Technical Analysis: Introduction

There are two primary methods used to analyze securities and make investment
decisions: fundamental analysis and technical analysis. Fundamental analysis involves
analyzing a company’s financial statements to determine the fair value of the business,
while technical analysis assumes that a security’s price already reflects all publicly-
available information and instead focuses on the statistical analysis of price movements.

Technical analysis may appear complicated on the surface, but it boils down to an
analysis of supplyand demand in the market to determine where the price trend is headed.
In other words, technical analysis attempts to understand the market sentiment behind
price trends rather than analyzing a security’s fundamental attributes. If you understand
the benefits and limitations of technical analysis, it can give you a new set of tools or
skills that will enable you to be a better trader or investor over the long-term.
Technical Analysis: The Basic Assumptions

What is Technical Analysis?

Technical analysis is a method of evaluating securities that involves a statistical analysis

of market activity, such as price and . Technical analysts do not attempt to measure a
security’s but rather, use charts and other tools to identify can be used as a basis for
investment decisions.

There are many different forms of technical analysis: Some rely on chart patterns, others
use technical and most use a combination of techniques. In any case, technical analysts’
exclusive use of historical price and volume data is what separates them from their
fundamental counterparts. Unlike fundamental analysts, technical analysts don’t concern
themselves with a stock’s valuation – the only thing that matters are past trading data and
what information the data might provide about future price movements.

Technical analysis is based on three assumptions:

1. The market discounts everything.

2. Price moves in trends.
3. History tends to repeat itself.

1. The Market Discounts Everything

Many experts criticize technical analysis because it only considers price movements and
ignores fundamental factors. The counterargument is based on the Efficient Market
Hypothesis, which states that a stock’s price already reflects everything that has or could
affect a company – including fundamental factors. Technical analysts believe that
everything from a company’s fundamentals to broad market factors to market
psychology are already priced into the stock. This removes the need to consider the
factors separately before making an investment decision. The only thing remaining is the
analysis of price movements, which technical analysts view as the product of supply and
demand for a particular stock in the market.
2. Price Moves in Trends

Technical analysts believe that prices move in short-, medium-, and long-term trend. In
other words, a stock price is more likely to continue a past trend than move erratically.
Most technical trading strategies are based on this assumption

3. History Tends to Repeat Itself

Technical analysts believe that history tends to repeat itself. The repetitive nature of price
movements is often attributed to market psychology, which tends to be very predictable
based on emotions like fear or excitement. Technical analysis uses chart patterns to
analyze these emotions and subsequent market movements to understand trends. While
many form of technical analysis have been used for more than 100 years, they are still
believed to be relevant because they illustrate patterns in price movements that often
repeat themselves.
Technical Analysis: Fundamental Vs. Technical Analysis

Technical analysis and fundamental analysis are the two main schools of thought when it
comes to analyzing the financial markets. As we’ve mentioned, technical analysis looks
at the price movement of a security and uses this data to predict future price movements.
Fundamental analysis instead looks at economic and financial factors that influence a
business. Let’s dive deeper into the details of how these two approaches differ, the
criticism against technical analysis, and how technical and fundamental analysis can be
used together.

The Differences

Tools of the Trade

Technical analysts typically begin their analysis with charts, while fundamental analysts
start with a company’s financial statements. (For further reading, see Introduction To
Fundamental Analysis and Advanced Financial Statement Analysis).

Fundamental analysts try to determine a company’s value by looking at its income

statement, balance sheet, and cash flow statement. In financial terms, the analyst tries to
measure a company’s intrinsic value by discounting the value of future projected cash
flows to a net present value. A stock price that trades below a company’s intrinsic value
is considered a good investment opportunity and vice versa.

Technical analysts believe that there’s no reason to analyze a company’s financial

statements since the stock price already includes all relevant information. Instead, the
analyst focuses on analyzing the stock chart itself for hints into where the price may be
headed.

Time Horizon

Fundamental analysis takes a long-term approach to investing compared to the short-term

approach taken by technical analysis. While stock charts can be delimited in weeks, days,
or even minutes, fundamental analysis often looks at data over multiple quarters or years.

Fundamentally-focused investors often wait a long time before a company’s intrinsic

value is reflected in the market. For example, value investors assume that the market is
mispricing a security over the short-term, but that the price of the stock will correct itself
over the long run. This “long run” can represent a timeframe as long as several years, in
some cases. (For more insight, read Warren Buffett: How He Does It and What Is Warren
Buffett’s Investing Style?).

Fundamentally-focused investors also rely on financial statements that are filed quarterly,
as well as changes in earnings per share that don’t emerge on a daily basis like price and
volume information. After all, a company can’t implement sweeping changes overnight
and it takes time to create new products, marketing campaigns, and other strategies to
turn around or improve a business. Part of the reason that fundamental analysts use a
long-term timeframe, therefore, is because the data they use to analyze a stock is
generated much more slowly than the price and volume data used by technical analysts.

Trading v. Investing

Technical analysis and fundamental analysis have different goals in mind. Technical
analysts try to identify many short- to medium-term trades where they can flip a stock,
while fundamental analysts try to make long-term investments in a stock’s underlying
business. A good way to conceptualize the difference is to compare it to someone buying
a home to flip versus someone that’s buying a home to live in for years to come.
The Critics

Many critics view technical analysis as unproven at best or wishful thinking at worst.
Don’t be surprised to hear these critics question the validity of the discipline to the point
where they mock supporters. While most Wall Street analysts focus on the fundamentals,
just about any major brokerage employs technical analysts. There are also professional
certifications for technical analysts and some techniques are included in the CFA exam,
among others.

Much of the criticism of technical analysis is focused on the Efficient Market Hypothesis,
which states that any past trading information is already reflected in the price of the
stock. Taken to the extreme, the ‘strong form efficiency’ hypothesis states that both
technical and fundamental analysis are useless because all information in the market is
accounted for in a stock’s price. This thinking is explained in detail in books like a
Random Walk Down Wall Street, which states that an investor is better of guessing than
stock picking. (For more insight, read What Is Market Efficiency? and Working Through
The Efficient Market Hypothesis).

The reality is that the EMH is still just that – a hypothesis. It’s up to investors to decide
who is correct and determine their own philosophy.
Can They Co-Exist?

Technical analysis and fundamental analysis are often seen as opposing approaches to
analyzing securities, but many investors have experienced success by combining the two
techniques. For example, an investor may use fundamental analysis to identify an
undervalued stock and use technical analysis to find a specific entry and exit point for the
position. Often times, this combination works best when a security is
severely oversold and entering the position too early could prove costly.

Alternatively, some primarily technical traders will look at fundamentals to support their
trade. For example, a trader may be eyeing a breakout near an earnings report and look at
the fundamentals to get an idea of whether the stock is likely to beat earnings.

The idea of mixing technical and fundamental analysis isn’t always well-received by the
most devoted groups in each school, but there are certainly benefits to at least
understanding both schools of thought.
Technical Analysis: The Use Of Trend

in technical analysis. The meaning in finance isn’t all that different from the general
definition of the term – a trend is really nothing more than the general direction in which
a security or market is headed.

Take a look at the following chart:

Figure 1 – 5-Year S&P 500 SPDR (SPY) Chart

It isn’t difficult to see the trend higher in Figure 1. However, it’s not always that easy, as
demonstrated in Figure 2 below.
 Figure 2 – 2-Month S&P 500 (SPY) Chart
There are a lot of ups and downs in this chart, but there isn’t a clear definition of which
direction the stock is headed.
A Formal Definition

Trends aren’t always easy to spot because prices almost never move in straight lines.
Rather, prices tend to move in a series of highs and lows over time. In technical analysis,
it is the overall direction of these highs and lows that constitute a trend. An uptrend is
classified as a series of higher highs and higher lows, while a downtrend consists of lower
lows and lower highs

Figure 3 – Trend Diagram

Figure 3 is an example of an uptrend. Each of the high points of the trend – 2, 4, and 6 –
are higher than the previous high, while each of the low points of the trend – 3 and 5 –
are higher than the previous low. For the uptrend to continue, the next low point must be
above 5 and the next high point must be above 6, else the trend will be deemed a reversal.
Types of Trends

There are three types of trends:

1. Uptrend
2. Downtrend
3. Sideways / Horizontal Trends

horizontal trends occur when there is little movement up or down in the peaks and
troughs of a trend. If you want to get technical, you might even say that a sideways trend
is actually the absence of any well-defined trend in either direction.

Trend Lengths

In addition to their direction, trends can be classified in terms of their length. Most
traders consider trends short-term, intermediate-term, or long-term. Long-term trends
occur over a timeframe of longer than one year; intermediate-term trends occur over one
to three months; and, short-term trends occur over less than one month.

Trends are also embedded within one another. For example, Figure 1 above is an
example of a long-term five-year trend and Figure 2 is a two-month subset of that trend.
In other words, long-term trends consist of a series of intermediate-term trends which
consist of a series of short-term trends. Long-term uptrends may have several short- and
intermediate-term downtrends along the way.

Here’s an example of how these trend lengths look in practice:

 Figure 4 – Trend Comparisons

Trendlines

A trendlines is a simple charting technique whereby a line is added to a chart to represent

the trend in a market or stock. Drawing a trendline is as simple as drawing a straight line
that connects lower lows or higher highs to show the general trend direction. These lines
are used to cut through the noise and show where the price is headed, as well as identify
areas of support and resistance. Support levels are where the price rebounds higher
multiple times, whereas resistance levels are where prices rebound lower multiple times.
The strength of support and resistance levels are determined by the number of rebounds
from the trendline.
 Figure 5 – Trendline Examples

Figure 5 shows an example of a downtrend trendline where the stock price experiences
resistance, as well as an uptrend trendline where the stock price experiences support.

Channels

A channel consists of two trendlines that act as strong areas of support and resistance
with the price bouncing around between them. The upper trendline consists of a series of
highs, while the lower trendline consists of a series of lows. A channel can
slope upward, downward, or sideways, but regardless of the direction, the interpretation
is always the same. Traders expect the price to trade between the support and resistance
trendlines until it breaks out beyond one of the two levels, in which case traders can
expect a sharp move in the direction of the breakout. Along with clearly displaying the
trend, channels are used to illustrate important areas of support and resistance for the
stock price.

The Importance of Trend

It is important to identify and understand trends so that you can trade with rather than
against them. Two important sayings in technical analysis are “the trend is your friend”
and “don’t buck the trend”, illustrating how important trend analysis is for technical
traders.
 Figure 6 – Price Channel

Figure 6 illustrates a sideways channel where the upper trendline connects a series of
highs and the lower trendline connects a series of lows. When the price breaks out from
the upper trendline, the upper trendline becomes a new support level as the stock moves
higher.
Technical Analysis: Support And Resistance

Support and resistance are the next major concept after understanding the concept of a
trend. You’ll often hear technical analysts talk about the ongoing battle between bulls and
bears, or the struggle between buyers (demand) and sellers (supply). The proverbial
‘battle lines’ can be defined as the support and resistance levels where the most trading
occurs. Support levels are where demand is perceived to be strong enough to prevent the
price from falling further, while resistance levels are prices where selling is thought to be
strong enough to prevent prices from rising higher.

Why Does This Happen?

Support and resistance levels are psychologically-important levels where a lot of buyers
and/or sellers are willing to trade the stock. When the trendlines are broken, the market
psychology shifts and new levels of support and resistance are established.
Round Numbers

Round numbers tend to be important support and resistance levels due to their
psychological importance. For instance, many investors watch the Dow Jones Industrial
Average’s 20,000 or other levels as key milestones. Traders watch round numbers like
10, 20, 35, 50, 100, and 1,000 since they often represent important turning points where
traders will make buy or sell decisions.

Buyers will often purchase large amounts of stock once the price starts to fall toward a
major round number, which makes it more difficult for shares to fall below that level. On
the other hand, sellers start to sell off a stock as it moves toward a round number peak,
making it difficult to move past the upper level. This increased buying and selling
pressure makes them important points of support and resistance and, in many cases,
major psychological points as well.
Role Reversal

A trendline doesn’t cease to be an important area of support or resistance when it’s

broken; rather, it’s role is simply reversed. If a price breaks out from a resistance
trendline, the trendline becomes a support level moving forward. The only catch is that
the reversal needs to be a true reversal rather than a false breakout or breakdown, which
generally means that it’s accompanied by significant volume and a price spike.
Technical Analysis: The Importance Of Volume

What is Volume?
Volume is simply the number of shares or contracts that trade over a given period –
usually a day. Often times, volume is expressed as a bar chart directly below the price
chart with the bars height illustrating how many shares have traded per period. Volume
charts can also be analyzed to show trends of increasing or decreasing volume over time.

Figure 8 – Volume on Chart

Why Volume is Important?

Volume is used by technical analysts to confirm trends and chart patterns. The strength of
any given price movement is measured primarily by the volume. In fact, a 50% rise in a
stock price may not be all that relevant at all if it occurs on very little volume – just look
at penny stocks.

For example, suppose that a stock jumps 5% in one trading day after being in a long-term
downtrend. Is this a reversal of the long-term trend? The answer depends on whether
there was a substantial amount of volume behind the move. If the volume was below
average, the move was likely a fluke and the downtrend is likely to continue. On the other
hand, if the volume was significantly higher than average, then it could be the start of a
reversal. (To read more, check out Trading Volume – Crowd Psychology).

In addition to single day moves, the trend in volume over time can be related to price
trends to determine if a stock is gaining or losing momentum. An example might be a
stock that has been trending higher with declining volume, which suggests that the rally
may be losing momentum. In that case, traders may want to be on the lookout for a
reversal and perhaps reduce or sell their long positions in preparation. This is known
as divergence.

Volume and Chart Patterns

Volume is invaluable when confirming chart patterns, such as head and

shoulders, triangles, flags, and other patterns. These chart patterns will be discussed in
greater detail later on, but for now, know that chart patterns try to predict pivotal
moments – like reversals. If volume isn’t present alongside these chart patterns, then the
resulting trading signal isn’t as reliable.

Volume Precedes Price

A final important concept to understand is that price is preceded by volume. Technical

analysts closely watch volume to see when reversals are likely to occur, which means that
volume changes can be a precursor to price changes. If volume is decreasing in an
uptrend, it could signal that the uptrend is coming to a close and a reversal may be likely.

Now that we have a better understanding of some of the most important core elements of
technical analysis, we will move on to charts, which help identify trading opportunities in
price movements.
Technical Analysis: What Is A Chart?

Charts are simply graphical representations of a series of prices over time. For example, a
chart might show a stock’s price movement over a one-year period where each point
represents an individual day’s closing price. Or, a chart might show a commodity’s price
movement over a period of just one hour with each point representing one second. The
common denominator is that price is typically on the Y-axis and time is usually on the X-
axis.

Figure 9 – Stock Chart Example

Figure 9 shows an example of a basic stock chart for Alphabet Inc. (GOOGL). It’s a
representation of the price movement of a stock over a roughly six-month period. The
bottom of the chart, running horizontally (X-axis), is the date or time scale. On the right-
hand side, running vertically (Y-axis), is the price of the security. This type of chart –
known as a candlestick chart – shows the daily price range of a stock that’s represented
by the length of each bar.
[ Charts are the most fundamental tool for technical analysts, similar to financial
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Chart Properties

There are several things that investors should be aware of when looking at a chart, since
these factors can affect the information that is provided. They include the time scale,
price scale, and price point properties that are used in the creation of the chart.

Time Scale

The time scale refers to the range of dates that appear at the bottom of the chart, which
can vary from seconds to decades. The most frequently used time scales are intraday,
daily, weekly, monthly, quarterly, and yearly. Shorter timeframes are commonly used by
day traders or investors looking for greater detail, although these smaller timeframes tend
to have more ‘noise’ that can make trends harder to spot.

Intraday charts plot price movements over the course of a single day and are often used
exclusively by day traders. Often times, the time scale of these charts is denominated in
seconds or minutes to show maximum detail.

Daily charts are commonly used by traders and investors with each price point
representing a single day. In line charts, each point represents the closing price for the
day. In candlestick charts, such as Figure 9, each point represents the open, high, low,
and close for the day. These data points can be spread out over weeks, months, or years to
monitor both short-term and intermediate-term trends in price over time.

Weekly, monthly, quarterly, and yearly charts are used to analyze long-term trends in
stock prices. Each data point in these graphics is a condensed version of what happened
over a specified period. For example, a weekly chart’s data point represents the price
movement over the course of an entire week or the closing price of the last trading day.
Price Scale and Price Point

The price scale appears on the right side of the chart and shows the stock’s price ranges.
This may seem like a simple concept – in that prices move from lower to higher – but
price scales can be either linear (arithmetic) or logarithmic in nature.

Linear v. Logarithmic – Source: TD Ameritrade Charts

Linear price scales (Figure 10 – Left Side) have even spacing between each price point,
which means that a price that moves from $10 to $20 is the same distance as a price that
moves from $40 to $50. In other words, the price scale measures absolute moves and
doesn’t show the effects of percentage changes in value over time.

Logarithmic scales (Figure 10 – Right Side) look at price movements in percentage

terms, which means that the spacing between each point is equal to the percentage
change. For instance, price change from $10 to $20 is 100% while a price change from
$40 to $50 is only 25% even though the absolute difference is the same - $10.
Logarithmic charts will show a smaller space between $40 and $50 than between $10 and
$20 for this reason.

Many professionals use logarithmic charts because it’s easier to spot how large price
movements are on a percentage basis, whereas linear charts can be a little distorted in fast
moving markets.
Technical Analysis: Chart Types

Line Charts
Line charts are the most basic type of chart because it represents only the closing prices
over a set period. The line is formed by connecting the closing prices for each period over
the timeframe. While this type of chart doesn’t provide much insight into intraday price
movements, many investors consider the closing price to be more important than the
open, high, or low price within a given period. These charts also make it easier to spot
trends since there’s less ‘noise’ happening compared to other chart types.

Figure 11 – Line Chart Example

Bar Charts

Bar charts expand upon the line chart by adding the open, high, low, and close – or the
daily price range, in other words – to the mix. The chart is made up of a series of vertical
lines that represent the price range for a given period with a horizontal dash on each side
that represents the open and closing prices. The opening price is the horizontal dash on
the left side of the horizontal line and the closing price is located on the right side of the
line. If the opening price is lower than the closing price, the line is often shaded black to
represent a rising period. The opposite is true for a falling period, which is represented by
a red shade.

Figure 12 – Bar Chart Example

Candlestick Charts
Candlestick charts originated in Japan over 300 years ago, but have since become
extremely popular among traders and investors. Like a bar chart, candlestick charts have
a thin vertical line showing the price range for a given period that’s shaded different
colors based on whether the stock ended higher or lower. The difference is a wider bar or
rectangle that represents the difference between the opening and closing prices.

Figure 13 – Candlestick Chart Example

Point and Figure Charts
Point and figure charts are not very well known or used by the average investor, but they
have a long history of use dating back to the first technical traders. The chart reflects
price movements without time or volume concerns, which helps remove noise – or
insignificant price movements – that can distort a trader’s view of the overall trend.
These charts also try to eliminate the skewing effect that time has on chart analysis. (For
further reading, see Point and Figure Charting).

Figure 14 – Point and Figure Chart Example

Point and figure charts are characterized by a series of Xs and Os. The Xs represent
upward price trends and the Os represent downward price trends. There are also numbers
and letters in the chart that represent months and given investors a rough idea of dates.
Each box on the chart represents the price scale, which adjusts depending on the price of
the stock: The higher the stock’s price the more each box represents. On most charts, a
box represents $1 or 1 point.

Another key point to remember is that point and figure charts have reversal criteria that
must be set by the technical analyst – although it’s usually set to three. The reversal
criteria represents how much the price has to move away from the higher or low in the
price to create a new trend, or in other words, how much the price has to move in order
for a column of Xs to become a column of Os, or vice versa. When the price trend has
moved from one trend to another, it shifts to the right, signaling a trend change.

Conclusion

Charts are the most fundamental aspect of technical analysis. It’s important for traders to
understand what’s being shown on a chart and the information it provides. Now that we
have a clear idea of how charts are constructed, we can move on to the different types of
chart patterns.
Technical Analysis: Chart Patterns

There are millions of different investors transacting billions of dollars’ worth of securities
each day and it’s nearly impossible to decipher everyone’s motivations. Chart patterns
look at the big picture and help to identify trading signals – or signs of future price
movements.

One of the three assumptions discussed earlier in this tutorial was that history repeats
itself. The theory behind chart patterns is based on this assumption – that certain patterns
consistently reappear and tend to produce the same outcomes. For example, as market
sentiment shifts from optimism to fear, a certain pattern might emerge before traders and
investors start selling and send the stock price lower.

Chart patterns have an established definition and criteria, but there are no patterns that
tell you with 100% certainty where a security is headed. After all, the richest man in the
world would be a trader in that case rather than an investor! The process of identifying
chart patterns based on these criteria can be subjective in nature, which is why charting is
often seen as more of an art than a science. (For more insight, see Is finance an art or
science?).

The two most popular chart patterns are reversals and continuations. A reversal pattern
signals that a prior trend will reverse upon completion of the pattern, while a continuation
pattern signals that the trend will continue once the pattern is complete. These patterns
can be found across any timeframe. In this section, we will review some of the more
popular chart patterns.

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and advanced technical analysis, chart patterns, and technical indicators, with over
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Head and Shoulders

The Head and Shoulders is a reversal chart pattern that indicates a likely reversal of the
trend once it’s completed. A Head and Shoulder Top is characterized by three peaks with
the middle peak being the highest peak (head) and the two others being lower and
roughly equal (shoulders). The lows between these peaks are connected with a trend line
(neckline) that represents the key support level to watch for a breakdown and trend
reversal. A Head and Shoulder Bottom – or Inverse Head and Shoulders – is simply the
inverse of the Head and Shoulders Top with the neckline being a resistance level to watch
for a breakout higher.

Figure 22 – Head and Shoulders

Cup and Handle

The Cup and Handle is a bullish continuation pattern where an upward trend has paused,
but will continue when the pattern is confirmed. The ‘cup’ portion of the pattern should
be a “U” shape that resembles the rounding of a bowl rather than a “V” shape with equal
highs on both sides of the cup. The ‘handle’ forms on the right side of the cup in the form
of a short pullback that resembles a flag or pennant chart pattern. Once the handle is
complete, the stock may breakout to new highs and resume its trend higher.

Figure 23 – Cup and Handle Example

Double Tops and Bottoms

The Double Top or Double Bottom pattern are both easy to recognize and one of the most
reliable chart patterns, making them a favorite for many technically-orientated traders.
The pattern is formed after a sustained trend when a price tests the same support or
resistance level twice without a breakthrough. The pattern signals the start of a trend
reversal over the intermediate- or long-term.

Figure 24 – Double Top Example

Triangles

Triangles are among the most popular chart patterns used in technical analysis since they
occur frequently compared to other patterns. The three most common types of triangles
are symmetrical triangles, ascending triangles, and descending triangles. These chart
patterns can last anywhere from a couple weeks to several months.

Figure 25 – Symmetrical Triangle Example

Flags & Pennants

Flags and Pennants are short-term continuation patterns that represent a consolidation
following a sharp price movement before a continuation of the prevailing trend. Flag
patterns are characterized by a small rectangular pattern that slopes against the prevailing
trend, while pennants are small symmetrical triangles that look very similar.

Figure 26 – Pennant Example

The short-term price target for a flag or pennant pattern is simply the length of the
‘flagpole’ or the left vertical side of the pattern applied to the point of the breakout, as
with the triangle patterns. These patterns typically last no longer than a few weeks, since
they would then be classified as rectangle patterns or symmetrical triangle patterns.
Wedges
The Wedge pattern is a reversal or, less commonly, continuation pattern that’s similar to
the symmetrical triangle except that it slants upward or downward. Rising wedges are
bearish chart patterns that occur when trend is moving higher and the prices are
converging and the prevailing trend is losing momentum. Falling wedges are bullish chart
patterns that occur when the trend is moving lower and prices are converging, which
signifies that the bearish trend is losing momentum and a reversal is likely.

The wedge pattern can be very difficult to identify and trade, which means it’s important
to look for confirmations in other technical indicators, as we’ll learn about in the next
section. For example, most traders watch for a diverging relative strength index or
moving average convergence-divergence trend line that confirms a reversal is likely to
occur.

Gaps
Gaps occur when there is empty space between two trading periods that’s caused by a
significant increase or decrease in price. For example, a stock might close at $5.00 and
open at $7.00 after positive earnings or other news. There are three main types of
gaps: Breakaway gaps, runaway gaps, and exhaustion gaps. Breakaway gaps form at the
start of a trend, runaway gaps form during the middle of a trend, and exhaustion gaps for
near the end of the trend. (For more insight, read Playing the Gap).
Triple Tops & Bottoms

Triple Tops and Triple Bottoms are reversal patterns that aren’t as prevalent as Head and
Shoulders or Double Tops or Double Bottoms. But, they act in a similar fashion and can
be a powerful trading signal for a trend reversal. The patterns are formed when a price
tests the same support or resistance level three times and is unable to break through.

Figure 27 – Triple Bottom Example

Rounding Bottom

The Rounding Bottom – or Saucer Bottom– is a long-term reversal pattern that signals a
shift from a downtrend to an uptrend and lasts anywhere from several months to several
years.

The chart patterns looks similar to a Cup and Handle pattern but without the handle. The
long-term nature of the pattern and lack of a confirmation trigger – such as the handle –
makes it a difficult pattern to trade.

Conclusion

Chart patterns are a valuable part of technical analysis – even if they are more art than
science. Many traders use them to identify potential trades that they can confirm using
other forms of technical analysis to maximize their odds of success. You should now be
able to recognize some of these chart patterns as we move on to other forms of technical
analysis.
Technical Analysis: Moving Averages

Chart patterns can be difficult to read given the volatility in price movements. Moving
averages can help smooth out these erratic movements by removing day-to-day
fluctuations and make trends easier to spot. Since they take the average of past price
movements, moving averages are better for accurately reading past price movements
rather than predicting future past movements. (To learn more, read the Moving
Averages tutorial).

Types of Moving Averages

The three most popular types of moving averages are Simple Moving
Averages (SMA), Exponential Moving Averages (EMA), and Linear Weighted Moving
Averages. While the calculation of these moving averages differs, they are used in the
same way to help assist traders in identifying short-, medium-, and long-term price
trends.

Simple Moving Average

The most common type of moving average is the simple moving average, which simply
takes the sum of all of the past closing prices over a time period and divides the result by
the total number of prices used in the calculation. For example, a 10-day simple moving
average takes the last ten closing prices and divides them by ten.

Figure 15 – Simple Moving Averages

Figure 15 shows a stock chart with both a 50-day and 200-day moving average. The 50-
day moving average is more responsive to price changes than the 200-day moving. In
general, traders can increase the responsiveness of a moving average by decreasing the
period and smooth out movements by increasing the period.

Critics of the simple moving average see limited value because each point in the data
series has the same impact on the result regardless of when it occurred in the sequence.
For example, a price jump 199 days ago has just as much of an impact on a 200-day
moving average as one day ago. These criticisms sparked traders to identify other types
of moving averages designed to solve these problems and create a more accurate
measure.

Linear Weighted Average

The linear weighted average is the least common moving average, which takes the sum of
all closing prices, multiplies them by the position of the data point, and divides by the
number of periods. For example, a five-day linear weighted average will take the current
closing price and multiple it by five, yesterday’s closing price and multiple it by four, and
so forth, and then divide the total by five. While this helps resolve the problem with the
simple moving average, most traders have turned to the next type of moving average as
the best option.
Exponential Moving Average

The exponential moving average leverages a more complex calculation to smooth data
and place a higher weight on more recent data points. While the calculation is beyond the
scope of this tutorial, traders should remember that the EMA is more responsive to new
information relative to the simple moving average. This makes it the moving average of
choice for many technical traders.

Figure 16 – EMA v. SMA Moving Averages

Figure 16 shows how the EMA (red line) reacts more quickly than the SMA (blue line)
when sudden price movements occur. For example, the breakout in late-November
caused the EMA to move higher more quickly than the SMA even though both are
measuring the same 50-day period. The difference may seem slight, but it can
dramatically affect returns.
How to Use Moving Averages

Moving averages are helpful for identifying current trends and support or resistance
levels, as well as generating actual trading signals.

The slope of the moving average can be used as a gauge of trend strength. In fact, many
momentum based indicators (as we will see in the next section) look at the slope of the
moving average to determine the strength of a trend. For example, Figure 16 (above) has
moving average slopes that clearly show a moderate sideways period between September
and October and a significant upswing between December and April.

Many technical analysts often look at multiple moving averages when forming their view
of long-term trends. When a short-term moving average is above a long-term moving
average, that means that the trend is higher or bullish, and vice versa for short-term
moving averages below long-term moving averages.

Moving averages can also be used to identify trend reversals in several ways:

1. Price Crossover. The price crossing over the moving average can be a powerful
sign of a trend reversal, while the price crossing above the moving average
indicates a bullish breakout ahead. Often, traders will use a long-term moving
average to measure these crossovers since the price frequently interacts with
shorter-term moving averages, which creates too much noise for practical use.

2. MA Crossover. Short-term moving averages crossing below long-term moving

averages is often the sign of a bearish reversal, while a short-term moving average
crossover above a long-term moving average could precede a breakout higher.
Longer distances between the moving averages suggest longer term reversals as
well. For instance, a 50-day moving average crossover above a 200-day moving
average is a stronger signal than a 10-day moving average crossover above a 20-
day moving average.
 Figure 17 – Crossover and Support Illustrations

And finally, moving averages can be used to identify areas of support and resistance.
Long-term moving averages, such as the 200-day moving average, are closely watched
areas of support and resistance for stocks. A move through a major moving average is
often used as a sign from technical traders that a trend is reversing.

Conclusion

Moving averages are a powerful tool for traders analyzing securities. They provide a
quick glimpse at the prevailing trend and trend strength, as well as specific trading
signals for reversals or breakouts. The most common timeframes used when creating
moving averages are the 200, 100, 50, 20, and 10-day moving averages. The 200-day
moving average is a good measure for a year timeframe, while shorter moving averages
are used for shorter timeframes.

These moving averages help traders smooth out some of the noise found in day-to-day
price movements and give them a clearer picture of the trend. In the next section, we will
take a look at some of the other techniques used to confirm price and movement patterns.