Categories
Technical Analysis

Tips on Using Indicators

It’s time to get serious! From here on out we’re going to be concocting consistent trades, using the instruments seen in the past lessons.

Before we start our adventure, however, allow me to share some suggestions and ideas that have matured through years of experience.

  • The 80-20 rule applies more to trading than other aspects of life. 80% of your results will be determined by 20% of your effort. So whatever approach you decide to use, make sure you eliminate all unnecessary clutter from charts. Similarly, don’t waste time trying to orchestrate complex theories connecting fundamentals and market movement. Be efficient above all else!
  • The KISS rule also applies to trading in a big way. In order for the 80-20 rule to “work” for you, you need to have a simple & subtle approach. You want to combine simple technical prompts with an equally simple yet logical way of absorbing & digesting emerging fundamentals. If you can’t explain what you do to a 5-year old, then it’s too complicated. Simplify!
  • Know precisely what you’re waiting for. Don’t go “looking” for trades. Our brain is trained to “find” what we are searching for. If you are actively “looking” for trades, your brain will find them for you. However, they will most likely be losing trades – the reason being that you were not “letting the market come to you”. You were “forcing your view” upon the market. This is easier said than done…but if you catch yourself “searching” for a trade, it’s probably best to stop immediately and do something else. Chances are, there really was no good trade to get stuck into, and you were looking for action where there was none. A bored trader looking for action is seldom more than a gambler.

How to set up your chartshttps://ads.actionforex.com/www/delivery/afr.php?zoneid=74

With that said, it is time to take action. And that does not mean opening up a chart, overlaying all the indicators we have seen in the past lessons, and then clicking “Buy”. A chart can say more than 1000 words…but that’s only useful if you can understand them.

1. The first thing to do is remember what exactly we are seeing, when we look at charts. Nowadays the most common chart is a Candlestick chart. But what exactly are we watching? As we noted in the previous lesson, price (as highlighted by candles or bars or even a line chart) is a reflection of current market psychology.

It’s too easy to think of “price action” as an independent or impersonal concept. In reality, at any given time, the price of a financial asset is determined by the forces of supply and demand. Edwards & Magee, in 1948, had already defined price action appropriately:

“The market price reflects not only the differing value opinions of many orthodox security appraisers, but also the hopes and fears and guesses and moods, rational and irrational, of […] buyers and sellers, as well as their needs and the resources…”

Edwards & Magee gave a very precise definition that included the psychological aspect of human decision making. Price movement is determined by investors’ decisions in response to a complex mix of psychological, sociological, political, economic and monetary factors.

So when you watch a price chart, the right questions to ask are:

“what is the market thinking?”
“is the market showing signs of strength, weakness or consolidation?”
“how (and why) is the market reacting to this level/piece of news/situation?”

For Example, in December 2015 the market was surprised by the ECB. The EUR/USD burst upwards and many traders were wondering at what point it might stop. Using the logic described above, we shall attempt to make an educated guess.

The first thing to do is observe where, in the past, the market has “made a decision”. Where are the most recent points from which the market has moved aggressively in one direction or the other?

After finding our “reaction zone”, we need to have patience and wait until the market reaches the zone again. Only then does it make sense to observe price action, and “ask the market what it thinks” this time round. This is the “strategic” plan, which tends to be more robust on the higher time frames (4H/Daily/Weekly). Instead, from a tactical point of view, it is entirely possible to use various time frames and in the chart below, we have “magnified” the reaction zone using a 4H chart.

Hence, the important thing isn’t the candle in itself; it’s WHEN & WHERE you see certain candle formations that make them “important”.

NZDUSD 1H Chart – the best places to proceed with “candle watching” are at prior levels/zones of importance. That is where it makes sense to ask the market “what are you thinking?” Conversely, the beautiful long Doji in the middle of nowhere has much less significance.

2. The second thing to do is “zoom out”. By learning to “zoom out” you can automatically avoid “confusing the trees for the forest”. Observe the chart below. By just taking into account recent developments, you might be thinking that we’re headed for a massive break to the downside.

However, if you just broaden your view a little, you can see how flawed that hypothesis was. We were in fact just popping below an ugly range, and had yet to challenge the origin of the recent upwards momentum.

3. We have seen the importance of watching market reactions at previously important junctures. You can think of them as “conflict zones” where the bulls & bears, for whatever reason, fought it out and one side dominated the other, causing some sort of evident order flow imbalance.

These evident levels that have turned the tide in the past, are likely to react in the same way in the future, if the fundamental background remains the same. Otherwise, what was a prior level of support might flip to resistance as reverse orders hit the market, caused by a shift in market sentiment.

NZD/USD 4H – Examples of levels that have shifted from support to resistance and vice-versa.

So the key is to have a firm grasp on market direction at all times:

if the market is trending upwards, ask yourself where likely support will be;
if the market is trending downwards, ask yourself where likely resistance will be.

4. This brings us to the next topic: indicators. Too often, aspiring traders start to overlay indicators on their charts without the slightest idea of what the indicators actually indicate. Here is the key: anything you overlay on top of a pure price chart should be thoroughly understood. You must know why you’re using something, rather than just doing it because it should give you some magical power of intuition.

Generally speaking, markets can be in “trend mode” or “range mode”. Some indicators can assist with making decisions during trending modes, while some indicators are useless and will lead to steep losses in this same phase. Vice versa, some indicators are useful tools during range-bound markets, but will lead to steep losses during trending phases.

Observe the following charts.

NZDUSD Daily Chart – The entire group of “trend indicators”, which is made of many permutations of Moving Averages, TrendLines, SuperTrend, Ichimoku, etc. all “indicate” the same thing: a tendency in prices. When prices are trending, these indicators can be useful tools.

NZDUSD Daily Chart – the entire group of “Oscillators” (Stochastics, Momentum, MACD, CCI, etc) “indicates” the same thing: price is currently “high” or “low” compared to the range in the lookback period, which is usually 14 Candles. When prices are in a range, these tools can be useful.

As a rule of thumb:

  • Trend Indicators are useful in evidently trending markets, because they keep you on the right side of the move and are “automatic trend lines” from which price may find support or resistance. Common moving averages are the 10, 20, 50, 55, 100, and 200. In range-bound markets, trend indicators will lead to “whipsaws” where price continues to flip from above to below the averages in a non-directional fashion.
  • Oscillators are useful in range-bound markets, because they will suggest shorting at tops and buying bottoms. Of course, this works great in range-bound situations but is suicide in a strong trending market. Just like the Oscillator chart above, strong trends can maintain oscillators in “oversold” or “overbought” territory for long periods of time, generating many false signals.

That is why you really need to understand the nature of the indicators you overlay on your price chart. For example, what is an RSI? Many traders use RSI without knowing what it actually means. A logical approach would be to study the formula: it is showing you whether the bullish bars or bearish bars are bigger. That’s it!

Below is a basic calculation of the RSI:

Source: Proprietary Calculation

And what does it look like on a Price chart?

This is the ONLY way to utilize indicators: know what they are. Know what they can and can’t do for you. Do not overlay indicators thinking they can solve your problems for you, or give you some kind of edge. They can’t. Indicators are mostly “eye candy” that can facilitate your job, but they cannot do your job for you.

We know that identifying market direction is of fundamental importance. You need to know whether to be looking North or South, so you can know whether to be Long, Short or Flat on any given day. No confusion is tolerable on this matter.

One indicator that can be of use in this case is a simple moving average. But which SMA to choose? There are many common permutations, but essentially you need to decide what your objectives are. Are you going to trade shorter term cycles? Maybe a 20-period SMA might suit you well. If you’re looking for longer term cycles, maybe a 50 or 55-period SMA would suit you better. In any case, the moving average is not magical. It will only tell you the strength of the trend you are watching, at any given time.

Observe the following example: the USD vs. all major trading partners.

USD Screen: which is the best looking currency pair to bet your hard earned capital on?

Which are the strongest, most evident trends to trade? Confused? Use these two measures:

  • inclination of the moving average. The more inclined the average, the stronger the trend.
  • distance between price and the moving average. The further away price is, the stronger the trend.

You can immediately see that the bottom three – USD/CAD, NZD/USD and GBP/USD – are the winners!

4.1 Overbought and Oversold. Many indicators are “normalized” and oscillate between 0 and 100. Traditional technical analysis would hold that “above 80” or “below 20” are “overbought” and “oversold” areas respectively, where the market has run enough and is due for a correction.

Unfortunately, by following this kind of mantra, you will end up catching falling knives and fading into strong rallies.

The market does not know “overbought” or “oversold”. The market will continue to trot along relentlessly, snatching the stops of anyone who gets in its way.

GBP/USD 1H – whenever price pushes beyond the lookback period of your indicator, you will have an “extreme reading”. However, the market does not always care, and will often push right through it after a brief pause.

So what is a more savvy way to use the “overbought/oversold” concept, in a useful way? Simply go with the flow! Instead of using the indicators to trade against the trend, look for the indicator to help you leg into the trend!

If the market is trending down so strongly that it pulls back when overbought but largely ignores oversold, you could look to short the next overbought period to get maximum value:

GBP/USD 1H – Using an oscillator like the stochastic, to help you leg into an existing trend at potential turning points, is an effective and simple way of including the instrument into your plan.

4.2 Divergences. One useful aspect of indicators, that is more difficult to see with the naked eye, is the divergence trade. A divergence happens when price and indicator go their separate ways:

  • price makes a higher high while the indicator does not;
  • price makes a lower low while the indicator does not.

But once again, we first need to understand what exactly a divergence is. Observing the chart above, it becomes evident. A momentum divergence occurs when you get the range over X bars (the lookback period in the indicator – 14 is usually the default) being less than the range over X bars to the previous high or low (essentially price did not push as hard this time, to get there).

Of course, triggering trades by using divergences works best when prices are vibrating clear previous supply or demand zones.

5. We are almost finished setting our stall. However, we still need to make the acquaintance of the only chart pattern that matters: peak & trough action. Natural peaks (swing highs) and troughs (swing lows) reveal the “pulse” of the market on any given time frame.

GBP/USD 4H chart highlighting the peak-trough sequence.

By observing the sequence of peaks and troughs, it becomes quite easy to spot the first signs of strength (a higher low in a downtrend) or weakness (a lower high in an uptrend). Traders will be on guard if this happens, since it’s a warning sign that momentum is fading and a reversal might be in store.

Putting it all together

Now let us observe how we can combine all elements, both technical and fundamental, to create effective trade opportunities. Here is a recent example on USD/CAD:

As of January 19th 2016, the Loonie had been the worst performing currency over the past quarter. This weakness was due to Crude Oil having fallen continuously over the course of 2015, which caused job losses in the Canadian energy sector and took its toll on manufacturing activity as well.

USD/CAD Daily Chart

On January 20th the market was on the lookout for the Bank of Canada policy decision, and the accompanying statement by Governor Poloz. CPI, Employment, Ivey PMI, Housing were all trending lower heading into the Bank of Canada’s decision. Regarding rates, consensus was for no change, but there was a small chance of a 0.25% cut given the general situation. Governor Poloz had said back in December 2015: “The bank is now confident that Canadian financial markets could also function in a negative interest rate environment.”

USD/CAD had been a’ buy-on-dips’ for the longest time, due to fundamental factors and externalities.

What happened next?

USD/CAD – Source

If we’re only observing a chart, then we can notice how the orders around the day’s low at 4550 were taken, and the orders around 4500 (Big Round Number) were also probed but resisted and pushed USD/CAD back up. Technically speaking, we’ve had a large reversal intraday and the drop was bought – all in the context of a clear uptrend on the Daily charts. So looking long would be the right course of action for a pure chart reader.

But what about the chart reader who also pays attention to the day’s fundamental flavour? The message from Governor Poloz, who declined to forecast the Loonie’s fate, focused on the currency’s “shock absorber” role in protecting the Canadian economy from the impact of falling Oil prices. Hence, he downplayed domestic economic developments (which helped form the market’s dovish expectations) by saying that CAD has been a hostage to Commodities. This implied that the Bank of Canada could tolerate even more weakness in its currency.

On balance, the message was: rates on hold but less dovish/slightly encouraging talk. The fundamental backdrop has changed and it would seem logical to sell USD/CAD, at least in the near term.

The market started to invert the peak/trough cycle, and made a couple of clear breakouts to the downside in the following 2 days.

USD/CAD in the following 2 days.

And as the trend progressed, it was quite simple to use the technical indicators we have explored, in order to leg back into the new trend. For example, after a few days, the market started pulling back to a prior resistance zone and printed an evident divergence, which allowed for a solid opportunity to get short again.

USD/CAD 1H divergence

And as the days progressed, there were other opportunities as well. For example, a clear doji rejection of a prior support level, alongside an extreme stochastic reading; and then another divergence trade.

Yet another example is NZD/USD, from the beginning of February 2016.
During the Asian session on February 3rd, 3 events brought the Kiwi under the spotlight:

  1. Despite a poor GDT dairy auction, Kiwi was not affected. This was a sign of strength, since the prior GDT auctions had a negative impact on the “bird”.
  2. Employment surprised to the upside – and we know that employment is one of the more important fundamental drivers in FX.
  3. Last but not least, RBNZ Governor Wheeler downplayed the importance of low inflation. The market was expecting dovish remarks, and instead got a confident stand from Wheeler.

These were, without a doubt, positive surprises. Here is what the chart looked like, as the London session got under way on February 3rd.

NZD/USD: fundamental shift – enough to flip the technicals?

And in fact, it was quite easy to spot potential “pullbacks” using the extreme stochastic reading, in line with the moving average directional cue and the recent fundamental improvement, to leg into NZD/USD longs multiple times during the same day.

Categories
Technical Analysis

Combining Fundamental and Technical Analysis

Technical Analysis definitely has a magnetic pull. It’s difficult to resist the temptation to use the wide array of technical indicators available, creating masterpieces of modern art.

On the left: 4H chart of EUR/USD with various technical methods applied (source: Twitter)

On the right: Kandinsky horizontale (Source: Google Images)https://ads.actionforex.com/www/delivery/afr.php?zoneid=74

Up to this point, we’ve explored Support & Resistance, Candle Patterns, Moving Averages, Fibonacci Retracements, Oscillators, Bands, Channels and Envelopes. However, it would be too simplistic to reduce successful speculation to mere technicals. Sure, technical analysis is an easy empirical method, which is actually very useful for:

  • Measuring market sentiment on a given asset
  • Timing potential entries and exits
  • Managing risk.

However, it is rare to find a successful FX speculator that relies on technicals alone. In reality, behind successful FX speculation lies a decision making process that most likely blends technical analysis and fundamental analysis.

Picture this: you are a trader for a hedge fund, prop desk or an asset management shop. You decide to buy USD/CAD. The Chief Investment Officer approaches you for an explanation of why you decided to risk some of the company’s capital on your idea. Would you imagine yourself saying something like this:

“…the 211 Day Weighted Exponential Moving Average crossed the 71 Day Simple Moving Average and the Slow Stochastic Oscillator was oversold.”

Or something like this:

“…The Bank of Canada decided to cut rates today, which was a little surprising given that recent economic data wasn’t all that bad. Furthermore, Crude Oil is still nowhere near a bottom and inflation expectations continue to drop. On top of all that, we just broke out of a consolidation in an evident uptrend.”

I think we all agree that a Chief Investment Officer would find it difficult to allocate risk capital to decisions made solely using one’s technical prowess. More likely, he or she would want to see a mixture of logical fundamental reasoning and simple technical observations.

The Seductive Side of Technical Analysis

Observe the following chart. What do you see?

The only thing you can actually see is a multitude of indicators. You can’t even see the market! A trader with this kind of chart is usually searching for certainty. Technical Analysis can give traders the illusion of certainty and robustness. This of course can be fatal to your account, because any technical measurement is merely a derivative of price.

Technical Analysis is seductive:

  • It’s simple and democratic: anyone with a half-decent charting package can add/remove/create indicators;
  • It helps measure sentiment;
  • It helps time entries & exits;
  • without a universally valid framework for forecasting FX moves, it seems like the only way to play the game;
  • It helps us understand traders’ positioning: traders resist negative (positive) news when they are long (short) and exaggerate negative (positive) news when they are short (long), and this can be seen on the chart;
  • Market Wizards like Paul Tudor Jones refer to common indicators like the 200 simple moving average. If it works for them, surely it can work for the common retail trader?

However, if you are only making decisions based on charts, how can you explain the times when charts fail you?

It can be frustrating when a solid chart pattern or analysis method suddenly fails. Sure, “it may be one of those days” …but how can you be sure? Furthermore, how can you continue to have confidence in your charting method, without constantly questioning the validity of each signal you get?

What is Price?

All chart patterns & technical methods are based on price behaviour. So it’s useful to investigate price a little further. What exactly is price in the first place? What are we actually watching, when we stare at our glamorous charts?

It’s too easy to think of “price action” as an independent or impersonal concept. In reality, at any given time, the price of a financial asset is determined by the forces of supply and demand. Edwards & Magee, in 1948, had already defined price action appropriately:

“The market price reflects not only the differing value opinions of many orthodox security appraisers, but also the hopes and fears and guesses and moods, rational and irrational, of […] buyers and sellers, as well as their needs and the resources…”

Edwards & Magee gave a very precise definition that included the psychological aspect of human decision making. Price movement is determined by investors’ decisions in response to a complex mix of psychological, sociological, political, economic and monetary factors. Technical Analysis attempts to measure the strength of these moves and to forewarn of potential changes.

In other words: price is the reflection of the aggregate perception regarding the future of the currency pair, stock, bond or whatever asset we’re trading. We’re observing expectations of future outcomes.

How market participants form their expectations

We now know that we are actually trading expectations, not facts or hard data. But where do these expectations come from? Surely they aren’t formed out of thin air…or are they?

Fundamental data, or better stated, the evolution of fundamentals over time, is what drives demand and supply in the FX market. Fundamental analysis is the process through which we should strive to understand how price could react to certain economic events. These events can come in many forms:

  • headline data (for example, PMI reports or housing data)
  • top tier data (for example, central bank decisions or minutes, or NFP)
  • themes (for example, monetary policy divergence between the USA and the Eurozone, or the weakness in the commodity sector)

The release of this data, and the evolution of the themes that the market is currently focused on, changes the economic mindset of participants – and this is what creates the reaction from investors. To be even more precise, it’s not even the release of the data or the event that creates a re-allocation of capital: frequently, it’s the expectation of such releases/events that gets things moving. This is why we frequently say the market is “forward looking”: participants tend to “discount” or “price in” their expectations for future foreseeable events.

The fundamental picture is ever evolving. It’s like a slideshow, where each slide represents “the fundamental influences of a session” (like the NY session or the EU session). But without knowing what was on the slide before it, it’s impractical to guesstimate what will be on the slide after it.

But which fundamentals contribute to forming expectations, and why?

Paying attention to the primitive illustration above, the most important question is: who can “force” the FX market in a certain direction? Who has the most influence? The answer is of course: Central Banks and Treasury Heads.

They hold the thick sticks. All it takes is the Bank of Japan to be “actively checking prices” at their agent banks for the word to spread along the grapevine and alert market participants. So, which fundamentals matter to the people that matter? What do the policy makers base their policies on? The list certainly encompasses:

  • Interest rates (yields)
  • Inflation (growth)
  • Employment/Housing/Mortgages
  • Capital Inflows/Outflows (directly correlated with the various Equity Indexes)
  • Imports/Exports

By now, you’re probably thinking: “how am I ever going to keep track of everything?” Here’s the key: the market is made up of humans, and humans cannot possibly keep track of all variables at the same time. So what happens is that the market focuses only on a few themes and stories at any one time.

How to keep track of the matters that matter

If you want to stay in tune with the evolving fundamental picture, the first step is to pull up an economic calendar in the morning, and take a good look at the market moving events due for the day. This is valid for FX, as it is for Futures, Equities and Bonds as well, because these market movers are telling us something about the economy. All investors are interested. Here is what a calendar looks like:

Once you verify that there are important events on tap, be sure to look at what the market is expecting.

You may find it helpful to review prior events, to see (a) how often there is a hit or miss and (b) what tends to happen when forecasts are off.

By comparing the forecast with the previous print, you can discover whether the market is discounting a better number or a worse number. This can help you plan for possible scenarios, but keep in mind that:

  • one data print cannot generally alter the course of a trend, if there is one (exceptions are Central Bank meetings and NFP);
  • not every event offers a tradable opportunity;
  • definitely do NOT trade right before news – that’s called gambling.

A little bit on scenario planning:

  • If the market is in an uptrend, and the market has a positive expectation, then a negative surprise will probably have the largest temporary impact, but might also be ignored as the week progresses;
  • If the market is in a downtrend, and the market has a negative expectation, then a positive surprise will probably have the largest temporary impact, but might also be ignored as the week progresses.

There is usually an initial response, called “knee-jerk reaction”, which is short-lived, full of action, and where most traders get chopped up. Then, there is a secondary reaction, where traders have had some time to think about the release. It’s at this point that the market decides whether the release should generate a move. Was the outcome expected or not? Was it with or against the market’s expectation, and is the market currently moving in a logical fashion?

These are quick questions that can help you digest the constant stream of headline events in an actionable manner.

More on economic data prints

So now that we know how to use an economic calendar (which should be checked daily), what are the market movers that usually generate the most volatility and, in some cases, opportunities?

a) Central Bank Meetings: it is not a wise thing to trade around a central bank meeting. But central bank meetings can set the tone for the days ahead, which can be traded on the back of the theme (if there is one). Central banks set the price of money by controlling the short term lending rate. Generally speaking, when a central bank increases interest rates it attracts capital to the country because investments will yield more. This is all positive for the domestic currency. The opposite is also true: if a central bank decreases interest rates, then it is negative for the domestic currency.

But even more important than the interest rates themselves is the general direction of interest rates. If a central bank is pointing at rising rates, then the market will already be in “buy the dip mode”. Another important factor, in this day and age, is the amount of alternative accommodative policies (like Quantitative Easing in its various forms), which increase the money supply and thus are negative for the domestic currency.

b) Central Bank Minutes: it is generally not wise to trade around the minutes of a central bank meeting, although these can provide valuable details as to the central bank’s members’ true policy direction and preferences. The minutes can confirm or contradict the actual decision taken previously.

c) Employment Reports: it is generally not wise to trade right before employment reports and definitely not around NFP. Employment reports are important because jobs create income which turns into spending and thus into GDP growth. The monthly US NFP report is the most volatile news release in the FX markets. In Europe, the most highly watched is the German jobs report.

d) PMI & ISM: The Purchasing Managers Index and the Institute of Supply Management survey the corporate purchasing managers in the economy and therefore provide a good “feeling” of the strength/weakness of the economy. In addition to watching the composite number (above or below 50), the sub-components can be used to gauge the strength/weakness of any sub-sector like jobs, orders, warehouse stocks, etc. These data prints can lead to tradable market reactions.

e) Retail Sales: yet another important data print. Consumption spending makes up to 70% of the GDP and therefore consumer demand is fundamental for the health of the economy. The general trend in retail sales can often be more important than the headline number, because of cyclical factors (Christmas, Easter, Weather, etc). Retail Sales can lead to tradable market reactions.

f) Consumer Confidence/Economic Confidence surveys: The volatility is usually much lower than other releases. Confidence reports are a “sentiment” indicator built by economists. After all, without confidence there is no spending or investing, and there is no growth. In export driven economies like Japan, Canada and Germany, these reports are watched closely. These data prints can lead to tradable market reactions

g) Consumer Price Index (CPI): Controlling inflation is generally the prime objective of the central banks. Therefore, inflation data is directly connected to monetary policy. Higher inflation generally pushes the domestic currency higher, on the back of the expectation of rising interest rates. The opposite is also true: softer inflation data is generally negative for the domestic currency, as the central bank might have to lower rates. These data prints can lead to tradable market reactions.

Putting it all together: a recent opportunity on USDCAD

As of January 19th 2016, the Loonie had been the worst performing currency over the past quarter. This weakness was due to Crude Oil having fallen continuously over the course of 2015, which caused job losses in the Canadian energy sector and took its toll on manufacturing activity as well.

On January 20th the market was on the lookout for the Bank of Canada policy decision, and the accompanying statement by Governor Poloz. CPI, Employment, Ivey PMI, Housing were all trending lower heading into the Bank of Canada’s decision. Regarding rates, consensus was for no change but there was a small chance of a 0.25% cut given the general situation. Governor Poloz had said back in December 2015: “The bank is now confident that Canadian financial markets could also function in a negative interest rate environment.”

So what were the possible scenarios that could play out, and what was the probability of each scenario?

  1. Bank of Canada raises rates and talks hawkish = least probable outcome, given the worse fundamental background AND the strength of the trend.
  2. Bank of Canada holds rates stable and gives neutral/hawkish talk = rates may remain stable but there was definitely a low chance of Poloz talking down the situation.
  3. Bank of Canada holds rates and talks dovish = probably the most likely outcome.
  4. Bank of Canada cuts rates and talks dovish = the rate cut was a very minor possibility, but the dovish statement from Poloz was a given.

What happened next?

If we’re only observing a chart, then we can notice how the orders around the day’s low at 4550 were taken, and the orders around 4500 (Big Round Number) were also probed but resisted and pushed USD/CAD back up. Technically speaking, we’ve had a large reversal intraday and the drop was bought – all in the context of a clear uptrend on the Daily charts. So looking long would be the right course of action for a pure chart reader.

But what about the chart reader, that also pays attention to the day’s fundamental flavour? The message from Governor Poloz, who declined to forecast the Loonie’s fate, focused on the currency’s “shock absorber” role in protecting the Canadian economy from the impact of falling Oil prices. Hence, he downplayed domestic economic developments (which helped form the market’s dovish expectations) by saying that CAD has been a hostage to Commodities. This implied that the Bank of Canada could tolerate even more weakness in its currency.

The outcome, then, was scenario B: rates on hold, but less dovish/slightly encouraging talk. The fundamental backdrop has changed, and it would seem logical to sell USD/CAD, at least in the near term.

Who had the better handle on the situation? The pure technical trader, or the trader that keeps an eye on the charts and an ear on the evolving fundamental developments?

In the following 2 days, the market fell from a high near 1.4700 to a low of 1.4110, with two evident breakout situations that may not have made sense to the pure technical trader, but were golden opportunities for those tracking the ever-evolving fundamental picture.

Key Points:

  • Technical Analysis is useful for measuring market sentiment, managing risk, and timing entries & exits;
  • Technical Indicators are derivatives of Price, so you should understand the nature of any indicator you place on the chart. Know what it is, how it’s built, and what you need it for.
  • Price, on the other hand, is the aggregate perception of the future value of the FX pair at hand. In other words, the price of any FX pair at any given time is based on expectations, not facts.
  • Market expectations are based on the evolving fundamental environment, and some economic releases carry more weight than others.
  • Understanding market expectations allows you to understand market reactions and arrive at logical conclusions.
  • By using simple technical analysis to complement logical fundamental reasoning and scenario generation, you have greater odds of surviving & thriving in the market, than those that choose to ignore them.
Categories
Technical Analysis

Momentum Indicators

If one thing is certain about Forex, it is that it trends. Not always and never forever, but market trends do definitely emerge, and do definitely continue – sometimes for months or years.

One currency will trend against another, as long as there are enough buyers (for an uptrend) or sellers (for a downtrend) to sustain the move. Trends in Forex can be strong… and they can be lucrative for the trader with the know how to capture them.

There are a number of ways we can plot, chart, poke and prod trends to see what they’re up to and where they might be headed, but one excellent way of doing this Is by using momentum indicators. Indicators that can be used for momentum Many of the previous indicators we have covered in this guide can be used to gauge momentum. These include:https://ads.actionforex.com/www/delivery/afr.php?zoneid=74

  • Stochastics
  • Moving average crossovers
  • MACD
  • RSI

Some indicators are specifically designed for this purpose. We will cover some of those here.

It is also worth noting that some momentum indicators can be used to tell both when the momentum is beginning and coming to an end.

Momentum Indicator

The first indicator that can be used in momentum studies is the aptly named “momentum”.

The momentum indicator simply calculates the rate of change between the current price and the price of X number of periods ago.

As the momentum increases upwards, it signifies a bull trend. If it increases downwards, it is a sign of bear trend.

There are three main ways a technician uses a momentum indicator.

1. Momentum is used to determine changes in a trend. To do this, you mark trend lines on the momentum indicator. A break of the trendline indicates a change in trend.

2. If price and momentum are both moving in unison, it is a sign of a clear trend. You can then trade in alignment with the trend.

3. Once the momentum starts to diverge from the trend in price, then this is a sign that the trend may be coming to an end. You can then take profit, or perhaps stalk a reversal.

Average Directional Movement Index (ADX)

The ADX is like a friend with a really good instinct. If the ADX starts to perk up, you can be assured something’s in the air, even if you can’t be sure exactly what.

In essence, the ADX indicates (a) whether or not there is a trend to speak of, and then (b) how strong or weak the trend is. Its job is to keep a detailed record of how things have been going, so that it becomes clear very quickly when something might be about to go down.

The ADX was developed by Welles Wilder. It compares recent highs and lows to determine the strength of the trend. Unlike the momentum indicator above, it does not measure the direction of the trend, just its velocity.

The ADX has three parts. Aside from the main component itself, the +DI and -DI can be useful for planning your entries in trending markets. The strength of the trend is measured by a scale. The higher the number, the stronger the trend.

There are two main ways traders use the indicator:

1. To make sure you are trading only trending markets, wait for the ADX to be trading above 25. Alternatively, you can work out a level that suits the markets you are trading. For example, some currency traders will take the ADX trading above 20 as a sign that a trend has emerged. This keeps you from getting caught trading choppy markets. (Note: you might want to mark your level on the indicator using a horizontal line)

2. Secondly, you can look for crossovers. If the +DI crosses above the -DI, then it can be a signal to buy, and vice versa. Note that for the signal to be valid, the ADX should be above the 25 line, or the level you have pre-determined.

Note: there are facets of the ADX indicator that give you the direction of the trend also. These are a secondary consideration because for our purposes the direction should be fairly self-evident. They are still well worth looking into if you feel like doing some self-directed study.

Williams %R

This is a very handy indicator to get to grips with, because it allows you to identify overbought/oversold conditions, and then look to trade momentum swings between the two levels.

So what do we mean by overbought and oversold with this indicator? You can see that the Williams %R value is charted between 0 (the top) and -100 (bottom).

If the Williams score is high (above -20), then the pair is said to be overbought. If it’s low (below -80), it’s said to be oversold. The basic theory is that a correction, even if a small one, should eventually bring the Williams score to a more equilibrial point. In other words, nothing can stay overbought or oversold forever…

So, for example, say the price is making new lows in a normal downtrend. The indicator is showing you that the pair has moved from -60 to -90 very quickly. It is now oversold. You might look to go long, as those who are short take profits, and those who are flat go long with you.

What momentum traders will look to do is trade the swings between the overbought and oversold conditions. This can be done by trading the crosses back over the -20 and -80 lines.

You will note this indicator does a slightly different job than the ADX and momentum. Its focus is more on capturing the short-term swings in momentum, while the others keep you trading with the longer-term trend. Because of this, it is perhaps better suited to trading the swings within a wider range trading market.

Your turn…

To make the most of this lesson, jot down some of the ideas you like the most and how you might apply them to your trades.

You might just surprise yourself with some great insights.

And remember, there are no hard and fast right answers with technical analysis. Take your time. Play with the indicators until they are doing the job you want to them to do.

Categories
Technical Analysis

Bands and Envelopes

Technical Analysis is a curious pursuit.

Charts attract all walks of life; not just those mathematically inclined.

Maybe the rhythmic patterns appeal to us on a deep level. The harmony of the price movements touches something primordial in us…https://ads.actionforex.com/www/delivery/afr.php?zoneid=74

Perhaps we enjoy the puzzle. The interplay of indicators challenges us to master something we never quite can… the perfect puzzle to enthral us.

Then again, the sceptic might say it’s because we are monetarily inclined. We are here to make some dough.

The truth is it’s likely a mix of all of the above (and more). Without money to keep score, would the game be as much fun? Without the challenge, would we be so interested in making money in the market over, say, starting a business in something we were passionate about?

For the aspiring technical analyst, bands and envelopes are the ideal lure. These indicators pair pattern recognition with practical application.

They have utility for trading both ranges and trends, making them some of the most flexible indicators in your trading toolbox.

But perhaps more importantly, they provide a crucial framework for your trading.

The critical importance of having a framework for your trades

Too many traders are looking for the Holy Grail trading strategy. That is, a set of rules that will work in all conditions.

But this is not what top traders do. Top traders have a framework for their trading, so they can apply the appropriate strategy at the correct time.

By knowing how and when to trade profitably, you can position yourself ahead of the pack.

Bands and envelopes are a fundamental part of this framework. A careful application of the techniques in this article will help you determine which approach to use at the right time.

This is a crucial step that most traders fail to take. But with Bands and Envelopes it does not have to be that way for you.

Bands and envelopes will tell you if you should be bullish or bearish. They’ll tell you if you should be trading with the trend, or applying a reversion to the mean approach – if the market is overbought or oversold, about to reverse, and more.

Bollinger Bands

These were invented in the 1980’s by John Bollinger, to factor in the volatility of the price along with the trend.

Bollinger bands measure the standard deviation of the price from a moving average (typically 20 periods), and have a wide variety of uses.

Bollinger bands are used to trade a range or reversal. When the price hits the upper or lower bands it is an indication to sell or buy respectively.

This can be particularly effective when the bands are wide (meaning the price is more volatile) and the price is trading within a range (as opposed to trending).

You can combine this technique with a candlestick reversal pattern, support and resistance levels, or an overbought/oversold reading on an oscillator like RSI or stochastics.

Bollinger bands are also used for capturing trends.

You can trade a breakout when the price closes over the Bollinger Bands. This is most effective when the Bollinger Bands have condensed into a tight range.

Another use of Bollinger Bands is for market type identification. As mentioned above, it is important to trade the right strategy for the current market type. You can read more about this here.

Moving Average Envelopes

Moving Average Envelopes provide context to the price. They act as a roadmap of sorts, to guide your trading decisions.

Envelopes are simply the standard deviation of the underlying moving average envelope. Unlike the Bollinger Bands, they do not contain a volatility component.

While you can use a single set of envelopes on their own, you might find it more useful to use 2 or 3 sets at different levels of deviation, along with a moving average.

Here you can see two sets of envelopes and a moving average (the red line)

Configuring envelopes needs to be done separately for each pair and timeframe you trade. As a general rule, you want the first set of envelopes to encompass around 80% of the price movements.

The wider set of envelopes should encompass around 95%, with the price falling outside of them a maximum of 5% of the time. You may need to adjust these rules over time to ensure the envelopes continue to fit these conditions.

Unlike some other indicators, envelopes don’t provide you with specific entry signals, rather they act as a framework.

Here is how they can be interpreted:

If the price is winding around the central moving average, the trend is flat or weak.

If the price is moving with the upper mid envelope and the envelope itself is pointing upwards then the trend is bullish. The reverse is true for a bearish trend.

If the price is trading between the upper-mid envelope and the upper-outside envelope then the trend is strong. The reverse is true for a bearish trend.

If the price is trading beyond the upper outside envelope, then conditions are at extremes. You can expect a reversal or pull-back.

Be careful here. The price can still continue in the direction of the trend for some time before reversing, so it may be best to wait for a confirmation signal from the price, or another indicator such as the RSI or Stochastics.

Band Benefits

By applying bands, we can judge volatility and jump aggressively on possible breakouts. By constructing envelopes, we can trade within a calm and collected framework.

If charts are your thing, then these indicators can make them tell you a compelling story. If you apply your best technical judgement, you can greatly increase your success in the markets.

Categories
Technical Analysis

Oscillators

The markets are said to trade within a range 70-80% of the time. Trends are the exception, and not the rule.

So what to do when the markets are flat?

The smart trader dons their range trading hat.https://ads.actionforex.com/www/delivery/afr.php?zoneid=74

As a range trader, you are looking to enter near the top or bottom of a range, for a reversal back towards the opposite edge.

If the range persists, this can be done several times in a row before a trend breaks out.

Some of the best tools for this job include the Relative Strength Index (RSI) and stochastics.

Oscillators can be used for trading in trends too. For this we turn to the MACD. More on that later.

Picking tops and bottoms can be done… but it takes a few attempts

RSI and Stochastics be used to pick tops and bottoms.

While not typically recommended for most traders, picking tops and bottoms can be lucrative.

Generally you would wait for a combination of indicator signals, a strong chart pattern, and a key level.

If you do want to pick tops and bottoms, then you need have a thick skin. You will often be stopped out, and then, once you do get in on a reversal, you need to have the courage to hold on and not cut your profits short.

“Overbought” and “Oversold”

Indicators like RSI and Stochastics are designed to let the trader know if conditions are “overbought” or “oversold”.

Overbought occurs when the price reaches “overvalued” levels and is primed for a pull-back. This may be because there are no new longs to continue the move, or existing longs start to take profits. The inference is that the high price can no longer sustain itself, so it must fall.

Oversold is the opposite. When the price has been pushed to low levels and is ready for a bounce, it is said to be oversold. In this case, the sellers have run out of steam, or are looking to take profit, causing the price to rise.

Be wary that just because an indicator says the price is overbought or oversold, it does not mean that a reversal will always occur. When the markets trend, a currency pair can stay overbought or oversold for a long time.

Another term commonly used for indicators that predict overbought and oversold conditions is “Oscillators”, so named for their fluctuation around a central point, or between two numbers.

Divergence

One of the ways traders use these indictors is to spot “divergence” between the price and the indicator.

When the price makes a new high or low, and this is not supported by the indicator, it is a sign of an impending reversal.

This is perhaps best illustrated with a chart. On this cart of the GBPUSD, you can see the price made a new low, but the RSI did not.

Relative Strength Index (RSI)

One of the most popular oscillators in the Relative Strength Index (RSI).

It was developed by Welles Wilder, and was first published in 1978 in Futures Magazine. Its continued popularity speaks to its usefulness.

The RSI uses a calculation that measures price movement between the ranges of 0 to 100.

The price is said to be oversold when it is trading below 30 and overbought when it is trading above 70. NB: this does not have to be perfectly applied. Get to know the cadence of the pair you are trading and how it interacts with the indicator. You might find that a pair typically reverses after a reading of above 60 rather than 70 for example.

You can see the RSI here on the chart of the AUDUSD. In several cases the RSI printing near 30 or 70 coincides with the price changing direction.

You would look to combine a reading of below 30 with price action off a support level, or with a reversal pattern for a buy.

For a sell, you would be looking for a reading above 70 with price action off a resistance level or with a reversal pattern.

As well as looking to trade reversal patterns, RSI is commonly used to identify divergences. As mentioned above, a divergence occurs when the price makes a new high or low, and this is not confirmed by a similar high or low in the RSI.

Stochastics

The Stochastics Oscillator was developed by George Lane in the 1950’s in order to track shifts in price momentum.

There are three types of stochastic indicator:

  • Fast
  • Slow
  • Standard

The standard version is the original developed by Lane. The fast version is used for very short-term price swings and can be a bit choppy. The slow version cut down on noise by smoothing out the oscillator.

Which one is right for you? Get very clear on your purpose for using the indicator in your plan, and then test which one does the best job. As a general rule, the slower the stochastics, the less signals it will generate, but the higher the quality.

Like the RSI, the Stochastics indicator oscillates in a range between 100 and 0. In this case, traders look for a read above 80 to indicate conditions are overbought and a read below 20 to indicate they are oversold.

Also similar to the RSI, you use stochastics to trade range bound conditions, or look for reversals in conjunction with chart patterns, candlesticks or key levels.

Here is an example on the EURJPY.

Here is an example of divergence between stochastics and price on USDCAD.

Another way traders use the stochastics, is to wait for either a cross of the two averages, or for the price to move back over the 20 or 80 lines before entering. This serves to ensure that they are not “trying to catch a falling knife”. Wait for the momentum to shift back in your favour before entering.

MACD

The Moving Average Convergence Divergence indicator (or MACD as it is more commonly known) is perhaps a more flexible oscillator than the RSI or Stochastics.

The MACD measures, as the name implies, the convergence or divergence of two moving averages – a 12-day Exponential Moving Average (EMA) and a 26 day EMA.

The indicator has three main parts:

  • The MACD, which is the 12 day EMA less the 26 Day EMA
  • The signal line with is typically a 9 day EMA of the MACD
  • The MACD Histogram.

Sometimes the MACD is only plotted as a histogram without the MACD line.

The MACD can be used as to identify overbought and oversold conditions like the RSI or Stochastics, but is more commonly used to identify trends and for divergence studies.

When the MACD cross the Signal line, or the Histogram crosses over zero, then it is an indication of a change in the trend.

You can see here on the chart of NZDUSD how the cross of the MACD signals a new trend has broken out.

Here you can see a new high in the price of the EURGBP is not matched with a new high in the MACD, indicating divergence.

MACD can also be nicely combined with other oscillators to confirm signals.

Here we see divergence (twice) on the MACD, RSI reading above 70, and a bearish candlestick pattern combine prior to a downtrend in GBPUSD.

A final note

Oscillators are particularly useful tools for the trader.

The trick with using them is to make sure they serve a specific purpose in your trading. Be it helping you to time a reversal, or trade the range.

There is probably no need to use all three indicators at once. Pick the one that works best for you and the pairs you like to trade. Then learn it back to front.

Become a master in your indicator of choice, and eventually it will give you all the insight you need to generate winning trades.

Categories
Technical Analysis

Chart Patterns

To the uninitiated, a chart is just random noise. To a trader, it’s a precise portrait of the past. By isolating and analysing chart patterns, we can use this “noise” to plan high probability trades.

No matter what currency pair you’re observing, every pattern says something profound about the mood of the market. In a wider sense, every group of candlesticks gives us an insight into the bigger picture.

When read in the right way, chart patterns can be the key to unlocking where the market may be headed. With the right skills, these patterns can be identified, interpreted, and exploited.https://ads.actionforex.com/www/delivery/afr.php?zoneid=74

Continuation vs. reversal patterns

On a basic level, a chart pattern can tell us one of two things. Either the trend looks set to resume (in which case you will want to plan your trade accordingly), or the trend looks set to reverse. In the latter case, you would want to plan a counter-trend trade.

It sounds simple enough, right? But it’s not always. Reading chart patterns isn’t a magic bullet technique. It requires an appreciation for ambiguity, uncertainty, and (perhaps more than anything else) the ability to tolerate being wrong once in a while.

But let’s not undersell it, either. Armed with a strong ability to read the charts, a trader can greatly enhance their entries and exits, not to mention stop-loss placement and risk management on the whole.

Which timeframes are patterns effective on?

Patterns are effective on every timeframe (with a caveat). On faster timeframes when we’re talking in terms of minutes, there is more noise to contend with. It’s easy to get jumpy when every medium sized intra-minute move looks like the start of a selloff.

Conversely, when the big moves do happen, it’s helpful to examine the faster timeframes to get some idea of the shorter-term momentum.

On the higher timeframes – daily, weekly, monthly – the chart patterns will be the most accurate. Traders in aggregate pay more attention to established trends, and look to filter out as much noise as possible.

This is where the majority of real market players will be formulating their ideas, so it pays to look at the same information they are.

By all means, if you suspect you’re seeing the start of something, then it makes sense to confirm on the low timeframes.

Beware, though. Their very nature means they are volatile. A huge move on the 5-minute chart is a blip on the daily radar, which some people will never notice or worry about.

When you base your perceptions on lower time-frame chart patterns – 4 hour and lower – you are much more vulnerable to noise. There is such a thing as too much information.

Double top and bottom

Double tops look like the letter M. Double bottoms look like the letter W. Simply put, if you see either M or W, it could indicate a reversal.

The psychology behind a double top is that market participants have attempted to breach a new high and failed, leading to a broad based sell-off. The reverse is true for double bottom.

Here is a double top followed by a double bottom on the daily chart of the EURJPY.

Triple top and bottom

This is what happens when price doesn’t break out after a double top or bottom, but falls back to the original point for the third time. This is an even stronger reversal pattern.

A triple top signifies a third failure for the bulls to reach new highs and will often result is a complete capitulation with the bears taking charge. Of course the opposite is true for a triple bottom.

Here is a triple bottom on the EURGBP which signalled a reversal of around 400 pips.

Cup and handle

A cup and handle is a bullish continuation pattern.

This patterns is a longer-term base followed by a breakout with a re-test of the breakout point (the handle) before the trend resumes.

Flag

This is a continuation pattern marked by a steep upward trend, and then a jagged decline that bounces between two upward sloping parallel lines.

Eventually, price is expected to touch the bottom line and fall slightly, then rebound and continue the trend before making it back to the top line.

Pennant

A pennant is much like a flag, except that with a pennant, the first low creates a support line, meaning price converges like a funnel, rather than falling steadily.

Consider the chart directly above. We’re in an uptrend. Price is consolidating because some traders are exiting long positions to take profit, and some are betting on a reversal. Both of these factors are causing the trend to lose a slight amount of steam.

Of course not everybody is abandoning long positions. The trend is still alive. Plus, some of those traders who had been flat are now looking for a good price within the consolidation to go long, betting that this is in fact a continuation pattern.

What you’re witnessing is a skirmish within the greater war: the naysayers against the faithful. In essence, what causes this type of pattern is a relatively even split of people betting either way within a short space of time.

But consider the facts: the overall trend is still long and strong. Why would it reverse violently without a big catalyst? This is why we consider this a continuation pattern.

As stated above, the flag and pennant are both continuation patterns. It would be wise to stalk your entry when you see these patterns. Wait for confirmation that price has broken out in favour of the trend.

Ascending and descending triangle

An ascending triangle is a pennant with a clearly defined resistance line. It may look like a triple top with slightly higher lows each time.

If this follows an uptrend, you can consider it a period of consolidation with a favourable bullish breakout coming.

A descending triangle is the reverse of an ascending triangle with a clearly defined support line.

Symmetrical triangle

A symmetrical triangle looks a bit like a pennant that has broken out, and whose new high connects to the old high in such a way as to form two tessellating triangles of the same angle.

Don’t just shoot for the moon if this pattern appears, though. It’s contextual, and you should be looking at is as confirmation of an existing trend, rather than an arbitrary indication that the price is about to skyrocket upwards.

Head and shoulders

The simplest explanation is often the best. If it seems like you’re looking at a mountain on your charts, then you’ve probably already seen the top.

A head and shoulders is a reversal pattern marked by three triangles: a left shoulder, a head, and a right shoulder. If you draw a line under the head’s lows, you should find the point at which price is expected to drop off as it completes the right shoulder.

Inverse head and shoulder

This is the exact reverse of a head and shoulders – a pattern that indicates reversal of a bearish trend.

Descending wedge

A descending wedge is quite similar to a flag, except that the price is not range-bound between two parallel lines. Instead, the lows get lower until an upside breakout occurs and the bullish trend resumes.

As you can see, not every wedge is going to conform to the stereotype, or break out in exactly the way you want it to. Once the lows get low enough, look for a quick shooting star up to the top trend line before you place a bullish trade.

Ascending wedge

The wedges are said to be hard to identify and trade accurately. A lot of times, charts are going to show you rising wedges that are just made of noise. The key is to know when it means something significant.

Look for a doji or a hammer (preferably both) around the support line before you take a rising wedge seriously. You will need something to confirm.

Broadening wedge

A broadening wedge comes in two varieties; ascending and descending.

An ascending broadening wedge is a bearish reversal pattern. In an ascending broadening wedge, the two lines are upwards sloping and move away from each other near the end.

A descending broadening wedge is a bullish reversal pattern. In a descending broadening wedge, the two downwards lines move away from each other near the end. Notice that the lines begin by seeming almost parallel, but do quickly deviate is the lows become lower.

Broadening top and bottom

“Broadening top and bottom” is a lower probability reversal pattern, but these can be useful to take note of. As you can see in the next section, a very similar chart setup can also indicate the exact opposite.

Right-angled descending and ascending broadening formations

Broadening tops and bottom are continuation patterns that occur during a trend.

These patterns can be quite useful in Forex as they indicate a failed attempt to reverse the trend. Stops have been taken out, and the way is clear for a continuation once support or resistance is broken.

There is a clear resistance line in this instance, unlike with the broadening top and bottom. New lows are being created within the pattern itself, but no new highs until the eventual breakout.

Make sure to differentiate properly between the above chart patterns.

Conclusion

No trading technique is 100%. These patterns will let you down at times, especially when it comes to unexpected news or announcements (or a bang moment).

The key is not to win all the time, but to lose less. By taking these techniques on board, you can vastly increase your win rate overall, by looking for smarter trading opportunities more often.

Remember, you are a risk manager first and a trader second. When you know the charts like the back of your hand, it’s much easier to exist comfortably in both of these roles.

Categories
Technical Analysis

Fibonacci Levels

You would not think that one of the most popular modern technical analysis tools would be named after a 13th century monk, but then stranger things have happened.

Fibonacci was an Italian mathematician born circa 1170, who introduced the golden ratio to European mathematics.

He also came up with a sequence in which each number, plus the previous number, equals the next number. Thus, the Fibonacci sequence: 1,1,2,3,5,8,13,21 and on it goes forever. His work is interesting for many reasons.https://ads.actionforex.com/www/delivery/afr.php?zoneid=74

It has interesting applications in algebra and geometry (check out the Fibonacci spiral), as well as describing natural phenomena, such as plants flowering and the way leaves grow on trees.

As far as the markets go, some 20th century traders noticed they could apply Fibonacci’s work for their own purposes. Trends, they found, would often conform to certain Fibonacci ratios such as 38.2%, 61.8% or 161.8%.

How to draw Fibonacci levels on your charts

There are several different methods of drawing Fibonacci levels, and within each method several different approaches.

Let’s look at one of the more common ones here.

First you start by drawing from the high of the move to the low of the move using the Fib tool.

You may also draw retracements from the smaller high/lows.

Ideally you would draw them both. When two Fibonacci levels line up it will create a “confluence” which is a stronger technical pattern.

How many timeframes should you look at, or retracements should you draw? It depends on your objectives for your trading plan. Think about the retracements that are going to be relevant to the moves you want to capture.

For example, if you are looking to capture long-term moves that last for 3 months, there is no point drawing intra-day Fibonacci levels.

You can also draw Fibonacci retracements the other way around. That is from the low to the high. This is also how you draw the extension, so sometimes it can be easier to do it this way. If this were, the case, you would invert the comments about the 38.2% and 61.8% retracements, and ignore the 23.6 in the following section.

While technically less correct, I find this way works well for me. You will need to decide what best fits your beliefs about the market.

Fibonacci Retracements

The first way traders use Fibonacci levels is to help time our entries when we buy dips or sell rallies.

Buyers will look for a retracement to a Fibonacci level in an uptrend and sellers will look for a retracement in a downtrend.

The main levels that are used for this purpose are 23.6%, 38.2% and 61.8%. 50% is also important, although it is not strictly a Fibonacci level (see below).

At 23.6%, the pullback has not been adequately tested. You would need to be very confident in your trade to buy here.

38.2% is a safer level. It’s more plausible to buy here than at 23.6%, but not without a good reason. Perhaps the currency you’re backing is strong for fundamental reasons, or perhaps you’ve just seen a strong reversal pattern.

The two main places to bet on a trend resuming organically are the 50% and 61.8% retracement levels, as the sellers look to take their short term profits in what is still a bull market.

The next level of 61.8% is one to watch closely. Once a trend has fallen too far below 61.8%, it’s hard to be confident that the buyers will find their feet again. Often, the 61.8% level can be a good place to hide your stop behind after having made a purchase on the 38.2 or 50% levels.

In general, you want to place your stop behind a level below. Just because you expect the price to move upwards doesn’t mean it won’t poke and prod at lower levels, potentially hitting your stop if it’s placed too close to market price.

As the trade progresses for you, you can look to trail your stop by one level, so that you lock in some profits no matter where the price ends up heading.

The 50% retracements

50% retracement is an important level, even if it doesn’t come directly from Fibonacci’s work. Many traders will look for a 50% pull-back so it is of psychological significance.

For trading purposes you can treat the 50% level just like an “official” Fibonacci level.

Extensions

To create extensions, draw your Fib line the opposite way than you did to get your retracements. In a bull market, you would get extensions by drawing your line from top to bottom.

Extensions help you to plan your exits. These are (again) psychologically significant numbers that market participants tend to respect and plan around time and time again.

161.8% is the first extension. If you have been successful in capturing a move from a retracement level, this is the first level at which it will definitely be tested, and can be a good place to take some profits.

261.8% is the next extension. If the price has made it this far, then it’s again time to think about scaling out or exiting.

423.6% is less commonly used, but if your trade gets here you’ve likely made some serious pips. The chances of a reversal have increased, so you may only want to retain a small portion of your original trade.

Using a retracement as a profit target

You can use previous retracements as profit targets in the short term. If you’re confident the trend has steam left in it, but it has fallen below 61.8%, you can pick off some pips on the way back up to 23.6%.

Alternatively, you may have your eye on a short-term resistance level, such as a double head and shoulders at the 50% retracement from a previous move.

There is no one-size-fits-all approach to trading the markets, and Fibonacci is not a magic bullet. The key is to observe what the market has been doing, as well as what it is doing, and use this to your advantage at all times.

Confluences

When Fibonacci levels combine with other key levels, this creates higher probability trades, as we just discussed.

If price is poised to break out through the 50% retracement on a daily chart, and through another key level on a short-term chart, this can be considered a higher probability trade since buying is clearly beneficial, at least in the short term.

The same goes when price is hovering around ‘big figures’, and especially support and resistance levels. When two or more psychologically important levels align in the same direction, it adds credence to the idea that the trade will be successful, and removes reasons to think the opposite.

There are no certainties, but if you can learn to spot high value trades and execute them quickly, you will be in a much better position than somebody who takes only mediocre trades.

Fibonacci levels and candlestick patterns

Imagine you’re examining a trend, and the very first thing it does is pull back quickly to the 50% retracement. You watch and wait, and see a stubborn doji form. It just won’t seem to budge.

The next candle drags below the 50% retracement, heading for 61.8%. But it quickly picks back up, and becomes a shooting star. You can have a certain amount of confidence now that the trend is set to resume. Why?

Market participants (big and small) were watching this drama unfold, just like you. They had their Fib lines drawn, just like you. If everybody is watching the sellers run out of steam and exit their positions at psychologically important levels, where is the smart money going to be?

This holds true for almost any reversal pattern. The key is to examine what is going on in front of you, in the context of psychologically important Fib levels, because you know everybody else is watching as well.

You can see here a hammer:

Conclusion

We all want to ride the wave, but in order to do this it pays to know where the wave is, and where it may be heading.

Fibonacci can’t tell you what the future will bring, but that’s not where its value lies. Its value lies in the fact that retail traders and institutions alike are conscious of its importance. In many ways it levels the playing field, because everybody is acting on the same information.

If everybody wants to make money, nobody wants to be wrong. If nobody wants to be wrong, everybody is going to try to be right. If everybody is trying to be right, they will examine the best information they have to hand, and act on it.

It’s not magical or prophetic, but it is an essential window into market psychology, and a way to plan your entries, exits, and opportunities to scale in or out. How will you use Fib levels in your trading plan?

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Technical Analysis

Moving Averages

Moving Averages

Moving averages are a staple in the Forex trader’s arsenal.

They help the discerning trader identify, and trade in alignment with, the trend. Both critical components of a winning trading plan.

There are a variety of ways to use moving averages, the most important of which we will cover today.https://ads.actionforex.com/www/delivery/afr.php?zoneid=74

What is a moving average?

Moving averages are simply a visual representation of the average price over a number of time periods. For example, the 200-day moving average is the average price of the last 200 days.

Moving averages are plotted alongside the price on the chart:

Simple vs. Exponential Moving Averages

The most common types of moving average are simple (SMA) and exponential (EMA).

A simple moving average is, as described above, an average of the price over a period of time.

An exponential moving average changes this formula slightly by giving extra weight to recent data, making it more responsive to current price movements.

Which is better?

Both work well, and it is simply a matter of testing what is right for you in terms of what you’re trying to achieve at any given point in time.

Leading vs lagging

Moving averages are lagging indicators.

Lagging indicators tell you what has happened in the past, but do not forecast future price moments. This is useful for defining the trend, or identifying support and resistance levels.

In contrast, a leading indicator is designed to predict where the price will move to next. There is a way to turn a moving average into a leading indicator, which we will discuss later in this article.

Defining the trend

One of the most popular ways to use moving averages is to define the longer-term trend.

This is done by plotting a long-term moving average on your chart: 100 or 200 periods are both common, or 50 period for shorter trends.

When the price is trading below the moving average, it confirms we are in a downtrend. When it is trading above the moving average, then it confirms the uptrend.

Moving average cross-overs

One of the most common uses of the moving average is the cross-over.

When a shorter-term moving average crosses over the longer-term moving average it signals a shift in momentum.

For example, suppose a moving average of the price over the last 10 days crosses over the moving average of the last 100 days. Something has happened to the momentum, and it seems to be continuing to happen. Better yet, you have the proof right in front of you.

A cross up indicates the buyers are regaining control, while a cross down indicates the sellers are in the ascendance.

A variation of this approach is to watch for the price to cross over the moving average. You could wait for a price to trade over the moving average, or you could wait for the price to close over the moving average.

These cross overs can be used as entry signals to capture trends.

Avoiding whipsaws

One mistake traders make is to trade every cross-over of the moving average.

This is a dangerous practice in choppy conditions, as you will get stopped out for a loss time and time again.

Thus, you should only trade a cross-over when you have an expectation that a trend is going to either eventuate or continue.

This could be for fundamental reasons, because you are in a longer-term technical trend, or because you have seen a chart pattern that you think will act as a catalyst.

Some traders will wait for the price to close over the moving average, rather than simply crossing it, in order to avoid false breaks. This is another strategy you can test.

Multiple moving averages

Another method of using moving averages is to combine several progressively faster moving averages on the chart at once.

This could be 200, 100, 50, 25, 10 period moving averages.

When the moving averages are spread out like a fan in the correct order, then it is an indication that the trend is clearly established and you can confidently trade in that direction (for the time being).

When they are not in alignment, or are tightly coiled around each other, then it is an indication that the markets are sideways. You should either stay out, or apply a counter-trend approach to trading these conditions.

Perhaps you have a feeling a breakout is coming, but want to confirm that the market is still technically sideways before you place the trade. Whatever your perception, it is helpful to have the facts in front of you, in an easy to read format such as with moving averages.

Displaced Moving Averages

Displacing a moving average is the practice of shifting it forward in time.

This turns the moving average into a leading indicator, as it is now predicting where the trend will be in future, rather than telling you where it has been in the past.

For example, if the moving average is displaced forward in time by 5 periods, and you believe that the trend is going to hold relatively steady, then you have a visual marker of where the price will be if you’re correct. This can be helpful in timing entries and picking where to take profits.

Moving Averages as support and resistance

Some major moving averages will act as support and resistance levels. The 200 day moving average is an example of moving average that is commonly used like this:

The reason that some moving averages work as support and resistance has to do with market psychology. As the moving average is so closely watched by a large number traders, when the price gets near it, then buying or selling activity kicks in.

This means that if the price falls to the moving average it can cap losses and vice-versa for gains.

Sometimes the simplest approach is the best

Moving averages have stood the test of time.

They are visually simple, easy to apply, and allow for a common-sense approach to the markets.

When you add a moving average into your trading plan, it should have a specific job to do. Understand the type of trend you are looking to capture, and pick the moving average that is best suited helping you trade it.

Don’t overcomplicate things, and you will find moving averages to be one of the most powerful tools in your trading arsenal.

Categories
Technical Analysis

Candlesticks

The development of the school of charting called Candlestick analysis is initially credited to a 17th century Japanese rice trader named Homma form the town of Sakata.

Over time, Candlesticks have evolved to become one of the predominant methods of technical analysis used universally across markets and cultures.

Candlesticks can be used not only to determine the market’s direction, but its turning points as well. They also work nicely in conjunction with support and resistance levels as outlined in part 1 of this series.https://ads.actionforex.com/www/delivery/afr.php?zoneid=74

Candlestick analysis is a broad topic, and can be studied in-depth. Today, we keep it simple by looking at two powerful yet easy to use methods, for trading trends and reversals.

But first let’s cover some basics.

Candlestick Basics

A candlestick consists of four data points over any given time period: the high, low, open and close. The thin part (the wick) represents the high and low. The fat part (the body) represents the open and close.

If the body of the candle is dark (or red in the below example), it means the price closed below the open (a bearish candle). If it is hollow (or green in the below example), it means the price closed above the open (a bullish candle).

You can see here a candlestick chart of the AUDUSD

Strategy #1 Candlestick Reversals Patterns

There are several reversal patterns you can use in your trading, the first of which is Pin Candles.

Pin Candles have a large wick and a short body, and are excellent for identifying turning points. A Pin candle is also known as a “hammer” (bullish) and a “shooting star” (bearish).

The reason pin candles are of significance is due to market psychology. The pin candle represents an attempt by participants to reach a new high or low, but the market quickly rejects the attempts. This indicates the buyers are coming back into the market in force for a bullish pin candle, or the sellers are regaining control for a bearish pin candle.

You want to look for these candles to occur against an existing trend and not within it.

Yes /No

Here is an example of a pin candle reversal on a 4 hour chart of the EURUSD

For a high probability trade, look for the pin candle to occur at a key support and resistance level.

Another reversal pattern is a Doji in combination with a long bodied candle.

A doji is a compressed looking candlestick with a small body and small wicks. It signifies an intense struggle between buyers and sellers, in which neither side gains any real ground.

As you can see below, the open is barely any different to the close. Same goes for the high and low. Over the course of an hour, for instance, the price may have moved only 10 pips.

In an uptrend, this can mean the buyers have run out of momentum. In a downtrend, this can mean the sellers have exhausted themselves. It is a sign of equilibrium, and equilibrium is a sign of a changing power dynamic.

Doji

Therefore, look for a doji after a long bullish or bearish candle to signal the trend may be coming to an end.

Once you see a doji, it’s best to wait for an entry signal in the form of a bullish or bearish candle against the trend.

Another very useful reversal pattern is “three white soldiers” (bullish) or “three black crows” (bearish). Look for three candles to form against the trend:

Here is an excellent example of this pattern occurring on this AUDUSD chart.

Strategy #2 Engulfing candles in a trend

An engulfing candle is when a larger candle “engulfs” the previous smaller candle. While they occur often at support and resistance levels, they are commonly found in trends.

A bullish engulfing candle signals an uptrend is about to continue, whereas a bearish engulfing candle indicates a downtrend is likely to resume.

The trick to this approach is waiting for the price to be in a trend first.

Here is an example on the 15 minute chart of the USDJPY.

Engulfing candles work well on both short and long-term charts.

Here is an example on the weekly chart of the USDCAD.

You can also look for Pin candles to signal a resumption of the trend. Look at the pin candle below. The buyers took the price right up to the high, and yet it fell to the close, which is halfway to the low.

In simple terms, the buyers tried unsuccessfully to push the price up to a new high, but were defeated. They found it impossible to break the trend. Given this knowledge, where would your loyalties lie?

Tick Volume

In Forex, unlike in stocks, you do not have access to volume in the traditional sense. Forex is not traded on an exchange like stocks are, and therefore there is no central place for recording volume.

Instead, Forex traders use “tick volume”, which represents the number of price changes per trading period rather than the total volume of trades. These volumes can be very telling.

Consider:

If the price has changed few times, and even this is enough to move a candlestick significantly in one direction, then there was little confidence in the trend, and little resistance to change. More traders may be about to jump on board and move the price even further. (Be wary of volatile price action, especially in illiquid pairs.)

If 2000 price changes have produced nothing but a doji, opinions are clearly divided and price may trend sideways for some time to come.

Alternatively, dojis can precede an imminent breakout: the rationale here being that fierce competition will lead to an avalanche if one side pulls out of the war completely. When this happens, look for an engulfing candle to confirm, and then place a trade in the direction of the new trend.

As you can see, it can be immensely useful to add a tick volume indicator to your chart. When you see a candlestick pattern with above average tick volume, then it can lead to a higher probability trade if you are able to interpret its meaning.

Keep it simple

It can be easy to overcomplicate your technical analysis methods. It’s not rocket science, and there’s no need to treat it as such. We’re simply trying to become attuned to the market. Every candle tells a story, and once you can contextualise these stories, your trading will be a lot more intuitive.

Candlesticks provide some simple ways to get in on a trend, or to trade a reversal. Not a whole lot more, but certainly nothing less. Get out your trading plan now and have a think about how candlestick techniques can work for you.