Technical Analysis: Definition, Examples & Strategies
Updated: Nov 1, 2022
Technical Analysis Definition
Technical analysis refers to investors finding common patterns in historical forex prices to improve their success in trading. These technical patterns help traders enter their trades, manage their risk, and potentially predict the future.
What Is Technical Analysis?
Technical analysis is a form of research that uses pattern recognition on historical price data in order to predict the financial markets. It is one of the most popular analysis tools amongst retail traders.
Technical analysis can be used on any piece of data as long as they have historical trading data, these consist of things such as stocks, futures, commodities, currencies and other securities.
This idea of technical analysis stems from the fact that traders feel like they can identify market patterns, which in turn will allow them to form an educated guess or prediction for the future price of that chosen stock or currency.
Technical Analysis Examples
What are the examples of technical analysis? Here are the top 8 most popular examples investors use:
Moving Averages
MACD (Moving Average Convergence Divergence)
RSI (Relative Strength Index)
Stochastic Oscillator
Bollinger Bands
Fibonacci Patterns
Chart Patterns
Candlestick Patterns
1. Moving Averages in Technical Analysis
The moving average is a lagging indicator that is used by traders to help identify and determine a trends direction, as well as its support and resistance levels.
Moving Averages On Daily Time Frame:
The moving average is a totally customisable tool which can be adjusted to preference by the trader, thus meaning that they can choose the time frame they want when calculating an average.
The most commonly used time periods for the moving average indicator are; 15, 20, 30, 50, 100 and 200 days.
One thing to note is that the longer the timeframe a trader uses, the greater the lag will be.
For example, I have shown that, a weekly moving average will have a significantly larger degree of lag to that of a daily moving average. This is because it contains price points for the past week compared to one day.
Moving Averages On Weekly Time Frame
In addition to this, the shorter the timeframe, the more price sensitive it will be to changes.
Whereas, longer time frames are less sensitive to price changes. Short term traders also tend to use short-term moving averages, in contrast long term traders tend to use longer term moving averages.
Types of Moving Averages
Simple Moving Average (SMA)
The SMA is calculated by taking the average closing prices of an asset over a certain period of time. Therefore, to calculate it the closing prices are divided by the number of periods.
For example, if you are using the 15-day moving average, there will be 15 different closing prices, so all you have to do is add them together and then divide by the number of periods (in this case it is 15).
SMA = A1 + A2 +… + An / n
Where:
A= Average in period
n= Number of time periods
Exponential Moving Averages (EMA)
The EMA places more weight on recent data points. The reason for this is because EMA’s react significantly to the most recent price changes.
When it comes to EMA’s the most popular time frames are the 12 and 26 day for short term averages. On the other hand, 50–200-day averages are the most popular EMA’s for long term trading.
“To calculate an EMA, you must first compute the simple moving average (SMA) over a particular time period.
Next, you must calculate the multiplier for weighting the EMA (referred to as the "smoothing factor"), which typically follows the formula: [2/ (selected time period + 1)]. So, for a 20-day moving average, the multiplier would be [2/ (20+1)] = 0.0952.
Then you use the smoothing factor combined with the previous EMA to arrive at the current value. The EMA thus gives a higher weighting to recent prices, while the SMA assigns equal weighting to all values.”
EMAt = [Vt × (s/1+d)] + EMAy × [1−(s/1+d)]
Where:
EMAt=EMA today
Vt=Value today
EMAy=EMA yesterday
s= Smoothing
d=Number of days
A good example of a moving average indicator is the Bollinger band indicator that I will discuss later on in this section.
Moving Averages Drawbacks
The main limitation of moving averages is that it is a lagging indicator. Therefore, it means that it is based and calculated from PAST data, hence meaning that it is not good at accounting for FUTURE changes in an assets price.
2. MACD (Moving Average Convergence Divergence) in Technical Analysis
The MACD is a trend following momentum indicator. The way in which the MACD is calculated is by subtracting the 26- period exponential moving average (EMA) from the 12- period EMA.
This shows the relationship between two different moving averages of a security’s price.
By identifying moving averages, the MACD can assist in indicating whether there may be a new bullish or bearish trend on the horizon.
After all, the trend is your friend! When it comes to visualising the MACD indicator, you will see three different numbers which are used for its settings.
- The first is the number of periods that are used to calculate the faster moving average
- Second is the number of periods that are used in the slower moving average
- Lastly, the third number is the number of bars that are used to calculate the moving average difference between the faster and slower.
In this example, you can see that the MACD limits are set to 12,26,9 (these are the default settings for most charting software).
- 12 represents moving average of previous 12 bars
- 26 portrays the moving average of previous 26 bars
- 9 signifies a moving average of the difference between the two moving averages mentioned above.
You will also notice that there are two lines on the MACD indicator, one is the MACD line and the second is the Signal line.
The MACD line is the difference between two moving averages, whilst the signal line indicates the moving average of the MACD line.
The MACD line is considered to be the ‘faster’ moving average, whereas, the signal line portrays the ‘slower’ moving average. From the example above, the slower moving average line would be a 9-period moving average.
What this indicates, is that we are taking the average of the last 9-periods of the ‘faster’ MACD line and now plotting it as our ‘slower’ moving average. The purpose of this signal line is to smoothen the sensitivity of the MACD line.
Alongside the MACD indicator, you will also notice a histogram. It is just a graphical representation of the difference between the MACD line and signal line. This may sometime give you an early sign that a crossover is about to take place.
Here you can see that, when the MACD line and signal line separate, the histogram gets larger. This is called the MACD divergence. The reason for this is because the MACD line moving away from the signal line, hence creating a divergence.
However, when the MACD line and signal line get closer to one another, the histogram will reduce in size. This is what is known as a convergence.
And voilà, this is how the Moving Average Convergence Divergence indicator got its name! Now that you know what the MACD indicator is, let me walk you through how you can trade using the MACD indicator.
How to trade using MACD
Before telling you how to trade using MACD, I wanted you to get a brief understanding of what it was.
Now you have that understanding, I will explain how you can use the MACD when trading, and why you may see it as a potentially viable indicator when choosing a trading strategy.
Firstly, what you need to know is that when a new trend appears, the MACD line (faster line) will react first and then begin to cross over the signal line (slower line).
This cross over is known to be called a ‘divergence’. What this indicates is that the current trend may be coming to an end, as well as indicating that a new reversal trend could be fashioned.
Here you can see that when the two lines cross over the histogram will temporarily disappear, this happens because at the time of the crossover the difference between the MACD line and the Signal line is 0.
When the trend reversal continues, the MACD line will diverge away from the Signal line, this causes the histogram to get larger. This is a good thing, as it gives a good indication of a strong trend.
MACD Drawbacks
The one most noticeable drawback of the MACD indicator is that it is a lagging indicator.
What this means is that a trend becomes apparent only after a large shift has already taken place. Thus, meaning that the MACD confirms long term trends, but cannot predict them.
3. Relative Strength Index (RSI) in Technical Analysis
When looking at the RSI, you can see that it has a range between zero and one hundred. Between those ranges it plots the recent price gain versus the recent price loss of an asset.
What this does is it then helps a trader gauge the momentum and strength of a trend.
Traders mainly tend to use the RSI as an indicator to identify when an asset is overbought or oversold. For example, when the RSI is 70 or above, the asset is considered to be overbought with the potential to decline.
On the other hand, when an assets RSI is 30 or below, the asset is deemed to be oversold, depicting that there could be a rally in the price of an asset.
My colleague Mark Wilson has a great article which solely goes over RSI, be sure to check it out!
RSI Being used in conjunction with candlestick patterns
RSI is not always the most accurate bit of tech that a trader can use. However, to optimise the RSI’s ability to tell you when an asset is overbought or oversold, traders can use other technical signals such as candlesticks to help them determine the strength of the trend.
In this example AUD/JPY's the trend is at a high and a bearish engulfing appears, the RSI being at 70 or above can tell you that the asset is being overbought. In this case RSI was at 73, after this AUD/JPY shorted and has never recovered to that price since.
This would have made a great short idea as long as you had done your fundamental analysis prior to looking at the charts. Remember that charts are used to time your trades!
RSI Divergences
When it comes to RSI divergences, it is not a hard concept to grasp, but it does sound confusing.
A bearish divergence in the RSI will be created when the RSI shapes an overbought reading that is followed by a higher high, this is corresponded on the assets price as a lower high.
What this indicates is that there is a rise in bearish momentum which could lead to a decline in the assets price. This is depicted by GBP/USD's price chart below.
Comparatively, a bullish divergence is created on the RSI as an oversold reading that is followed by a higher high, this is corresponded by the assets price which then makes a higher low.
This indicates to a trader that bulls are starting to gain momentum, potentially creating a trend reversal.
Traders must take into consideration that divergences in the RSI are rare when an asset is in a stable long-term trend. Ergo, using flexible overbought or oversold readings can help recognise more potential signals.
RSI SWING REJECTIONS
Divergence is one way to trade using RSI. In addition to that RSI swing rejection scan also be used.
This examines the RSI’s behaviour after it has emerged from an overbought or oversold area. Bullish wing rejection is composed of 4 parts:
1. RSI falls into oversold territory.
2. RSI crosses back above 30%.
3. RSI forms another dip without crossing back into oversold territory.
4. RSI then breaks its most recent high.
Now when looking for a bearish swing rejection, it is very similar to the bullish, but just the other way around. It is also comprised of four parts:
1. RSI rises into overbought territory.
2. RSI crosses back below 70%.
3. RSI forms another high without crossing back into overbought territory.
4. RSI then breaks its most recent low.
Difference between RSI and MACD
When it comes to the MACD and RSI, the MACD measures the relationship between two EMA’s, whilst the RSI measures a change in price correlated to recent highs and lows.
Both are used to measure the momentum of a certain asset. But you have to realise that they measure different factors, meaning that sometimes they give contradictory indications.
For example, the MACD could be indicating that buying momentum is still increasing for an asset, whereas RSI may be showing a reading that is at 70% or above (overbought).
With all this taken into consideration, both signals can be used to signal that there may be an upcoming change in the trend’s direction, this can come from the divergence, of which I have spoken about in this section previously.
Limitations of RSI
The main limitation of the RSI is that the indicator displays momentum. Therefore, an asset can stay overbought or oversold for a very long time.
Consequently, meaning that the RSI will be most useful where asset price is alternating between bullish and bearish movements.
4. Stochastic Oscillator in Technical Analysis
Akin to the RSI, a stochastic oscillator is another momentum indicator that compares a closing price of an asset to a range of that assets prices over a certain period of time.
Typically, 14-day periods are used when the stochastic oscillator is at work.
The reason it compares the closing price to prior price movements of an asset is because the indicator is attempting to predict price reversal points.
It is a two-line indicator that can be applied to any chart. It fluctuates between 0-100 and as I said before, it consists of 14 individual periods. To put this into perspective, on a weekly chart this will be 14 weeks and on an hourly it would be 14 hours.
Formula for the stochastic oscillator:
%K= (C-L14 /H14−L14C−L14) ×100
Where: C = The most recent closing price
L14 = The lowest price traded of the 14 previous trading sessions
H14 = The highest price traded during the same14-day period
%K = The current value of the stochastic indicator
How to read the stochastic oscillator
The indicator Is scaled between 0-100, the general rule is that a score above 80 indicates that an asset is trading near the top of its high-low range (overbought).
On the other hand, a reading below 20 indicates that the asset is trading at the bottom of its high low range (oversold).
Non the less, when prices hit these levels it is not always indicative of an impending trend reversal. If the trend of an asset is strong, it can maintain in an overbought and oversold state for a long period of time.
Therefore, traders should take these changes and clues from the oscillator to look for potential trend shifts in the future.
Stochastic Oscillator Divergences
Just like the RSI, traders can look for divergences in the stochastic oscillator.
For example, if a bullish trend is nearing a higher high, but the oscillator prints out a lower high, it can be seen as a trend reversal where the bulls are exhausting their momentum and the bears are gaining momentum.
In this image below on AUDJPY, there is an example of a stochastic divergence. The trend has reached the top of an uptrend, there is a higher high being made.
In contrast the stochastic identifies a lower low. Thus hinting at a change in the prices direction. Lone behold, bears take over and AUD/JPY's price falls.
When combined with other indicators, the stochastic oscillator can help a trader identify support and resistance levels, as well as entry and exit points.
Difference between stochastic oscillator and RSI
Both the RSI and stochastic oscillator are momentum oscillators. However, they each have different theories and methods of how to use.
“The stochastic oscillator is predicted on the assumption that closing prices should close near the same direction as the current trend.”
“Meanwhile, the RSI tracks overbought and oversold levels by measuring the velocity of price movements.” – Investopedia
In other words, RSI is more useful during trending markets, whereas the stochastic oscillator is most effective in sideways or choppy markets.
Limitations of the stochastic oscillator
The primary limitation with the stochastic oscillator is that it can produce false signals when it is not used properly. This problem mainly arises when traders trade against the trend.
As I have said before, if the trend of an asset is strong, it can remain overbought or oversold for a long time.
5. Bollinger Bands in Technical Analysis
In this section I will only briefly be going over Bollinger bands, the reason for this is because my colleague has an article that is dedicated to explaining in depth what Bollinger bands are and how they are used.
Bollinger bands are a technical indicator that was developed by a man named John Bollinger. They are used to measure whether an asset is overbought or oversold.
It also indicates to use market volume. When the market is loud (prices increase or decrease dramatically), the bands expand as shown in the image below.
However, when the market is quiet what would you expect the bands top do? If you said correct then well done! Can you spot the difference?
The Bollinger bands consist of a central line and two price channels (bands) that are located above and below the central line. The centreline is the exponential moving average.
The two lines above and below the EMA represent the standard deviation for price above and below the EMA.
Standard deviation is just a mathematical formula that helps measure how spread-out numbers are.
One thing to note with Bollinger bands is that the price of an asset always returns to the middle of the bands. The upper line is seen as an area where price is overbought and the lower line is seen as the area where price is oversold.
The two lines above the EMA tend to act as dynamic support and resistance levels. The longer the timeframe you are in, the stronger these bands tend to be.
Avoid trading Bollinger bands when the bands are expanding, this usually means that price is not moving within a range but in a trend. Instead look for areas where the bands are stable or contracting.
This is when the bands squeeze together, this normally depicts that a breakout is about to occur.
“If the candles start to break out above the TOP band, then the move will usually continue to go UP.
If the candles start to break out below the BOTTOM band, then price will usually continue to go DOWN.”
Looking at the chart above, it is evident that the bands are squeezing together. The price has just started to break out at the bottom of the bands.
So, where do you think price will go?
If you said down, then well done! This is how the Bollinger squeeze tends to work. It is designed to help you catch a trend as early as possible.
Limitations of Bollinger Bands:
They are not a standalone trading system. They were created to give traders information in regards to the volatility of an assets price.
The creator John Bollinger has suggested that you should use two to three other indicators to provide more market signals. These include MACD and RSI.
6. Fibonacci Patterns in Technical Analysis
Fibonacci numbers are a technical indicator that are generated by mathematical sequences. It was developed by Leonardo Pisano Bigollo who was an Italian mathematician.
The most commonly used Fibonacci method is the Fibonacci retracement levels. The Fibonacci retracement levels are horizontal lines that help identify areas of support and resistance on an assets price chart.
Each level of the Fibonacci indicator is associated with as percentage. The percentage is how much of a prior move the price has retraced. The retracement levels sit at 23.6%, 38.2%, 61.8%, and 78.6%.
The way in which people use the Fibonacci retracements is when there’s a trend, the Fibonacci retracements can be used to help determine how deep a retracement could be.
There are two different types of waves, the first being impulse waves. These are larger waves in the trending direction. The second type of waves are the pullbacks, these are the smaller waves in-between.
The Fibonacci levels are mainly used to identify areas of support and resistance. The reason for this, is that if price is consolidating near those areas and then starts moving in a trending direction, a trader will enter a trade in the direction the trend is moving in.
For example, if there is an uptrend, you might wait for a retracement or pull back to buy the asset that is near an area of support within the Fibonacci levels.
On the other hand, if there is a downtrend, you would look to sell an asset when it retraces up to a key area of resistance that is identified by the Fibonacci levels.
Another effective way in which to use the Fibonacci levels are by also using other indicators in conjunction. A good indicator to use alongside the Fibonacci levels is the stochastic indicator.
Combining the two indicators allows traders to see oversold and overbought areas. In this strategy, it looks for key signals in the stochastic indicator when the price touches an important Fibonacci level.
If a trader sees these two things, it can be a strong signal to open a position.
Limitations of Fibonacci
One limitation is that Fibonacci levels are subjective, but this is like any technical indicator. In addition to this, another possible issue with the Fibonacci levels is that there are so many of them in the market.
Thus, meaning that price is bound to change direction near one of these areas.
This makes the indicator look effective in hindsight, but in real time it may be hard to identify which level will be significant.
7. Chart Patterns in Technical Analysis
Firstly, what are chart patterns? Chart patterns are the shape that a market will take based on its historical data. Chart patterns allow you to gain a potential idea of the possibility on which way a trend will continue or reverse.
It is important that you understand the idea of support and resistance when using chart patterns. This indicates price areas on a chart where a currency or stock may have been over brought or oversold.
Support is referring to the level at which an assets price stops falling and rises back up. Resistance is where the price usually stops rising and drops back down.
Think of support and resistance as supply and demand. When there are more buyers than sellers in the market (demand > sellers) the price tends to rise.
On the other hand, when there are more sellers than buyers in the market, price tends to fall (sellers > buyers).
To put this into perspective, when a woman sees a price of a designer handbag, she will be willing to pay a lot of money for that handbag because it looks nice.
However, there will always come a point where she realises that a handbag should never be worth that much (max consumer is willing to pay)
This is where her demand for that handbag will decrease. Here is a great example of what I was talking about before, the decrease in demand for the handbag ultimately becomes an area of resistance.
This is where the price of the handbag will start to fall towards a level of support as supply begins to outweigh demand.
Then, once the price of the handbag has fallen enough, women will tend to jump back into the market because the price is seen as ‘more acceptable’
However, if the increased buying continues, price will be driven up towards a further level of resistance from the past.
This occurs because demand will begin to increase relative of supply. Once a price breaks through a level of resistance, it may become a future level of support.
Now that I have explained what support and resistance are, I will be describing the 10 best chart patterns are, but first let me explain the different types of chart patterns.
Types of chart patterns
“Chart patterns fall broadly into three categories: continuation patterns, reversal patterns and bilateral patterns.
A continuation signals that an ongoing trend will continue
Reversal chart patterns indicate that a trend may be about to change direction
Bilateral chart patterns let traders know that the price could move either way – meaning the market is highly volatile”
You’ve made it this far into the article, here I will be depicting what I find to be the top 10 best chart patterns out there for you to use.
Top 10 best chart patterns in Technical Analysis
1. Head and shoulders
The head and shoulder chart patterns are formed when a security’s price rises to a peak (shoulder), falls back down to the base of the prior move, rises again to form the largest peak (head), price then retreats again to the original base, rises again, but only to the peak of the first initial peak (shoulder)
So, what does the head and shoulders pattern tell you? Well, the initial peak is due to the prior force of the bullish trend.
The buyers want to sustain their momentum for as long as possible, this is where they rally the price up to the highest peak.
Price can continue to rise and carry on the upwards trend. But, when the price declines for a second time, it is evident that the sellers are very much so in the running.
The buyers will try once again to push the price higher, but in doing so they will only reach the high of the first uptrend.
In doing so, the failure to pass the highest high (peak) signals that the sellers have reversed the trend and outnumbered the buyers.
The head and shoulders formation I have spoken about above is for a bearish signal. However, an inverted head and shoulders, otherwise known as head and shoulders bottom chart formation indicates a bullish signal at the bottom of a downtrend.
What this tells you is identical to the normal head and shoulders pattern. However, the inverted head and shoulders pattern is used as an indicator to signal the end of a bearish rally and indicate the formation of a bullish reversal.
2. Double Top
Once again, the double top is a chart pattern that will help a trader indicate the reversal of a trend.
With the double top, an asset will experience a peak, it will then retrace back to a level of support. Next, it will climb up towards the high of the first peak, this followed by a perpetual downtrend. When looking for a double top, look for an ‘M’ shape to help you.
The most effective double tops are the ones that have broken the support level created by the two previous peaks. This will indicate a strong decline in an asset.
It is important to identify whether it has broken that support level, this is because a double top can form, but traders who aren’t experienced will enter a short position without looking to see if the initial support area has been broken.
By the price not breaking that level of support, a failed double top will form, at that point price will continue its uptrend. Thus, causing the bears to have to pull out of their positions early.
3. Double Bottom
The double bottom is the opposite of the double top. The double bottom is a chart pattern that indicates a period of selling (downtrend) that causes a price of an asset to drop below a level of support.
In doing so, the price will rise to the level of resistance which used to be the support, but price broke through it, deeming it a useless area of support now. Price will get rejected again, but here the trend will reverse.
Again, you must keep in mind that for it to be a successful double bottom and not a failed double bottom, price must break through the area of resistance to deem it a successful indication that the bulls have reversed the bearish trend.
To make the limitation of double tops and double bottoms clear, one must understand that they are a very effective reversal pattern.
But, if the area of support is not broken in a double top and the area of resistance isn’t broken in the double bottom, it could be detrimental to your results.
4. Wedges
Wedges are formed when the price action of an asset moves between two sloping trend lines. There are two different types of wedges, these include; rising and falling wedges.
In the picture below there is an example of what a rising wedge looks like. It is formed when there are two trendlines are going in an upwards direction.
What this pattern tells you is that if the price of the asset breaks through the line of support shown in the image below, there will be a potential reversal in the price of an asset from an uptrend to a downtrend.
On the other hand, the falling wedge is formed when there is a downtrend that is occurring between two downward sloping levels of support and resistance.
When looking at the falling wedge, it is evident that the resistance line is steeper than the support line.
What the falling wedge indicates to a trader is that an assets price will rise when it breaks through the level of resistance which is shown below.
5. Bullish and Bearish Pennants or Flags
The two indicate the same thing. However, traders have different names for them. The pennant or flag is created when an asset undergoes a period of either bullish or bearish movement, this is followed by an area of consolidation.
This area of consolidation inside of the pennant can represent a continuation of price.
In the pictures above, we can see the continuation of a trend when identifying the pennant. The pennant looks very similar to the wedge pattern.
But it is important to note that wedge patterns are usually narrower, in comparison to the pennant.
In addition to this, pennants are always formed after a strong upward or downward move in price, followed by an area of consolidation (horizontal) before the trend continues in the same direction.
Whereas, wedges are always formed when price is up trending or down trending.
To identify a bullish pennant, you will have to first identify an upward movement, otherwise known as the ‘pole’.
Secondly, you must look out for the consolidation of price which is formed by a near enough symmetrical triangle with support and resistance.
What happens in the bullish pennant is that, due to a high bullish market sentiment the ‘pole’ is formed. After that buyers that pushed the price up will back out of their positions, this causes sellers top come in with the hope they can retrace price.
The parity between buyers and sellers causes the price to consolidate. However, the parity between the bulls and bears cannot last forever.
The positive market sentiment win, this is because the traders who have been waiting to buy the asset flood back in and continue to uptrend.
The bearish pennant on the other hand, can be identified after a downtrend.
What the bearish pennant indicates to traders is that after price breaks through the support line, the downwards trend of price will continue.
What happens in the bearish pennant, is the complete opposite as to what takes place in the bullish pennant.
After a downtrend, there is parity between buyers and sellers, but without enough bullish sentiment in the market, the market carries on to descend down after consolidating.
The key thing to take away when trading using pennants, is that the best place to enter a trade is after the area of resistance is broken during an uptrend. As well as, when the area of support is broken during the bearish pennant.
6. Rounding Bottom and Rounding Top
The rounding bottom chart pattern looks like the letter ‘U’. It can indicate a reversal in long term price movements. The rounding bottom is found at the bottom of an extended downward trend.
The patterns time frame can vary from weeks to even months, this is why it is deemed as a very rare occurrence to many traders out there that use technical analysis.
The first declining slope that is visible in the rounding bottom identifies the excess of supply that brings the asset prices down.
The reversal from a downtrend to an uptrend then occurs when buyers enter the market when price is low, this increases the demand of that asset.
Once the rounding bottom is then complete, the assets price will breakout and then continue its new uptrend. Thus, making it an indication of a positive market reversal.
Traders will look to profit by entering half way through the bottom of the rounding bottom. They will then begin to capitalise on their position once it breaks through the level of resistance - as specified in the picture below.
The rounding top is basically the same as the rounding bottom. Nevertheless, what the rounding top indicates is that after an initial uptrend, the bears are starting to flood the market, which reverses price into a downtrend.
7. Cup and Handle and Inverted Cup and Handle
The cup and handle chart pattern is a bullish continuation pattern which identifies a period of bearish market sentiment before the overall trend continues in a bullish direction.
Here it is evident that the pattern involves a rounding bottom and a wedge pattern all in one.
Subsequent of the rounding bottom, the price of an asset will retrace slightly, as sellers will begin to enter the market- this is shown by the price which is narrowed between the support and resistance lines on the right in the image (representing the wedge).
Once the price of an asset eventually reverses past the resistance level in the ‘handle’ it will continue the bullish trend.
The inverted cup and handle on the other hand is a bearish continuation pattern. Therefore, it comes after there has been a downfall in price. Then comes a bullish retracement where buyers will enter the market.
But ultimately, once you see the support level of the wedge get breached by price, you know that it will be a good time to enter a short position as price is likely to continue its downtrend motion.
8. Ascending Triangle
The ascending triangle is a chart pattern that signifies a continuation of an uptrend. The triangles lines can be drawn onto a chart by using two horizontal lines to represent the support and resistance between the swing highs and swing lows, as identified by the image below.
The ascending triangle often has two or more peaks, this enable an accurate resistance line to be drawn. This line indicates the overall uptrend of the pattern.
Whereas, the horizontal line underneath represents historical levels of resistance for that asset.
Therefore, once price breaks through that resistance level it gives the trader a clear indication of the continuation of the bullish sentiment within the market.
9. Descending Triangle
On the contrary to the ascending triangle chart pattern. The descending triangle suggests the continuation of a downtrend.
The descending triangle can be identified using a horizontal line of support and a downward sloping line of resistance that consists of lower highs.
Once the line of support is broken in a descending triangle, it can signify to a trader that the trend will continue to descend.
10. Symmetrical Triangle
When it comes to the symmetrical triangle, it can be either bullish or bearish, it really just depends on the direction the market is currently moving in. Nevertheless, it is considered to be a continuation pattern.
The triangle is made up of two converging trend lines that connect a series of sequential peaks and troughs.
In the image below, the overall trend is seen to be bearish. But the symmetrical triangle shows us that there has been a brief period of upward reversals.
The trader must take into consideration that if there is no clear trend before the symmetrical triangle takes shape, the market could break out in either a bearish or bullish direction. This makes symmetrical triangles a bilateral pattern.
Chart Patterns Summed Up
All of the chart patterns that I have depicted in this section will allow a trader to understand why or how an assets price has moved in a certain direction, as well as identifying the direction it may move in in the future.
The reasons that chart patterns are helpful to a trader is due to the fact that they can help a trader identify areas of support and resistance, ultimately helping the trader decide whether they want to long or short an asset.
Or, it could also help a trader in deciding whether they should close out their positions in case a trend reversal may be forthcoming.
In addition, chart patterns can be even more effective at telling a trader about a potential reversal or continuation, this is if candle stick formations appear inside of them. This leads me on nicely to the next topic which is candlestick formations.
8. Candlestick Patterns in Technical Analysis
A candlestick? What has this got to do with trading? I hear you ask.
A candlestick is an important tool that is used by technical traders, it helps them interpret possible market trends or potential reversals within the market. These can be both bullish and bearish.
So, what does a candlestick look like? Well, in the picture below, you can see that a candlestick is made up of 3 parts. The wick (or tail) at the top represents the highest price for the candle, the wick at the bottom represents the lowest price of the candle.
The main body of the candlestick itself represents the difference between the opening and closing prices of the candle.
For example, if the candlestick was green it means that the close was higher than the open. Whereas, if the candle was red, it would mean close was lower than the open.
Candlesticks can be found in bar form and candle form. The image above represents candlesticks but in a bar form.
Whereas, the image below represents candles in candle form. Both depict the same thing.
Bullish Candle Stick Patterns
Bullish patterns are formed after a downtrend in the market. It also signals reversal within the markets price. The first bullish candle stick pattern I will be discussing will be:
1. Hammer
The hammer is formed by a small body and long wick. What the hammer shows you is that, ultimately even though there was selling pressure during the day, strong buying pressure drove the price of the price of the asset back up.
The colours of hammers can vary, the only difference is that a green hammer may represent a stronger bull market sentiment than red hammers.
2. Inverse Hammer
In truth the inverse hammer is very similar to the normal hammer. However, the only difference is that the upper wick is much longer on the inverted hammer. Whereas, the bottom wick is longer on the normal hammer.
What the inverted hammer tells you is that although there has been buying pressure, it was followed by selling pressure that drove price down, but it was not strong enough to bring the price down below its opening value.
Ergo, what it implies is that buyers will soon have the control of the market.
3. Piercing Line
Like the bullish engulfing pattern, the piercing line pattern is also a two-stick pattern. It is made up of a long red candle, followed by a long green candle.
When looking at the image above, it is clear to see that there is a big difference in the red candlesticks closing price and the green candles opening price. The difference indicates that buyers have come into the market with a lot of volume.
Therefore, when price is pushed up to, or above the middle price of the red candle, it will indicate a reversal after a downtrend as buyers have a lot more power than the sellers.
4. Morning Star
Unlike any of the previous bullish candlestick patterns I have spoken about above, the morning star is composed of 3 candlesticks, it is most effective when seen after a down trending market.
The three candles are made up of two long bodied candles which sandwich, one short bodied candle ion between them. The ‘star’ (small candle) will usually not tend to overlap with the longer bodied candlesticks as the market gaps both on open and close.
A great way to use the morning star candlestick formation is when it is forming at the bottom of a downtrend, when price is nearing an area of resistance, or when using the RSI, it can show you whether an asset is overbought or oversold.
So, when price looks oversold and an evening star forms, it can be a great signal of reversal to enter a long position.
5. Bullish Engulfing
The bullish engulfing pattern is formed by two different candlesticks. The first candlestick must be a short red bodied candlestick, followed by a larger green candlestick that engulfs the red candlestick.
The engulfing pattern depicts to a trader that, although on the second day (green candle) price opens lower than that of the first day (red candle), the bulls in the market push the price up high enough to indicate that they are taking over the market sentiment.
6. Three white soldiers
Similar to the evening star, the three white soldier formation occurs over a 3-day period, meaning that it is formed by three candles. It consists of three green candles with small wicks which open and close gradually higher than that of the previous day.
It is a great bullish signal especially after a downtrend in price, this is due to the fact that, it shows a steady advance of buying pressure within the market, in turn reversing price from bearish to bullish.
Bearish Candle Stick Patterns
Now that I’ve gone over some of the most popular bullish candlestick patterns, I will explain the most widely used bearish candlestick patterns for traders that use technical analysis.
1. Shooting star
The shooting star looks the exact same as the inverted hammer, however it is formed at the end of an uptrend. In comparison to the inverted hammer which is shaped at the bottom of a downtrend. It has a small body and long upper wick.
The shooting star is most effective when it forms after a series of higher highs (normally two or three). What happens in a shooting star is that the buying pressure over the past couple of days is halted.
This is due to the fact that, as the day progresses sellers’ step in, this then pushes the price of an asset back down near to where it opened.
This erases the gains that were made throughout that day, subsequently pointing towards buyers losing control and sellers taking over.
Consequently, if price continues to rise after a shooting star formation at the top of a trend, the price might consolidate in that area and use the shooting star as resistance. However, if price still continues to rise, traders should stay in their long positions.
2. Hanging man
This candlestick formation is identical to that of the hammer. Just try to imagine this candle stick formation as a hammer that is hammering a nail down. But instead of a nail it hammers price downwards after an uptrend.
What the hanging man formation indicates is that there was a substantial sell off during the day, but buyers were able to push the price up again.
Nevertheless, the large sell off is frequently seen as an indication that sellers are taking control over the market.
3. Evening star
Similar to the morning star, the evening star is also a three-candle formation. The only difference is that the evening star is formed at the top of an uptrend, unlike the morning star that is formed at the bottom of a downtrend.
The first candle consists of a large green candle, the second candle is much smaller and shows a modest increase in price. Finally, the third and final red candle opens at a price below the previous day and closes near the middle of the first day.
In the image above, you will notice that the evening star also contains a hanging man, this being visible at the top of a trend is a great indication of a bearish reversal incoming.
4. Bearish engulfing
This candle stick formation takes place at the end of an uptrend once again. It contains two candlesticks. Of which, the first one is a small green body that gets ‘engulfed’ by a much larger long red candlestick.
What it signifies is that price is slowing down and that sellers are beginning to take over the market. The bigger and longer that the red candlestick is, the more significant the indicator will be to suggest that there is a bearish trend reversal on the way.
When looking at the bearish engulfing pattern, the trader must take into consideration that if price action is choppy, even if the price is rising overall, the significance of the engulfing pattern is diminished as it is a commonly appearing signal.
So, when looking for a bearish engulfing pattern, you can also use an RSI indicator to help identify whether an asset is overbought or not. If so, it is a great indication that price is on its way down.
5. Three black crows
This pattern is comprised from three consecutive long red candles that have little to no wicks on the end of them.
Each candle opens at a similar level to the close of the previous days candle. However, selling pressure pushes the price down lower and lower with each close.
This candlestick formation is seen to be very effective at interpreting the start of a bearish downtrend. This is because sellers have overtaken buyers for the last three consecutive trading days.
What can make the three black crows more accurate is volume. What I mean by this is that if volume on the uptrend prior to the three black crows is low, and the volume of the three black crows is relatively high.
It indicates that the uptrend was established by a small group of buyers, only to be reversed by a larger group of sellers.
6. Dark cloud cover
Think about how your mood changes when a gloomy day arrives straight after a day of intense sunshine the day before. It gets worse right? Well, that is exactly what happens when the dark cloud cover is formed at the top of an uptrend.