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5 Jun 2013 | www.pinoyinvestor.com

INTRODUCTION TO TECHNICAL ANALYSIS: PART 3

(by Investopedia.com)

So far, we have tackled the basics of Technical Analysis, Trends, Support/Resistance,

and Volume. Here in Part 3, the longest installment in this series, we will tackle what
Technical Analysts unceasingly look at and analyze. You guessed it: Charts.

What Is A Chart?
In technical analysis, a chart is simply a graphical representation of a series of prices
over a set time frame. It may show a stock's price
movement over a one-year period, where each
point on the graph represents the closing price for
each day the stock is traded.
The figure on the right is an example of a
basic chart. It is a representation of the price
movements of a stock over a 1.5 year period. The
bottom of the graph, running horizontally (x-axis),
is the date or time scale. On the right hand side,
running vertically (y-axis), the price of the security
is shown.
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By looking at the chart, we see that in October 2004 (Point 1), the price of this stock was
around P245, whereas in June 2005 (Point 2), the stock's price is around P265. This tells us
that the stock has risen between October 2004 and June 2005.
Chart Properties
There are several things that you should be aware of when looking at a chart, as these
factors can affect the information that is provided. They include the time scale, the price scale
and the price point properties used.
The Time Scale. The time scale refers to the range of dates at the bottom of the chart,
which can vary from decades to seconds. The most frequently used time scales are
intraday, daily, weekly, monthly, quarterly and annually. The shorter the time frame,
the more detailed the chart. Each data point can represent the closing price of the period
or show the open, the high, the low and the close depending on the chart used.
Intraday charts plot price movement within the period of one day. This means that the
time scale could be as short as five minutes or could cover the whole trading day from the
opening bell to the closing bell.
Daily charts are comprised of a series of price movements in which each price point on
the chart is a full days trading condensed into one point. Again, each point on the graph
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can be simply the closing price or can entail the open, high, low and close for the stock
over the day. These data points are spread out over weekly, monthly and even yearly
time scales to monitor both short-term and intermediate trends in price movement.
Weekly, monthly, quarterly and yearly charts are used to analyze longer term trends in
the movement of a stock's price. Each data point in these graphs will be a condensed
version of what happened over the specified period. So for a weekly chart, each data point
will be a representation of the price movement of the week.
For example, if you are looking at a chart of weekly data spread over a five-year period
and each data point is the closing price for the week, the price that is plotted will be the
closing price on the last trading day of the week, which is usually a Friday.
The Price Scale and Price Point Properties. The price scale is on the right-hand
side of the chart. It shows a stock's current price and compares it to past data points.
This may seem like a simple concept in that the price scale goes from lower prices to
higher prices as you move along the scale from the bottom to the top.
The problem, however, is in the structure of the scale itself. A scale can either be
constructed in a linear (arithmetic) or logarithmic way, and both of these options are
available on most charting services.

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If a price scale is constructed using a linear scale, the space between each price point (10,
20, 30, 40) is separated by an equal amount. A price move from 10 to 20 on a linear scale
is the same distance on the chart as a move from 40 to 50. In other words, the price scale
measures moves in absolute terms and does not show the effects of percent change.
If a price scale is in logarithmic terms, then the distance between points will be equal in
terms of percent change. A price change from 10 to 20 is a 100% increase in the price
while a move from 40 to 50 is only a 25% change, even though they are represented by
the same distance on a linear scale.
On a logarithmic scale, the distance of the 100% price change from 10 to 20 will not be
the same as
the 25%
change from
40 to 50. In
this case, the
move from
10 to 20 is
represented
by a larger
space one
the chart,
while the
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move from 40 to 50, is represented by a smaller space because, percentage-wise, it

indicates a smaller move. In the figure above, the logarithmic price scale on the right
leaves the same amount of space between 10 and 20 as it does between 20 and 40
because these both represent 100% increases.

Chart Types
There are four main types of charts that are used by investors and traders, depending on
the information that they are seeking and their individual skill levels: the line chart, the bar
chart, the candlestick chart, and the point and figure chart.
While we will no longer discuss the point and figure chart, you will see in the following
sections that even if the data used to create the charts is
the same, the way the data is shown in the different chart
types is different.
Line Chart
The most basic of the four charts is the line chart
because it represents only the closing prices over a set
period of time. As you can see on the left, the line is
formed by connecting the closing prices over the time
frame.
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Line charts do not provide visual information of the trading range for the individual
points such as the high, low and opening prices. However, the closing price is often considered
to be the most important price in stock data compared to the high and low for the day and this
is why it is the only value used in line charts.
Bar Chart
The bar chart expands on the line chart by adding several more key pieces of information
to each data point. The chart is made up of a series of vertical lines that represent each data
point. This vertical line represents the high and low for the trading period, along with the
closing price. The close and open are represented on
the vertical line by a horizontal dash. The opening
price on a bar chart is illustrated by the dash that is
located on the left side of the vertical bar.
Conversely, the close is represented by the dash
on the right. Generally, if the left dash (open) is lower
than the right dash (close) then the bar will be shaded
black, representing an up period for the stock, which
means it has gained value. A bar that is colored red
signals that the stock has gone down in value over that
period. When this is the case, the dash on the right
(close) is lower than the dash on the left (open).
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Candlestick Chart
The candlestick chart is similar to a bar
chart, but it differs in the way that it is
visually constructed. Similar to the bar chart,
the candlestick also has a thin vertical line
showing the period's trading range. The
difference comes in the formation of a wide bar
on the vertical line, which illustrates the
difference between the open and close. And,
like bar charts, candlesticks also rely heavily
on the use of colors to explain what has
happened during the trading period.
A major problem with the candlestick
color configuration, however, is that different
sites use different standards; therefore, it is important to understand the candlestick
configuration used at the chart site you are working with. There are two color constructs for
days up and one for days that the price falls. When the price of the stock is up and closes
above the opening trade, the candlestick will usually be white or clear. If the stock has traded
down for the period, then the candlestick will usually be red or black, depending on the site. If
the stock's price has closed above the previous days close but below the day's open, the
candlestick will be black or filled with the color that is used to indicate an up day.
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Chart Patterns
A chart pattern is a distinct formation on a stock chart that creates a trading signal, or a
sign of future price movements. Chartists use these patterns to identify current trends and
trend reversals and to trigger buy and sell signals.
In Part 1 of this series, we talked about the three assumptions of technical analysis, one
of which is that history repeats itself. The theory behind chart patters is based on this
assumption. The idea is that certain patterns are seen many times, and that these patterns
signal a certain high probability move in a stock! Based on the historic trend of a chart
pattern setting up a certain price movement, chartists look for these patterns to identify
trading opportunities.
While there are general ideas and components to every chart pattern, there is no chart
pattern that will tell you with 100% certainty where a security is headed. This creates some
leeway and debate as to what a good pattern looks like, and is a major reason why charting is
often seen as more of an art than a science.
There are two types of patterns within this area of technical analysis: reversal and
continuation. A reversal pattern signals that a prior trend will reverse upon completion of the
pattern. A continuation pattern, on the other hand, signals that a trend will continue once the
pattern is complete.
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These patterns can be found over charts of any timeframe. Let us tackle some of the more
popular chart patterns.
Head and Shoulders
This is one of the most
popular and reliable chart
patterns in technical analysis.
Head and shoulders is a
reversal chart pattern that
when formed, signals that the
security is likely to move
against the previous trend.
As you can see in the
figure, there are two versions
of the head and shoulders chart pattern. Head and shoulders top (shown on the left) is a chart
pattern that is formed at the high of an upward movement and signals that the upward trend
is about to end. Head and shoulders bottom, also known as inverse head and shoulders
(shown on the right) is the lesser known of the two, but is used to signal a reversal in a
downtrend.

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Both of these head and shoulders patterns are similar in that there are four main parts:
two shoulders, a head and a neckline. Also, each individual head and shoulder is comprised of
a high and a low.
For example, in the head and shoulders top image shown on the left side in the figure
above, the left shoulder is made up of a high followed by a low. In this pattern, the neckline is
a level of support or resistance.
Remember that an upward trend is a period of successive rising highs and rising lows.
The head and shoulders chart pattern, therefore, illustrates a weakening in a trend by
showing the deterioration in the successive movements of the highs and lows.
Cup and Handle
A cup and handle chart is a bullish continuation
pattern in which the upward trend has paused but will
continue in an upward direction once the pattern is
confirmed. As you can see in the figure, this price pattern
forms what looks like a cup, which is preceded by an
upward trend. The handle follows the cup formation and is
formed by a generally downward/sideways movement in the
security's price.
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Once the price movement pushes above the resistance lines formed in the handle, the
upward trend can continue. There is a wide ranging time frame for this type of pattern, with
the span ranging from several months to more than a year.
Double Tops and Bottoms
This chart pattern is another well-known pattern that signals a trend reversal! It is
considered to be one of the most reliable and commonly used. These patterns are formed after
a sustained trend and signal to chartists that the trend is about to reverse. The pattern is
created when a price movement tests support or resistance levels twice and is unable to break
through. This pattern is often used to signal intermediate and long-term trend reversals.
In the case of the double top
pattern in Figure 3, the price
movement has twice tried to move
above a certain price level. After
two unsuccessful attempts at
pushing the price higher, the trend
reverses and the price heads lower.
In the case of a double bottom
(shown on the right), the price
movement has tried to go lower twice, but has found support each time. After the second
bounce off of the support, the security enters a new trend and heads upward.
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Triangles
Triangles are some of the most well-known chart patterns used in technical analysis. The
three types of triangles, which vary in construct and implication, are the symmetrical
triangle, ascending and descending triangle. These chart patterns are considered to last
anywhere from a couple of weeks to several months.
The symmetrical triangle in the
figure is a pattern in which two
trendlines converge toward each other.
This pattern is neutral in that a breakout
to the upside or downside is a
confirmation of a trend in that direction.
In an ascending triangle, the upper
trendline is flat, while the bottom
trendline is upward sloping. This is
generally thought of as a bullish pattern
in which chartists look for an upside
breakout.
In a descending triangle, the lower
trendline is flat and the upper trendline
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is descending. This is generally seen as a bearish pattern where chartists look for a downside
breakout.
Flag and Pennant
These two short-term chart patterns are continuation patterns that are formed when
there is a sharp price movement followed by a generally sideways price movement. This
pattern is then completed upon another sharp price movement in the same direction as the
move that started the trend. The patterns are generally thought to last from one to three
weeks.
As you can see in the figure, there
is little difference between a pennant
and a flag. The main difference
between these price movements can be
seen in the middle section of the chart
pattern.
In a pennant, the middle section is
characterized by converging trendlines,
much like what is seen in a symmetrical triangle. The middle section on the flag pattern, on
the other hand, shows a channel pattern, with no convergence between the trendlines. In both
cases, the trend is expected to continue when the price moves above the upper trendline.
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Wedge
The wedge chart pattern can be either a continuation or reversal pattern. It is similar to
a symmetrical triangle except that the wedge pattern slants in an upward or downward
direction, while the symmetrical triangle generally shows a sideways movement. The other
difference is that wedges tend to form over longer periods, usually from three to six months.
The fact that wedges are classified as both continuation
and reversal patterns can make reading signals confusing.
However, at the most basic level, a falling wedge is bullish and a
rising wedge is bearish.
In the figure on the right, we have a falling wedge in which
two trendlines are converging in a downward direction. If the
price was to rise above the upper trendline, it would form a
continuation pattern, while a move below the lower trendline
would signal a reversal pattern.
Triple Tops and Bottoms
Triple tops and triple bottoms are another type of reversal chart pattern in chart
analysis. These are not as prevalent in charts as head and shoulders and double tops and
bottoms, but they act in a similar fashion. These two chart patterns, as can be seen in the
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figure on the left, are formed

when the price movement tests
a level of support or resistance
three times and is unable to
break through; this signals a
reversal of the prior trend.
Confusion can form with
triple tops and bottoms during
the formation of the pattern
because they can look similar to
other chart patterns. After the
first two support/resistance tests are formed in the price movement, the pattern will look like
a double top or bottom, which could lead a chartist to enter a reversal position too soon.
Rounding Bottom
A rounding bottom, also referred to as a saucer bottom, is a
long-term reversal pattern that signals a shift from a downward
trend to an upward trend. This pattern is traditionally thought
to last anywhere from several months to several years.
A rounding bottom chart pattern looks similar to a cup and
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handle pattern but without the handle. The long-term nature of this pattern and the lack of a
confirmation trigger, such as the handle in the cup and handle, make it a difficult pattern to
trade.

We have now finished our look at some of the more popular chart patterns. You should now be
able to recognize each chart pattern as well the signal it can form for chartists.
In the final installment of this series, Part 4, we will tackle other techniques like moving
averages and oscillators and examine how technical traders use them to gauge price
movements. Watch out for it!

Credits: Investopedia.com / Getty Images

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