by Phelim Keogan
There are many different ways to analyze the relative merits of currencies. No professional treasurer or investor should attempt to manage a foreign exchange exposure without a clear understanding of the main determinants of a currency’s value, ‘the fundamentals’.
But, there is such a vast array of criteria like economic conditions, trade balance, public finances, monetary policy, political stability to name but a few, that keeping abreast of all these developments can complicate investment decisions to a great extent. The main idea behind technical analysis (or charting) is that all material information is already reflected in the current price.
The first step is to identify the trend. An uptrend can be defined simply as ‘a sequence of higher peaks and higher troughs.’ A downtrend is ‘a sequence of lower peaks and lower troughs.’ If no discernible sequence is apparent, then the market is trendless.
There are three stages to a trend. A Primary trend lasts normally for longer than one year. A Secondary (or intermediate trend) usually lasts for less than one year. An Immediate (or short-term trend) generally lasts for less than one month. Other stages in a trend are the support stage, where buying interest accumulates, and a resistance stage where selling interests accumulates. When a support fails, it becomes resistance and vice-versa. Human nature dictates that having made an incorrect decision, some investors will seek to lighten their positions should the entry price be subsequently seen again. This means that sellers will be seen at a level where buyers were sited earlier in the trend.
Referring to the top chart, we can see that the Primary Trend is clearly upwards, whereas the Secondary Trend (last 12 months) could be seen as sideways/upwards. The Immediate Trend is also upwards, but will need to beat the previous high point from earlier this year to ensure the upward Primary Trend is maintained.
Chart Patterns
As Technical Analysis has become popular and more widely understood over the years, it has developed into a body of knowledge of its own. Practitioners noticed certain types of patterns developing repeatedly over time, enhancing their ability to forecast moves by examining results of previous patterns. Typically, trends go though phases of acceleration and consolidation. It is worth examining patterns which form during these consolidations in order to help anticipate whether the trend is set to continue, or is it set to turn around altogether.
Continuation Patterns
These occur during consolidations, which are pauses in the prevailing trend. Once the patterns are completed, prices resume their course in the direction of the prevailing trend.
• Triangles
During consolidation, price action gradually converges taking the shape of a triangle (bordered by two opposing trendlines). The trend resumes when prices break out of the triangle. The market should move a distance equal to the height of the triangle (see bottom chart). Triangles can sometimes prompt reversals in trend, so it’s important to watch and wait for the direction of the break out.
• Rectangle
Consolidation forms a rectangular shape, before eventually breaking out in the direction of the prevailing trend.
• Flag
Consolidation, in the shape of a parallel channel sloping against the prevailing trend. Break out in the direction of the prevailing trend indicates that consolidation is over and the trend has resumed. (see top chart).
• Pennant
Like a flag, except that the bands are not parallel. (see bottom chart). Flags and pennants normally ‘fly at half mast’ i.e. the trend should extend at least the same distance as the preceding move.
Reversal Patterns
Completion of these patterns warns of an imminent turnaround in the prevailing trend. As with all patterns, participants must wait for completion of the formation before making the investment decision.
• Outside Reversal Day
The market makes a higher high than the previous days high, but turns around and finishes the day below the previous day’s low. Indicates a big change in sentiment during the day, probably due to some unexpected fundamental development. The opposite occurs at troughs; the market reaches a new level, lower than the previous day’s low price, but closes the day higher than the previous day’s peak.
• Double Top
Price tests a previous high, but fails to close above it and subsequently reverses away from it. Confirmation that top is in place when the intervening low is breached. (see top chart).
• Double Bottom
Just the opposite of a Double Top.
• Head and Shoulders
An uptrend begins to wane, as the market fails to reach the previous high. A supporting trendline (called the ‘neck line’) is drawn connecting the two intervening lows. Violation of this line completes the reversal prompting the market to reverse a distance equal to the ‘height’ of the pattern, i.e. the distance between the highest peak and the trendline.
• Inverse Head and Shoulders
Just the opposite, the reversal of a downtrend. (see bottom chart)
Phelim Keogan is chief dealer of Money Markets at National Irish Bank. |
