Fundamental of Technical Analysis and Algorithmic Trading

Report
Doğu Akdeniz Üniversitesi
Faculty of Business and Economics
Department of Banking and Finance
Saeed Ebrahimijam
FINA417
Spring 2013
This Chapter presents a select group of reversal chart
patterns, ones that have proven to have considerable validity
over many years:
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Key reversal pattern
Head and Shoulder pattern(top and bottom)
Ascending and descending triangles
Rectangles
Double and triple top and bottom
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A reversal pattern, meaning that it signifies a change in the
trend.
These patterns, known as reversal chart patterns, help
identify when the market is changing direction, either
from up to down or down to up.
The primary importance of reversal patterns is that they
help one sell securities before substantial price declines
and 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 the
head-and-shoulders
formation.
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The forming of a market top and subsequent
price reversal to the downside occurs as a
result of supply overcoming demand (known
as distribution).
The opposite occurs at market bottoms when
demand
overcomes
supply
(known
as
accumulation). In both cases, this overcoming
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activity typically occurs gradually.
A reversal chart pattern develops as prices
move in a sideways fashion of some sort until
a complete reversal is accomplished.
“ At this time, first, the stock price will fluctuate around a certain level and then
the trend changes.”
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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 moving
higher (to a new high in an uptrend) than the previous
period’s high, but closing near the lows of the day (and, at
times, even lower than the previous period’s low).
Key reversal tops appear regularly in thinly traded stocks
after an active advance.
The opposite occurs for a key reversal bottom. Prices first
move sharply lower (to a new low in a downtrend) than the
previous period’s low and then move to the upside closing
near the high for the day (and often higher than the
previous period’s high). A key reversal bottom is
frequently called a selling climax as it often occurs at the
end of a panic decline.
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Typical Volume Action Key reversals
normally are accompanied by unusually high
volume.
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Frequency of Occurrence Key reversals appear
often.
They can develop independently or as a part
of a larger chart pattern (such as the top of
the head in a head-and-shoulders top
formation).
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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 period’s high penetrates the previous period’s
high significantly for a key reversal top, or the
period’s low penetrates the previous period’s low
significantly for a key reversal bottom.
2. The key reversal period was preceded by a long,
unbroken trend.
3. The period’s closing price was below (for a key
reversal top) or above (for a key reversal bottom) one
or more immediately prior period ranges.
4. The period volume was particularly high.
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This formation is characterized by two small
peaks on either side of a larger peak.
H & S Top
H ead
R ig h t S h o u ld e r
L e ft S h o u ld e r
N e cklin e
H & S B o tto m
N e cklin e
L e ft S h o u ld e r
R ig h t S h o u ld e r
H ead
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If the price diagram intersect the neck line,
this can be a strong signal of change in the
overall price trend.
The pattern is not completely symmetric
always.
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There will be high volume of trading at the
left shoulder, when the price is increasing but
then while descending price trend the volume
of trading decreases, again there will be an
increase by price boost and at last after
passing from head there will be low volume
of trading.
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volume is heavy on the rally portion of the left
shoulder. Volume declines on the dip from the left
shoulder peak and then again is heavy on the rally up
to the top of the head. A reduction in volume occurs
on the decline from the top of the head. The ensuing
rally to create the right shoulder occurs on less
volume than on previous rallies in this formation.
For a head-and-shoulders bottom, volume picks up
on each rally with greater volume on the rally
completing the right shoulder than on the rally
completing the head. Between rallies, volume
diminishes. If the neckline is broken on relatively low
volume, it could indicate a false signal, and a retest
of lows may be necessary.
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Upon the break of the neckline support level the chart
pattern is said to be in place so this is where traders will
commonly look to enter a short position (sell).
Their target will be calculated by measuring the distance
from the head of the pattern down to the neckline and then
projecting that distance downward from the breakpoint of
the neckline.
The stop loss will then be placed just above the right hand
shoulder of the pattern which is considered resistance. The
idea here is that once the neckline support has been broken
sellers will theoretically remain in control but if this does
not 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
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Typically, triangles should break out about half to
three-quarters of the way through the formation.
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- Typical Price Action For an ascending triangle:
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prices swing between a horizontal top boundary
line and an upward or downward sloping bottom
boundary line.
An ascending triangle develops when demand is
growing but continues to meet supply at a
certain 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 less
frequent in weakly prices.
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There are good opportunities for profit
making. i.e. The Ascending triangle pattern
shows bullish state regards to the share,
whereas descending triangles shows a
bearish state in the market.
After creating enough demand and
absorbing the supply volume, prices break
out of the pattern and suddenly continue
uptrend in advance.
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Volume decreases as prices move toward
the apex of either the ascending or the
descending
triangle.
Breakouts
are
accompanied by a marked increase in
trading volume.
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Ascending and descending triangles offer
excellent profit opportunities.
The ascending triangle provides a bullish
outlook.
Descending triangle suggests a bearish
future.
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It is recommended not to trade symmetric triangle
patterns because they are highly unreliable.
Triangles usually break after 2/3 of their size. If the
prices went beyond 2/3 of the triangle the breakout
will 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 the
pattern, or conservatively, it can be placed above or
below the breakout bar.
The target for this trade is a level equal to the height
of the base of the triangle, from the breakout point.
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
The rectangle is a classical technical analysis
pattern described by horizontal lines showing
significant support and resistance.
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The area within the lines is also known as a trading area or
range.
Rectangles are formed when there is a consistent supply of
a security at a certain price and a demand at a certain
lower price.
When the price reaches the lower price, the security is
purchased, driving up the price until it reaches the upper
boundary, and people are ready to sell and drive the price
back to the lower boundary. This occurs repeatedly until
one side or the other gives way, and the pattern is broken.
A closing price outside the upper- or lower-boundary line
suggests the direction of the trend. If the closing price is
above the upper-boundary line, the probability is that
prices will move higher. On the other hand, if the closing
price is below the lower-boundary line, prices are likely to
fall.
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Volume action can give a clue as to whether
the rectangle formation will ultimately be
broken to the upside or downside.
If volume is relatively higher on upward price
swings than on moves to the downside, it is
likely that the breakout will occur on the
upside.
On the other hand, if volume is relatively
higher on downward price swings than on
moves to the upside, it is likely that there will
be a downside breakout of the rectangle
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If the close price of a share was higher than
upper line or lower than bottom line of
rectangle, it can be considered as strong
probability of up/downtrend respectively.
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The following are two basic strategies for trading a
rectangle:
 The first, is to buy at support and sell at resistance (one
can also sell short at resistance and cover the short sale at
support). To mitigate risk, in case the stock breaks down
from support, a very tight stop can be employed of
perhaps 3%. For example, if one bought ImClone at
$37.50, the stop-loss would 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 the
breakout. As with all technical patterns, this breakout
should ideally occur on above-normal volume. To know
when to consider exiting the trade, the trader could use
the 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 the
pattern. In the case of ImClone Systems Figure shows the calculation as
follows:
Top:
$47.50
Bottom: $37.50
Height: 10.00 points
For a bullish breakout, once the height of the pattern has been
established, add the difference to the breakout level.
Since the breakout level is $47.50 and the height 10 points, the
minimum target is $57.50. Of course, it may take some time to reach
the target, so the trader must be patient. As well, the measuring
principle is a statement of probability, not a guarantee. The trader will
carefully monitor the technical picture of the stock despite the target.
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“ Some short-term traders make trades within
well-defined rectangles. They buy when prices
reach the bottom boundary and sell short when
prices reach the upper boundary. To protect
themselves in the event of a pattern breakout,
each time they buy or sell short, they also place
stop-loss orders just outside the lower or upper
boundary lines to minimize any potential losses.
If the pattern is broken, they are stopped out at a
small loss, and they quickly place a new order in
the direction of the breakout.”
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Some oscillators benefits of rectangles as
well.
They buy when the price fall to bottom line
and when the price reaches to top line start
to sell.
To decrease the investment risks if the price
exit from rectangle pattern, such people spot
a lower price less than bottom line price as
“Stop-loss” for 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&S
formations, but there is no head.
These are reversal patterns with the same
measuring 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, rise
again to near the previous peak, and then move
down a second time to below the valley between
the two peaks. The double bottom, which looks
like the letter W, is the same as the double top
except upside down. Triple tops and bottoms
make 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.
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Typical Volume Action For a double top,
Volume on the rise to the second peak is lower than
on the first peak.
- If volume is relatively higher, chances of a double
top occurring are reduced. For a double bottom,
volume shows a marked increase on the rally from
the second bottom. For triple tops, volume is
relatively less on the second advance than the first
and even less on the third advance. For triple
bottoms, volume is relatively higher on the second
rally than the first and still greater on the third
advance.
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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 not
occur until the price goes below the low price of the valley
between the two peaks (or above the high price of the peak
between 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) are
near each other, they could very well be part of a
consolidation area. As a yardstick, use the criteria of peaks
being one month apart and the valley being at least 15
percent lower than the top peak price.
True double and triple tops and bottoms do have measuring
implications. Expect prices to move in the direction of the
reversal 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 are
moving up again with low volume, it is an opportune point to
sell.
One can sell short with a stop (calculated loss) above the
highest peak of the Double top.
The next opportune point to sell would be after a Triple top
has formed and a fourth top is being formed at the lower
level.
The formation of Triple bottom occurs during the period of
accumulation.
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