Movement Index (DMI). Invented by J. Welles Wilder, who was a tremendous innovator in the field of technical analysis, and some of whose indicators we will examine in detail later on, the ADX is comprised of threebasic components: +DI, which indicates an up average of the tradable;–DI, which indicates the down average of the same instrument; and theADX itself, which smooths the difference between the up prices and thedown prices and then generates an oscillator reading between 0 and 100that tells the trader whether the instrument is in a strong trend. The general rules are that readings above 20 indicate the presence of trend andreadings below 20 suggest that markets are directionless. Like all ofWilder’s work, the logic behind his analysis is sound. The idea is that asprices begin to find direction the difference between +DI and –DI will expand, providing the trader with valuable clues to price action. Unfortunately, in real life trading the ADX is a day late and dollar short affair. Theindicator is woefully slow at producing any meaningful signals. Furthermore, since the ADX itself is directionally agnostic—simply telling thetrader that a trend exists but unable to tell the direction of that trend—thetrader can often be spectacularly faked out by relying on ADX readingsalone. For example, prices may originally rise, causing ADX readings toincrease, but then slowly change course and eventually begin a severe decline, while all the while ADX readings may be rising.The ADX, of course, is simply communicating that price is in atrend—but not that it was in an uptrend, then has quickly changed direction, and is now declining. A trend still exists, and may even be increasing—but now it’s a downtrend instead of an uptrend! It is easy to see howlooking at ADX the trader can easily become confused by its signals. In-
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TECHNICAL ANALYSIS OF THE CURRENCY MARKET
FIGURE 5.9 ADX versus Price PatternSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
stead of being trend followers, traders using ADX become the ultimatetrading sucker—they become trend chasers.Although some traders actively use ADX for their trend trading work,and some even swear by its effectiveness, I find its usefulness limited atbest. It is considered a classic trend indicator by technicians, which iswhy I have taken the time to discuss it, but I cannot leave without takingone final potshot at this tool. Note that when the price makes a sharp Vmove—that is, when prices suddenly reverse from declining to rising orvice versa—the ADX will often send completely contradictory messagesto the trader. As the turn in price action is processed in its calculations,the ADX will indicate that the trend is actually weakening when in fact it’sjust beginning to find direction. Furthermore, just as prices may havereached a temporary peak or bottom, the ADX reading will rise, suggesting that a trend is now in place (see Figure 5.9)!
BOLLINGER BAND “BANDS”Is there a more accurate way to glean trend? Yes, I believe there is. Surprisingly enough, one indicator that is often used for range-bound markets
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can be an extremely helpful tool for trend discovery. I discuss theBollinger bands (BBs) in more detail in Chapter 10, but for now note thatwe will use them in a unique way to detect trends in the currency market.Before we begin, let’s first examine the underlying notion of trend.What is trend really? I will postulate that trend is actually a deviance inprice. It is common wisdom in all markets that trends are generallyrare. Typically, in all markets, including the currency market, pricesstay in a range somewhere between 70 and 80 percent of the time.Therefore, when prices decide to trend they in fact deviate from thenorm. What is one of the best tools to measure deviation in technicalanalysis? Bollinger bands, of course. The Bollinger band formula contains the standard deviation (SD) calculation within it. Bollinger bandsmeasure the standard deviation of price away from its 20-period movingaverage. Here is where the use of Bollinger bands becomes quite interesting. If you superimpose a second set of Bollinger bands with a standard deviation setting of 1 onto the price chart that already has a set ofBBs with a default setting of 2 standard deviations, you will instantlysee that as prices begin to trend the majority of price action is capturedwithin the 1 SD–2 SD Bollinger bands.These Bollinger band “bands” divide the price action into three separate areas (see Figure 5.10). If prices are between the upper 1 standard
FIGURE 5.10 Bollinger Band “Bands”Source: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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TECHNICAL ANALYSIS OF THE CURRENCY MARKET
deviation Bollinger band and the upper 2 standard deviation Bollingerband, they are in the buy zone. If a specific currency is trading betweenthe lower 1 standard deviation Bollinger band and the lower 2 standarddeviation band, then its price is in the sell zone. Price candles that exist inthe area between the second Bollinger band “bands” are in effect in noman’s-land as markets struggle to find direction.In essence, Bollinger band “bands” act as dynamic trend channels in asuperior version of hand-drawn trend line channels covered earlier in thischapter. Because Bollinger bands are generated off the 20-period simplemoving average, their readings can be mathematically calculated with amuch better degree of accuracy than simple trend lines. Furthermore, thestandard deviation formula naturally adapts to the volatility of price action, widening or narrowing the Bollinger channels accordingly.For traders seeking a quick confirmation of trend, the Bollinger band“bands” approach offers an easy visual tool. One can use a variety of rulesto trade with them, but I prefer the following simple rules. The example Iwill use refers to detecting and trading the uptrend (for the downtrend therules are the same but simply reversed). To trade trend the trader needs toanswer three basic questions:1. Trend detection. When is a trend in place?2. Trade entry. How is a position initiated?3. Trade exit. What constitutes trend exhaustion?
With the Bollinger band “bands” approach, the trend detection rule isquite straightforward. I consider the uptrend to have commenced oncethe price closes—not simply penetrates, but closes—in the buy zone. Theidea behind this rule is that buyers must have enough conviction behindtheir actions to sustain a rally into the upper Bollinger channel. If pricesmerely pierce the channel but cannot hold their value, then we do nothave enough evidence of a clear up move in place.The second component of the trade is perhaps the most tricky. Instead of simply entering the trade at market we will look for an opportunity to buy on any small dip into the no-man’s-land zone. If the penetrationof the buy zone is so powerful that prices reach the upper 2 standard deviation Bollinger band, then we will wait for prices to retrace to the middleof the bands or to the 1 standard deviation band. Why such hesitation?Shouldn’t we just jump in the moment the trend becomes clear? No. Not ifyou want trade FX like a professional.When it comes to trend trading in FX, the difference between professionals and amateurs is that while the pros are trend followers, the amateurs are trend chasers. The distinction may seem like nothing more than
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semantics, but in fact it’s often what separates those who earn moneythrough trading from those who lose it. But perhaps before I explain thispoint in more detail I should disclose the final component of the setup—the exit.Where would the trader abandon his position? At what point on thechart will he be proven most likely wrong? If prices retreat all the wayback to the lower 1 standard deviation Bollinger band, then the tradershould stop out. The probability that trend is over is very high. Note thedifference in approach. In order for us to consider the trend valid, pricesmust not only touch but close through the upper 1 standard deviationBollinger band. As for our exit, a mere tag of the lower 1 standard deviation band will take us out of the trade. Why be so slow to enter and soquick to exit? Because, as I noted before, trend is not the common state ofprice, so price must really prove to the trader that it is making a directional move. Once price can’t hold trend, there is absolutely no reason forthe trend trader to stay around. His risks far outweigh potential rewards,because he now faces three possible scenarios—consolidation, trend reversal, or trend continuation. Two out of the three outcomes are unfavorable to his position and the last choice, which is advantageous, is usuallythe least likely under such circumstances.Using the lower 1 standard deviation band provides ample room forthe trend trader not to be falsely shaken out of the trade while the pricemeanders through the no-man’s-land zone before it decides whether itwants to continue its initial impulse higher.Understanding the exit—the third rule of the trade—may now behelpful to appreciating the second rule of buying only when the price retraces. It all has to do with risk and reward. Remember that in real lifeprices frequently fake out the trader. Just because price enters into thetrend channel is no guarantee that it will remain there. If markets werehighly predictable most traders would make money rather than lose it.The key to positioning in a trend-based setup is to minimize the amountof losses for the countless times you will inevitably be wrong, rather thanto maximize the gains for the few times that you will be right. In trading,as I will never tire of stating, trends are the exception, not the rule, and inorder to avoid being wiped out, traders need to try to always enter themarket under the most advantageous of circumstances no matter whatthe market environment holds. Novice traders tend to succumb to thelure of the crowd and not restrain themselves from buying at the top orselling at the bottom. Note in Figure 5.11 how a trader who buys the highof the candle exposes himself to fully 300 points of losses in theGBP/USD trade as the uptrend fails and price retreats all the way to thelower Bollinger band. The more patient trader, however, who would waitfor a retracement down to the upper 1 standard deviation Bollinger band,
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FIGURE 5.11 Buying on Retracement in GBP/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
would suffer only a 150-point loss. Both trades are losers but one is lessof a loss than the other.Football fans know that the win does not necessarily go to the bestathletic team but to the one that practices the best field management. JoeTheismann, the former quarterback for the Washington Redskins, oncestated that he became a much better quarterback once he understoodthat he did not have to convert every third down play into the first down.If the opportunity just did not present itself to make first down, it wasbetter to try for just a couple of extra yards, so the punter would havemore room and could bury the opposition deeper in their own territory.Trading trend with Bollinger bands follows the same philosophy: When inthe game the focus should always be on minimizing risk first, maximizingprofit second.In the example with the GBP/USD pair shown in Figure 5.12 the setupshows how well Bollinger bands can be used to trade trend with minimalrisk. First the price enters into the sell zone, signaling the potential for adownward move. Second, it retraces back to the 1 standard deviation line,offering the trader a low-risk entry into the trade. If the trader is wrong he
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FIGURE 5.12 Trading Downtrend in GBP/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
or she could stop out at the 20-period moving average, suffering only a minor loss. However, in this case the trader is correct and the profits turnout to be massive as the pair collapses for nearly 1,000 points of uninterrupted decline.
CONCLUSIONContrary to popular opinion, identifying a trend is not nearly as difficultas it may seem. Whether we use trend lines, moving averages, Bollingerband “bands,” or even, for some traders, the ADX, the technician’s arsenal is full of tools capable of accurate trend analysis. Yet while detectinga trend is easy, trading it is not. By definition, all of the technical analysisindicators use past price data and are therefore highly vulnerable towhipsaws and fakeouts. No technical analysis tool can predict futureprice action. Indicators can only suggest it. Generally, the more specificthe technical setup and the more the trader has thought through the va-
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riety of failures likely to befall it, the more robust the trade. In this chapter I have offered two setups (the compressed 3 SMA crossover andBollinger band “bands”) that not only utilize the basic tools of technicalanalysis but combine them in circumspect, logical ways to trade mosttraders’ favorite price action—trend. In the next chapter we look at thefar more common price behavior—range—and see how technical toolscan help us to trade it successfully.
CHAPTER 6
GaugingRange
I
n the FX market, much as in life, most of the time nothing much happens. Prices meander back and forth as neither buyers nor sellers areable to make much progress. The rough estimate is that 70 to 80 percent of the time prices in the FX market stay in a range. Although these directionless price movements may bore some traders to tears, others buildtheir whole livelihood on this fact. As I’ve discussed before, range tradingrequires a completely different set of skills and strategies than trend trading. Fortunately, technicians have a cornucopia of tools at their disposalto effectively analyze and properly trade range-bound markets. The classof indicators known as oscillators provides technically based traders witha set of very valuable clues to price action and helps them anticipate future price moves.
STOCHASTICSInvented by Dr. George C. Lane, the tool known as stochastics is one ofthe oldest, yet one the most robust, technical oscillators around. Stochastics—with its Greek-derived name and its arcane parameter nomenclature—can at first glance appear rather obscure and difficult tounderstand. However, this tool is built on the basic technical premise thatas prices rise in an uptrend, the close of each period will approach thehigh as bulls lift every offer, whereas in a downtrend the close will usuallyoccur near the low as bears hit every bid.79
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TECHNICAL ANALYSIS OF THE CURRENCY MARKET
Two measurements, which are normalized and bounded so that theirvalues cycle from 0 to 100, make up stochastics. The first value, called %K,is calculated as follows:%K = 100 ×
Close at End of Period n – Low for Entire Period nHigh for Entire Period n – Low for Entire Period n
Typically the period n is set to 14.The second measurement, called %D, is simply the three-period average of %K, which smooths out the moves of %K. %K and %D are awkwardnames for what are essentially two sets of moving averages that oscillatebetween 0 and 100. Stochastic is a term that refers to the location of thetradable’s price relative to its range over the past 14 periods. So, for example, a stochastic reading of 55 simply means that the price is in the 55thpercentile of its range or just about in the middle.
Fast and SlowThe stochastic indicator comes in two flavors: fast and slow. The formulafor the fast stochastic was already presented. The slow stochastic, as thename implies, slows the stochastic indicator by replacing %K with itsthree-period simple moving average %D. The formula then calculates anew %D of this slower %K value. The idea is to smooth out even furtherthe jumpiness of raw price data in order to ascertain the underlying trend.Though relatively simple in concept, stochastics are the cornerstone formany technicians’ range-bound setups because of their ability to gauge relatively oversold or overbought levels. The standard rule with stochastics isthat a reading of 80 indicates that the tradable is overbought and a reading of20 suggests an oversold price state. However, just because the currency pairis flashing a stochastic value of 80 does not mean that it cannot go materiallyhigher in price, and similarly it can also decrease much further even if itprints a value below 20. In fact, during very strong uptrends stochastics mayindicate a reading of 80 for many days, just as in a downtrend stochasticreadings may dive down into the teens or even single digits. Dr. Lane wasvery clear that a stochastic of 80 does not mean that the trader must immediately short, nor does a reading of 20 mean that bids must be placed. Rather,the proper way to use stochastics is to observe the indicator once it has entered the overbought or oversold zone. Only when the indicator slips backbelow 80 or moves up above 20 does the trader follow the signal. Stochasticsessentially measure momentum, and a break of the 80 line or a rally throughthe 20 line would indicate that buying or selling momentum has ceased andthe trader is offered a high-probability directional trade (see Figure 6.1).
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FIGURE 6.1 Trading with StochasticsSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
DivergenceGeorge Lane contended that one of the most useful ways to utilize stochastics is by spotting divergence between the price action and the indicator readings. Specifically, he found the setup where the %D line wouldmake lower highs while the price made higher highs a very useful shortsetup, and on the opposite side when the dynamic reversed itself with %Dmaking higher lows while the price continued to make lower lows, thissetup represented a potent long trade. He found that these types of tradeswere most reliable when divergence occurred as %D was between 10 and15 on the downside and 85 and 90 on the upside (see Figure 6.2).Stochastics are one of the earliest oscillator indicators and for thatreason they have been abused by traders who misinterpret their signals.In highly range-bound markets, this tool can accurately call turns in priceby simply flashing 80 or 20, but once the environment changes such simplistic trading will wreak havoc with your trading account, as price willcontinue to climb relentlessly against your shorts and fall against yourlongs. Stochastics are best used as a gauge of trend strength. Once trendweakens, stochastics will weaken as well. Even if price then resumes itsprior direction, and even sets new highs in an uptrend or new lows in a
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FIGURE 6.2 Trading Divergence with StochasticsSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
downtrend but stochastics do not confirm the price action, that piece ofinformation could be of enormous value to the trader. Such a setup couldsignal the possible start of consolidation and range trading or a full-scalecountertrend move. In either case, it’s at this point that stochastics can offer the greatest value and the indicator can prove its mettle as one of theoldest albeit still valuable technical tools.
RELATIVE STRENGTH INDEXInvented by master technician J. Welles Wilder, the Relative Strength Index (RSI) was first introduced in June 1978 in an article in Futures magazine. Since then, this indicator has become a mainstay of technicalanalysis, present in every single technical software package available onthe market. In fact, if there was ever an indicator Hall of Fame, the RSIwould no doubt be one of its founding members. The RSI, like stochastics,compares the strength of the currency pair to its price history. As an indicator it places more importance on recent price data and as such is verypopular with currency traders who use it in a variety of ways. Because of
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its built-in smoothing functions, the RSI filters out the noise generated byspikes in price and is even used by some traders as a proxy for volumesince volume reporting does not exist in FX.The formula for the RSI is:RSI = 100 −
100Sum of Closes of Up Days / Entire Period n+1Sum of Closes of Down Days / Entire Period n
Typically the period n is set to 14.Just like stochastics, the RSI is normalized and bounded so that itranges from 0 to 100. The essence of the RSI is to measure the internalstrength of the tradable by comparing the number of times that the currency pair is up in price versus the number of times that it is down in priceover a given period of time. The classic setting for the RSI usually utilizes14 periods, weighting the value of recent data by using the exponential averages for up days and down days to arrive at its final results. If the RSIregisters readings above 70 the currency pair is considered to be overbought and if the reading is below 30 it is oversold. However, just as withstochastics, the simple fact that RSI reaches readings of 70 or 30 is notenough reason to suddenly sell or buy the pair. Rather it merely alerts thetrader that price is now in an overbought or oversold state.One of the most common methods of trading the RSI is by uncoveringdivergence patterns. If price is continually making new highs but the RSIdoes not, then a trend reversal or trend consolidation is highly likely (seeFigure 6.3).Because the RSI so effectively smooths price action, some traderseven prefer to trade patterns off the RSI itself rather than off price action.In fact, a very strong argument can be made that trend lines and their concomitant breaks can be traded far more effectively off the RSI rather thanoff price action. Because price action, especially in the short term, can behighly volatile and unpredictable, it will often trigger numerous false signals and generate a large number of stop-outs for the trader. The RSI, incontrast, by smoothing out the price action may offer a truer picture of actual price direction (see Figure 6.4).One interesting way to trade the RSI is as a proxy for the volume indicator. One of my colleagues, Adam Rosen, who serves as a senior Powercourse instructor at my firm, invented the following setup using the RSI tofade short-term spikes in the FX market. It is a trick he brought over fromhis days of prop trading New York Stock Exchange (NYSE) stocks usingthe volume indicator.The rules of the setup are as follows. On an hourly chart look for
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FIGURE 6.3 Trading Divergence Using RSISource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
FIGURE 6.4 Trading Trend Lines on RSI Rather Than PriceSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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readings of RSI 70 or higher or RSI 30 or lower to appear. Make sure thatthis reading occurs during the currency pair’s active hours. The easiestway to define active hours for the currency pair is to use the stock markethours of each respective country as a time line guide. Since stock tradingin each country is done during prime business hours, that would be defined as the active trading session for the currency pair. For some pairsthis is actually a continuous time line of approximately 12 to 16 hours ofthe day, while for others active hours are comprised of two separate sessions during the 24-hour day. In the case of the EUR/USD, for example,the German DAX opens at 3 A.M. EST while the NYSE closes at 4 P.M. EST,so the active session for the EUR/USD is 3 A.M. until 4 P.M. EST. In the caseof the USD/JPY, the Nikkei opens at 7 P.M. EST and closes as 3 A.M. withthe NYSE then opening at 9:30 A.M. and closing at 4 P.M., so the active session for USD/JPY actually contains a gap in the time line. Table 6.1 provides active session times for the four major currency pairs and the threecommodity pairs.Once the price highs or price lows of the session are set and the RSIreading retreats from its oversold or overbought conditions and the activesession hours are over, the trader would then measure the full amplitude(from the highs to the lows) of the active session range. The key factor inthis setup is the RSI move off its extremes. If it maintains those levels,then the possibility of further price movement in the original direction isstrong and the trader would stand aside. If the price rallied during the active session, then the trader would demarcate a sell zone at the top 20 percent of that day’s range and further set a stop at 20 percent above the high
TABLE 6.1 Active Hours for Majors and CommodityCurrenciesPairs
Active Hours in Eastern Standard Time
EUR/USD
3:30 A.M.–4:00 P.M.
USD/JPY
9:30 P.M.–5:30 A.M. &9:30 A.M.–4:00 P.M.
GBP/USD
4:30 A.M.–4:00 P.M.
USD/CHF
4:30 A.M.–4:00 P.M.
USD/CAD
9:30 A.M.–4:00 P.M.
AUD/USD
5:00 P.M.–12:00 A.M. &9:30 A.M.–4:00 P.M.
NZD/USD
5:00 P.M.–12:00 A.M. &9:30 A.M.–4:00 P.M.
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TECHNICAL ANALYSIS OF THE CURRENCY MARKET
FIGURE 6.5 RSI Fade in EUR/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
of the range. As the price tries to retest the highs, the trader would shortthe move. Once the profit target reaches the same amount of points asrisked on the trade, then half the position would be covered and the stopwould be moved to break even. Figure 6.5 illustrates the RSI fade setup onthe EUR/USD.The RSI is one of the most robust oscillator tools in technical analysis.Its price-smoothing function frequently offers better clues to directionthan price action itself. By applying trend line analysis right on the RSI itself, traders can generate accurate entry signals on both shorts and longs.Although ostensibly the indicator generates overbought or oversold signals, like all oscillators its real value is in spotting divergence betweenmomentum and price.One novel way that some traders have utilized the RSI in the currencymarket is as a proxy for volume. RSI readings above 70 and below 30 areequated to volume spikes seen in exchange-based markets and, dependingon the immediate price action following those readings, can either betraded as trend-based volume breakouts or faded as signs of price exhaustion. Regardless of how one utilizes this tool, it is as versatile and as useful to a technically oriented trader as the Swiss army knife is to thetraveling businessperson.
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MOVING AVERAGE CONVERGENCE/DIVERGENCEIs there a better indicator than the moving average convergence/divergence (MACD)? Some traders will assuredly say yes, of course there is.But for me the MACD is the most potent technical tool in my arsenal. Infact, I use the MACD and my Bollinger band “bands” to trade most of mysetups in FX. The MACD is one of the simplest indicators around and isextremely versatile as it can be used both to gauge range as well as totrade trend.Invented by Gerald Appel in 1978, the MACD is undoubtedly one ofthe top five most popular technical indicators in existence. Appel’s brilliant insight was that as technicians we can learn more about price behavior from the interaction between moving averages than from the movingaverages themselves. The MACD essentially plots the difference betweenthe currency pair’s 12-period and 26-period exponential moving averages.The idea is that if prices are rising, the 12-period exponential moving average (the faster moving average) will increase at a faster rate than the 26period exponential moving average. The MACD therefore will slopeupward. The reverse dynamic will occur if prices are falling. The MACD isan unbounded indicator, but it does oscillate around zero with readingsbecoming increasingly positive as prices rise and increasingly negative asthey fall. One very simple method of trading the MACD is to buy when theMACD value turns positive and sell when it turns negative. Because theMACD records the difference between two moving averages rather thanthe moving averages themselves, it is far less prone to whipsaws as it filters out the periodic noise (see Figure 6.6).The MACD is also plotted with its trigger line, which is simply the 9period exponential moving average of the MACD itself. Much like themoving average crossover, the trigger line signal is traded when theMACD line crosses it from the upside or the downside. Because MACDcalculations are naturally slower than the price action, these signals arealways generated later than the price action itself. However, althoughthese signals may be late they tend to be more accurate than mere movingaverage crossovers (see Figure 6.7).In 1986 Thomas Aspray improved on Appel’s original idea by inventing the MACD histogram, for me one of the most useful technical tools inexistence. The histogram is simply the visual representation of the difference between the MACD line and its trigger line, but its real value rests onthe fact that it is a very effective momentum indicator. The MACD histogram oscillates around the zero line, which is the point at which theMACD and the trigger line cross each other. When prices rise, the MACDwill tend to pull away from its trigger line, as the most recent values willcause the MACD to increase at a faster rate than its 9-period EMA.
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FIGURE 6.6 MACD Zero Line Crossover in NZD/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
FIGURE 6.7 MACD Crossovers in GBP/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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At its core, the MACD histogram measures the velocity of price movement, which can offer a technically oriented trader a very strong clue tofuture price action. The key technical concept, in fact the essence of alltechnical analysis, is that changes in momentum precede changes in price.The concept is actually eminently reasonable if we just think for a moment of what happens during a strong directional move.Let’s imagine that prices are in an uptrend. Buyers have bid the currency pair up, making higher highs. Typically price action will have thefollowing pattern: First prices will break out as early buyers pile into thecurrency in anticipation of a rise. Then more traders seeing the rise inthe currency will join the price action in hopes of extending the trend.Additionally, short