Technical analysis is the analysis of repetitive patterns that were forged in the past and are forged currently. If we are able to find such patterns then why not earn money on them. What has to mentioned is that such patterns could be a signal to trend continuation but they could also be a signal to trend reversal. I would like to begin with two reversal patterns, which also happen to be one of my favorite patterns to opening a position on the market.
Double Top
This price pattern is also known as formation "M" due to its shape. It is made up of two tops where the second top should not be higher than the first one. A perfect "M" is where both tops are exactly on the same level, but these types of situations cannot be always found. Most often this pattern is formed, where the second top is lower than the first, though the difference between the two tops should not exceed 10% counting from the support break (green horizontal line in example below). Before explaining how you could make money on this pattern, let's take a look at the shape itself.
Example:
In this pattern the market forms one top and later forms a corrective movement, after which another top is formed. On the minimum of the bottom formed (correction), we should draw a horizontal line which will be called the support break. If the market breaks the support break then we could open a short position. What is interesting in this price pattern is that we can actually expect how far the market can go after breaking the support break. After breaking the support break the market should decrease by the distance counting from the first top to the support break itself.
X (distance) = Top 1 – Support Break
More Examples:
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Double Bottom
This price pattern is also known as formation "W" due to its shape. It is made up of two bottoms where the second bottom should not be lower than the first one. A perfect "W" is where both bottoms are exactly on the same level, but like in the previous patter, it is not always easy to find a perfect "W" . Most often this pattern is formed, where the second bottom is higher than the first, though the difference between the two bottoms should not exceed 10% counting from the resistance break (green horizontal line in example below).
Example:
In this pattern the market forms one bottom and later forms a corrective movement, after which another bottom is formed. On the maximum of the top formed (correction), we should draw a horizontal line which will be called the resistance break. If the market breaks the resistance break then we could open a long position. In this price pattern we can obviously also expect how far the market will increase. This distance is counted as follows:
X (distance) = Bottom 1 – Resistance Break
More Examples:
An interesting fact in double tops and bottoms is that when making a prognosis to where the market may move to, we automatically find a significant level of resistance or support for the next few weeks and sometimes even months. So keep in mind that the eventual range of both formations could be relevant information for making decisions in the future.
Conclusion:
Double tops and bottoms are not only easy to find, but they are also very effective. Many investors stray away from them stating that they are just too simple to make money on. That is only half true. They are simple but as mentioned before, they are also very effective if managed well. Managing your transactions is very important, sometimes even more important then the position you choose to take. More about capital management will still be mentioned in further materials where we will once more come back to double bottoms and tops and explain how to open a position well and not worry what the market does.
Triangle
Triangles are price patterns, that portray short market corrections. The breaking of the triangle is a signal to trend continuation.
There are three main types of triangles and they are:
Symmetrical Triangle
A symmetrical triangle is characterized by trend lines linking tops and bottoms, which narrow down, coming closer and closer to each other. If point A is broken in the diagram above then:
- If the investor has an long position open, then this will be an assurance that the position should be held and that the bulls are growing in power.
- If the investor does not have any position, then opening a long position is possible.
On the other hand if the bottom line of the triangle is broken then:
- If the investor has a long position open, then this will be the first signal that the bulls are losing power and that the position may be closed.
- If the investor does not have any position, then in my opinion nothing should be done, because breaking the bottom line is only an initial signal of trend change.
Increasing Triangle
An increasing triangle is characterized by an upper trend line that is horizontal, and a bottom trend line which becomes more and more dynamic in the increase trend, signaling the strengthening bulls.
The interpretation of this price pattern is exactly the same as above.
Decreasing Triangle
A decreasing triangle is characterized by a bottom trend line that is horizontal, and a top trend line which becomes more dynamic in the decrease trend, signaling the strengthening bears.
The interpretation of this price pattern is exactly the same as above.
Continuation - Rectangle
Rectangles, just like triangles are patterns which portray corrective movements on the markets. The only difference between them is the shape.
A rectangle is characterized by horizontal trend lines linking tops (Resistance) and bottoms (Support). This is a signal to market uncertainty where the fight between the bulls and bears should be decided. Due to the fact that trends tend to keep their direction more often then change, then we can conclude that continuation patterns like the rectangle are usually broken in the same direction as the trend.
I will try to explain the interpretation of this pattern based on the above given diagram.
If the resistance level (upper line) is broken in the diagram above then:
- If the investor has a long position open, then this will be an assurance that the position should be held and that the bulls are growing in power.
- If the investor does not have any position, then opening a long position is possible.
On the other hand if the support level (bottom line) of the rectangle is broken then:
- If the investor has a long position open, then this will be the first signal that the bulls are losing power and that the position may be closed.
- If the investor does not have any position, then in my opinion nothing should be done, because breaking the bottom line is only an initial signal of trend change.
These advanced methods help investors in:
- Deciding where to open a position on the market.
- Deciding where to adjust the stop loss to the open position.
Deciding which market levels can be reached and where support and resistance can be encountered.
The Flag
The flag, just as the rectangle and triangle price patterns, is a continuation price pattern. On the other hand what differentiates it from the previously mentioned is the fact that it portrays a deeper corrective movement on the market and is decisively more stressing for investors.
A flag is a deep corrective movement found within two parallel lines. What has to be mentioned is that a flag is formed after dynamic market movement.
I will explain the interpretation of the flag based on the above given diagram.
If the resistance level (upper line) is broken in the diagram above then:
- If the investor has a long position open, then this will be an assurance that the position should be held and that the bulls are growing in power.
- If the investor does not have any position, then opening a long position is possible.
On the other hand if the support level (bottom line) of the flag is broken then:
- If the investor has a long position open, then this will be a strong signal that the bulls are losing power and that the position may be closed. Additionally this is a strong signal of trend change.
- If the investor does not have any position, then in my opinion nothing should be done, despite being a strong signal to trend change. Market movement should be observed and depending on the outcome a decision should be taken.
An interesting fact about the flag is that the corrective movement should not break 50% of the impulse, as seen on the diagram above. What this means is that thanks to this price pattern investors are able to predict the depth of the correction being formed. Within the boarders of 50% of the impulse, the market should give investors a signal that this may be the end of the correction. What type of signal? Candlestick formations are the answer. So if there is a situation where a correction is coming closer to 50% of the current impulse, then investors should await a pro increase formation in an increase trend and a pro decrease formation in a decrease trend. What this also means is that investors are able to enter the market actually before breaking the flags resistance (increase trend) or support (decrease trend) levels.
Example:
After a strong impulse in the decrease trend the market started to forge a deep corrective movement. The corrective movement came closer and closer to 50% of the impulse and within the boarders of the mentioned level a variation of the evening star formation was formed (orange rectangle), which is a pro decrease candlestick formation. This was a signal that a short position could be open and that this may be the end of the correction.
Concluding this presentation I have to mention that even if you are not a fan of continuation patterns, the 50% rule should be remembered because it is not only a great source of information with regard to relevant support and resistance levels, but is also a great way to enter the market.