What you always wanted to know, but were afraid to ask
Even the best stocks, with very strong fundamentals have their ups and downs. The stock price is often driven my invertors’ emotions and the overall market sentiment. Sometimes it happens that people over-react on bad news, sell the stock, but then the news is forgotten or proven wrong and the stock rebounds.
There is a famous saying which goes: “Buy the rumors, sell the news”, which indicates exactly the price behavior and its influence by media.
We have justified the swing of the price, now it is time to see how to read the charts showing these swings.
❓ So first of all, what is Technical Analysis?
Technical analysis is the forecasting of price by using the data generated in the process of trading over a period of time. In Technical analysis we have to read historical charts to determine the future price of Stocks.
There is an important foreword before we start. Technical analysis is not a crystal ball predicting the future, it is rather a mathematical and graphical approach to help investors optimize their buy and sell points. The charts can simply reflect the investors sentiment and represent that in a graphical form, and this is why this technique can give results.
Now, let's look on the type of charts and which chart should be useful and easy for technical analysis.
📈 Type of charts 📉
The simplest possible chart is the Line chart or the Mountain chart. Here, the price is represented just by a line which goes from left to right:
It is straight forward to understand, thus there is nothing more to describe. It is good to get a feeling about the price evolution of time, however it does not give any information about the stock’s intraday price movements.
This is why people invented the so-called Candlestick charts. They are the most used when speaking about technical analysis.
This type of chart gives much more information about the intraday movements of the stocks, and it is quite simple to read them.
In the image below there are two types of candles, one is green, means bullish candle, and other one is red, means bearish candle. The filled area is called body, while the thin lines where high and low are marked are called wicks.
BULLISH CANDLE (Green) – is when a stock closes at a price higher than opening price. For example, a stock opened at 4$ and closed at 5$.
BEARISH CANDLE (Red) – is when a stock closes at a price lower than the opening price. For example, a stock opened at 5$ and closed at 4$.
The upper and the lower wicks, show where the price has been during the day, i.e., the top and the bottom of the intraday variation.
Please note, although I am always referring about one candle representing one day, it can be also that one candle represents 4 hours, 1 hour and so on, depending on how you setup the chart.
Now that you understood how to read them, we will move from the simplest patterns to more advanced techniques.
One candle patterns
Based on the behavior of the price indicated by a single candle, one could anticipate the behavior during the next period.
Of course, it is not possible to trade using solely one candle patterns, however is useful to understand them. Here are the most used.
MARUBOZU CANDLE – Candle having big body and low wick or no wick. It could be a green or a red candle.
It indicates strength and weakness of price but it doesn’t indicate any trend reversal (about that later). If it is green, it represents a strong bullish sign, and if red that’s a strong bearish sign.
You have to take a trade when candle closes above MARUBOZU candle if it’s green and closes below MARUBOZU if its red.
A simple example would help to understand better. So here are 3 of them, each candle representing a day on the chart of AMD:
According to patternswizard.com, Marubozu candle has a 30.5% success rate, when having a target of 2:1 reward to risk ratio.
Again, it is not advised to trade only relying on a single pattern, however you can get an impression of where the market is heading.
DOJI PATTERN - candle having very thin body, for example a stock opened at 4.9$ and closed at 5$.
During the day there were buyers who moved the price upward and there were sellers also, who moved the price down. Typically, it has a small body and a long wick, which indicates an indecision in the market, therefore it is a neutral pattern, but it plays a significant role when spotted in groups of patterns, as you will see later.
HAMMER PATTERN - Indicates a trend reversal. If a stock is going down and you find a hammer, then there is a chance that stock will change the direction upwards and vice versa.
This pattern has a significant probability of success, which is up to 40.8% according to patternwizard.com, when targeting for a 2:1 Reward/Risk ratio.
Here are 3 examples on the AMD stock:
We covered 3 of the frequently spotted single candle patterns. The next level is to analyze patterns formed by groups of candles.
Groups of candles
By examining 3 or 4 consecutive candles, we can identify trend reversals. Let’s have a look at 3 popular patterns.
Three Line Strike – it is formed by 3 consecutive red candles which close lower and lower, but then a 4th green candle comes which closes even higher than the first red candle. This is a sign the trend is going to reverse and continuing upwards.
Abandoned Baby – A bullish pattern appears when a Doji candle appears on a downtrend, with a gap from the previous candles. The thin Doji candle in this case indicates that there are no more fresh sellers to drive the price lower, thus the buyers are likely to over-drive the price direction.
Two Black Gapping – this is a bearish pattern. It appears after a remarkable top when there are two strong red candles posting lower lows. This pattern signals a possible longer down trend.
My final word before moving forward, is that none of these patterns will make you a fortune alone. Rather, you should understand and apply more patterns, as well as following higher order techniques. And this is the next chapter about.
📏 Now let’s talk about Support and Resistance Levels
Support levels are those price levels where there exists a sufficient number of buyers to stop the downward movement of price. Similarly, Resistance levels are the price levels where there exists a sufficient number of sellers to halt the upward movement of a price.
On the charts this appears as consecutive valleys or peaks which tend to behave as a barrier, which is touched over and over again. Investors can optimize their performance if they buy at the support level and sell at resistance.
However, traders shall be careful for breakouts, as break-out down through the support level could indicate a bearish trend is upcoming.
If the resistance breaks, then the above resistance will act as a new support line, and this cycle continues like this.
ALWAYS GO WITH A TREND. TREND IS YOUR FRIEND💹
I mentioned already the “Trend” term several times. Now it is time to understand what it means.
A trend line is a straight line that connects two or more price points and then extends into the future to act as a line of support or resistance as the case may be.
Trend lines connect a series of high or low price points in order to define or confirm a trend. The trend may be an up-trend or a down-trend, but in all cases at least two relative price highs or lows are needed to draw the trend line. You can also think of it as of an oblique support or resistance line.
If price breaks the trend line, it’s called a breakout, and a trend reversal might happen.
It is very important to determine the trend of the asset that you are going to trade, since making money by buying during a negative trend is barely possible.
Up to now we talked about the basic principles and techniques. Starting with the next chapter we will go through more advanced instruments.
Thanks for reading and feel free to share your thoughts in the comments section.
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