Three Cornerstones of Technical Analysis: Trends, Patterns and Indicators

I. Definition and Assumptions of Technical Analysis

Technical analysis is a method of predicting future market trends by studying historical price and trading volume data. It is based on three core assumptions:

• Market action discounts everything: Price has already reflected all known fundamental, news, and psychological factors
• Price moves in trends: Market prices do not fluctuate randomly, but follow certain trends
• History repeats itself: Market participants' psychological and behavioral patterns repeat

II. First Cornerstone: Trend Theory

Trend is the core concept of technical analysis, understanding and grasping trends is the key to successful technical analysis.

1. Definition and Classification of Trends

Trend refers to the phenomenon of prices moving continuously in one direction over a certain period of time. According to direction, trends can be divided into:

• Uptrend: A series of higher highs and higher lows, indicating a bullish market
• Down trend: A series of lower highs and lower lows, indicating a bearish market
• Sideways trend: Prices fluctuate within a certain range, with no obvious upward or downward direction

2. Levels of Trends

Trends can be divided into different levels according to time period:

• Primary trend: Long-term trends lasting from months to years
• Secondary trend: Medium-term trends lasting from weeks to months, usually corrections or rebounds to the primary trend
• Minor trend: Short-term fluctuations lasting from days to weeks

3. Trend Lines and Channels

Trend lines are straight lines connecting price highs or lows, used to confirm trend direction and support/resistance levels:

• Uptrend line: Connects lows in an uptrend, providing support
• Down trend line: Connects highs in a downtrend, providing resistance
• Trend channel: Composed of two parallel trend lines, including uptrend channels, downtrend channels, and sideways channels

4. Trend Reversal Signals

Trend reversals usually manifest as:

• Price breaks through trend lines
• Important support/resistance levels are broken
• Technical indicators show divergence
• Formation of reversal patterns

III. Second Cornerstone: Chart Patterns

Chart patterns are specific patterns formed by prices over a period of time, divided into two main categories: reversal patterns and continuing patterns.

1. Reversal Patterns

Reversal patterns indicate that the current trend is about to end, and the market direction may reverse. Common reversal patterns include:

Head and Shoulders Top

Head and shoulders top is the most reliable top reversal pattern, consisting of one head and two shoulders:

• Left shoulder: Price rises and then falls
• Head: Price breaks through the left shoulder high and then falls sharply
• Right shoulder: Price rises again but fails to break through the head high, then falls
• Neckline: Straight line connecting the bottoms of the left and right shoulders
• Confirmation signal: Price breaks below the neckline with increased volume

Head and Shoulders Bottom

Head and shoulders bottom is the mirror image of head and shoulders top, a reliable bottom reversal pattern, indicating that the downtrend is about to end.

Double Top (M Top) and Double Bottom (W Bottom)

• Double top: Price rises to the same level twice and then falls, forming an M shape, indicating a top reversal
• Double bottom: Price falls to the same level twice and then rebounds, forming a W shape, indicating a bottom reversal

Round Top and Round Bottom

Round patterns are slowly formed reversal patterns, usually taking weeks or months, indicating a gradual shift in trend.

2. Continuing Patterns

Continuing patterns indicate that the current trend is temporarily resting and will continue in the original direction. Common continuing patterns include:

Triangle Patterns

• Symmetrical triangle: Highs gradually decrease, lows gradually increase, forming a converging triangle, breakout direction is uncertain
• Ascending triangle: Highs are basically flat, lows gradually increase, usually breaking upward, is a bullish continuing pattern
• Descending triangle: Lows are basically flat, highs gradually decrease, usually breaking downward, is a bearish continuing pattern

Rectangle Patterns

Prices fluctuate between two parallel horizontal lines, forming a rectangular channel, breakout direction is usually consistent with the original trend.

Flags and Pennants

• Flag: Short-term inclined channel, usually opposite to the original trend, then resumes the original trend
• Pennant: Similar to a triangle, but with both sides inclined, divided into ascending pennants and descending pennants

IV. Third Cornerstone: Technical Indicators

Technical indicators are analytical tools calculated through mathematical formulas, used to assist in judging market trends, momentum, overbought/oversold states, etc.

1. Classification of Indicators

According to function, technical indicators can be divided into the following categories:

Trend Indicators

Used to identify and confirm market trends, common trend indicators include:

• Moving Average (MA): Simple Moving Average (SMA), Exponential Moving Average (EMA), Weighted Moving Average (WMA)
• Moving Average Convergence Divergence (MACD): Composed of fast line, slow line and histogram, used to judge trend and momentum
• Bollinger Bands: Composed of middle band (MA) and upper/lower bands (MA±2σ), used to judge price fluctuation range

Momentum Indicators

Used to measure the speed and strength of price changes, common momentum indicators include:

• Relative Strength Index (RSI): Value range 0-100, used to judge overbought/oversold states
• Stochastic Oscillator (KDJ): Composed of K line, D line and J line, used to judge short-term reversal points
• Williams %R (WR): Value range 0-100, used to judge overbought/oversold states

Volume Indicators

Used to analyze the relationship between volume and price, common volume indicators include:

• Volume (VOL): Directly reflects market activity
• Volume Weighted Average Price (VWAP): Average price considering volume
• On-Balance Volume (OBV): Predict price trends through volume changes

2. Coordinated Use of Indicators

Single indicators often have limitations, technical analysis experts usually combine multiple indicators for analysis:

• Trend + Momentum: Use trend indicators to confirm direction, use momentum indicators to find entry points
• Indicator Divergence: When price and indicators move in opposite directions, it may indicate a trend reversal
• Multi-period Verification: Use the same indicator on different time periods to improve signal reliability
• Indicator Resonance: When multiple indicators issue the same signal simultaneously, the signal is more reliable

3. Notes for Using Indicators

• Indicator lag: All indicators are calculated based on historical data, with a certain lag
• Avoid overtrading: Not every indicator signal is worth trading, combine with other factors for comprehensive judgment
• Adapt to market environment: Different indicators perform differently in different market environments, choose flexibly
• Combine with price patterns: Indicator signals should be used in conjunction with price patterns to improve accuracy

V. Practical Application of Technical Analysis

After mastering the three cornerstones of technical analysis, you can apply them to actual trading:

1. Trend Judgment

Use trend lines, moving averages and other tools to confirm the current market trend direction.

2. Pattern Recognition

Identify reversal patterns and continuing patterns in charts, predict possible market trends.

3. Entry Point Selection

Combine pattern breakouts and indicator signals to select appropriate entry points:

• In an uptrend, buy when pulling back to support levels
• In a downtrend, sell when rebounding to resistance levels
• When a pattern breaks out, follow the breakout direction to enter

4. Stop Loss and Take Profit Setting

Set reasonable stop loss and take profit levels based on technical analysis:

• Stop loss: Usually set outside important support/resistance levels
• Take profit: Can be set according to pattern targets, important resistance/support levels, or technical indicator signals

VI. Summary

Trends, patterns, and indicators are the three cornerstones of technical analysis, they are interrelated and mutually verified, together forming a complete system of technical analysis.

Successful technical analysis requires:

• In-depth understanding of the principles and applications of the three cornerstones
• Comprehensive analysis combining multiple tools
• Strict risk management
• Continuous practice and experience summarization

Technical analysis is not a crystal ball for predicting the market, but it can help investors better understand market behavior, improve the accuracy and consistency of trading decisions.