Technical analysis is based on the premise that all current market information is reflected in the price.
Technical analysis entails the examination of past price movements in order to identify patterns which may be indicative of future price trends.
By studying how prices have responded to certain events in the past, technical traders aim to determine the probability of similar outcomes.
Charting is the most common method of conducting technical analysis, as it provides a clear visual representation of price action and volume.
Through charting, technical analysts attempt to discern price patterns and market trends in financial markets, seeking to capitalize on such patterns.
As more traders rely on technical analysis, price patterns and indicator signals become self-fulfilling.
However, technical analysis is highly subjective, and different analysts may draw different conclusions from the same data.
Technical analysis utilizes models and trading rules based on transformations of price and volume, such as the relative strength index, moving averages, regressions, inter-market correlations, intra-market correlations, business cycles, stock market cycles, and chart pattern recognition.
Technical analysts employ a range of market indicators for the purpose of gauging an asset’s trending behaviour and to estimate the probability of its future direction and continued trend.
These indicators, which often involve mathematical transformations of price, e.g. up/down volume, advance/decline data and other inputs, are used in conjunction with price/volume indices and other analytical tools such as the moving average, relative strength index and MACD.
Sentiment indicators such as put/call ratios, bull/bear ratios, short interest and implied volatility are significant for analysis.
Many techniques exist for technical analysis, from candlestick analysis–originated by a Japanese grain trader–to harmonic, Dow, and Elliott Wave theories.
Certain practitioners may ignore other approaches, yet many traders combine elements from multiple techniques.
- The principles of technical analysis stem from centuries of financial market data.
- Joseph de la Vega, a merchant from Amsterdam, is credited as the first to explore such concepts in the 17th century.
- Homma Munehisa, an 18th-century Asian trader, further developed the use of candlestick techniques, a charting tool used in modern technical analysis.
- Charles Dow, a journalist from the 19th century, created the Dow theory, which suggests patterns and business cycles can be found in stock market data.
- In the 1920s and 1930s, Richard W. Schabacker published several seminal works which continued the work of Charles Dow and William Peter Hamilton in their books on Stock Market Theory and Practice and Technical Market Analysis.
- In 1948, Robert D. Edwards and John Magee released Technical Analysis of Stock Trends, which is widely considered a cornerstone of the discipline and is still used today.
- Charles Dow is credited with inventing a form of point and figure chart analysis.
- Paul V. Azzopardi combined technical analysis with this discipline, coining the term “Behavioral Technical Analysis”.
- Ralph Nelson Elliott, William Delbert Gann, and Richard Wyckoff developed their own techniques in the early 20th century.
Technical analysis vs fundamental analysis #
- Technical analysis assesses price, volume, psychology, money flow, and other market information, while fundamental analysis examines the facts of the company, market, currency, or commodity.
- Fundamental analysis involves the study of economic and other underlying factors that drive investors’ market valuation decisions.
- Examples of such factors include corporate metrics, such as EBITDA figures; changes to the board of directors; geopolitical considerations.
- On the other hand, technical analysis posits that prices already reflect all underlying fundamental factors.
- Technical indicators are used to uncover future trends, though neither technical nor fundamental indicators are infallible.
- Some traders rely exclusively on technical or fundamental analysis, while others employ both when making trading decisions.
- A cornerstone of technical analysis is the notion that a market’s price encapsulates all pertinent information influencing that market.
- Technical analysts thus analyze a security’s or commodity’s trading history rather than exogenous factors such as economic, fundamental, and news events.
- Prices exhibit directional trends according to Dow theory.
- History is recurrent.
- To a technician, the sentiments in the market may be irrational, yet they are present.
- Due to the recurrent nature of investor behaviour, technicians anticipate the formation of discernible (and predictable) price patterns on a chart.
- Systematic trading typically employs backtesting (or hindcasting) to evaluate investment strategies on historic data.
- It is a visual representation of the asset’s price over a predetermined period, with the y-axis depicting the price scale and the x-axis depicting the time scale.
- Price charts illustrate the aggregation of all transactions and expectations of future news, depicting supply and demand.
Line Chart #
- A line chart depicts the general price movement of a currency pair over a period of time via a series of connected closing prices.
- This chart type provides a broad overview of trends, as the rate of change between successive closing prices is easily visible.
- However, it does not supply much information regarding intra-period price behavior.
- The line chart’s reliance on the closing price alone neglects fluctuations within any individual session.
Bar chart #
- Bar charts are complex visual representations that display the open, high, low, and close prices for a given period, along with the trading range as a whole.
- They are also known as Open-High-Low-Close (OHLC) charts, as they provide insight into the volatility of the market.
- Bars may vary in size from one period to the next or over a range of bars, with the vertical height of the bar reflecting the range between the high and the low price of the period.
- The opening and closing prices of the period are denoted by horizontal lines attached to the left and right sides of the bar, respectively.
Candlestick chart #
- The candlestick chart is a variant of the bar chart, which displays the same price data in a more aesthetically appealing format.
- Traders have a preference for this chart type due to its easier readability.
- The vertical line of the candlestick bar denotes the high-to-low range, while the body in the middle, indicates the range between opening and closing prices.
- The color of the body helps to visualize bullish or bearish sentiment; a filled color denotes that the currency pair closed lower than it opened, while a hollow color indicates a higher closing price than opening price.
Japanese Candlestick Trading. #
Japanese candlesticks are used to depict the price action of a given time frame, and are composed of an open, high, low, and close.
If the close is higher than the open, a hollow candlestick (usually white) is drawn, and if the close is lower than the open, a filled candlestick (usually black) is drawn.
The body of the candlestick is the hollow or filled section, while the thin lines above and below the body represent the high and low range, respectively.
The size of candlesticks can provide insight into the intensity of buying or selling pressure.
Longer bodies indicate a greater degree of buying or selling activity, while shorter bodies imply a lack of activity.
Long white candlesticks demonstrate strong buying pressure, with the length of the body indicating the extent to which prices increased from open to close.
Conversely, long black candlesticks indicate strong selling pressure, with the length of the body indicating the extent to which prices decreased from open to close.
The shadows of Japanese candlesticks can also provide clues about the trading session.
Upper shadows signify the session high, while lower shadows signify the session low.
Long shadows indicate that trading action occurred well past the open and close, while short shadows indicate that most of the trading action was confined near the open and close.
If a Japanese candlestick has a long upper shadow and short lower shadow, this suggests that buyers initially drove prices higher, but sellers eventually drove prices back down to the open price.
Conversely, if a Japanese candlestick has a long lower shadow and short upper shadow, this suggests that sellers initially drove prices lower, but buyers eventually drove prices back up to the open price.
Basic Japanese Candlestick Patterns #
- The basic types of Japanese candlesticks, such as spinning tops, marubozus, and dojis, all share a commonality in terms of price action.
- Spinning tops, characterized by a long upper shadow, long lower shadow, and small real body, indicate a standoff between buyers and sellers, with neither side able to gain the upper hand.
- Marubozus, which translate to “bald head” or “shaved head” in Japanese, are candlesticks with no shadows from the bodies, and the open and close prices are the same as the high and low.
- Doji candlesticks, which have the same open and close price or extremely short bodies, suggest indecision or a struggle for turf positioning between buyers and sellers.
- Depending on the preceding candlesticks, Doji patterns can signal a weakening of buyers or sellers, and further strength is required to confirm any reversal.
Spinning Top #
- The Spinning Top pattern is indicative of the indecision between buyers and sellers, as evidenced by the small real body and long upper and lower shadows.
- This suggests that, while the session opened and closed with little change, prices moved significantly higher and lower in the interim, indicating that neither buyers nor sellers could gain the advantage.
- Consequently, the formation of a spinning top during an uptrend may suggest a lack of buyers and a potential reversal, while the formation of a spinning top during a downtrend may suggest a lack of sellers and a potential reversal.
The term “Marubozu” is derived from the Japanese phrase for “bald head” or “shaved head,” referring to the lack of shadows from the candle’s body.
This candlestick pattern is characterized by a long body with no shadows, indicating that the open price is equal to the low price and the close price is equal to the high price.
Depending on whether the body is filled or hollow, the high and low are the same as its open or close.
The formation of a White Marubozu at the conclusion of an uptrend suggests a continuation of the trend, while the emergence of a White Marubozu at the termination of a downtrend implies a reversal.
Conversely, the appearance of a Black Marubozu at the termination of a downtrend implies a continuation of the trend, while the formation of a Black Marubozu at the conclusion of an uptrend suggests a reversal.
Doji candlesticks, characterized by having the same open and close price or extremely short bodies, suggest indecision or a struggle for turf positioning between buyers and sellers.
Prices move above and below the open price during the session, but close at or very near the open price, indicating a draw between buyers and sellers.
There are four special types of Doji candlesticks, each with varying lengths of upper and lower shadows, appearing as a cross, inverted cross, or plus sign.
When a Doji forms on a chart, it is important to pay attention to the preceding candlesticks.
If a Doji forms after a series of candlesticks with long hollow bodies, it signals that buyers are becoming exhausted and weakening, while a Doji after a series of candlesticks with long filled bodies signals that sellers are becoming exhausted and weakening.
Single Candlestick Patterns #
- These single candlestick patterns, when appearing on a chart, may indicate a potential market reversal.
The Hammer and Hanging Man #
The Hammer and Hanging Man are single candlestick patterns that appear identical, yet signify opposite implications depending on the preceding price action.
Both patterns feature a small body (black or white) with a long lower shadow and a short or absent upper shadow.
The Hammer is a bullish reversal pattern that forms during a downtrend, signifying that the bottom is near and the price will start rising again.
Conversely, the Hanging Man is a bearish reversal pattern that can mark a top or strong resistance level, indicating that sellers are beginning to outnumber buyers.
To be recognized as a Hammer or Hanging Man, the long shadow should be approximately two to three times the size of the real body, with little or no upper shadow, and the real body should be at the upper end of the trading range.
The Inverted Hammer and Shooting Star #
- The Inverted Hammer and Shooting Star are single candlestick patterns that appear at the end of a downtrend and uptrend, respectively.
- The Inverted Hammer is a bullish reversal pattern, characterized by a petite body (filled or hollow), a long upper shadow, and a small or absent lower shadow.
- This pattern suggests that buyers have managed to close the session near the open, despite sellers attempting to push the price back down.
- Conversely, the Shooting Star is a bearish reversal pattern, which indicates that buyers attempted to push the price up, but were overpowered by sellers.
- This is a bearish sign, as it suggests that all buyers have been exhausted.
Double Candlestick Patterns #
Engulfing Candles #
- The Engulfing Candles pattern consists of two candlesticks, with the Bullish Engulfing pattern indicating a potential upswing and the Bearish Engulfing pattern suggesting a possible downturn.
- The Bullish Engulfing pattern is characterized by a bearish candle being superseded by a larger bullish candle, signifying that buyers are gaining strength and a strong upward move may follow a recent downtrend or period of consolidation.
- Conversely, the Bearish Engulfing pattern is the inverse of the Bullish Engulfing pattern, with a bullish candle being supplanted by a larger bearish candle, indicating that sellers have overpowered buyers and a strong downward move may be imminent.
Tweezer Bottoms and Tops #
- The Tweezer pattern is a two-candlestick reversal formation that typically appears after an extended uptrend or downtrend, suggesting that a reversal is imminent.
- This pattern is characterized by two candlesticks of equal or near-equal length, with the first candle representing the overall trend and the second candle being the opposite.
- For instance, if the price is moving up, the first candle should be bullish and the second candle should be bearish.
- The highs of the Tweezer Top should be the same, while the lows of the Tweezer Bottom should be the same.
- This candlestick formation is aptly named for its resemblance to a pair of tweezers.
Triple Candlestick Patterns #
Evening and Morning Stars #
- The Morning and Evening Stars are candlestick patterns that typically appear at the conclusion of a trend, signaling a potential reversal.
- The Morning Star Pattern is characterized by a bullish candle, followed by a small-bodied candle that may indicate indecision, and then a bearish candle that closes beyond the midpoint of the first candle.
- Similarly, the Evening Star Pattern is composed of a bearish candle, followed by a small-bodied candle that may suggest hesitation, and then a bullish candle that closes beyond the midpoint of the first candle.
Three White Soldiers and Black Crows #
- The Three White Soldiers pattern is a potent indication of a reversal from a downtrend, characterized by three consecutive long bullish candles.
- This triple candlestick pattern is considered one of the most powerful bullish signals, particularly when it follows an extended downtrend and a period of consolidation.
- The first candle of the pattern is the reversal candle, which either ends the downtrend or implies that the period of consolidation is over.
- For the Three White Soldiers pattern to be valid, the second candle should be larger than the previous candle’s body, closing near its high with a small or nonexistent upper wick.
- The third candle should be at least the same size as the second candle and have a small or no shadow.
- Conversely, the Three Black Crows pattern is a sign of a reversal from an uptrend, consisting of three consecutive bearish candles.
- The second candle should be larger than the first candle and close at or near its low.
- The third candle should be the same size or larger than the second candle’s body with a very short or no lower shadow.
Three Inside Up and Down #
The Three Inside Up candlestick formation is a trend-reversal pattern that signals the potential end of a downtrend and the commencement of an uptrend.
This triple candlestick pattern is characterized by a long bearish candlestick followed by a second candle that reaches the midpoint of the first candle, and a third candle that closes above the first candle’s high.
Conversely, the Three Inside Down candlestick formation is indicative of the possible conclusion of an uptrend and the start of a downtrend.
This triple candlestick pattern is characterized by a long bullish candlestick followed by a second candle that reaches the midpoint of the first candle, and a third candle that closes below the first candle’s low.
Chart Patterns #
- Chart patterns can provide insight into when the price is likely to reverse or continue in its current direction, as well as potential entry and exit signals.
Double Tops and Double Bottoms #
- Upon the emergence of a double top or double bottom chart pattern, a trend reversal is likely to occur.
- A double top is a reversal pattern that is formed after an extended move up, wherein two peaks, or “tops”, are created when the price reaches a certain level that cannot be broken.
- After the second peak is unable to break the high of the first peak, a reversal is likely to take place, and an entry order should be placed below the neckline.
- Similarly, a double bottom is a trend reversal formation that occurs after an extended downtrend, wherein two valleys, or “bottoms”, are created when the price reaches a certain level that cannot be broken.
- When the second bottom is unable to significantly break the first bottom, a reversal is likely to take place, and an entry order should be placed above the neckline.
The Head and Shoulders pattern is a reversal formation.
This pattern is composed of a peak (shoulder), followed by a higher peak (head), and then another lower peak (shoulder).
A “neckline” is drawn by connecting the lowest points of the two troughs, and the slope of this line can either be up or down.
When the slope is down, it produces a more reliable signal.
To trade this pattern, an entry order is placed below the neckline, and the target is calculated by measuring the high point of the head to the neckline.
This distance is approximately how far the price will move after it breaks the neckline.
An inverse Head and Shoulders pattern is the same formation, but flipped upside down.
To trade this pattern, a long entry order is placed above the neckline, and the target is calculated in the same manner.
Trade Wedge Chart Patterns #
In a Wedge chart pattern, two trend lines converge, indicating a decrease in the magnitude of price movement.
This formation signals a pause in the current trend.
A Falling Wedge is a bullish chart pattern that takes place in an upward trend, with the lines sloping down, while a Rising Wedge is a bearish chart pattern that’s found in a downward trend, with the lines sloping up.
Wedges can serve as either continuation or reversal patterns.
In the case of a Rising Wedge, the price consolidates between upward sloping support and resistance lines, with the slope of the support line steeper than that of the resistance, forming higher lows faster than higher highs.
This leads to a wedge-like formation, which signals a breakout to either the top or bottom.
If the Rising Wedge forms after an uptrend, it’s usually a bearish reversal pattern, while if it forms during a downtrend, it could signal a continuation of the down move.
- In the case of a Falling Wedge, it can either be a reversal or continuation signal.
- As a reversal signal, it is formed at a bottom of a downtrend, indicating that an uptrend would come next, while as a continuation signal, it is formed during an uptrend, implying that the upward price action would resume.
- Upon breaking above the top of the wedge, the pair typically makes a move upwards that’s approximately equal to the height of the formation.
Rectangle Chart Patterns #
- The Rectangle Chart Pattern is used to identify periods of consolidation or indecision between buyers and sellers.
- This pattern is characterized by parallel support and resistance levels, which the price tests multiple times before eventually breaking out.
- Depending on the direction of the breakout, the price could trend in the same direction, either to the upside or downside.
- A bearish rectangle is formed when the price consolidates during a downtrend, while a bullish rectangle is formed after an uptrend.
- When the price breaks out of the rectangle, it typically moves at least the size of the previous range, providing an opportunity for traders to capitalize on the move.
Bearish and Bullish Pennants #
- Pennants are continuation chart patterns that form after strong price movements, wherein buyers or sellers pause to catch their breath before continuing in the same direction.
- These patterns are typically characterized by a symmetrical triangle, with a bearish pennant formed during a steep, downward trend and a bullish pennant formed during a sharp, upward trend.
- To trade these patterns, traders may place a short order at the bottom of a bearish pennant and a long order above a bullish pennant, with a stop loss placed to avoid fakeouts.
- The size of the breakout move is usually estimated to be around the height of the earlier move.
Triangle Chart Patterns #
The triangle chart pattern is a visual representation of a battle between bulls and bears, typically categorized as a “continuation pattern”, indicating that the price will likely continue in the same direction it was moving before the pattern appeared.
This pattern is typically identified by at least five touches of support and resistance, such as three touches of the support line and two of the resistance line, or vice versa.
There are three types of triangle chart formations: symmetrical triangle, ascending triangle, and descending triangle.
A symmetrical triangle is characterized by the convergence of the price’s highs and lows to a point, indicating that neither the buyers nor the sellers are pushing the price far enough to create a clear trend.
An ascending triangle is identified by a resistance level and a slope of higher lows, suggesting that the buyers are gradually gaining strength.
Conversely, a descending triangle is identified by a string of lower highs and a support level, indicating that the sellers are gaining ground.
3 Main Groups of Chart Patterns #
- We discussed reversal patterns, which signal that the ongoing trend is about to change direction, as well as continuation patterns, which indicate that the trend will resume.
- Additionally, we discussed bilateral patterns, which suggest that the price could move either way.
Support and resistance #
Support and resistance are pre-established levels of an asset’s price at which it is anticipated that the price will tend to pause and reverse its movement.
These levels are indicated by multiple touches of the price without it surpassing the level.
Support and resistance are formed as the price moves up and down over time;
Support is a level where the price is predicted to find assistance as it declines due to a spike in the asset’s demand, thus tending to “bounce” off the level rather than break through it.
Resistance is the inverse of support and represents a level at which the price is expected to encounter opposition as it increases due to a boost in selling activity, thus usually “bouncing” off the level rather than breaching it.
It involves identifying surplus buyers and sellers at specific points as the price fluctuates.
Traders typically execute the “bounce” strategy by buying at support and selling at resistance, or the “break” strategy by buying at resistance and selling at support.
Support and resistance levels are not exact numbers; they are better characterized as zones.
Determining whether support or resistance has been broken can be controversial, with some claiming that a closing price past the threshold constitutes a breach, while others maintain that the evidence is inconclusive.
- For example, the price might temporarily closed below support but eventually rose back up, indicating that the support was not actually broken.
- To avoid such false breakouts, analysts should consider support and resistance as “zones” instead of concrete thresholds, which can be more easily identified by plotting the data on a line chart.
- Candlestick shadows often indicate temporary tests of these levels, but the price truly must close past them to signal a break.
The significance of a given support/resistance level increases with each successive “test” (i.e., price touch and bounce off).
- The more frequent testing of the level without breaking it, the greater its strength.
When a price breaks past a support level, it may become a new resistance level.
Conversely, when a price breaches a resistance level, it may find support at that level in the future.
Psychological Support and Resistance levels also constitute a critical component of technical analysis.
00 and 50 levels (e.g., 1.3350, 2.8000) can often signify potential interruptions in the current movement.
How to Trade Support and Resistance #
The Bounce involves waiting for price to rebound off of a support or resistance level before entering a trade.
This approach allows traders to tilt the odds in their favor and gain confirmation that the support or resistance will hold.
The Break involves entering a trade when price breaks through a support or resistance level.
This strategy is more aggressive and carries a higher risk, but can also yield greater rewards.
There are two ways to trade breaks: the aggressive approach and the conservative approach.
The aggressive approach involves buying or selling when price passes through a support or resistance zone with ease.
The conservative approach, on the other hand, involves waiting for the price to make a pullback to the broken support or resistance level and entering after the price bounces.
Retests of broken support and resistance levels do not always occur.
Therefore, use of stop loss orders should be considered.
Never hold onto a trade based on hope.
Trend Lines #
An ascending trend line is formed by connecting two distinct support areas, while a descending trend line is created by connecting two distinct resistance areas.
Drawing trend lines properly involves locating two major tops or bottoms and connecting them.
At least two tops or bottoms are needed to construct a trend line, yet THREE are required to verify its validity.
STEEP trend lines are inherently less dependable and are likely to be broken.
Similar to horizontal support and resistance levels, trend lines become more reliable with repeated testing.
Moreover, one should never fabricate trend lines to fit the market; if they do not fit naturally, the line is invalid.
Trend Channels #
Extending the concept of trend line, one may create a “channel” by plotting a parallel line of the same angle as the prevailing uptrend or downtrend.
These channels, also known as price channels, are used in technical analysis to identify potential points of support or resistance.
The upper trend line denotes resistance, while the lower trend line indicates support.
Bearish channels have a negative slope (down) and bullish channels have a positive slope (up).
Construct an ascending channel by paralleling an uptrend line with a line that touches the most recent peak; do likewise to form a descending channel.
Prices at the lower trend line may signal a buying opportunity, while those at the upper trend line may denote a selling opportunity.
Moving Averages #
Moving averages are used to smooth out price fluctuations and distinguish between typical market “noise” and the actual trend direction.
By “moving average”, we mean that the average closing price of a currency pair is taken over a specified number of periods, which is then displayed as a squiggly line overlayed on the price chart.
This type of technical indicator is referred to as a “chart overlay”.
Moving averages are used to forecast future prices, as they help to reduce random price movements and make it easier to identify the underlying trend.
The “length” or the number of reporting periods included in the moving average calculation affects how the moving average is displayed on a price chart.
There are two major types of moving averages: Simple and Exponential.
It is important to select the length that provides the level of price detail appropriate for the trading timeframe.
Moving averages smooth price data to form a trend-following technical indicator, but they do not predict price direction; instead, they define the current direction with a lag.
Simple Moving Average (SMA) #
The Simple Moving Average (SMA) is the most basic form of moving average, calculated by summing the last “X” period’s closing prices and then dividing that figure by X.
For example, if one were to plot a 5 period SMA on a 1-hour chart, they would add up the closing prices for the last 5 hours and then divide that number by 5.
As with almost any other indicator, the SMA operates with a delay, as it is based on past price history and thus only provides an indication of the general direction of short-term price action.
The SMA is susceptible to spikes, which can lead to false signals.
To avoid this problem, another type of moving average can be used.
Exponential Moving Average (EMA) #
- Simple moving averages might be distorted by spikes.
Suppose we have a 10-period SMA on the daily chart of USD/JPY.
The closing prices for the last 10 days are as follows: Day 1: 110.50. Day 2: 111.20. Day 3: 110.80. Day 4: 111.00. Day 5: 110.90. Day 6: 111.10. Day 7: 110.70. Day 8: 111.30. Day 9: 111.40. Day 10: 111.50.
The simple moving average would be calculated as follows: (110.50 + 111.20 + 110.80 + 111.00 + 110.90 + 111.10 + 110.70 + 111.30 + 111.40 + 111.50) / 10 = 111.04.
However, if there were a natural disaster on Day 6 that caused the yen to appreciate sharply, resulting in USD/JPY closing at 108.00, the 10-period SMA would be calculated as follows: (110.50 + 111.20 + 110.80 + 111.00 + 110.90 + 108.00 + 110.70 + 111.30 + 111.40 + 111.50) / 10 = 110.63.
This would give a false impression of the price trend, as the spike on Day 6 was a one-time event.
A SMA is sensitive to outliers or extreme values that deviate from the normal range. A spike is a sudden and sharp movement in price that may be caused by unexpected events, such as news reports, natural disasters, political turmoil, etc. A spike can affect the SMA calculation by adding or subtracting a large amount from the sum of the prices, which in turn changes the average value.
In this example, the spike on Day 6 was caused by a natural disaster that made the yen stronger against the dollar. This resulted in USD/JPY closing at 108.00, which was much lower than the previous days. This lowered the sum of the last 10 days’ closing prices and thus lowered the 10-period SMA from 111.04 to 110.63. This might suggest that the price trend was downward, when in fact it was just a temporary reaction to an external event.
A SMA does not distinguish between normal and abnormal price movements. It treats every price equally and gives equal weight to each period. Therefore, a SMA might be distorted by spikes that do not reflect the true direction of the market.
- To address this issue, one can use an exponential moving average (EMA), which gives more weight to the most recent periods.
- This ensures that the spike has a lesser effect on the moving average, as it puts more emphasis on what traders are doing recently.
SMA vs EMA #
By giving more weight to recent activity, the EMA reflects the current price action more closely.
The EMA is more responsive to price action, allowing traders to catch trends early and potentially reap higher profits.
However, this can also lead to false signals during consolidation periods.
Conversely, the SMA is slower to respond to price action, making it more suitable for longer-term trading.
It is also less prone to false signals, but may delay entry into a trade.
Ultimately, traders may choose to use a combination of both types of moving averages to gain a comprehensive understanding of the market.
- When determining which type of moving average to use, one must consider the speed of response to price action.
- An exponential moving average (EMA) is more responsive to price action than a simple moving average (SMA), making it more suitable for short-term trading.
- However, this same attribute can lead to false signals during consolidation periods.
- Conversely, an SMA is slower to respond to price action, making it more suitable for longer-term trading, as it is less likely to be whipsawed.
Use Moving Averages to identify the Trend #
- By plotting a single moving average on a chart, one can determine whether the price action is in an uptrend or downtrend; if the price action tends to remain above the moving average, it is indicative of an uptrend, while if it tends to remain below the moving average, it is indicative of a downtrend.
- However, this approach is overly simplistic and can lead to false signals.
- To avoid this, traders may plot multiple moving averages on their charts, with the faster moving average above the slower moving average in an uptrend and vice versa in a downtrend.
Use Moving Average Crossovers to Enter Trades #
- Moving Average Crossovers can be a useful tool for trend traders seeking to identify when to enter and exit the market.
- A trend can be defined as the general direction of the price over the short, immediate, or long term, and a moving average crossover system can help to discern the direction of the trend, as well as potential entry and exit points.
- A crossover occurs when two distinct moving average lines intersect, and while this technique may not capture exact tops and bottoms, it can help to identify the bulk of a trend.
- However, it is important to note that this system is not as effective when price is ranging, as one may be inundated with numerous crossover signals and be subject to multiple stop-outs before catching a trend again.
Using moving averages as dynamic support and resistance levels #
- Moving averages can they provide a constantly changing area of interest.
- It is referred to as dynamic due to the fact that the levels are constantly shifting in accordance with recent price action.
- It can serve as a reliable form of support or resistance, as the price might consistently bounces off it.
- However, it is important to note that these levels can be broken.
Use Moving Average Envelopes #
Moving Average Envelopes (MAE) are a technical analysis tool used to confirm trend direction and identify overbought and oversold conditions.
MAE consists of a moving average line and two other lines, one above and one below, which form an upper and lower envelope.
To calculate MAE, one must decide whether to use a simple moving average (SMA) or exponential moving average (EMA), select the number of time periods to apply, and set the percentage value for the envelopes.
When the envelopes are moving higher, the price is in an uptrend; when the envelopes are moving lower, the price is in a downtrend; and when the envelopes are moving sideways, the price is considered directionless.
To confirm the trend direction, one should pay attention to when the price moves above or below the envelopes.
If the price surges above the upper envelope, this is considered bullish, and if the price plunges below the lower envelope, this is considered bearish.
To generate a buy signal, one should wait for the price to close above the UPPER envelope, and to generate a sell signal, one should wait for the price to close below the LOWER envelope.
A buy signal is triggered when the price closes above the upper envelope, and a sell signal is triggered when the price closes below the lower envelope.
- In sideways markets, when the moving average slope is flat, MAE can be used to identify overbought and oversold levels.
- When the price moves above the upper envelope, this can be interpreted as an indication of overbought conditions, while a move below the lower envelope can be seen as an indication of oversold conditions.
- To confirm overbought and oversold levels, it is recommended to also consider support and resistance levels.
- A buy signal is triggered when the price touches or falls beneath the lower envelope and then rises back above, while a sell signal is triggered when the price touches or rises above the upper envelope and then falls back below.
Moving average ribbon #
- A moving average ribbon is a collection of moving averages of varying lengths plotted on a chart.
- This technique allows traders to assess the strength of a trend by examining the smoothness of the ribbon, as well as identify potential areas of support or resistance by comparing the price to the ribbon.
- When setting up a moving average ribbon, the number of moving averages used is typically determined by the trader’s preference.
- Some traders prefer to use six to eight simple moving averages (SMA) set at 10-period intervals, such as the 10, 20, 30, 40, 50, and 60-day SMAs.
- Others may opt for a larger number of SMAs, ranging from a 50-day to a 200-day SMA.
- Some traders may choose to use exponential moving averages (EMA) instead of SMAs.
- The sensitivity of the moving average ribbon can be adjusted by changing the number of time periods used in the moving average or by switching from a SMA to an EMA.
- Shorter periods will make the ribbon more sensitive to slight price changes, while longer periods will make the ribbon smoother.
- The positioning of short-term moving averages relative to long-term moving averages can be used to discern the direction of a trend (down, neutral, up), while the spacing between the moving averages can be used to gauge the strength of the trend (weak, neutral, strong).
- When the moving averages start to widen out and separate, known as ribbon “expansion”, this signals that the recent price direction has reached an extreme and could be the end of a trend.
- Conversely, when the moving averages start to converge and get closer to each other, known as ribbon “contraction”, a trend change has possibly started.
- When the moving average ribbons are parallel and evenly spaced, this indicates that the current trend is strong.
- By monitoring the spacing between the moving averages, as well as when the short-term moving averages cross above (or below) the long-term moving averages, traders can gain insight into the direction and strength of a trend.
Parabolic SAR #
- This indicator places points, or dots, on a chart that suggest potential reversals in price movement.
- When the dots are below the candles, it is a signal to buy, and when the dots are above the candles, it is a signal to sell.
- This tool is most effective in markets that are trending and should not be used in choppy markets.
- Additionally, Parabolic SAR can be used to exit trades.
- When three dots form at the bottom of the price, it may be an indication that the downtrend is over and it is time to close the trade.
Ichimoku Kinko Hyo #
- Ichimoku Kinko Hyo (IKH) is an indicator that can be used to gauge future price momentum and identify potential areas of support and resistance.
- Ichimoku can be used in all time frames for any tradeable asset, and in both rising and falling markets, though it is not effective when the market is trading sideways or trendless.
- The indicator consists of five lines: the Kijun Sen (blue line), the Tenkan Sen (red line), the Chikou Span (green line), and the two Senkou Span (orange lines).
- Each of these lines is calculated differently, and it is important to understand how to interpret them in order to effectively use the indicator.
How to Trade Using Ichimoku Kinko Hyo. #
- The Senkou span serves as a support or resistance level depending on the price’s position relative to it, while the Kijun Sen can be used to predict future price movement.
- The Tenkan Sen is an indicator of the market trend, and the Chikou Span provides buy and sell signals.
Pivot Points #
What Are Pivot Points? #
- Pivot points are a tool used by professional traders and market makers to identify potential support and resistance levels.
- These levels are areas where the direction of price movement may be altered.
- Pivot points are attractive due to their objectivity, as opposed to other indicators which require some degree of discretion.
- They are similar to Fibonacci levels, however, the latter involves some subjectivity in the selection of Swing Highs and Swing Lows.
- Pivot points are especially useful for short-term traders seeking to capitalize on minor price movements, as well as range-bound traders who use them to identify reversal points.
- Breakout traders also use pivot points to identify key levels that must be broken for a move to be considered a true breakout.
How to Calculate Pivot Points #
- This process involves using the previous trading session’s open, high, low, and close.
- Pivot point (PP) = (High + Low + Close) / 3
- First resistance (R1) = (2 x PP) – Low
- First support (S1) = (2 x PP) – High
- Second resistance (R2) = PP + (High – Low)
- Second support (S2) = PP – (High – Low)
- Third resistance (R3) = High + 2(PP – Low)
- Third support (S3) = Low – 2(High – PP)
- PP = Pivot Point.
- S = Support.
- R = Resistance.
- Most charting software will automatically perform these calculations.
How to Use Pivot Points for Range Trading #
It is used as support and resistance levels.
When a currency pair repeatedly touches a pivot level and then reverses, the level is considered to be of greater strength.
“Pivoting” is defined as the act of reaching a support or resistance level and then reversing.
If the price is nearing an upper resistance level, traders may opt to SELL the pair and place a stop just above the resistance.
Conversely, if the price is nearing a support level, traders may opt to BUY and put a stop just below the level.
For example, if the price is testing the S1 support level.
If traders believe the level will hold, they may buy at the market and then put a stop loss order past the next support level.
- If the price reaches past S2, it is likely that it will not return, as both S1 and S2 could become resistance levels.
As for take profit points, traders may target PP or R1, which could also provide some sort of resistance.
How to Use Pivot Points to Trade Breakouts #
There are two primary approaches to trading breakouts: the aggressive approach or the safe approach.
If one opts for the safe approach, which involves waiting for a retest of support or resistance, they may miss out on the initial move.
If one had taken the aggressive method, they would have been subject to a fakeout as the price failed to sustain the initial break.
When trading breakouts, one looks for strong, fast moves.
As for setting targets, one would typically aim for the next pivot point support or resistance level as their take profit point.
- One must be cognizant of news events and spikes in volatility.
How to Use Pivot Points to Measure Market Sentiment #
- By utilizing pivot points, traders can gain insight into market sentiment and determine whether buyers or sellers have the upper hand.
- For instance, if the price opens and remains above the pivot point, it is a sign of bullish sentiment.
- Conversely, if the price opens and remains below the pivot point, it is a sign of bearish sentiment.
- However, it is important to note that market sentiment can shift quickly, so traders should combine pivot point analysis with other indicators to gain a more comprehensive understanding of the market.
Know the 3 Other Types of Pivot Points #
The traditional approach to calculating pivot points is not the only available option; traders have developed alternative methods to determine these levels.
The Woodie pivot point formula is distinct from the standard method, as it takes into account the difference between the previous day’s high and low, or the range.
As the formulas for the Woodie pivot point are different from the standard method, the levels obtained through the Woodie calculations are distinct from those obtained through the standard method.
Some traders prefer the Woodie formulas as they give more weight to the closing price of the previous period, while others prefer the standard formulas as they are more widely used and thus may be self-fulfilling.
R2 = PP + High – Low
R1 = (2 X PP) – Low
PP = (H + L + 2C) / 4
S1 = (2 X PP) – High
S2 = PP – High + Low
C – Closing Price, H – High, L – Low
The Camarilla pivot point formula is similar to the Woodie formula, as it also takes into account the previous day’s close and range to calculate the support and resistance levels.
However, the Camarilla formulas calculate for 8 major levels (4 resistance and 4 support), each of which is multiplied by a multiplier.
The Fibonacci pivot point formula is determined by first calculating the pivot point like the standard method, then multiplying the previous day’s range with its corresponding Fibonacci level.
R3 = PP + ((High – Low) x 1.000)
R2 = PP + ((High – Low) x .618)
R1 = PP + ((High – Low) x .382)
PP = (H + L + C) / 3
S1 = PP – ((High – Low) x .382)
S2 = PP – ((High – Low) x .618)
S3 = PP – ((High – Low) x 1.000)
C – Closing Price, H – High, L – Low
Most traders use the 38.2%, 61.8% and 100% retracements in their calculations.
- There are four main methods of calculating pivot points: Standard, Woodie, Camarilla, and Fibonacci.
- These levels are often utilized by range, breakout, and trend traders, as the price of a currency pair typically fluctuates between the R1 and S1 levels.
- Range-bound traders may enter a buy order near identified levels of support and a sell order when the pair nears resistance, while breakout traders may use pivot points to identify key levels that must be broken for a move to be considered a strong momentum move.
- Sentiment traders may also use pivot points to gauge the bullishness or bearishness of a currency pair.
Bollinger Bands #
Bollinger Bands, a technical indicator developed by John Bollinger, is used to measure a market’s volatility and identify “overbought” or “oversold” conditions.
The Bollinger Bands are typically plotted as three lines: an upper band, a middle line, and a lower band.
The middle line is a simple moving average (SMA), while the upper and lower bands represent two standard deviations above and below the middle line.
Bollinger Bounce is characterized by the tendency of prices to return to the middle of the Bollinger Bands.
The Bollinger Bands can be used dynamic support and resistance levels.
It is important to note that this is most effective when the market is range-bound and there is no clear trend.
Conversely, when the bands are expanding, it is usually indicative of a trend, and thus the Bollinger Bounce should not be employed.
The Bollinger Squeeze occurs when the bands converge, indicating an upcoming price breakout.
If the candles break out above the upper band, the price is likely to continue to rise, and if the candles break out below the lower band, the price is likely to continue to fall.
Therefore, the Bollinger Squeeze is a useful tool for traders to identify potential breakouts.
Keltner Channels #
- Keltner Channels, a volatility indicator introduced by Chester Keltner in his 1960 book, How To Make Money in Commodities, and later revised by Linda Raschke in the 1980s, are similar to Bollinger Bands in that they also consist of three lines.
- However, the middle line in a Keltner Channel is an Exponential Moving Average (EMA) and the two outer lines are based on the Average True Range (ATR) rather than on standard deviations (SD).
- As the channel is derived from the ATR, a volatility indicator itself, the Keltner Channel adjusts to recent volatility, yet is less volatile than the Bollinger Bands.
- Keltner Channels serve as a guide for setting trade entries and exits, as they help identify overbought and oversold levels relative to a moving average, particularly when the trend is flat, and can provide clues for new trends.
- Comparable to an ascending or descending channel, the Keltner Channel automatically adjusts to recent volatility and is not composed of straight lines.
- Although Keltner Channels and Bollinger Bands are similar, the underlying indicators and calculations that generate them yield differences in price sensitivity and the smoothness of the indicators.
- Keltner Channels provide an indication of the area where a currency pair typically trades.
- The upper line of the channel typically functions as dynamic resistance, while the lower line serves as dynamic support.
- Commonly, the settings used are 2 x ATR (10) for the upper and lower lines and EMA (20) for the middle line, which is particularly significant as it often acts as a pullback level during ongoing trends.
- In an uptrend, the price action is usually confined to the upper half of the channel, between the middle line as support and the top line as resistance.
- Conversely, in a downtrend, the price action is typically found in the bottom half of the channel, with the middle line acting as resistance and the bottom line as support.
- In a ranging market, the price swings between the top and bottom lines.
- Breakouts from the Keltner Channel can be used to predict where the price is heading next.
- If the candles break out above the top line, the move is likely to continue upwards, and if the candles break below the bottom line, the price is likely to continue downwards.
Average True Range (ATR) is a technical indicator that quantifies the volatility of an asset’s price.
The Average True Range (ATR) is a technical analysis volatility indicator developed by J. Welles Wilder, Jr., which provides an indication of the degree of price volatility without indicating the direction of the trend.
High volatility is characterized by frequent price fluctuations, while low volatility is associated with minimal price activity.
Markets with high volatility present more risk/reward opportunities, as prices can rise and fall rapidly, providing traders with more chances to buy or sell.
When a market becomes increasingly volatile, the ATR tends to peak, increasing in value.
- ATR can reach high values when price fluctuations are large and rapid, and low values when the market is in a period of sideways movement or consolidation.
Conversely, during periods of low volatility, the ATR decreases in value.
The higher the value of the indicator, the higher the probability of a trend change, while a lower value indicates a weaker trend movement.
- The ATR is a smoothed moving average of the true range values, with Wilder recommending a 14-period smoothing.
- The True Range is the maximum of the following three intervals: the distance from the current day’s high to the current day’s low, the distance from the prior day’s close to the current day’s high, and the distance from the prior day’s close to the current day’s low.
- The ATR can be used to calculate the trade volume based on a trader’s risk tolerance, providing a self-adjusting risk limit dependent on the market volatility for strategies without a fixed stop-loss placement.
The MACD (Moving Average Convergence Divergence) is a trend-following momentum indicator that helps traders identify the direction and strength of a trend.
Generally, the MACD chart will display three numbers as its settings.
- The first is the number of periods used to calculate the faster-moving average, the second is the number of periods used in the slower moving average, and the third is the number of bars used to calculate the moving average of the difference between the faster and slower moving averages.
For instance, if the MACD parameters are “12, 26, 9”, this means that the 12 represents a moving average of the previous 12 bars, the 26 represents a moving average of the previous 26 bars, and the 9 represents a moving average of the difference between the two moving averages.
It is important to note that the two lines drawn on the MACD chart are not moving averages of the price.
- The MACD Line is the difference (or distance) between two moving averages, usually exponential moving averages (EMAs).
- The Signal Line is the moving average of the MACD Line.
- The Histogram plots the difference between the MACD Line and Signal Line, providing a graphical representation of the distance between the two lines.
As the two moving averages (MACD Line and Signal Line) separate, the histogram gets bigger, which is known as a MACD divergence.
Conversely, as the moving averages get closer to each other, the histogram gets smaller, which is known as convergence.
Using MACD for trading purposes involves two moving averages with varying “velocities”; the faster one will respond to price movements more quickly than the slower one.
When a new trend is established, the faster line (MACD Line) will cross the slower line (Signal Line), and the fast line will begin to “diverge” from the slower line, indicating the formation of a new trend.
For example, when the fast line (e.g. 12-day EMA) crosses below the slow line (e.g. 26-day EMA), it signals the start of a downtrend.
- During the crossover, the Histogram, which measures the difference between the two lines, disappears as the difference is 0.
- As the downtrend persists, the fast line moves further away from the slow line, causing the Histogram to increase, indicating a strong trend.
Despite its advantages, MACD is subject to the lagging nature of moving averages, as it is composed of the MACD Line, Signal Line, and Histogram, all of which are based on historical prices.
How to Use MACD to Confirm a Trend #
- Identifying trends can be facilitated by the use of lagging indicators such as MACD and moving averages.
- While these indicators may provide delayed entry, they also reduce the likelihood of being wrong.
Stochastic Indicator #
The Stochastic oscillator is used to measure the momentum of price.
It is based on the premise that during an uptrend, prices will remain equal to or above the previous closing price, and during a downtrend, prices will likely remain equal to or below the previous closing price.
Developed by George Lane in the late 1950s, the Stochastic oscillator measures the degree of change between prices from one closing period to predict the continuation of the current direction trend.
The two lines of the oscillator are similar to the MACD lines, with one line being faster than the other.
By analyzing the momentum of price, traders can better anticipate when a trend might be ending.
How to Trade Forex Using the Stochastic Indicator #
- The Stochastic technical indicator provides insight into when the market is overbought or oversold(scaled from 0 to 100).
- When the Stochastic lines are above 80, it indicates that the market is overbought, while when the lines are below 20, it suggests that the market is possibly oversold.
- As a general rule, traders buy when the market is oversold and sell when it is possibly overbought.
- Although traders may employ the Stochastic in various ways, its primary purpose is to indicate when the market is overbought or oversold.
- It is important to note that the Stochastic can remain above 80 or below 20 for extended periods, thus it is not advisable to blindly sell or buy when the indicator reads “overbought” or “oversold” respectively.
RSI (Relative Strength Index) #
- The Relative Strength Index (RSI) is a technical indicator developed by J. Welles Wilder to evaluate the strength of the market.
- This indicator is similar to Stochastic in that it identifies overbought and oversold conditions, and is scaled from 0 to 100.
- Generally, readings of 30 or lower suggest oversold market conditions and an increased likelihood of price appreciation, while readings of 70 or higher indicate overbought conditions and an increased probability of price depreciation.
- Traders may also look for centerline crossovers, which occur when the RSI value crosses above or below the 50 line on the scale.
- A movement from below the centerline to above indicates a rising trend, while a movement from above the centerline to below suggests a falling trend.
How to Trade Using RSI. #
- The Relative Strength Index (RSI) can be employed in a similar manner to the Stochastic indicator, allowing for the identification of potential market tops and bottoms depending on whether the market is overbought or oversold.
- Additionally, RSI can be used to confirm trend formations.
- If a trend is suspected, the RSI should be examined to determine whether it is above or below 50.
- If an uptrend is anticipated, the RSI should be above 50, while a downtrend should be indicated by the RSI being below 50.
Williams %R (Williams Percent Range) #
The Williams Percent Range, also referred to as Williams %R, is a momentum indicator that indicates the position of the most recent closing price in relation to the highest and lowest prices of a given time period.
As an oscillator, Williams %R provides insight into when a currency pair may be considered “overbought” or “oversold.”
It is a less popular, yet more sensitive, version of the Stochastic indicator.
Williams %R is also used to measure the strength of a current trend, similar to the Relative Strength Index (RSI), but instead of using the mid-point figure (50) to determine trend strength, traders use %R’s extreme levels (-20 and -80).
Stochastic and %R share the same formula for determining the relative position of a currency pair.
The only distinction between the two is that Stochastic utilizes the lowest price within a given time frame to ascertain the closing price’s position, while %R relies on the highest price.
If the %R line is inverted, it would be identical to Stochastic’s %K line.
This is why Williams %R is scaled from 0 to -100, while Stochastic is scaled from 0 to 100.
A reading above -20 is indicative of an OVERBOUGHT condition, while a reading below -80 is indicative of an OVERSOLD condition.
It is important to note that these readings do not guarantee that the price will reverse.
ADX (Average Directional Index). #
- The Average Directional Index (ADX) is a popular technical indicator for gauging the strength of a trend, which fluctuates from 0 to 100.
- Readings below 20 suggest a weak trend, while readings above 50 indicate a strong trend.
- The higher the ADX, the more powerful the trend.
- Conversely, when the ADX is low, it indicates that the price is usually trading sideways or in a range.
- When the ADX surpasses 50, it suggests that the price has gained momentum in one direction.
- Unlike Stochastic, ADX does not determine whether the trend is bullish or bearish; rather, it measures the strength of the current trend.
- As such, ADX is often used to identify whether the market is ranging or initiating a new trend.
Use ADX #
- When using the ADX indicator, it is important to observe the 20 and 40 levels as key thresholds.
- While ADX does not explicitly indicate whether to buy or sell, it can be used to confirm whether a pair is likely to continue in its current trend or not.
- ADX can be used to determine when to close a trade early, as when it begins to drop below 50, it signals that the current trend is weakening.
Trading with Multiple Chart Indicators #
- To maximize the accuracy of trade signals, many traders opt to combine different indicators.
How to Use Oscillators to Warn You of the End of a Trend #
- Oscillators are objects or data that move between two points, oscillating between point A and point B.
- These oscillators are often used to signal a possible trend reversal, as a decrease in momentum may indicate that the current trend is weakening.
- Examples of oscillators include the Williams %R, Stochastic, and Relative Strength Index (RSI).
- However, these indicators may give conflicting signals, as each one is based on different calculations.
- It is important to not force a trade if the chart does not meet all of your criteria.
Leading vs. Lagging Indicators #
- There are two types of indicators: leading and lagging.
- Leading indicators provide signals prior to the emergence of a new trend or reversal, and are typically used to measure how “overbought” or “oversold” a currency pair is.
- Conversely, lagging indicators provide signals after the trend has started, and are useful for identifying long-term trends.
- While leading indicators may offer the potential for greater profits, they are also prone to generating false signals.
- Conversely, lagging indicators may not provide the same level of profits, but they are less likely to generate false signals.
- Therefore, it is important to understand the potential pitfalls of each type of indicator, and to use a combination of leading and lagging indicators to maximize profits while minimizing risk.
- The two types of technical indicators based on the timing of the signals they provide: leading indicators, which are typically oscillators that give a signal prior to the emergence of a new trend or reversal, and lagging indicators, also known as trend-following or trend-confirming indicators, which provide signals after the trend has begun.
- The advantages of leading indicators are that they can alert traders to potential reversals early, while the disadvantage is that they often generate false signals.
- Conversely, lagging indicators can be late to the party, missing out on a significant portion of the price move, but they are more reliable.
- Popular leading indicators include the Stochastic, the Relative Strength Index (RSI), Williams %R, and the Momentum indicator, while popular lagging indicators are Moving Averages (Simple, Exponential, Weighted), Parabolic SAR, and the Moving Average Convergence Divergence (MACD).
This Fibonacci ratio, which is found in many natural objects, is known as the golden ratio and is often denoted by the Greek letter, phi (φ).
The Fibonacci retracement levels are 0.236, 0.382, 0.618, 0.764, while the Fibonacci extension levels are 0, 0.382, 0.618, 1.000, 1.382, 1.618.
Fibonacci retracement levels are based on the theory that after a large price move in one direction, the price will retrace or return partway back to a previous price level before resuming in the original direction.
Traders use the Fibonacci retracement levels as potential support and resistance areas, while the Fibonacci extension levels are used as profit-taking levels.
They are horizontal lines that indicate potential support and resistance levels where price may reverse direction.
To apply Fibonacci levels to your charts, you’ll need to identify Swing High and Swing Low points.
- A Swing High is a candlestick with at least two lower highs on both the left and right of itself, while a Swing Low is a candlestick with at least two higher lows on both the left and right of itself.
- The expectation is that if the price retraces from a high or low, it will find support or resistance at one of the Fibonacci retracement levels due to traders placing orders at these levels.
- Price will not always bounce from these levels, and they should be viewed as areas of interest.
- It is difficult to determine the Swing High and Swing Low points, as different traders may have different interpretations of the chart.
- Therefore, it is necessary to combine the Fibonacci retracement tool with other tools in order to increase the likelihood of success.
Use Fibonacci Retracement with other tools #
If Fibonacci levels also act as support and resistance levels, and these levels align with other price areas that are widely watched by traders, then the likelihood of price bouncing off these areas is higher.
Traders may consider former resistance levels that may become support levels in the future, as well as diagonal support or resistance levels drawn with trendlines, when determining areas of price interest.
By considering the collective attention of other traders, recognizing these areas of interest can bolster traders’ confidence in their trades.
However it is essential to remember that trading is all about probabilities and there is no assurance that the price will bounce off these levels.
Traders may gain further confirmation that a Fibonacci retracement level may be holding by identifying exhaustive candlestick patterns (for example, doji), which is also known as “Fib Sticks”.
Take Profit with Fibonacci Extensions #
- In an uptrend, the idea is to take profits on a long trade at a Fibonacci Price Extension Level.
- The levels at which the price encounters resistance, such as 61.8%, 100%, and 161.8%, often serve as advantageous points to take profits.
- Conversely, in a downtrend, taking profits at the Fibonacci extension levels is also a common approach since the market often finds support at these levels, such as 38.2%, 50.0%, and 61.8%.
- It is important to exercise discretion in selecting the Swing Low and assessing the strength of the trend.
Use Fibonacci to Place Your Stop #
The first method is to set the stop loss just beyond the next Fibonacci level.
For example, if one is planning to enter at the 38.2% Fib level, the stop loss should be placed beyond the 50.0% level.
This method assumes that the 50.0% level will act as a resistance point, and if the price rises beyond this point, the trade idea is invalidated.
This method is best used for short-term, intraday trades.
The second method is to place the stop loss past the recent Swing High or Swing Low.
If the price is in an uptrend and one is in a long position, the stop loss should be placed below the latest Swing Low.
Conversely, if the price is in a downtrend and one is in a short position, the stop loss should be placed above the Swing High.
This method provides more room for the trade to breathe and increases the chances of the market moving in favor of the trade.
This method is best used for longer-term, swing trades.
Trading Divergences #
- Divergence is characterized by the divergence of the price from a technical indicator.
- Examples of momentum oscillators include the Commodity Channel Index (CCI), Relative Strength Index (RSI), Stochastic, and Williams %R.
- This is done by observing the discrepancy between price action and the movement of an indicator.
- There are two types of divergence: regular and hidden.
Regular Divergence #
- Regular divergence is a potential indication of a trend reversal, which can be either bullish or bearish.
- Bullish divergence occurs when the price is making lower lows (LL) while the oscillator is making higher lows (HL), typically at the end of a downtrend.
- This suggests that, as price and momentum are usually expected to move in tandem, the price will likely rise.
- Conversely, bearish divergence is seen when the price is making higher highs (HH) while the oscillator is making lower highs (LH), usually in an uptrend.
- This implies that the price will likely reverse and drop.
- Regular divergence is thus useful for identifying potential tops and bottoms.
Hidden Divergence #
- Regular divergences, which indicate a potential trend reversal.
- Hidden divergences, on the other hand, signify that the trend is likely to continue.
- For instance, a hidden bullish divergence will become evident when the price makes a higher low (HL) but the oscillator displays a lower low (LL).
- This signal is most likely to occur in an uptrend.
- In contrast, hidden bearish divergence is observed when the price makes a lower high (LH) and the oscillator shows a higher high (HH).
- This usually occurs in a downtrend.
- Regular divergences are linked to trend reversals, while hidden divergences are indicative of trend continuation.
How to Avoid Entering Too Early When Trading Divergences #
- There is a risk of entering too early without sufficient confirmation.
- To avoid this, one can wait for an indicator crossover or for the oscillator to move out of overbought/oversold region.
What is a Trending Market? #
- A trending market is one in which the price is generally moving in a single direction, with occasional retracements.
- This trend can be identified by observing the pattern of “higher highs” and “higher lows” in an uptrend, or “lower highs” and “lower lows” in a downtrend.
Trading Ranges #
What is a Range-Bound Market? #
A range-bound market is one in which the price fluctuates between a specific high and low, with the high acting as a major resistance level and the low as a major support level.
This type of market movement is often referred to as horizontal, ranging, or sideways.
It is also referred to as a “choppy market”.
Popular tools used for range trading include channels and oscillators such as Stochastic or Relative Strength Index (RSI).
Traders should be aware of both trending and range-bound environments and employ the appropriate strategies for each.
Trend Retracement or Reversal? #
- Price action may be exhibiting a temporary deviation from the established trend, known as a retracement, or a change in the overall trend, known as a reversal.
- To protect oneself from false signals, it is important to recognize the difference between the two.
How to Identify Reversals and Retracements #
Fibonacci retracement levels, pivot points, and trend lines are all useful tools for discerning whether a price movement is a temporary retracement or a long-term reversal. For instance, Fibonacci retracement levels can indicate a reversal if the price surpasses the 38.2%, 50.0%, or 61.8% levels. Similarly, a break in a major trend line may signal a reversal.
Protect Yo Self From Reversals #
- Trading Reversals can be tricky, as reversals can occur without warning and retracements can quickly turn into reversals.
- To mitigate this risk, some traders use trailing stops in trending markets, which could help to prevent exiting a position too early during a retracement and enable a timely exit during a reversal.
How to Trade Breakouts #
- Breakouts refer to when the price surpasses a certain level of consolidation or trading range.
- Such levels may include support and resistance levels, pivot points, and Fibonacci levels.
- The objective of breakout trades is to enter the market when the price makes a breakout and then ride the trade until volatility decreases.
- In the forex market, traders are unable to access volume data, which is essential for making good breakout trades in stocks or futures.
- As there is no way to view the volume of trades in the forex, volatility must be used to detect potential breakouts.
How to Measure Volatility #
- By measuring the overall price fluctuations over a given period, one can detect potential breakouts.
- Several indicators can be employed to gauge volatility, such as moving averages, Bollinger Bands, and Average True Range (ATR).
- Moving averages measure the average movement of the market for a specified amount of time, while Bollinger Bands plot two lines two standard deviations above and below a moving average.
- ATR provides the average trading range of the market for a given period.
Break Out #
- A breakout is when prices surpass and remain beyond an area of support or resistance.
- Generally, price will fluctuate between the areas of support and resistance, and when it breaches either one of these thresholds, it can be interpreted as a trend in the direction of the breach.
- Frequently, the resistance level that the price surpasses becomes a new support level, and vice versa.
Types of Breakouts #
- Two primary varieties: Continuation and Reversal.
- Breakouts are significant as they indicate a shift in supply and demand, potentially leading to extensive movements that offer lucrative opportunities.
- Continuation Breakouts occur when traders decide that the initial trend was the correct decision and continue to drive the price in the same direction.
- Reversal Breakouts, on the other hand, take place when traders conclude that the trend is exhausted and push the price in the opposite direction.
- False Breakouts may also occur, wherein the price surpasses a certain level but fails to maintain its momentum.
- To trade a breakout safely, it is advisable to wait until the price retraces back to the original breakout level and then observe if it bounces back to create a new high or low.
- One may also opt to not take the first breakout they observe.
How to Trade Breakouts Using Trend Lines, Channels and Triangles #
Breakouts are more likely to be successful when there is an economic event or news catalyst.
Chart patterns, such as double tops/bottoms, head and shoulders, and triple tops/bottoms, can be used to indicate a reversal breakout.
Trend lines are drawn to connect at least two tops or bottoms together, and when the price approaches the trend line, it can either bounce off and continue the trend or break out and cause a reversal.
Trend channels are similar to trend lines, except that after a trend line is drawn, the other side is added.
When the price reaches one of the channel lines, a breakout can occur in either direction of the trend.
Triangles are formed when the market price starts off volatile and begins to consolidate into a tight range.
Ascending triangles are generally bullish signals, and when the resistance level is breached, traders should go long.
Descending triangles are generally bearish signals, and when the support level is breached, traders should go short.
Symmetrical triangles have no directional bias, and traders should be ready to trade a breakout on either side.
How to Measure the Strength of a Breakout #
- MACD can be displayed as a histogram to measure the strength of a breakout, while RSI can be used to detect divergences and determine whether a market is overbought or oversold.
- Signs that the trend may be reversing.
- When MACD begins to decrease even when the trend is continuing, it can be inferred that momentum is waning and the trend may be close to its end.
- RSI divergence.
- RSI has been in overbought or oversold territory for an extended period of time and begins to move back
How to Detect Fakeouts (False breakouts) #
- Fakeouts can occur, wherein the price appears to break out of a support or resistance level, only to quickly reverse direction.
- Support and resistance levels are areas in which a predictable price action often occurs, with support levels representing areas of buying pressure that can halt or reverse a downtrend, and resistance levels representing areas of selling pressure that can halt or reverse an uptrend.
Trading false breakouts #
- Fading breakouts(trading false breakouts), or trading in the opposite direction of the breakout is a short-term trading strategy for traders who believe that a breakout from a support or resistance level is false.
- Fakeouts are usually found at support and resistance levels created through trend lines, chart patterns, or previous daily highs or lows, and are more likely to occur in a range-bound market with no major economic event or news catalyst.
Multiple Time Frame Analysis #
The optimal time frame for trading is contingent upon the individual trader’s personality, preferences, the amount of capital available, trading stategy etc.
To determine the most suitable time frame, it is recommended that new traders experiment with different time frames through demo trading.
Multiple Time Frame Analysis.
- 1 Move up to higher time frames to determine the direction of the trend
- 2 Returning to your preferred time frame to look at short-term trend and find suitable entry and exit points.