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Chart technique for beginners: The most important chart patterns

"I can calculate the movement of stars, but not the madness of men." He could calculate the movement of the stars, but not the madness of people. This is what Isaac Newton is supposed to have said when the South Seas bubble burst in 1720 and he lost a considerable fortune speculating on this hoax.

Roughly speaking, the technical analysis of stock market prices is about precisely this question: What use are the sober calculations of charts: of trends, resistance and formations when it comes to human actions?

What does chart technology do? Why is it omnipresent and determine the actions of so many practitioners in the stock market? And why does it meet with such violent rejection from its opponents?

Technical analysis is controversial

And there are quite a few such opponents. There are a number of amusing bonmots around technical analysis. The most successful investor of all time, Warren Buffett, said in 2005, "When I flipped the chart and got the same result, I realized that technical analysis wasn't working."

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Exceptional fund manager Peter Lynch says, "Charts are great for predicting the past." From stock exchange legend André Kostolany comes the sentence: "Chart reading is a science that searches in vain for what creates knowledge." It's easy to make fun of chart analysis, as you can see. But does that do justice to it?

Example of a candlestick chart for the leading German index Dax. Source: Stuttgart Stock Exchange.

Originally, the chart technique was not intended to be a scientific theory for predicting the future prices of stocks. Charles Dow, the developer of the Dow Jones Index, published a series of articles in the Wall Street Journal on his "Dow Theory" from 1884 and has since been considered the founder of technical analysis. Charles Dow viewed his findings as a tool for analysts to better define general market trends. He assumed that financial markets behave cyclically and that prices run in short, medium and long-term waves.

As early as the 18th century Japan, the "god of the markets", Munehisa Homma, had forecast the prices on the rice exchange by recording the development over many years and using candlestick charts for analysis, as they are in principle still today are common.

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Do I analyze technically or fundamentally?

Technical analysis therefore approaches its considerations very differently than fundamental analysis. The "technicians" only take into account the price history and possibly also the trading volume. Unlike the value investors, they ignore the fundamental factors: business data of a company or the economic environment play no role. This also explains the point of view of Warren Buffett, a staunch value investor who starts out from fundamental analysis. Other critics also come from this fundamental school.

The starting point of the technical analysis is that all decision-relevant information about the past and future is already included in the course of the course. In this way, they should enable forecasts of the likely price developments. So one assumes that one can predict the course on one's own.

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Technical analysis assumes that recurring events can be observed in graphics that have similar probable future courses. Geometric patterns in graphics can then be used as direction indicators, as can purely statistical, quantitative indicators. These are, for example, time series on production and incoming orders.

"The trend is your friend"

Upward trend reversal.

A basic rule is: "The trend is your friend." The sentence is shortened in an American-style way. In a little more detail, it reads: A direction remains in place until a significant movement in the course of the course signals a turning point. Trends can be up, sideways or down.

Chart technicians connect the highs and lows of the price development with each other and thus determine a trend line. If the price chart breaks this line - up or down - it may indicate an end to the trend. However, this requires a sustained outbreak. A short outlier is not enough.

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Trend reversal downwards.

If you determine the average of the closing prices of X past days every day, you get the moving average: If you combine the arithmetic mean of approximately the last 200 trading days, you see "curved trend lines". They have a similar function to the trend lines just mentioned.

However, they are not used for forecasting, but rather they indicate a trend that has started. If a price is above the average line, then there is an upward trend and therefore a buy signal. Conversely, there is a downtrend and thus a sell signal when the price falls below the moving average.

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Example of a 200-day line from the leading German index Dax. Source: Stuttgart Stock Exchange.

Rising 200-day lines signal a bull market, falling 200-day lines indicate a bear market. If the price is far from the average, there are signs of a trend reversal. The time periods can be freely selected. 90 and 38 days are also used for the average. Shorter periods of time indicate trend changes more quickly, but deliver false signals more frequently.

Chart technicians look for patterns

Example trend reversal in a V formation.

In the course of a price, distinctive points often appear, which are called resistance upwards and support downwards. These highs and lows in the chart are at the same level and can be connected. This line can be interpreted as a limit that a course can only break through with difficulty. The more such high or low points are at the same level, the stronger the support or resistance. The technical analysis assumes that price developments will repeat themselves.

If, on the other hand, a price breaks such a limit, then that is a strong signal that such a break will continue in the same direction as if a dam break. If a downward support is broken, it mutates into an upward resistance and vice versa. Resistance and support can also be described as a "course goal".

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Technical analysts always want to know when a trend will end. To do this, they look for patterns in the graphic. Such reversal formations are triangles with acute angles upwards or downwards. However, there are no reliable indications in advance for a trend change, for example in the case of a V-formation (steeply down and straight up again). The reversal also happens very quickly, and when one has recognized the acute angle with the reversal, it is already too late to act.

Example of an M formation.

Example of a W formation.

When do trends reverse?

Therefore, in practice, double formations are used. The solitary acute angles are also rarely found. Double tops or double bottoms are more common. With their two acute angles they resemble an M (upwards) or a W (downwards). Aside from the fact that such patterns are more common than simple triangles, fortunately they are also more reliable as an indication of a trend reversal. An M signals the end of an upward trend, a W, conversely, the end of a downward trend.

It is crucial that with a double top or bottom, the price peaks are at the same level. The formation becomes complete when a course after the second top or bottom crosses the intermediate tip of the M or W. (There are also triple tops or bottoms.) This means for technical analysts: The trend has reversed.

The classic shoulder-head-shoulder formation (SKS).

And when do trends continue?

The focal point remains the question of the trend. Unlike the last chart patterns, the next ones are about the continuation of a trend, not its end. Such continuation formations include triangles; they arise when a course of the price gradually deflects less and less up and down until it comes to a peak on the right edge. The basic direction of the trend remains in the triangle, even if the oscillating course cannot seem to decide. (In the case of the symmetrical triangle - the lower side rises, the upper side falls.)

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A shoulder-head-shoulder formation has three points. One ascribes enormous expressiveness to it. In an upward trend, the price development reaches a first high point (the first shoulder). This is followed by a short setback (towards the neck) and then an even higher top (the head). This is followed by a reset to the level of the first one. It goes up again to the level of the first climax (second shoulder). Here the trend now finally turns and breaks the neckline (the level of the two lows) down. In this formation, trading volumes typically decline continuously.

Descending triangle.

Ascending triangle.

Triangles can also have their own directions if the upper side is horizontal and the lower side rises (ascending triangle) or, conversely, the lower side is horizontal and the upper side falls (descending triangle). Ascending and descending triangles tend to indicate a bull or bear market. A triangle is closed when the courses clearly leave the triangle. Such an outbreak is often accompanied by higher sales.

Example chart of a bullish flag.

Flags also indicate the continuation of a trend. They are similar to the triangles shown above, but their upward and downward price excursions remain the same. So these formations form rectangles. Flags are short breaks in an overarching trend. A mast has formed in front of a flag, a sharp upward or downward trend. The flag cloth itself runs counter to the big trend for a short time. So on an uptrend, it points down and on a downtrend, it points up. If the price breaks the flag, the overall trend will continue. As a rule, this happens when trading volumes increase.

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