Study Notes for the course Technical Analysis

Technical Analysis

Chart patterns are specific formations on the stock price charts. These formations represent recognizable patterns that are repeatedly seen in the market, and are used to determine the future movement of the stock prices.

The patterns represent the psychology of the market and investors, and also determine the future behaviour of the market.

In a completely rational market, these patterns may not exist. However, investors, traders, and managers react with similar emotions all the time, and exhibit repeated behaviour, which leads to these patterns. We can say that the patterns reflect the collective psychology of the market.

Traders can read these patterns, and forecast the future market movement to their advantage.

The chart patterns can be broadly classified as reversal patterns and continuation patterns.

Reversal chart patterns signal the ending on an ongoing trend, i.e., it signifies a reversal of asset’s price direction. For example, if the reversal pattern forms when the price is moving upwards, this signifies that the upward movement is over and the prices will move downwards now, and vice versa. There are various types of reversal chart patterns, such as Double Top, Double Bottom, Head and Shoulders, Inverse Head and Shoulders, Rising Wedge, and Falling Wedge.

Continuation chart patterns, on the other hand, signal that the ongoing trend will continue for some time. This means that after the formation, the price movement will continue to follow the same trend as it was before the formation. So, if the prices were moving upwards before the formation, they will continue to move upwards after the pattern formation also. This kind of pattern is also called healthy correction. If the price moves downwards, it will quickly start moving upwards, as another set of investors will start buying. The long term trend will continue to be the same. There are various continuation patterns, such as wedges, rectangles, pennants, and flags.

Apart from reversal and continuation chart patterns, there are also bilateral chart patterns. These are a little confusing and signal that the prices and move in either direction; upward or downward. The most common type of bilateral formations is triangle formations. At the end of the triangle formation, the price can break either upwards or downwards. When seeing triangle formations, the traders should be prepared for the action taking place on either side to benefit from the movements.

We will discuss each of these patterns in details in the coming articles.

Chart Patterns in Technical Analysis

In the <a title="Chart Patterns in Technical Analysis" href="https://financetrain.com/chart-patterns-in-technical-analysis/">Chart Patterns Overview</a>, we discussed that reversal chart patterns signal the ending on an ongoing trend, i.e., they signify a reversal of asset’s price direction. Head and Shoulders is the most common reversal pattern. There can be a normal head and shoulders pattern or inverse head and shoulders pattern, depending on whether the price trend before the formation is an uptrend or a downtrend.

Head and Shoulders

A head and shoulder pattern is preceded by an uptrend in the asset’s price. When the head and shoulders formation is seen, it signifies that the prices will now start moving downwards. The formation is depicted below. You will notice that there is a left shoulder, a head followed by a right shoulder.

<img class="aligncenter size-full wp-image-3636" title="Head and Shoulders Chart Pattern" src="https://financetrain.com/wp-content/uploads/2011/11/SH06.gif" alt="" width="388" height="269" />
<div>

The graph is read in conjunction with the volume of trade. The left shoulder is formed at the end of an extensive uptrend. The slope of the left shoulder uptrend is more than the one in the normal uptrend prevalent prior to it. This is followed by selling and the price falls down to its previous level. The left shoulder exhibits significantly high volumes. The rally begins again and the head is formed. This time the volume is high or normal. Followed by the head, the right shoulder is formed similar to the left shoulder but with significantly less volume. Once the price crosses below the neckline, it signifies the end of the head and shoulder formation.

The head and shoulder formation will rarely be perfect. However, the general characteristics will remain the same. The head will rise above both the shoulders, and the two shoulders will be very similar. The right shoulder will have significantly less trading volume, than the left one.

Once the formation is identified, it signifies that the price trend will reverse, and the prices will start moving downwards below the neckline. The trader should take advantage by placing a short order below the neckline.

Inverse Head and Shoulders

The inverse head and shoulders pattern is exactly the opposite of the normal head and shoulders pattern. It is preceded by a downtrend in the asset’s price, and the formation signifies that there will be a price uptrend after the formation. The inverse formation is depicted below:

<img class="aligncenter size-full wp-image-3638" title="Inverse Head and Shoulders Chart Patern" src="https://financetrain.com/wp-content/uploads/2011/11/SH07.gif" alt="" width="386" height="248" />

Once the formation is identified, it signifies that the price trend will reverse, and the prices will start moving upwards and will cross above the neckline. The trader should take advantage by placing a long order above the neckline.

</div>

Reversal Chart Patterns: Head and Shoulders

In the <a title="Chart Patterns in Technical Analysis" href="https://financetrain.com/chart-patterns-in-technical-analysis/">Chart Patterns Overview</a>, we discussed that reversal chart patterns signal the ending on an ongoing trend, i.e., they signify a reversal of asset’s price direction.

In this article, we will discuss the two popular reversal patterns, namely, Double Top and Double Bottom

Double Tops: The Double Top pattern is formed when an uptrend reverses twice in a very short interval, at almost the same price level. The pattern is depicted below:

<img class="aligncenter size-full wp-image-3641" title="Double Tops" src="https://financetrain.com/wp-content/uploads/2011/11/SH08.gif" alt="" width="393" height="220" />
Some of the characteristics of double top are:
<ul>
	<li>The price reversal happens at almost the same price high.</li>
	<li>The volume on the second high is lower compared to the first high. This signifies a decrease in demand.</li>
	<li>The distance between the two tops and the depth of the valley signify the strength of the formation.</li>
	<li>At the end of the formation, the price is expected to fall below the neckline by atleast the difference between the valley low to the high of the tops. For example, suppose that for ABC stock, the first top is $90.1, the valley low is at $88, and the second top is at $90.2, the price will fall to atleast $88 – ($90.1 - $88) = $86.1.</li>
</ul>
Double Bottoms: The double bottom pattern is formed during a downtrend, when the price rebounds twice, and reaches back the same level. The pattern is depicted below:

<img class="aligncenter size-full wp-image-3642" title="Double Bottoms" src="https://financetrain.com/wp-content/uploads/2011/11/SH09.gif" alt="" width="393" height="203" />

The double bottoms are exactly the same as the double tops, except that they are observed in a downtrend, and traders use these to predict changes from downturns to uptrends in security prices.

At the end of the formation the price is expected to rise above he neckline. When a trader observes a double bottom, he can place a long order at the top of the formation's neckline. The target can be set as high as the distance from the bottoms to the neckline.

Reversal Chart Patterns: Double Tops and Bottoms

In the <a title="Chart Patterns in Technical Analysis" href="https://financetrain.com/chart-patterns-in-technical-analysis/">Chart Patterns Overview</a>, we discussed that reversal chart patterns signal the ending on an ongoing trend, i.e., they signify a reversal of asset’s price direction.

In this article, we will discuss the two popular reversal patterns, namely, Rising and Falling Wedge.

The wedge pattern is a commonly found pattern in security prices. It is characterized by a gradually contracting range of security price in an upward or a downward direction. During the time of the formation, the prices oscillate up and down between a range, and this price range keeps reducing. An upward sloping wedge is known as Rising wedge, while the downward sloping wedge is known as Falling wedge.

A rising wedge is formed during an uptrend, and is used to predict the price movement from an uptrend to a downtrend. A falling wedge is formed during a downtrend, and is used to predict the price movement from a downtrend to an uptrend. The wedge pattern is depicted below:

<img class="aligncenter size-full wp-image-3647" title="Rising and Falling Wedge" src="https://financetrain.com/wp-content/uploads/2011/12/SH10.gif" alt="" width="574" height="279" />

Some of the important characteristics of the wedge pattern are listed below:
<ol>
	<li>A falling wedge is bullish in nature signaling a reversal of trend from downtrend to uptrend. The opposite is the case for rising wedges, i.e., it is bearish in nature.</li>
	<li>In the falling wedge the upper trend line (the resistance), has a greater slope than the bottom trend line (the support).</li>
	<li>The rising wedge pattern is considered complete, when the price breaks out below the bottom trend line, i.e., the sellers have taken control.</li>
	<li>The falling wedge pattern is considered complete, when the price breaks out above the top trend line, i.e., buyers have taken control of the security.</li>
	<li>The strength of the wedge is judged by how many time the price movement tests the support and resistance trend line. The more number of times it tests the trend lines, the stronger is the pattern signal.</li>
</ol>

Reversal Chart Patterns: Rising and Falling Wedge

In the Chart Patterns Overview, we discussed that continuation chart patterns signal that the ongoing trend will continue for some time. This means that after the formation, the price movement will continue to follow the same trend as it was before the formation.

Rectangles are common continuation pattern. They suggest that the prices will continue to move in the same direction as it was before the pattern was formed. A rectangle is like a period of consolidation. The traders are indecisive about the security. The prices start moving upwards and downwards, bound by parallel support and resistance trend lines. There are equal buyers and sellers, and the price is tested against the trend lines multiple times. This continues for around 3 weeks (or even more) after which the prices start moving towards the prior direction. The rectangles are also seen during intra-day trading.

<img class="aligncenter size-full wp-image-3653" title="Rectangle Patterns" src="https://financetrain.com/wp-content/uploads/2011/12/SH11.gif" alt="" width="542" height="271" />

The rectangle pattern formed in an uptrend is called bullish rectangle, while the rectangle pattern formed during a downtrend is called bearish rectangle.

During the rectangle patterns, the volumes generally dive, however, they increase quite a bit during the breakout. The rectangle is generally formed in a very narrow price range.

Continuation Chart Patterns: Rectangles

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Technical Analysis

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