The Key to Unlocking the Power of Technical Analysis

02/18/2016 6:00 am EST

Focus: FUTURES

A market technician needs to be able to recognize chart patterns and implement a trading strategy based on what he believes the charts are telling him is going to happen next, so Phillip Streible of RJO Futures highlights three important indicators and cites a chart of the crude oil futures contract for support.

There are many different types of fundamental and technical chart patterns market technicians focus on when making trading decisions and multiple ways to interpret them. This is why technical analysis is an art form. The key is to be able to recognize these patterns and implement a trading strategy based on what you believe the charts are telling you is going to happen next. As a trader, it is important to have a good understanding of the basic patterns before you can develop a strategy to give you a potential edge. When you combine a couple of these different methods, you really unlock the power of technical analysis.

The Trend Line

You probably know the classic adage: the trend is your friend. There are dangers to fighting the trend; it leaves you with headaches and sleepless nights, wondering why you went against it. Sometimes the trend isn’t all that easy to identify, but it can help to look at charts over several time frames.

The trend line is one of the most basic charting tools. These are lines drawn across successively higher bottoms in bullish markets (moving up from lower left to top right) or successively lower tops in bearish markets (moving down from upper left to bottom right). A bullish trend is indicated by a series of higher highs and higher lows, and a bearish trend, by lower highs and lower lows. Look for three good tests of support or resistance. Breaking through a trend line is an important signal a trend is coming to an end.

You can see the trend in a very basic chart of the crude oil futures contract. In this case, I am looking at a daily continuation chart. The key to determine whether this is, in fact, a solid bearish trend is to look for three tests of resistance. To the far right of the chart, we see a possible shift in the long-term trend. The market bounces to a key resistance point, then bounces without much follow through, trading in an up down, up down pattern. To signal a shift in trend, you want to look for two days of higher closes, with the second high above the previous day’s high. We can see in this crude oil chart below how the market has stayed below the trend line from November until the time this article was published.

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Retracements

A retracement is a significant price adjustment of an existing trend. Traders commonly focus on Fibonacci retracements and the three main levels are 38%, 50%, and 62% of a prior move. I’m not going to get into all the complexities of Fibonacci analysis; just know what these levels are and what price points coincide with them in the market you are trading. They are key levels that act as a gravitational pull.

A two-day close through one retracement level can signal the market’s next move could likely be to the next retracement level. When a market closes below the 38% retracement for two days, we’ll often see a quick move down to the 50% level, because so many professional traders are watching and trading based on these levels. Participants may also try to defend these levels for as long as possible to minimize their losses on positions.

Looking at the crude oil chart again, I will add the Fibonacci retracements to it. You can see the move up from low at about 26.13 on January 20 to the high at about 34.82 on January 28 pushing up to the 38% retracement. As a trader, you would want to watch for a two-day close above the 38% retracement level (which comes in around 35.00). If this occurs, the market is likely to head higher and could push up to 50% retracement near 38.53.

chart
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Double Top and Double Bottom

A double top resembles the letter “M” and is marked by a resistance point that the market hits and then falls, rises back to the same resistance point—or close to it—and falls again. A double bottom is the opposite of the pattern, resembling the letter “W.” Often, double tops and double bottoms lead to head-and-shoulders patterns. The head and shoulders top is represented by three prominent peaks, while the bottom, three prominent lows.

The head-and-shoulders pattern is rarely in perfect symmetry. The first time the market makes the move, it retraces back, and the second time it tries to retest it, it’s typically not as high or low as the first peak or bottom. What tends to occur is that market participants will pile in the market on the first move. When the market reverses, half of the people take positions off and tend not to pile back in when the market reverses again. To see the last chart and read the entire article, click here…

By Phillip Streible, Senior Market Strategist, RJO Futures

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