Technical analysis

The concept of a trend

One of the clearest definitions of trend comes from Dow Jones Industrial Average founder Charles Dow.

In his Dow theory, he described how prices did not rise or fall in a straight line, but rather moved in a series of zigzags. He pointed out that it was the relative positioning of the peaks and troughs that defined the trend.

For a stock to be in an uptrend, Dow reasoned, it must make successively higher peaks (highs) and higher troughs (lows). Similarly, for a stock to be in a downtrend (see graph on right), it must make successively lower peaks and lower troughs.

Price patterns

Trends are fairly easy to identify, but it’s not so obvious how long a trend will continue before going into reverse.

However, by looking for certain chart patterns, you can often get a good indication of the likely future movements of the market.

Double tops and bottoms

Double tops or double bottoms form after a sustained trend, signalling to chartists that the trend may be about to reverse.

These patterns are created when a price movement nudges support or resistance levels twice and fails to break through them. This behaviour is often a signal of an intermediate or long-term trend reversal.

The graph on the right depicts a double top formation.

Triple tops

The triple top is a bearish reversal pattern, as the price eventually takes a turn downwards.

These patterns form when a security tries and fails to pass a key level of resistance three times. After the three failed attempts, it falls through the support level and is then expected to move in a downward trend.

This pattern can be difficult to spot in the early stages, as it will initially look like a double-top or double-bottom pattern. The key is to wait for the price to move past the level of support or resistance before entering the market, otherwise it could trade sideways within the same range for some time.

Triple bottoms

The triple bottom is a bullish reversal pattern, as the price eventually takes a turn upwards. It is effectively the opposite of a triple top, as it involves a market trying to drop below a support level three times before giving up and moving above the resistance level.

Head and shoulders

This is another trend reversal pattern that’s popular with traders, again based on three chart features. It focuses more on volumes than the other triple patterns we’ve looked at. This pattern signals a likely downward move.

Here’s how it works – check the chart to see these points in action:

  1. Sellers come in at the highs of the left ‘shoulder’
  2. These sellers force prices back to the support level of the base ‘neckline’
  3. Buyers soon return to the market and push through to the new highs of the ‘head’
  4. However, the sellers turn these new highs back again, testing the support once more
  5. Buyers tentatively re-enter and the market rallies once more, but with less strength this time, and they fail to take out the previous high of the ‘right shoulder’
  6. The buyers give up, which dries up demand, and the market tests the support yet again, perhaps even breaking through it

Trading with charts

Chart analysis is an exciting area to explore, and there are many other patterns which have been identified as potential trading signals.

People have been using chart pattern recognition theory to discover oversold or overbought securities since the 1930s, and many regard it as the benchmark way to gauge market psychology. It’s also appealing because it enables you to apply a scientific approach to your trading, basing your decisions on a solid framework which others have used successfully.

Nowadays you can even use software to alert you when patterns are indicating possible trading opportunities in your favoured markets. This means that technical analysis, which was once seen as an advanced trading technique requiring substantial time and commitment, is now accessible to every trader.