CHART
PATTERNS
Chart
construction is the first step of market analysis practice, after forming
the chart an analyst identifies the various patterns and shapes to forecast
the future direction or trend of the market. The chart is simply the price
data of the market. Although, the price change is the expectation about
the future trend, it’s the traders who decide the exact timing for
its buying and selling, therefore, charting helps in identifying those
signals. In other words, market participants according to their understanding
of the markets make buying and selling decisions.
Market
doesn’t generally move in a straight line in any direction, market
moves are characterized by a series of ups and downs (zigzags). These
zigzags resemble a series of successive waves with fairly obvious peaks
and troughs. It is the direction of these peaks and troughs that constitute
the market trend.
TREND
LINE
A trend line constructs two points. If successive low points approach
but do not break through this line, it can be taken as a correct interpretation
of the direction of the trend. One of the basic concepts of a trend is
that a trend in motion will tend to remain in motion. As long as the trend
line is not violated, it can be used to determine buying and selling areas.
RESISTANCE
LEVELS
A resistance level is a price range characterized by increased selling
pressure. If the market is in a downtrend, and previously established
congestion area in that up-trend is an area of resistance; or in a down
trending market, any previous high will be an important resistance. Once
a resistance level is penetrated on the topside, it becomes the nearest
level of support to a subsequent incline.
RETRACEMENT
LINES
Retracement lines are used to predict potential levels of retracement
following a market move. Retracement lines are constructed by identifying
the two extremes of a market retracement. The centerline is then drawn
at the 50% level: a value mid-way between the two extremes. The other
lines are drawn at the Fibonacci ratios 38.2% and 61.8% of the market
move. It is proven that after a big move market retraces, a trader uses
these numbers to calculate the possible retracement.
HEAD
AND SHOULDER FORMATION
Head and Shoulder is probably the best known most reliable of all major
reversal patterns. Most of the other reversal patterns are just variations
of the head and shoulder and do not require extensive treatment.
In this situation a major up trend of ascending peaks and troughs gradually
begin to lose momentum. The up trend then levels off for a while. During
this time the forces of supply and demand are in relative balance. Once
this distribution phase has been completed, support levels along the bottom
of the horizontal trading range are broken and a new downtrend is established.
The new downtrend now has descending peaks and troughs. The opposite is
the inverted head and shoulder formation.
DOUBLE TOP AND BOTTOM
A much more common reversal pattern is the double top and bottom. It is
the most frequently seen and the most easily recognized. Both figures
below show the top and bottom variety of this formation. For obvious reason,
the top is often referred to as an “M” formation and the bottom
as a “W” formation.
TRIANGLES
Triangles are usually continuation patterns, but sometimes act as reversal
patterns. Although triangles are usually considered intermediate patterns,
they may occasionally appear on long-term charts and take on major trend
significance. The minimum requirement for a triangle is four reversal
points. Remember that it always takes two points to draw a trend line,
therefore, in order to draw two converging trend lines, each line must
be touched twice. There are three types of triangles:
Symmetrical
triangle
The symmetrical triangle is usually a continuation pattern. It represents
a pause in the existing trend after which the original trend is resumed.
In the following chart, the prior trend was up and that suggests that
the chances of breakage of this triangle is on the upper side, if the
trend would have been down the trend would have had a bearish implication.
Ascending
Triangle
This type of triangle has a flat top, while the lower line is rising.
This line indicates that buyers are more aggressive than the sellers are
and considered as a bullish pattern and is usually resolved with a break
out on the upside.
Descending
Triangle
This type of triangle has a flat bottom, while the upper line is falling.
This line indicates that sellers are more aggressive than the buyers are
and considered as a bearish pattern and is usually resolved with a break
out to the downside.
Flag
and Pennants
The flag and pennant formations are quite common. They are usually treated
together because they are very similar in appearance, tend to show up
at about the same place in an existing trend, and have the same volume
and measuring criteria. The flag and pennant represent brief pauses in
a dynamic market move. In fact, one of the requirements, for both the
flag and the pennant is that a sharp and almost straight-line move that
precedes them. They represent situations where a steep advance or decline
has gotten ahead of itself and where the market pauses briefly to “catch
its breath” before running off again in the same direction.
