Learn to Trade FOREX
Learn to Trade FOREX is a self study online training program designed to introduce investors to the global Foreign Exchange (Forex) market. Developed by GAIN Capital Group, the program shares the considerable expertise of GAIN's senior traders and market analysts.
Study and learn at your own pace.
Learn to Trade FOREX consists of seven web-based lessons and will teach you how to:
Understand currency quoting and the factors that drive individual currency movements
Read and analyze currency charts using advanced technical tools
Recognize trends in the market
Utilize tools to help you manage risk
Anticipate and react to major economic event impacting global currenciesEmploy sound money management techniques
Introduction to Fundamental Analysis
Fundamental analysis refers to the study of the core underlying elements that influence the economy of a particular entity. It is a method of study that attempts to predict price action and market trends by analyzing economic indicators, government policy and societal factors (to name just a few elements) within a business cycle framework. If you think of the financial markets as a big clock, the fundamentals are the gears and springs that move the hands around the face. Anyone walking down the street can look at this clock and tell you what time it is now, but the fundamentalist can tell you how it came to be this time and more importantly, what time (or more precisely, what price) it will be in the future.
There is a tendency to pigeonhole traders into two distinct schools of market analysis - fundamental and technical. Indeed, the first question posed to you after you tell someone that you are a trader is generally "Are you a technician or a fundamentalist?" The reality is that it has become increasingly difficult to be a purist of either persuasion. Fundamentalists need to keep an eye on the various signals derived from the price action on charts, while few technicians can afford to completely ignore impending economic data, critical political decisions or the myriad of societal issues that influence prices.
Bearing in mind that the financial underpinnings of any country, trading bloc or multinational industry takes into account many factors, including social, political and economic influences, staying on top of an extremely fluid fundamental picture can be challenging. At the same time, you'll find that your knowledge and understanding of a dynamic global market will increase immeasurably as you delve further and further into the complexities and subtleties of the fundamentals of the markets.
Fundamental analysis is a very effective way to forecast economic conditions, but not necessarily exact market prices. For example, when analyzing an economist's forecast of the upcoming GDP or employment report, you begin to get a fairly clear picture of the general health of the economy and the forces at work behind it. However, you'll need to come up with a precise method as to how best to translate this information into entry and exit points for a particular trading strategy.
A trader who studies the markets using fundamental analysis will generally create models to formulate a trading strategy. These models typically utilize a host of empirical data and attempt to forecast market behavior and estimate future values or prices by using past values of core economic indicators. This information is then used to derive specific trades that best exploit this information.
Forecasting models are as numerous and varied as the traders and market buffs that create them. Two people can look at the exact same data and come up with two completely different conclusions about how the market will be influenced by it. Therefore is it important that before casting yourself into a particular mold regarding any aspect of market analysis, you study the fundamentals and see how they best fit your trading style and expectations.
Don't succumb to 'paralysis by analysis.' Given the multitude of factors that fall under the heading of "The Fundamentals," there is a distinct danger of information overload. Sometimes traders fall into this trap and are unable to pull the trigger on a trade. This is one of the reasons why many traders turn to technical analysis. To some, technical analysis is seen as a way to transform all of the fundamental factors that influence the markets into one simple tool, prices. However, trading a particular market without knowing a great deal about the exact nature of its underlying elements is like fishing without bait. You might get lucky and snare a few on occasion but it's not the best approach over the long haul.
For forex traders, the fundamentals are everything that makes a country tick. From interest rates and central bank policy to natural disasters, the fundamentals are a dynamic mix of distinct plans, erratic behaviors and unforeseen events. Therefore, it is best to get a handle on the most influential contributors to this diverse mix than it is to formulate a comprehensive list of all "The Fundamentals."
There is a tendency to pigeonhole traders into two distinct schools of market analysis - fundamental and technical. Indeed, the first question posed to you after you tell someone that you are a trader is generally "Are you a technician or a fundamentalist?" The reality is that it has become increasingly difficult to be a purist of either persuasion. Fundamentalists need to keep an eye on the various signals derived from the price action on charts, while few technicians can afford to completely ignore impending economic data, critical political decisions or the myriad of societal issues that influence prices.
Bearing in mind that the financial underpinnings of any country, trading bloc or multinational industry takes into account many factors, including social, political and economic influences, staying on top of an extremely fluid fundamental picture can be challenging. At the same time, you'll find that your knowledge and understanding of a dynamic global market will increase immeasurably as you delve further and further into the complexities and subtleties of the fundamentals of the markets.
Fundamental analysis is a very effective way to forecast economic conditions, but not necessarily exact market prices. For example, when analyzing an economist's forecast of the upcoming GDP or employment report, you begin to get a fairly clear picture of the general health of the economy and the forces at work behind it. However, you'll need to come up with a precise method as to how best to translate this information into entry and exit points for a particular trading strategy.
A trader who studies the markets using fundamental analysis will generally create models to formulate a trading strategy. These models typically utilize a host of empirical data and attempt to forecast market behavior and estimate future values or prices by using past values of core economic indicators. This information is then used to derive specific trades that best exploit this information.
Forecasting models are as numerous and varied as the traders and market buffs that create them. Two people can look at the exact same data and come up with two completely different conclusions about how the market will be influenced by it. Therefore is it important that before casting yourself into a particular mold regarding any aspect of market analysis, you study the fundamentals and see how they best fit your trading style and expectations.
Don't succumb to 'paralysis by analysis.' Given the multitude of factors that fall under the heading of "The Fundamentals," there is a distinct danger of information overload. Sometimes traders fall into this trap and are unable to pull the trigger on a trade. This is one of the reasons why many traders turn to technical analysis. To some, technical analysis is seen as a way to transform all of the fundamental factors that influence the markets into one simple tool, prices. However, trading a particular market without knowing a great deal about the exact nature of its underlying elements is like fishing without bait. You might get lucky and snare a few on occasion but it's not the best approach over the long haul.
For forex traders, the fundamentals are everything that makes a country tick. From interest rates and central bank policy to natural disasters, the fundamentals are a dynamic mix of distinct plans, erratic behaviors and unforeseen events. Therefore, it is best to get a handle on the most influential contributors to this diverse mix than it is to formulate a comprehensive list of all "The Fundamentals."
Economic Indicators 101
Economic indicators are snippets of financial and economic data published by various agencies of the government or private sector. These statistics, which are made public on a regularly scheduled basis, help market observers monitor the pulse of the economy. Therefore, they are religiously followed by almost everyone in the financial markets. With so many people poised to react to the same information, economic indicators in general have tremendous potential to generate volume and to move prices in the markets. While on the surface it might seem that an advanced degree in economics would come in handy to analyze and then trade on the glut of information contained in these economic indicators, a few simple guidelines are all that is necessary to track, organize and make trading decisions based on the data.
Know exactly when each economic indicator is due to be released. Keep a calendar on your desk or trading station that contains the date and time when each stat will be made public..
Keeping track of the calendar of economic indicators will also help you make sense out of otherwise unanticipated price action in the market. Consider this scenario: it's Monday morning and the USD has been in a tailspin for three weeks. As such, it's safe to assume that many traders are holding large short USD positions. However, on Friday the employment data for the U.S. is due to be released. It is very likely that with this key piece of economic information soon to be made public, the USD could experience a short-term rally leading up to the data on Friday as traders pare down their short positions. The point here is that economic indicators can effect prices directly (following their release to the public) or indirectly (as traders massage their positions in anticipation of the data.)
Understand what particular aspect of the economy is being revealed in the data. For example, you should know which indicators measure the growth of the economy (GDP) vs. those that measure inflation (PPI, CPI) or employment (non-farm payrolls). After you follow the data for a while, you'll become very familiar with the nuances of each economic indicator and what part of the economy they are measuring.
Not all economic indicators are created equal. Well, they might've been created with equal importance but along the way, some have acquired much greater potential to move the markets than others. Market participants will place higher regard on one stat vs. another depending on the state of the economy.
Know which indicators the markets are keying on. For example, if prices (inflation) are not a crucial issue for a particular country, inflation data will probably not be as keenly anticipated or reacted to by the markets. On the other hand, if economic growth is a vexing problem, changes in employment data or GDP will be eagerly anticipated and could precipitate tremendous volatility following their release.
The data itself is not as important as whether or not it falls within market expectations. Besides knowing when all the data will hit the wires, it is vitally important that you know what economists and other market pundits are forecasting for each indicator. For example, knowing the economic consequences of an unexpected monthly rise of 0.3% in the producer price index (PPI) is not nearly as vital to your short-term trading decisions as it is to know that this month the market was looking for PPI to fall by 0.1%. As mentioned, you should know that PPI measures prices and that an unexpected rise could be a sign of inflation. But analyzing the longer-term ramifications of this unexpected monthly rise in prices can wait until after you've taken advantage of the trading opportunities presented by the data. Once again, market expectations for all economic releases are published on various sources on the Web and you should post these expectations on your calendar along with the release date of the indicator.
Don't get caught up in the headlineNews. Part of getting a handle on what the market is forecasting for various economic indicators is knowing the key aspects of each indicator. While your macroeconomics professor might have drilled the significance of the unemployment rate into your head, even junior traders can tell you that the headlineNew figure is for amateurs and that the most closely watched detail in the payroll data is the non-farm payrolls figure. Other economic indicators are similar in that the headlineNew figure is not nearly as closely watched as the finer points of the data. PPI for example, measures changes in producer prices. But the stat most closely watched by the markets is PPI, ex-food and energy. Traders know that the food and energy component of the data is much too volatile and subject to revisions on a month-to-month basis to provide an accurate reading on the changes in producer prices.
Speaking of revisions, don't be too quick to pull that trigger should a particular economic indicator fall outside of market expectations. Contained in each new economic indicator released to the public are revisions to previously released data. For example, if durable goods should rise by 0.5% in the current month, while the market is anticipating them to fall, the unexpected rise could be the result of a downward revision to the prior month. Look at revisions to older data because in this case, the previous month's durable goods figure might've been originally reported as a rise of 0.5% but now, along with the new figures, is being revised lower to say a rise of only 0.1% Therefore, the unexpected rise in the current month is likely the result of a downward revision to the previous month's data.
Don't forget that there are two sides to a trade in the foreign exchange market. So, while you might have a great handle on the complete package of economic indicators published in the United States or Europe, most other countries also publish similar economic data. The important thing to remember here is that not all countries are as efficient as the G7 in releasing this information. Once again, if you are going to trade the currency of a particular country, you need to find out the particulars about their economic indicators. As mentioned above, not all of these indicators carry the same weight in the markets and not all of them are as accurate as others. Do your homework and you won't be caught off guard.
General information regarding major economic indicators
When focusing exclusively on the impact that economic indicators have on price action in a particular market, the foreign exchange markets are the most challenging, and therefore, have greatest potential for profits of any market. Obviously, factors other than economic indicators move prices and as such make other markets more or less potentially profitable. But since a currency is a proxy for the country it represents, the economic health of that country is priced into the currency. One very important way to measure the health of an economy is through economic indicators. The challenge comes in diligently keeping track of the nuts and bolts of each country's particular economic information package. Here are a few general comments about economic indicators and some of the more closely watched data.
Most economic indicators can be divided into leading and lagging indicators.
Leading indicators are economic factors that change before the economy starts to follow a particular pattern or trend. Leading indicators are used to predict changes in the economy.
Lagging Indicators are economic factors that change after the economy has already begun to follow a particular pattern or trend.
Major Indicators
The Gross Domestic Product (GDP) - The sum of all goods and services produced either by domestic or foreign companies. GDP indicates the pace at which a country's economy is growing (or shrinking) and is considered the broadest indicator of economic output and growth.
Industrial Production - It is a chain-weighted measure of the change in the production of the nation's factories, mines and utilities as well as a measure of their industrial capacity and of how many available resources among factories, utilities and mines are being used (commonly known as capacity utilization). The manufacturing sector accounts for one-quarter of the economy. The capacity utilization rate provides an estimate of how much factory capacity is in use.
Purchasing Managers Index (PMI) - The National Association of Purchasing Managers (NAPM), now called the Institute for Supply Management, releases a monthly composite index of national manufacturing conditions, constructed from data on new orders, production, supplier delivery times, backlogs, inventories, prices, employment, export orders, and import orders. It is divided into manufacturing and non-manufacturing sub-indices.
Producer Price Index (PPI) - The Producer Price Index (PPI) is a measure of price changes in the manufacturing sector. It measures average changes in selling prices received by domestic producers in the manufacturing, mining, agriculture, and electric utility industries for their output. The PPIs most often used for economic analysis are those for finished goods, intermediate goods, and crude goods.
Consumer Price Index (CPI) - The Consumer Price Index (CPI) is a measure of the average price level paid by urban consumers (80% of population) for a fixed basket of goods and services. It reports price changes in over 200 categories. The CPI also includes various user fees and taxes directly associated with the prices of specific goods and services.
Durable Goods - Durable Goods Orders measures new orders placed with domestic manufacturers for immediate and future delivery of factory hard goods. A durable good is defined as a good that lasts an extended period of time (over three years) during which its services are extended.
Employment Cost Index (ECI) - Payroll employment is a measure of the number of jobs in more than 500 industries in all states and 255 metropolitan areas. The employment estimates are based on a survey of larger businesses and counts the number of paid employees working part-time or full-time in the nation's business and government establishments.
Retail Sales - The retail sales report is a measure of the total receipts of retail stores from samples representing all sizes and kinds of business in retail trade throughout the nation. It is the timeliest indicator of broad consumer spending patterns and is adjusted for normal seasonal variation, holidays, and trading-day differences. Retail sales include durable and nondurable merchandise sold, and services and excise taxes incidental to the sale of merchandise. Excluded are sales taxes collected directly from the customer.
Housing Starts - The Housing Starts report measures the number of residential units on which construction is begun each month. A start in construction is defined as the beginning of excavation of the foundation for the building and is comprised primarily of residential housing. Housing is very interest rate sensitive and is one of the first sectors to react to changes in interest rates. Significant reaction of start/permits to changing interest rates signals interest rates are nearing trough or peak. To analyze, focus on the percentage change in levels from the previous month. Report is released around the middle of the following month.
Know exactly when each economic indicator is due to be released. Keep a calendar on your desk or trading station that contains the date and time when each stat will be made public..
Keeping track of the calendar of economic indicators will also help you make sense out of otherwise unanticipated price action in the market. Consider this scenario: it's Monday morning and the USD has been in a tailspin for three weeks. As such, it's safe to assume that many traders are holding large short USD positions. However, on Friday the employment data for the U.S. is due to be released. It is very likely that with this key piece of economic information soon to be made public, the USD could experience a short-term rally leading up to the data on Friday as traders pare down their short positions. The point here is that economic indicators can effect prices directly (following their release to the public) or indirectly (as traders massage their positions in anticipation of the data.)
Understand what particular aspect of the economy is being revealed in the data. For example, you should know which indicators measure the growth of the economy (GDP) vs. those that measure inflation (PPI, CPI) or employment (non-farm payrolls). After you follow the data for a while, you'll become very familiar with the nuances of each economic indicator and what part of the economy they are measuring.
Not all economic indicators are created equal. Well, they might've been created with equal importance but along the way, some have acquired much greater potential to move the markets than others. Market participants will place higher regard on one stat vs. another depending on the state of the economy.
Know which indicators the markets are keying on. For example, if prices (inflation) are not a crucial issue for a particular country, inflation data will probably not be as keenly anticipated or reacted to by the markets. On the other hand, if economic growth is a vexing problem, changes in employment data or GDP will be eagerly anticipated and could precipitate tremendous volatility following their release.
The data itself is not as important as whether or not it falls within market expectations. Besides knowing when all the data will hit the wires, it is vitally important that you know what economists and other market pundits are forecasting for each indicator. For example, knowing the economic consequences of an unexpected monthly rise of 0.3% in the producer price index (PPI) is not nearly as vital to your short-term trading decisions as it is to know that this month the market was looking for PPI to fall by 0.1%. As mentioned, you should know that PPI measures prices and that an unexpected rise could be a sign of inflation. But analyzing the longer-term ramifications of this unexpected monthly rise in prices can wait until after you've taken advantage of the trading opportunities presented by the data. Once again, market expectations for all economic releases are published on various sources on the Web and you should post these expectations on your calendar along with the release date of the indicator.
Don't get caught up in the headlineNews. Part of getting a handle on what the market is forecasting for various economic indicators is knowing the key aspects of each indicator. While your macroeconomics professor might have drilled the significance of the unemployment rate into your head, even junior traders can tell you that the headlineNew figure is for amateurs and that the most closely watched detail in the payroll data is the non-farm payrolls figure. Other economic indicators are similar in that the headlineNew figure is not nearly as closely watched as the finer points of the data. PPI for example, measures changes in producer prices. But the stat most closely watched by the markets is PPI, ex-food and energy. Traders know that the food and energy component of the data is much too volatile and subject to revisions on a month-to-month basis to provide an accurate reading on the changes in producer prices.
Speaking of revisions, don't be too quick to pull that trigger should a particular economic indicator fall outside of market expectations. Contained in each new economic indicator released to the public are revisions to previously released data. For example, if durable goods should rise by 0.5% in the current month, while the market is anticipating them to fall, the unexpected rise could be the result of a downward revision to the prior month. Look at revisions to older data because in this case, the previous month's durable goods figure might've been originally reported as a rise of 0.5% but now, along with the new figures, is being revised lower to say a rise of only 0.1% Therefore, the unexpected rise in the current month is likely the result of a downward revision to the previous month's data.
Don't forget that there are two sides to a trade in the foreign exchange market. So, while you might have a great handle on the complete package of economic indicators published in the United States or Europe, most other countries also publish similar economic data. The important thing to remember here is that not all countries are as efficient as the G7 in releasing this information. Once again, if you are going to trade the currency of a particular country, you need to find out the particulars about their economic indicators. As mentioned above, not all of these indicators carry the same weight in the markets and not all of them are as accurate as others. Do your homework and you won't be caught off guard.
General information regarding major economic indicators
When focusing exclusively on the impact that economic indicators have on price action in a particular market, the foreign exchange markets are the most challenging, and therefore, have greatest potential for profits of any market. Obviously, factors other than economic indicators move prices and as such make other markets more or less potentially profitable. But since a currency is a proxy for the country it represents, the economic health of that country is priced into the currency. One very important way to measure the health of an economy is through economic indicators. The challenge comes in diligently keeping track of the nuts and bolts of each country's particular economic information package. Here are a few general comments about economic indicators and some of the more closely watched data.
Most economic indicators can be divided into leading and lagging indicators.
Leading indicators are economic factors that change before the economy starts to follow a particular pattern or trend. Leading indicators are used to predict changes in the economy.
Lagging Indicators are economic factors that change after the economy has already begun to follow a particular pattern or trend.
Major Indicators
The Gross Domestic Product (GDP) - The sum of all goods and services produced either by domestic or foreign companies. GDP indicates the pace at which a country's economy is growing (or shrinking) and is considered the broadest indicator of economic output and growth.
Industrial Production - It is a chain-weighted measure of the change in the production of the nation's factories, mines and utilities as well as a measure of their industrial capacity and of how many available resources among factories, utilities and mines are being used (commonly known as capacity utilization). The manufacturing sector accounts for one-quarter of the economy. The capacity utilization rate provides an estimate of how much factory capacity is in use.
Purchasing Managers Index (PMI) - The National Association of Purchasing Managers (NAPM), now called the Institute for Supply Management, releases a monthly composite index of national manufacturing conditions, constructed from data on new orders, production, supplier delivery times, backlogs, inventories, prices, employment, export orders, and import orders. It is divided into manufacturing and non-manufacturing sub-indices.
Producer Price Index (PPI) - The Producer Price Index (PPI) is a measure of price changes in the manufacturing sector. It measures average changes in selling prices received by domestic producers in the manufacturing, mining, agriculture, and electric utility industries for their output. The PPIs most often used for economic analysis are those for finished goods, intermediate goods, and crude goods.
Consumer Price Index (CPI) - The Consumer Price Index (CPI) is a measure of the average price level paid by urban consumers (80% of population) for a fixed basket of goods and services. It reports price changes in over 200 categories. The CPI also includes various user fees and taxes directly associated with the prices of specific goods and services.
Durable Goods - Durable Goods Orders measures new orders placed with domestic manufacturers for immediate and future delivery of factory hard goods. A durable good is defined as a good that lasts an extended period of time (over three years) during which its services are extended.
Employment Cost Index (ECI) - Payroll employment is a measure of the number of jobs in more than 500 industries in all states and 255 metropolitan areas. The employment estimates are based on a survey of larger businesses and counts the number of paid employees working part-time or full-time in the nation's business and government establishments.
Retail Sales - The retail sales report is a measure of the total receipts of retail stores from samples representing all sizes and kinds of business in retail trade throughout the nation. It is the timeliest indicator of broad consumer spending patterns and is adjusted for normal seasonal variation, holidays, and trading-day differences. Retail sales include durable and nondurable merchandise sold, and services and excise taxes incidental to the sale of merchandise. Excluded are sales taxes collected directly from the customer.
Housing Starts - The Housing Starts report measures the number of residential units on which construction is begun each month. A start in construction is defined as the beginning of excavation of the foundation for the building and is comprised primarily of residential housing. Housing is very interest rate sensitive and is one of the first sectors to react to changes in interest rates. Significant reaction of start/permits to changing interest rates signals interest rates are nearing trough or peak. To analyze, focus on the percentage change in levels from the previous month. Report is released around the middle of the following month.
Tailoring Your Technical Approach
Tailoring Your Technical Approach to Currency "Personalities"
Much has been written about the suitability of technical analysis for trading in the currency markets. While this is undoubtedly true, it can leave traders, particularly those new to the currency markets, with the impression that all technical tools are equally applicable to all major currency pairs. Perhaps most dangerous from the standpoint of profitability, it can also seduce traders into searching for the proverbial silver bullet: that magic technical tool or study that works for all currency pairs, all the time. However, anyone who has traded forex for any length of time will recognize that, for example, dollar/Yen (USD/JPY) and dollar/Swiss (USD/CHF) trade in distinctly different fashions.
Why, then, should a one-size-fits-all technical approach be expected to produce steady trading results? Instead, traders are more likely to experience improved results if they recognize the differences between the major currency pairs and employ different technical strategies to them. This article will explore some of the differences between the major currency pairs and suggest technical approaches that are best suited to each pair's behavioral tendencies.
The Biggie
By far the most actively traded currency pair is euro/dollar (EUR/USD), accounting for 28 percent of daily global volume in the most recent Bank for International Settlements (BIS) survey of currency market activity. EUR/USD receives further interest from volume generated by the Euro-crosses (e.g. euro/British pound (EUR/GBP), EUR/CHF and EUR/JPY, and this interest tends to be contrary to the underlying U.S. dollar direction. For example, in a U.S. dollar-negative environment, the Euro will have an underlying bid stemming from overall U.S. dollar selling. However, less liquid dollar pairs (e.g. USD/CHF) will be sold through the more liquid Euro crosses, in this case resulting in EUR/CHF selling, which introduces a Euro offer into the EUR/USD market.
This two-way interest tends to slow Euro movements relative to other major dollar pairs and makes it an ideal market for short-term traders, who can exploit "backing and filling." On the other hand, this depth of liquidity also means EUR/USD tends to experience prolonged, seemingly inconclusive tests of technical levels, whether generated by trendline analysis or Fibonacci/Elliott wave calculations. This suggests breakout traders need to allow for a greater margin of error: 20-30 pips. (A pip is the smallest increment in which a foreign currency can trade with respect to identifying breaks of technical levels.) Another way to gauge whether EUR/USD is breaking out is to look to the less liquid USD/CHF and GBP/USD. If these pairs have broken equivalent technical levels, for example recent daily highs, then EUR/USD is likely to do the same after a lag. If "Swissy" and "Cable" (popular name for British pound) are stalling at those levels, then EUR/USD will likely fail as well.
Customize Your Settings
In terms of technical studies, the overwhelming depth of EUR/USD suggests that momentum oscillators are well-suited to trading the euro, but traders should consider adjusting the studies' parameters (increase time periods) to account for the relatively plodding, back-and-fill movements of EUR/USD. See Figure 1. In this sense, reliance on very short-term indicators (less than 30 minutes) exposes traders to an increased likelihood of "whipsaw" movements. Moving average convergence divergence (MACD) as a momentum study is well-suited to EUR/USD, particularly because it utilizes exponential moving averages (greater weight to more recent prices, less to old prices) in conjunction with a third moving average, resulting in fewer false crossovers. Short-term (hourly) momentum divergences routinely occur in EUR/USD, but they need to be confirmed by breaks of price levels identified though trendline analysis to suggest an actionable trade. When larger moves are underway, traders are also likely to find the directional movement indicator (DMI) system useful for confirming whether a trend is in place, in which case momentum readings should be discounted, and might choose to rely on DI+/DI- crossovers for additional trade entry signals.
Second Place
The next most actively traded currency pair is USD/JPY, which accounted for 17 percent of daily global volume in the 2004 BIS survey of currency market turnover. USD/JPY has traditionally been the most politically sensitive currency pair, with successive U.S. governments using the exchange rate as a lever in trade negotiations with Japan. While China has recently replaced Japan as the Asian market evoking U.S. trade tensions, USD/JPY still acts as a regional currency proxy for China and other less-liquid, highly regulated Asian currencies. In this sense, USD/JPY is frequently prone to extended trending periods as trade or regional political themes (e.g. yuan revaluation) play out.
For day-to-day trading, however, the most significant feature of USD/JPY is the heavy influence exerted by Japanese institutional investors and asset managers. Due to a culture of intra-Japanese collegiality, including extensive position and strategy information-sharing, Japanese asset managers frequently act in the same direction on the yen in the currency market. In concrete terms, this frequently manifests itself in clusters of orders at similar price or technical levels, which then reinforce those levels as points of support or resistance. Once these levels are breached, similar clusters of stop loss orders are frequently just behind, which in turn fuel the breakout. Also, as the Japanese investment community moves en masse into a particular trade, they tend to drive the market away from themselves for periods of time, all the while adjusting their orders to the new price levels, for instance raising limit buy orders as the price rises.
An alternate tactic frequently employed by Japanese asset managers is to stagger orders to take advantage of any short-term reversals in the direction of the larger trend. For example, if USD/JPY is at 115.00 and trending higher, USD/JPY buying orders would be placed at arbitrary price points, such as 114.75, 114.50, 114.25 and 114.00, to take advantage of any pullback in the broader trend. This also helps explain why USD/JPY frequently encounters support or resistance at numerically round levels, even though there may be no other corresponding technical significance.
Take A Look at Trendlines
Turning to the technical side of USD/JPY, the foregoing discussion suggests trendline analysis as perhaps the most significant technical tool for trading USD/JPY. Because of the clustering of Japanese institutional orders around technical or price levels, USD/JPY tends to experience fewer false breaks of trendlines. For example, large-scale selling interest at technical resistance will need to be absorbed if the technical level is to be broken. This is likely to happen only if a larger market move is unfolding, and this suggests any break will be sustained. This makes USD/JPY ideal for breakout traders who employ stop-loss entry orders on breaks of trendline support or resistance. Short-term trendlines, such as hourly or 15 minutes, can be used effectively, but traders need to operate on a similarly short-term basis; daily closing levels hold the most meaning in USD/JPY. In terms of chart analysis, Japanese institutional asset managers rely heavily on candlestick charts (which depend heavily on daily close levels) and traders would be well-advised to learn to recognize major candlestick patterns, such as doji, hanging man, tweezer tops/bottoms and the like. See Figure 2. When it comes to significant trend reversals or pauses, daily close (5 p.m. EST), candlesticks are highly reliable leading indicators.
The yen discussion above also highlighted the factors behind the propensity of USD/JPY to trend over the medium-term (multiweek). This facet suggests traders should look to trend following tools such as moving averages (21- and 55-day perio ds are heavily used), DMI, and Parabolic SAR. (This refers to J. Welles Wilder Jr.'s Parabolic System. SAR stands for stop and reverse.) Momentum oscillators such as the relative strength index (RSI), MACD or stochastics should generally be avoided, especially intraday, due to the trending and institutional nature driving USD/JPY. While a momentum indicator may reverse course, typically suggesting a potential trade, price action often fails to reverse enough to make the trade worthwhile due to underlying institutional interest. Instead of reversing along with momentum, USD/JPY price action will frequently settle into a sideways range, allowing momentum studies to continue to unwind, until the underlying trend resumes. Finally, Ichimoku analysis (roughly translated as one-glance cloud chart) is another largely Japanese-specific trend identification system that highlights trends and major reversals.
A Look At Some Illiquid Currencies
Having looked at the two most heavily traded currency pairs, let's now examine two of the least liquid major currency pairs, USD/CHF and GBP/USD, which pose special challenges to technically oriented traders. The so-called Swissy holds a place among the major currency pairs due to Switzerland's unique status as a global investment haven; estimates are that nearly one-third of the world's private assets are held in Switzerland. The Swiss franc has also acted historically as a so-called "safe-haven" currency alternative to the U.S. dollar in times of geo-political uncertainty, but this dimension has largely faded since the end of the Cold War. Today, USD/CHF trades mostly based on overall U.S. dollar sentiment, as opposed to Swiss-based economic fundamentals. The Swiss National Bank (SNB) is primarily concerned with the franc's value relative to the euro, since the vast majority of Swiss trade is with the European Union, and Swiss fundamental developments are primarily reflected in the EUR/CHF cross rate.
Liquidity in USD/CHF is never very good, and this makes it a favorite "whipping horse" for hedge funds and other speculative interests looking to maximize the bang for their buck. The lower liquidity and higher volatility of Swissy also makes it a significant leading indicator for major U.S. dollar movements. Figure 3 illustrates an example of a recent break of major daily trendline support in USD/CHF that took place a full day before EUR/USD and USD/JPY broke equivalent levels. Swissy will also lead the way in shorter-term movements, but the overall volatility and general jitteriness of USD/CHF price action makes false breaks of technical levels common. These false breaks are frequently stop-loss driven and it is not unusual for prices to trade 15-25 points through a support/resistance level before reversing after the stop losses have been triggered. In strong directional moves, USD/CHF price action tends toward extreme one-way traffic, with minimal backing and filling in comparison to EUR/USD.
Cable (GBP/USD), or sterling, also suffers from relatively poor liquidity and this is in part due to its higher pip value (U.S. dollars) and the relatively Euro-centric basis of U.K. trade. Sterling shares many of the same trading characteristics of Swissy outlined just above, but Cable will also react sharply to U.K. fundamental data as well as to U.S. news. Sterling's price action will also display extreme one-way tendencies during larger moves, as traders caught on the wrong side chase the illiquid market to the extremes.
Focus On Risk Management
The volatility and illiquidity of Swissy and sterling suggests traders need to use a more proactive overall approach to trading these pairs, particularly concerning risk management (i.e. position size in relation to stop levels). With regard to technical tools, the tendency for both pairs to make short-term false breaks of chart levels suggests breakout traders need to be particularly disciplined concerning stop entry levels and should consider a greater margin of error on the order of 30-35 points. In this sense, trendline analysis of periods less than an hour tends to generate more noise than tradable break points, so a focus on longer time periods (four hours-daily) is likely to be more successful in identifying meaningful breaks. By the same token, once a breakout occurs, surpassing the margin of error, the ensuing one-way price action favors traders who are quick on the trigger, and this suggests employing resting stop-loss entry orders to reduce slippage. For those positioned with a move, trailing stops with an acceleration factor, such as parabolic SAR, are well suited to riding out directional volatility until a price reversal signals an exit.
The volatility inherent in Cable and Swissy makes the use of short-term (hourly and shorter) momentum oscillators problematic, due to both false crossovers and divergences between price/momentum that frequently occur in these time frames. Longer-period oscillators (four hours and more) are best used to highlight potential reversals or divergent price action, but volatility discourages initiating trades based on these alone. Instead, momentum signals need to be confirmed by other indicators, such as breaks of trendlines, Fibonacci retracements or parabolic levels, before a trade is initiated.
Try A Larger Retracement
With regard to Fibonacci retracement levels, the greater volatility of Cable and Swissy frequently sees them exceed 61.8-percent retracements, only to stall later at the 76.4-percent level, by which time most short-term Elliott wave followers have been stopped out. Short-term spike reversals of greater than 30 points also serve as a reliable way to identify when a directional surge, especially intraday, is completed, and these can be used as both profit taking and counter-trend trading signals. For counter-trend, corrective trades based on spike reversals, stops should be placed slightly beyond the extreme of the spike low/high. A final technical study that is well suited to the explosiveness of Swissy and sterling is the Williams %R, an overbought/oversold momentum indicator, which frequently acts as a leading indicator of price reversals. The overbought/oversold bands should be adjusted to -10/-90 to fit the higher volatility of Cable and Swissy. As with all overbought/oversold studies, however, price action needs to reverse course first before trades are initiated.
It's Not One Size Fits All
Traders who seek to apply technical trading approaches to the currency market should be aware of the differences in the trading characteristics of the major currency pairs. Just because the euro and the pound are both traded against the dollar does not mean they will trade identically to each other. A more thorough understanding of the various market traits of currencies suggests that certain technical tools are better suited to some currency pairs than others. A currency-specific approach to applying technical analysis is more likely to produce successful results than a one-size-fits-all application across all currency pairs.
Much has been written about the suitability of technical analysis for trading in the currency markets. While this is undoubtedly true, it can leave traders, particularly those new to the currency markets, with the impression that all technical tools are equally applicable to all major currency pairs. Perhaps most dangerous from the standpoint of profitability, it can also seduce traders into searching for the proverbial silver bullet: that magic technical tool or study that works for all currency pairs, all the time. However, anyone who has traded forex for any length of time will recognize that, for example, dollar/Yen (USD/JPY) and dollar/Swiss (USD/CHF) trade in distinctly different fashions.
Why, then, should a one-size-fits-all technical approach be expected to produce steady trading results? Instead, traders are more likely to experience improved results if they recognize the differences between the major currency pairs and employ different technical strategies to them. This article will explore some of the differences between the major currency pairs and suggest technical approaches that are best suited to each pair's behavioral tendencies.
The Biggie
By far the most actively traded currency pair is euro/dollar (EUR/USD), accounting for 28 percent of daily global volume in the most recent Bank for International Settlements (BIS) survey of currency market activity. EUR/USD receives further interest from volume generated by the Euro-crosses (e.g. euro/British pound (EUR/GBP), EUR/CHF and EUR/JPY, and this interest tends to be contrary to the underlying U.S. dollar direction. For example, in a U.S. dollar-negative environment, the Euro will have an underlying bid stemming from overall U.S. dollar selling. However, less liquid dollar pairs (e.g. USD/CHF) will be sold through the more liquid Euro crosses, in this case resulting in EUR/CHF selling, which introduces a Euro offer into the EUR/USD market.
This two-way interest tends to slow Euro movements relative to other major dollar pairs and makes it an ideal market for short-term traders, who can exploit "backing and filling." On the other hand, this depth of liquidity also means EUR/USD tends to experience prolonged, seemingly inconclusive tests of technical levels, whether generated by trendline analysis or Fibonacci/Elliott wave calculations. This suggests breakout traders need to allow for a greater margin of error: 20-30 pips. (A pip is the smallest increment in which a foreign currency can trade with respect to identifying breaks of technical levels.) Another way to gauge whether EUR/USD is breaking out is to look to the less liquid USD/CHF and GBP/USD. If these pairs have broken equivalent technical levels, for example recent daily highs, then EUR/USD is likely to do the same after a lag. If "Swissy" and "Cable" (popular name for British pound) are stalling at those levels, then EUR/USD will likely fail as well.
Customize Your Settings
In terms of technical studies, the overwhelming depth of EUR/USD suggests that momentum oscillators are well-suited to trading the euro, but traders should consider adjusting the studies' parameters (increase time periods) to account for the relatively plodding, back-and-fill movements of EUR/USD. See Figure 1. In this sense, reliance on very short-term indicators (less than 30 minutes) exposes traders to an increased likelihood of "whipsaw" movements. Moving average convergence divergence (MACD) as a momentum study is well-suited to EUR/USD, particularly because it utilizes exponential moving averages (greater weight to more recent prices, less to old prices) in conjunction with a third moving average, resulting in fewer false crossovers. Short-term (hourly) momentum divergences routinely occur in EUR/USD, but they need to be confirmed by breaks of price levels identified though trendline analysis to suggest an actionable trade. When larger moves are underway, traders are also likely to find the directional movement indicator (DMI) system useful for confirming whether a trend is in place, in which case momentum readings should be discounted, and might choose to rely on DI+/DI- crossovers for additional trade entry signals.
Second Place
The next most actively traded currency pair is USD/JPY, which accounted for 17 percent of daily global volume in the 2004 BIS survey of currency market turnover. USD/JPY has traditionally been the most politically sensitive currency pair, with successive U.S. governments using the exchange rate as a lever in trade negotiations with Japan. While China has recently replaced Japan as the Asian market evoking U.S. trade tensions, USD/JPY still acts as a regional currency proxy for China and other less-liquid, highly regulated Asian currencies. In this sense, USD/JPY is frequently prone to extended trending periods as trade or regional political themes (e.g. yuan revaluation) play out.
For day-to-day trading, however, the most significant feature of USD/JPY is the heavy influence exerted by Japanese institutional investors and asset managers. Due to a culture of intra-Japanese collegiality, including extensive position and strategy information-sharing, Japanese asset managers frequently act in the same direction on the yen in the currency market. In concrete terms, this frequently manifests itself in clusters of orders at similar price or technical levels, which then reinforce those levels as points of support or resistance. Once these levels are breached, similar clusters of stop loss orders are frequently just behind, which in turn fuel the breakout. Also, as the Japanese investment community moves en masse into a particular trade, they tend to drive the market away from themselves for periods of time, all the while adjusting their orders to the new price levels, for instance raising limit buy orders as the price rises.
An alternate tactic frequently employed by Japanese asset managers is to stagger orders to take advantage of any short-term reversals in the direction of the larger trend. For example, if USD/JPY is at 115.00 and trending higher, USD/JPY buying orders would be placed at arbitrary price points, such as 114.75, 114.50, 114.25 and 114.00, to take advantage of any pullback in the broader trend. This also helps explain why USD/JPY frequently encounters support or resistance at numerically round levels, even though there may be no other corresponding technical significance.
Take A Look at Trendlines
Turning to the technical side of USD/JPY, the foregoing discussion suggests trendline analysis as perhaps the most significant technical tool for trading USD/JPY. Because of the clustering of Japanese institutional orders around technical or price levels, USD/JPY tends to experience fewer false breaks of trendlines. For example, large-scale selling interest at technical resistance will need to be absorbed if the technical level is to be broken. This is likely to happen only if a larger market move is unfolding, and this suggests any break will be sustained. This makes USD/JPY ideal for breakout traders who employ stop-loss entry orders on breaks of trendline support or resistance. Short-term trendlines, such as hourly or 15 minutes, can be used effectively, but traders need to operate on a similarly short-term basis; daily closing levels hold the most meaning in USD/JPY. In terms of chart analysis, Japanese institutional asset managers rely heavily on candlestick charts (which depend heavily on daily close levels) and traders would be well-advised to learn to recognize major candlestick patterns, such as doji, hanging man, tweezer tops/bottoms and the like. See Figure 2. When it comes to significant trend reversals or pauses, daily close (5 p.m. EST), candlesticks are highly reliable leading indicators.
The yen discussion above also highlighted the factors behind the propensity of USD/JPY to trend over the medium-term (multiweek). This facet suggests traders should look to trend following tools such as moving averages (21- and 55-day perio ds are heavily used), DMI, and Parabolic SAR. (This refers to J. Welles Wilder Jr.'s Parabolic System. SAR stands for stop and reverse.) Momentum oscillators such as the relative strength index (RSI), MACD or stochastics should generally be avoided, especially intraday, due to the trending and institutional nature driving USD/JPY. While a momentum indicator may reverse course, typically suggesting a potential trade, price action often fails to reverse enough to make the trade worthwhile due to underlying institutional interest. Instead of reversing along with momentum, USD/JPY price action will frequently settle into a sideways range, allowing momentum studies to continue to unwind, until the underlying trend resumes. Finally, Ichimoku analysis (roughly translated as one-glance cloud chart) is another largely Japanese-specific trend identification system that highlights trends and major reversals.
A Look At Some Illiquid Currencies
Having looked at the two most heavily traded currency pairs, let's now examine two of the least liquid major currency pairs, USD/CHF and GBP/USD, which pose special challenges to technically oriented traders. The so-called Swissy holds a place among the major currency pairs due to Switzerland's unique status as a global investment haven; estimates are that nearly one-third of the world's private assets are held in Switzerland. The Swiss franc has also acted historically as a so-called "safe-haven" currency alternative to the U.S. dollar in times of geo-political uncertainty, but this dimension has largely faded since the end of the Cold War. Today, USD/CHF trades mostly based on overall U.S. dollar sentiment, as opposed to Swiss-based economic fundamentals. The Swiss National Bank (SNB) is primarily concerned with the franc's value relative to the euro, since the vast majority of Swiss trade is with the European Union, and Swiss fundamental developments are primarily reflected in the EUR/CHF cross rate.
Liquidity in USD/CHF is never very good, and this makes it a favorite "whipping horse" for hedge funds and other speculative interests looking to maximize the bang for their buck. The lower liquidity and higher volatility of Swissy also makes it a significant leading indicator for major U.S. dollar movements. Figure 3 illustrates an example of a recent break of major daily trendline support in USD/CHF that took place a full day before EUR/USD and USD/JPY broke equivalent levels. Swissy will also lead the way in shorter-term movements, but the overall volatility and general jitteriness of USD/CHF price action makes false breaks of technical levels common. These false breaks are frequently stop-loss driven and it is not unusual for prices to trade 15-25 points through a support/resistance level before reversing after the stop losses have been triggered. In strong directional moves, USD/CHF price action tends toward extreme one-way traffic, with minimal backing and filling in comparison to EUR/USD.
Cable (GBP/USD), or sterling, also suffers from relatively poor liquidity and this is in part due to its higher pip value (U.S. dollars) and the relatively Euro-centric basis of U.K. trade. Sterling shares many of the same trading characteristics of Swissy outlined just above, but Cable will also react sharply to U.K. fundamental data as well as to U.S. news. Sterling's price action will also display extreme one-way tendencies during larger moves, as traders caught on the wrong side chase the illiquid market to the extremes.
Focus On Risk Management
The volatility and illiquidity of Swissy and sterling suggests traders need to use a more proactive overall approach to trading these pairs, particularly concerning risk management (i.e. position size in relation to stop levels). With regard to technical tools, the tendency for both pairs to make short-term false breaks of chart levels suggests breakout traders need to be particularly disciplined concerning stop entry levels and should consider a greater margin of error on the order of 30-35 points. In this sense, trendline analysis of periods less than an hour tends to generate more noise than tradable break points, so a focus on longer time periods (four hours-daily) is likely to be more successful in identifying meaningful breaks. By the same token, once a breakout occurs, surpassing the margin of error, the ensuing one-way price action favors traders who are quick on the trigger, and this suggests employing resting stop-loss entry orders to reduce slippage. For those positioned with a move, trailing stops with an acceleration factor, such as parabolic SAR, are well suited to riding out directional volatility until a price reversal signals an exit.
The volatility inherent in Cable and Swissy makes the use of short-term (hourly and shorter) momentum oscillators problematic, due to both false crossovers and divergences between price/momentum that frequently occur in these time frames. Longer-period oscillators (four hours and more) are best used to highlight potential reversals or divergent price action, but volatility discourages initiating trades based on these alone. Instead, momentum signals need to be confirmed by other indicators, such as breaks of trendlines, Fibonacci retracements or parabolic levels, before a trade is initiated.
Try A Larger Retracement
With regard to Fibonacci retracement levels, the greater volatility of Cable and Swissy frequently sees them exceed 61.8-percent retracements, only to stall later at the 76.4-percent level, by which time most short-term Elliott wave followers have been stopped out. Short-term spike reversals of greater than 30 points also serve as a reliable way to identify when a directional surge, especially intraday, is completed, and these can be used as both profit taking and counter-trend trading signals. For counter-trend, corrective trades based on spike reversals, stops should be placed slightly beyond the extreme of the spike low/high. A final technical study that is well suited to the explosiveness of Swissy and sterling is the Williams %R, an overbought/oversold momentum indicator, which frequently acts as a leading indicator of price reversals. The overbought/oversold bands should be adjusted to -10/-90 to fit the higher volatility of Cable and Swissy. As with all overbought/oversold studies, however, price action needs to reverse course first before trades are initiated.
It's Not One Size Fits All
Traders who seek to apply technical trading approaches to the currency market should be aware of the differences in the trading characteristics of the major currency pairs. Just because the euro and the pound are both traded against the dollar does not mean they will trade identically to each other. A more thorough understanding of the various market traits of currencies suggests that certain technical tools are better suited to some currency pairs than others. A currency-specific approach to applying technical analysis is more likely to produce successful results than a one-size-fits-all application across all currency pairs.
Forex Market Drivers
How Interest Rate Increases Drive Currency Prices
How Rising Gold Prices Affect Currencies
Translating Rising Oil Prices to Currency Trading Opportunities
How Interest Rate Increases Drive Currency Prices
A common way to think about U.S. interest rates is how much it's going to cost to borrow money, whether for our mortgages or how much we'll earn on our bond and money market investments. Currency traders think bigger. Interest rate policy is actually a key driver of currency prices and typically a strategy for new currency traders.
Fundamentally, if a country raises its interest rates, the currency of that country will strengthen because the higher interest rates attract more foreign investors. When foreign investors invest in U.S. treasuries, they must sell their own currency and buy U.S. Dollars in order to purchase the bonds.
If you believe U.S. interest rates will continue to rise, you could express that view by going long U.S. Dollars. If you believe that the Fed has finished raising rates for the time being, you could capitalize on that view by buying a currency with a higher interest rate, or at least the prospect of relatively higher rates. For example, U.S. rates may be higher than those of Euroland now but the prospect of higher rates in Euroland, albeit still lower than the U.S., may drive investors to purchase Euros.
How Rising Gold Prices Affect Currencies
It's not hard to understand why we've experienced a run-up in gold prices lately. In the US, we're dealing with the threat of inflation and a lot of geo-political tension. Historically, gold is a country-neutral alternative to the U.S. dollar. So given the inverse relationship between gold and the U.S. Dollar, currency traders can take advantage of volatility in gold prices in innovative ways.
For example, if gold breaks an important price level, one would expect gold to move higher in coming periods. With this in mind, forex traders would look to sell dollars and buy Euros, for example, as a proxy for higher gold prices. Moreover, higher gold prices frequently have a positive impact on the currencies of major gold producers. For example, Australia is the world's third largest exporter of gold, and Canada is the world's third largest producer of gold. Therefore, if you believe the price of gold will continue to rise you could establish long positions in Australian Dollar or the Canadian Dollar - or even position to be long those currencies against other major countries like the UK or Japan.
Translating Rising Oil Prices to Currency Trading Opportunities
Equity investors already know that higher oil prices negatively impact the stock prices of companies that are highly dependent on oil such as airlines, since more expensive oil means higher expenses and lower profits for those companies.
In much the same way, a country's dependency on oil determines how its currency will be impacted by a change in oil prices. The US's massive foreign dependence on oil makes the US dollar more sensitive to oil prices than other countries. Therefore, any sharp increase in oil prices is typically dollar-negative.
If you believe the price of oil will continue to increase for the near term, you could express that viewpoint in the currency markets by once again favoring commodity-based economies like Australia and Canada or selling other energy-dependent countries like Japan
How Rising Gold Prices Affect Currencies
Translating Rising Oil Prices to Currency Trading Opportunities
How Interest Rate Increases Drive Currency Prices
A common way to think about U.S. interest rates is how much it's going to cost to borrow money, whether for our mortgages or how much we'll earn on our bond and money market investments. Currency traders think bigger. Interest rate policy is actually a key driver of currency prices and typically a strategy for new currency traders.
Fundamentally, if a country raises its interest rates, the currency of that country will strengthen because the higher interest rates attract more foreign investors. When foreign investors invest in U.S. treasuries, they must sell their own currency and buy U.S. Dollars in order to purchase the bonds.
If you believe U.S. interest rates will continue to rise, you could express that view by going long U.S. Dollars. If you believe that the Fed has finished raising rates for the time being, you could capitalize on that view by buying a currency with a higher interest rate, or at least the prospect of relatively higher rates. For example, U.S. rates may be higher than those of Euroland now but the prospect of higher rates in Euroland, albeit still lower than the U.S., may drive investors to purchase Euros.
How Rising Gold Prices Affect Currencies
It's not hard to understand why we've experienced a run-up in gold prices lately. In the US, we're dealing with the threat of inflation and a lot of geo-political tension. Historically, gold is a country-neutral alternative to the U.S. dollar. So given the inverse relationship between gold and the U.S. Dollar, currency traders can take advantage of volatility in gold prices in innovative ways.
For example, if gold breaks an important price level, one would expect gold to move higher in coming periods. With this in mind, forex traders would look to sell dollars and buy Euros, for example, as a proxy for higher gold prices. Moreover, higher gold prices frequently have a positive impact on the currencies of major gold producers. For example, Australia is the world's third largest exporter of gold, and Canada is the world's third largest producer of gold. Therefore, if you believe the price of gold will continue to rise you could establish long positions in Australian Dollar or the Canadian Dollar - or even position to be long those currencies against other major countries like the UK or Japan.
Translating Rising Oil Prices to Currency Trading Opportunities
Equity investors already know that higher oil prices negatively impact the stock prices of companies that are highly dependent on oil such as airlines, since more expensive oil means higher expenses and lower profits for those companies.
In much the same way, a country's dependency on oil determines how its currency will be impacted by a change in oil prices. The US's massive foreign dependence on oil makes the US dollar more sensitive to oil prices than other countries. Therefore, any sharp increase in oil prices is typically dollar-negative.
If you believe the price of oil will continue to increase for the near term, you could express that viewpoint in the currency markets by once again favoring commodity-based economies like Australia and Canada or selling other energy-dependent countries like Japan
Trend vs. No Trend
Which Technical Indicators to Use?
If "the trend is your friend," what happens when there is no trend? This is more than just a rhetorical question, since markets tend to move sideways much more frequently than they trend. For example, currency markets are particularly well known for long-term trends, which are in turn caused by long-term macro-economic trends, such as interest rate tightening or easing cycles. But even in currency markets, historical analysis reveals that trending periods only account for about 1/3 of price action over time, meaning that about two-thirds of the time there is no trend to catch.
The Trend/No Trend Paradox
To make matters worse, many traders typically utilize only one or two technical indicators to identify market direction and trade-timing. This one-size-fits-all approach leaves them exposed to the trend/no-trend paradox – an indicator that works well in trending markets can give disastrous results in sideways markets and vice versa. As a result, individual traders frequently find themselves exiting positions too early and missing out on larger moves as a bigger trend unfolds. Conversely, traders may end up holding onto a short-term position for too long following a reversal, believing they are "with the trend," when no trend exists.
To avoid getting caught in the paradox, this article will suggest using several technical tools in conjunction to determine whether or not a trend is in place. This will in turn dictate which technical indicators are best used to gauge entry/exit points as well as provide some risk management guidance. Rather than setting forth a list of concrete trading rules, this article seeks to outline a dynamic approach to the use of technical analysis to avoid getting caught in the trend/no-trend paradox.
Trend-friendly Tools
The obvious starting point for this discussion is to define what is meant by a trend. In terms of technical analysis, a trend is a predictable price response at levels of support/resistance that change over time. For example, in an uptrend the defining feature is that prices rebound when they near support levels, ultimately establishing new highs. In a downtrend, the opposite is true – price increases will reverse as they near resistance levels, and new lows will be reached. This definition reveals the first of the tools used to identify whether a trend is in place or not – trendline analysis to establish support and resistance levels.
Trendline analysis is sometimes underestimated because it is perceived as overly subjective in nature. While this criticism has some truth, it overlooks the reality that trendlines help focus attention on the underlying price pattern, filtering out the noise of the market. For this reason, trendline analysis should be the first step in determining the existence of a trend. If trendline analysis does not reveal a discernible trend, it's probably because there isn't one. Trendline analysis will also help identify price formations that have their own predictive significance.
Trendline analysis is best employed starting with longer time frames (daily and weekly charts) first and then carrying them forward into shorter timeframes (hourly and 4-hourly) where shorter-term levels of support and resistance can then be identified. This approach has the advantage of highlighting the most significant levels of support/resistance first and minor levels next. This helps reduce the chances of following a short-term trendline break while a major long-term level is lurking nearby.
A more objective indicator of whether a market is trending is the directional movement indicator system (DMI). Using the DMI removes the guesswork involved with spotting trends and can also provide confirmation of trends identified by trendline analysis. The DMI system is comprised of the ADX (average directional movement index) and the DI+ and DI- lines. The ADX is used to determine whether or not a market is trending (regardless if it's up or down), with a reading over 25 indicating a trending market and a reading below 20 indicating no trend. The ADX is also a measure of the strength of a trend – the higher the ADX, the stronger the trend. Using the ADX, traders can determine whether or not there is a trend and thus whether or not to use a trend following system.
As its name would suggest, the DMI system is best employed using both components. The DI+ and DI- lines are used as trade entry signals. A buy signal is generated when the DI+ line crosses up through the DI- line; a sell signal is generated when the DI- line crosses up through the DI+ line. (Wilder suggests using the "extreme point rule" to govern the DI+/DI- crossover signal. The rule states that when the DI+/- lines cross, traders should note the extreme point for that period in the direction of the crossover (the high if DI+ crosses up over DI-; the low if DI- crosses up over DI+). Only if that extreme point is breached in the subsequent period is a trade signal confirmed.
The ADX can then be used as an early indicator of the end/pause in a trend. When the ADX begins to move lower from its highest level, the trend is either pausing or ending, signaling it is time to exit the current position and wait for a fresh signal from the DI+/DI- crossover.
Non-trend Tools
Momentum oscillators, such as RSI, stochastics, or MACD, are a favorite indicator of many traders and their utility is best applied to non-trending or sideways markets. The primary use of momentum indicators is to gauge whether a market is overbought or oversold relative to prior periods, potentially highlighting a price reversal before it actually occurs.
However, this application fails in the case of a trending market, as the price momentum can remain overbought/oversold for many periods while the price continues to move persistently higher/lower in line with the underlying trend. The practical result is that traders who rely solely on a momentum indicator might exit a profitable position too soon based on momentum having reached an extreme level, just as a larger trend movement is developing. Even worse, some might use overbought/oversold levels to initiate positions in the opposite direction, seeking to anticipate a price reversal based on extreme momentum levels.
The second use of momentum oscillators is to spot divergences between price and momentum. The rationale with divergences is that sustained price movements should be mirrored by the underlying momentum. For example, a new high in price should be matched by a new high in momentum if the price action is to be considered valid. If a new price high occurs without momentum reaching new highs, a divergence (in this case, a bearish divergence) is said to exist. Divergences frequently play out with the price action failing to sustain its direction and reversing course in line with the momentum.
In real life, though, divergences frequently appear in trending markets as momentum wanes (the rate of change of prices slows) but prices fail to reverse significantly, maintaining the trend. The practical result is that counter-trend trades are frequently initiated based on price/momentum divergences. If the market is trending, prices will maintain their direction, though their rate of change is slower. Eventually, prices will accelerate in line with the trend and momentum will reverse again in the direction of the trend, nullifying the observed divergence in the process. As such, divergences can create many false signals that mislead traders who fail to recognize when a trend is in place.
Putting the Tools to Work
Let's look at some real-life trading examples to illustrate the application of the tools outlined above and see how they can be used to avoid the trend/no-trend paradox. For these examples, MACD (moving average convergence/divergence) will be used as the momentum oscillator, though other oscillators could be substituted according to individual preferences.
The first example (Figure1) illustrates 4-hour EUR/USD price action with MACD and the DMI system (ADX, DI+, DI-) as accompanying studies. Following the framework outlined above, trendline analysis reveals several multi-day price movements, identified by trendlines 1 and 2. Looking next at the ADX, it rises above the "trend" level of 25 at point A, indicating that a trend is taking hold and that momentum readings should be discounted. This is helpful, because if one looked only at the MACD at this point, it might be tempting to conclude that the upmove was stalling as the MACD begins to falter. Subsequent price action, however, sees the market move higher.
Along the way however, trendline 1 is broken and the ADX tops out and begins to move lower (point B). While the price action has been extremely volatile around this point, it should be noted that the ADX over 25 negated the premature crossover signal of MACD as well as the break of support on trendline 1. At point C, the ADX has fallen back below 25 and this suggests taking another look at the MACD, which is beginning to diverge bearishly, as new price highs are not matched by new MACD highs. A subsequent sharp downmove in price generates another negative crossover on the MACD, and since ADX is now below 25, a short position is taken at about 1.3060 (point D).
Following along with trendline 2 now, MACD is clearly weakening as prices move lower. The ADX initially continues to fall indicating the absence of any trend, but begins to turn up after a failed test of trendline resistance at point E. The focus remains on the MACD at this point as the ADX is still below 25. As price declines slow, MACD crosses upward indicating it is time to exit the position at around 1.2900 at point F. Subsequent price action is extremely whippy and the ADX again fails to signal an extended trend, confirming the decision to exit.
The above example showed the interplay between ADX and momentum (MACD), where the absence of a trend indicated traders should focus on the underlying momentum to gauge price direction. Let's now look at an example where a trend is present and it essentially cancels out signals given by momentum.
Figure 2 shows USD/CHF in an hourly format with DMI and MACD as the studies. Beginning with trendline analysis again, trendline resistance from previous highs is broken at point A. Momentum as shown by MACD has been moving higher and supports the break higher. The ADX also rises above 25, confirming the break higher and indicating a long position should be taken at approximately 1.1650. The trade entry could also have been signaled earlier by the crossover of DI+ over DI- and the application of Wilder's 'Extreme Point Rule.'
Subsequent price moves are modest initially, but the relevant feature to note is that the ADX remains well above 25, suggesting momentum signals should be disregarded. This is critical since the MACD quickly generates a signal to exit the trade at point B. Relying on the ADX alone at this point, however, the long position is maintained and subsequent price gains cause MACD to reverse higher again. ADX continues to rise with the price gains, which are also adhering to trendline support. MACD again generates a sell signal at point C, but this is ignored as the ADX approaches 50, suggesting a strong trend is now in place. Price gains become more explosive and the ADX goes on to register new highs. Contrast that with the MACD which is indicating a bearish divergence from point D onwards, even though the uptrend remains intact. The ADX also indicates a bearish divergence, implying trend intensity is fading. Only at point E are exit signals given by the break of trendline support and the decline of ADX below 25 at point E around 1.2000. In this example, a short-term trade was able to capitalize on a much larger move by employing the ADX in addition to the MACD. A strictly momentum based approach would have been caught in multiple whipsaws, or even a premature short based on bearish divergence.
Bottom line
Financial markets are inherently dynamic environments. Nowhere is this more apparent than in the trend/no trend paradox. Trading rules or themes that apply one day might be obsolete by the next day. Carrying that notion over to technical analysis suggests traders need to employ dynamic technical tools to adapt to ever changing markets. An approach that utilizes trendline analysis, Wilder's DMI system, and momentum oscillators can yield far better results across varying market conditions than a single-indicator approach.
If "the trend is your friend," what happens when there is no trend? This is more than just a rhetorical question, since markets tend to move sideways much more frequently than they trend. For example, currency markets are particularly well known for long-term trends, which are in turn caused by long-term macro-economic trends, such as interest rate tightening or easing cycles. But even in currency markets, historical analysis reveals that trending periods only account for about 1/3 of price action over time, meaning that about two-thirds of the time there is no trend to catch.
The Trend/No Trend Paradox
To make matters worse, many traders typically utilize only one or two technical indicators to identify market direction and trade-timing. This one-size-fits-all approach leaves them exposed to the trend/no-trend paradox – an indicator that works well in trending markets can give disastrous results in sideways markets and vice versa. As a result, individual traders frequently find themselves exiting positions too early and missing out on larger moves as a bigger trend unfolds. Conversely, traders may end up holding onto a short-term position for too long following a reversal, believing they are "with the trend," when no trend exists.
To avoid getting caught in the paradox, this article will suggest using several technical tools in conjunction to determine whether or not a trend is in place. This will in turn dictate which technical indicators are best used to gauge entry/exit points as well as provide some risk management guidance. Rather than setting forth a list of concrete trading rules, this article seeks to outline a dynamic approach to the use of technical analysis to avoid getting caught in the trend/no-trend paradox.
Trend-friendly Tools
The obvious starting point for this discussion is to define what is meant by a trend. In terms of technical analysis, a trend is a predictable price response at levels of support/resistance that change over time. For example, in an uptrend the defining feature is that prices rebound when they near support levels, ultimately establishing new highs. In a downtrend, the opposite is true – price increases will reverse as they near resistance levels, and new lows will be reached. This definition reveals the first of the tools used to identify whether a trend is in place or not – trendline analysis to establish support and resistance levels.
Trendline analysis is sometimes underestimated because it is perceived as overly subjective in nature. While this criticism has some truth, it overlooks the reality that trendlines help focus attention on the underlying price pattern, filtering out the noise of the market. For this reason, trendline analysis should be the first step in determining the existence of a trend. If trendline analysis does not reveal a discernible trend, it's probably because there isn't one. Trendline analysis will also help identify price formations that have their own predictive significance.
Trendline analysis is best employed starting with longer time frames (daily and weekly charts) first and then carrying them forward into shorter timeframes (hourly and 4-hourly) where shorter-term levels of support and resistance can then be identified. This approach has the advantage of highlighting the most significant levels of support/resistance first and minor levels next. This helps reduce the chances of following a short-term trendline break while a major long-term level is lurking nearby.
A more objective indicator of whether a market is trending is the directional movement indicator system (DMI). Using the DMI removes the guesswork involved with spotting trends and can also provide confirmation of trends identified by trendline analysis. The DMI system is comprised of the ADX (average directional movement index) and the DI+ and DI- lines. The ADX is used to determine whether or not a market is trending (regardless if it's up or down), with a reading over 25 indicating a trending market and a reading below 20 indicating no trend. The ADX is also a measure of the strength of a trend – the higher the ADX, the stronger the trend. Using the ADX, traders can determine whether or not there is a trend and thus whether or not to use a trend following system.
As its name would suggest, the DMI system is best employed using both components. The DI+ and DI- lines are used as trade entry signals. A buy signal is generated when the DI+ line crosses up through the DI- line; a sell signal is generated when the DI- line crosses up through the DI+ line. (Wilder suggests using the "extreme point rule" to govern the DI+/DI- crossover signal. The rule states that when the DI+/- lines cross, traders should note the extreme point for that period in the direction of the crossover (the high if DI+ crosses up over DI-; the low if DI- crosses up over DI+). Only if that extreme point is breached in the subsequent period is a trade signal confirmed.
The ADX can then be used as an early indicator of the end/pause in a trend. When the ADX begins to move lower from its highest level, the trend is either pausing or ending, signaling it is time to exit the current position and wait for a fresh signal from the DI+/DI- crossover.
Non-trend Tools
Momentum oscillators, such as RSI, stochastics, or MACD, are a favorite indicator of many traders and their utility is best applied to non-trending or sideways markets. The primary use of momentum indicators is to gauge whether a market is overbought or oversold relative to prior periods, potentially highlighting a price reversal before it actually occurs.
However, this application fails in the case of a trending market, as the price momentum can remain overbought/oversold for many periods while the price continues to move persistently higher/lower in line with the underlying trend. The practical result is that traders who rely solely on a momentum indicator might exit a profitable position too soon based on momentum having reached an extreme level, just as a larger trend movement is developing. Even worse, some might use overbought/oversold levels to initiate positions in the opposite direction, seeking to anticipate a price reversal based on extreme momentum levels.
The second use of momentum oscillators is to spot divergences between price and momentum. The rationale with divergences is that sustained price movements should be mirrored by the underlying momentum. For example, a new high in price should be matched by a new high in momentum if the price action is to be considered valid. If a new price high occurs without momentum reaching new highs, a divergence (in this case, a bearish divergence) is said to exist. Divergences frequently play out with the price action failing to sustain its direction and reversing course in line with the momentum.
In real life, though, divergences frequently appear in trending markets as momentum wanes (the rate of change of prices slows) but prices fail to reverse significantly, maintaining the trend. The practical result is that counter-trend trades are frequently initiated based on price/momentum divergences. If the market is trending, prices will maintain their direction, though their rate of change is slower. Eventually, prices will accelerate in line with the trend and momentum will reverse again in the direction of the trend, nullifying the observed divergence in the process. As such, divergences can create many false signals that mislead traders who fail to recognize when a trend is in place.
Putting the Tools to Work
Let's look at some real-life trading examples to illustrate the application of the tools outlined above and see how they can be used to avoid the trend/no-trend paradox. For these examples, MACD (moving average convergence/divergence) will be used as the momentum oscillator, though other oscillators could be substituted according to individual preferences.
The first example (Figure1) illustrates 4-hour EUR/USD price action with MACD and the DMI system (ADX, DI+, DI-) as accompanying studies. Following the framework outlined above, trendline analysis reveals several multi-day price movements, identified by trendlines 1 and 2. Looking next at the ADX, it rises above the "trend" level of 25 at point A, indicating that a trend is taking hold and that momentum readings should be discounted. This is helpful, because if one looked only at the MACD at this point, it might be tempting to conclude that the upmove was stalling as the MACD begins to falter. Subsequent price action, however, sees the market move higher.
Along the way however, trendline 1 is broken and the ADX tops out and begins to move lower (point B). While the price action has been extremely volatile around this point, it should be noted that the ADX over 25 negated the premature crossover signal of MACD as well as the break of support on trendline 1. At point C, the ADX has fallen back below 25 and this suggests taking another look at the MACD, which is beginning to diverge bearishly, as new price highs are not matched by new MACD highs. A subsequent sharp downmove in price generates another negative crossover on the MACD, and since ADX is now below 25, a short position is taken at about 1.3060 (point D).
Following along with trendline 2 now, MACD is clearly weakening as prices move lower. The ADX initially continues to fall indicating the absence of any trend, but begins to turn up after a failed test of trendline resistance at point E. The focus remains on the MACD at this point as the ADX is still below 25. As price declines slow, MACD crosses upward indicating it is time to exit the position at around 1.2900 at point F. Subsequent price action is extremely whippy and the ADX again fails to signal an extended trend, confirming the decision to exit.
The above example showed the interplay between ADX and momentum (MACD), where the absence of a trend indicated traders should focus on the underlying momentum to gauge price direction. Let's now look at an example where a trend is present and it essentially cancels out signals given by momentum.
Figure 2 shows USD/CHF in an hourly format with DMI and MACD as the studies. Beginning with trendline analysis again, trendline resistance from previous highs is broken at point A. Momentum as shown by MACD has been moving higher and supports the break higher. The ADX also rises above 25, confirming the break higher and indicating a long position should be taken at approximately 1.1650. The trade entry could also have been signaled earlier by the crossover of DI+ over DI- and the application of Wilder's 'Extreme Point Rule.'
Subsequent price moves are modest initially, but the relevant feature to note is that the ADX remains well above 25, suggesting momentum signals should be disregarded. This is critical since the MACD quickly generates a signal to exit the trade at point B. Relying on the ADX alone at this point, however, the long position is maintained and subsequent price gains cause MACD to reverse higher again. ADX continues to rise with the price gains, which are also adhering to trendline support. MACD again generates a sell signal at point C, but this is ignored as the ADX approaches 50, suggesting a strong trend is now in place. Price gains become more explosive and the ADX goes on to register new highs. Contrast that with the MACD which is indicating a bearish divergence from point D onwards, even though the uptrend remains intact. The ADX also indicates a bearish divergence, implying trend intensity is fading. Only at point E are exit signals given by the break of trendline support and the decline of ADX below 25 at point E around 1.2000. In this example, a short-term trade was able to capitalize on a much larger move by employing the ADX in addition to the MACD. A strictly momentum based approach would have been caught in multiple whipsaws, or even a premature short based on bearish divergence.
Bottom line
Financial markets are inherently dynamic environments. Nowhere is this more apparent than in the trend/no trend paradox. Trading rules or themes that apply one day might be obsolete by the next day. Carrying that notion over to technical analysis suggests traders need to employ dynamic technical tools to adapt to ever changing markets. An approach that utilizes trendline analysis, Wilder's DMI system, and momentum oscillators can yield far better results across varying market conditions than a single-indicator approach.
Using Indicators to Identify Trends
Of the many market sayings thrown around by traders, perhaps none is more overused and less understood than the old adage 'the trend is your friend'. All too often, the phrase is used after a trader has taken a counter-trend position and subsequently been stopped out at a loss. Remorse sets in at this point and most traders kick themselves not only for having lost on a counter-trend trade, but also for not having caught the latest move in the trend itself.
To avoid this all too common scenario, we will suggest using several technical tools to identify whether or not a trend is in place and then use additional indicators to help maximize trading profits. Having a strategy in place to identify trends is essential to successful trading in any market, but especially so in the case of the forex markets. Currencies have a greater tendency to move in trending fashion due to the longer-term macroeconomic elements that drive exchange rates, such as interest rate cycles or global trade imbalances. Currencies are also pre-disposed to short-term, intra-day trends due to international capital flows reacting in unison to day-to-day economic and political news.
Identifying the Trend
In its most basic sense, a trend is simply a prolonged market movement in one general direction, either up or down. From a traders' perspective, though, that simple definition is so broad as to be relatively meaningless. A more relevant definition of a trend would be one where a trend is defined as a predictable price response at levels of support/resistance that change over time. For example, in an uptrend the defining feature is that prices rebound when they near support levels, ultimately establishing new highs. In a downtrend, the opposite is true-price increases will reverse as they near resistance levels, and new lows will be reached. This definition reveals the first of the tools used to identify whether a trend is in place or not-trendline analysis to establish support and resistance levels.
Trendline analysis is often underestimated because it is perceived as overly subjective and retrospective in nature. While both criticisms have some truth, they overlook the reality that trendlines help focus attention on the underlying price pattern, filtering out the noise of the market. For this reason, trendline analysis should be the first step in determining the existence of a trend. If trendline analysis does not reveal a discernible trend, it's probably because there isn't one
.
Trendline analysis is best employed starting with longer timeframes (daily or weekly charts) first and then carrying them forward into shorter timeframes (hourly or 4-hourly) where shorter-term levels of support and resistance can then be identified. This approach has the advantage of highlighting the most significant levels of support/resistance first and less important levels next. This helps reduce the chances of following a short-term trendline break while a major long-term level is lurking nearby
.
Another technical tool that can be deployed to verify the existence of a trend is the directional movement indicator system (DMI), developed by J. Welles Wilder (see Wilder, New Concepts in Technical Trading Systems, c. 1978). Using the DMI removes the guesswork involved with spotting trends and can also provide confirmation of trends identified by trendline analysis. The DMI system is comprised of the ADX (average directional movement index) and the DI+ and DI- lines. The ADX is used to determine whether or not a market is trending (regardless if it's up or down), with a reading over 25 indicating a trending market and a reading below 20 indicating no trend. The ADX is also a measure of the strength of a trend--the higher the ADX, the stronger the trend. Using the ADX, traders can determine whether or not there is a trend and thus whether or not to use a trend following system.
As its name would suggest, the DMI system is best employed using both components. The DI+ and DI- lines are used as trade entry signals. A buy signal is generated when the DI+ line crosses up through the DI- line; a sell signal is generated when the DI- line crosses up through the DI+ line. (Wilder suggests using the "extreme point rule" to govern the DI+/DI- crossover signal. The rule states that when the DI+/- lines cross, traders should note the extreme point for that period in the direction of the crossover (the high if DI+ crosses up over DI-; the low if DI- crosses up over DI+). Only if that extreme point is breached in the subsequent period is a trade signal confirmed.
The ADX can then be used as an early indicator of the end/pause in a trend. When the ADX begins to move lower from its highest level, the trend is either pausing or ending, signaling it is time to exit the current position and wait for a fresh signal from the DI+/DI- crossover.
CHART 1: JUMP IN AND HANG ON FOR THE RIDE. If you are an aggressive trader and entered a long position at Point A, and only exited your position at Point C, you would be pleased with the results. This can be achieved with a few simple indicators.
Let's look at recent long-term trend (chart 1) and put trendline analysis together with the DMI system to illustrate the utility of these tools when used in conjunction with each other. An aggressive trader might initiate a long position as the daily resistance line is breached on 11/12/03 (point A). A trader looking for confirmation might wait a day, when the DI+ crosses up through the DI- line, generating a buy signal. A conservative trader might wait for confirmation of the DI+/- crossover by waiting for the extreme point (high) to be exceeded, in line with Wilder's extreme point rule. This confirmation is given the following day (11/14/03). As the market begins to move higher, the support trendline drawn off the lows is tested, but holds, underscoring its validity to a nascent trend. Although the market has moved higher in line with the DI+/DI- crossover and trendline support, the ADX is still below 25 until 12/2/03 (point B), when a trend is finally confirmed. At this point, a trader should recognize that they are in a trending market and trend following systems can usefully be employed.
This brings us to the point of introducing some additional tools that can be used to maximize profit within a trending market. We have already suggested using the ADX as an early indicator of the end of a trend. Note that from point B, when it first registers above 25 indicating a trending market, the ADX continues to make new highs until 01/14/04 (point C) when it closes lower signaling a likely end to the uptrend and that it's time to exit the long position.
A second tool used to identify an exit point and possibly the end of a trend is the parabolic indicator. The parabolic indicator follows the price action but accelerates its own rate of increase over time and in response to the trend. The result is that the parabolic is continually closing in on the price, and only a steadily accelerating price rise (the essence of a trend) will prevent the price from falling below the parabolic, signaling an end to the trend. Chart 2 shows the parabolic indicator overlaid on the previous chart. Note that the parabolic gives an exit signal (point D) the day after the ADX experienced its first lower close.
CHART 2: ADD A COUPLE MORE INDICATORS. Here, the parabolic indicator was used. The exit signal was given one day after the ADX gave its exit signal.
The very basic trendlines that are drawn also could have signaled the end to the uptrend. Note that the price accelerates above the upper channel line in the final extension of the uptrend, tests back to the break and then goes on to make new highs. The subsequent price decline back below the upper channel line would then signal the end of the up-move. As well, another support line similar to the parabolic could also be drawn, and its breach would have been the earliest signal of the end of the upmove.
What About Short-term Trading?
The same tools outlined above can be used for short-term decision making, even in markets that are trading sideways, or so-called trendless markets. While the market may not be trending in a long-term sense, there are multiple smaller, short-term movements taking place that can be exploited. (One caveat must be noted, though: traders need to be aware of what is happening in the bigger picture. If shorter term ADX readings indicate a trending market, traders must be circumspect in initiating trades that are counter to the larger, daily trend.)
CHART 3: INTRADAY BASIS. On this hourly chart of the Australian dollar, the first entry signal was at point A. You could have held until point D, where you should have sold your position. The next entry signal was point AA (short) with a signal for covering that short position at point CC.
Let's then look at a short-term scenario using an hourly chart of the Australian dollar (chart 3). The first hint of a potential trading opportunity is the quick convergence of the DI+/DI- lines in the hour marked by point A. This is caused by the sharp bounce in price during that hour. The next hourly bar breaks through and closes above trendline resistance, precipitating DI+ crossing up through DI-. Following Wilder's extreme point rule, we wait for the previous high to be surpassed, which happens in the next hour at point B. At this point, we have several signals indicating a long position-the break of trendline resistance, crossover of DI+/DI-, extreme point rule satisfied, break of parabolic. As the market moves higher, the ADX begins to rise as well, peaking at point C and declining at point D, giving us our signal to exit the long. Basic trendline and parabolic supports are then broken several hours later setting the stage for the next potential move.
The next signal is given at point AA as the DI- crosses up through the DI+, generating a sell signal. This coincides with the price falling below recent hourly lows. The ADX begins to move up, indicating the possibility of a trend forming and eventually rises over 25 at point BB indicating a trend is in place and that the parabolic should be followed. Trendline and parabolic resistance are then breached and the ADX stalls at point CC, indicating an early, but profitable exit to the trade.
The Trend is Your Friend
Profiting from market trends is the essence of making the trend your friend. The first step to profiting from both short- and long-term trends is understanding what constitutes a trend and knowing how to identify them. The next step is employing a disciplined trading strategy that is specific to trends. A conscientious approach utilizing trendline analysis, the DMI system, and the parabolic indicator should help traders make more friends of market trends.
To avoid this all too common scenario, we will suggest using several technical tools to identify whether or not a trend is in place and then use additional indicators to help maximize trading profits. Having a strategy in place to identify trends is essential to successful trading in any market, but especially so in the case of the forex markets. Currencies have a greater tendency to move in trending fashion due to the longer-term macroeconomic elements that drive exchange rates, such as interest rate cycles or global trade imbalances. Currencies are also pre-disposed to short-term, intra-day trends due to international capital flows reacting in unison to day-to-day economic and political news.
Identifying the Trend
In its most basic sense, a trend is simply a prolonged market movement in one general direction, either up or down. From a traders' perspective, though, that simple definition is so broad as to be relatively meaningless. A more relevant definition of a trend would be one where a trend is defined as a predictable price response at levels of support/resistance that change over time. For example, in an uptrend the defining feature is that prices rebound when they near support levels, ultimately establishing new highs. In a downtrend, the opposite is true-price increases will reverse as they near resistance levels, and new lows will be reached. This definition reveals the first of the tools used to identify whether a trend is in place or not-trendline analysis to establish support and resistance levels.
Trendline analysis is often underestimated because it is perceived as overly subjective and retrospective in nature. While both criticisms have some truth, they overlook the reality that trendlines help focus attention on the underlying price pattern, filtering out the noise of the market. For this reason, trendline analysis should be the first step in determining the existence of a trend. If trendline analysis does not reveal a discernible trend, it's probably because there isn't one
.
Trendline analysis is best employed starting with longer timeframes (daily or weekly charts) first and then carrying them forward into shorter timeframes (hourly or 4-hourly) where shorter-term levels of support and resistance can then be identified. This approach has the advantage of highlighting the most significant levels of support/resistance first and less important levels next. This helps reduce the chances of following a short-term trendline break while a major long-term level is lurking nearby
.
Another technical tool that can be deployed to verify the existence of a trend is the directional movement indicator system (DMI), developed by J. Welles Wilder (see Wilder, New Concepts in Technical Trading Systems, c. 1978). Using the DMI removes the guesswork involved with spotting trends and can also provide confirmation of trends identified by trendline analysis. The DMI system is comprised of the ADX (average directional movement index) and the DI+ and DI- lines. The ADX is used to determine whether or not a market is trending (regardless if it's up or down), with a reading over 25 indicating a trending market and a reading below 20 indicating no trend. The ADX is also a measure of the strength of a trend--the higher the ADX, the stronger the trend. Using the ADX, traders can determine whether or not there is a trend and thus whether or not to use a trend following system.
As its name would suggest, the DMI system is best employed using both components. The DI+ and DI- lines are used as trade entry signals. A buy signal is generated when the DI+ line crosses up through the DI- line; a sell signal is generated when the DI- line crosses up through the DI+ line. (Wilder suggests using the "extreme point rule" to govern the DI+/DI- crossover signal. The rule states that when the DI+/- lines cross, traders should note the extreme point for that period in the direction of the crossover (the high if DI+ crosses up over DI-; the low if DI- crosses up over DI+). Only if that extreme point is breached in the subsequent period is a trade signal confirmed.
The ADX can then be used as an early indicator of the end/pause in a trend. When the ADX begins to move lower from its highest level, the trend is either pausing or ending, signaling it is time to exit the current position and wait for a fresh signal from the DI+/DI- crossover.
CHART 1: JUMP IN AND HANG ON FOR THE RIDE. If you are an aggressive trader and entered a long position at Point A, and only exited your position at Point C, you would be pleased with the results. This can be achieved with a few simple indicators.
Let's look at recent long-term trend (chart 1) and put trendline analysis together with the DMI system to illustrate the utility of these tools when used in conjunction with each other. An aggressive trader might initiate a long position as the daily resistance line is breached on 11/12/03 (point A). A trader looking for confirmation might wait a day, when the DI+ crosses up through the DI- line, generating a buy signal. A conservative trader might wait for confirmation of the DI+/- crossover by waiting for the extreme point (high) to be exceeded, in line with Wilder's extreme point rule. This confirmation is given the following day (11/14/03). As the market begins to move higher, the support trendline drawn off the lows is tested, but holds, underscoring its validity to a nascent trend. Although the market has moved higher in line with the DI+/DI- crossover and trendline support, the ADX is still below 25 until 12/2/03 (point B), when a trend is finally confirmed. At this point, a trader should recognize that they are in a trending market and trend following systems can usefully be employed.
This brings us to the point of introducing some additional tools that can be used to maximize profit within a trending market. We have already suggested using the ADX as an early indicator of the end of a trend. Note that from point B, when it first registers above 25 indicating a trending market, the ADX continues to make new highs until 01/14/04 (point C) when it closes lower signaling a likely end to the uptrend and that it's time to exit the long position.
A second tool used to identify an exit point and possibly the end of a trend is the parabolic indicator. The parabolic indicator follows the price action but accelerates its own rate of increase over time and in response to the trend. The result is that the parabolic is continually closing in on the price, and only a steadily accelerating price rise (the essence of a trend) will prevent the price from falling below the parabolic, signaling an end to the trend. Chart 2 shows the parabolic indicator overlaid on the previous chart. Note that the parabolic gives an exit signal (point D) the day after the ADX experienced its first lower close.
CHART 2: ADD A COUPLE MORE INDICATORS. Here, the parabolic indicator was used. The exit signal was given one day after the ADX gave its exit signal.
The very basic trendlines that are drawn also could have signaled the end to the uptrend. Note that the price accelerates above the upper channel line in the final extension of the uptrend, tests back to the break and then goes on to make new highs. The subsequent price decline back below the upper channel line would then signal the end of the up-move. As well, another support line similar to the parabolic could also be drawn, and its breach would have been the earliest signal of the end of the upmove.
What About Short-term Trading?
The same tools outlined above can be used for short-term decision making, even in markets that are trading sideways, or so-called trendless markets. While the market may not be trending in a long-term sense, there are multiple smaller, short-term movements taking place that can be exploited. (One caveat must be noted, though: traders need to be aware of what is happening in the bigger picture. If shorter term ADX readings indicate a trending market, traders must be circumspect in initiating trades that are counter to the larger, daily trend.)
CHART 3: INTRADAY BASIS. On this hourly chart of the Australian dollar, the first entry signal was at point A. You could have held until point D, where you should have sold your position. The next entry signal was point AA (short) with a signal for covering that short position at point CC.
Let's then look at a short-term scenario using an hourly chart of the Australian dollar (chart 3). The first hint of a potential trading opportunity is the quick convergence of the DI+/DI- lines in the hour marked by point A. This is caused by the sharp bounce in price during that hour. The next hourly bar breaks through and closes above trendline resistance, precipitating DI+ crossing up through DI-. Following Wilder's extreme point rule, we wait for the previous high to be surpassed, which happens in the next hour at point B. At this point, we have several signals indicating a long position-the break of trendline resistance, crossover of DI+/DI-, extreme point rule satisfied, break of parabolic. As the market moves higher, the ADX begins to rise as well, peaking at point C and declining at point D, giving us our signal to exit the long. Basic trendline and parabolic supports are then broken several hours later setting the stage for the next potential move.
The next signal is given at point AA as the DI- crosses up through the DI+, generating a sell signal. This coincides with the price falling below recent hourly lows. The ADX begins to move up, indicating the possibility of a trend forming and eventually rises over 25 at point BB indicating a trend is in place and that the parabolic should be followed. Trendline and parabolic resistance are then breached and the ADX stalls at point CC, indicating an early, but profitable exit to the trade.
The Trend is Your Friend
Profiting from market trends is the essence of making the trend your friend. The first step to profiting from both short- and long-term trends is understanding what constitutes a trend and knowing how to identify them. The next step is employing a disciplined trading strategy that is specific to trends. A conscientious approach utilizing trendline analysis, the DMI system, and the parabolic indicator should help traders make more friends of market trends.
Cashing in on Short-Term Currency Trends
Trends may be rarer than trading ranges, but that doesn't mean they can't be traded. This strategy uses two time frames to identify the trend, an overbought-oversold indicator to pinpoint entry and a trailing stop to protect gains on profitable trades.
Many technical trading strategies revolve around the assumption that markets will hover within a given range — and with good reason. Seventy percent of the time markets will bounce back and forth between support and resistance levels, or fluctuate randomly. The rest of the time, market behavior is characterized by persistent price moves — trends — that shatter support and resistance levels.
Although these basic probabilities work against traders who try to exploit trends, the potential rewards can be worth the risk. It is possible to increase your ability to capitalize on trends by locating trend signals, identifying specific entry points within the trend and using risk management techniques to limit losses.
The following sections will explain how a trading system basedon these concepts works especially well in the foreign exchange (Forex), or currency, market, particularly with the "major" currencies — the U.S. dollar, Euro, Japanese yen, British pound, Swiss franc, Canadian dollar and Australian dollar. More than 85 percent of transactions in the $1 trillion per day Forex market involve the majors.
Tools and Rules
Stochastic RefresherThe stochastic oscillator consists of two lines: %K and a moving average of %K called %D.
The basic stochastic calculation compares the most recent close to the price range (high of the range - low of the range) over a particular period. A basic five-bar stochastic calculation is the difference between the most recent bar's close and the lowest low of the last five days divided by the difference between the highest high and the lowest low of the last five days. The result is multiplied by 100. The formula for this calculation, which is %K, is:
%K = 100*{(Ct-Ln)/(Hn-Ln)}
whereCt = the most recent bar's closing price
Ln = the lowest price of the most recent n bars
Hn = the highest price of the most recent n bars(for a stochastic calculated on daily bars, the default is five days)
The second line, %D, is simply a three-period moving average of %K:
average(%K,3)
Because this basic "fast" stochastic calculation is very volatile, an additionally smoothed version of the indicator, where the original %D line becomes a new "slow" %K line and a three-period average of this line becomes the "slow"%D line, is more commonly used.
The stochastic can be made to reflect longer- or shorter-term price movementand to be less or more sensitive to small price fluctuations by increasing or decreasing the number of bars used to calculate %K and/or increasing or decreasing the length of the moving average used to calculate %D. For example, a stochastic using a 10-bar %K and a three-bar moving average for %D [stochastic(10,3)] would be shorter-term and more sensitive than a stochastic using a 20-bar %K and a five-bar moving average for %D [stochastic(20,5)].
The strategy uses two charts with different time periods (10-minute and hourly), along with two technical indicators: a 200-bar moving average and a 14-bar slow stochastic study (see "Stochastic refresher," right).
Step 1: Identify a trend. Compare the moving averages on the 10-minute and hourly charts. A trend is in effect when price is consistently above/below the moving averages on both charts.
Step 2: Pinpoint entry. Once you've identified a trend, look for the following two conditions at the same time on the 10-minute chart: 1) the market is no more than 20 points above (to buy) or 20 points below (to sell) the moving average; and 2) the fast stochastic line crosses above the slow stochastic line below 20 (to buy) or crosses below the slow stochastic line above 80 (to sell).
These conditions indicate: 1) the currency is currently in a short-term uptrend or downtrend; and 2) the currency has paused or pulled back (reflected by the higher low stochastic reading and the fact that price is within 20 points of the moving average) and is poised to turn (because the fast stochastic line is crossing back above or below the slow line).
Step 3: Ride the trend. Set a trailing stop after the initial trade entry. On a long position, enter a stop-loss order 10 points below the 200-period moving average on the 10-minute chart. In the case of a short position, place the initial stop 10 points above this moving average. As the trade goes in your favor, raise (for a long trade) or lower (for a short trade) the stop to protect profits. For simplicity's sake, the following examples use a trailing stop 25 points from each new top or bottom. The charts in the next section illustrate the application of this strategy in two currency pairs.
Trade Examples
The first example took place in the Euro currency-dollar (EUR/USD) currency pair during the fourth week of June 2002.
First, compare the hourly and 10- minute EUR/USD charts. Look for a time when price is above the 200-period moving averages on both charts. On the hourly chart (Figure 1 - Click here to view), the fact that price is almost exclusively above the 200-hour moving average indicates a persistent uptrend. On the 10-minute chart (Figure 2 - Click here to view), price moves (and remains above) the moving average in the last third of the chart. The next step is to pinpoint the entry zone — when the market is within 20 points of the moving average on the 10- minute chart and the stochastic lines cross.
The range between 1 p.m. and midnight on June 27 meets these requirements. The entry point occurs when the fast stochastic crosses above the slow stochastic when the indicator is below 20. A long position is entered at .9883 around 8 p.m., with an accompanying stop-loss at .9858 (10 points below the 200-bar moving average value of .9868). The stop is then trailed upward as the market makes new peaks. The EUR/USD tops out at .9992, so the stop scaled up to .9967, where the position was closed for an 84-point ($840) gain.
Figures 3 and 4 illustrate a similar example in the dollar-yen rate (USD/JPY). The hourly chart(Figure 3 - Click here to view) shows price was trading well below the 200-bar moving average after June 21. On the 10-minute chart (Figure 4 - Click here to view), price fell below the moving average after 10 a.m. on June 27, indicating a sell opportunity. Also, price was within 20 points of the moving average at this point. A short trade was opened around 5 p.m. at 119.57 when the fast stochastic line crossed below the slow stochastic line when the indicator was above 80.
The trade was protected with a stop-loss order at 119.86. In this case, the stop remained intact until the following day, when USD/JPY began to decline. After trailing the stop down as the market continued to decline, profits were taken at 118.58 (25 points off the 118.33 low), for a gain of 99 points.
Search and Exploit
This short-term trading method works well in the Forex market, but it is also applicable to others. Each step of the system helps identify areas where effective trades can be made. If at any point one of the criteria is not met, you'll instantly know not to make a trade. This model also gives you the freedom to experiment with different chart intervals. When you're equipped with a system that can help you catch the trend early, you can wait for the rest of the market to follow.
Quoting Currencies
Because currencies are quoted in a different manner than equities, reading a foreign exchange quote may seem a bit confusing at first. However, it's really quite simple if you remember two things: 1) The first currency listed first is the base currency and 2) the value of the base currency is always 1. For example, if you see a quote of USD/CAD 1.54825, that means that one U.S. dollar is equal to 1.54825 Canadian dollars. Likewise, USD/JPY 122.01 shows that one U.S. dollar is equal to 122.01 Japanese yen.
In every trade involving the U.S. dollar, the dollar will be the base currency, with three exceptions — the British pound (GBP), the Australian dollar (AUS) and the European currency unit, or Euro (EUR). In these cases, you might see a quote such as GBP/USD 1.4366, meaning that one British pound equals 1.4366 U.S. dollars.
Whenever the U.S. dollar is the base unit and a currency quote goes up, it means the dollar has appreciated in value and the other currency has weakened. If the USD/JPY quote we previously mentioned increases to 123.01, the dollar is stronger because it will now buy more yen than before.
However, in the three instances where the U.S. dollar is not the base rate, a rising quote means a weakening dollar, as it now takes more U.S. dollars to equal one pound, Euro or Australian dollar.
In other words, if a currency quote goes higher, that increases the value of the base currency. A lower quote means the base currency is weakening.
Trades that do not involve the U.S. dollar are called cross rates, but the premise is the same. A quote of GBP/CHF 2.4577 signifies that one British pound is equal to 2.4577 Swiss francs.
Many technical trading strategies revolve around the assumption that markets will hover within a given range — and with good reason. Seventy percent of the time markets will bounce back and forth between support and resistance levels, or fluctuate randomly. The rest of the time, market behavior is characterized by persistent price moves — trends — that shatter support and resistance levels.
Although these basic probabilities work against traders who try to exploit trends, the potential rewards can be worth the risk. It is possible to increase your ability to capitalize on trends by locating trend signals, identifying specific entry points within the trend and using risk management techniques to limit losses.
The following sections will explain how a trading system basedon these concepts works especially well in the foreign exchange (Forex), or currency, market, particularly with the "major" currencies — the U.S. dollar, Euro, Japanese yen, British pound, Swiss franc, Canadian dollar and Australian dollar. More than 85 percent of transactions in the $1 trillion per day Forex market involve the majors.
Tools and Rules
Stochastic RefresherThe stochastic oscillator consists of two lines: %K and a moving average of %K called %D.
The basic stochastic calculation compares the most recent close to the price range (high of the range - low of the range) over a particular period. A basic five-bar stochastic calculation is the difference between the most recent bar's close and the lowest low of the last five days divided by the difference between the highest high and the lowest low of the last five days. The result is multiplied by 100. The formula for this calculation, which is %K, is:
%K = 100*{(Ct-Ln)/(Hn-Ln)}
whereCt = the most recent bar's closing price
Ln = the lowest price of the most recent n bars
Hn = the highest price of the most recent n bars(for a stochastic calculated on daily bars, the default is five days)
The second line, %D, is simply a three-period moving average of %K:
average(%K,3)
Because this basic "fast" stochastic calculation is very volatile, an additionally smoothed version of the indicator, where the original %D line becomes a new "slow" %K line and a three-period average of this line becomes the "slow"%D line, is more commonly used.
The stochastic can be made to reflect longer- or shorter-term price movementand to be less or more sensitive to small price fluctuations by increasing or decreasing the number of bars used to calculate %K and/or increasing or decreasing the length of the moving average used to calculate %D. For example, a stochastic using a 10-bar %K and a three-bar moving average for %D [stochastic(10,3)] would be shorter-term and more sensitive than a stochastic using a 20-bar %K and a five-bar moving average for %D [stochastic(20,5)].
The strategy uses two charts with different time periods (10-minute and hourly), along with two technical indicators: a 200-bar moving average and a 14-bar slow stochastic study (see "Stochastic refresher," right).
Step 1: Identify a trend. Compare the moving averages on the 10-minute and hourly charts. A trend is in effect when price is consistently above/below the moving averages on both charts.
Step 2: Pinpoint entry. Once you've identified a trend, look for the following two conditions at the same time on the 10-minute chart: 1) the market is no more than 20 points above (to buy) or 20 points below (to sell) the moving average; and 2) the fast stochastic line crosses above the slow stochastic line below 20 (to buy) or crosses below the slow stochastic line above 80 (to sell).
These conditions indicate: 1) the currency is currently in a short-term uptrend or downtrend; and 2) the currency has paused or pulled back (reflected by the higher low stochastic reading and the fact that price is within 20 points of the moving average) and is poised to turn (because the fast stochastic line is crossing back above or below the slow line).
Step 3: Ride the trend. Set a trailing stop after the initial trade entry. On a long position, enter a stop-loss order 10 points below the 200-period moving average on the 10-minute chart. In the case of a short position, place the initial stop 10 points above this moving average. As the trade goes in your favor, raise (for a long trade) or lower (for a short trade) the stop to protect profits. For simplicity's sake, the following examples use a trailing stop 25 points from each new top or bottom. The charts in the next section illustrate the application of this strategy in two currency pairs.
Trade Examples
The first example took place in the Euro currency-dollar (EUR/USD) currency pair during the fourth week of June 2002.
First, compare the hourly and 10- minute EUR/USD charts. Look for a time when price is above the 200-period moving averages on both charts. On the hourly chart (Figure 1 - Click here to view), the fact that price is almost exclusively above the 200-hour moving average indicates a persistent uptrend. On the 10-minute chart (Figure 2 - Click here to view), price moves (and remains above) the moving average in the last third of the chart. The next step is to pinpoint the entry zone — when the market is within 20 points of the moving average on the 10- minute chart and the stochastic lines cross.
The range between 1 p.m. and midnight on June 27 meets these requirements. The entry point occurs when the fast stochastic crosses above the slow stochastic when the indicator is below 20. A long position is entered at .9883 around 8 p.m., with an accompanying stop-loss at .9858 (10 points below the 200-bar moving average value of .9868). The stop is then trailed upward as the market makes new peaks. The EUR/USD tops out at .9992, so the stop scaled up to .9967, where the position was closed for an 84-point ($840) gain.
Figures 3 and 4 illustrate a similar example in the dollar-yen rate (USD/JPY). The hourly chart(Figure 3 - Click here to view) shows price was trading well below the 200-bar moving average after June 21. On the 10-minute chart (Figure 4 - Click here to view), price fell below the moving average after 10 a.m. on June 27, indicating a sell opportunity. Also, price was within 20 points of the moving average at this point. A short trade was opened around 5 p.m. at 119.57 when the fast stochastic line crossed below the slow stochastic line when the indicator was above 80.
The trade was protected with a stop-loss order at 119.86. In this case, the stop remained intact until the following day, when USD/JPY began to decline. After trailing the stop down as the market continued to decline, profits were taken at 118.58 (25 points off the 118.33 low), for a gain of 99 points.
Search and Exploit
This short-term trading method works well in the Forex market, but it is also applicable to others. Each step of the system helps identify areas where effective trades can be made. If at any point one of the criteria is not met, you'll instantly know not to make a trade. This model also gives you the freedom to experiment with different chart intervals. When you're equipped with a system that can help you catch the trend early, you can wait for the rest of the market to follow.
Quoting Currencies
Because currencies are quoted in a different manner than equities, reading a foreign exchange quote may seem a bit confusing at first. However, it's really quite simple if you remember two things: 1) The first currency listed first is the base currency and 2) the value of the base currency is always 1. For example, if you see a quote of USD/CAD 1.54825, that means that one U.S. dollar is equal to 1.54825 Canadian dollars. Likewise, USD/JPY 122.01 shows that one U.S. dollar is equal to 122.01 Japanese yen.
In every trade involving the U.S. dollar, the dollar will be the base currency, with three exceptions — the British pound (GBP), the Australian dollar (AUS) and the European currency unit, or Euro (EUR). In these cases, you might see a quote such as GBP/USD 1.4366, meaning that one British pound equals 1.4366 U.S. dollars.
Whenever the U.S. dollar is the base unit and a currency quote goes up, it means the dollar has appreciated in value and the other currency has weakened. If the USD/JPY quote we previously mentioned increases to 123.01, the dollar is stronger because it will now buy more yen than before.
However, in the three instances where the U.S. dollar is not the base rate, a rising quote means a weakening dollar, as it now takes more U.S. dollars to equal one pound, Euro or Australian dollar.
In other words, if a currency quote goes higher, that increases the value of the base currency. A lower quote means the base currency is weakening.
Trades that do not involve the U.S. dollar are called cross rates, but the premise is the same. A quote of GBP/CHF 2.4577 signifies that one British pound is equal to 2.4577 Swiss francs.
Leverage & Margin
The leverage available in forex trading is one of main attractions of this market for many traders. Leveraged trading, or trading on margin, simply means that you are not required to put up the full value of the position.
Forex provides more leverage than stocks or futures. In forex trading, the amount of leverage available can be up to 200 times the value of your account.
There are several reasons for the higher leverage that is offered in the forex market. On a daily basis, the volatility of the major currencies is less than 1%. This is much lower than an active stock, which can easily have a 5-10% move in a single day. With leverage, you can capture higher returns on a smaller market movement. More importantly, leverage allows traders to increase their buying power and utilize less capital to trade. Of course, increasing leverage increases risk.
Margin Trading: Stocks vs Forex
The word "margin" means something very different in forex than it does in stocks.
With stocks, trading on margin means that a trader can borrow up to 50% of a stock's value to buy that stock. This can be a costly move because the investor must pay interest to the brokerage firm on the amount borrowed. This is not the case in forex trading.
For example, at $400/share, 100 shares of Google are valued at $40,000 ($400 x 100 shares). To trade this stock on margin, the money required for the trade is 50%, or $20,000. The remaining $20,000 is borrowed and interest must be paid on that amount. Margin interest is different from broker to broker, but a good rule of thumb is typically Prime plus 1-3% or more.
In forex, margin is the minimum required balance to place a trade. When you open a forex trading account, the money you deposit acts as collateral for your trades. This deposit, called margin, is typically 1% of the value of the position.
For example, if you want to purchase $100,000 of USD/JPY at 100:1 leverage, the money required is 1%, or $1000. The other $99,000 is collateralized with your remaining account balance. You pay no interest.
It is very important to remember that increasing leverage increases risk. You should monitor your account balance on a regular basis and utilize stop-loss orders on every open position in an attempt to limit downside risk.
Here's a hypothetical example that demonstrates the upside of leverage:
With a US$5,000 balance in your account, you decide that the US Dollar (USD) is undervalued against the Swiss Franc (CHF).
To execute this strategy, you must buy Dollars (simultaneously selling Francs), and then wait for the exchange rate to rise.
The current bid/ask price for USD/CHF is 1.2322/1.2327 (meaning you can buy $1 US for 1.2327 Swiss Francs or sell $1 US for 1.2322 francs)
Your available leverage is 100:1 or 1%. You execute the trade, buying a one lot: buying 100,000 US dollars and selling 123,270 Swiss Francs. At 100:1 leverage, your initial margin deposit for this trade is $1,000.
As you expected, USD/CHF rises 50 pips to 1.2372/77. Since you're long dollars (and are short francs), you must now sell dollars and buy back the francs to realize any profit.
You close out the position, selling one lot (selling 100,000 US dollars and receiving 123,720 CHF) Since you originally sold (paid) 123,270 CHF, your profit is 450 CHF.
To calculate your P&L in terms of US dollars, simply divide 450 by the current USD/CHF rate of 1.2372. Your profit on this trade is $364.3
SUMMARY
Initial Investment: $1000
Profit: $364.31
Return on investment: 36%
If you had executed this trade without using leverage, your return on investment would be less than 1%.
Forex provides more leverage than stocks or futures. In forex trading, the amount of leverage available can be up to 200 times the value of your account.
There are several reasons for the higher leverage that is offered in the forex market. On a daily basis, the volatility of the major currencies is less than 1%. This is much lower than an active stock, which can easily have a 5-10% move in a single day. With leverage, you can capture higher returns on a smaller market movement. More importantly, leverage allows traders to increase their buying power and utilize less capital to trade. Of course, increasing leverage increases risk.
Margin Trading: Stocks vs Forex
The word "margin" means something very different in forex than it does in stocks.
With stocks, trading on margin means that a trader can borrow up to 50% of a stock's value to buy that stock. This can be a costly move because the investor must pay interest to the brokerage firm on the amount borrowed. This is not the case in forex trading.
For example, at $400/share, 100 shares of Google are valued at $40,000 ($400 x 100 shares). To trade this stock on margin, the money required for the trade is 50%, or $20,000. The remaining $20,000 is borrowed and interest must be paid on that amount. Margin interest is different from broker to broker, but a good rule of thumb is typically Prime plus 1-3% or more.
In forex, margin is the minimum required balance to place a trade. When you open a forex trading account, the money you deposit acts as collateral for your trades. This deposit, called margin, is typically 1% of the value of the position.
For example, if you want to purchase $100,000 of USD/JPY at 100:1 leverage, the money required is 1%, or $1000. The other $99,000 is collateralized with your remaining account balance. You pay no interest.
It is very important to remember that increasing leverage increases risk. You should monitor your account balance on a regular basis and utilize stop-loss orders on every open position in an attempt to limit downside risk.
Here's a hypothetical example that demonstrates the upside of leverage:
With a US$5,000 balance in your account, you decide that the US Dollar (USD) is undervalued against the Swiss Franc (CHF).
To execute this strategy, you must buy Dollars (simultaneously selling Francs), and then wait for the exchange rate to rise.
The current bid/ask price for USD/CHF is 1.2322/1.2327 (meaning you can buy $1 US for 1.2327 Swiss Francs or sell $1 US for 1.2322 francs)
Your available leverage is 100:1 or 1%. You execute the trade, buying a one lot: buying 100,000 US dollars and selling 123,270 Swiss Francs. At 100:1 leverage, your initial margin deposit for this trade is $1,000.
As you expected, USD/CHF rises 50 pips to 1.2372/77. Since you're long dollars (and are short francs), you must now sell dollars and buy back the francs to realize any profit.
You close out the position, selling one lot (selling 100,000 US dollars and receiving 123,720 CHF) Since you originally sold (paid) 123,270 CHF, your profit is 450 CHF.
To calculate your P&L in terms of US dollars, simply divide 450 by the current USD/CHF rate of 1.2372. Your profit on this trade is $364.3
SUMMARY
Initial Investment: $1000
Profit: $364.31
Return on investment: 36%
If you had executed this trade without using leverage, your return on investment would be less than 1%.
Introduction to the Forex Market
The Foreign Exchange market, also referred to as the "Forex" or "FX" market is the largest financial market in the world, with a daily average turnover of US$1.9 trillion.
"Foreign Exchange" is the simultaneous buying of one currency and selling of another. Currencies are traded in pairs, for example Euro/US Dollar (EUR/USD) or US Dollar/Japanese Yen (USD/JPY).
There are two reasons to buy and sell currencies. About 5% of daily turnover is from companies and governments that buy or sell products and services in a foreign country or must convert profits made in foreign currencies into their domestic currency. The other 95% is trading for profit, or speculation.
For speculators, we believe the best trading opportunities are with the most commonly traded (and therefore most liquid) currencies, called "the Majors." Today, more than 85% of all daily transactions involve trading of the Majors, which include the US Dollar, Japanese Yen, Euro, British Pound, Swiss Franc, Canadian Dollar and Australian Dollar.
A true 24-hour market from Sunday 5:00 PM ET to Friday 5:00PM ET, Forex trading begins each day in Sydney, and moves around the globe as the business day begins in each financial center, first to Tokyo, London, and New York. Unlike any other financial market, investors can respond to currency fluctuations caused by economic, social and political events at the time they occur - day or night.
The FX market is considered an Over The Counter (OTC) or 'interbank/interdealer' market, due to the fact that transactions are conducted between two counterparts over the telephone or via an electronic network. Trading is not centralized on an exchange, as with the stock and futures markets
"Foreign Exchange" is the simultaneous buying of one currency and selling of another. Currencies are traded in pairs, for example Euro/US Dollar (EUR/USD) or US Dollar/Japanese Yen (USD/JPY).
There are two reasons to buy and sell currencies. About 5% of daily turnover is from companies and governments that buy or sell products and services in a foreign country or must convert profits made in foreign currencies into their domestic currency. The other 95% is trading for profit, or speculation.
For speculators, we believe the best trading opportunities are with the most commonly traded (and therefore most liquid) currencies, called "the Majors." Today, more than 85% of all daily transactions involve trading of the Majors, which include the US Dollar, Japanese Yen, Euro, British Pound, Swiss Franc, Canadian Dollar and Australian Dollar.
A true 24-hour market from Sunday 5:00 PM ET to Friday 5:00PM ET, Forex trading begins each day in Sydney, and moves around the globe as the business day begins in each financial center, first to Tokyo, London, and New York. Unlike any other financial market, investors can respond to currency fluctuations caused by economic, social and political events at the time they occur - day or night.
The FX market is considered an Over The Counter (OTC) or 'interbank/interdealer' market, due to the fact that transactions are conducted between two counterparts over the telephone or via an electronic network. Trading is not centralized on an exchange, as with the stock and futures markets
Introduction to Technical Analysis
Technical analysis is a method of forecasting price movements by looking at purely market-generated data. Price data from a particular market is most commonly the type of information analyzed by a technician, though most will also keep a close watch on volume and open interest in futures contracts. The bottom line when utilizing any type of analytical method, technical or otherwise, is to stick to the basics, which are methodologies with a proven track record over a long period. After finding a trading system that works for you, the more esoteric fields of study can then be incorporated into your trading toolbox.
Almost every trader uses some form of technical analysis. Even the most reverent follower of market fundamentals is likely to glance at price charts before executing a trade. At their most basic level, these charts help traders determine ideal entry and exit points for a trade. They provide a visual representation of the historical price action of whatever is being studied. As such, traders can look at a chart and know if they are buying at a fair price (based on the price history of a particular market), selling at a cyclical top or perhaps throwing their capital into a choppy, sideways market. These are just a few market conditions that charts identify for a trader. Depending on their level of sophistication, charts can also help much more advanced studies of the markets.
On the surface, it might appear that technicians ignore the fundamentals of the market while surrounding themselves with charts and data tables. However, a technical trader will tell you that all of the fundamentals are already represented in the price. They are not so much concerned that a natural disaster or an awful inflation number caused a recent spike in prices as much as how that price action fits into a pattern or trend. And much more to the point, how that pattern can be used to predict future prices.
History repeats itself and therefore markets move in fairly predictable, or at least quantifiable, patterns. These patterns, generated by price movement, are called signals. The goal in technical analysis is to uncover the signals given off in a current market by examining past market signals.
The building blocks of any technical analysis system include price charts, volume charts, and a host of other mathematical representations of market patterns and behaviors. Most often called studies, these mathematical manipulations of various types of market data are used to determine the strength and sustainability of a particular trend. So, rather than simply relying on price charts to forecast future market values, technicians will also use a variety of other technical tools before entering a trade.
As in all other aspects of trading, be very disciplined when using technical analysis. Too often, a trader will fail to sell or buy into a market even after it has reached a price that his or her technical studies identified as an entry or exit point. This is because it is hard to screen out the fundamental realities that led to the price movement in the first place.
As an example, let's assume you are long USD vs. euro and have established your stop/loss pips away from your entry point. However, if some unforeseen factor is responsible for pushing the USD through your stop/loss level you might be inclined to hold this position just a bit longer in the hopes that it turns back into a winner. It is very hard to make the decision to cut your losses and even harder to resist the temptation to book profits too early on a winning trade. This is called leaving money on the table. A common mistake is to ride a loser too long in the hopes it comes back and to cut a winner way too early. If you use technical analysis to establish entry and exit levels, be very disciplined in following through on your original trading plan.
Price Chart
Chart patterns There are a variety of charts that show price action. The most common are bar charts. Each bar will represent one period of time and that period can be anything from one minute to one month to several years. These charts will show distinct price patterns that develop over time.
Candlestick patterns
Like bar charts patterns, candlestick patterns can be used to forecast the market. Because of their colored bodies, candlesticks provide greater visual detail in their chart patterns than bar charts.
Point & figure patterns
Point and figure patterns are essentially the same patterns found in bar charts but Xs and Os are used to market changes in price direction. In addition, point and figure charts make no use of time scales to indicate the particular day associated with certain price action.
Technical Indicators
Here are a few of the more common types of indicators used in technical analysis:
Trend indicators
Trend is a term used to describe the persistence of price movement in one direction over time. Trends move in three directions: up, down and sideways. Trend indicators smooth variable price data to create a composite of market direction. (Example: Moving Averages, Trend lines)
Strength indicators
Market strength describes the intensity of market opinion with reference to a price by examining the market positions taken by various market participants. Volume or open interest are the basic ingredients of this indicator. Their signals are coincident or leading the market. (Example: Volume)
Volatility indicators
Volatility is a general term used to describe the magnitude, or size, of day-to-day price fluctuations independent of their direction. Generally, changes in volatility tend to lead changes in prices. (Example: Bollinger Bands)
Cycle indicators
A cycle is a term to indicate repeating patterns of market movement, specific to recurrent events, such as seasons, elections, etc. Many markets have a tendency to move in cyclical patterns. Cycle indicators determine the timing of a particular market patterns. (Example: Elliott Wave)
Support/resistance indicators
Support and resistance describes the price levels where markets repeatedly rise or fall and then reverse. This phenomenon is attributed to basic supply and demand. (Example: Trend Lines)
Momentum indicators
Momentum is a general term used to describe the speed at which prices move over a given time period. Momentum indicators determine the strength or weakness of a trend as it progresses over time. Momentum is highest at the beginning of a trend and lowest at trend turning points. Any divergence of directions in price and momentum is a warning of weakness; if price extremes occur with weak momentum, it signals an end of movement in that direction. If momentum is trending strongly and prices are flat, it signals a potential change in price direction. (Example: Stochastic, MACD, RSI)
Almost every trader uses some form of technical analysis. Even the most reverent follower of market fundamentals is likely to glance at price charts before executing a trade. At their most basic level, these charts help traders determine ideal entry and exit points for a trade. They provide a visual representation of the historical price action of whatever is being studied. As such, traders can look at a chart and know if they are buying at a fair price (based on the price history of a particular market), selling at a cyclical top or perhaps throwing their capital into a choppy, sideways market. These are just a few market conditions that charts identify for a trader. Depending on their level of sophistication, charts can also help much more advanced studies of the markets.
On the surface, it might appear that technicians ignore the fundamentals of the market while surrounding themselves with charts and data tables. However, a technical trader will tell you that all of the fundamentals are already represented in the price. They are not so much concerned that a natural disaster or an awful inflation number caused a recent spike in prices as much as how that price action fits into a pattern or trend. And much more to the point, how that pattern can be used to predict future prices.
Technical analysis assumes that:
All market fundamentals are depicted in the actual market data. So the actual market fundamentals and various factors, such as the differing opinions, hopes, fears, and moods of market participants, need not be studied.
History repeats itself and therefore markets move in fairly predictable, or at least quantifiable, patterns. These patterns, generated by price movement, are called signals. The goal in technical analysis is to uncover the signals given off in a current market by examining past market signals.
Prices move in trends. Technicians typically do not believe that price fluctuations are random and unpredictable. Prices can move in one of three directions, up, down or sideways. Once a trend in any of these directions is established, it usually will continue for some period.
The building blocks of any technical analysis system include price charts, volume charts, and a host of other mathematical representations of market patterns and behaviors. Most often called studies, these mathematical manipulations of various types of market data are used to determine the strength and sustainability of a particular trend. So, rather than simply relying on price charts to forecast future market values, technicians will also use a variety of other technical tools before entering a trade.
As in all other aspects of trading, be very disciplined when using technical analysis. Too often, a trader will fail to sell or buy into a market even after it has reached a price that his or her technical studies identified as an entry or exit point. This is because it is hard to screen out the fundamental realities that led to the price movement in the first place.
As an example, let's assume you are long USD vs. euro and have established your stop/loss pips away from your entry point. However, if some unforeseen factor is responsible for pushing the USD through your stop/loss level you might be inclined to hold this position just a bit longer in the hopes that it turns back into a winner. It is very hard to make the decision to cut your losses and even harder to resist the temptation to book profits too early on a winning trade. This is called leaving money on the table. A common mistake is to ride a loser too long in the hopes it comes back and to cut a winner way too early. If you use technical analysis to establish entry and exit levels, be very disciplined in following through on your original trading plan.
Price Chart
Chart patterns There are a variety of charts that show price action. The most common are bar charts. Each bar will represent one period of time and that period can be anything from one minute to one month to several years. These charts will show distinct price patterns that develop over time.
Candlestick patterns
Like bar charts patterns, candlestick patterns can be used to forecast the market. Because of their colored bodies, candlesticks provide greater visual detail in their chart patterns than bar charts.
Point & figure patterns
Point and figure patterns are essentially the same patterns found in bar charts but Xs and Os are used to market changes in price direction. In addition, point and figure charts make no use of time scales to indicate the particular day associated with certain price action.
Technical Indicators
Here are a few of the more common types of indicators used in technical analysis:
Trend indicators
Trend is a term used to describe the persistence of price movement in one direction over time. Trends move in three directions: up, down and sideways. Trend indicators smooth variable price data to create a composite of market direction. (Example: Moving Averages, Trend lines)
Strength indicators
Market strength describes the intensity of market opinion with reference to a price by examining the market positions taken by various market participants. Volume or open interest are the basic ingredients of this indicator. Their signals are coincident or leading the market. (Example: Volume)
Volatility indicators
Volatility is a general term used to describe the magnitude, or size, of day-to-day price fluctuations independent of their direction. Generally, changes in volatility tend to lead changes in prices. (Example: Bollinger Bands)
Cycle indicators
A cycle is a term to indicate repeating patterns of market movement, specific to recurrent events, such as seasons, elections, etc. Many markets have a tendency to move in cyclical patterns. Cycle indicators determine the timing of a particular market patterns. (Example: Elliott Wave)
Support/resistance indicators
Support and resistance describes the price levels where markets repeatedly rise or fall and then reverse. This phenomenon is attributed to basic supply and demand. (Example: Trend Lines)
Momentum indicators
Momentum is a general term used to describe the speed at which prices move over a given time period. Momentum indicators determine the strength or weakness of a trend as it progresses over time. Momentum is highest at the beginning of a trend and lowest at trend turning points. Any divergence of directions in price and momentum is a warning of weakness; if price extremes occur with weak momentum, it signals an end of movement in that direction. If momentum is trending strongly and prices are flat, it signals a potential change in price direction. (Example: Stochastic, MACD, RSI)
Calculating Profit and Loss
For ease of use, most online trading platforms automatically calculate the P&L of a traders' open positions. However, it is useful to understand how this calculation is derived.
To illustrate a typical FX trade, consider the following example.
The current bid/ask price for EUR/USD is 1.2320/23, meaning you can buy 1 euro with 1.2323US dollars or sell 1 euro for 1.2320 US dollars.
Suppose you decide that the Euro is undervalued against the US dollar. To execute this strategy, you would buy Euros (simultaneously selling dollars), and then wait for the exchange rate to rise.
So you make the trade: to buy 100,000 euros you pay 123,230 dollars (100,000 x 1.2323). Remember, at 1% margin, your initial margin deposit would be $1,232 for this trade.
As you expected, Euro strengthens to 1.2395/98. Now, to realize your profits, you sell 100,000 euros at the current rate of 1.2395, and receive $123,950.
You bought 100k Euros at 1.2323, paying $123,230. You sold 100k Euros at 1.2395, receiving $123,950. That's a difference of 72 pips, or in dollar terms ($123,950 - $123,230 = $720).
Total profit = US $720
(TIP: When trading any USD counter currency pair, each pip is worth $10, per 100,000 trades).
To illustrate a typical FX trade, consider the following example.
The current bid/ask price for EUR/USD is 1.2320/23, meaning you can buy 1 euro with 1.2323US dollars or sell 1 euro for 1.2320 US dollars.
Suppose you decide that the Euro is undervalued against the US dollar. To execute this strategy, you would buy Euros (simultaneously selling dollars), and then wait for the exchange rate to rise.
So you make the trade: to buy 100,000 euros you pay 123,230 dollars (100,000 x 1.2323). Remember, at 1% margin, your initial margin deposit would be $1,232 for this trade.
As you expected, Euro strengthens to 1.2395/98. Now, to realize your profits, you sell 100,000 euros at the current rate of 1.2395, and receive $123,950.
You bought 100k Euros at 1.2323, paying $123,230. You sold 100k Euros at 1.2395, receiving $123,950. That's a difference of 72 pips, or in dollar terms ($123,950 - $123,230 = $720).
Total profit = US $720
(TIP: When trading any USD counter currency pair, each pip is worth $10, per 100,000 trades).
Using Technical Indicators
A good understanding of the basic tenets of technical analysis can vastly improve one's trading skills.
When using technical analysis, price is the primary tool. Simply put, "everything is already in the rate." However, technical analysis involves a bit more than simply staring at price charts hoping to find a "yellow brick road" to a bonanza payday. Along with various methods of plotting price action on charts by using bars, candlesticks, and Xs and Os on point and figure charts, market technicians also employ many technical studies that help them to delve deeper into the data. By using these studies in conjunction with their price charts, traders are able to build much stronger cases to buy, sell or remain on the sidelines than they could by simply looking at price charts alone.
Here are descriptions of some of the more widely used and time-tested studies that technicians keep in their toolboxes:
Moving Averages
One of the most basic and widely used indicators in a technical analyst's tool box, moving averages help traders verify existing trends, identify emerging trends, and view overextended trends about to reverse. Moving averages are lines overlaid on a chart indicating long term price trends with short term fluctuations smoothed out.
There are three basic types of moving averages:
Simple
Weighted
Exponential
A simple moving average gives equal weight to each price point over the specified period. The user defines whether the high, low, or close is used and these price points are added together and averaged. This average price point is then added to the existing string and a line is formed. With the addition of each new price point the sample set drops off the oldest point. The simple moving average is probably the most widely used moving average.
A weighted moving average gives more emphasis to the latest data. A weighted moving average multiplies each data point by a weighting factor which differs from day to day. These figures are added and divided by the sum of the weighting factors. A weighted moving average allows the user to successfully smooth out a curve while having the average more responsive to current price changes.
An exponential moving average is another way of "weighting" the more recent data. An exponential moving average multiplies a percentage of the most recent price by the previous period's average price. Defining the optimum moving average for a particular currency pair involves "curve fitting". Curve fitting is the process of selecting the right number of periods with the correct type of moving average to produce the results the user is trying to achieve. By trial and error, technicians work with the time periods to fit the price data.
Because the moving average is constantly changing based on the latest market data, many traders will use different "specified" time frames before they come up with a series of moving averages that are optimal for a particular currency.
For example, a trader might create a 5-day, a 15-day and a 30-day moving average for a currency and then plot them on his or her price chart. He might start out using simple moving averages and end up using weighted moving averages. In creating these moving averages, traders need to decide on the exact price data that will be used in this study; meaning closing prices vs. opening prices vs. high/low/close etc. After doing so, a series of lines are created that reflect the 5-day, 15-day and 30-day moving average of a currency.
Once the data is layered over a price chart, traders can determine how well these chosen periods keep track of the trend being followed. If, for example, a market is trending higher, you'd expect the 30-day moving average to be a very accurate trend line, providing a line of support for prices on their way higher. If prices seem too close under this 30-day moving average on several occasions without resulting in a halt in the up trend, a trader will simply adjust the time period to say a 45-day or 60-day moving average in order to optimize the average. In this way, the moving average will act as a trend line.
After determining the optimum moving average for a currency, this average price line can be used as a line of support in maintaining a long position or resistance in maintaining a short position. Breaches of this line can also be used as a signal that a currency is in the process of reversing course, in which case a trader will want to pare back an existing position or come up with entry levels for a new position. For example, if you determine that a 30-day moving average has shown itself to be a good support line for USD-JPY in an upward trending market, then market closes under this 30-day moving average line could be a signal that this trend could be running out of steam. However, it is important to wait for confirmation of these signals. One way to do this is to wait for another close below the level. On the second close under the average, you should begin to pare down your position. Another confirmation involves using other, shorter term moving averages.
While a longer term moving average can help to define and support a particular trend, shorter term moving averages can provide lead signals that a trend is ending before prices dip below your longer term moving average line. For this reason, most traders will plot several moving averages on the same chart. In a market that is trending higher, a shorter term moving average might signal a market reversal by turning down and crossing over the longer term moving average. For example, if you are using a 15-day and a 45-day moving average in a market that is in an up trend, and the 15-day moving average turns down and crosses over the 45-day moving average, this could be an early signal that the up trend is ending and it is probably time to begin to pare down your position.
Stochastics
Stochastic studies, or oscillators, are another useful tool for monitoring the expected sustainability of a trend. They provide a trader with information about the closing price in the current trading period relative to the prior performance of the instrument being analyzed.
Stochastics are measured and represented by two different lines, %K and %D and are plotted on a scale ranging from 0 to 100. Indications above 80 represent strong upward movement while level indications below 20 represent strong downward movements. The mathematics behind the studies are not as important as knowing what the stochastics are telling you. The %K line is the faster, more sensitive indicator while the %D line takes more time to turn. When the %K line crosses over the %D line, this could be an indication that a market is about to reverse course. Stochastic studies are not useful in choppy, sideways markets. At times when prices are fluctuating in a narrow range, the %K and %D lines might be crossing many different times and will be telling you nothing more than the market is moving sideways.
Stochastics are most useful in measuring the strength of a trend and as augurs of a coming reversal in prices. When prices are making new highs or lows and your stochastics are doing the same, you can be reasonably certain that the trend will continue. On the other hand, many traders finds that the best trading opportunity comes when their stochastic indicator is flattening out or moving in the opposite direction of prices. When these divergences occur, it's time to book profits and/or to establish a position in the opposite direction of the prior trend.
As should always be the case when using any technical tool, do not act on the first signal you see. Wait at least one or two trading sessions for confirmation of what the study is indicating before you commit to a position.
Relative Strength Index (RSI)
RSI measures the momentum of price movements. It is also plotted on a scale ranging from 0 to 100. Traders will tend to look at RSI readings over 80 as an indicator of a market that is overbought or susceptible to a downturn, and readings under 20 as a market that is oversold or ready to turn higher.
This logic therefore implies that prices cannot rise or fall forever and that by using an RSI study, one can determine with a reasonable degree of certainty when a reversal will come about. However, be very wary of trading on RSI studies alone. In many instances, an RSI can remain at very lofty or sunken levels for quite a while without prices reversing course. At these times, the RSI is simply telling you that a market is quite strong or quite weak and shows no signs of changing course.
RSI studies can be adjusted to whatever time sensitivity a trader feels necessary for his or her particular style. For instance, a 5-day RSI will be very sensitive and will tend to give many more signals, not all of them sustainable, than say a 21-day RSI, which will tend to be less choppy. As with other studies, try a variety of time periods for the currency that you are trading based on your trading style. Longer term, position type traders, will tend to find that shorter time frames used for an RSI (or any other study for that matter) will give too many signals and will result in over-trading. On the other hand, shorter time frames will probably be ideal for day-traders trying to capture many shorter-term price fluctuations.
As with stochastics, look for divergences between prices and the RSI. If your RSI turns up in a slumping market or turns down during a bull run, this could be a good indication that a reversal is just around the corner. Wait for confirmation before you act on divergent indications from your RSI studies.
Bollinger Bands
Bollinger Bands are volatility curves used to identify extreme highs or lows in relation to price. Bollinger Bands establish trading parameters, or bands, based on the moving average of a particular instrument and a set number of standard deviations around this moving average.
For example, a trader might decide to use a 10-day moving average and 2 standard deviations to establish Bollinger Bands for a given currency. After doing so, a chart will appear with price bars capped by an upper boundary line based on price levels 2 standard deviations higher than the 10-day moving average and supported by a lower boundary line based on 2 standard deviations lower than the 10-day moving average. In the middle of these two boundary lines will be another line running somewhat close to the middle area depicting in this case, the 10-day moving average. Both the moving average and the number of standard deviations can be altered to best suit a particular currency.
Jon Bollinger, creator of Bollinger Bands recommends using a simple 20-day moving average and 2 standard deviations. Because standard deviation is a measure of volatility, Bollinger Bands are dynamic indicators that adjust themselves (widen and contract) based on the current levels of volatility in the market being studied. When prices hit the upper or lower boundaries of a given set of Bollinger Bands, this is not necessarily an indication of an imminent reversal in a trend. It simply means that prices have moved to the upper limits of the established parameters. Therefore, traders should use another study in conjunction with Bollinger Bands to help them determine the strength of a trend.
MACD - Moving Average Convergence Divergence
MACD is a more detailed method of using moving averages to find trading signals from price charts. Developed by Gerald Appel, the MACD plots the difference between a 26-day exponential moving average and a 12-day exponential moving average. A 9-day moving average is generally used as a trigger line, meaning when the MACD crosses below this trigger it is a bearish signal and when it crosses above it, it's a bullish signal.
As with other studies, traders will look to MACD studies to provide early signals or divergences between market prices and a technical indicator. If the MACD turns positive and makes higher lows while prices are still tanking, this could be a strong buy signal. Conversely, if the MACD makes lower highs while prices are making new highs, this could be a strong bearish divergence and a sell signal.
Fibonacci Retracements
Fibonacci retracement levels are a sequence of numbers discovered by the noted mathematician Leonardo da Pisa during the twelfth century. These numbers describe cycles found throughout nature and when applied to technical analysis can be used to find pullbacks in the currency market.
Fibonacci retracement involves anticipating changes in trends as prices near the lines created by the Fibonacci studies. After a significant price move (either up or down), prices will often retrace a significant portion (if not all) of the original move. As prices retrace, support and resistance levels often occur at or near the Fibonacci Retracement levels.
In the currency markets, the commonly used sequence of ratios is 23.6 %, 38.2%, 50% and 61.8%. Fibonacci retracement levels can easily be displayed by connecting a trend line from a perceived high point to a perceived low point. By taking the difference between the high and low, the user can apply the % ratios to achieve the desired pullbacks.
One final word of advice: Don't get too caught up in the mathematics involved in putting together each study. It is much more important to understand how and why studies can and should be manipulated based on the time periods and sensitivities that you determine are ideal for the currency you are trading. These ideal levels can only be determined after applying several different parameters to each study until the charts and studies begin to reveal the "details behind the details."
When using technical analysis, price is the primary tool. Simply put, "everything is already in the rate." However, technical analysis involves a bit more than simply staring at price charts hoping to find a "yellow brick road" to a bonanza payday. Along with various methods of plotting price action on charts by using bars, candlesticks, and Xs and Os on point and figure charts, market technicians also employ many technical studies that help them to delve deeper into the data. By using these studies in conjunction with their price charts, traders are able to build much stronger cases to buy, sell or remain on the sidelines than they could by simply looking at price charts alone.
Here are descriptions of some of the more widely used and time-tested studies that technicians keep in their toolboxes:
Moving Averages
One of the most basic and widely used indicators in a technical analyst's tool box, moving averages help traders verify existing trends, identify emerging trends, and view overextended trends about to reverse. Moving averages are lines overlaid on a chart indicating long term price trends with short term fluctuations smoothed out.
There are three basic types of moving averages:
Simple
Weighted
Exponential
A simple moving average gives equal weight to each price point over the specified period. The user defines whether the high, low, or close is used and these price points are added together and averaged. This average price point is then added to the existing string and a line is formed. With the addition of each new price point the sample set drops off the oldest point. The simple moving average is probably the most widely used moving average.
A weighted moving average gives more emphasis to the latest data. A weighted moving average multiplies each data point by a weighting factor which differs from day to day. These figures are added and divided by the sum of the weighting factors. A weighted moving average allows the user to successfully smooth out a curve while having the average more responsive to current price changes.
An exponential moving average is another way of "weighting" the more recent data. An exponential moving average multiplies a percentage of the most recent price by the previous period's average price. Defining the optimum moving average for a particular currency pair involves "curve fitting". Curve fitting is the process of selecting the right number of periods with the correct type of moving average to produce the results the user is trying to achieve. By trial and error, technicians work with the time periods to fit the price data.
Because the moving average is constantly changing based on the latest market data, many traders will use different "specified" time frames before they come up with a series of moving averages that are optimal for a particular currency.
For example, a trader might create a 5-day, a 15-day and a 30-day moving average for a currency and then plot them on his or her price chart. He might start out using simple moving averages and end up using weighted moving averages. In creating these moving averages, traders need to decide on the exact price data that will be used in this study; meaning closing prices vs. opening prices vs. high/low/close etc. After doing so, a series of lines are created that reflect the 5-day, 15-day and 30-day moving average of a currency.
Once the data is layered over a price chart, traders can determine how well these chosen periods keep track of the trend being followed. If, for example, a market is trending higher, you'd expect the 30-day moving average to be a very accurate trend line, providing a line of support for prices on their way higher. If prices seem too close under this 30-day moving average on several occasions without resulting in a halt in the up trend, a trader will simply adjust the time period to say a 45-day or 60-day moving average in order to optimize the average. In this way, the moving average will act as a trend line.
After determining the optimum moving average for a currency, this average price line can be used as a line of support in maintaining a long position or resistance in maintaining a short position. Breaches of this line can also be used as a signal that a currency is in the process of reversing course, in which case a trader will want to pare back an existing position or come up with entry levels for a new position. For example, if you determine that a 30-day moving average has shown itself to be a good support line for USD-JPY in an upward trending market, then market closes under this 30-day moving average line could be a signal that this trend could be running out of steam. However, it is important to wait for confirmation of these signals. One way to do this is to wait for another close below the level. On the second close under the average, you should begin to pare down your position. Another confirmation involves using other, shorter term moving averages.
While a longer term moving average can help to define and support a particular trend, shorter term moving averages can provide lead signals that a trend is ending before prices dip below your longer term moving average line. For this reason, most traders will plot several moving averages on the same chart. In a market that is trending higher, a shorter term moving average might signal a market reversal by turning down and crossing over the longer term moving average. For example, if you are using a 15-day and a 45-day moving average in a market that is in an up trend, and the 15-day moving average turns down and crosses over the 45-day moving average, this could be an early signal that the up trend is ending and it is probably time to begin to pare down your position.
Stochastics
Stochastic studies, or oscillators, are another useful tool for monitoring the expected sustainability of a trend. They provide a trader with information about the closing price in the current trading period relative to the prior performance of the instrument being analyzed.
Stochastics are measured and represented by two different lines, %K and %D and are plotted on a scale ranging from 0 to 100. Indications above 80 represent strong upward movement while level indications below 20 represent strong downward movements. The mathematics behind the studies are not as important as knowing what the stochastics are telling you. The %K line is the faster, more sensitive indicator while the %D line takes more time to turn. When the %K line crosses over the %D line, this could be an indication that a market is about to reverse course. Stochastic studies are not useful in choppy, sideways markets. At times when prices are fluctuating in a narrow range, the %K and %D lines might be crossing many different times and will be telling you nothing more than the market is moving sideways.
Stochastics are most useful in measuring the strength of a trend and as augurs of a coming reversal in prices. When prices are making new highs or lows and your stochastics are doing the same, you can be reasonably certain that the trend will continue. On the other hand, many traders finds that the best trading opportunity comes when their stochastic indicator is flattening out or moving in the opposite direction of prices. When these divergences occur, it's time to book profits and/or to establish a position in the opposite direction of the prior trend.
As should always be the case when using any technical tool, do not act on the first signal you see. Wait at least one or two trading sessions for confirmation of what the study is indicating before you commit to a position.
Relative Strength Index (RSI)
RSI measures the momentum of price movements. It is also plotted on a scale ranging from 0 to 100. Traders will tend to look at RSI readings over 80 as an indicator of a market that is overbought or susceptible to a downturn, and readings under 20 as a market that is oversold or ready to turn higher.
This logic therefore implies that prices cannot rise or fall forever and that by using an RSI study, one can determine with a reasonable degree of certainty when a reversal will come about. However, be very wary of trading on RSI studies alone. In many instances, an RSI can remain at very lofty or sunken levels for quite a while without prices reversing course. At these times, the RSI is simply telling you that a market is quite strong or quite weak and shows no signs of changing course.
RSI studies can be adjusted to whatever time sensitivity a trader feels necessary for his or her particular style. For instance, a 5-day RSI will be very sensitive and will tend to give many more signals, not all of them sustainable, than say a 21-day RSI, which will tend to be less choppy. As with other studies, try a variety of time periods for the currency that you are trading based on your trading style. Longer term, position type traders, will tend to find that shorter time frames used for an RSI (or any other study for that matter) will give too many signals and will result in over-trading. On the other hand, shorter time frames will probably be ideal for day-traders trying to capture many shorter-term price fluctuations.
As with stochastics, look for divergences between prices and the RSI. If your RSI turns up in a slumping market or turns down during a bull run, this could be a good indication that a reversal is just around the corner. Wait for confirmation before you act on divergent indications from your RSI studies.
Bollinger Bands
Bollinger Bands are volatility curves used to identify extreme highs or lows in relation to price. Bollinger Bands establish trading parameters, or bands, based on the moving average of a particular instrument and a set number of standard deviations around this moving average.
For example, a trader might decide to use a 10-day moving average and 2 standard deviations to establish Bollinger Bands for a given currency. After doing so, a chart will appear with price bars capped by an upper boundary line based on price levels 2 standard deviations higher than the 10-day moving average and supported by a lower boundary line based on 2 standard deviations lower than the 10-day moving average. In the middle of these two boundary lines will be another line running somewhat close to the middle area depicting in this case, the 10-day moving average. Both the moving average and the number of standard deviations can be altered to best suit a particular currency.
Jon Bollinger, creator of Bollinger Bands recommends using a simple 20-day moving average and 2 standard deviations. Because standard deviation is a measure of volatility, Bollinger Bands are dynamic indicators that adjust themselves (widen and contract) based on the current levels of volatility in the market being studied. When prices hit the upper or lower boundaries of a given set of Bollinger Bands, this is not necessarily an indication of an imminent reversal in a trend. It simply means that prices have moved to the upper limits of the established parameters. Therefore, traders should use another study in conjunction with Bollinger Bands to help them determine the strength of a trend.
MACD - Moving Average Convergence Divergence
MACD is a more detailed method of using moving averages to find trading signals from price charts. Developed by Gerald Appel, the MACD plots the difference between a 26-day exponential moving average and a 12-day exponential moving average. A 9-day moving average is generally used as a trigger line, meaning when the MACD crosses below this trigger it is a bearish signal and when it crosses above it, it's a bullish signal.
As with other studies, traders will look to MACD studies to provide early signals or divergences between market prices and a technical indicator. If the MACD turns positive and makes higher lows while prices are still tanking, this could be a strong buy signal. Conversely, if the MACD makes lower highs while prices are making new highs, this could be a strong bearish divergence and a sell signal.
Fibonacci Retracements
Fibonacci retracement levels are a sequence of numbers discovered by the noted mathematician Leonardo da Pisa during the twelfth century. These numbers describe cycles found throughout nature and when applied to technical analysis can be used to find pullbacks in the currency market.
Fibonacci retracement involves anticipating changes in trends as prices near the lines created by the Fibonacci studies. After a significant price move (either up or down), prices will often retrace a significant portion (if not all) of the original move. As prices retrace, support and resistance levels often occur at or near the Fibonacci Retracement levels.
In the currency markets, the commonly used sequence of ratios is 23.6 %, 38.2%, 50% and 61.8%. Fibonacci retracement levels can easily be displayed by connecting a trend line from a perceived high point to a perceived low point. By taking the difference between the high and low, the user can apply the % ratios to achieve the desired pullbacks.
One final word of advice: Don't get too caught up in the mathematics involved in putting together each study. It is much more important to understand how and why studies can and should be manipulated based on the time periods and sensitivities that you determine are ideal for the currency you are trading. These ideal levels can only be determined after applying several different parameters to each study until the charts and studies begin to reveal the "details behind the details."
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