LESSON 4 TECHNICAL ANALYSIS

LESSON 4

TECHNICAL ANALYSIS

It is the study of price movement, volume and price relationships.

There are three types of technical analysis:

• Charts –    Line chart, candle sticks, bar charts
• Indicators – e.g. Bollinger bands, stochastics, MACD, Parabolic Sar, RSI
• Chart patterns and signals – Double tops, double bottoms, head and shoulders,                       reversed head and shoulders, etc.

CHARTS  

1. Line chart

A simple line chart draws a line from one closing price to the next closing price.  When strung together with a line we can see the general price movement of a currency pair over a period of time.

1. Bar charts

            It also shows closing prices while simultaneously showing opening prices as well as highs and lows.  Bar charts are also called OHLC chart because they indicate the open, the high, the low and the close for that particular currency.

Here is  an example of a price bar going long:

HIGH

CLOSE

OPEN

LOW

Open:  The little horizontal line on the left is the opening price.

High:   The top of the vertical line defines the highest price of the time period

Low:    The bottom of the vertical line defines the lowest price of the time period

Close:  The little horizontal line on the right is the closing price

1. CANDLESTICKS

Candlesticks is a system that started back in the 16^th century by the Japanese while trading in rice to analyze the price of rice.  A Westerner by name of Steve Nison “discovered” this secret technique on how to read charts from a fellow Japanese broker and Japanese candlesticks lived happily ever after.  Steve researched, studied, lived, breathed, ate candlesticks and began writing about it and slowly grew in popularity in 90s.  Today it is famously used by most traders in trading platforms.

High –  The highest price moved

Open – The opening price

Real Body – The main activity

Close – The closing price

Low –  The lowest price moved

NB:     In most platforms the candles are colored Blue (bullish) and Red (bearish)

The advantages of candlestick charting are:

• They are easy to interpret, and are a good place for a beginner to start figuring out chart analysis.
• They are easy to use.  Your eyes adapt almost immediately to the information in the bar notation.
• They are good at identifying market turning points – reversals from an uptrend to down trend or a down trend to an uptrend.

INDICATORS

Technical indicators – is a quantitative study of past financial market data used to spot and predict future price movement.

They serve three purposes:

• To alert (e.g. warn of potential breakouts)
• To verify (e.g. confirm a breakout on price chart)
• To predict (e.g.  forecast future price direction)

1. Bollinger Bands

–           It is a pair of trading bands representing an upper and lower trading range

–           They are used to measure a market’s volatility

–           It is a tool that tells whether the market is quiet or loud.  When the market is

quiet, the bands contract; when the market is loud the bands expand.

–           They determine when to enter and exit the market.  When they squeeze      together it means a breakout is about to occur in either direction.

1. MACD

–           It is an acronym for Moving Average Convergence Divergence.

–           This tool is used to identify moving averages that are indicating a new trend,                         whether it is bullish or bearish.

–           It is the most technical indicator used and easy to apply.  It uses two types             of   moving averages i.e. 12 day MA that moves at a faster rate and 26 day MA that moves at a slower rate.

MACD crossovers

–           Whenever there is a crossover, it confirms a new trend.

–           Wait until the faster MA crosses above the slow MA and enter a long trade.

–           Consequently, wait until the fast MA crosses below the slow MA and enter a         short trade

1. PARABOLIC SAR

• It helps to identify where a trend ends. This helps to plan for timely exits. It uses dots.
• In an uptrend the dots are below the candles. In a down trend the dots go above the candles.

Therefore;

–           When dots are below the candles it is a buy signal.

–          When the dots are above the candles it is a sell signal.

1. STOCHASTIC

• It helps us determine where a trend might be ending.
• By definition it is an oscillator that measures over bought and oversold conditions in the market.
• When above 70 mark the market is overbought hence prepare to sell
• When below 30 mark the market is oversold hence prepare to buy

1. RSI (Relative Strength Index)

• It is similar to stochastic in that it identifies overbought and oversold conditions.
• When RSI is above 80 the market is overbought
• When RSI is below 20 the market is oversold
• The RSI also helps determine the strength of that market

CHART PATTERNS SIGNALS

A price chart is a sequence of prices plotted over a specific timeframe.  In statistical terms charts are referred to as time series plots.

• Double top

It is a reversal pattern formed after there is an extend move-up.  The “tops” are peaks formed when prices hit a certain level that “CAN’T BE BROKEN’, bounce off slightly but then returns back to test the level again.  If it bounces up again to the neckline there is a double top! After a double top in an uptrend, a reversal occurs which is a downtrend hence you should look to go short.

After noticing a double top a trader is generally safe to assume that for the time being the market will move in downwards trend, thus affording an opportunity to sell or exit a soon to be falling long position.

Double bottom

                        Double bottoms are just the opposite of double tops.  Twice the market                                          will test a new low and twice the market will refuse the idea of pushing                                          beyond that point.  The buyers will rally and an uptrend will follow.

• Head and shoulders

This is a trend reversal pattern formation.  It is formed by a peak (shoulder) followed by a higher peak (head) and then a lower peak (shoulder).  A neckline is drawn by connecting the lowest points of the two troughs.

A trader who has spotted a forming head and shoulders pattern can usually be quite sure that he or she has seen the end of a long upward trend. It is time to cut your losses, secure your profits or short the market.

• Reverse head and shoulders

Instead of head and shoulders represented by new peak highs they are represented by new peak lows.  It tips the trader that the downward trend is losing steam as three new lows have been tested and each time bested by the buyers in the market.  Again it is time to cut your losses, secure your profits or this time, long.

• Support and resistance

They are one of the most widely used concepts in trading.

When the market moves up and then pulls back, the highest point reached before it is pulled back is the resistance.

When the market moves down and then pulls up the lowest point reached is the support.

They guide on the exit and entrance point.

One thing to remember is that support and resistance levels are not exact numbers. Think of support and resistance more of as “zones” rather than concrete numbers.

• When the price passes through resistance, that resistance could potentially become support.
• The more often price tests a level of resistance or support without breaking it, the stronger the area of resistance or support is.
• When a support or resistance level breaks, the strength of the follow-through move depends on how strongly the broken support or resistance had been holding.