Fundamentals of Technical Analysis

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This series of blogs by Best Broker India is dedicated to cover the basics of technical analysis and then progress step by step to the advanced concepts so that, by the end of this series of blogs, we will be able to interpret and trade any kind of chart.

Even those who have prior experience in trading should not skip the following section. It contains a different approach that is not often addressed in conventional technical analysis and it is a prerequisite for successful price analysis.

Line Charts

For most people, line charts usually provide the first impression of the world of financial markets because we frequently see them on the news and on our television/desktop screens.

A line chart can describe the price development of a stock, a currency pair, a cryptocurrency, a commodity and any other financial instrument over time.

The advantage of a line chart is that the information is highly compressed. One glance at a line chart tells you all you want to know for elementary analysis.

If we see a rising line chart, it indicates a rally or a bull market. If the line chart shows a falling price, it indicates a bear market.

We move one unit to the right on the chart. The unit time can vary from 1 second (intrday line chart) to 1 year. Line charts with a unit time of 1 day are also called a daily chart.

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The disadvantage of a line chart is that the price fluctuations within the chosen unit time cannot be recorded since the line chart shows only the closing prices.

However, we all know that there can be strong price fluctuations in the financial markets and neglecting them can be a disadvantage for precise technical analysis.

BPCL Line Chart showing Bearish Trend on a 1-D time frame

Candlestick Charts

Candlestick charts are further developed line charts that serve to compensate for the disadvantage of less information. Candlestick charts have their origin in 17th century Japan.

Today, candlestick charts are preferred tool for analysis for most traders and investors as they provide all the information at a glance.

The Candlestick

As the name suggests, a candlestick chart is made up of so-called candlesticks. These candlesticks are in turn made up of different components to describe price movements of financial instruments.

The below figure shows that a candlestick consists of a solid part, the body and two thinner lines which are called candle wicks or candlestick shadows.

A Bullish Candlestick on the left and a Bearish Candlestick on the right along with explanations of terms used for individual candlestick components

The candlesticks are color-coded to illustrate the direction of the price movements. A green candlestick represents rising prices, whereas a red candlestick represents that the price fell during that period.

The length of the shadows shows how much the price has moved up and down with respect to a candlestick within a specific duration. If we set our charts so that one candlestick corresponds to one day, then we can read the daily price fluctuations in the financial market using the shadows of a candlestick.

The candlestick body describes the difference between the opening and closing prices for the corresponding time period.

The trend of candlesticks from the opening price to the closing price is shown by the candlestick body. The shadows show the entire fluctuation width.

The body of the white, rising candlestick shows that the price opened at Rs. 10 and closed at Rs. 20 in the selected time interval, but has fluctuated between Rs. 5 to Rs. 25 in the meantime, as indicated by the shadows.

If we line up several candlesticks, we can reproduce the progression of line charts by following the candlestick bodies as shown in the below figure.

Reconstruction Line Chart using Candlestick prices

The candle shadows shows the severity of price fluctuations in each case. We thus, get an effective price analysis at a glance.

This is why candlestick charts are used for technical analysis these days.

Basics of Candlesticks

Candlestick can be divided into four elements, where each element reveals a different aspect of current trading behavior and the prevailing market sentiment.

Intro: The strength ratio – bulls vs bears

To understand the price and candlestick analysis, it helps if you imagine the price movements in financial markets as a battle between the buyers and sellers.

Buyers speculate that prices will increase and drive the price up through their trades to show buying interest. Sellers bet on falling prices and push the prices down with their selling interest.

If one side is stronger than the other, the financial markets will see the following trends emerging:

  • If there are more buyers than sellers or more buying interest than selling interest, the buyers do not have anyone they can buy from. The prices will increase until the sellers find it attractive to get involved. At the same time, the price becomes too high for the buyers to keep buying.
  • However, now if there are more sellers than buyers, the prices will fall until a balance is restored and more buyers enter the market.
  • The greater the imbalance between these two market players, the faster the movement of the market in one direction.
  • When the buying and selling interests are in equilibrium, there is no reason for the price to change. Both parties are satisfied with the current price and there is a market balance.

Market participants use candlesticks, volume and open interest tables to understand the strength ratio between the two sides.

Element 1 : Size of the Candlestick body

The size of the candlestick body shows the difference between the opening and closing price and it tells a lot about the strength of buyers and sellers.

Below, the most important characteristics of the analysis of the candlestick body are listed.

  • A long candlestick body, that leads to quickly rising prices, indicates buying interest and a strong price move.
  • If the size of the candlestick bodies increases over a period, then the price trend accelerates, and the trend is intensified.
  • When the size of the bodies shrinks, this means that the prevailing trend has come to an end, owing to an increasing balanced strength ratio between the buyers and sellers.
  • Candlestick bodies that remain constant confirm a stable trend.
  • If the market suddenly shifts from long rising candlesticks to long falling candlesticks, it indicates a sudden change in trend and highlights strong market forces.
Left: Long Candlestick bodies signifying downward and upward trend phases. Right: Rising Candlesticks are stronger in uptrend, at the peak ratio tilts and a sideways phase is characterised by smaller candlesticks

Element 2 : Length of Candlestick shadows

The length of shadows helps in determining the volatility, i.e. the entire range of price fluctuations.

Characteristics of candlestick shadow analysis:

  • Long shadows can be a sign of uncertainty because it means that the buyers and sellers are strongly competing, but neither side has been able to gain the upper hand so far.
  • Short shadows indicate a stable market with little instability.
  • We often see that the length of the candlestick shadow increases after a long duration of a trend. Increasing fluctuation indicates that the battle between buyers and sellers is intensifying and the strength ratio is no longer as one-sided as it was during the trend.
  • Healthy trends that move quickly in one direction, usually show candlestick with small shadows as only one side of the market dominates the proceedings.

Element 3 : Body to shadow ratio

For a better understanding of price movements and market behavior, the first two elements must be correlated into the third element. Some important factors of this context are:

  • During a strong trend, the candlestick bodies are often significantly longer than the shadows. The stronger the trend, the faster the price pushes in the trend direction. During a strong upward trend, the candlesticks usually close near the high of the candlestick body and thus, do not leave a candlestick shadow or have only a small shadow.
  • When the trend slows down, the ratio changes and the shadows become longer in comparison to the candlestick bodies.
  • Sideways phases (no sign of up or down trend) and turning points are usually characterized by candlesticks that have a long shadow and only short bodies. This means that there is a relative balance between the buyers and sellers and there is uncertainty about the direction of the next price movement.
There are almost no shadows in the left rising phase, confirming the strong trend. Suddenly long candlestick shadows are visible in the sideways phase, these indicate uncertainty. When shadow increases, this means the end of a trend.

Element 4 : Position of the body

As far as the position of the candlestick body is concerned, we can distinguish between two scenarios in most cases:

  • If you see only one dominant shadow which sticks out on one side and the candlestick body on the opposite side, then this scenario is referred to as rejection, a hammer or a pinbar.

The shadow indicates that although the price has tried to move in a certain direction, the opposition market players have strongly pushed the price in the other direction. This is an important behavior pattern which we will analyze in later blogs.

  • Another typical scenario shows a candlestick with two equally long shadows on both sides and a relatively small body. The fifth candlestick in the figure above shows such indecision.
From Left to Right: The size of the candlestick body describes the strength of the price movement. The longer the body, the stronger the impulse. If the shadows increases there is a balance between buyers and sellers.

On the other had this pattern can indicate uncertainty, but it can also highlight a balance between the market players.

This was a detailed analysis on how to understand Line and Candlestick charts for those are who fairly new to technical analysis.

Learn more on how to analyse candlestick patterns here.

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