Trend is your friend

In technical analysis, there is an unwritten assumption that prices follow comparable patterns as they have in the past. Due to similar reactions of investors, for lack of a better word: “history repeats itself.” Chart Traders (traders who base their trading decisions on technical analysis in order to determine a potential future price direction) usually look at historical charts identifying similar patterns in price movement or a technical indicator to signal possible trend changes.

Many traders analyze price patterns as one method to identify a potential change in trend. Additionally, chart patterns can be used to designate that an existing trend is likely to continue.

There are basically two styles of chart patterns:

  1. Reversal patterns – These patterns indicate potential trend reversals during existing up and downtrends.
  2. Continuation patterns –These patterns indicate potential continuation of the existing up or downtrend.

Each pattern has a specific set of requirements that must be met before the trend reversal or continuation signal is officially confirmed.

Pattern time frames play very important roles in how a particular pattern is read. Depending on the time frame, some patterns do not take long to form and occur more frequently. Still, other patterns may take longer time to establish and may appear less regularly.

In short, it is generally believed the longer a time frame is covered by a particular pattern, the stronger a signal will be established. That being said, some very short-term patterns can be useful in signaling the future direction of impending market action.

Technical traders often use an analysis tool simply referred to as an “indicator” in conjunction with price movement and/or other indicators in order to:

  • Identify potential trading signals

and/or

  • confirm trading signals from other indicators or chart patterns

Another type of an analysis technique used in technical analysis is often called “studies”. Studies typically involve mathematical and statistical formulas used to measure current situations, while also forecasting future price direction.

Indicator Styles

According to Technical Analysis of the Financial Markets by John J. Murphy, there are generally two styles of indicators:

  1. Leading Indicators – these are indicators designed to signal a change in price movement in advance of the actual move in the near future. These “leading” indicators may highlight a future continuation of the current trend or rather signify an approaching reversal in price direction. Some popular leading indicators are Commodity Channel Index, Momentum, Relative Strength Index (RSI), and Stochastic Oscillator.
  2. Lagging Indicators – these indicators follow the price movement and describe past performance. They are primarily used to predict price action. While these indicators may not necessarily offer any predictive value, trend-following traders use these indicators to keep a trade in gear with important trends for additional perceived security. Moving averages (exponential, simple, Weighted, Variable) are a popular example of lagging indicators.

Chart patterns can also be used in combination with other indicators and studies to help technical analysts with their forecasts. In any event, using only one indicator reveals a fraction of the whole picture. Accounting for this, it can be very useful to utilize two or more indicators/studies/chart patterns simultaneously in an attempt to acquire more meaningful evidence or a better confirmation on potential trade signals.

In conclusion

Trends themselves are considered indicators. A trend is a lagging indicator that describes past price performance, yet because price action is so important in technical analysis, traders use trends to confirm price movement. Based on those trends, they can use the information to help them decide on potential entry and exit points.

Important Disclosures

Tradeview does not recommend the use of technical analysis as sole means of investment research. The information here is for general informational purposes only and should not be considered an individualized recommendation or endorsement of any particular security, chart pattern, or investment strategy. Past performance is not a reliable guide to future performance. If you invest or invest using the above methodology, you may lose some or all of the money you invest. These methodologies are not a reliable guide to the future performances.
Kazem Ghouchani

 

Kazem Ghouchani
Tradeview Director- Middle East and North Africa
kghouchani@tvmarkets.com