Technical analysis is an excellent way for options traders to increase their chances of success. Technical analysis involves the study of historical price data, which you can use to predict the future direction of share prices. Following the techniques derived from technical analysis makes it possible to accurately identify market trends and take advantage of them with suitable options trading strategies.
A primary goal of technical analysis is to identify favourable trading opportunities based on chart patterns. A look at many charts reveals recurring price patterns identified by different names such as head and shoulders, double top/bottom, triangle etc. These are called ‘chart patterns’. Recognizing these patterns gives an idea about the impending direction of prices.
Learn to read a five-minute chart
Learn to identify the different types of price movement on a chart. There are mainly four types:
- Increase at a constant rate for an extended time – Ascending channel.
- Decrease at a constant rate for an extended time – Descending channel.
- Increase and then decrease within a set range – Horizontal channel / sideways market.
- Decrease and then increase within a set range backwards with horizontal channels/ Sideways market.
When you master this step, you should easily recognize these four patterns. It will help improve your trading decisions as well as timing. Soon, you will be able to use the information provided by the patterns and identify significant changes in trends.
Differentiate between continuation and reversal patterns
Once you get an idea about the different types of price movements, new traders need to understand that not all of them lead to a reversal or trend change. For example, if there is a series of higher highs and higher lows on a chart, prices rise. However, even after several such price increases, if they start falling steadily till another ascending channel forms, we can conclude that we have reached the top of the ongoing rise and might see prices fall soon. This pattern – formed on charts due to ongoing rise with intermittent falls would be called a continuation pattern. On the other hand, prices are falling with intermittent rises regularly to form a series of lower highs and lows regularly; this would be called a reversal pattern. It is because it has formed after prices have been falling regularly due to the price rise regularly falling before reversing course.
The basics of chart analysis
You need to understand that specific rules are associated with trendlines that you will need to apply while drawing them across charts. If you didn’t start at an extreme point (high or low), your line can never cross another one, meaning if the current price reverses away from your trendline, don’t try drawing another one against the new direction of price movement. You should only draw one trendline against the direction of the trend. Make your top trendline touch or break previous highs for an ascending channel, while the bottom trendline should not cross any low points below it.
Identifying Patterns on Charts
Now that you are aware of different price patterns, you can apply them to charts to derive useful information about future prices. The simplest type of pattern is a Double Top/Bottom, which occurs when there are two consecutive peaks at nearly the same levels followed by price fall. It could be because prevailing bullish sentiment has reached its peak and bearish sentiment takes over, leading to falls in share prices. Whatever be the reason, if this pattern repeatedly forms on your chart, it usually reverses existing trends that have run for a long time.
On the other hand, a Double bottom forms after a significant fall in prices that take it to low levels and then prices rise again and touch or break previous highs before falling to around the same lows as before. A reversal of trends also follows this.
Triangle patterns
Triangle patterns form when there are three consecutive price movements towards the upper or lower end of the range, with each rally or decline touching or coming close to the one before it. It implies that buyers (in case of an uptrend) can’t push prices beyond a certain level while sellers (for downtrend) fail to drive prices below a particular level even though many tries are made regularly. It breaks out either at the top or the bottom based on which side was tested previously.
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