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Technical Analysis

 

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Technical Analysis

Let's start leaning the technical analysis from the giving it classical definition and some axioms that are widely used by professionals. First, sound and common definition of technical analysis was formulated by John Murphy in the beginning of 1980s. John Murphy is a well-known trader and analyst, he is author of several widely read books, including "Technical Analysis of the Financial Markets" which has been translated into eight languages and has become a standard text book for the subject. Two things have set Murphy apart from other analysts. Firstly, the clear and concise writing style is a rarity in a field where often, the standard of writing is appalling. Secondly, his work on Intermarket Analysis was the first to set out in a formal way the effects that various markets have upon each other.

According to Murphy, technical analysis is a method of forecasting future price moves using charts that show past market moves. By market moves, most analysts understand 3 main types of information: price, volume and open interest.

The price could be either the actual price of goods on stock exchanges, or the value of currency or other indexes.

Trading Volume - total number of concluded contracts during some period of time, for example, during one trading week.

Open Interest - number of positions that are not closed at the end of any trading day. 

We have to mention that not all of the above indicators have the same weight. The most important among them, obviously, is the price. It is more convenient to analyze the price and most methods are applied particularly to it. Price data is widely available on any markets and accessible with no interruption.  

Professional technical analysis usually is based on the usage of maximum number of available indicators, ideally all 3 above mentioned components. That is why when someone says that technical analysis is the price forecast based on its movements is not a totally correct statement. 

There are 3 axioms in technical analysis that everyone should be familiar with. First one reads that market moves take into account everything. This statement is the foundation of technical analysis and you must understand it in full to make positive progress in your learning of technical analysis endeavor. This axiom means that any factor that impacts the price - economic, political or psychological - has been pre-accounted for and reflected in the price graph. Here is a good example to illustrate the above statement. In fundamental analysis it is said that if demand is higher than supply then the price will go up. Technical analyst would say, on contrary, if the price is going up then demand is higher than supply. This shows that technical analysts understand that price movements are caused by some fundamental factors, but in most cases they don't care which factors in particular. They are just trying to examine, using different tools, price movements' chart, assuming that all fundamental factors are already priced in.

Second axiom states that all prices have directional movement. This assumption was used as basis for all technical analysis methods. Trend is means a particular direction of price movements. The most important task of technical analysis is to determine the trend. There are 3 types of trend:  bullish - prices increase, bearish - prices decrease and sideways or trading range - price is not increasing or decreasing substantially.  You should understand that it is hard to find pure bearish, bullish or sideways trend. Most of the times they are mixed and change each other and to determine the actual trend we should look at some period of time and see which one is dominating the market. For example, during a bullish market the price increases are predominant, although we do see some price decreases too.  The picture below demonstrates you this point.

 

If there is a trend then it is even possible to paraphrase and use some of the Newton Laws, such as "existing trend has more chances to continue than to change the direction" or "the trend will be moving in one direction until exhausts its force".  Indeed, all theories and technical analysis methods are based on the assumption that the trend is moving in one direction until some special reversal signs are seen.

Third and last axiom reads that history repeats itself. This is natural and clear to everyone and it happens because for centuries human psychology in its core has not changed. It is safe to say that technical analysis is dealing with the history of some particular events that are connected to the market, which in its turn is connected to human psychology. The most important price mover remains a social and emotional sentiment. The most essential characteristics of the human psychology are repeated throughout the history and reflected in price movement graphs. Most analysts think that if particular types of analysis worked in the past then they will be working in the future too, because it is based on fundamentals of human psychology. In other words, from the point technical analysis view, to understand the future we need to study the past.

Now that we have given some formal definition to what technical analysis is and tried to understand what it is based on and what kind of universal assumption most analysts use in their analysis, we can proceed learning specific technical analysis tools, basic chart patterns and most commonly used indicators.

Support and Resistance

As it was already said trend is a price movement in one particular direction. There are three types of trend - bullish, bearish and sideways/range trading. Naturally, in real life, the price is not moving at one straight line either up or down. There are always ups and downs in the price movement and we determine a trend by analyzing what is dominating ups or downs.

Trends are also differentiated by time periods. On each market there are long-term (1-2 years), mid-term (3-6 months) and short-term trends (1-2 months). This kind of classification is of course, approximate but it gives us an ability to see with what time periods we are dealing when forecasting the price behavior.

Depending on what kind of trend we are facing during the period of time we are interested in, our trading strategy will change. It is safe to assume that if we want to achieve profits in our trading, then we will be buying during bullish trend, selling during bearish and most likely stay of the market when it is range trading.

As we know by now, the price is moving in some kind of a zigzag motion and we need to ask ourselves one important question - how important is this or that up or down movement of a price? Is this just a temporary move or is our trend is changing?  The simplest answer to these questions is given by support and resistance levels.

When there is a rise in prices, in other words during bullish trend, at some point the price hits a barrier - resistance level. When the price reaches that level, it starts to fall or just stops growing. For different reasons bears start to dominate the market. The same happens during bearish trend, at some moment the bulls' pressure increases and the price goes up after it hits the support level.

 

Support and resistance levels can develop spontaneously but sometimes can be forecasted in advance. For example, when the price come close to some whole numbers at those levels develops so called psychological barrier - 1.3000 for EUR/USD pair is a psychological barrier. At this kind of numbers most of the times support or resistance levels are developed. This is not a rule of thumb but can be very important in your analysis.

One of the trend criteria of trend's power is its reaction to the support and resistance levels. If the trend reacted to support or resistance just one time and then broke it with confidence this means that the trend is still pretty powerful and got some steam to move forward. For example, if bullish trend has broken its resistance level, sometimes it would be appropriate to buy even at higher levels.

When the trend is hitting its support or resistance couple times and can not break it, this means that the trend is loosing its power and has little steam left to continue with its direction. From this we can conclude that trend reversal might be coming soon.  

 

 

Some times support and resistance are trading their places with each other. This could be explained by purely psychological factors - no one wants to make the same mistakes twice. If for example, a dealer was not willing to buy at resistance level and as a result endured some losses, so next time he would want to correct his mistake in similar situation. This can explain such common daily event - support becoming resistance and vice versa. It is important to understand this concept and use it in your analysis as it could be very effective.

Also, by following the changes in the trading volume when the price reaches support or resistance levels, we can notice many interesting things. For example, when the price reaches the support level and starts to go up. If at this moment the trading volume has increased substantially, we can safely say that the bearish trend reversed to bullish and it would be appropriate to start buying as soon as possible.  In cases when the volume is decreasing substantially, we can presume that current bullish movement is temporary but we should not rush in making decision at this point. This correctional movement some times can continue for a long period of time. 

 

We have described above most important and widely used characteristics of support and resistance levels. If you study them long enough, you will be able to use them in your trading system, or maybe even develop a system based on support and resistance levels.  

Chart Types

Price fluctuations have been recorded by people for centuries. That is why there are so many chart types available for usage. Nowadays, technical analysts and traders use 4 main chart types: bar, line, candlesticks, point and figure. Bar and line charts are basis of the classical technical analysis, candlesticks together with point and figure charts have spurred the creation of special forecasting types.

There some other chart types, for example, market profile and forest. We will not cover these types of charts in our course, moreover we will bypass point and figure charts, since they are not used widely and a not a lot of tools for technical analysis are available based on this charts. We will only cover 3 main and widely used types bar, line and candlesticks charts.

Bar Charts

This type of charts widely used by technical analysts or forecasters, as well as, by other market participants. This chart type reflects almost all market/price events that occurred during defined time period. Bar charts are also called "High-Low-Open-Close Charts" because these parameters are used to create the chart. Sometimes it is shortened to "High-Low-Close Charts" this happens when open price is not used to create a chart.

 

  Bar charts are very useful because of their representativeness and help to make better forecasts using classical trend and reversal patterns, moving averages, etc. For each method that we will use with bar charts we will get most number of signals and most precise coincidence with calculated price levels.

To create one bar of a bar chart, a vertical line is drawn between highest and lowest price for the period on time in question. On the left and right side of that line small extensions that indicate open and close price are drawn.

 

 

Bar chart itself is not that interesting for the analysis. There were some attempts to try and forecast price movements using bar chart forms but when candlesticks appeared, those attempts were given up. Candlestick charts were created specifically for such analysis and forecasts. Nevertheless, bar charts are better to use in all other cases to insure the "purity" of each method.  

Line Charts

Line charts are the first type of charts that were created by people. What is simpler than to connect to dots with a line? This kind of work can be done even manually. The role of the line charts in modern technical analysis world is diminishing. Line charts are only used in cases when there is not enough information to construct bar charts or candlesticks. For example, line charts are used to give forecasts for a very long period of time or with charts that are based on different fixing types.

Let us take a line chart with daily time period. Each dot of the line chart can represent either opening or closing price level for each particular day, or some averaged price fluctuations for the period in question. You can create lines that reflect the highest or the lowest price for the day or you can come up with something your own. There is a huge room for your fantasy but why loose your time?

 

We recommend you to use for your forecasts and analysis this type of charts only in cases when there is not alternative. In daily life, for example, line charts could be used for educational purposes because they do not have any additional signs/tools that overload a chart. It is easier for beginners to understand how the price moves when they look at the line charts, simply because our eyes are used to this kind of charts, since we have seen them many time throughout our school time and even on TV and newspapers.

 

Japanese Candlesticks Charts

Forecasting using candlesticks charts is one of the most popular methods of technical analysis that started in late 80s. This method is one of the most vivid and natural. Candlesticks are mostly used with daily charts. This is because originally the method was created and used for one trading day. The psychology behind the forecasting using candlesticks is based on taking into consideration the ratio between an opening and a closing price during one day, plus the ratio of the previous day closing price to the next day opening price.

 

To create candlesticks we need the same data as for the creation of bar charts. A candle differs from a bar by its form. During price opening and closing intervals a rectangle is drawn with so called real body of a candle. Vertical lines that are drawn on top and bottom of a body are called shadows. The body of a candle is colored differently and is depends on opening and closing price order. Usually white color (empty candle) is used when trading day has closed on higher price level than opened, i.e. the price increased. When closing price is lower than opening price black is used to color the body of a candle.

 

  

During a trading day, you will notice that the candle will be pulsing - the body will be changing its length and color and shadows - will appear and disappear.  From this you can see which tendency of the market is predominant - bullish or bearish. There are many other things that you can conclude from analyzing candlesticks charts and we will cover it in depth later on in this course. 

 

Time Frames  

Markets have a tendency to often trend in different directions. EUR/USD currency pair can be in a bullish trend for several years, while the secondary cycle corrects downward over several month, and a short-term rally is happening for past couple days.  This kind of picture we can see very often when analyzing charts, so it is very important to pay attention to such things.  

 

 

You have to learn to recognize different market cycles. Market cycles may include long-term (primary) trends that are measured in years; intermediate (secondary) trends of 3 weeks up to 6 months; short-term cycles of less than 3 weeks; and intraday cycles.

Here are some laws of multiple time frames defined by well-know trader Robert Krausz:

1. Every time frame has its own structure.

2. The higher time frames overrule the lower time frames.

3. Prices in the lower time frame structure tend to respect the energy points of the higher time frame structure.

4. The energy points of support/resistance created by the higher time frame's vibration (prices) can be validated by the action of lower time periods.

5. The trend created by the next time period enables us to define the tradable trend.

6. What appears to be chaos in one time period can be order in another time period.

When deciding on a trade or investment, be it short, intermediate or long term, multiple time frame analysis can help clear the noise and offer a balanced view. The proper way to analyze any market is to analyze it in at least two or three time frames. If you analyze daily charts, you must first examine the weekly charts and so on.

Multiple time frame analysis is based on the concept that every time period has its own trend, as well as its own support and resistance levels. For example, comparing a 10-minute chart to a daily chart reveals the trend and support-resistance levels of the 10-minute bars differ from those of the daily bars.

 

Main Technical Chart Patterns 

A technical chart pattern is some recognizable formation/figure on any chart that gives a sign of future price movement direction.  Technical analysts use these patterns to identify trends, reversals and to issue signals to buy or sell a certain currency pair in accordance with the pattern. There are many known chart patterns but we will cover only most important and widely used. We encourage you to self-study the rest of the patterns because they can be very useful in trading. 

In the beginning of our course, we talked about the three axioms of technical analysis; one of them was that in technical analysis, history repeats itself. The theory behind chart patters is based on this assumption. The idea is that certain patterns are seen many times, and that these patterns signal a certain high probability move in a market. Based on the historic trend of a chart pattern setting up a certain price movement, technical analysts look for these patterns to identify trading opportunities. 

Although there are common ideas and components to every chart pattern, there is no chart pattern that will tell you with 100% certainty where the price is going, what will happen to it. This creates some leeway and debate as to what a good pattern looks like, and is a major reason why charting is often seen as more of an art than a science. 

Patterns are divided into two groups - reversal and continuation chart patterns. A reversal pattern signals that a prior trend will reverse after the pattern in question is completed. A continuation pattern, on the other hand, signals that a trend will continue once the pattern is complete. These patterns can be found over charts of any timeframe.  

Head and Shoulders Chart Pattern

Head and shoulders belongs to the reversal group of patterns. Before starting to look and identify any reversal pattern it is necessary to make sure that there is a well defined previous trend (bullish or bearish) in place. First signal for correctly identified pattern is a break of some important trend line/level.  

One of the most important and well-known reversal patterns for bullish trend is Head & Shoulders. Its distinctive parts are head and two shoulders. It is possible to confuse this pattern with some other, to avoid that pay attention to the neckline of head and shoulders - it determines support and resistance. 

For additional verification take a look at trading volume and compare that to head and shoulders pattern. When there is a downward movement starting from the left shoulder the volume should be increasing, when there is an upward movement the volume should increase. After the head is formed trading volume when the price is rising should be very small, and when the price is decreasing should substantially larger.  

After you have confirmed that this is indeed the head and shoulders pattern, wait for the break of the neckline, which will signal that the pattern is formed and a new bearish trend is starting. The minimal decrease in price should equal to distance between head and the neckline. When technical analysts determine optimal upward and downward price movements they talk about targets. When the target is met you should be watching closely how the trend is developing.  

 

 

The head and shoulders pattern can sometimes be inverted.  The inverted head and shoulders is typically seen in downtrends.  What is noteworthy about the inverted head and shoulders is the volume aspect.  The inverted left shoulder should be accompanied by an increase in volume.  The inverted head should be made on lighter volume. The rally from the head however, should show greater volume than the rally from the left shoulder. Ultimately, the inverted right shoulder should register the lightest volume of all.  When the market then rallies through the neckline, a big increase in volume should be seen.

 

Double Tops, Double Bottoms & Triple Tops, Triple Bottoms

A triple top is considered to be a variation of the head and shoulders top. Often the only thing that differentiates a triple top from a head and shoulders top is the fact that the three peaks that make up the triple top are more or less at the same level. The head and shoulders top displays a higher peak - the "head" - between the two shoulders.

According to experts including Murphy, making a distinction between these two patterns is largely academic because they both imply the same thing. They are both "reversal" patterns of an upward trend in a stock. The triple top marks an uptrend in the process of becoming a downtrend.

As shown below, the triple top pattern is comprised of three sharp peaks, all at the same level. A triple top occurs when prices are in an uptrend. Prices rise to a resistance level, retreat, return to the resistance level again, retreat, and finally, return to that resistance level for a third time before declining. In a classic triple top, the decline following the third peak marks the beginning of a downtrend. While the three peaks should be sharp and distinct, the lows of the pattern can appear as rounded valleys. The pattern is complete when prices decline below the lowest low in the formation. The lowest low is also called the "confirmation point."

A double top occurs when prices form two distinct peaks on a chart. A double top is only complete, however, when prices decline below the lowest low - the "valley floor" - of the pattern. The double top is a reversal pattern of an upward trend in a stock's price. The double top marks an uptrend in the process of becoming a downtrend.

Sometimes called an "M" formation because of the pattern it creates on the chart, the double top is one of the most frequently seen and common of the patterns. Because they seem to be so easy to identify, the double top should be approached with caution by the investor.

As illustrated below, a double top consists of two well-defined, sharp peaks at approximately the same price level. A double top occurs when prices are in an uptrend. Prices rise to a resistance level, retreat, return to the resistance level again before declining. The two tops should be distinct and sharp. The pattern is complete when prices decline below the lowest low in the formation. The lowest low is called the confirmation point.

Analysts vary in their specific definitions of a double top. According to some, after the first top is formed, a reaction of at least 10% should follow. That decline is measured from high to low.

According to Edwards and Magee, there should be at least a 15% decline between the two tops, on diminishing activity. The second rally back to the previous high (plus or minus 3%) should be on lower volume than the first. Other analysts maintain that the decline registered between the two tops should be at least 20% and the peaks should be spaced at least a month apart.

There are a few points of agreement, however. Investors should ensure that the pattern is in fact comprised of two distinct tops and that they should appear near the same price level. Tops should have a significant amount of time between them -ranging from a few weeks to a year. Investors should not confuse a consolidation pattern with a double top. Finally, it is crucial to the completion of the reversal pattern that prices close below the confirmation point.

A triple bottom pattern displays three distinct minor lows at approximately the same price level. The triple bottom is considered to be a variation of the head and shoulders bottom. Like that pattern, the triple bottom is a reversal pattern.

The only thing which differentiates a triple bottom from a head and shoulders bottom is the lack of a "head" between the two shoulders. The triple bottom illustrates a downtrend in the process of becoming an uptrend. It is, therefore, vital to the validity of the pattern that it commence with prices moving in a downtrend.

As illustrated below, the triple bottom pattern is composed of three sharp lows, all at about the same price level. Prices fall to a support level, rise, fall to that support level again, rise, and finally fall, returning to the support level for a third time before beginning an upward climb. In the classic triple bottom, the upward movement in the price marks the beginning of an uptrend.

When prices hit the first low, sellers become scarce, believing prices have fallen too low. If a seller does agree to sell, buyers are quick to buy at a good price. Prices then bounce back up. The support level is established and the next two lows also are sharp and quick. While the three lows should be sharp and distinct, the highs of the pattern can appear to be rounded. The pattern is complete when prices rise about the highest high in the formation. The highest high is called the "confirmation point."

A double bottom occurs when prices form two distinct lows on a chart. A double bottom is only complete, however, when prices rise above the high end of the point that formed the second low.
The double bottom is a reversal pattern of a downward trend in a stock's price. The double bottom marks a downtrend in the process of becoming an uptrend.

Double bottoms are often seen and are considered to be among the most common of the patterns. Because they seem to be so easy to identify, the double bottom should be approached with caution by the investor.

According to Schabacker, the double bottom is a "much misunderstood formation." Many investors assume that, because the double bottom is such a common pattern, it is consistently reliable. This is not the case. Bulkowski estimates the double bottom has a failure rate of 64%, which he terms surprisingly high. If an investor waits for a valid breakout, however, the failure rate declines to 3%. The double bottom is a pattern; therefore, that requires close study for correct identification

As seen below, a double bottom consists of two well-defined lows at approximately the same price level. Prices fall to a support level, rally and pull back up, then fall to the support level again before increasing.

Analysts vary in their specific definitions of a double bottom. According to some, after the first bottom is formed, a rally of at least 10% should follow. That increase is measured from high to low. According to Edwards and Magee, there should be at least a 15% rally following the first bottom. This should be followed by a second bottom. The second bottom returning back to the previous low (plus or minus 3%) should be on lower volume than the first. Other analysts maintain that the rise registered between the two bottoms should be at least 20% and the lows should be spaced at least a month apart.

There are a few points of agreement, however. Investors should ensure that the pattern is in fact comprised of two distinct bottoms and that they should appear at or near the same price level. Bottoms should have a significant amount of time between them - ranging from a few weeks to a year depending on whether an investor is viewing a weekly chart or a daily chart. Investors should not confuse a consolidation pattern with a double bottom. Finally, it is crucial to the completion of the reversal pattern that prices close above the confirmation point.

Diamond Chart Patterns

A Diamond Top is considered a bearish signal, indicating a possible reversal of the current uptrend to a new downtrend. Diamond patterns usually form over several months in very active markets. Volume remains high during the formation of this pattern. The Diamond Top indicates a reversal to a downtrend.

The Diamond Top pattern occurs because prices create higher highs and lower lows in a broadening pattern. Then the trading range gradually narrows after the highs peak and the lows start trending upward. The Technical Analysis occurs when prices break downward out of the diamond formation.

Consider the duration of the pattern and its relationship to your trading time horizons. The duration of the pattern is considered to be an indicator of the duration of the influence of this pattern. The longer the pattern the longer it will take for the price to move to its target. The shorter the pattern the sooner the price move. If you are considering a short-term trading opportunity, look for a pattern with a short duration. If you are considering a longer-term trading opportunity, look for a pattern with a longer duration.

The target price provides an important indication about the potential price move that this pattern indicates. Consider whether the target price for this pattern is sufficient to provide adequate returns after your costs (such as commissions) have been taken into account. A good rule of thumb is that the target price must indicate a potential return of greater than 5% before a pattern should be considered useful. However you must consider the current price and the volume of shares you intend to trade. Also, check that the target price has not already been achieved.

The inbound trend is an important characteristic of the pattern. A shallow inbound trend may indicate a period of consolidation before the price move indicated by the pattern begins. Look for an inbound trend that is longer than the duration of the pattern. A good rule of thumb is that the inbound trend should be at least 2 times the duration of the pattern.

A Diamond Bottom is considered a bullish signal, indicating a possible reversal of the current downtrend to a new uptrend. Diamond patterns usually form over several months in very active markets. Volume remains high during the formation of this pattern.

The Diamond Bottom pattern occurs because prices create higher highs and lower lows in a broadening pattern. Then the trading range gradually narrows after the highs peak and the lows start trending upward. The Technical Analysis occurs when prices break upward out of the diamond formation.

Consider the duration of the pattern and its relationship to your trading time horizons. The duration of the pattern is considered to be an indicator of the duration of the influence of this pattern. The longer the pattern the longer it will take for the price to move to its target. The shorter the pattern the sooner the price move. If you are considering a short-term trading opportunity, look for a pattern with a short duration. If you are considering a longer-term trading opportunity, look for a pattern with a longer duration.

The target price provides an important indication about the potential price move that this pattern indicates. Consider whether the target price for this pattern is sufficient to provide adequate returns after your costs (such as commissions) have been taken into account. A good rule of thumb is that the target price must indicate a potential return of greater than 5% before a pattern should be considered useful. However you must consider the current price and the volume of shares you intend to trade. Also, check that the target price has not already been achieved.

The inbound trend is an important characteristic of the pattern. A shallow inbound trend may indicate a period of consolidation before the price move indicated by the pattern begins. Look for an inbound trend that is longer than the duration of the pattern. A good rule of thumb is that the inbound trend should be at least 2 times the duration of the pattern.

 

Triangle Chart Patterns 

Continuation or sideways patterns tell us that previous bullish or bearish trend is still in force and the market is just in the correction phase. To identify any continuation pattern it is necessary to have well defined previous trend. If the previous trend has continued after the pattern in question was completely formed then this is a sign that you correctly identified a pattern.

The most common continuation patterns are triangles. They differ depending on their boundary lines positioning. Upper boundary line plays the role of resistance, and lower boundary line serves as support. This is true for all price fluctuations inside a triangle. 

Contracting triangles are most common types of triangle patterns. Its boundaries come together at one point and symmetrically angled to horizon. Contracting triangle can correct bullish as well as bearish trend. 

A bit less common are ascending and descending triangles. One of the boundaries of such triangles is parallel (almost parallel) to the abscissa axis and another boundary line angled towards the first line of the triangle. Ascending triangle is more typical for correction of the bearish market. This is because its upper boundary line is parallel to horizon and serves as well-defined resistance level.  At the same time, its lower boundary line is a bit degraded and it is hard to precisely define its support level. This is indicative of a bearish trend, which in this case is dominant. Descending triangle is more seen during bullish market. 

Expanding triangles are infrequently met in the market. Its boundaries, as a time evolves, tend to symmetrically disperse. An expanding triangle (more often appears at highs) consists of three gradually rising highs and two gradually falling bottoms. 

When the downward price movement crosses the level of the second bottom, this means that the pattern formation is about to end, and that is a signal to open a Sell position. Once the signal has been given prices may pull back up half of the range they have moved downward. After this pull back, the bearish trend resumes. Although, as a rule, the third top is higher than the previous two tops, sometimes it may be at some level of the second one or even a little bit lower. 

When each triangle formation is finished you should expect the movement in direction of the previous trend. Here are some tips on how to identify the moment when the triangle formation is complete: 

  1. Inside of each triangle there is an odd (but not less than 5) number of waves.
  2. Contracting, ascending and descending triangles are usually completed close the crossing point of their boundaries, and never later on.
  3. After the triangle formation is complete the price must sharply move up or down, i.e. break the corresponding border.

Triangles are classical example of sideway trend because their fluctuations compared to bullish or bearish movements are very insignificant.

 

Flags, Pennants and Wedges Chart Patterns

Flags and pennants are short-term continuation chart patterns that are formed when there is a sharp price movement followed by a generally sideways price movement. This pattern is then completed upon another sharp price movement in the same direction as the move that started the trend. The patterns are generally thought to last from one to three weeks.

As you can see on the picture below, there is little difference between a pennant and a flag. The main difference between these price movements can be seen in the middle section of the chart pattern. In a pennant, the middle section is characterized by converging trendlines, much like what is seen in a symmetrical triangle. The middle section on the flag pattern, on the other hand, shows a channel pattern, with no convergence between the trendlines. In both cases, the trend is expected to continue when the price moves above the upper trendline.

The wedge chart pattern can be either a continuation or reversal pattern. It is similar to a symmetrical triangle except that the wedge pattern slants in an upward or downward direction, while the symmetrical triangle generally shows a sideways movement. The other difference is that wedges tend to form over longer periods, usually between three and six months. 

The fact that wedges are classified as both continuation and reversal patterns can make reading signals confusing. However, at the most basic level, a falling wedge is bullish and a rising wedge is bearish. In Figure 6, we have a falling wedge in which two trendlines are converging in a downward direction. If the price was to rise above the upper trendline, it would form a continuation pattern, while a move below the lower trendline would signal a reversal pattern. 

 

 

 

Related Topic on Technical Analysis:

  

Home: Fully Automated Forex Trading Systems with Automated Trade Execution on 300+ Forex Trading Strategies

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Part 7: Fibonacci Analysis

Part 8: Elliot Wave Theory

Part 9: Candlestick Chart Analysis

Part 10: Money Management

Part 11: Trading Psychology 

 

 

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Unique experiences and past performances do not guarantee future results! Testimonials herein are unsolicited and are non-representative of all clients; certain accounts may have worse performance than that indicated. Trading stocks, options and spot currencies involves substantial risk and there is always the potential for loss. Your trading results may vary. Because the risk factor is high in the foreign exchange market trading, only genuine "risk" funds should be used in such trading. If you do not have the extra capital that you can afford to lose, you should not trade in the foreign exchange market. No "safe" trading system has ever been devised, and no one can guarantee profits or freedom from loss.
Hypothetical or simulated performance results have certain limitations. Unlike an actual performance record, simulated results do not represent actual trading. Also, since the trades have not actually been executed, the results may have under or over-compensated for the impact, if any, of certain market factors such as lack of liquidity. Hypothetical trading programs in general are benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. Substantial risk is involved.
Forex trading has large potential rewards, but also large potential risk. You must be aware of the risks and be willing to accept them in order to invest in the Forex markets. Don't trade with money you can't afford to lose. Nothing in our course or website shall be deemed a solicitation or an offer to Buy/Sell futures and/or options. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed on our site. Also, the past performance of any trading methodology is not necessarily indicative of futures results. Day trading involves high risks and you can lose a lot of money.

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