Technical Analysis

Technical Analysis

This is the 7 Circles home page for Technical Analysis.

Here you will find three things:

  1. a live Technical Analysis spreadsheet
  2. a FAQ for Technical Analysis
  3. links to all of the articles about Technical Analysis
Live Technical Analysis Spreadsheet
Technical Analysis Q&A
What is Technical Analysis?

The key distinction is with fundamental analysis.

  • Fundamental analysis looks at the overall characteristics of a company to work out its (future) value.
  • Technical analysis (TA) ignores the “value” of a company (or commodity, currency pair or index) and looks only at the price and volume action

TA studies supply and demand, to try to work out the direction of the market – its trend.

It’s an attempt to understand the emotions in the market by studying the market itself.

What is the goal of Technical Analysis?

TA is used to buy and sell (or sell then buy) at a profit. It’s not about buy and hold for the long-term.

  • The goal of TA is to make better (more profitable) and safer (lower risk) trades.
  • Every trade driven by TA comes with a time-frame, and an exit plan.
  • Trading with TA is all about putting together your own system – your set of trading rules – and sticking to it.
Who uses TA?

There are two types of trader, split by holding period:

  1. Trend-followers will wait out retracements and sideways range-trading situations until they turn back into a trend
  2. Swing traders buy at relative lows and sell at relative highs within sideways channels or trends
Why should TA work?

The idea underlying TA is that human beings repeatedly exhibit the same behaviours over time.

But TA techniques don’t work all the time (think weather forecasting, or cooking). TA can work best when many of the market participants believe that it will work – a kind of self-fulfilling prophecy.

Stocks are different from other products for two reasons:

  1. people buy them to sell on at a profit
  2. normally, demand disappears as the price of something rises - but when a stock price goes up, more people want to buy it

It’s like an auction model – people get carried away with the excitement. This is price momentum.

Think of the tulip mania in Holland, or the dot-com boom, or panics like the 1929 crash, or 2008.

Are you a Technical Analysis expert?

Not really. I first learned TA back in the 1980s, when it was still called charting, and chartists waited hours for printouts they could draw all over with pens and rulers.

I used TA off and on, for entry points and momentum trading. But I gradually developed more of a long-term, vaguely value perspective, and stopped using it so much.

It came back with a vengeance during the dot-com boom of 1999-2000. This was all about momentum and swing trading. TA worked very well for me until the crash.

Afterwards I went back to a long-term investing style, until the 2008 crash forced me to re-evaluate my entire approach. I forgot about TA.

Why start TA again?

Two reasons:

  1. starting this website has brought me into contact with people who combine TA with fundamental analysis, and there seems to be a fair amount of interest in the topic
  2. I met up with an old friend who has left it too late to “get rich slow”, and who has been on several of those “training courses” advertised in the money magazines and at the shows.

I want to help, and as he still works full time, that will have to be through TA-based swing trading.

Which means I have to take a refresher course in TA, by going back to the textbooks. You’re welcome to join me.

Which instruments do you trade with TA?

As of today, none. I’m still working my way through my refresher course. At the moment I’m just using TA for entry points on stocks.

During 2016, I will put together a trend following portfolio using the following instruments:

  1. FX (£/$, £/€, $/€ – maybe some Yen)
  2. Commodities (Oil, Gold, basket)
  3. Indices (FTSE, S&P-500, Euro-Stoxx, Nikkei)
  4. UK Stocks – FTSE 100, liquid and high beta
  5. Possibly some US stocks, probably techs like GOOG, AAPL, TSLA, NFLX, AMZN
  6. Pairs trades of “matched” FTSE-100 stocks
Which products and accounts are best to use with TA?

Spread Bets look like the obvious approach – we need to be able to go short easily.

IG seems to be the market leader in the UK, but we may need more than one account to cover all of the trades I’ve mentioned above.

If you want to start trading with paper money, we reviewed demo accounts here. IG and CMC looked like the best options.

Is there anywhere I can study good charts for free?

We took a look at this here. StockCharts came out on top.

Are there any other tools to help me understand TA?

Yes. We have a 7 Circles Technical Analysis spreadsheet, which you can find on this page, above this Q&A section.

At the moment it contains the following indicators, with graphs:

  • moving averages (20-, 50- and 200-day MAs) against price
  • relative moving averages (relative to index) against relative price
  • Bollinger bands
  • RSI (relative strength index)
  • MACD (moving average convergence / divergence)
  • Williams %R (percentage range)

It also contains the following additional graphs:

  • price over time
  • relative price versus price

And the following indicators without graphs:

  • position in yearly price range
  • relative price range

The sheet uses live data from Google Finance and Yahoo Finance:

  • one year’s data for the stock being analysed
  • one year’s data for the relevant index (for relative strength etc.)

If you would like to experiment with your own copy, just drop us an email and we’ll send you a link. It helps if you have a Google account, as the spreadsheet is built with Google Sheets (which is free).

What is the most fundamental concept in TA?

The most fundamental concept in TA is the trend. There’s an old market saying: “the trend is your friend - until the end”.

Your goal as a Technical Analyst (TA) is to follow the crowd until it’s about to turn, and then get out before most people realise that sentiment has changed.

Identifying trends and trading with them is more profitable than ignoring them.

  • You buy into an uptrend, and sell out of a downtrend
  • Trends often work in tandem with additional support and resistance lines (known as tramlines)
  • Primary trends are punctuated by secondary trends in the opposite direction, known as retracements or pullbacks
  • Trends remain in place until some major event (catalyst) ends them, by pushing the price breaks through a support or resistance line – this is known as a breakout.
What defines a trend?

There is no fixed definition, but generally a trend consists of a series of higher lows (for an uptrend) or lower highs (for a downtrend).

How do I know when a trend will end?

There are lots of indicators to help you, but the most important thing is to understand market sentiment.

The crowd is right most of the time, but not at market extremes (known as pivot points):

  • When everyone is bullish, there’s no-one left to push the market higher
  • Similarly, when everyone is bearish, who will continue to sell in order to force prices lower?
How can volume help?

Volume is the number of shares traded in a particular stock on a particular day. An index won’t have a volume figure since it is calculated rather than traded.

A price move on greater than normal volume is more significant than a move on lower than average volume.

When the move in price is matched by an increase in volume, this is known as confirmation – both indicators are saying the same thing.

What is a volume spike?

A volume spike is a volume number that is double or more the average volume over some number of preceding days.

This could indicate the end of a trend.

What is an indicator?

Indicators are a shorthand way to measure two things:

  • the amount of trend
  • whether we are approaching a turning point

We will concentrate on the maths-based indicators derived from price and volume data, but we will also occasionally use chart patterns.

What are we trying to identify?

We have four conditions to identify:

  1. A trend is beginning (moving average crossover or pattern breakout)
  2. A trend is strong OR weak OR a market is range-trading (slope of linear regression or moving average)
  3. A trend is retracing but will likely resume (RSI)
  4. A trend is ending and may reverse (momentum, moving average cross-over, or pattern breakout)
Should I put all my money into trading with TA?

No. At 7 Circles we follow a multi-portfolio approach.

There are a number of proven ways to win in the markets, and the momentum / trend-following approach that TA is suited to is just one of them.

More importantly, they don’t all work at all times. Using several portfolios (large cap, small cap, value, dividends, passive ETFs, investment trusts – as well as real assets like property) should reduce overall volatility.

I might put 10% of my overall net-worth into a TA portfolio, and scale up and down from there depending on results.

During the dot-com boom I had something north of 50% of my net worth in a TA portfolio, but it would need a similar extreme bull market for me to go that high again.

How much money should I risk on a single trade?

The answer to this question depends on your portfolio size / net worth.

The general rule of thumb is that you shouldn’t risk more than 2% of your money on a single trade.

  • That way you can have 50 losing trades (in a row) before you go bust.

Let’s say for example that you are trading £10K:

  • So your maximum loss per trade is £10,000 / 50 = £200.

This is your money at risk, called R by Van Tharp, author of the Definitive Guide to Position Sizing.

  • Note that this is real risk – ie. loss of £££ – not the volatility proxy as used in business schools and economics departments.

So you need to set your stop-loss so that if it is hit, you only lose R (£200).

So I just put my stop 1 R away from the price?

Ideally you will look at the technical situation on the security, and choose a stop position which - if hit - would show that your idea for the trade was wrong.

If putting the stop this far away means that you would lose more than R, then you need to reduce your position size until the loss is less than R.

How much should I be looking to gain on a trade?

Like so many things, this is up to your personal judgment, but many traders wouldn’t enter a trade unless they thought they had a chance of making 2 R profit.

You need your average win to be be bigger than your average loss, so that you have a good chance of coming out ahead in the long run.

Again, you need to be realistic.

If you are trading over a period of a week, and your target gain needs the stock to go up by 5%, but its normal range over a week is 2%, then you don’t really have an expected gain of 2R.

How many trades should I have on at once?

This is another matter for personal judgement. The more trades you have at once – certainly up to 25 or more – the better your diversification.

But more simultaneous trades means more monitoring and analysis you need to carry out.
Some people are happy with five trades, others with fifty.

Start small - say three to five - and find out from experience how many you can handle. Aim to get to at least 15 if you can.

Should I bet the same amount on every trade?

Equal weighting is a good way to start out, but if a particular stock / index / currency / commodity has been producing a lot of winning trades recently, feel free to overweight it, so long as you stick within your 2% maximum loss.

Some traders like to have two levels of conviction on a trade, with those they are most convinced about receiving more capital - say twice as much.

Others feel that it’s important to only bet on your highest conviction trades.

Some TAs allocate capital according to the volatilities of the securities they are trading.

How do I decide when to sell?

There are four possible approaches to exiting a trade:

  1. a price target - a rise of 2R, say
  2. a trailing stop-loss: set it initially at -1R, then move it up with the price eg. at +2R your stop would be at +1R
  3. use true-range: use indicators to get you into the trade close to the bottom of the range, and define what proportion of this range that you would like to capture (say 60% to 80%) - sell when you hit this target
  4. use indicators to get you out as well as in
How can charts help?

Charts are used to simplify the trading data in a security.

They are made up of price bars which show the open, high, low and closing price for the security during a time period (usually a day, but potentially anything from a minute to a month).

The closing price is the most important, which is why it’s normally used to draw price charts (those which show just one line).

Most TA indicators work in a similar way to the price bar - they are a mathematical manipulation of the OHLC price data, together with volume.

What does a price bar mean?

The price bar summarises the real-money transactions in a security during a day. Here are a few rules of thumb on how to interpret it:

  • the close is the most important of the four data points
  • up days are bullish, down days are bearish (duh)
  • close at the high is especially bullish, close at the low especially bearish
  • open at the high is bearish, open at the low is bullish
  • a series of higher highs is bullish, lower lows are bearish - this is the definition of a trend
How can trading range help?

Trading range (high to low) can be significant when it is different to the normal trading range for the stock:

  • a small bar within a series of larger bars indicates conflict, and can mean that a trend is coming to an end
  • a large bar within a series of small bars also means that something has changed - the stock is either in demand or is being dumped (high volume is a similar indicator)
Are there any special patterns to look for?

It’s generally easier to spot patterns when using candlestick charts (see below), but there are a few patterns worth looking for:

  1. inside day
  2. outside day
  3. close near the open
  4. spikes
  5. gaps
  6. range expansion and contraction
What is an inside day?

When a price bar has a lower high and a higher low than the previous bar (ie. it is smaller, and within the earlier bar), this is known as an inside day.

It reflects indecision, and a change may be on the way.

What is an outside day?

A higher high and a lower low than the previous day (ie. a bigger bar) is an outside day.

This is especially significant when the open and / or the close are at the extremes - low open, high close is bullish, high open, low close is bearish.
Interpretation of an outside day depends on context:

  • with no trend in place, it can mean one is about to start
  • with a trend in place, an outside day can be either an continuation or a reversal signal, depending on whether it confirms or conflicts with the trend
What does a close near the open mean?

This reflects indecision, and can be either a continuation or a reversal signal, depending on the existing trend:

  • if the open and close are near the high, it’s bullish
  • if they are near the low, its bearish
What are price spikes?

Price spikes are bars that are much bigger than those before them.

A spike can often indicate a reversal, especially when it's clear what external news / shock has caused it.

The close is the most important indicator:

  • in an uptrend, a close near the high is a continuation signal
  • a close near the low would be a reversal signal
What is a gap?

A gap is a discontinuity between bars - white space on a chart.

The most common gap is the opening gap, where the open for today is outside yesterday’s range. If the price action remains outside that range for the day, there will be a gap.

Gaps indicate further movement in the direction of the gap, so their interpretation depends on what trend is already in place.

As with spikes, they are more significant when the cause (news or rumour) is clear. High volume, and large gap size relative to the trading range are also significant.

Thinly traded companies will have lots of gaps, and they are not necessarily significant.

What is an island reversal?

Sometimes a gap occurs at the end of a trend, on low volume. This is known as an exhaustion gap, and it is often followed by a reversal.

Sometimes it is followed by a gap in the opposite direction, leaving a single bar (usually a long bar) isolated at the end of the trend.

This is an island reversal. The volume on the reversal gap should be high.

What does a change in range signify?

A change in the average range can be a leading indicator of change:

  • Range expansion is usually a continuation pattern; with increasing volume and higher closes it is a strong bullish signal.
  • Range contraction is a reversal signal; with high volume and lower closes it is a strong bearish signal.
What are candlesticks?

Candlestick charts are another way of drawing the price bar.

  • They use the same OHLC data, but produce patterns that many people find easier to understand.
  • I think they should be called candles, not candlesticks, as that‘s what they look like.
  • Candlestick charting was developed in Japan in the 19th century and introduced to the West in the 1990s.

They are mainly used to identify reversals - market turning points.

Since they have been around now for more than 20 years, there is an element of the self-fulfilling prophesy about them.

  • Lots of TAs are looking for these patterns, and acting on them.

A candlestick has a body (open and close) and an upper and lower shadow (high and low). A white bar means an "up" day (Close > Open) and a dark bar means a "down" day.

  • This is different from standard price bars, where the colour relates to whether today's close is higher or lower than yesterday's close.
What is a doji?

A doji is the Japanese version of the “close near the open” that we saw above. The candle has a very small - or ideally non-existent - body.

As with most candlestick patterns, a doji is a transitional indicator. It needs to be interpreted in the context of the bars around it.

  • A doji after an uptrend indicates the end of the trend, especially if it comes after a long white bar. In this case it is known as a "bearish doji star".
  • A "bullish doji star" is the opposite - a doji after a big black bar in a downtrend.

The length of the shadows on a doji is also significant:

  • a long lower shadow indicates a dragonfly doji
  • a long upper shadow indicates a gravestone doji

A dragonfly doji has an open and close near the high:

  • in a downtrend, this may mean that buyers are emerging, and the trend is ending
  • in an uptrend, it means that buyers couldn't push the price any higher, and the trend may be in trouble

So a dragonfly doji is a reversal signal.

A gravestone doji has the open and close near the low:

  • in an uptrend, the buyers have failed to close at the high, which is bearish
  • in a downtrend, it could mean that buyers are emerging and the trend may be ending

So again, a gravestone doji is a reversal signal.

What is a shaven candle?

Missing shadows produce candles that are described as shaven.

  • To get a shaven top or bottom, the open or close must be exactly at the high or the low.

Unlike the doji, shaven candles have bodies, and so they have a colour.

  • A dark shaven top means the open was at the high.This is bearish.
  • A white shaven top means that the close was at the high. This is bullish.
  • A white shaven bottom means that the open was at the low. This is bullish.
  • A dark shaven bottom means that the close was at the low, which is bearish.

So white shaven candles are bullish, and dark ones are bearish.

What does a long shadow signify?

A long shadow is one that is at least as long as the body, and indicates extreme sentiment.

Long shadows are reversal indicators.

A long upper shadow means that the high is well above the open and the close:

  • in an uptrend, this is a failure to close near the high, and may indicate weakening near a resistance level
  • in a downtrend, this means that some people were buying at much higher prices, and again the trend may be over
  • if the long upper shadow follows a doji, it is more significant

A long lower shadow means that the low was well below the open and the close:

  • in a downtrend, this is a failure to close near the low, which may indicate weakening near a resistance level
  • in an uptrend, this means that there was some buying at lower levels, which again indicates weakness
What is a harami?

Harami means pregnant in Japanese. The harami pattern is a two-bar pattern, with a small body candle coming after a larger one, ideally within the larger bar.

This again is a reversal signal. The smaller the second body, the more powerful the signal - a doji is best.

Are there any classic candlestick reversal patterns?

Engulfing patterns - where the body of the second candle extends both above and below the first - are reversal signals.

  • Note that this is the opposite of harami, yet indicates the same thing.
  • A dark engulfing pattern is bearish and a white engulfing pattern is bullish.

Shooting stars have a small body and a long upper shadow - the opposite of a hammer.

  • This is also a reversal signal, especially when it comes after a doji of indecision.
Are there any classic candlestick continuation patterns?

The "rising window" is just another term for an upward gap. A downward gap is a "falling window". Depending on the existing trend, these can be continuation signals.

"Three white soldiers" are just three large white candlesticks in a row - this is a bullish continuation.

"Three black crows" is the opposite of three white soldiers - three large black bars in a row, which is a bearish continuation.

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Technical Analysis articles

Here are all the Technical Analysis articles, by topic:

TA theory
  1. Trends and Reversion
  2. Volume and market sentiment
  3. Indicators
  4. Trading Rules
  5. Bar Patterns
  6. Candlesticks
TA spreadsheet
  1. Starting a Technical Analysis spreadsheet
  2. Bollinger Bands
  3. Relative Strength Index (RSI)
  4. MACD (Moving Average Convergence Divergence) Indicator
  5. Williams %R oscillator
Other
  1. Starting Technical Analysis
  2. Spread Betting demo account
  3. Free Charting Software