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Trading Knowledge

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While Fundamental Analysis looks at the intrinsic value of an asset, Technical Analysis studies the cause of market movement. It is the use of statistical patterns to identify possible trends in a financial instrument.

This is done by analysing historical prices and the price action of an instrument to determine future patterns. Technical analysis does not attempt to measure intrinsic value, with the assumption that price movements already factor in the fundamentals of an asset.

Put simply, technical analysis helps investors to predict what will happen in the future by looking at what has happened in the past.

Why is technical analysis useful

It’s a common misconception that technical analysis is all about charts. There are plenty of skills involved in technical analysis which, if applied correctly, can increase the probability of making a winning trade. It is a way of reducing risk when making trading decisions.

Support and Resistance

Support and resistance is a concept used within technical analysis that suggests that the market price of an asset will have a higher chance to pause or reverse at certain predetermined levels due to a concentration of supply or demand.

Support
The support level is the price value at which an asset on the downtrend is more likely to pause or “bounce” off. If the price of an asset does continue dropping, and goes below the support level, it is called a breakout. If a price does break through its support original support level, it will often continue to fall until a new support level is identified.

Resistance
Resistance is the opposite of support. The resistance level is the price value at which an asset on the uptrend is more likely to pause or “bounce off” rather than break through. In the event that a price does break through its resistance level, it will often continue to rise until it finds another resistance level.

The diagram above gives an example of support and resistance levels.

The zig-zag pattern that we see here shows an upwards trend and demonstrates how new levels of support and resistance are determined as the market moves.

How do I find support and resistance

Now that you have a general idea of what support and resistance levels are, it is time to learn how to identify them.

Unfortunately, support and resistance levels aren’t exact numbers that can be worked out using a formula or rule. A support or resistance level might appear to have been broken, but it can also be a case where the market is testing said levels. The support levels thus remain in place.

The fact that support and resistance levels are often depicted as lines is sometimes misleading as they are not exact figures. So, it is often simpler to think of support and resistance as zones as opposed to definitive levels.

The two types of support and resistance

There are essentially two types of support and resistance: major and minor.

A minor support or resistance level is a weak one – and is usually broken to test a major support or resistance level. A support or resistance level is considered minor when it is broken through after a few tests, while a major level is defined as such if it can withstand three or more tests – or cases where the price bounces off it.

Trendline Channels

“The trend is your friend” is a popular expression used by traders. That’s because trends form the basis of many a trading plan. After all, trends are an indication of the general direction the price of an asset is going – and should be given some attention.

An uptrend, which is characterised by successive higher highs and higher lows, is depicted as a line connecting two or more pivot points, drawn along the bottom of easily identifiable support areas

In a downtrend, which is characterised by successive lower highs and lower lows, the trend line connects two or more pivot points, drawn along the top of easily identifiable resistance areas.

How to Draw Trend Channels

Channels add a dimension to the trend line theory. A channel is created by drawing a parallel line at the same angle as the uptrend or downtrend line.

  • To create an uptrend channel, draw a parallel to an uptrend line, then move that line to a position where it touches the most recent high
  • To create a downtrend channel, draw a parallel to the downtrend line, then move that line to a position where it touches the most recent low.

When drawn correctly, channel lines can be used as a guide to buy or sell. Prices on and beyond the bottom trend line might be used as a buying area. Prices that hit, and go beyond the upper trend line might be used as a selling area.

Indicators

Technical indicators broadly fall into two categories: leading indicators and lagging indicators.

  • Leading indicators will change in advance of expected economic trends. They are often used to predict future movements but are not always necessarily accurate.
  • Lagging indicators are used to summarise past movements as opposed to predicting the future. They change after the economy has already begun to follow a particular pattern or trend.

Types of Lagging Indicators

Moving Averages
A moving average is a type of technical indicator that traders use to calculate the average price of a security over a given period.

There are two different types of moving averages: the simple moving average (SMA) and an exponential moving average (EMA)

Simple Moving Average (SMA)
A simple moving average is calculated by adding up the last “X” period’s closing prices and then dividing that number by X. 

If you wanted to plot a point for a 10-period simple moving average on a 1-hour chart, you would add up the closing prices for the last 10 hours, and then divide that number by 10. 

A simple moving average shows us the overall sentiment of the market at a point in time. It helps with identifying the market direction by smoothing out market noise (price fluctuations) over time and can also be used to identify support and resistance levels as well as to generate buy/sell signals.

One problem that traders often experience with SMAs is that they are very susceptible to price spikes.

Exponential Moving Average (EMA)
EMAs place more weight on the most recent periods and react faster to recent prices than SMAs. The shorter the EMA period, the higher the weight that the current price will carry in the MA curve, and vice versa.

When to use SMAs or EMAs?
Deciding between simple and exponential moving averages is a matter of your trading style. Each has its pros and cons, and traders should pick the one that better fits their trading strategy.

EMAs:

  • Respond faster to price movement, helping you catch trends faster and more accurately than SMAs.
  • However, a fast reaction can cause a price spike to be misinterpreted as the start of a trend

SMAs:

  • Are more suited to a long-term view of the market and is best applied to trends over a longer period. Sudden price spikes carry less weight and are less likely to mislead.
  • However, SMAs are slow to react, which makes it harder to take advantage of short-term price movements. 

Now that we have compared the two, consider whether your trading strategy involves looking at the long term or short term.  Both can be used simultaneously too.

How to use moving averages
Moving averages are used to facilitate trading strategies such as:

  • Identifying trends and reversals
  • Measuring the strength of the market’s momentum
  • Recognising support and resistance levels
  • Spotting potential entry and exit points

Identifying trends

As mentioned, moving averages are lagging indicators. They do not predict new trends but confirm trends once they have started.

Moving averages are often used to identify trends like the one displayed in the graph above. When the price of the product is higher than that of the moving average, the price can be said to be in an uptrend.  For example, many traders will only consider going long when the price is trading above a moving average.

The opposite is also true. In instances where there is a downward slope with the graph displaying prices lower than the moving average, traders will use this to confirm a downtrend.

Identifying momentum with Moving Averages
The strength and direction of a market’s momentum can also be assessed by the use of moving averages. On the graph below, two moving averages have been applied

In this graph, an upward momentum can be seen in instances where the shorter-term averages are located above longer-term averages.

When the shorter-term averages are located below the longer-term averages, the momentum is in the downward direction.

Finding Support and Resistance with Moving Averages

The falling price of a market can stop and reverse direction at the same level as an important average.  This means that moving averages can often be used to identify support and resistance levels on a chart.

An example can be seen in the graph below when the 200-day moving average can be seen to have provided a support level.

Moving averages that are based on longer time periods will give you a stronger and reliable view of a support level than shorter time frames.

In cases where the price falls below an important moving average, it can then act as a resistance level which traders often use as a sign to take profits or to close out any existing long positions.

Traders also use these averages as entry points to go short because the price often bounces off the resistance and continues its move lower.

Finding crossovers with Moving Averages

Moving Averages can be used to generate buy and sell signals by identifying when an uptrend or downtrend is starting

As we discussed previously, moving averages can be used to define up and downtrends. Therefore, moving averages can also be used as signals to buy or sell.

A price crossing above a moving average can be a signal to go long or close out a short position.

A price crossing below a moving average can be a signal to go short or close out a long position.

The most common type of crossover is when the price moves from one side of a moving average and closes on the other – this can be seen in the graph below.

When the line for a short-term average crosses the line for a long-term average, it can mean momentum is shifting in one direction and that a strong move is approaching.

A buy signal is when the short-term average crosses above the long-term average.

A sell signal is when a short-term average crosses below a long-term average.

Leading Indicators

As mentioned, leading indicators are meant to give a prediction of movement or expected economic trends. They are often used to forecast future changes – but are not always accurate. Some key examples of leading indicators will be discussed below:

Relative Strength Index (RSI)
The Relative Strength Index [RSI] is a momentum indicator that determines the speed and change of price movements. It allows traders to measure the buying or selling momentum of a product.

The RSI oscillates between 0 and 100. While it can vary based on the current price trend or a trader’s personal choice, an asset is generally thought to be overbought when the RSI goes above 70; and oversold when it goes below 30.

What does overbought and oversold mean?

Being overbought is a situation in which the price of a market has risen to such a degree – usually on high volume – that an oscillator like the RSI has reached its upper bound, indicating that the demand for an asset has pushed its price up to unjustifiable levels.

Generally, when a market is overbought, it is an indication that the market is becoming overvalued and may experience a pullback.

Meanwhile, a market is oversold when it has declined too steeply and too fast relative to underlying fundamental factors. This condition is usually a result of market overreaction or panic selling.

Overselling is generally interpreted as a sign that the price of the asset is becoming undervalued and may represent a buying opportunity for investors.

Where there are quantifiable indicators and general ideas on how to gauge the outlook in the market, determining the degree to which an asset is overbought or oversold is very subjective and can differ between traders.

Stochastic Oscillator

The Stochastic Oscillator is another example of a leading indicator. It is a momentum indicator that measures the speed of change of price or the impulse of price. It does this by comparing an asset’s closing price against its price range over a given time period.

Similar to the RSI, Stochastic Oscillators also have levels that indicate potential trends or points of entry or exit

Traders will often look to sell when the Stochastic Oscillator line rises above 80m predicting that it will inevitably then fall back below. Traders will also look to buy when the level falls below 20 predicting that it will increase above this level.

Another way of utilising stochastic oscillators is to watch timing trades. The graph below gives an example of this:

The %K is called the faster moving of the two lines and compares the latest closing price to the recent trading range. %D is a signal line calculated by smoothing out %K; It is a 3-day simple moving average of %K which is plotted alongside %K to act as a signal or trigger line.

Traders will look to sell when the %K (Fast) line shifts below the %D (Slow) line and will look to buy when the %K line shifts over the %D line.

The theory behind this indicator is that in an upward-trending market, prices tend to close near their high, and during a downward-trending market, prices tend to close near their low. Transaction signals occur when the %K crosses through a three-period moving average called the “%D”.

The sensitivity of the oscillator can be adjusted by changing the time period for the %D or %K lines.

Bollinger Bands

The Bollinger Bands is an analytical tool based on the SMA and used by traders to identify a market’s volatility and looks at the levels of current prices relative to previous trades. This gives a trader a higher chance of identifying when an asset is overbought or oversold. The tool is named after its creator, John Bollinger, a well-known technical trader.

In its basic form, a Bollinger Band is two “bands” on a chart plotted around an SMA line. There is an upper band, drawn two standard deviations above the line; and a lower band, drawn two standard deviations below the line.

Applying the Bollinger Band to your analysis

Because it is calculated from a moving average, the Bollinger Bands function as a dynamic form of support and resistance, meaning that the levels change according to how volatile a price movement is.

From the above graph, we can see that in times of low volatility, the bands are narrow. As the market becomes increasingly volatile, the bands expand, creating more space between the support and resistance levels. 

Because the upper and lower bands function as a form of resistance and support, we often see that the prices deviating within the bands will tend to return to the middle. This is what is sometimes known as the Bollinger Bounce.

Another signal to look out for is when the bands “squeeze” together. This happens when volatility is low – which many traders see as an indication of a pending breakout in the market. If the graph is seen moving towards, and breaking the upper band, then a bullish trend is usually expected. The opposite is true when the candlestick is approaches the lower bound.

A Bollinger squeeze is not a common occurrence. When looking at a 15-minute candlestick chart, it will be experienced only a few times a week.

Fibonacci Sequence

Fibonacci sequence is used widely in many different industries in the world which is why it may sound the most familiar to you out of all the technical analysis tools we have covered so far.

The Fibonacci sequence is a sequence of numbers where each one is the sum of the two preceding it, starting from 0 and 1.

Fibonacci Numbers are as follows; 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55 and so on.

Named for Italian mathematician Leonard Fibonacci (1200 AD), the Fibonacci sequence is used to derive what is known as the Golden Ratio, which is commonly found in patterns and sets in everything: from the natural world to mathematics. It is this Golden Ratio that is particularly significant.

The Golden Ratio is calculated as the limit of the ratios of adjacent terms in the Fibonacci sequence and is approximately 1.618. This means that the further down the sequence you go (and the larger the numbers are), the closer one gets to the value of the Golden Ratio.

Fibonacci Retracement

The Fibonacci sequence is also used in technical analysis. Fibonacci retracement is a popular technical analysis tool and works by taking two extreme points on a chart and dividing the vertical distance between the two points into 5 sections. The proportion of height for each section follows what is known as the Fibonacci ratios.

These ratios are 23.6%, 38.2%, 50%, 61.8% and 100%, with 0% starting at the bottom point of the chart; and 100% at the highest point.

Once the points are defined, horizontal lines are drawn on the chart. These lines are interpreted by many traders as levels of support and resistance. They are also used to help identify strategic places for transactions to be placed, and target prices or stop losses to be selected.

Do note that like many other forms of technical analysis, Fibonacci Retracement is best used as a confirmation for, and in conjunction with other forms of analysis.

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