Technical Analysis Methods & Tools

In finance, technical analysis is the combination of probabilistic methods that use a lot of interesting tools in order to explain past and to predict future price movements of assets. The most powerful tools of TA are:

a. Dow Theory

Charles Dow is considered as the father of technical analysis and his theory comes from the 19th century which is still followed by modern technical analysts. The basic form of Dow's theory contains the following assumptions:

1. Markets have three movements, the primary or major, the secondary or intermediate and last the minor or short swing trend

2. Trends have three phases, the accumulation, the rapid price change and finally the distribution

3. Markets discounts all news

4. Markets' averages must confirm each other; for example if manufacturers produce rising amounts of goods, the transporters should have bigger contracts for goods transportation respectively. That is a signal that the manufacturers stocks will move up because there is no divergence in the chain

5. Trends are confirmed by volume, e.g. you cannot see a rapid change in an asset's price without sustainable trading volumes, either for an upwards or downwards direction

6. On the other hand, market "noise", which is an opposite temporarily trend to the major move, exists simultaneously with the second one, where only huge and constant moves can affect markets for a reversal that will be considered as the new primary trend   

b. Elliot Wave Principle

Ralph Nelson Elliot was another one pioneer of technical analysis who studied stock market data and developed the wave principle. The theory divides the dominant trend into 5 waves and the opposite (corrective) trend into 3 waves. We make the assumption of a bull market to make understandable the Elliot's principle of these 5-3 combined waves that complete a cycle, including all the basic rules & guidelines of his theory (the same characteristics apply in reverse, in bear markets):

1. Wave 1 is the startup of a new bull market. At this phase the only news are the bad news

2. Wave 2 is the correction of the first one, but there is no retracement over 100% of the last upwards move (usually reaches max 61.8% of Fibonacci levels). Also, the forms for wave 2 and wave 4 will alternate. If wave 2 has a sharp correction, wave 4 will be a flat correction and vice versa

3. Wave 3 is the most powerful part of the trend. Almost everyone now considering as fair the up looking of the market. Wave 3 cannot be the shortest of the three up waves. Also, When wave 3 is the longest wave, wave 5 will approximately be equal to wave 1

4. Wave 4 is a clear correction with less opposite power that in most cases doesn't reach 38.2% of Fibo sequence levels. Wave 4 can never overlap wave 1. As we have already written before, the forms for wave 2 and wave 4 will alternate. If wave 2 has a sharp correction, wave 4 will be a flat correction and vice versa

5. Wave 5 is the last leg of this uptrend before coming to an end. At this level everyone is optimistic and there is a spread positive thinking for the markets

6. Wave A seems like a correction, markets watch the retracement without any specific fear and the economic environment looks good enough

7. Wave B. At this stage prices reverse higher, fundamentals are probably not improving and some investors suppose that the market will be back on an upwards track

8. Wave C. Large retacement taking place and everybody believes now that the bears beat the bulls. Corrective wave C usually ends in the area of wave 4 lows


c. Trendlines

The lines that define a trend

d. Support / Resistance Zones

Zones that a price could find support or resistance to crossover respectively when the breakthrough doesn't happen after some attempts at specific price levels. Fibonacci sequence gives support and resistance zones too

e. Channels

A chart scheme that put prices of a time period into a channel

f. Chart Patterns

Chartists explain upcoming upwards / downwards / horizontal formations by analyzing specific patterns such as "head & shoulders", double / triple tops and bottoms, triangles, gaps, market cycles and so on 

g. The Importance of Volume

Trading volumes are used as a confirmation of a trend e.g. when higher volumes accompany higher prices is a signal that the uptrend didn't come to an end yet and vice versa 

h. Moving Averages

Moving averages are useful technical lagging indicators due to past data analyzing by creating a series of averages that define trends although they don't give signals for the next price levels. The most famous MAs are the SMAs (simple), the EMAs (exponential) and the LWMA (linear weighted) moving averages 

i. Technical Oscillators / Indicators

The main technical oscillators and indicators are, the stochastic oscillator, the MACD, the RSI, the momentum, the ATR and some dozens more. Moreover, thousands of hybrid oscillators / indicators have been created the past years, with most of them based upon the basics above

j. Volume Oscillators / Indicators

The most popular volume oscillators are the money flow index and the accumulation / distribution index

(Instrument: AUDUSD  –  Period: Dec, 2012 to June, 2015  –  Weekly Candlesticks  –  Support / Resistance Levels  –  Channel  –  Major Trendline  –  RSI  –  20-SMA  –  Trading Volumes)

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