Like most who become interested in the financial markets, fundamentals are usually the first and only port of call in evaluating investment opportunities. That was certainly an approach that I adopted, and still do, when I first became interested in markets in the early 1980's. However, my mind was also open to other forms of analysis that may give me an edge. Technical Analysis or "charting" as some like to call it provided that edge.
Many times the fundamentals will still look good on a stock after the price has been rising for some time and most brokers are bullish, but the chart picture is starting to deteriorate. Technical indicators especially may have been warning of a weakening outlook, such as non-confirmation of a new high for example. Other technical factors such as attainment of previously forecast price targets (based on either point and figure/Fibonacci projections/retracement levels) may also be relevant, together with moving average cross overs/historically overextended extensions beyond moving averages and trend ending characteristics from the price chart itself. Here, warning signs could come from a number of chart patterns, such as rising wedges, head and shoulders, double and triple tops, accelerations, failed breaks and price gaps on the chart. These last three are particularly indicative of human emotions at work, such as crowd behaviour, euphoria, fear and panic.
Elliott Wave is another approach that is adopted by many technicians. This can be very accurate in terms of forecasting the extent that a trend will run for, where you are in the trend and 'safe' places to go long or short. It is based on the observation that market cycles move in waves. Five waves in the upward phase (three impulsive and two corrective) and three waves in the downward phase (two impulsive and one corrective). That of course is an extremely simplistic explanation. Elliott Wave comprises certain rules that have to be applied to confirm where you are in the wave count.
Also, corrective waves take many forms and can at times be difficult for even the most experienced practitioners to accurately predict. In such circumstances alternative wave counts are often highlighted.
Despite such shortcomings, when the wave count is clear then its usefulness as an excellent forecasting tool becomes apparent.
Share prices can seem to move in a random manner for a lot of the time and many investors find this confusing, not to mention costly at times. However, there is a logic to this supposedly erratic fluctuation. Elliott waves are one, and cycles are the other. Below you will find repeating cycles in different stocks and of different cycle lengths. Each stock tends to operate on its own cycle - its own personal DNA if you like. Some stocks have more easily identifiable cycles than others.
Of course there are fundamentals to consider, but some of the time a stock does not move in the way that the fundamentals suggest it should. Cycles are a way of cutting through this confusion and see the advance and decline of underlying market forces that cause prices to fluctuate in the way that they do.
A very clear 55 week cycle in Accsys Technologies, very close to a yearly cycle which is quite common in many stocks.
A longer 30 month cycle in FIH Group which is also very clear but also highlights the different amplitudes or variation in vertical heights of the cyclic price movements.
The following two charts show Sainsbury and Tesco in the food retailing sector. These both operate on a 35 month or near three year cycle. Three year cycles are quite common in the stock market, and it must be said that these two are very clear indeed. Note that in the case of Sainsbury, the news in 2018 of the proposed mega merger with ASDA came not many months after the 35 month cycle had bottomed. While knowing when price sensitive news hits the market is not possible, it is very possible to buy shares in a stock at or near the cycle low and benefit from a rise in the price that follows a ‘fundamental’ event.
Cycles are one way to give you the ‘edge’ in the hunt for profitable trades or investments. Knowing where you are in the cycle can determine whether you should be buying or selling.
Finally, one of the most useful tools in any technician’s toolbox are Japanese candlesticks. Most of the charts we use are drawn in candlestick format. These show the open, high, low and close for a trading session in a unique style which instantly portrays the state of the market. At turning points in the trend, be it just a correction or perhaps something larger, a combination of either one, two or three consecutive sessions candlesticks will form instantly recognizable patterns, which when combined with other technical tools provide very powerful signals and low risk entry and exit set-ups.
Candlestick charts can be based on whatever time frame is appropriate for the trading or investment requirement, going down to as low as hourly or five minute charts. However, the latter tend to be of use in extremely liquid markets such as FX or interest rate futures where trades are held for less than a day. The most commonly used are based on a one day trading session. However, weekly candlesticks are immensely useful and, when combined with technical indicators such as RSI, MACD and stochastics, not to mention chart patterns and Elliott Wave, particularly when the wave pattern is clear, then a very low risk/high reward entry or exit point can be established. These are some of the most useful patterns:
Bullish Candlestick Patterns
The MORNING STAR is a bottom reversal pattern which usually occurs after a noticeable downtrend. The 'star' of the pattern is the small white candlestick which occurs on the 2nd day of the formation and denotes indecision with the open and closing levels much closer together than either the larger black (down day) or large white (up day) candlesticks. At this point the bears have started to lose their grip, and a strong element of reversal potential has developed. A strong rise the next day (white candle) confirms the trend change and the bulls are now in control. The close on this day must be at least halfway up the 'body' of the black candle. A gap (as in this example) is more desirable and gives the pattern a greater chance of success.
The PIERCING LINE is a two day candlestick bottom reversal pattern, which like all bottom reversal patterns will need a significant or noticeable downtrend to 'reverse'. The 2nd day of the formation will see the market open beneath the low of the previous day before reversing to the upside and closing the session beyond the mid-point of the black 'body'. The longer both candles are the more pronounced should be the reversal, while a bigger gap down on the 2nd candle is also desirable. Higher volume than normal over these two days is another bonus.
The BULLISH ENGULFING pattern is also a two day reversal pattern, similar to the piercing line. It develops in the same way by seeing the 2nd candle form by opening beneath the previous session low. However, once it starts to reverse to the upside it goes higher and closes above the open of the 1st (black) candle, completely 'engulfing' it. While it does not have to engulf the top and bottom 'tails' of the black candle it is more forceful if it does. Also, higher volume than normal on the 2nd day will increase the odds of success.
A BULL HAMMER as it is called usually occurs after a lengthy downtrend, which is what we want to see for its bullish implications to be fulfilled. It doesn't necessarily have to show a white 'body' though it is slightly better if it does, but the body does need to be small in relation to the 'tail'. Certainly, the tail (which should be on the downside and hardly any, if at all, on the top) should be at least as twice as long as the body for a higher potential of a reversal. The longer the tail the greater chance of a reversal. Sometimes, several bull hammers will appear on consecutive days and if so, the chances of a meaningful recovery can be enhanced.
The BULLISH HARAMI pattern is made up from two candlesticks, the first a long black candle, further extending a downward trend. The second, a white candle, opens within the lower bounds of the black candle and reverses to the upside but closes within the black candle, and is sometimes referred to as an 'Inside day'. With the Harami though, the entire range of the 2nd day need not be contained within the body of the black candle, unlike the Western or bar chart style of 'Inside day'. The Japanese definition for Harami is a pregnant woman, or 'body within'. Confirmation is though required the next day with a strong upmove, ideally closing over the opening or high of the black candle. Also, the higher the white candle closes up on the black candle, the more convincing the reversal will be.
An INVERTED HAMMER follows a long black candle, ideally gapping down, though not always, and does not necessarily need to be a white candle, though preferred, but should have a small (smaller the better) 'body'. The tail needs to be at least twice the height of the body, the longer the better, and ideally no tail on the bottom at all. Large volume on the day of the inverted hammer increases the chance that a selling climax has occurred. A positive next day is required to confirm the reversal.
The DOJI is a single candle and implies indecision. The market opens and closes at the same level despite swinging around during the session. If a Doji appears after a long downtrend, or uptrend, particularly if the market is overbought or oversold, then there is a good chance of a reversal. In an uptrend if this overbought condition exists then it could warrant at least taking profits. In an oversold downtrend situation, the Doji really needs to be followed by a positive session to confirm the reversal otherwise the weight of the market may take the price lower. Higher than usual volume on the day of the Doji would be advantageous as would a gap away from the previous session close. The length of the upper and lower tails should not be too long.
The KICKER SIGNAL, in this case the bullish version, is a very strong indication that the trend has reversed. In fact a severe change in investor sentiment has occurred and should be acted upon immediately. Either going long if the last candle is white (as here) or doing the opposite if a white candle is followed by a black candle. If it does not follow through in the next session then get out of the position immediately. Its significance is magnified when it occurs in overbought or oversold areas. In an uptrend, the 2nd candle is black and opens at the same or lower level than the preceding session white candle opening level. Conversely in a downtrend, the 2nd candle is white and opens at or above the prior sessions opening black candle. Surprise news is usually the cause of such a pattern.
Bearish Candlestick Patterns
The EVENING STAR is a top reversal signal. This is the exact opposite of the morning star signal. The pattern usually occurs after a noticeable uptrend and everyone, supposedly, is bullish. However on the 2nd day indecision creeps in and this leads to a smaller range, a 'star', with the open and closing levels much closer together than either the larger white (up day) or large black (down day) candlesticks. At this point the bulls have started to lose their grip, and a strong element of reversal potential has developed. A sell-off the next day (black candle) confirms the trend change and the bears are now in control. The close on this day must be at least halfway down the 'body' of the white candle. Gaps (as in this example) are more desirable and gives the pattern a greater chance of success.
DARK CLOUD COVER is the opposite to the piercing line and is a two day candlestick top reversal pattern, which needs a significant or noticeable uptrend to 'reverse'. The 2nd day of the formation will see the market open above the high of the previous day before reversing to the downside and closing the session beyond the mid-point of the preceding white 'body'. The longer both candles are the more pronounced should be the reversal, while a bigger opening gap up on the 2nd day is also desirable. Higher volume over these two days than is normally seen will be another bonus and add to the potential for a reversal.
The BEARISH ENGULFING pattern is also a two day reversal signal, similar to the dark cloud cover pattern. It develops in the same way by seeing the 2nd candle form by gapping above the previous session high. However, once it starts to reverse to the downside it continues lower and closes beneath the open of the 1st (white) candle, completely 'engulfing' it. While it does not have to engulf the top and bottom 'tails' of the white candle it is much better if it does. Also, higher volume than normal on the 2nd day will increase the chances that the bearish implications are fulfilled.
A HANGING MAN candlestick is essentially a single candle (though two appear here) which is found at the top of an uptrend. The colour of the body is not important, though black will have slightly more bearish implications, but the body must be small in relation to the length of tail, no more than a third of the tail - ideally less, or wick as it is sometimes called. Also, the body is very small relative to the size of the white bullish candles that preceded it. The Japanese named this candlestick so, as it looks like a head with the legs dangling down. There should be no upper tail or wick, or very little. While this pattern is a bearish warning it needs confirmation before you should act. A black candle in the next session would do this, ideally with an opening gap down.
The BEARISH HARAMI is a two day pattern and is the mirror image of the bullish harami. The first of the two candles is a bullish white, extending an uptrend. However, on the next day sellers appear, with the market opening lower, the fall extending, but the lower close is still within the boundary of the preceding days' white candle. However, a change in sentiment has now occurred. Confirmation that this triggers a reversal of the uptrend is still needed by weakness in the next session, ideally beneath the low of the first candle. The Longer the white and black candles the more significant should be the reversal. The black candle should though be 'within' the white candle. Higher than usual volume on these days also adds to the force of the ensuing down move.
The SHOOTING STAR is seen at the end of an uptrend and is aptly named as it looks like a shooting star dropping from the sky with its tail trailing behind it. The body should be small and the tail should be at least twice as long, the longer the better as this will add to scope for a significant down move. There should be no or very little lower tail. The colour is not important, though a black body will have a slightly more bearish implication. The next day needs to confirm with a black candle and ideally a gap down at the open with a lower close. Higher than normal volume on this day increases the chance that this was a buying climax and with it scope for a substantial sell-off.