Technical analysis relies on using historical stock market price data to find patterns and make predictions. There are various methods and components of technical analysis. This section will encompass the components of our technical analysis strategy. Using each of these components on its own may not yield a reliable strategy, but when used in combination, they have proven to be reliable through historical trading performance. The technical analysis guide is meant to be used as a starting point for those who are new to technical analysis, and we encourage you to read more in the resources provided.
Flags and Pennants: Flags and pennants are formations which signal that the stock price has been consolidating in a short-term reversal of the current trend, and the current trend is set to continue. A pennant pattern is a triangular shape, whereas a flag pattern is a skewed rectangle, with the slope opposite to the current trend.
Cup and Handle: This pattern forms during a downtrend, followed by a long period of consolidation and an uptrend (the cup portion), which is then followed by another short-term correction (the handle). The cup and handle is most often used to signal a reversal in the trend, and estimate a breakout in the price of a stock.
Wedges and Triangles: Triangles form when a stock price is facing resistance or support and bouncing multiple times at one or both levels. It means that a breakout is likely to occur by the tip of the triangle, but the direction of the breakout must be predicted in combination with other indicators. Wedges are like triangles; however, they are skewed in one direction. Refer to the images below to gain a better understanding of the difference between the two.
Bottom triangle: Lows are lined up flat horizontally, while highs are descending. This means that the stock price is currently in a downtrend but is finding a consistent level of support. It will eventually fall under the resistance or bounce off in a breakout move.
Top triangle: Ascending lows, while highs are lined up flat horizontally. This means that the price is currently in an uptrend and cannot get over a resistance level. It will eventually break through or become rejected by the resistance.
Symmetrical triangle: Formed when there are descending highs and ascending lows, whose trendlines cross at a point, thus forming a triangle.
Ascending wedge: Ascending highs and lows. Wedge is formed between the skewed support and resistance trendlines, where the slope of the support trendline has a higher slope than the resistance trendlines. Typically signifies a continuation of a downward move, or the reversal of an uptrend, as the uptrend in resistance is slowing down.
Descending wedge: Descending highs and lows. Wedge is formed between the skewed support and resistance trendlines, where the slope of the resistance is further downwards than the slope of the support. This signifies that the downtrend of the support is slowing down and is used to signify the continuation of a previous uptrend, or the reversal of a downtrend.
Head and Shoulders: Head and shoulders and inverse head and shoulders are also used to predict breakouts in prices. The head and shoulders are called such due to its appearance; the head is the highest peak in the pattern, and the shoulders are the two secondary lower peaks on either side of the head.
The head and shoulders pattern is used to identify a peak in the uptrend, followed by a reversal into a downtrend. A head and shoulders signify that an uptrend made a new high, and afterwards broke underneath a support level, attempted to continue the uptrend, but the previous support is now acting as resistance. This is a bearish formation.
The inverse head and shoulders is used to identify a low point in the downtrend, followed by a reversal into an uptrend. An inverse head and shoulders signify that a downtrend made a new low, and afterwards broke over a resistance level, attempted to continue the downtrend, but the previous resistance is now acting as support. This is a bullish formation.
Gaps: Gaps are when a stocks price skips through a range of prices before reaching a new price. In our charts, we focus on gaps between the opens and closes of trading days. A gap up is considered an open higher than the previous day’s close whereas a gap down is considered an open lower than the previous day’s close. Gaps are important to observe when performing technical analysis, because it is very common for gap fills to occur. Gap fills are when the price moves into the range of prices that was skipped (the gap). For example, in a gap up it is common for the price to move downwards into the gap, whereas in a gap down, it is common for the price to move upwards into the gap. The close before and the open after the gap should be considered as a level of resistance/support.
Trendlines: Trendlines are lines which are used to describe the general trend. The trendline typically connects the supports or resistances (i.e. bars are either below or above the trendline). Trendlines can also be curved, however we focus on using straight trendlines. Trendlines and the intersection of trendlines with each other and with levels of support and resistance are important components of our strategy. Trendlines can be used to create better estimates of price movements, quickly identify changes in trend, and allow us to set stop losses accordingly to reduce risk.
Elliot Wave Patterns: Elliot Wave Theory was developed by author and accountant Ralph Nelson Elliott in the 1930s. Mr. Elliott studied stock market data and determined that there were common patterns in which stock prices moved, and these patterns were formed by a certain number and combination of “waves”. Elliot Wave Theory can be a powerful technical analysis method when used in combination with other indicators, and support and resistance levels. We only use the simplest aspect of this theory; the 5-wave impulse pattern and the ABC correction (also known as a 5-3 move). This pattern describes the common movement of stock prices in 5 waves upwards, followed by corrective moves of 3 waves downwards in an uptrend, and vice-versa in downtrends.
In our charts we use candlestick charts to draw technical formations, and the candlesticks provide deeper insight into the price action of each timeframe. There are two types of candlesticks, bullish candlesticks and bearish candlesticks. Bullish candlesticks occur when the close price is higher than the open price during that timeframe (1d, 1h, 15min, etc.), whereas bearish candlesticks occur when the closing price is lower than the opening price of that timeframe. The candlesticks have two parts, the body and the wicks. The body shows the spread between open and close prices whereas the wick shows the spread between minimum and maximum prices during the timeframe.
There are some shapes and patterns of candlesticks which can help us predict the movement in the time period that follows. There is a long list of patterns that can be used to predict prices. Below are the ones that we most often use:
Bullish/Bearish Engulfing: An engulfing candlestick occurs when the body of the current candlestick “covers” or engulfs the body of the previous candlestick. In a bullish engulfing candlestick, a bullish candle engulfs the previous candle, signaling an incoming uptrend. In a bearish engulfing candlestick, the opposite occurs, where the body of the bearish candle engulfs the previous candle, and signals an incoming downtrend.
Doji Star: The Doji star is a candle the forms when the spread between the open and close during a timeframe is very small and forms a small body. With the wicks extended past the thin body, this candle looks like a cross or a star. The Doji star candle is used to help signal reversals of current trends, as it often occurs when the price cannot push past a support or resistance level.
Hammer/Inverted Hammer: A hammer is a candlestick which is shaped like a hammer and is used to signal the reversal of downtrends. Hammers are formed when there is a small body with no upper wick, and the lower wick extends below the body. The hammer candlestick shows that the price dipped low within the timeframe, but came back and closed near the opening price. The inverted hammer is the same shape as the hammer, except upside down. There is no lower wick, and the upper wick extends above the body. This can also be used to signal the reversal of downtrends, because it shows that the price attempted the push higher above the close within the timeframe
Relative Strength Index (RSI): RSI is a momentum indicator. It uses a combination of two formulas which provides a value between 0 and 100, and RSI oscillates between these two bounds over a period. When the number and size of the gains increases, the value of RSI increases, indicating a stronger uptrend. When the number and size of the losses increases, the value of RSI decreases, indicating a stronger downtrend. RSI is commonly used to identify overbought and oversold conditions; overbought conditions signify the uptrend is nearing an end, whereas oversold conditions signify the downtrend is nearing an end. Typically, an RSI value below 30 is considered oversold and an RSI value above 70 is considered overbought. However, it is best to study the specific ticker, as RSI patterns are specific to each stock. Divergence can also be used to identify reversals; divergence is when the trend of RSI is opposite to the trend of the price action. For example, if the price is in an uptrend, but the RSI is in a downtrend, this is bearish divergence, signifying that the uptrend is likely to reverse.
Moving Average: A moving average price is an average price from a certain number of bars which is updated after each new bar. Moving averages are used in many ways for trading. Moving averages can be used to demonstrate a general trend and identify the levels of resistance and support. The crossing of moving averages from different time periods can also be used to predict movements (i.e. moving average from a lower timeframe crossing over the moving average from a higher timeframe is considered bullish), however rarely use this aspect of moving averages in our analysis. There are a few types of moving averages. The simple moving average is the sum of the closing prices divided by the number of bars, and each bar has an equal weight. The exponential moving average gives a higher weight to the most recent prices. The smoothed moving average is like the simple moving average, but it smooths out the large fluctuations. We most often use the smoothed moving average.
Volume: Volume shows the number of transactions occurring during a single bar (1hr, 1d, 1w, etc.). Increases in volume are usually accompanied by large movements in stock price, which is why the observation of volume and volume trends is important. For example, increasing volume in a trend is a sign that the trend will continue, whereas low volume movements are typically not sustained. It is also important to observe the movement of the price, and the volume during the movement. This is a technique that we find reliable in identifying peaks. On an uptrend, as soon as the volume on a bearish candle exceeds significant volume on the previous bullish candle, this is usually a sign of an incoming dip. A similar idea can be applied to downtrends; when the volume on a bullish candle exceeds significant volume on the previous bearish candle, it is usually a good sign of an incoming spike in price.
Bollinger bands: Bollinger Bands is a tool which helps determine additional levels support and resistance, provides an idea of the volatility of a stock price, and allows us to determine the likely range of prices between which a stock will trade. Bollinger Bands are an indicator that shows a simple moving average (which is sometimes referred to as the mid band). The top band is calculated by adding twice the standard deviation of the stock price within a certain period to the moving average, whereas the lower band is determined by subtracting twice the standard deviation from the moving average. The standard deviation simply put is an average of the difference in price from the average price within a certain time period. The position of the price in relation to the bands can help us get an idea of incoming trends:
1. When the price is trading between the top and mid bands, this is typically a bullish sign. We look for the price to hold support on the mid band to continue an uptrend, and watch dips below the mid band to signal the end of an uptrend. 2. When the price is trading between the lower and mid bands, this is typically a bearish sign. We look for the price to face resistance at the mid band to signal continuation of downtrend, and watch for a move above the mid band to signal a reversal 3. Bands can also be used to identify oversold/overbought conditions. When the price is trading above the upper band, this is commonly a sign that it is overbought, and a dip will occur as it returns inside the bands. When the price is trading below the lower band, this is commonly a sign that it is oversold, and a spike will occur where it returns inside the bands.
Support and resistance levels are essentially barriers to stock movement. A support level is a lower fence where the stock will be prevented from dropping in price, whereas a resistance level is an upper fence where the stock will be prevented in increasing in price. The support and resistance levels are very important because these areas where commonly see changes in trend. Combined with other indicators, support and resistance levels can also provide clear targets for the price, and allow us to set stop losses to manage risk. The support and resistance levels are marked by horizontal lines on our charts. Our technique for placing support and resistance levels does not follow a specific algorithm, but rather a set of guidelines. Here are some steps to help determine where levels of support and resistance are located:
1. Observe the chart for peaks and place lines at the tips of the peaks. 2. Observe the chart for gaps, and place horizontal lines at the top and bottom of the gap. 3. Observe the chart for volume spikes, place horizontal lines at the top and bottom of the candles at these spikes. 4. Observe the chart for flat price action, place horizontal lines at the top and bottom of the range of the flat price action.