the individual chart phases. This procedure is helpful for using the following concepts of technical analysis in the correct context.
Application and chart analyses
The price charts in figures 21 and 22 show the different price phases. During the long-term trends, short correction phases, or consolidations, can be seen time and again. If a consolidation continues for a long time, it shows that the buyers and the sellers are in equilibrium and that the previous trend is coming to an end. If a breakout occurs, a new trend starts and the same pattern repeats.
The chart phases can be universally observed since they represent the battle between the buyers and the sellers. This concept is timeless and it describes the mechanism that causes all price movements. The trend phase pushes the price upwards, indicating the buyer overhang. The consolidations mark temporary trend pauses; however, a trend is continued until the price does not reach a new high during an upward trend. Corrections show the short-term increase of the opposition. If these are fended off, the trend continues its movement. On the other hand, long correction phases eventually develop into new trends when the strength ratio shifts completely.
Figure 22: This chart cross-section shows the slow change from a buyer's market to a seller's market. The individual chart phases are clearly defined and each phase is driven by the so-called price waves.
Although the sequence and strength of individual chart phases can vary greatly, any chart contains only these phases. If we understand them comprehensively, price analysis becomes relatively simple.
Chart components
Similar to the candlestick analysis, it is also helpful to break down chart patterns into their individual components to understand complex facts more easily.
A closer look at the chart phases reveals that each phase can be characterised by only two features – price waves and swing points. In the following sections, price waves and swing waves are explained and analysed in the chart context.
Introduction to price waves
Price waves are the most important components available to technical traders, because every chart phase and every chart pattern can be clearly described using only price waves.
As already mentioned, the price on the charts usually does not move in a straight line from point A to point B, but always in an up and down fashion. These individual upward and downward movements represent the so-called price waves.
Figure 23: During the primary upward trend, correction waves in the opposite direction can be repeatedly observed. At the beginning, these are still short and not deep. If they become longer and deeper, e.g. at the right edge, this indicates that the buyers have lost their majority.
As already seen with the candlestick analysis, imaging all chart movements as a fight between the sellers and the buyers also helps in understanding the price waves.
In an upward trend, the upward price waves are steeper and longer than the downward correction price waves, because this is the only way for the price to move upwards. Buyers are therefore pushing up the price faster than the ability of sellers to resist this during the correction waves. The faster the price can rise during an uptrend, the greater the imbalance
between buying and selling interest. The smaller the correction waves, compared to the trend waves, the stronger the trend is as well.
Figure 24: A strong trend has long trend waves and short correction waves and, thus, rises faster. A weak trend has a more balanced relationship between the trend waves and correction waves and, thus, rises flower.
In case of a trend reversal, like in figure 25, a shifting ratio between the upward and downward waves can be observed. If a chart changes from an upward trend to a downward trend, this means that the downward trend waves are more dominant now and the sellers have absorbed all the buying interest. A trend reversal is often preceded by longer correction waves that turn into new trend waves into the opposite direction. This indicates that the strength ratio has shifted.
Figure 25: In case of a trend reversal, the correction wave becomes so long that they form new trend waves in the opposite direction.
During a sideways market, like in figure 26, the upward and downward price waves are equally strong and, hence, they neutralise each other. The buyers and the sellers are in equilibrium. The breakout then indicates that one side of the market participants has taken the initiative and is starting a new trend by absorbing all the interest. The breakout happens when the bullish trend waves, like in the example below, become longer and break the upper boundaries of a sideways market.
Figure 26: During the sideways phase, the upward and downward price waves are equally long. If a breakout occurs, new trend waves, which herald the upward trend, are formed.
Definition of swing points
The end points of price waves are also called swing points. Swing points offer us good supplementary aid for our chart analysis. If an upward trend wave comes to a temporary stop, for example if it is followed by a correction wave, then this is called a (swing) high. Likewise, the end point of a downward movement is also called the (swing) low.
Figure 27: The sequence and characteristics of highs and lows describe trend and sideways phases in the technical analysis. We can interpret any chart situation using them. HH stands for a higher high, HL is a higher low. Used in a downward trend
According to the classic trend definition, an upward trend can occur only if the price waves form higher highs and higher lows. A strong uptrend is characterized by rapidly rising swing highs and shallow swing lows.
Although this insight appears simple at first glance, it is the fundamental premise of technical analysis and even the Dow theory, developed around 1900, is based on this type of price analysis. The fact that it is still used today proves the timeless and universal principles of trend analysis.
Figure 28 shows the classic definition of trend movements using high and lows. During an upward trend on the left, the upward waves are longer and form correspondingly higher highs (1, 3, 5). The correction waves are
shallow and the respective lows (2, 4) are trending higher as well, confirming that the buying interest is predominant and absorbing all the selling interest earlier each time.
Figure 28: Classic Dow Theory defines an uptrend by higher highs and higher lows (right). A downtrend consists of lower lows and lower highs.
A trend reversal can be effectively described by using of highs and lows as shown in figure 29. If the price suddenly reaches a new lower low (6) and forms a lower high (5) during an upward trend, then the upward trend is broken according to the trend definition. A new downward trend can then emerge, because the sellers now have the upper hand and the downward trend waves are steeper and longer. The continuation of the upward trend has failed because it would have required a breakout above point 3.
Figure 29: The trend reversal is confirmed if the price fails to reach a new high after point 5 and, at point 6, even sets a new low below 3.
Figure 30 shows a wheat price chart. The price starts in an upward trend on the left. Although some of the correction waves are pronounced, we do not see a break of a single (swing) low. The first break of a low occurs after the price at the peak has already formed lower highs and hinted declining buyer interest even before the actual break, marked with an X.
Figure 30: We can now effectively link price wave analysis to high and lows to understand any chart. Price waves and swing points are the building blocks of any chart and they build the foundation for all technical analysis.
Advanced wave analysis
Now, we are going even more granular. After seeing that any chart can only be made up of the various chart phases, which are made up of price waves themselves, we will explore the four different elements of wave analysis. Those conclude our foundational work. Every following chart formation, and any chart in general, can then be explained and understood with the previously learned building blocks.
Wave length
The length of the individual trend waves is the most important factor for assessing the strength of a price movement.
During an upward trend, long rising trend waves that are not interrupted by correction waves show that buyers have the majority. On the other hand, smaller trend waves or slowing trend waves show that a trend is not strong or is losing its strength. Figure 31 shows that the trending phases are clearly described by long price waves into the underlying trend direction.
Figure 31: Left: Long trend waves confirm the high trend strength. The trend comes to a standstill as soon as the waves shorten. Right: The downward trend is characterised by long falling trend waves. However, the length decreases downwards and the trend reverses shortly thereafter.
Angle / steepness
The rate with which the price rises during a trend is also of great importance. In general terms, moderate trends have a longer life span and a sudden increase in price usually indicates a less sustainable trend. We can often observe this phenomenon during so-called (price) bubbles, wherein the price falls again just as quickly after an explosive rise.
The development of the steepness of trends and price waves, compared to the overall chart context, is also important: Accelerating or weakening price waves might show that a trend is picking up speed or is slowly coming to a standstill.
Interesting correlations can be made together with the concept of length: A trend is intact if we find long trend waves or trend waves that become longer with a moderate or increasing angle. On the other hand, a trend with trend waves that become increasingly shorter, and which is simultaneously losing its steepness, indicates a possible imminent end. Figure 32 shows such a situation where the length and the steepness changed during the uptrend. The complete reversal soon followed.
Figure 32: The angle of the trend waves describes the strength of a trend. Decreasing angles and longer correction waves at the peak indicate the downward trend in advance.
Impulse vs. correction
If we add the ratio between the trend waves that move in the prevailing trend direction, the so-called impulsive waves, and correction waves as a third element to length and angle, we can understand almost every chart.
A trend with long trend waves and only short correction waves shows a greater imbalance between the buyers and the sellers. An upward trend with small correction waves signals that buying interest strongly outweighs selling interest and that the sellers have no great interest in current price developments or that the buyers immediately absorb all sellers.
A trend with longer correction waves which run deeper against the prevailing trend direction shows a different picture. Deep downward correction waves during an upward trend suggest that the sellers are active
in the market and can move the price sharply in the meantime. This suggests that the strength ratio between the buyers and the sellers is more balanced. A trend like this is easier to turn, if the sellers become just a little stronger or the buyers withdraw a little. Thus, it always stands on the brink. The previous chart setup in figure 32 demonstrates how the downward trend was foreshadowed by an increase in size of the correction waves.
Swing structure
The swing structure refers to the formation of highs and lows. The interpretation is similar to the one of price waves.
For example, an intact upward trend usually manages effortlessly to set new highs. If the price has problems breaking through previous highs or does not manage to exceed the last ones, this may be a signal indicating that the trend will soon come to a standstill. Traders should be particularly watchful if the price immediately reverses after a breaking through a high and cannot continue to move in the trend direction. Such a trend weakness and it can often be a sign of exhaustion.
A complete break of a swing structure is often a clear sign indicating that the current trend is over. If the price does not break through the previous high and if the price falls even below the previous low, the upward trend is over. As soon as the price reaches a new low during an upward trend, the prevailing trend is over. In figure 33 the price first made a lower low during the uptrend (first X). This is already a strong bearish signal. Shortly after, the price also failed to make a new higher high (second X) and the complete trend reversal followed.
Figure 33: As already mentioned, trends and trend waves can be effectively analysed using high and lows. The points marked with X indicate the reversal of the highs and lows. First the price forms a new low (LL – lower low) and then the price does not manage to set a new high (LH – lower high).
We set up the URL www.tradeciety.com/waves/ which contains additional chart analyses and all cheat sheets from this chapter.
The most important chart patterns
Although I have said it many times during this book, it is worth repeating because it demonstrates the optimal approach for understanding technical analysis: not only do mindless memorisation and stereotyped template-thinking make little sense, but it also prevents traders from understanding the overall context. This kind of trading is restricted to only a few situations. Furthermore, traders like this, who learn by rote, are completely lost when they suddenly realise that the financial markets do not always follow their textbook formations and they lack the knowledge to deal with these unknown situations.
The following sections describe how to understand classical chart patterns based on the analysis tools that you have already learnt and how to apply the knowledge of elements like price waves, trends and price analyses to any other chart.
The Head-and-shoulders (HAS) formation
The Head-and-shoulders formation is an ideal introduction since what it communicates about the market activity and the balance between the buyers and the sellers is immediately clear, even without prior charting knowledge. A Head-and-shoulders formation (HAS) is best sought during an established trend since it usually indicates a trend reversal scenario. The price waves at the left shoulder, and then at the head, confirm the conventional trend structure since they form higher highs. The right shoulder is the first lower high point and it indicates that buyers are no longer as strongly represented in the market.
If you connect the lows of the correction waves, you will get the so- called neckline. A break of this neckline after the right shoulder confirms that the price is now at a first lower low point and, thus, signals the end of the upward trend. The HAS formation rings in the new downward trend with the break of the neckline. Figure 34 illustrates the shift in the trend structure with a clear HAS formation.
It is important to wait for a confirmed breakout to avoid false signals. It can be often observed that the neckline is tested several times and rejections occur repeatedly at this neckline. The battle between the buyers and the sellers is intense at these points and many traders use such price levels to execute trades or place their trading orders.
I use different variations of the HAS formation and we will explore a few now. It is the cornerstone of one of my own trading strategies.
Figure 34: A classic Head-and-shoulders pattern at the end of an upward trend rings in the downward trend with the break of the neckline when price makes a first lower low.
Variations of the HAS formation
To move away from stereotyped thinking even further, it’s worth considering a few variations of the HAS formation and thereby also the variations of the trend analysis.
Small heads and weak shoulders
If a deep correction wave follows the left shoulder before the price forms the head, it may already be an indication that there is increasing interest in selling and that the buyers are no longer dominant. The deeper the correction waves during an established trend, the stronger is the opposition. The impulse wave to the head in figure 35 below is short and also indicates that the buyers are not absolutely dominant anymore.
When the peak point of the right shoulder is formed far below the head, like in the chart scenario below, this further confirms that the buyers can no longer move the price up.
Figure 35: The move up into the head is short. The right shoulder is barely developed and further indicates that there is little interest in buying. The sell-off was foreshadowed by those characteristics.
Figure 36 shows that the distance between the peak of the left shoulder and the head is relatively small. This indicates that the majority of the buyers has moved away from the market and the price can no longer rise as easily as before.
Figure 36: The last price wave towards the head is very small and hardly manages to form a new high. The subsequent break of the neckline follows with a lot of momentum, since the market has no buyers any longer.
Break of the neckline and the retest
The break of the neckline is usually the entry signal for most traders, because it completes the HAS formation. The break confirms that the price makes a lower high at the right shoulder and it forms the first lower low as well. Those two points signal a trend change based on the Dow Theory as well.
The stronger the break and the more impulsive the price wave that breaks through the neckline, the higher the probability that the new downward trend will continue.
An alternative entry signal is given when the price moves back to the neckline from below and conducts a so-called retest. If the trend structure remains intact and the price does not manage to move above this point, the HAS formation can indicate the second entry point. This retest shows that
the buyers have once again tried to increase the price, but ultimately did not have the power to achieve this. The sellers defended the high and took the opportunity to get into the market at an even better price one last time. Subsequently, a rapid drop in price can often be observed when buyers completely withdraw from the market.
Figure 37: The retest of the neckline is a frequently observed pattern that can provide an additional trade signal.
Inverse HAS formations
The inverse HAS formation is the counterpart of the regular HAS formation and can be observed during a downward trend. The idea is the same: After a downward trend with lower lows that form the left shoulder and the head, the right shoulder is the first higher low that indicates a slowly changing buyer-seller ratio. If the subsequent price wave then also breaks the neckline upwards, it confirms the start of a new bullish trend.
The variations and the retest principles are similar to those of the regular HAS formation.
Figure 38: The inverse Head-and-shoulders formation is observed at the end of a downward trend. The new upward trend starts after breaking the neckline. Here we can also see a retest of the neckline as well.
Cup and Handle
The “Cup and Handle" (CAH) formation describes the slowly reversing market sentiment effectively as well.
The CAH formation is often preceded by an upward trend. The uptrend then flattens and the price even falls when it forms the left half of the cup. However, the downward trend is not pronounced and the right half of the cup shows the initiation of another uptrend phase once again. The rounded- off pattern can arise only when the price gradually moves from the lower highs and lows to the higher highs and lows. You can clearly see the slow change of trend direction during the cup in figure 39.
When the price returns to the previous high, which formed the left edge of the cup, there is usually no direct breakout; instead, the price drops again for a short time and the cup handle is formed. However, the handle indicates only a brief correction phase and the buyers return quickly to push the price upwards.
The averted downward trend of the cup already indicates that the buyers are slowly gaining the majority. The final signal with the CAH formation is given when the price breaks the handle to the upside.
The CAH formation is, thus, classified as a trend continuation formation since the previous upward trend is only briefly interrupted during the cup phase and the sellers' attempt to reverse the trend is fended off.
Figure 39: The Cup and Handle formation is a breakout or trend continuation formation. The handle indicates that the buyers immediately push the price back to the same high and the breakout then indicates the trend continuation.
Ascending triangle
The ascending triangle is also a trend continuation formation. During an upward trend, it indicates a temporary consolidation before the price continues the trend.
This formation has two important characteristics which indicate that the buyers still have the majority. Firstly, the price always manages to return to the same high, which means that the sellers do not have great interest in catching up with the price earlier. Secondly – and this point is the most important part of the ascending triangle – the lows show an upward trend,
i.e. the buyers push up the price earlier with each downward movement and the sellers cannot raise enough interest to form a new lower low. The two chart studies in figure 40 show how the ascending triangle looks on an actual price chart.
If the sellers finally withdraw from the market, there will be an upward breakout and the upward trend will continue at a higher high. The breakout point, or when the price closes outside the triangle, is the entry signal for most traders.
The focus should be on the angles of the trend lines (the diagonal price lines), because if we can interpret these correctly, we can also read numerous other chart situations. The way the price moves to a high or a low says a lot about the prevailing ratio between the buyers and the sellers.
Figure 40: The ascending triangle is a trend continuation signal and it shows that the price is repeatedly pushing into the same highs. The lows are already rising and indicate increasing buyer interest.
Wedges
Although the wedges are similar to triangles, they are not like the consolidation patterns. Wedges are normally trend reversal formations, i.e. a wedge often indicates the end of a dominant trend.
Classical wedge
Figure 41 shows a classical wedge formation. During the upward trend, the price moves in a narrowing area towards the end of the wedge. Even if the price is still rising, the flatter angle of the rising highs indicates that the buyers no longer have a significant surplus. The price rises slower and slower. Towards the end of the wedge, there are no clear trend waves any longer, and we can only observe narrow price movements. All this indicates an end of the trend.
If it then leads to a downward breakout, the sell signal is given. The price now makes lower lows and lower highs. Figure 41 shows a wedge during an upward trend. It is obvious that the uptrend slowed down during the formation of the wedge. The X marks the final breakout point and the trigger point of the wedge pattern.
Figure 41: The wedge indicates that the trend waves converge at the peak of the formation. The highs do not rise significantly which indicates the dwindling buying interest.
The same principles apply to the reverse variant: If we see a wedge during a downward trend, like in figure 42, wherein the lows flatten out and the price no longer pushes down as easily, it indicates that the sellers are losing their majority. In a wedge, we can often notice rejection candles, where long downward shadows indicate failed attempts to continue the downward trend. All this points to a slowly reversing balance between the buyers and the sellers. The upward outbreak then completes this trend reversal formation.
Figure 42: This chart analysis shows a wedge at the end of a downward trend. The candlestick with a long downward shadow further confirms the rejection and leads to a strong change to the upside when the sellers completely withdraw.
The wedge as a trend continuation
The example in figure 43 shows a wedge that has formed during a correction phase in an overall downward trend. The wedge phase is marked with dotted lines. Although the wedge shows higher highs and higher lows, the highs flatten and the buyers cannot get the upward trend to work.
Such a wedge formation becomes a continuation when the price fails to make a new high. The downward trend continues when the wedge is broken to the downside and the price continues to make lower lows. The continuation point is marked with an X in figure 43. Sometimes, such a pattern is also referred to as a flag.
Figure 43: Wedges can also appear as trend continuation formations. Initially, these look like possible reversal signals, but the highs do not rise significantly, indicating low buyer interest. If the wedge breaks, the trend continues.
Naturally, the same applies to a falling wedge in an upward trend as shown in figure 44. Although we can see lower highs and lows during the wedge, the new lows are weak and the sellers do not have the majority to start a strong downward trend. At the end of the wedge, the price fails to make a convincing new low. In the previous section about wave analysis, we learned that such a situation indicates a slowing trend. The downward trend is fended off when the price breaks higher and makes a new high, as indicated by the X in figure 44. The uptrend can then be resumed and traders looking for trend-trading opportunities use such breakout points to time their trades.
Figure 44: This wedge looks like a deep correction wave in an overall uptrend. The lows at the end of the wedge are no longer able to drop further. If it leads to a breakout, the upward trend continues.
Double and triple top
Double and triple tops are common; they are one of the most popular formations in technical analysis and it’s easy to misinterpret them. An attentive and well-educated trader, however, can use those patterns to find trading opportunities.
Figure 45 shows that the price is repeatedly trying to break the last high
(1) during an upward trend. The price fails every time and is pushed lower multiple times at points 2 and 3. This could indicate a lack of interest by the buyers and increasing selling interest. The double and triple top is, therefore, a trend reversal formation. If buyers then withdraw completely from the market and give up trying to break the high, a new downward trend usually starts.
The signal at the double and triple top is given when the price breaks out of the pattern and forms a new low. The X in figure 45 marks this breakout point.
Figure 45: After the upward trend, the buyers try three times to break out the price upwards before the sellers reverse the trend after the breakout from the triple top.
Retests
Like the Head-and-shoulders formation, the so-called retest often takes place at double tops/lows after the initial breakout.
Figure 46 shows a triple top and a triple bottom formation. After the breakout upwards, the price does not rise immediately, but it returns to the upper edge of the structure one last time. The arrow in figure 46 marks this retest point. Traders can find a second entry signal here and if the previous highs hold, an uptrend is often continued.
Figure 46: This chart analysis shows a sideways movement with three highs and three lows. The high finally breaks out and the price then undergoes a retest before the upward trend is continued.
I put together a video at www.tradeciety.com/patterns where you can learn more about the mentioned chart formations and how to track them on your charts.