August 12, 2020
Technical Analysis Tutorial: A Practical Guide

Technical Analysis Tutorial: A Practical Guide

TECHNICAL ANALYSIS BASICS 1 1128x484 1

Technical Analysis: Trend Lines and Moving Averages

Trends Lines

A widely used tool to define a trend is a trend line. A rising or ascending trend line is constructed by connecting the first two higher lows in an uptrend and extending the line into the future.

Forex Trend Trading: rising trend line
Rising Trend Line

You need at least two higher lows to connect a rising trend line and extend it as shown on the chart above. The trend line usually acts as a support for the price, as obvious in the third and fourth touch in the above chart.

falling trend line
Falling Trend Line

The opposite goes for a falling trend line. We need at least two lower highs to connect, and the trend line should be treated a resistance.

Trend lines represent the slope of the move or the slope of supply and demand. If for instance, the trend line is very steep, that indicates a strong overwhelming demand compared to supply.

As the trend line represents the slope of supply and demand, a break of it is indicative of a change in the supply/demand trend.

Remember:

– The steeper the trend line the less reliable it is. And it will most likely be broken quickly. As sharp moves are usually indicative of excessive emotions and in most cases not sustainable.

– The longer the trend line and the more times that the trend line is touched by prices, the more significant it is, and the more significant the reversal when the trend line is finally broken.

– A break of a trend line is merely a warning signal, it doesn’t conclude a trend reversal, but warns of a possible one.

– The breakout of a trend line is one tool that should be used alongside other technical tools and within a broad trading strategy.

Adjusting Trend Lines With The Price Action

Usually, the price penetrates a trend line during the trading session of the time interval under analysis. But never closes the session below or above the trend line, whether it’s rising or falling trend line.

Remember: These intra-day breakouts should be ignored, and the trend line should be adjusted to this newly recorded low.

Also, the trend line should be adjusted following minor false breakouts.

 Trend Line Adjustment

Accelerating and Decelerating Trend lines

A repetitive phenomenon in the Forex markets is the price acceleration and deceleration. It is very common that you see the price trend starts suddenly to accelerate and the upward wave gets sharper and steeper, especially in times of speculative bubbles.

Accelerating Trend Lines

The chart above illustrates this phenomenon, where U.S. Crude Oil futures started a healthy uniform uptrend in early 2017, before starting to accelerate early 2008.

A rising trend line can be drawn for each acceleration. Where a break below the steeper trend line signals a move to the next less steep trend line.

Decelerating Trend Lines

The above chart is an example of decelerating trend lines. This phenomenon is the opposite of the accelerating one. Where the first upward wave is steeper than the subsequent waves. The price decelerates breaking the first rising trend line, but not resulting in a reversal, and moves back higher. A new trend line is then drawn to account for the new trough or peak.

Remember: In theory, the price could repeat this pattern endlessly, but practitioners have concluded that three decelerating lines are the maximum that can be expected before a real sustained reversal.

Trend Channels

A channel looks like a rising or falling tube that carries the price motion. It is constructed with two parallel trend lines.

In an ascending channel, two rising trend lines form the channel. The first rising trend line is the main trend line that connects the higher lows, which is the support line. The other trend line is an exact parallel for the first one, plotted starting from the first peak in the trend and projected to the future, and it is the resistance or supply line.

ascending trend channel - Technical Analysis tutorial
Ascending Channel

Trend Channels usually contain most of the price action.

In ascending channel the price tends to find demand near the bottom of the channel, while supply increases near the top of channel.

descending channel
Descending Channel

A falling or descending channel is constructed by parallel falling trend line. The upper falling trend line is considered a resistance, while the lower falling trend line is support.

Some chart examples:

Descending channel example
Descending Channel Example on USDNOK Forex pair

Remember: A breakout above the falling or descending channel is similar to breaking a trend line. The outcome is a warning of an upward movement or a trend change.

Ascending channel example
Ascending Channel Example on GBPCHF Forex pair

Remember: Sometimes the price breaks in the direction of the channel. For instance, the price breaks above the rising trend line for the ascending channel. And that could be interpreted as an acceleration of the upward move as new demand is entering the markets.

However, false breakouts are also common, where if the price failed to sustain trading above the channel and moves back within the channel, it is an indication that it might be just a false breakout and the supply/demand slope is back to the prior stage.

Forex False Breakout above ascending channel
False Breakout Above Ascending Channel on GBPCHF Forex pair

Always keep in mind that technical analysis is more of an art than sciences. Don’t be very specific or look for perfection, you will rarely find it. The market may not react exactly at the trend lines every time. Sometimes prices may move a bit higher or lower on an intra-day basis but close on or near the lines.

Moving Averages

Moving averages are one of the most popular and reliable tools in technical analysis. It is used mainly for trend determination.

Moving averages are one of the many of what technicians call “Technical Indicators”. Simply what technical indicators do is take the prices and process it in a mathematical equation. Then produce the result on a chart.

There are plenty of them, each one has its unique formula or equation. But, remember that all these indicators are coming from the price it self, it is a source.

Simply a moving average is an average of the -closing- price in the past X periods. It’s calculated each new period and plotted on the chart. The result is a smooth continuous line that represents the price average for that past X period.

moving averages

A Moving average smooths the erratic price action, and lessen the effect of short term fluctuations. And that helps the analyst focus on the main underlying movement or trend.

Moving averages can be calculated in several methods, the most important and common are the simple and exponential moving averages.

Simple Moving Average (SMA)

The most basic and popular is the simple moving average. And is calculated by a simple arithmetic mean equation. 


SMA(n) = Pr1+Pr2+……..+Pr(n) / n

n: Number of periods Pr: Price(usually closing price)

To calculate the 10 days moving average:

SMA(10)= Pr(1)+Pr(2)+…..+Pr(10) / 10

Exponential Moving Average (EMA)

Another popular type is the exponential moving average. The exponential moving average equation gives more weight to the recent data. And that makes it more responsive to the recent price changes. It is said to be faster than the simple moving average.

Exponential VS Simple moving averages
Exponential VS Simple Moving Averages

How To Use Moving Averages in Forex

Using the 10 days moving average is simply like having the general direction for the past group of 10 days.

Having that in mind, choosing a short period will represent the short term trend. While using a longer period, i.e 200 days will give a longer-term view. In that manner, you can focus on the trend that fits the time horizon of your interest.

Moving average are better used on the longer term time intervals. The most common and key moving average periods are:

  • 200,100,50,20,10 days
  • 52 and 200 weeks
  • 12 month

For the short time horizon, the 10,20 and 50 days moving averages are the most useful. While for longer time horizons, the 200 days and 52 weeks are the very reliable.

Moving averages provide the analyst with important information:

  • Identify the underlying short, medium and long term trend.
  • Two moving averages crossover(one short and one long) is considered a trading signal in mechanical systems or a trend change.
  • A moving average often acts as support and resistance.
  • Moving averages crossover or intersection level is a support or resistance.
  • By comparing the distance between the price and the moving average, you can gauge price extremes. Because moving averages represent the mean, if the current price has deviated substantially from that moving average, the price has a tendency to return to it.
  • The price cross of a moving average can be considered a signal.
Moving Averages Use Cases -technical analysis tutorial
Moving Averages Use Cases in Forex

Remember: The longer the time period of the moving average the most reliable and important support and resistance it is.

Warning: Be confident that a directional trend exists before using a multiple moving average cross over signal. As these crossovers will result in many whipsaws if the price is trading sideways.

10 & 20 day Exponential Moving Averages Crossovers  - Technical Analysis Tutorial
10 & 20 day Exponential Moving Averages Crossovers

Remember: Technical indicators such as the moving averages are called “Lagging Indicators“. This is because the indicator is always lagging the price action. The signals it provides is after the actual price change.

Technical Analysis: Chart Patterns

chart patterns - technical analysis tutorial

While trending, the market usually create chart patterns. Those chart patterns can provide indications whether the trend will continue or reverse.

A chart pattern or formation is simply a configuration of the price action. Many of these configurations can be bounded by trend lines. 

For example, the triangle pattern in the chart below is bounded by two opposing trend lines. The falling trend line is constructed by connecting the swing highs and the rising trend line by connecting the swing lows.

triangle

Remember: All patterns must be a preceded by either an advance or decline. I.e. if the triangle pattern shown above was not preceded by a directional trend, that would suggest it’s not a valid pattern.

triangle entry and exit

The entry to the pattern from the preceding trend is called the “Entry” of the pattern. All patterns have entries and exits. The entry is the direction before the pattern and the exit the direction of the breakout of the pattern.

Note:  We will be using the terms support and resistance, upper and lower bound, and upward and downward trend lines interchangeably in this section. So don’t be confused, they all have the same meaning.

invalid pattern

There are plenty of chart patterns, dozens. However, in this technical analysis tutorial we will mention the most important and reliable ones.

Double Top and Double Bottom

The simplest chart patterns are the double top and bottom patterns.

double top and double bottom - technical analysis basics

The double top pattern consists of two peaks separated by a trough. Both peaks must happen roughly near the same price (less than 5% percent difference).

The double top pattern must be preceded by an advance or an uptrend. Otherwise it is not a double top, it is just a sideways market.

The pattern completes on a breakout below the middle trough.  And suggest a trend reversal or at least a deep retracement of the prior trend.

A downside potential target of the breakout is identified by measuring the distance from the highest peak to the trough between the two peaks. Then projecting this distance from the point of breakout (This is called the Measured Rule). A safer target would be 75% of the this distance.

double top example

The double bottom pattern is the exact opposite of the double top.

double bottom example

Triple Top and Bottom

Triple top is like a double top, but it consists of three peaks instead of two. And two troughs instead of one.

triple top and triple bottom

Like the double top, the triple top peaks must be within the same price range with a maximum of 5 percent difference.

The pattern completes on a break below the trend line that connects the first trough with the second trough. And suggests a trend reversal or at least a deep retracement of the prior trend.

The downside potential target of the breakout is identified by projecting the the distance from the highest peak to the trough from the point of breakout.

Chart examples:

triple top example
triple bottom example

Rectangle

A Rectangle is simply a sideways movement that consists of multiple peaks and throughs, that is contained above a horizontal support and below a horizontal resistance. Each peak must touch the resistance level at least twice and each trough must touch the support twice.

In other words, connecting the swing highs we will get a horizontal line and connecting the swing lows we will get a horizontal line. Both lines are parallel.

Unlike double and triple top/bottom patterns, the price may fail to reach the resistance or support area, it may fail short ahead of it. And this might be an indication of the direction of the eventual breakout. 

rectangle pattern - Technical Analysis Tutorial

The target of a breakout of a rectangle whether up or down, is identified by measuring the distance between the resistance and support lines, then projecting this distance from the point of breakout.

Remember: The rectangle can be a reversal or a continuation pattern depending on the direction of the entry (prior trend) and the exit(breakout).

i.e. if the price was in an uptrend then paused and formed a rectangle formation, then a breakout completed to the upside, that would suggest the continuation of the uptrend.

Oppositely, if a downside breakout of the rectangle occurs, that suggests the uptrend might be reversing.

Charts example:

rectangle example Technical Analysis Basics Tutorial

Triangles

The rectangle pattern is bound by two parallel trend lines forming a rectangle shape. What if the trend lines are not parallel?

Symmetrical Triangle

If the result of connecting the swing highs is a downward sloping trend line. And the result of connecting the lows is an upward sloping trend line. The formation constructed will be a symmetrical triangle.

symmetrical triangle

The triangle’s upper bound is a downward slopping trend line, and the lower bound is upward sloping trend line. The two trend lines are opposing.

Both trend lines must have the similar (or close) angle. The price must touch each trend line at least twice and the area within the triangle must be covered with the price action.

Remember: The point where the two trend lines meet is called the apex. The price must breakout before reaching the apex. Otherwise, the triangle will be no longer valid. The optimal breakout area is within the last quarter of the triangle.

symmetrical triangle apex

The target for the triangle is identified by measuring the distance between the first trough and the first peak of the triangle, then projected from the breakout point.

Chart example:

symmetrical triangle example Technical Analysis Tutorial

The triangle can be a reversal or a continuation pattern, depending on the direction of the entry(prior trend) and the exit(breakout).

Ascending and Descending Triangles

The ascending triangle consists of a horizontal trend line resistance and an upward sloping trend line support.

For all triangles, the price must breakout before reaching the apex. Otherwise, the triangle is no longer valid. The optimal breakout area is within the last quarter of the triangle.

ascending triangle

The target for the triangle is identified by measuring the distance between the first trough and the first peak of the triangle, then projected from the breakout point.

ascending triangle example

The ascending triangle is mostly a bullish continuation pattern. But it can be a reversal or a continuation pattern depending on the direction of the entry(prior trend) and the exit(breakout).

Descending Triangle

The descending triangle consists of a horizontal trend line support and a downward sloping trend line.

The point where the two trend lines meet is called the apex. The price must breakout before reaching the apex. Otherwise, the triangle is no longer valid. The optimal breakout area is within the last quarter of the triangle.

descending triangle

The target for the triangle is identified by measuring the distance between the first trough and the first peak of the triangle, then projected from the breakout point.

descending triangle example Technical Analysis Tutorial

The descending triangle is mostly a bearish continuation pattern. But it can be a reversal or a continuation pattern depending on the direction of the entry (prior trend) and the exit(breakout).

Flag and Pennant

A flag pattern is very similar to a channel, but it has a smaller size and it forms in short period of time. Also, the pennant is similar to a symmetrical triangle, but smaller in size and shorter in time. Both patterns are continuation patterns.

Both patterns are small corrective moves within a strong trend.

Both patterns can be bullish or bearish. Bullish flag and pennant form in the context of an uptrend. While bearish flag and pennant form in the context of a down trend.

bullish and bearish flags
Technical Analysis Basics Tutorial

Remember: Usually, trends pause for corrections that take the shape of flag or pennant. If you spot one, expect the price to resume the trend after a breakout of the flag or pennant.

bullish and bearish pennants
Technical Analysis Basics Tutorial

The target of the breakout is identified by measuring the distance between the the start of the wave preceded the pattern to the first high of the pattern. Then, projecting this distance from the breakout point.

Wedges

A wedge is a form of a triangle pattern, where the two-trend line are heading in the same direction but with different slopes.

Remember: A breakout of the all wedge formations usually signals a trend reversal or at least a deep correction.

Wedges come in several shapes, here are the main wedge patterns.

Rising Wedge

The rising wedge forms when both trend lines are upwards, and the lower bound trend line is steeper the upper bound trend line.

rising wedge Technical Analysis Tutorial

The breakout in rising wedge usually occurs to the downside but sometimes the price can break to the upside.

A break out of a rising wedge to the upside is a signal of unhealthy acceleration of the uptrend.

rising wedge example
Falling Wedge

In a falling wedge, both trend lines are downward. And the upper bound trend line is steeper the upper lower bound trend line.

falling wedge

The breakout in falling wedge is usually to the upside, but in some occasions it breaks to the downside.

falling wedge example
Rising Broadening Wedges

A rising broadening wedge has two trend line pointing upwards. The lower bound trend line has a smaller slope than the upper bound trend line.

The breakout in rising broadening wedge usually occurs to the downside but sometimes the price can break to the upside.

rising broadening wedge example
Falling Broadening Wedges

A falling broadening wedge has the two trend lines point downward. The lower bound trend line has a larger slope than the upper bound trend line.

The breakout in falling broadening wedge is usually to the upside, but sometimes it breaks to the downside.

falling broadening wedge

There is no specific rule for measuring targets for wedges patterns.  Other technical analysis techniques should be used to forecast price target.

Head and Shoulders Patterns

The pattern is considered a reversal pattern, it can be bullish reversal (head and shoulders top) or bearish reversal (head and shoulders bottom).

Head and shoulder top pattern consists of three swing highs. The middle(second) high is higher than the first one, and the third high is lower than the second one and near the price of the first peak.

The first and third peaks are called shoulders, while the middle peak is the head.

head and shoulders top and bottom - Technical Analysis Basics Tutorial

The pattern completes when the price breakout of the trend line that connects the swing lows between the peaks. This line is called the neckline of the pattern.

Remember: The neckline can be horizontal, upward or downward sloping.

The target of the pattern is measured by projecting the distance between the neckline and the head of the pattern, from the point of breakout of the neckline.

head and shoulders top example

A head and shoulders bottom is a bullish reversal pattern. It is the exact opposite of head and shoulders top.

head and shoulders bottom example

In both top and bottom head and shoulder patterns, if the pattern has a symmetry in both side of the head, the pattern is considered more reliable.

Head and shoulders pattern symmetry

There is a variation of the head and shoulders patterns, where more than two shoulders are formed. This is called a complex head and shoulders pattern. It has the same implications of the normal head and shoulders pattern.

complex head and shoulders bottom

Cup and Handle Top and Bottom

A cup and handle pattern is rounding patterns that is formed when the price reverses direction gradually and in a slow manner. The reversal forms a curve like shape. The price then enters a small and short pullback, before resuming the upward reversal.

cup and handle pattern

The high of the retracement is called a lip. The lip is the key breakout level to watch. As the pattern is confirmed when the price breaks back above the lip.

cup and handle pattern example -Technical Analysis Tutorial

Target of the pattern is identified by measuring the distance between the lowest low in the pattern towards the lip level. Then projected from the breakout level (lip level).

If you are interested in exploring more about chart patterns, you can check the encyclopedia of chart pattern book by Bulkowski , or visit his website.

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