Technical Analysis I

Continuing patterns 2 : Triangles

Whenever there is a convergence of two trend lines – flat, ascending or descending – with the price of the security moving between the two trendlines, it takes shape of a triangle. A triangle formation can be any of the following types : Symmetrical Triangle , Ascending Triangle and Descending Triangle. All the three are continuing patterns, meaning that it signals a period of consolidation in a trend followed by a resumption of the prior trend.

Symmetrical triangle formation: it is formed by the convergence of a descending resistance line and an ascending support line. The two trendlines in the formation of this triangle should have a similar slope converging at a point known as the apex. The price of the security will bounce between these trendlines, towards the apex, and typically breakout in the direction of the prior trend. that is , if preceded by a downward trend, the focus should be on a break below the ascending support line. If preceded by an upward trend, look for a break above the descending resistance line. As the symmetrical triangle extends and the trading range contracts, volume should start to diminish. This refers to the tightening consolidation before the breakout. The symmetrical triangle can extend for a few weeks or many months. If the pattern is less than 3 weeks, it is usually considered a pennant. Typically, the time duration is about 3 months. Symmetrical triangle is a ‘neutral’ formation. The future direction of the breakout can only be determined after the break has occurred.  Attempting to guess the direction of the breakout can be dangerous. Even though a continuation pattern is supposed to breakout in the direction of the long-term trend, this is not always the case .A break in the opposite direction of the prior trend should signal the formation of a new trend.

Example :

Ascending Triangle: The ascending triangle is a bullish pattern, which gives an indication that the price of the security is headed higher upon completion. The pattern is formed by two trendlines: a flat trendline being a point of resistance and an ascending trendline acting as a price support. The ascending triangle indicates that the sellers are now less interested in the stock and the buyers volume is increasing. Once the demand increases, the price naturally will tend to go up and break the resistance levels and resume the upward trend.

Descending Triangle: Descending triangle is just the opposite of ascending triangle. If an ascending triangle was a bullish pattern, a descending triangle is a bearish pattern .In a descending triangle formation, the two trendlines drawn will show a flat support line and a downward-sloping resistance line. Indicating that the prices will fall further. As the pattern develops,  volume usually contracts. When the downside break occurs, there would ideally be an expansion of volume for confirmation. Volume confirmation is important.

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Continuing patterns 1 : Flag & Pennant

A continuing pattern indicates that the prior trend will continue onward upon the pattern’s completion.

The Flag and pennant are two short-term continuation chart patterns that are formed when there is a sharp price movement followed by a generally sideways consolidation. The price then moves sharply either upwards or downwards but generally in the same direction as the move that started the trend. By using the term ‘Flag’ it doesn’t mean that the trend formation would look exactly like a flag. The basic characteristic of a flag pattern is that it will have two trend lines sloping generally in the opposite direction of the initial price movement The buy or sell signal is formed once the price breaks through the support or resistance level, with the trend continuing in the prior direction. This breakthrough should be backed by heavier volume to improve the signal of the chart pattern.

EXAMPLE

You may notice the following –

There are two trendlines drawn, both sloping downwards e in the opposite direction of the initial price movement. Through the trend lines you see certain price level beyond which the stock prices neither fall nor rise. These points are support and resistance levels in the flag pattern. Once the price breaks out of the resistance level, the stock prices continues to move in the initial direction ie upwards.

PENNANT

The pennant is slightly different from the flag pattern. Here the two trendlines converge towards each other and the direction of the pennant is not important as in the case of flag.

EXAMPLE

The attributes of the flag and pennant are similar and it can be summarized as follows:

SHARP PRICE MOVEMENT

It all starts from a prior trend. There should be evidence of a prior trend – either upwards or downwards. Such a price movement should be backed by heavy volume.Such moves may also contain gaps (we’ll discuss the theory of gaps later). Such a move usually halts or pauses temporarily causing sideways movement for sometime, resulting in a flag or pennant formation.

DURATION

The sideways movement (flag/pennant) can last from 1 to 12 weeks. There is some debate on the timeframe and some consider 8 weeks to be pushing the limits for a reliable pattern. Ideally, these patterns will form between 1 and 4 weeks. Once a flag becomes more than 12 weeks old, it would be classified as a rectangle. A pennant more than 12 weeks old would turn into a symmetrical triangle. The reliability of patterns that fall between 8 and 12 weeks is therefore debatable.

BREAKING THE FLAG/PENNANT

For a bullish flag or pennant, a break above resistance signals that the previous advance has resumed. For a bearish flag or pennant, a break below support signals that the previous decline has resumed.

HEAVY VOLUME

Volume is the key. Volume should be heavy during the advance or decline that forms the flagpole. Heavy volume provides legitimacy for the sudden and sharp move that creates the flagpole. An expansion of volume on the resistance (support) break lends credibility to the validity of the formation and the likelihood of continuation.

We’ll take up triangles in our next article.

Bye for now..

have a nice day !!

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A study of chart patterns

One of the basic assumptions of technical analysis is that- history repeats itself, mainly in terms of price movement. Chart patterns are graphical representations of historical price movements of stocks. So, when you analyse those price movements on chart , it reveals certain repeating patterns .It shows where the prices have been, where the buyers and seller lurk and often times the trading psychology at work in the market. If human emotions drive buying and selling behavior, then careful analysis of the chart patterns can help to determine where such emotions may next surface. Chart patterns depict trading psychology in motion.

However it should be remembered that identifying chart patterns and their subsequent signals is not an exact science. While there is a general idea and components to every chart pattern, in our opinion, the price movement does not necessarily correspond to the pattern suggested by the chart.

TYPES OF CHART PATTERNS

There are two basic types of patterns – continuing patterns and reversal patterns.

A continuing pattern indicates that the prior trend will continue onward upon the pattern’s completion. A reversal pattern signals that a prior trend will reverse on completion of the pattern. The main patterns are discussed below.

Types of continuing Patterns

  • Flag, Pennant
  • Triangles- Symmetrical Triangle , Ascending Triangle and Descending Triangle
  • Cup with Handle

Types of reversal patterns

  • Double Top and Double Bottom
  • Head and Shoulders and Inverse Head and Shoulders.
  • Falling Wedge and Rising Wedge
  • Rounding Bottom
  • Triple Top and Triple Bottom

In the next few pages we’ll look in detail about each of the above patterns.

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Importance of Volume in Technical Analysis

VOLUME

Volume is simply the total number of buyers and sellers exchanging shares over a given period of time, usually a day. Higher the volume,  more active the share. The data regarding volume of a share will be readily available on your online trading screen. Most financial sites carry data about volume.

For example if the Stocks volume for the day was 1,500,000 shares that means 1,500,000 shares were sold by someone and bought by someone on that day.

Volume as such may not be an attractive piece of information. But try to combine the volume data with support and resistance levels – you‘ll get the real picture.

For example – Say stock A ltd broke a ‘resistance level’ and went up further. Also since it broke through a critical level we would expect it to go up even more in the near future.

Now, let us also consider the volume traded on that day – say 3 lakh shares were exchanged.  On a normal day 1o lakh  shares are traded. That means, Volume was way below average for that day. So, all the big investors were not trading.  They could come in the very next day and decide they are bearish on the stock. They sell and cause a panic. So the stock goes down the next day.

This is the importance of ‘volume’. Most traders will not buy a stock when it breaks a critical level unless volume is high. The reverse is also true. If a stock goes down with little volume it could mean the same thing.  The majority of investors were not trading.  When they come back they could see this stock and decide it is too low. So they buy it and the price goes up.

In short, Volume is a critical factor in technical analysis. Any support and resistance level is not valid unless it is backed by adequate volume. Volume should move with the trend. If prices are moving in an upward trend, volume should increase (and vice versa). If the previous relationship between volume and price movements starts to deteriorate, it is usually a sign of weakness in the trend. For example, if the stock is in an uptrend but the up trading days are marked with lower volume, it is a sign that the trend is starting to lose its legs and may soon end.

TIPS ON VOLUME ANALYSIS

  • Investors must always look at price patterns in conjunction with their associated volume pattern, never alone. A stock may appear to go up but the volume pattern must confirm that analysis
  • Careful analysis of the volume of selling that occurred above current resistance will help you estimate how long a stock will stall at that level
  • Well-above-normal volume is essential when separating a true from a false breakout above resistance.
  • If a stock is truly in a healthy uptrend, then volume should rise as prices rise. If this is the case, then the volume indicates that buyers are chasing the stock. This increases the probability that the uptrend will continue.

Hope you are now clear about volume and it’s importance.

In our next series of posts, we will look at some basic price chart patterns and their meaning.

Till then,

Have a nice day !!

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