Learn Chart Analysis: The 6 Most Popular Formations

If you want to learn chart technique, here you will find a guide and at the same time the 6 most popular formations of chart analysis.
Chart analysis is a popular tool among traders and investors to optimize trading in securities or derivatives. The goal is to forecast the price development on the basis of chart technique.

Unfortunately, there are also big misunderstandings, which I will also present to you here.

The chart technique consists of individual indicators, but also of certain chart patterns or candlestick formations. In all cases it is the graphical representation of the price of an underlying asset and the various tools.

Anyone who wants to learn chart techniques must also understand the construction and processing of an order book. How does a price come about? What do supply and demand mean?

It starts with the fact that many traders do not understand that a chart is the graphical representation of the historical order book, i.e. the result of past prices. But if it is a historical price, how can it help me in trading?

Please make it clear right at the beginning of the article that charting is not a miracle cure, but a means to an end. There is no blanket statement such as: “Chart technique is absolutely necessary” or vice versa: “Chart technique … all nonsense.”

As always, the truth lies somewhere in the middle. So that you can learn the chart technique, I will now show you 6 popular formations and tools that should help you to develop a working trading strategy.

Learn chart technique: The trend channel

A trend gives you the direction. In fashion as well as in trading, where it can generally be “long” or “short”. A trend channel illustrates a zone in which the price moves. Traders try to recognize a trend as quickly as possible in order to be able to position themselves accordingly.

In the following picture you can see the trend channel by the red lines. The price moves for a time in this channel. But of course it is never clear how long the price will remain in this formation. It is important that the lines are symmetrical to each other. I need at least three points (2 above, 1 below or vice versa) to be able to draw a channel.

A trend is divided into an uptrend and a downtrend. The time units must also be taken into account. For example, the 5 minute chart may have a downtrend, but the 4 hour chart may have an uptrend. Which trend is decisive now? That again depends on the trading style, but in general the higher ranking time units are more significant.

What is the benefit of recognizing a trend channel?

Firstly, I can optimise a planned entry into a stock, currency pair, etc., and secondly, I can plan a good exit from an existing trade. In the red trend channel, I could place a short on the upper side of the trend channel and place an exit on the lower side of the trend channel.

There are also traders who position themselves in the opposite direction in an existing trend. In the example above this would be a long entry in a downtrend. However, I cannot recommend this. It also makes sense to only trade if the trend in superior and inferior time units coincides.

Also be aware that a trend will end at some point.

Learn chart technique: Resistance and support

Similar to the trend channel, resistances and supports are visual aids to identify certain zones in the chart. These are areas where the price has not easily moved forward in the past. If this area is above the currently traded price, then it is a resistance, if the area is below the current price, then it is a support.

The names already reveal a bit of the meaning of these lines. A resistance blocks the current upward movement, a support “supports” the price in a downward trend.

One assumes that the price will not simply continue its current trend along these lines. In the following picture you can see from the red line that this area blocked both the uptrend (far left) for a few periods and then supported it after the breakthrough.

You should remember this special feature: If the price has overcome a resistance-range permanently, it serves as support for the intact upward-trend from now on. Conversely, a downward broken support becomes a resistance in a downward trend.

I myself use support and resistance lines to optimize the entry and exit of my trades in Forex trading. When I see that resistance is ahead, I put my take profit a few pips ahead of this zone, depending on the risk/reward ratio. I can also align my Stop Loss based on these zones.

The basic idea behind these lines is that many market participants recognize this zone and place their orders there. This should result in a rebound.

Learn chart technique: Moving averages

Similarly popular as trends and resistance/support lines are moving averages. These are mean values of historical prices. An average is thus formed from a history of prices. This average is displayed as a “moving” line in the chart.

One of the most popular moving averages is the Exponential Moving Average (EMA). Using various scaling options, I can construct this indicator. However, when we talk about chart analysis, we must always remember that only those tools that are taken into account by the market will get us ahead. The most attention is paid to the EMA200, both at institutional and private trader level.

The EMA200 shows me the average of the last 200 closing prices in a chosen time unit. This means that there is a difference between the individual time units, because the EMA200 in the 5min chart shows me the average of the last 200 5min candlesticks, the EMA200 in the 4h chart shows me the average of the last 200 candlesticks from the 4-hour chart. Since this is an exponential moving average, in contrast to the simple moving average, there is a stronger weighting of the last traded prices. However, with the SMA, each of the 200 candlesticks is equally weighted.

You can see that the price always runs away from the EMA200, but comes back the same way. Similar to supports and resistances, traders rely on a rebound. Especially at the first contact after a longer absence, the EMA is used as exit for existing trades and entry for rebound trades.

In addition to traders, investors who generally have a longer time horizon for their investment also use the moving averages to determine their position. Basic rule of thumb: If the price is above the average – upward trend, it is below the average – downward trend.

Decide for yourself whether you include the EMA or another average in your position management, or perhaps just see it as a position-fixing.

Learn chart technique: Bollinger Bands

After we got to know moving averages and trend channels, I would like to introduce you to the Bollinger Bands. These are a combination of Simple Moving Average and Standard Deviation. You see the moving average (red) accompanied by two outer bands (green).

The scaling is again freely selectable. Often the SMA is chosen with a scale of 200 and the deviation 2 for the two outer bands.

The Bollinger Bands can help you figure out how far a move will go. Since assets always alternate between volatile and quiet, trendy phases, the Bollinger Bands will sometimes contract (quiet phase) and sometimes expand strongly.

We see a downward trend on the chart. The price has moved away from the SMA and is slowly approaching it again. The lower Bollinger Band served as a support against further price losses and could be used to exit a short or enter a long trade.

As mentioned before, the same applies here: If the tool convinces you, test it in many time units and with various parameters until you achieve the desired result.

Learn chart technique: Fibonacci retracements

The Fibonacci Retracements got their name from a famous mathematician (Fibonacci). Strangely enough, we find Fibonacci’s number sequences not only in trading, but also in nature, architecture, etc. The English term “retracement” is used to describe a reset. So we use this tool to anticipate a rebound in the market.

In doing so, we look for a chart in which a relevant, impulsive upward or downward trend can be seen and where a small recovery/correction has already occurred. We now want to know how far this correction is likely to go and then we want to find the “perfect” trade entry. No, we delete “perfect” and add “good”. Perfectionism is quickly punished in trading…

To get an idea of how far the correction will go, we draw different levels in the chart. Every modern chart software, like the Metatrader, does this automatically. All you have to do is to connect the highs and lows with the tool.

In this hourly chart of the EURJPY we see the downward trend clearly. We draw the Fibonacci retracement from the high point to the low point. The retracement levels 23.6, 38.2, 50.0 and 61.8 are inserted automatically.

You will recognize a rebound on first contact with each level. Here it is a good idea to sell longs or build shorts (depending on your own setup).

Learn chart technique: Trading candles

Candle charts have many advantages over line charts. For example, I can read information about trends and volumes from the candle formation. This in turn can help me decide for or against a trade.

I have written my own blog post here about the 7 most important candle patterns. In this article here I go into what I think is the most interesting candle, the “Hammer”.

Before I explain the meaning of the hammer, let’s talk about what a trading candle actually is and how to interpret it.

You can see that a candle shows you both the highs and lows and thus the trading range of the period under consideration, as well as the opening and closing price. I can tell from the colours whether the period was positive or negative.

Now that the basics are clear, let’s look at the hammer.

The hammer is characterized by a long wick and a small candle body. It indicates that there was a movement within the observed period that was completely levelled out towards the end.

Many traders look for this pattern at the end of a volatile up or down movement to determine a trend change in higher time units. So this pattern marks the end of an up or down trend.

But again, a candle formation alone does not constitute a trading signal with a good risk/reward ratio. It is an orientation and can be one of several parameters.

Learn chart technique: Average Daily Range

The Average Daily Range indicates how high the average volatility was in a particular period. Translated it is the average trading range of a day. But of course I can also choose other periods.

Assuming that an asset class like the FX pair EURUSD has an average trading range of 40 pips on a daily basis, I can include this information in my trading setup.

If I am a day trader and want to close my position at the end of the trading day, I can use the ADR to anticipate whether or not there will be a big move on that trading day.

On the other hand, if I am not yet positioned and would like to make another trade towards the end of a trading session, I can use the ADR to check whether or not the average trading range for this session has already been reached. If there is no more volatile event, the price will tend to oscillate in a sideways phase.

But beware: It is not an indicator to justify a trade or trade entry. The ADR only tells me how high the probability is that a movement in my favor will or will not occur in the period under consideration. It does not mean that after reaching the ADR there can’t be a big movement. What is decisive is the market sentiment and the associated situation in the order book.

One must also take into account that there are days with low and high volatility. By looking at the economic calendar, I can plan for volatile phases (for example, when deciding on key interest rates).
I can calculate the Average Daily Range myself by taking the pip range of each daily candle and dividing it by the number of days considered.

Important:

You have now seen six chart formations which you can follow if you want to learn charting techniques. Test these formations by placing entries and exits at the individual points on demo accounts without risk. Papertrading and backtesting will also help you.

You should not base your trading setup only on the chart technique. Depending on which asset you trade, which trading style you use and how you define your risk management, you have to increase or decrease the importance of chart technique.

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