Background
BANK3014 – Private and investment Banking Notes on Technical Trading Analysis Models
These notes have been produced to provide some information on the operation of the most commonly used models in technical trading. This is not an exhaustive list of models and individual traders will develop variations on these to suit the particular the markets in which they trade and to identify market opportunities that they believe they have unique insight into.
Technical trading analysis at its essence recognises that markets do not move from one equilibrium level to another in an orderly manner. Rather, markets can be very volatile as they move to a new equilibrium and will respond to the forces of demand and supply during this process, referred to as momentum. Technical analysis also identifies that markets tend to move in trends. These trends can persist for extremely short time frames to longer time frames but usually no longer than a matter of days or weeks. These trends reflect changes in the attitudes of investors toward a variety of economic, monetary, political and psychological forces. Technical analysis also asserts that traders are likely to react in a similar way to certain market circumstances, thus suggesting that these reactions repeat and hence the analysis of past data can assist in identifying the likely reactions.
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Care needs to be exercised in the use of technical analysis tools, because there is a risk of reading too much into the historical patterns. This is referred to in psychology as the problem of Pareidolia or the risk of seeing patterns in random data. In fact it is common for different traders to identify different patterns from the same data.
These market patterns are shown viain a price chart, typically a “candlestick” chart as described in the following figures. The candlestick chart shows the high and low for the day displayed as the top and bottom of the line, the difference between the opening and closing prices for the day, shown in the block. A black block indicates a “bearish day” where the close is lower than the open, whilst a white of clear block indicates a bullish day, where the opening price is lower than the closing price.
We will examine two commonly used models in technical trading:
1. Moving Averages
2. Market Reversals
1. MovingAverages
Moving averages represent a time series derived from a set of price observations. The model develops two sets average prices over a number of past days data. These moving averages (MA) are calculated for a short term (e.g. over the past 10 days) and a long term (e.g. over the past 20 days). The short term MA reflects changes in market momentum (demand and supply) over the more recent past, whilst the longer term MA reflects the longer term market momentum factors. As the day changes so do the 10 or 20 prices from which the average is calculated.
Note the choice of length of time will be determined by the trader. The choice will be based on the trader’s experience with the use of this model and will be supported by considerable back-testing
analysis to determine from history what terms (number of days) for the fast (shorter term MA) and the slow (longer term MA) has produced the most reliable and profitable trading signals in the past.
MA’s have the effect of smoothing a dataset, and are used as a trend following tool. The MA technical model suggests that when the short MA and the long MA crossover, this represents a change in momentum and hence a change in trend. These points in the model therefore represent buy or sell entry or exit points for the trader, or indeed the trading engine if this model is used as part of an Algo Trading engine. These Algo trading engines need to be distinguished from the Algo execution engines which were examined in Week 4.
1.1 Example 1 – MA Crossover, leading to a short trade
In the chart the two crossover points are noted as 1 and 2 respectively.
MA(fast) MA(slow)
Leading up to Point 1, the fast (or short-term MA, say a 10 day MA) is moving down faster than the slow (or long term MA). These two cross over at point 1 above. This represents a point at which the short term momentum or market forces are pushing the market lower. As a consequence the model suggests that future prices will be lower. This provides the trader with a sell signal.
Leading up to Point 2, the fast (or short-term MA, say a 10 day MA) is moving up faster than the slow (or long term MA). These two cross over at point 2 above. This represents a point at which the short term momentum or market forces are pushing the market higher. As a consequence the model suggests that future prices will be higher. This provides the trader with a buy signal. If the trader entered the short position at point 1 earlier this would also represent a take profit level for the trader. Note the trader could, as well as closing the short position out at point 2, now reverse the position to a long position at this point. The trader would choose the latter strategy if confident that this point represents a reversal of the down-trend that previously existed in the market.
1.2 Example 2 – MA Crossover, leading to a long trade
In the chart the two crossover points are noted as 1 and 2 respectively.
Leading up to Point 1, the fast (or short-term MA, say a 10 day MA) is moving up faster than the slow (or long term MA). These two cross over at point 1 above. This represents a point at which the short term momentum or market forces are pushing the market higher. As a consequence the model suggests that future prices will be higher. This provides the trader with a buy signal.
Leading up to Point 2, the fast (or short-term MA, say a 10 day MA) is moving down faster than the slow (or long term MA). These two cross over at point 2 above. This represents a point at which the short term momentum or market forces are pushing the market lower. As a consequence the model suggests that future prices will be lower. This provides the trader with a sell signal. If the trader entered the long position at point 1 earlier this would also represent a take profit level for the trader. Note the trader could, as well as closing out the long position (entered into at point 1) at point 2, could also now reverse the position to a short position at this point. The trader would choose the latter strategy if confident that this point represents a reversal of the up-trend that previously existed in the market.
The two red lines also indicate an upward price channel, the top line is price resistance and the bottom line is price support). Point 3 above also indicates a point at which support for the uptrend (shown by the bottom red line in the above chart) has broken and hence also indicates that the market may move lower. This would provide added support the crossover of the MA at point 2 and the taking and profit and/or moving the market position to a short position.
These red lines indicate the support and resistance for the uptrend.
MA(fast) MA(slow)
1.3 Example 3 – MA Crossover, whipsawing
The main drawback of MA’s is that they are prone to “whipsawing” when a market is not trending, but rather mean reverting. This leads to the antithesis of the golden rule of trading, buying high and selling low. This is shown in the following example.
Long Exit/Short Entry
Long Exit/Short Entry
Long Exit/Short Entry
This is not unfortunately not an uncommon market condition and is characterised by higher levels of volatility and regularly changing market momentum. In these markets the trader is required to be highly flexible and be prepared to move in and out of positions rapidly or alternatively if the market is considered excessively volatile and unpredictable, the prudent trader will reduce positions or even stand back from or exit the market until volatility subsides.
2. Reversals
A reversal in the current trend, can last days or weeks. Traders try to identify reversal patterns because they have predictive value. These patterns represent a development of the theory of market support and resistance. The technical analysis suggests that these points indicate that the market momentum, reflected in a series of trends, is to push higher or lower, and this has been attempted and failed, but the recent patterns suggest that market momentum is now poised to break through these levels.
There are two common types of reversal patterns: 1. Double bottom & top:
The market experiences a new low(high) price in a down(up)trend, before moving back up(down) to form a reaction high(low) level, the market then moves back down(up) on low volume and stops near or right on the previous low(high).
Returning to the previous reaction level on high volume, this forms an inverted “W”. If the market breaks this neckline, it’s a signal to buy (sell) the market. The expected price move is the price range from extreme level to neckline.
2. Head and Shoulders:
These are market price patterns that exhibit the characteristics of a pair of shoulders with a head (larger spike) between them. The left shoulder is the continuation of the existing trend with heavy volume, and a reversion to the reaction level (representing a base of support or resistance) that will form the neckline, (the reaction level) in the market. The head surpasses the previous level, and returns to the reaction level. The right shoulder completes the pattern, and the neckline is now the trigger zone for future expected market movements.
2.1 Example 1 – reversal: double bottom
The following is an example of a double bottom which suggests that market momentum is likely to break above the neckline and the market will move higher.
Take Profit
H = distance
Stop Loss 1⁄2 H
Bottom 1 Bottom 2
The neckline represents the market resistance. Market momentum has tested this resistance on two previous occasions but has been unable to breakthrough, moving back to bottom 1 and bottom 2 in the above diagram. This forms the two bottoms in this pattern. If the market momentum pushes the market back up to the neckline, forming the classic “W” pattern, the model suggests that the market will break through the neckline and move higher. The entry point above therefore represents a point to enter a long position in the market.
The model suggests that the target for the upward move is the same price distance from the neckline to Bottom 2 above the neckline. For example if the price at Bottom 2 is $0.50 below the neckline, the target level is $0.50 above the neckline price. The model would also indicate that a conservative trader should place a stop loss order at half the distance between the Bottom 2 price and the Neckline (in the above example $0.25 below the entry price). This would limit the trader’s loss in the event that market momentum was unable to push the market to new higher levels. If the model is correct, and the market increases above the neckline, the trader should move the stop loss level up. Thus in our example, once the market moves to a price $0.25 above the neckline the stop loss would be at the entry price.
2.2 Example 2 – Reversal: double top
The following is an example of a double bottom which suggests that market momentum is likely to break above the neckline and the market will move higher:
Top 1 Top 2
Stop Loss 1⁄2 H
The neckline represents the market support. Market momentum has tested this support on two previous occasions but has been unable to breakthrough, moving back to top 1 and top 2 in the above diagram. This forms the two tops in this pattern. If the market momentum pushes the market back down to the neckline, forming the classic “M” pattern, the model suggests that the market will break through the neckline and move lower. The entry point above therefore represents a point to enter a short position in the market.
The model suggests that the target for the downward move is the same price distance from the neckline to Top 2 above the neckline. For example if the price at Top 2 is $0.60 above the neckline, the target level is $0.60 below the neckline price. The model would also indicate that a conservative trader should place a stop loss order at half the distance between the Top 2 price and the Neckline (in the above example $0.30 above the entry price). This would limit the trader’s loss in the event that market momentum was unable to push the market to new lower levels. If the model is correct, and the market falls below the neckline, the trader should move the stop loss level down. Thus in our example, once the market moves to a price $0.30 below the neckline the stop loss would be at the entry price.
2.3 Example 3 – Reversal: head and shoulders
A head and shoulders pattern is a variation on the double bottom and double top model.
Stop Loss Level 1⁄2 H
The above head and shoulders pattern reveals that the market has attempted to move higher on three occasions. The second move upwards is higher than the first and third move up and has resulted in the development of a head and shoulders pattern. The neckline represents a price level of support that the market has returned to after momentum has failed to break upwards and hence lacks sufficient momentum to be able to move to a higher equilibrium. The market again returns to the neckline for a fourth time, but the model suggests that this will no longer act as a price support level, and the market is expected to trade through the neckline and move lower. The point that the market meets the neckline is an entry point; in this case the trader will establish a short position. In line with other reversal models the head and shoulders model identifies that the downside target take profit level is equal to the price distance between the neckline and the “head”. The second shoulder represents the appropriate stop loss level for the entry trade.
Target Take Profit
2.4 Example 4 – Reversal: inverse head and shoulders
The inverse head and shoulders pattern is the reverse of the pattern in 2.3 above, and indicates a reversal to the upside.
Take Profit
H = distance between neckline and bottom
The above inverse head and shoulders pattern reveals that the market has attempted to move lower on three occasions. The second move down is larger than the first and third move down and has resulted in the development of an inverted head and shoulders pattern. The neckline represents a price level of resistance that the market has returned to after momentum has failed to break downwards and hence lacks sufficient downward momentum. The market again returns to the neckline for a fourth time, but the model suggests that this will no longer act as a price resistance level, and the market is expected to trade through the neckline and move higher. The point that the market meets the neckline is an entry point; in this case the trader will establish a long position. In line with other reversal models the inverse head and shoulders model identifies that the upside target take profit level is equal to the price distance between the neckline and the “head” (in the above the low point in the price pattern). The second shoulder represents the appropriate stop loss level for the entry trade.
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