Technical Analysis, Reversal Chart Patterns

Double Top

The double top is made up by two extreme peaks like the illustration below:

[Image 3]

After the first peak, there must be a decline of no more than 25% of the uptrend. (This decline makes up a support that must be broken for the pattern to be complete). Then the price rallies again to the resistance made by the first peak. Highs should be roughly equal. Then the price falls back down from resistance to support, and finally breaks the support (yellow box).

This type of patterns can be used during trending markets signaling a possible reversal or during trendless markets, to signal a possible change in the direction of the market.

Double Top in Action

[Chart 1]

See top #1 and top #2 have similar highs. The pattern is not valid until the market breaks the main support which happens in the yellow box. Notice also how the support zone becomes a resistance and stopped the market from reaching higher levels.

Double top commonly used target

Measure the amount of pips from the first peak to the support line (where it bounced back up to the second peak). Subtract the same amount of pips from the support line. This last quote will give us the target price.

Double Bottom

The double bottom pattern is made up by two extreme lows like the illustration below:

[Image 3]

After the first low, there must be a rally of no more than 25% of the downtrend. (This rally makes up the main resistance that must be broken for the pattern to be complete). Then the price drops again to the resistance made by the first low. Lows should be roughly equal. Then the price rallies again from the second low to the main resistance, and finally breaks the main resistance zone (yellow box).

This type of pattern can be used during trending markets signaling a possible reversal or during trendless markets, to signal a possible change in the direction of the market.

Double Bottom in Action

[Chart 2]

Lows #1 and #2 have similar levels. The pattern not considered valid until the market breaks the main resistance zone. Notice how the resistance zone becomes a support zone preventing prices from falling below those levels.

Double bottom commonly used target

Measure the amount of pips from the first low to the resistance line. Add the same amount to the resistance line; this last quote will give us the target price.

Both patterns reflect changes in supply and demand. In a double top, it reflects the inability of buyers to take the prices to new highs and trade above them. In a double bottom, the inability of sellers to break the lows and pull the prices further down.

Remember: The resistance/support made after the first peak/sell off could act as a support/resistance after the price breaks the zone.

Triple Top

The triple top is similar to double tops, but has three peaks (instead of two):

Triple Top

[Image 6]

Same mechanics are followed here. A prior trend has to be reversed, three peaks reasonably equivalent to each other, and an important support to be broken in order to complete the pattern. In this pattern the changes in supply and demand take a little longer to change the perspective of traders about the markets.

Triple top in Action

[Chart 3]

Three peaks form the triple top, the pattern becomes valid when the market breaks the main support area. Notice how the market retraces back to the resistance zone (previously a support zone) to test it.

The mechanics to get the target price for these patterns are the same as the double top and bottom.

Triple Bottom

The triple bottom is similar to double bottoms, but has three troughs (instead of two):

Triple Bottom

[Image 8]

Same mechanics are followed here, a prior trend has to be reversed, three troughs reasonably equivalent to each other, and an important resistance to be broken in order for the pattern to be complete. In this pattern the balance in supply and demand take a little longer to change the perspective of traders and investors about the markets.

Triple Bottom in Action

[Chart 4]

This triple bottom becomes valid when the market breaks through the main resistance area (yellow box).

The mechanics to get the target price for these patterns are the same as the double top and bottoms.

Head & Shoulders Top

The pattern is formed by three successive peaks:

[Image 4]

The second peak or the “head” must be the highest peak. The two other peaks or “shoulders” should be roughly equal. A support is made by the first and second bounces from the first and second peaks; this is commonly named as a neckline. The pattern is completed after the neckline is broken through and the price trades below it. The neckline becomes an important resistance once it has been broken.

Head and Shoulders in Action

[Chart 5]

This is a head & shoulders pattern under development, the market has not been able to break the neckline, thus it isn’t a valid head and shoulders pattern yet. Why did we use this one? Because it is important to track them when they are forming (not after the fact, when we know what happened) and see how they look like. This is the GBPJPY weekly chart, so if this pattern proves to be valid, it has a potential of more than 2,000 pips.

Head and shoulders top commonly used target

Measure the amount of pips from the highest peak (head) to the neckline. Subtract the same amount from the neckline; this final price will give you the target price.

Head & Shoulders Bottom

This pattern is made off three consecutive lows.

The second low is the deepest low (head), while the other two lows are roughly equal (shoulders). The pattern is considered complete when the neckline is broken.

Head and Shoulders in Action

Notice here the neckline is similar to a trendline (instead of a resistance).

Head and shoulders bottom commonly used target

Measure the amount of pips from the lowest low reached (head) to the neckline, and add this amount to the neckline to get the target price.

Forex Trading, Technical Analysis - Support and Resistance

Establishing well-defined support and resistance zones is a key element that will help us have better trading results. Here are a few questions and answers that will help you gain a better understanding of the use of support and resistance zones.

Is there an exact level where support and resistance levels should be placed? 

No, as we have already seen, support and resistance are more like “zones” rather than “levels”. It is common however to place resistance zones just above price action and support zones just below price action, but some traders put them at or near price action. At times, it is difficult to find the exact level of support or resistance; in these cases it is valid to place support and resistance zones near price action (like we did in charts 1 and 2). 

What different methods exist to define support and resistance zones?

Based on Previous highs or lows –

                                                  When ever the market approaches to previous highs or lows it has the potential to act as a resistance or support (you will see this in the next lesson on chart patterns). 

Round Numbers –

                                    Many experts and bank traders put their orders at round numbers (entry orders or take profit orders) because there are so many orders around these levels that the market sometimes has some trouble getting through them. These levels tend to have a psychological support and resistance zones. Round numbers are 1.4500 or 1.0000, etc. 

Based on Moving Averages –

                                                A moving average is a technical indicator that could be useful to determine support and resistance areas (we will see MA in more detail in the following lessons). 

Based on other technical indicators –

                                               Other technical indicators can also be used to determine possible support or resistance areas, en example would be Fibonacci Retracements.

From the methods above, which one is more effective?

There is no correct answer for that question. Sometimes one methodology forecast support and resistance levels better than the other ones. What I recommend you is to see what is the market’s feel each day of trading, and see what is working for that particular day (i.e. there is no case to use round numbers as support or resistance if the market is not taking them in consideration).

What are false breaks?

Take a look at the chart below:

This chart is the same one as Chart 2, take a close look at what happen in the red oval, the market actually traded above the support zone but it bounced back. This is what we call a false break: the market fails to trade consistently above/below a resistance or support zone.

Whenever the market approaches to a support or resistance zone, what should I do?

That depends in your situation. Here are a few scenarios:

- If you have no open positions and intend to go long, if the market approaches to a support zone, try to find a long signal.

- If you have no open positions and intend to go short, if the market approaches to a resistance zone, try to find a short signal.

- If you have a long position and the market approaches a resistance level, try to find an exit signal.

- If you have a short position and the market approaches to a support level, try to find an exit signal.

Technical Analysis - Support and Resistance

These two are probably the most important concepts in technical analysis. Basically, support and resistance are points or levels where forces of supply and demand meet.

As the prices go down, the demand for one given instrument tends to increase, because it attracts buyers interested in cheaper prices. At some point, the demand for the given instrument will outperform the supply for it, making the price bounce back up from certain zone (support). This makes the price go up again, but there is again a certain zone in which the price is so high that it attracts more sellers interested in selling high. At this point, the supply for that instrument will outperform the demand for it, making prices to bounce back down again (resistance).

Every one of us (at least must of us) have seen a demand curve back in our school and college days, so it will probably be a good idea to illustrate these two concepts with the famous curve.

Take a look at the following image.

Imagine that curve is the demand for EURUSD, as the price goes down it will attract:

- Buyers interested in low prices (buying low to sell high), and

- Traders already short looking to take profits on their short positions.

Those two forces will make the market to go back up again because the demand for it will increase, that zone is what we call “support”.

As the prices go up again, it will attract:

- More sellers interested in high prices (to sell high and buy back at low prices), and

- Traders already long looking to take profits on their long positions.

Those two forces will make the price go down again, that zone is what we call “resistance”.

And what happens when the market breaks one support or resistance? Ahh Sharp eye... we will get to that. But for now, here is a brain feeder for you.

How do you think the market behaves when the supply for one currency meets the demand for it over a considerable period of time?

Remember, support and resistance are more like “zones” rather than “levels”. So even if we refer to “support and resistance levels”, from now on they are really zones.

Now let’s get to some real life examples.

Support Zone

A support is a price level or zone in which the demand for one given instrument outperforms its supply, preventing prices from falling below this zone. It “supports” the price from falling below it. 

In this chart, the support zone is marked by the black line. There were several points where the market was stopped from falling below. At this level, the buyers (bulls) outperformed the sellers (bears) and the buying becomes so strong that it prevents the price from falling further.

Resistance Zone

A resistance is a price zone in which the supply for a given instrument is greater than the demand for it. This prevents prices from going above this level. The price “resists” going higher. 

In the chart above, the level at which the bears outperformed the bulls is clearly seen and it’s market with a black line. At this level, the selling (product of traders attracted by the high prices and traders closing long positions thus selling back their trade) is so strong that it prevents the price from reaching higher levels. At this zone bears outperform bulls.

NOTE: Support and resistance levels are only considered to be broken when there is a sustained break, otherwise the level is considered intact, so when prices break through any important level and bounces back quickly (like the third peak on chart 2), the important level is still considered valid.

This takes us to our next concept...

Sustained Breaks

A sustained break happens when the prices are traded above the resistance or below the support zone for several periods. Should this happen, the old resistance now becomes an important support (in the case of a break “up”) or the old support becomes an important resistance (in a break “down”).

Below are two examples that picture these scenarios

Support zone becomes a resistance.

The support zone is clearly seen at the left hand side of the chart, the price is rejected from that zone at least two times. Once the market breaks the support zone and continues to trade below the support zone it is considered a sustained break. The market goes down and retraces again to the support zone which is now a resistance zone. The price action gets rejected once, and on the last part of the chart, the market approached again to the resistance zone and it should be rejected again as it is now a resistance zone.

In the next chart, a resistance zone becomes a support.

 

Here the sustained break happened when the market traded continuously above the resistance zone, as we can see the resistance zone became a support zone preventing the market from falling below it. This creates a possible buying opportunity.

When the price of a certain market breaks the support or resistance level, the balance between supply and demand has changed. When the price breaks an important support level, what investors thought to be a low price, now becomes a high price. When the price breaks an important resistance level, what was thought to be a high price, becomes a low price.

In terms of the demand curve this is what happens when there is a break of a resistance zone:

There is a shift to the right in the demand curve when there is a break of an important level. “The balance between demand and supply changes”, what was once considered “high”, is now considered “low”.

We just saw what would happen to the demand curve once the market breaks a resistance zone, but what would happen if the market breaks a support zone?

Technical Analysis

As we have already stated in the previous lesson, technical analysis tries to determine the future performance of any financial instrument based in the study of historic prices (price behavior).

By studying the price behavior and technical analysis we are actually analyzing the behavior of all traders involved in a certain market. Traders and investors are behind every price movement; after all, they all drove the price to a certain level. The price moves based on traders’ expectations; on what they think the future price of any given instrument should be.

Most of the time traders are driven by their emotions (fear, greed, hope, etc.) and these emotions are visible on the charts as repetitive price patterns. The outcome of these specific patterns is what technical analysis tries to forecast.

Technical analysis is based on the Dow Theory which has three main principles:

Price Discounts Everything - All information available is already reflected in price, it reflects the knowledge of everyone involved, including fundamentalists.

Price Behavior is not Random - Although there are periods of trendless or random behavior, the price tends to trend. Our job as technicians is to identify those periods where the price is trending and profit from them.

The “What” (or “Where”) Question is more Important than “Why” - The “What question” refers to where is price and what is its historical behavior. Those questions are to be answered by technical analysts. Why is price at certain level? This one is of concern of fundamental analysts; they look for reasons behind certain price movements.

And here we go with Technical Analysis...

This will be  in the following way:

   

1-Types of Charts - We will review the most common types of charts used by technical analysts.

2-Support and Resistance - We will review one of the most important concepts of trading; we will see what makes support and resistance and how to identify them.

3-Support and Resistance FAQ’s – Here you will find common questions about support and resistance zones. 

4-Trends and Range Bound Conditions - How to identify a trend and a range market. We will also see how to measure its intensity through trendlines.

5-Candlesticks Intro - We will review the most popular type of charting used by technical analysts.

Forex Trading Strategy

There are many different Forex trading strategies. However, there are some basics of reading a price chart that you need to know before you can move on to learning any one strategy in-depth. Let’s cover the basic building blocks of trading the Forex market from a technical analysis approach:
• Support and Resistance levels – How to identify and plot them
Support levels are created as a market turns higher. So, if a market is moving lower for example and it then changes direction and begins moving higher, it either has created a level of support or bounced off a previously existing level of support.
Resistance levels are created as a market turns lower. So, if a market is moving higher for example, and it then changed direction and beings moving lower, it either has created a level of resistance or bounced off a previously existing level of resistance:
Identifying and plotting support and resistance levels is by no means an exact science. Instead, it requires the use of the discerning human eye and a little bit of brain power…don’t be worried though, it’s really not that difficult to become proficient and confident in drawing support and resistance levels on your charts.
In the chart below, we can see the daily GBPUSD chart, with all the relevant support and resistance levels drawn in:
Now, one important point that I want you to know about support and resistance levels is that they are not concrete. Many traders seem to think support and resistance levels are concrete and that they should never trade a setup if there is a support or resistance level close by, this can result in them getting analysis paralysis and never entering a trade. While it is true that you need to take into consideration the key support and resistance levels in the market, you also need to look at the overall market condition. You see, in trending markets, support and resistance levels will often be broken by the trend momentum; so don’t be afraid of support and resistance levels, as they will often break. Instead, watch these levels for trading signals. You see, when a Forex trading signal like a price action setup forms at a key support or resistance level, it is a very high-probability even to take notice of.