areextended into the future. The trader doesn’t know if the price will get there! The tradermakes the assumption that if the price is able to get to a Fib level, it will experiencestrong support or resistance. Also, if the price is able to probe a future Fib level but failsto go through it, the trader can make a reliable assumption that there is key support atthat level.
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Let’s get back to the chart. The price moved from the low of point A to the highof point B and then proceeded to retrace or fall back. What did it do? It probed the50 percent line but failed to close below it. It was as if it were performing a Fibonaccidance scripted in advance. But a chart using a 15-minute U.S. dollar–Swiss franc (USDCHF) chart follows a Fibonacci pattern, and we see the price falling and trying to retracebut failing at the key 38.2 percent fib line (see Figure 11.2). Experienced traders wouldbe ready to sell this pair upon these failures.Figure 11.3 shows a day chart of the EURUSD and another use of Fib lines. TheEURUSD completed a move from a high at 1.3293 to a low at 1.2854. Remember, onlyafter it completed the move would a trader be able to put on the Fib levels. The Fib levelsthen projected out the key Fib lines, which are the projected areas where retracementmight occur. We can see that the price moved during a two-day period to point A (the38.2 percent level) and then failed to close above it. The EURUSD proceeded to moveinto a three-day trend down nearly 150 pips. It then moved back up and actually wentnear the 50 percent Fib level but returned below it and proceeded to fall over 100 pips.
FIGURE 11.2 USDCHF 15-Minute Chart Showing Price Failure at Fib Points.Source: www.tradesignal.com.
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FIGURE 11.3 Sell Conditions Using Fib Points.Source: www.tradesignal.com.
What is instructive here for the trade is that if the trader were looking to sell, knowingin advance where the Fib levels were meant, while the price was going above point A orB the trader would look to put on a sell trade when the price fell below the Fib lines(of course, confirmed, as we shall see with other indicators). Point C is interesting. Ifthe price falls to point C and stops, the trader with a buying strategy would focus on theprice action at this point because stopping at a key Fib line means that support is strong.In contrast, if the trader were looking to sell, the price would have to go below the Fiblevel at point C to prove it had the energy to keep going.Let’s look some more. In the USDJPY 4-hour chart (Figure 11.4), we see the yenstrengthening and probing a key Fib line. Traders looking to sell would be watchingthis chart. The 4-hour period is particularly important because a 4-hour trend directionrepresents a great deal of money flowing. Consider the fact that over $2 trillion per dayis transacted in forex.
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FIGURE 11.4 4-Hour USDJPY Candles Probe Fib Points.Source: www.tradesignal.com.
Fib lines should not be treated as predictions of what the price will do. They aremaps of potential support or resistance. They are areas where great care should be takenby the trader. Rest assured that any professional trader knows where the key Fib levelsare. Perhaps because these levels are projected and therefore known in advance, theygenerate a self-fulfilling process and increase in importance. But the phenomenon of Fibbehavior is real and should never be ignored. Take a look at the Fib behavior of theEURUSD in response to the September 11, 2001, terrorist attacks and in response to theJuly 5, 2006, London train bombings.
WHICH TIME INTERVALS SHOULD WE CHOOSE?In using Fib lines, the question often asked is: Which lines and which points should bechosen? In answering this question, it’s important to be practical. There are many Fiblines in any of the chart time frames used. Even though trades may be taken off an
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intraday interval, with the 15- and 5-minute time intervals being common, it is still important to use the big Fib levels that are generated off the weekly, daily, or 4-hour charts.The way the Fib lines can be correctly chosen is to start where the price is at the hardright edge. Figure 11.5 shows the steps in drawing a Fib line.The key is to first ask yourself: Where is the price, and where is it coming from?The trader wants to find the preceding significant low or high and its preceding low orhigh. Doing so will locate the most recent completed movement. In Figure 11.5, the pricewas coming from a preceding high, which came from a preceding low connecting point2 to point 3. Select point 3 as the starting point of the Fib tool, and the Fib lines will begenerated. Notice that the 100 percent level is at the low, meaning that if the price fallsback to that level it will have given back 100 percent of the move.Even if the point of start was switched to either point 2 or point 3, what would notchange would be the middle three Fib lines. Some firms do not show any Fib levels andsimply show the lines.Knowing basic Fib retracement levels will provide the new forex trader a tool thatcan be used to help improve an understanding of when to put on the trade. There aremany variations of Fib levels. Fib extension levels take the retracement ratios beyond100. There are graphic tools such as Fib fans and Fib circles. There are even Fib timezones. Whatever tool you choose, the core concept that price behavior often moves inFib ratios is a major principle of trading forex, and, in fact, Fib patterns are commonplacein many other fields.
THE MUSIC OF FOREXIn The Psychology of the Foreign Exchange Market (John Wiley & Sons, 2004), ThomasOberlechner provides the results of research on how professional traders view the markets. In Chapter 7, Professor Oberlechner demonstrates that traders actually think aboutforex markets metaphorically. He shows that metaphors are an important way tradersorganize information, as well as form their own expectations of the market. ProfessorOberlechner cites the main metaphors used by forex traders: a bazaar, a machine, a living beast, gambling, sports, war, and the ocean.Many of us have probably used one or more of these concepts to characterize theforex market. The point of this research is to better understand how one proceeds totrade. The person who views the forex market as sports will look to winning tradesas the main focus, but may become emotionally damaged when confronted with a losingtrade. In contrast, the person who views forex as an ocean may tend to adopt longerterm views of market moves. Many view the forex market as a war, and as a result mayformulate trading strategies that capture pips as if they were the enemy. Even if you do
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Steps infinding FiblinesStep 1. Locatethe price.Step 2. Locatethe precedinghigh or low.Step 3. Locatenow again theprecedinghigh or low.Step 4. Drawthe Fib line.
FIGURE 11.5 Steps in Finding Fib Lines.Source: www.tradesignal.com.
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not read the book, it will be useful to ask yourself which metaphor applies to your ownviews of the forex market and why.Forex traders also bring to their trading different perspectives based on their job andlife experiences. Each perspective provides different strengths as well as weaknesses.Engineers who seek to learn forex often have a tendency to try to model the marketand project direction based on equations. In contrast, doctors approach forex tradingwith the medical mind-set of diagnosing the price action. While the medical workplaceprovides an environment where patients convey a great deal of respect to their doctors,the forex market provides no such ego gratification. The market is not a patient that returns respect. Those traders who come from a sports background, such as the martialarts, bring a disciplined mind-set and ability to control emotions. Emotions can providevaluable insight into managing a trade, so too much control of emotions may be counterproductive. It turns out that forex trading is a great equalizer among all professions,leaving most people challenged, as never before, in mastering profitable trading.One profession that appears to provide important insight for forex trading is music, because there is harmony in forex price movements and rhythm in the market.The Webster Unabridged Dictionary of the English Language defines harmony as“a consistent, orderly or pleasing arrangement of parts; congruity.” What is most interesting is that one doesn’t need an in-depth knowledge of music to recognize when oneis hearing a harmonic set of sounds or an opposite cacophony of noise. More experienced forex traders focus less on applying more indicators as they become familiar withthe inherent rhythm of the market. Yet, those new to forex trading face the huge challenge of trying to separate the noise in price movements and find an inner pattern orharmony.The entire body of technical analysis has been evolving to provide tools that enablepattern analysis and the ability to smooth out the data. The person new to forex tradingseeks to master technical analysis and is challenged by the overwhelming number ofindicators and information streaming all day. What is important, and what is permissibleto ignore? How does the forex trader know what to pay attention to? Part of the answerderives from looking at forex price movements as a form of harmony. Let’s explore thisfurther.In searching for trades, many traders have a favorite time interval. They could havea day chart or a 1-hour chart and then they apply a variety of analytical techniques andshape a trade. While this may be a rational set of procedures to evaluate the market, aneffective technique to consider is to let the time interval choose you! To clarify whatwe mean, consider the everyday experience of driving your car and trying to find a radiostation that you would like to listen to. Selecting the scan button allows you to listen for afew moments to each station until the right tune comes along. The driver did not need toknow in advance all of the songs being played at every station. All that was necessary wasto hear the song that is appealing. Similarly, the forex market is constantly streaming a
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T=
A
yt
1
fωf =2π
ω =
k
time
m
FIGURE 11.6 Forex Prices Often Look Like Sinusoidal Waves.
variety of patterns. There are many potential trades. By scanning through the price actionthat is playing, a tradable pattern will be perceived.For example, you might see a sideways pattern (as shown in Figure 11.6) in almostany time interval. If you notice that the pattern has a repetition of the movement upand down the price scale, such patterns reveal an inner harmony. The engineer wouldrecognize this pattern as a simple harmonic motion that is sinusoidal in time with a single resonant frequency. He might even be tempted to formulate an equation to projectits path.A person versed in music would not need equations to sense the pattern as beingclearly melodic with a repetition of the tones. Whether the source was the vibration ofa string on a violin, or a result of the energy released by the clash of buyers or sellerstrading a currency pair, it is an unmistakable nonrandom cycle of self-similarity. Traderswith different backgrounds may all come ultimately to the same conclusion about theprice action and its structure of movement.
FIBONACCI TONESIn further understanding forex prices and how they move, we cannot ignore the pervasive presence of Fibonacci ratios. It is certainly the case that professional tradersknow and use Fibonacci ratios to map market patterns. One of the milestones in becoming a savvier forex trader is developing your own understanding of how to recognizeand use Fibonacci ratios to shape the trade. Fibonacci is important because currencypairs often move between support and resistance in tune to Fibonacci syncopation. Aftersome base of experience, looking at almost any chart, one can see retracement patternsoften along Fibonacci lines. Figure 11.7 shows such a sequence of upward and downward moves followed by retracement stopping at Fibonacci ratios. We can observe thatfirst the pair made a move from a low to a high and then retraced back to 38.2 percent ofthe way down (point 1) and starting moving back up. It in fact, created a new high and
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High
High1.000
0.618
3
0.5000.5020.5020.5000.618
2EURUSD 30 MIN
Low1.000
FIGURE 11.7 EURUSD 30-Minute Candles Participate in Fibonacci Rhythms.Source: www.tradesignal.com.
then moved down to a low (point 2). Having completed that low, it proceeded to moveback up again, but stopped at 50 percent of the way up (point 3). This is a sequence that,like music, provides an underlying theme to market moves.The application of Fibonacci patterns as a universal phenomenon is further underscored, as musicologists have discovered them in the works of many composers including Debussy, Bartok, and the like. The next time you listen to the second half of ScottJoplin’s “Maple Leaf Rag,” notice the pattern of 13 stressed and 8 unstressed notes. Infact, one can find Fibonacci patterns in the basic structure of instruments themselves.The piano, for example, has 13 notes that separate each octave, which has 8 whitekeys and 5 black keys. Forex traders will recognize the ratio of 13/8 as a Fibonacciratio. When using moving average crossovers, try the 13 and 8 time intervals on thecharts.What does this mean to the forex trader? By understanding that currency prices arenot linear movements, but expressions of emotions and human behavior, the forex traderbegins to move beyond a linear approach to trading. By expanding one’s perspectiveon the underlying tones of the market, he or she will likely see nested patterns thatare recursive and, as a result, new trading opportunities. As one trader notes, “Everyone’s got the same information at the same time; therefore, you need to find a differentway of finding an edge over your competitor” (The Psychology of the Foreign ExchangeMarket, p. 203). The ability to obtain the sought-after trading edge may very well depend on how one looks for it. It would be wise to look for patterns and “listen tothe market.” It may be playing a Fibonacci melody or, for a brief moment, anotherprofitable tune.
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PIVOT POINT SUPPORT AND RESISTANCEThe idea that price patterns follow a retracement ratio is also expressed in the technicalconcept of pivot points. Pivot points are used by many traders and were developed byfloor traders at the exchanges. John L. Person’s book, Forex Conquered (John Wiley &Sons, 2007), presents a very specific variation on the use of pivot points. We want tointroduce the concept here.The advantage of pivot points is that they are essentially objective in nature. Otherforms of resistance projections such as Fibonacci levels, Elliot wave, and so on, have anelement of subjectivity, and as a result people may draw those lines differently.Pivot points focus on the immediate trading session behavior and ranges. They provide a good sense of the psychology of the session. The pivot point equation generatesa number that combines the high, low, and close and divides it by three, generating thepivot point number. The basic idea is for traders to assess what happens when the priceprobes that number. The pivot point number is, in the words of John Person, “the focalpoint.” What is particularly interesting is the pivot point’s overlapping or converging witha Fib line or with another important indicator. Figure 11.8 shows an EURUSD hour candle chart where the pivot point converges with a hesitation candle known as the “Doji.”
FIGURE 11.8 EURUSD 15-Minute Chart Showing Pivot Points and Fib Lines.Source: www.tradesignal.com.
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In this particular case, it is near a Fib line. Remember that the lower the time intervalused, the less stable or reliable are the pivot points.This is a handy tool, and one you can access at www.learn4x.com/calculator.
PSYCHOLOGICAL SUPPORT AND RESISTANCEUnderstanding whether there is psychological support and resistance should not beignored because hedge funds and institutional investing creates recognizable patterns.Ignoring psychological expressions in the markets increases the risks that the trades willbe going against the “smart” money. Psychological support reveals itself in several waysand in many ways is a self-reinforcing process. For example, since traders assign importance to key Fibonacci levels, this results in aggregating more significance to thoselevels. A greater number of parked orders such as stops and limits become located in Fibonacci zones. Option orders at key strike prices play a key role that the average traderin spot has little accessible knowledge of. Additionally, prices at round numbers such as1.2500 receive more attention from traders. Finally, psychological support emerges whena key support or resistance level, such as a daily, weekly, or monthly high or low, is beingprobed by the currency pair.Up to this point, we have looked at price in relationship to support and resistancelines and pivot points, but mapping price movement is not yet complete. The trader needsto consider the dimension of time.
PRICE AND TIME IN FOREXThe language of technical analysis really starts with the description of price inrelationship to time. Much of the architecture of technical analysis explores this
FIGURE 11.9 Pivot Point Calculator.
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multidimensional relationship. Let’s start with the fact that the charts themselves aresnapshots of what has occurred in a selected time interval. Whether one uses bar chartsor candlestick charts, the vocabulary of technical analysis has only four basic words.These words are the opening, the close, and the high and the low of the price (seeFigure 11.10).With only these four units of knowledge, the trader can start to talk the languageof technical analysis. We can build an entire architecture of trading strategy. We canbuild trend lines that connect consecutive highs and lows. We can deduce sentiment.For example, when the price closes above the opening, we have a bullish sentiment.When the price closes below the opening, we have a bearish sentiment. Another keyrelationship that is revealed by looking at the price bars or candles is the range, which isdefined as the difference between the low and the high action.The range of a currency pair reflects deeper psychological characteristics of the priceaction that can’t be ignored. As the distance between a low and a high increases, the total energy of buyers versus sellers has increased. Accompanying this increase in rangeis also the anxiety of the trader. A widening range is a signal of increasing volatility. Anarrowing range denotes the ebbing of interest and consolidation as the market needsnew energy. Depending on the shape of the range, the trader can employ different strategies. In a sideways range pattern known as a “channel,” trading off each side representsa common strategy. But the width of the range should be 40 pips or more to achieve areasonable chance of capturing 10 to 15 pip moves. If the range is compressing in theshape of a triangle, the trade should be ready for a breakout. There is no guarantee as towhich side the price will break out of. More often than not, a breakout in the direction of
HIGHOPEN
OPENANDCLOSECLOSE
OPEN
FIGURE 11.10 All Candles Show the Low, High, Opening, and Close.Source: www.tradesignal.com.
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FIGURE 11.11 Narrow Range of 30 Pips in GBPUSD-Is It Worth Trading?Source: www.tradesignal.com.
the trend is a good bet. If the range is very narrow (less than 20 pips), no trade is preferable because the market is really in a period of noise. Figure 11.11 shows a chart with arange of 30 pips, but notice that the price is near the middle of the range. It would takevery good timing to trade this pair from where the price is. Whatever the range is tradingnear, support or resistance is preferable.
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Volatility in Forex andIts Dimensions
his chapter reviews how volatility should be used in helping the forex trader evaluate market conditions. Volatility conditions, when added to classical support andresistance, and trend analysis identify high-probability trading opportunities andpatterns.By identifying currency pair volatility and associated exhaustion conditions, thetrader gains knowledge of what the currency pair is doing. What the trader is most interested in is the behavior at prices at the extreme. A currency pair can reach a new daily orweekly high, but it doesn’t mean that the price is likely to return to its average or meanprice. When a currency is at a high, it is there for a reason. Perhaps new economic information pushed it to that new level. However, it is when a currency is at volatility highthat the trader can deduce a potential for a reversal. This is because volatility cannot beinfinite, then return to an average level. Understanding the behavior of the price in termsof volatility is a building block of forex technical knowledge.It’s helpful in understanding volatility of currency pair prices to recall our everyday experience with volatility. A strong snow- or rainstorm has periods of varying intensity. But when the storm reaches its most intense period, one knows that it will soonbe over. All of us have heard the phrase “the calm before the storm.” When the priceis quiet, with small ranges and little change over time, it is recognized as a prelude toa breakout—exactly mirroring the phenomenon of the calm before the storm. Tradingstrategies emerge from applying volatility knowledge. A peak in volatility suggests tothe trader that a reversal trade may be shaping up and to be ready for that. A declinein volatility may suggest near-term lack of any significant move, suggesting waiting forconditions to change.
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A technical quantitative measure of volatility is the standard deviation of the pricerange over time. Zero volatility doesn’t mean that the price has stayed the same. It meansthat there hasn’t been a change in the price range. The key notion to understand is forthe forex trader to observe market ranges and notice whether they are stable or varying.Once a currency pair starts changing frequently the shape of its range, we havevolatility increasing. A surge in volatility may be a prelude to continued movement inthe direction of the surge. New energy coming from increased sentiment has to go somewhere. It’s important to note when a surge occurs, if it occurs at a key resistance, itmay be a reversal indicator as well. Trading volatile markets that have expanding andcontracting ranges requires special attention to risk controls because the trader has anexpectation that the price can fluctuate more rapidly and more widely.In Figure 12.1, we see a recent visualization of the volatility increasing. The currencypair British pound-Japanese yen (GBPJPY) experienced a significant increase in volatilityright before and after the February 2007 Bank of Japan’s decision to increase interestrates. Notice how the volatility ebbed into a very quiet and narrow range afterward. Agood clue to volatility is when it takes only one or two candles to pass through the range.
FIGURE 12.1 Volatility Increases for GBPJPY 1-Hour Chart.Source: www.tradesignal.com.
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Visualizing volatility is helped by the use of several technical indicators, which wewill discuss in the next section.
14 KEY TECHNICAL INDICATORSBecause we have reviewed the basic geometry of prices and know how to create a forexmap of price action, a next step in shaping a trade is to diagnose what the prices areexhibiting in terms of strength and weakness. There are dozens of indicators that accompany many of the forex platforms. This multitude of indicators can lead to confusionfor the new trader. Many of these indicators are not all useful for forex trading. Manyof the indicators offered by forex platforms reproduce indicators that have been a standard part of the trader tool box for generations in other markets. Whichever indicatorsare used, they should be evaluated as to how well they contribute to identifying marketconditions and help determine the best location and time to put on the trade.A first step in choosing indicators to use in trading is to understand what they do.Technical indicators are algorithms, which are equations that take price data and generate a smoothing out of the data. The value to the trader of any indicator occurs whenthey help confirm several technical conditions, as shown in the checklist below:
r How strong is the trend?r How strong is support and resistance?r Are there signs of weakness in the trend or in support and resistance?r Are there signs of volatility or momentum peaks or exhaustion?r Is there a divergence between the indicator and prices?The overall goal is to find the set of indicators that increase the level of confidencethat the opportunity to put on the trade is at hand. It’s useful to think of indicators asingredients in a recipe to create the basis of a trade. However, the trader needs to alsorecognize that the key disadvantage of indicators relates to their inherent lagging behindthe market and their potential instability when applied to very short time frames, such asunder five minutes.
VOLUME INDICATORS: A KEY MISSING ELEMENTIN SPOT FOREXVolume information is one of the most important components of technical analysis ofmarkets. Volume indicates the quantity of money flow into a particular investment instrument. An increase in volume often precedes an increase in price, and a decreasein volume is considered early identification of weakness. The best equity traders could
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not conceive of trading without volume data. Yet there is no volume data for spot forexprices when trading through spot forex firms.This lack of volume data makes many indicators offered irrelevant. Because volumeand changes in volume are highly related to indicators of sentiment and market psychology, the forex trader needs to rely on technical indicators that act as a substitute forvolume data. For example, knowing that a currency pair is probing a daily support levelfor a few days represents a great deal of volume at that daily support level. The positionof the currency pair price in relationship to support and resistance and how close it isto either level becomes a good substitute for volume. Additionally, when economic datareleases comes out, the entire market focuses on the report, and the trader knows thatmaximum volume is at these news events. Therefore, one of the best ways to overcomethe lack of volume data is to trade where there is certainty on maximum volume.However, for those traders who want the best of all worlds, there is a way to obtainvolume data for the spot forex trader. Futures on currency trading include volume data inthe form of open interest contracts. This means that all of the technical indicators on thefutures side that include volume are valid. While trading the euro-U.S. dollar (EURUSD)through the spot market, a serious trader could also observe the volume data of thefutures on the EURUSD contract. While this is cumbersome and involves extra cost,those traders who favor using volume data to gain an edge in their trading are able toovercome this gap. The limiting factor is that the maximum benefit of such volume dataoccurs during U.S. trading hours only.An additional volume-related data involves the Commitment of Traders (CoT)Report. This is a weekly report from the Commodity Futures Trading Commission(CFTC; available at www.cftc.gov/cftc/cftccotreports.htm) providing a breakdown ofeach Tuesday’s open interest for markets in which 20 or more traders hold positionsequal to or above the reporting levels established by the CFTC. Open interest is broken down by aggregate commercial, noncommercial, and nonreportable holdings. Whilethe data provided by the CoT Report is lagging (the Friday report reflects the previousTuesday’s data), when extremes are reached in positions by the noncommercials, it isa situation that is especially noteworthy for the forex spot trader. The trader can gaingreater confidence in aligning his or her next trade in the direction of the noncommercials, which are representative of the sentiment of the “smart money.”Until Forex firms provide the CoT data