Lesson 14 – Application of Technical Analysis
Technical Analysis Step 1: Learn to read the charts
The first step to technical analysis is to learn how to read charts. There are many types of charts but they are generally similar. The most basic and commonly used one is the candlestick chart.
As shown below, each candlestick represents a specific time frame. If you have chosen a 30-minute time frame, then each candlestick will depict the trading activities within a 30-minute period. If you have chosen a day as the base time frame, then each candlestick will represent the transactions within the day.
A black candle refers to a drop in price, meaning that the closing price is lower than the opening price. A white or unfilled candle refers to a rise in price, meaning that the closing price is higher than the opening price.
The horizontal lines at the top and bottom of the candlestick represent the opening or closing price, while the vertical lines that extend from above and below the real body are the highest and lowest traded prices within the set time frame respectively.
The candlestick patterns can be used to indicate when a market trend starts to reverse. If we can predict in advance when an upward trend will reverse, we can profit by going short in the market as early as possible. Similarly, if we can forecast that a downward trend is about to stabilize and rebound, we can grab this great opportunity to go long in the market. Candlestick patterns can also be used to determine whether the current trends will continue. Once you are able to master these patterns, you will be able to trade according to the trends. This will give you a lot of confidence to hold your positions or even add positions to earn bigger profits.
Technical Analysis Step 2: Learn to spot trends
The second step in technical analysis is to learn how to draw trend lines, as well as resistance and support positions. Support position is the price position which is supported by buyers. When price falls and approaches the support position, it will tend to rebound. Resistance position is the price position where there will be tremendous selling pressure. When price rises and approaches the resistance position, it will tend to retrace. The support and resistance positions are usually determined using trend lines. Alternatively, you can also use other technical indicators such as Fibonacci lines, moving averages and Bollinger bands.
Drawing Trend Lines
In an upward trend, choose two ascending low points and join them to make an upward trend line. In a downward trend, choose two descending high points and join them to create a downward trend line. In order to improve the accuracy of the trend lines in predicting future market movements, we will filter away those trend lines that are not good enough, leaving behind those that will be useful for our analysis.
A trend line must undergo a series of tests before it can be considered useful and effective. Those that fail to meet these stringent criteria should be discarded.
First, the existence of a trend must be verified. An upward trend must have two consecutive ascending lows while a downward trend must have two consecutive descending highs. Only then a trend can be considered real and the straight line that joins the two points can be called a trend line.
Next, after the trend line is drawn, a third point must be identified to verify that the line is an effective one. In general, the more points a trend line touches, the more effective it is and the more accurate it will be in predicting future movement.
In addition, we must continue to adjust a trend line based on subsequent market situations. For example, when an exchange rate breaks below an upward trend line but then quickly rebounds to move above it, the analyst must redraw the trend line from the first low point to the new low point or try to produce a more effective line using the second low point and the new low point.