s3_fundamental of technical analysis and algorithmic trading

8/13/2019 S3_Fundamental of Technical Analysis and Algorithmic Trading

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Saeed Ebrahimijam

Spring 2013

Faculty of Business and EconomicsDepartment of Banking and FinanceuAkdeniz niversitesi

FINA417


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This Chapter presents a select group of reversal chartpatterns, ones that have proven to have considerable validityover many years:

Key reversal pattern

Head and Shoulder pattern(top and bottom) Ascending and descending triangles

Rectangles

Double and triple top and bottom

2Fundamental of Technical Analysis and Algorithmic Trading


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A reversal pattern, meaning that it signifies a change in thetrend.

These patterns, known as reversal chart patterns, helpidentify when the market is changing direction, eitherfrom up to down or down to up.

The primary importance of reversal patterns is that theyhelp one sell securities before substantial price declinesand cover short sales ahead of considerable advances.

Many of the price patterns are based on geometrical figures. Occasionally, more fanciful shapes are seen, such as thehead-and-shoulders formation.

http://www.investopedia.com/terms/h/head-shoulders.asphttp://www.investopedia.com/terms/h/head-shoulders.asphttp://www.investopedia.com/terms/h/head-shoulders.asphttp://www.investopedia.com/terms/h/head-shoulders.asphttp://www.investopedia.com/terms/h/head-shoulders.asphttp://www.investopedia.com/terms/h/head-shoulders.asphttp://www.investopedia.com/terms/h/head-shoulders.asp


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The forming of a market top and subsequentprice reversal to the downside occurs as aresult of supply overcoming demand (knownas distribution).

The opposite occurs at market bottoms whendemand overcomes supply (known asaccumulation). In both cases, this overcomingactivity typically occurs gradually.

A reversal chart pattern develops as pricesmove in a sideways fashion of some sort untila complete reversal is accomplished.

At this time, first, the stock price will fluctuate around a certain level and thenthe trend changes.

Fundamental of Technical Analysisand Algorithmic Trading 4


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Typical Price Action Key reversals occur during one period(usually one day) of market activity.

A key reversal top is the result of prices quickly movinghigher (to a new high in an uptrend) than the previousperiodshigh, but closing near the lows of the day (and, attimes, even lower than the previous periodslow).

Key reversal tops appear regularly in thinly traded stocksafter an active advance.

The opposite occurs for a key reversal bottom. Prices firstmove sharply lower (to a new low in a downtrend) than theprevious periodslow and then move to the upside closingnear the high for the day (and often higher than the

previous periods high). A key reversal bottom isfrequently called a selling climax as it often occurs at theend of a panic decline.



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Typical Volume Action Key reversalsnormally are accompanied by unusually highvolume.

Frequency of Occurrence Key reversals appearoften.

They can develop independently or as a part

of a larger chart pattern (such as the top ofthe head in a head-and-shoulders topformation).



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only short-term (minor trend) significance. Its significance is, however, greatly enhanced if one

or more of the following occurs:

1. The periods high penetrates the previous periodshigh significantly for a key reversal top, or theperiods low penetrates the previous periods lowsignificantly for a key reversal bottom.

2. The key reversal period was preceded by a long,unbroken trend.

3. The periods closing price was below (for a keyreversal top) or above (for a key reversal bottom) oneor more immediately prior period ranges.

4. The period volume was particularly high.Fundamental of Technical Analysis

and Algorithmic Trading 9


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This formation is characterized by two smallpeaks on either side of a larger peak.

10

Head

Head

Left Shoulder

Left Shoulder

Right Shoulder

Right Shoulder

Neckline

Neckline

H&S Top

H&S Bottom

Fundamental of Technical Analysis and Algorithmic Trading


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If the price diagram intersect the neck line,this can be a strong signal of change in theoverall price trend.

The pattern is not completely symmetricalways.



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There will be high volume of trading at theleft shoulder, when the price is increasing butthen while descending price trend the volumeof trading decreases, again there will be an

increase by price boost and at last afterpassing from head there will be low volumeof trading.



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volume is heavy on the rally portion of the leftshoulder. Volume declines on the dip from the leftshoulder peak and then again is heavy on the rally upto the top of the head. A reduction in volume occurson the decline from the top of the head. The ensuingrally to create the right shoulder occurs on lessvolume than on previous rallies in this formation.

For a head-and-shoulders bottom, volume picks upon each rally with greater volume on the rallycompleting the right shoulder than on the rally

completing the head. Between rallies, volumediminishes. If the neckline is broken on relatively lowvolume, it could indicate a false signal, and a retestof lows may be necessary.



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Upon the break of the neckline support level the chartpattern is said to be in place so this is where traders willcommonly look to enter a short position (sell).

Their target will be calculated by measuring the distancefrom the head of the pattern down to the neckline and thenprojecting that distance downward from the breakpoint of

the neckline. The stop losswill then be placed just abovethe right hand

shoulder of the pattern which is considered resistance. Theidea here is that once the neckline supporthas been brokensellers will theoretically remain in control but if this doesnot happen then you are protected with a stop loss just

above the nearest resistance level. For the reverse head and shoulders the strategy is a mirror.

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Estimation of next price level. (price goal)



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http://www.newyorkfed.org/research/staff_reports/sr4.pdf

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Triangles are continuation formations. Three flavors:

Ascending

Descending

Symmetrical

Typically, triangles should break out about half tothree-quarters of the way through the formation.

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Typical Price Action For an ascending triangle:prices swing between a horizontal top boundaryline and an upward or downward sloping bottomboundary line.

An ascending triangle develops when demand isgrowing but continues to meet supply at acertain price level. Once the supply is absorbed,prices break out of the pattern and move up

rapidly. For a descending triangle, the opposite is true.



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Reputation of the pattern: Triangles are considered intermediate-term patterns, usually

taking from one to three months to complete.

These can be recognized in intraday share prices, but lessfrequent in weakly prices.



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There are good opportunities for profitmaking. i.e. The Ascending triangle patternshows bullish state regards to the share,whereas descending triangles shows abearish state in the market.

After creating enough demand andabsorbing the supply volume, prices break

out of the pattern and suddenly continueuptrend in advance.



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Volume decreases as prices move towardthe apex of either the ascending or thedescending triangle. Breakouts areaccompanied by a marked increase intrading volume.



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Ascending and descending triangles offerexcellent profit opportunities.

The ascending triangle provides a bullishoutlook.

Descending triangle suggests a bearishfuture.



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It is recommended not to trade symmetric trianglepatterns because they are highly unreliable.

Triangles usually break after 2/3 of their size. If theprices went beyond 2/3 of the triangle the breakoutwill be even less reliably and not recommended to

trade. Take trades at the break out of the trend lines, with

the Stop-Loss order placed above or below thepattern, or conservatively, it can be placed above orbelow the breakout bar.

The target for this trade is a level equal to the heightof the base of the triangle, from the breakout point.



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The rectangleis a classical technical analysispattern described by horizontal lines showingsignificant supportand resistance.

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The area within the lines is also known as a trading area orrange. Rectangles are formed when there is a consistent supply of

a security at a certain price and a demand at a certainlower price.

When the price reaches the lower price, the security is

purchased, driving up the price until it reaches the upperboundary, and people are ready to sell and drive the priceback to the lower boundary. This occurs repeatedly untilone side or the other gives way and the pattern is broken.

A closing price outside the upper- or lower-boundary linesuggests the direction of the trend. If the closing price isabove the upper-boundary line, the probability is thatprices will move higher. On the other hand, if the closingprice is below the lower-boundary line, prices are likely tofall.



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Volume action can give a clue as to whetherthe rectangle formation will ultimately bebroken to the upside or downside.

If volume is relatively higher on upward price

swings than on moves to the downside, it islikely that the breakout will occur on theupside.

On the other hand, if volume is relatively

higher on downward price swings than onmoves to the upside, it is likely that there willbe a downside breakout of the rectangle



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If the close price of a share was higher thanupper line or lower than bottom line ofrectangle, it can be considered as strongprobability of up/downtrend respectively.



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The following are two basic strategies for trading arectangle: The first is to buy at support and sell at resistance (one

can also sell shortat resistance and coverthe short sale atsupport). To mitigate risk, in case the stock breaks downfrom support, a very tight stop can be employed of

perhaps 3%. For example, if one bought ImClone at$37.50, the stop-losswould be 3% lower than $37.50 or$1.12. The trader would exit the position if the stock hit$36.38 ($37.50-$1.12).

Second method to trade the rectangle is to wait for thebreakout. As with all technical patterns, this breakout

should ideally occur on above-normal volume. To knowwhen to consider exiting the trade, the trader could usethe measuring principle described below.

(Learn more about volume in Gauging Support And Resistance With Price By Volume.)

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To calculate the minimum target, first establish the height of thepattern. In the case of ImClone Systems Figure shows the calculation asfollows:

Top: $47.50Bottom: $37.50Height: 10.00 points

For a bullish breakout, once the height of the pattern has beenestablished, add the difference to the breakout level.Since the breakout level is $47.50 and the height 10 points, theminimum target is $57.50. Of course, it may take some time to reachthe target, so the trader must be patient. As well, the measuringprinciple is a statement of probability, not a guarantee. The trader willcarefully monitor the technical picture of the stock despite the target.



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Some short-term traders make trades withinwell-defined rectangles. They buy when pricesreach the bottom boundary and sell short whenprices reach the upper boundary. To protect

themselves in the event of a pattern breakout,each time they buy or sell short, they also placestop-loss orders just outside the lower or upperboundary lines to minimize any potential losses.

If the pattern is broken, they are stopped out at asmall loss, and they quickly place a new order inthe direction of the breakout.



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Some oscillators benefits of rectangles aswell.

They buy when the price fall to bottom lineand when the price reaches to top line start

to sell. To decrease the investment risks if the price

exit from rectangle pattern, such people spota lower price less than bottom line price as

Stop-lossfor themselves. ( i.e.: if 10% less than their bid price, so at

most they will loss 10% )



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These formations are similar to the H&Sformations, but there is no head.

These are reversal patterns with the samemeasuring implications as the H&S.

It happens rarely.



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Typical Price Action On a chart,a double top looks like the letter M. It forms when

prices advance to a certain level, turn down, riseagain to near the previous peak, and then movedown a second time to below the valley betweenthe two peaks. The double bottom, which lookslike the letter W, is the same as the double topexcept upside down. Triple tops and bottomsmake three tops and bottoms instead of two.

Frequency of Occurrence :True double tops and double bottoms are rare;

triple tops and triple bottoms are even rarer.Fundamental of Technical Analysis

and Algorithmic Trading 45


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Typical Volume Action For a double top,

Volume on the rise to the second peak is lower thanon the first peak.- If volume is relatively higher, chances of a doubletop occurring are reduced. For a double bottom,volume shows a marked increase on the rally fromthe second bottom. For triple tops, volume is

relatively less on the second advance than the firstand even less on the third advance. For triplebottoms, volume is relatively higher on the secondrally than the first and still greater on the thirdadvance.

Triple Top: at up warding side, V1>V2 >V3 Triple bottom: at up warding side, V3>V2>V1



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One must wait for confirmation of the pattern, which does notoccur until the price goes below the low price of the valleybetween the two peaks (or above the high price of the peakbetween two valleys for double bottoms).

A further test of validity is the time element. Peaks should be

separated by a significant reaction. If the two tops (peaks) arenear each other, they could very well be part of aconsolidation area. As a yardstick, use the criteria of peaksbeing one month apart and the valley being at least 15percent lower than the top peak price.

True double and triple tops and bottoms do have measuringimplications. Expect prices to move in the direction of thereversal at least the distance from the valley to the peak.



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First and second peaks are perfect point to place sell orders.

After the double top has been confirmed and if prices aremoving up again with low volume, it is an opportune point tosell.

One can sell short with a stop (calculated loss) above thehighest peak of the Double top.

The next opportune point to sell would be after a Triple tophas formed and a fourth top is being formed at the lowerlevel.

The formation of Triple bottom occurs during the period ofaccumulation.
http://en.wikipedia.org/wiki/Double_top_and_double_bottomhttp://en.wikipedia.org/wiki/Capital_accumulationhttp://en.wikipedia.org/wiki/Capital_accumulationhttp://en.wikipedia.org/wiki/Double_top_and_double_bottom

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