Categories
3. Advance Tutorials

Trading Rules to Live By

What most professional traders have in common is the discipline to follow some of the basic forex trading rules.

Let us now see what these rules are. The rules are listed as follows −

Start slow

For an amateur trader, it is always better to start slow and with less money. Do not expect or think that your first trade will be a jackpot. It is common that your first trade will not work as planned. If you lose too much money, you will be out of the game soon and if you make too much (then you anticipated) money, then because of your over-confidence, you will do over-trading and loose most of what you gain.

Limit your losses

You should have an exit plan before you enter any trade. You should have strict stop loss in case trade is not going in your favour. If your trade is with the trend, you should readjust your stop losses and hold onto your profit. In order to keep these nightmares (your losses) from occurring, a trader should follow strict stop loss and exit the trade in case of losing trades before they turn into disasters.

Hold on to your profits

Many traders have no problem cutting losses but they also insist on exiting trades at the first sign of profits. However, they eventually see that their small profits could turn huge if they hold onto their position for little longer. The strategy here should be – “cut your losses and hold onto your gains”.

Trading strategy

A good trading strategy is required. However, money management is also very important. Your trade risk should not be more than 2% of your account in each trade.

Listen to the charts (technical indicators)

Everything is reflected in the price and volume when it comes to technical analysis. Master the skill of understanding different indicators and use it.

Categories
3. Advance Tutorials

Foreign Exchange Risks

Banks have to face exchange risks because of their activities relating to currency trading, control management of risk on behalf of their clients and risks of their own balance sheet and operations. We can classify these risks into four different categories −

  • Exchange rate risk
  • Credit risk
  • Liquidity risk
  • Operational risk

Exchange Rate Risk

This relates to the appreciation or depreciation of one currency (for example, the USD) to another currency (base currency like INR). Every bank has a long or short position in a currency, depreciation (in case of long position) or appreciation (in case of short position), runs the risk of loss to the bank.

This risk mainly affects the businesses but it can also affect individual traders or investors who make investment exposure.

For example, if an Indian has a CD in the United States of America worth 1 million US Dollar and the exchange rate is 65 INR: 1 USD, then the Indian effectively has 6,50,00,000 INR in the CD. However, if the exchange rate changes significantly to 50 INR: 1 USD, then the Indian only has 5,00,00,000 INR in the CD, even though he still has 1 million dollars.

Credit Risk

Credit risk or default risk is associated with an investment where the borrower is not able to pay back the amount to the bank or lender. This may be because of poor financial condition of the borrower and this kind of risk is always there with the borrower. This risk may appear either during the period of contract or at the maturity date.

Credit risk management is the practice of avoiding losses by understanding the sufficiency of a bank’s capital and loan loss reserves at any given time. Credit risk can be reduced by fixing the limits of operations per client, based on the client’s creditworthiness, by incorporating the clauses for overturning the contract if the rating of a counterparty goes down.

The Basel committee recommends the following recommendations for containment of risk −

  • Constant follow up on risk, their supervision, measurement and control
  • Effective information system
  • Procedures of audit and control

Liquidity Risk

Liquidity refers to how active (buyers and sellers) a market is. Liquidity risk refers to risk of refinancing.

Liquidity risk is the probability of loss arising from a situation where −

  • there is not enough cash to meet the needs of depositors and borrowers.
  • the sale of illiquid assets will yield less than their fair value
  • the sale of illiquid asset is not possible at the desired time due to lack of buyers.

Operational Risk

The operational risk is related to the operations of the bank.

It is the probability of loss occurring due to internal inadequacies of a bank or a breakdown in its control, operations or procedures

Interest Rate Risk

The interest rate risk is the possibility that the value of an investment (for example, of a bank) will decline as a result of an unexpected change in interest rate.

Generally, this risk arises on investment in a fixed-rate bond. When the interest rate rises, the market value of the bond declines, since the rate being paid on the bond is now lower than the current market rate. Therefore, the investor will be less inclined to buy the bond as the market price of the bond goes down with a demand decline in the market. The loss is only realized once the bond is sold or reaches its maturity date.

Higher interest rate risk is associated with long-term bonds, as there may be many years within which an adverse interest rate fluctuation can occur.

Interest rate risk can be minimized either by diversifying the investment across a broad mix of security types or by hedging. In case of hedging, an investor can enter into an interest rate swap.

Country Risk

Country risk refers to the risk of investing or lending possibly due to economic and/or political environment in the buyer’s country, which may result in an inability to pay for imports.

Following table lists down the countries, which have lower risks when it comes to investment −

RankRank Change (from previous year)CountryOverall Score (out of 100)
1Singapore88.6
2Norway87.66
3Switzerland87.64
4Denmark85.67
52Sweden85.59
6HTML-5 1Luxembourg83.85
7HTML-5 2Netherlands83.76
8HTML-5 3Finland83.1
9Canada82.98
10HTML-5 3Australia82.18

Source: Euromoney Country risk – published January 2018

Trading Rules To Live By

Money Management and Psychology

Money management is an integral part of risk management.

Understanding and implementation of proper risk management is as much more significant than understanding of what moves the market and how to analyse the markets.

If you as a trader making huge profits in the market on a very small trading account because your forex broker is providing you 1:50 leverage, it is most likely that you are not implementing sound money management. May be you are lucky for one or two days but you have exposed yourself to obscene risk because of an abnormally high “trade size”. Without proper risk management and if you continue trading in this fashion, there is a high probability that very soon you would land with series of losses and your loose you entire money.

Against the popular belief, more traders fail in their trade not because they lack the knowledge of latest technical indicator or do not understand fundamental parameters, but rather because traders do not follow most basic fundamental money management principals. Money management is the most overlooked, yet also the most important part of financial market trading.

Money management refers to how you handle all aspects of your finances involving budgeting, savings, investing, spending or otherwise in overseeing the cash usage of an individual or a group.

Money management, risk to rewards works in all markets, be it equity market, commodity or currency market.

Categories
3. Advance Tutorials

Position Sizing & Money Management

An important aspect of forex trading success is taking the correct position size on each trade. A trader position size or trade size is considered more important than your entry or exit point especially in forex day trading. You might have the best trading strategy but if you do not have proper trade size, you will end up facing risks. Finding the proper position size will keep you within your risk comfort level is relatively safe.

In forex trading, your position size is how many lots (mini, micro or standard) you take on your trade.

We can divide the risk into two parts −

  • trade risk
  • account risk

Determining your Position Size

Follow these steps to get the ideal position size, irrespective of the market conditions −

Step 1: Fix your account risk limit per trade

Set aside the percentage amount of your account you are willing to risk on each trade. Many professionals and big traders choose to risk 1% or less of their total account on each trade. This is as per their risk taking capacity (here they can deal with 1% loss & the other 99% amount still remains).

Risking 1% or less is ideal but if your risk capacity is higher and you have a proven track record, risking 2% is also manageable. Higher than that of 2% is not recommended.

For example, on a 1,00,000 INR trading account, risk no more than 1000 INR (1% of account) on single trade. This is your trade risk and is controlled by the use of a stop loss.

Step 2: Determine pip risk on each trade

Once your trade risk is set, establishing a stop loss is your next step for this particular trade. It is the distance in pips between your stop loss order and your entry price. This is how many pips you have at risk. Based on volatility or strategy, each trade is different.

Sometimes we set 5 pips of risk on our trade and sometimes we set 15 pips of risk. Let us assume you have 1,00,000 INR account and a risk limit of 1,000 INR on each trade (1% of account). You buy the USD/INR at 66.5000 and place a stop loss at 66.2500. The risk on this trade is 50 pips.

Step 3: Determining your forex position size

You can determine your ideal position size with this formula −

Pips at Risk * Pip Value * Lots traded = INR at Risk

It is possible to trade in different lot sizes in forex trading. A 1000 lot (called micro) is worth $0.1 per pip movement, 10,000 lot (mini) is worth $1, and a 100, 000 lot (standard) is worth $10 per pip movement. This applies to all pairs where the USD is listed second (base currency).

Consider you have $10,000 account; trade risk is 1% ($100 per trade).

  • Ideal position size = [$100 / (61 * $1)] = 1.6 mini lots or 16 micro lots

Creating a Forex trading spreadsheet to track your performance

Creating and maintaining a forex trading spreadsheet or journal is considered a best practice, which not only helps an amateur forex trader but also a professional trader.

Why do we need it?

We need a trading spreadsheet to track our trading performance over time. It is important to have a way to track your results so that you can see how you are doing over a couple of trades. This also allows us to not get caught up on any particular trade. We can think of a trading spreadsheet as a constant and real reminder that our trading performance is measured over a series of trades not only based on one particular forex trade.

Not only we keep track of our trades with the help of spreadsheet, we keep track of trends with different currency pairs, day after day, without layers of technical indicators.

Consider this sample of a forex trading spreadsheet −

Spreadsheet

Documenting your forex trading activity is necessary and serves as a helpful component to becoming a professional forex trader.

Foreign Exchange Risks

Every country has its own currency just as India has the INR and the USA has USD. The price of one currency in terms of another is known as exchange rate.

The assets and liabilities or cash-flow of a company (like Infosys), that are denominated in foreign currency like the USD (US dollar) undergo a change in their value, as measured in domestic currency like the INR (Indian rupees), over a period of time (quarterly ,halfyearly etc.), because of variation in exchange rate. This change in the value of assets and liabilities or cash flows is called the exchange rate risk.

So, foreign exchange risk (also called “currency risk”, “FX risk” or “exchange risk”) is a financial risk that exists when the company financial transaction is done in currency other than that of the base currency of the company.

This uncertainty about the rate that would prevail on a future date is known as exchange risk.

Categories
3. Advance Tutorials

The Commodity Connection

The movement of foreign exchange prices is based on multiple factors including demand & supply, economic factors (GDP, CPI, PPI), interest rates, inflation, politics. Since the economic growth and exports of a country are directly related, it is very natural for some currencies to heavily depend on commodity prices.

The economic growth of countries like Saudi Arabia, Russia, Iran (largest oil producing countries) is heavily dependent on the prices of crude oil (commodity). A couple of years back, when crude oil prices exceeded $100 per barrel, stock market and currency market responded very positively (strong currency) and then in 2016-17 when crude oil prices went down below $30 per barrel, financial market responded very negatively. The prices went down by 7% in a single day (stock market, extreme volatility), currency prices goes down. Since specifically few countries which are commodity exporting countries, economic growth is directly related to commodity prices. As we know, strong economic growth in a country means stronger its currency.

Specifically in case of dollar, there is an inverse relationship between the dollar prices and commodity prices. When the dollar strengthens against other major currencies, the commodity prices drops and when dollar weaken against other major currencies, the prices of commodities generally moves higher.

But why so??

The main reason is that the dollar is the underlying (benchmark) pricing mechanism for most commodities. The US dollar ($) is considered as the reserve currency of the world. As it is considered as the safe-haven currency ($), most countries hold dollars as reserve assets. In case of raw material trade (export/import), the dollar is the exchange mechanism for many countries if not all. When the dollar is weak, it costs more dollars to buy commodities. At the same time, it costs lesser amount to other country currency (JPY, EURO, INR) when dollar prices are down.

Generally Higher Interest rates lead to lower commodity prices. For example, if the RBI (India central bank) raises interest rates, that may reduce the level of economic activity and thereby lower commodity demand.

For countries like India, which is very large oil importer. Low oil prices is good for oil importing countries because when oil prices come down, inflation will cool down and with that interest rates will come down and that will increase economic growth.

Categories
3. Advance Tutorials

The Role of Inflation

Inflation gives very good indication of the current account balance of a country. Inflation measures the rate of change in prices of goods and services over a given period. An increase in inflation indicates prices are quickly rising and if the rate of inflation decreases, the prices of goods and services are increasing at a slower rate.

The rise and fall of inflation within a country also provides information about the medium term direction in foreign exchange and the current account balance of a country is also used to determine the long term movements of foreign exchange.

Higher and Lower Inflation

It is a general belief (among economic theories) that low inflation is good for the economic growth of a country while high inflation points to poor economic growth. High inflation in a country means the cost of consumer goods is high; this points to less foreign customers (less foreign currency) and the country’s trade balance is disturbed. Lesser demand of the currency will ultimately lead to a fall in currency value.

Foreign exchange is very much affected by inflation which directly affects your trades. Declining exchange rate decreases your purchasing power. This in turn will influence the interest rates.

Following diagrams show the relation between inflation, interest rates and the economic growth of a country −

Relation Between Inflation

A detailed knowledge on inflation helps you to make your forex market trades profitable.

Let us now see the major indicators of inflation that the market tends to watch at all times especially in forex market trades.

Gross National Product (GNP)

It is the output of the citizens of the country (like India or US) and the income from assets owned by the country entities, regardless of the location; whereas, the Gross Domestic Product (GDP) represents the total monetary value of all goods and services produced ver a specific time period – the size of the economy.

GDP is usually expressed in comparison to previous year or previous quarter (3 month). For example, if the year-to-year GDP is 4%, this means the economy has grown by 4% over the last year.

GNP defines its scope according to ownership (irrespective of location); whereas, GDP defines its scope according to location.

In 1991, the US switched from using GNP to using GDP as its primary measure of production.

GDP has a direct impact on nearly every individual of the country. A higher GDP indicates there is low unemployment rate, higher wages as businesses demands labor to meet the growing economy.

How GDP affects Forex market?

Every economic data release is essential for a forex trader; the GDP data holds a lot of importance as it directly indicates the overall state of a country. As GDP data may create lots of volatility in the currency market, traders try to create a new position or may hedge their existing position (long or short position).

If the country economy is growing (GDP), the benefit will eventually affect the consumer; this leads to an increase in spending and expansion. Higher spending leads to increase in prices of consumer goods which country central bank will try to tame if they begin to outpace the rate of economic growth (high inflation).

Producer Price Index

The producer price index or PPI in short, is a monthly report detailing the purchasing price of various consumer goods. It measures the change in prices charged by wholesalers to their clients like the retailers who then add their own profit margin to the producer’s price and sell it to consumer.

It is important because traders mainly use the PPI as an indicator of price inflation over time. One major drawback especially for forex market traders is that PPI excludes all data on imported goods, making it difficult for traders or investor to detect the influence of one country’s market on another with respect to currency prices.

In general, the PPI is more volatile with larger fluctuations than the CPI (Consumer Price Index), is giving a macro sense of the underlying price developments that are not necessarily reflected on consumer’s bills.

Consumer Price Index (CPI)

The Consumer Price Index (CPI) proves effective on central banks (like RBI, US Federal Reserve), and market participants. It holds more significance when compared with the PPI.

CPI indicates the cost of living in a country, has a direct effect on interest rates.

It CPI index measures the prices changes at the retail level. It stores the price fluctuations only to extent that a retailer is able to pass them on to the consumer.

Higher CPI gives central banks (RBI, FED) the necessary supportive data to rate hikes (though it’s not the only factor which central bank looks for). Higher interest rates are bullish for the country’s currency.

The CPI includes sales taxes number but excludes income taxes, prices of investments like bonds or prices of homes.

The CPI report is generated monthly and covers data of the preceding month.

The core CPI is the most noticeable figures among market participants. This does not include food and energy prices and central bank (to adjust its monetary policy

Categories
3. Advance Tutorials

Oscillator Divergences

Divergence simply means “separate”. Generally, the price of a security and indicator follow the same path. This is confirmed by the oscillator and traders can expect the trend to continue.

There comes a point when the path of the oscillator and price divert from each other. At this point, divergence pattern also indicates that the trend is weaker. After the divergence signal appears, there is a higher chance of reversal, especially if divergence appears on a higher time frame.

Technical Indicators

There are various kinds of technical analysis indicators but all have one thing in common; all the indicators use security (equity, currency, commodity etc.) prices (open, high, low, close and volume) in their calculations.

We can divide all technical indicator into two main types −

  • Leading Indicators − Leading indicators lead the price movement. These indicators give signal before a new trend or when a reversal occurs.
  • Lagging Indicators − Lagging indicators follow the price action. These indicators give signal after the trend or when a reversal has started.

Categories of Indicators

The different types of indicators fall under the following categories −

  • Trend Indicators
  • Volume Indicators
  • Momentum Indicators
  • Volatility Indicators

Trend Indicators

Trend indicators show traders/investors the trend or direction of the security being traded. A trend can be one of these −

  • Bullish trends (security prices go up with minor downfall).
  • Bearish trends (security prices come down with minor up movement).
  • Sideways trends (security prices are moving in a tight range and not giving any signal of upward or downward major movement).

Note − Security can be an equity (stock), commodity (like gold) or currency (USD).

Following are some of the major trend indicators −

  • Moving averages
  • MACD
  • Average directional index
  • Linear regression
  • Forecast oscillator
  • Parabolic SAR

Example

We can buy a security (USD) if its closing price is higher than the 30 days simple moving average −

  • BUY (when) close > sma(30)

Volume Indicators

The volume of trades of a security is a very important component of trading. Every trader takes notice of the volume of trades in determining the signal (buy, sell or hold) strength.

Following are some important volume indicators −

  • Money Flow Index
  • Ease Of movement
  • Chaikin money flow
  • On balance volume
  • Demand index
  • Force index

Example

Many tradersr sell the security when Money Flow Index enters an oversold area −

  • sell (when) mfi(30) < 30

Momentum Indicators

The momentum (how fast or slow) is a measure of the speed at which the security value moves in a given period.

Most traders follow momentum indicators where security price is moving in one direction with huge volumes.

Commonly used momentum indicators are as follows −

  • RSI
  • Stochastics
  • CCI
  • Commodity Channel Index
  • Williams %R

Chande’s momentum oscillator

Traders used momentum indicators to determine overbought and oversold positions.

Example

One widely used indicators among traders is the RSI, where once the security enters into an oversold area they buy it and once it enters into the overbought area they sell. It is determined by the Relative Strength Index indicator (RSI).

Volatility Indicators

Most traders use volatility indicators to get the buy or sell signals .

The volatility is the rate of change or relative rate at which the security prices move (up or down). A high volatile security means prices can suddenly move very high or very low over a short period of time. Inversely, if the security is less volatile, it means its prices move gradually.

Following are a few commonly used volatility indicators −

  • Bollinger bands
  • Envelopes
  • Average true range
  • Volatility channels indicators
  • Chaikin volatility indicator
  • Projection oscillator

Though volatility is usually measured in standard deviation, there are many other measures to check the volatility of assets −

  • Close-to-Close ( C )
  • Exponentially weighted ( C)
  • Parkinson (HL)
  • Garman-Klass (OHLC)
  • Rogers-Satchell (OHLC)
  • Yang-Zhang (OHLC)

Here,

  • O = Open price
  • C = Close price
  • L = Low price
  • H = High price of the security

Example

Let us take the Bollinger band indicator for example. A trader may sell a security when the prices go below the lower Bollinger band.

  • sell (when) prices cross(BbandsLower (30, 2, _MaSma), close)

Relative Strength Index (RSI)

The RSI is part of a class of indicators called the momentum oscillators.

An oscillator is an indicator that moves back and forth across a reference line or between prescribed upper and lower limits. When an oscillator reaches new high, it shows that an uptrend is gaining speed and will continue to do so. Inversely, when an oscillator traces a lower peak, it means the trend has stopped accelerating and a reversal can be expected from there.

The momentum oscillator like the RSI is referred to as a trend-leading indicator. The momentum is calculated as the ratio of positive price changes to negative price changes. The RSI analysis compares the current RSI against neutral (50%), oversold (30%) and overbought (70%) conditions.

The following figure shows the RSI analysis of USDINR where RSI shows a value of 57.14 % value, which is between neutral and oversold.

Relative Strength

Application of RSI

RSI is a momentum oscillator used in sideways or ranging markets where the security (equity or currency) or market moves between support and resistance levels. Many traders to measure the velocity of directional price movement use it.

Overbought and Oversold

The RSI is a price-following oscillator that ranges between 0 and 100. Mostly, traders use 30% as oversold region and 70% as overbought region to generate buy and sell signals. Traders or TA generally abide by the following −

  • Go long when the indicator moves from below to above the oversold line.
  • Go short when the indicator moves from above to below the overbought line.

Following is a silver chart showing buy and sell point, and failure in trending market.

Oscillator Ranges

Divergence

The way to look at RSI is through divergences between price peaks/troughs and indicator peaks/ troughs.

A positive divergence occurs when the RSI makes a higher bottom despite lower trending by share price. This indicates the downward movement is running out of strength and an upward reversal can soon be expected.

Similarly, a negative divergence occurs when the RSI starts failing and makes a lower top despite share prices moving higher. Since there is less power or support for the new higher price a reversal could be expected.

A bullish divergence represents upward price pressure and a bearish divergence represents downward price pressure.

The following diagrams show strong divergence −

Strong Divergence

The following diagram shows moderate divergence −

Moderate Divergence
Negative Divergence

Estimating Price Targets

Traders and investors benefit by trading in the direction of the trend. The RSI is also used for determining and confirming the trend.

A security (stock or currency) which is in strong uptrend will rarely fall below 40 and usually moves between 40 and 80 levels. In such a case, when the RSI approaches 40, a trader can use this opportunity to buy, and when it comes close to 80, it can be a squareoff signal. Therefore, traders should not go short on a counter that is in a strong uptrend. Similarly, if the security is in a strong downtrend, its RSI usually moves between 60 and 20; and if it comes close to 60, it can be used for selling short.

Failure swings are considered as strong signals of an impending reversal.

Bullish Failure Swing (for buying)

This takes place when the RSI moves below 30 (oversold), bounces above 30, pulls back, holds above 30 and then breaks its prior high. It moves to oversold levels and then a higher low above oversold levels.

Bearish Failure Swing (for selling)

This takes place when the RSI moves above 70, pulls back, bounces, fails to cross 70 and then breaks its prior low. It is a move to overbought levels and then a lower high below overbought levels.

The following diagrams show the Bullish and Bearish Swing Failure −

Bearish Failure Swing

برآورد اهداف قیمت

معامله گران و سرمایه گذاران از معامله در جهت روند سود می برند. RSI همچنین برای تعیین و تأیید روند استفاده می شود.

یک اوراق بهادار (سهام یا ارز) که در روند صعودی قوی قرار دارد به ندرت به زیر 40 سقوط می کند و معمولاً بین 40 تا 80 سطح حرکت می کند. در چنین حالتی، زمانی که RSI به 40 نزدیک می شود، یک معامله گر می تواند از این فرصت برای خرید استفاده کند و زمانی که به 80 نزدیک شود، می تواند یک سیگنال مربعی باشد. بنابراین، معامله گران نباید از کانتری که در یک روند صعودی قوی است کوتاه بیایند. به طور مشابه، اگر امنیت در یک روند نزولی قوی باشد، RSI آن معمولا بین 60 تا 20 حرکت می کند. و اگر نزدیک به 60 باشد می توان از آن برای فروش کوتاه استفاده کرد.

نوسان‌های شکست به‌عنوان سیگنال‌های قوی از یک برگشت قریب‌الوقوع در نظر گرفته می‌شوند.

نوسان شکست صعودی (برای خرید)

این زمانی اتفاق می‌افتد که RSI به زیر 30 می‌رسد (افراد فروش)، به بالای 30 می‌رود، عقب می‌نشیند، بالای 30 نگه می‌دارد و سپس بالاترین قیمت قبلی خود را می‌شکند. به سطوح فروش بیش از حد و سپس پایین تر از سطوح فروش بیش از حد می رود.

نوسان شکست نزولی (برای فروش)

این زمانی اتفاق می‌افتد که RSI بالاتر از 70 حرکت می‌کند، عقب می‌کشد، پرش می‌کند، از 70 عبور نمی‌کند و سپس پایین‌ترین حد قبلی خود را می‌شکند. این حرکتی است به سطوح خرید بیش از حد و سپس بالاترین پایین تر زیر سطوح خرید بیش از حد.

نمودارهای زیر شکست نوسان صعودی و نزولی را نشان می‌دهند –

Barish Failure Swing
Categories
3. Advance Tutorials

Technical Strategy in Price Patterns

Technical analysis is based on the assumption that security (e.g. currency pair) prices move in trends. In addition, trends do not last forever. They eventually change direction from one trend to another. Typically, prices move randomly from decelerate, pause and then reverse. This change in phases (trends) occurs as traders or investors form new expectations and by doing so, shift the security (equity or currency pair) supply/demand lines.

This change of expectation of traders/investor often causes price patterns to emerge.

Price patterns can last for couple of days to multi-months and sometime multi-years also.

Price Action Patterns

To understand price action, you need to know how the security or market behaved in the past. This is followed by observing what is happening in the present and then based on past and present market behavior; predict where the market will move next.

A technical analyst or a trader tries to make a trading decision or suggestion based on repeated price patterns of past that were once formed, they predict what direction the security or market is most likely to move.

The common tools to find price patterns are −

  • chart pattern
  • candlestick patterns
  • trendlines
  • price bands
  • support and resistance levels
  • Fibonacci retracement levels, etc.

Because price patterns are technical strategy, we ignore the fundamental analysis – the underlying factor that moves the market. Nevertheless, if we are dealing with FX trade, this fundamental has a huge impact specially on major economic news announcements like the Interest Rate decisions from the central bank, Non-Farm Payroll data, FOMC meet, etc.

Pattern Types

The pattern types are divided into two major categories −

  • Continuation pattern
  • Reversal pattern

Continuation Patterns

Continuation patterns are used to find opportunities for traders or technical analyst to continue with the trend.

Generally after a huge price rally, buyers usually close all their long positions, take a pause to “breath” before starting to buy again. Similarly, after a big drop in prices, sellers will take a pause and get out of their short position before continuing to sell again. During pause after a huge rally or selloff, prices consolidate and end up forming certain patterns.

Continuation patterns are said to be complete once the prices break out and continue in the direction of their prevailing trend (uptrend or downtrend).

The most common continuation patterns are −

  • Flags
  • Pennants
  • Triangles
  • Wedges
  • Rectangles

Reversal Patterns

It shows a transitional phase that points to the turning point between up trending or down trending market or security.

We can consider this as a point where in a downtrend of a market or security, more buyers find a value attractive (in investing or trading, may be buyers find the fundamentals are not that weak and its current value is good to buy) and they outweigh the sellers. At the end of uptrend market or security, the reverse process occurs (the sellers outweigh the buyers).

The most important reversal patterns are −

  • Head & Shoulders & Inverse Head and Shoulders
  • Rounding Bottom
  • Double tops and bottoms
  • Triple tops and bottoms
  • Spike (V)

Building the Price Pattern Rules

A market participant who knows how to use the price action pattern correctly can often increase his performance and his way of looking at charts significantly.

Follow these rules while building price patterns −

Highs and lows

The correct analysis of high and low points of a security or market provides information about trend strength, trend direction and can even give some hint on the end of trends and trade price reversal in advance. These high and low points also build the foundation of the Dow Theory, which has been around for decades and is a principle commonly practised by technical analysts.

Uptrends – Higher highs and higher lows

A security (stock/ currency) is in uptrend if the highs and lows rise. The rising highs show that there are more buyers to push the price higher and rising lows show that during security correction, sellers are losing ground on each correction.

A trend change

Whenever we see a market or security price fail to make a new high (previously uptrend) or new low (previously downtrend), it can serve as an early warning signal that a change in direction (trend is breaking) is imminent.

Strength of a trend: length and steepness of trend-waves

The strength of a trend is determined by the trend waves it creates between the highs and lows. The length/size and the steepness of those individual trend waves determine the strength of a trend.

Consider the following chart to understand this −

Strength Trend

In the above chart, we can see the first trend wave (1) was the longest and very steep. The second trend wave (2) is shorter and less steep and the third trend wave (3) is the shortest and marginally passes the previous high (that shows the saturation point is near, and a trend reversal might happen.). Therefore, we can anticipate the trend reversal (direction) by understanding the concepts of trend-wave length and its steepness.

Strength of trends: depth of pullbacks

Once we have identified the current trend of the market/security, the pullbacks within that trend can provide valuable information about the future direction.

Provide Valuable Information

In the above chart, we can see that the major trend (trend line 1) is uptrend with many consolidation and retracements (minor trend line – 2, 3, 4, 5, 6). However, just before the trend reversal sign indicates (downtrend), the final retracement is much larger in size and duration (time), indicating a change in demand-supply scenario.

Categories
3. Advance Tutorials

Pattern Study of Trends, Support and Resistance

In technical analysis, support and resistance represent the critical point where the forces of supply and demand meet. The other key points of TA, such as price patterns, are based on support and resistance points.

A support line refers to that level beyond which a stock (or currency pair) price will find buyers and chances of it (security) will not fall. Therefore, it denotes, the price level at which there is a sufficient amount of demand.

Similarly, a resistance line refers to that level beyond which a stock (or currency pair) price will find sellers and chances of it (security) will not rise. It indicates the price point at which there is sufficient amount of supply available to stop and possibly, for a time, turn upward trend.

Kinds of Trends

In the forex market, trends reflect the average rate of change in price over time. Trends exist in all markets (Equity, FX or commodity) and in all time frames (minutes to multiyears). A trend is one of the most important aspects, which traders need to understand. The traders should analyse which way the market or security (stock, currency pair) is heading and should take position based on that.

Following are the different types of trends in the forex market −

  • Sideways trends (range bound)
  • Uptrend (higher lows)
  • Downtrend (lower highs)

Sideways Trends

Sideways trends indicates that a currency movement is range-bound between levels of support and resistance. It usually occurs when the market does not have a sense of direction and ends up consolidating most of the time in this range only.

To identify if it is a sideways trend, traders often draw horizontal lines connected by the highs and lows of the price, which then form resistance and support levels. Clearly, market participants are not sure of which way the market will move and there will be LITTLE or NO rate of price change.

Resistance Level

Uptrend

An uptrend signifies that the market is heading in the upward direction, creating a bullish market. It indicates the price rallies often with intermediate periods of consolidation or movement (small downward move) against the major (prevailing) trend.

An upward trend continues until there is some breakdown in the charts (going down below some major support areas). If the market trend is upwards, we need to be cautious on taking short position (against the overall market trend) on some minor correction in the market.

Uptrend Signifies

Another way to figure an upward trend of market or currency price is shown below −

Upward Trend

Above the primary waves move the currency pair (USD/INR) in the direction of the broader trend (upward move), and secondary waves act as corrective phases (minor correction in currency, downward) of the primary waves (upward).

Downward Trend

A downward trend in the forex market is characterized by a price decline in the currency pair (USD/INR), with slight upward swing for a period of consolidation against the prevailing trend (downward trend). Unlike upward trend, a downward trend results in a negative rate of price change over time. In a chart, the price movements indicating a downtrend form a sequence of lower peaks and lower lows.

As currency is always traded in pair, the downtrend in forex market is not much affected as other financial markets. In case of downtrend of a currency pair (USD/INR), the fall in price of USD gives way to a rise in price of INR. It means something is always going up even in times of financial or economical downtrend.

Downward Trend

Another way to look at the downward trend figure is in the form of primary (major trend) and secondary (minor correction) wave, as shown in the diagram below.

Downward Trend Figure

In the above figure, the primary wave (downtrend) moves the currency pair in the direction of the broader trend (downward trend), and secondary waves (uptrend) act as corrective phases of the primary waves (downtrend).

Percentage Retracement

A retracement is a secondary wave (temporary reversal) in the direction of a currency that goes against the primary wave (major trend).

Like all other financial markets, foreign exchange market too does not move straight UP or DOWN, even in the strong trending market (Uptrend or Downtrend market). Traders keenly watch several percentage retracements, in search of price objective.

The amount of prices retreat following a higher-high (or higher-low) can be measured using a technique called “percent retracement”. This measures the percentage that prices “retraced”.

For example, if a stock price moves from the one year low of INR 50 to a recent high of 100 and then retraces back to 75 INR, this backward movement of prices from 100 INR to 75 INR (25 INR) retraced 50% of the previous move from 50 INR to 100 INR (100% upward journey).

Percentage Retracement

Percent retracement is strategic for Technical Analysts as based on this they determine the price levels at which prices will reverse and continue upward afterward. During any strong bull or bear market, prices often retrace from 33% to 66% of the original move. Retracement of more than 66% nearly signifies an end to the bull market.

The Trendline

The basic principle of technical analysis is that we can identify future trends and to some extent the duration of that trend (upward or downward). During a bull market, we see a series of higher (upward or primary wave) highs and correction lows (downward or secondary wave) and in a bear market, lower downswings (primary wave) and correction highs (secondary wave).

Drawing trendlines correctly is the legitimate extension of identifying the support and resistance levels and providing opportunities to open and close positions.

Trendlines are drawn at an angle above or below the price.

Technical Analysis

The above chart shows the trendline with downward and upward trends for a EUR/USD currency pair. In addition, we can the following in the chart −

  • Three swing highs on the downtrend
  • Three swing lows on the uptrend.

Therefore, when drawing trendlines in a downtrend, we draw them above the price and when drawing trend lines in an uptrend, we draw them below the price.

During a downtrend, it is the high point and in uptrend, it is the low point that will determine a trend line.

For confirmation, we require at least three swing highs or three swing lows to draw a trend line in either direction (uptrend or downtrend). Higher the number of times the price touches a trend line, the more acceptable it is, as more traders are using it for the support and resistance levels.

Using trend lines to trade

Most traders frequently use two methods to trade using trend lines −

  • Entry or exit when the price finds support or resistance at the trend line.
  • Entering when the price breaks through the trend line.

Trend line as support or resistance

As support is equal to demand and resistance signifies supply, it is the imbalance between supply and demand, which triggers price movement. If both supply and demand are static, there will be no price movement. Security prices stop falling and reverses when support/demand is below the current price. Similarly, security uptrend will stop its upward journey when resistance/supply is above the current price.

Resistance Signifies

So in up trending market, each new resistance (higher levels) will be set. If the security(equity or currency pair) or market is in uncharted territory, there is no resistance level set (can reach any new high).

Resistance Higher Levels

Support and Resistance Levels in Uptrend

Similarly in a downtrend, the security (equity or currency pair)/ market is making new lows thereby going below the multi support levels. If the security/market is in downtrend and going down below all-time lows, finding exact support levels is not possible (only way is to go with retracement levels.)

Support and Resistance Levels
Categories
3. Advance Tutorials

Technical Indicators

What is a chart?

Charts are the main tools of technical analysis. In technical analysis, we use charts to plot a sequence of prices (price movements) of an asset over a certain duration. It is a graphical way of showing how the stock prices have performed in the past.

The period to represent the price movement of an asset (ex. currency) vary from minutes (30 min), hour, day, week, month or many years. It has an x-axis (horizontal axis) and a y-axis (vertical axis). On the chart, the vertical axis (y-axis) represents price and the horizontal axis (x-axis) represents the time. Thus, by plotting a currency pair price over a period of time (time frame), we end up with a pictorial representation of any asset (stock, commodity or FX) trading history.

A chart can also represent the history of the volume of trading in an asset. It can illustrate the number of shares (in case of equity) that change hands over a certain period.

Types of Charts

The asset price (stock, currency pair, commodity, etc.) charts come in many varieties. It is the choice of the individual traders or investors to choose one type over another. This decision may be based on −

  • Familiarity and comfort
  • Ease of use
  • Underlying purpose

The line chart

Line charts are formed by connecting the closing price of a specific stock or market over a given period. It means, if we want to draw a line chart of a particular currency pair (USD/INR) in a 30 min time frame, we can draw the line chart by putting a straight line between prices before 30 min and current price after 30 min. The charts provide a clear visual illustration of the trend of a particular currency (or stock price) or a market’s (index) movement. It is an extremely valuable analytical tool for technical analysts, traders and also investors.

Line charts are mostly used when two or more trends have to be compared. For example, comparing closing prices of two more companies (same exchange listed and from same domain) or for a currency pair (USD/INR) compared to all the other listed currency pair in the region (ex. Asia).

The line chart exhibits price information with a straight line (or lines) connecting data (price or volume) values.

Below is the line chart of USDINR of 1-year time frame.

line chart

Bar Chart

Bar chart is a commonly used type of chart by technical analysts. It is called bar chart because each day’s range is represented by a vertical bar.

Although daily bar charts are best known, bar charts can be created for any period – weekly, monthly and yearly for example. A bar shows the high price for the period at the top and the lowest price at the bottom of the bar. Lines on either side of the vertical bar serve to mark the opening and closing prices of an asset (stock, currency pair). A small tick on the left side of the bar shows the opening price and a tick to the right of the bar shows closing price.

Many traders work with bar charts created over a matter of minutes during a day’s trading.

Bar Chart

Following is a 5-Day Bar chart of USDINR in 5 minutes interval.

Bar chart of USDINR

With 1-Day interval, 1-month chart of USDINR will be shown like this −

One Month Chart

Candlesticks Chart

The candlesticks chart is very popular among the traders community. This chart provides visual insight to current market psychology. A candlestick displays the open, high, low and closing price of a security very similar to a modern-day bar chart, but in a manner that mitigates the relationship between the opening and closing prices. Each candlestick represents one time frame (e.g., day) of data. The figure given below displays various elements of a candle.

Candlesticks Formation

Elements of a Candle

A candlestick chart can be created using the data of High, Open, Low and Closing prices for each time period that you want to display. The middle portion (filled portion) of the candlestick is called “the body (“the real body”). The long thin lines above and below the body represent the high/low range and are called “shadows” (sometimes called “wicks” and “tails”).

The body of the candlestick represents a stock’s opening and closing price of the security (stock or currency pair).

Stock Or Currency Pair

The following image shows Candlestick chart of USDINR (3 month) on 1-Day interval. The color of the candlestick denotes a higher close in green whereas lower close in red, for the day.

Candlestick Chart

The red candles in the above figure show days when the USDINR closed than the previous day. In contrast, green candles denotes days when the USDINR closed higher than the previous day.

Professional traders and investors sometimes prefer using candlestick chart because there are patterns in the candlesticks that can be actionable. However, candlestick charts consume time and skills to identify the patterns.

What is the chart pattern to use when trading?

The professional traders try to check the same security across different chart types. You may find one type of chart that works for you. Once we decided on what type of chart to follow, next step is to look for historical patterns like trends, support and resistance and other actionable patterns.

Categories
3. Advance Tutorials

Fundamental Market Forces

Any news and information regarding the country’s economy can have a direct impact on the direction the country’s currency is heading towards; just as how the current events and financial news affect the stock prices.

Several factors prove helpful in building long-term strength or weakness of the major currencies and will have a direct impact on you as a forex trader.

Economic Growth and Outlook

Countries with strong economic growth will surely attract foreign investors and thereby strong currency value. If the economic growth and outlook is positive, it indicates there is low unemployment rate, which in turn means higher wages to the people. Higher wages means people have more spending power, which in turn indicates higher consumption of goods and services. Thereby, this propels the economic growth of the country and there is an increase in the currency prices.

Inversely, if the economic growth and outlook of a country is weak, it indicates the unemployment rate is high. This shows that the consumers do not have the spending power; there are not too many business setups. The government (central bank) is the only entity that is spending. This leads to a decrease in the currency price.

Therefore, the positive and negative economic outlook will have direct impact on the currency markets.

Capital Flows

All thanks to globalization and technological advances which have kind of provided wings to the market participant to invest or spend virtually anywhere in the world.

Capital flows means the amount of capital or money flowing in or out of a country or economy because of capital investment via purchasing or selling.

We can check how many foreign investors have invested in our country by looking at the capital flow balance, which can be positive or negative.

When a country has positive capital flow balance, it indicates more people have invested in the country than investments heading out of the country. While a negative capital flow balance indicates investments leaving the country is much more than investment coming in.

A higher capital flow means more foreign buyers have invested, which in turn increases the currency prices (as investors want to buy your currency and sell their own).

Consider an example of USDINR currency pair – if on one particular month, capital flow is very large, directly it indicates that more foreign buyers are keen on investing in our home country. For this, they need local currency. Therefore, the demand of INR will increase and the supply of foreign currency (USD or Euro) will increase. The decrease in the price of USDINR depends on what the overall capital balance is.

In simple terms, if the supply is high (sellers are more) for a currency (or demand is weak), the currency tends to lose value (buyer are less).

Foreign investor are happy to invest in a country with −

  • high interest rates
  • strong economic growth
  • an up trending financial market

Trade Flows and Trade Balance

The Export and Import of goods from one country to another is a continuous process. There are exporting countries, which sell their own goods to other countries (importing countries) that are keen on buying the goods. Simultaneously, the exporting country becomes an importing country when it in turn buys something from another country.

The buying and selling of goods is accompanied by the exchange of currencies, which in turn changes the flow of currency, depending on how much we export (value) and import (value).

The trade balance is a measure to calculate the ratio of exports to imports for a given economy.

  • If the export bills of a country are higher than our import bills, we have trade surplus and the trade balance is positive.
    • export bills > import bills = Trade surplus = positive (+) trade balance
  • If the import bills of a country are higher than our export bills, we have trade deficit situation, and the trade balance is negative.
    • import bills > export bills = Trade deficit = negative (-) trade balance

Positive trade balance (trade surplus) comes with the prospects of pushing the currency price up compared to other currencies.

The currencies of the countries with trade surplus are more in demand and tend to be valued higher than those in less demand (trade deficit countries’ currencies).

The socio political environment of a country

Foreign investors prefer to invest in countries where the government is stable, having stable laws for business. Instability in the current government or major changes in the current administration can have direct impact on the business environment, which in turn can have an impact on the country’s economy. Any impact to an economy positive or negative will directly affect the exchange rates.