large moves,retracements, continuances, and reversals.The goal is to observe how each indicator shows direction, entry, exit,or weakness or strength of markets in trending or nontrending conditions.Each indicator performs differently in both trending markets and nontrending markets, and therefore, these differences must be noticed, memorized,and catalogued to make the best use of these tools.
BOLLINGER BANDSWhat are Bollinger bands? They are curves drawn in and around theprice structure that provide relative definitions of high and low.What are Bollinger bands used for? Knowing whether prices are highor low, the investor/trader can make rational investment decisionsby comparing price action with the actions of indicators.What can Bollinger bands be applied to? Most anything—currencypairs, indices, futures, and mutual funds.How are Bollinger bands calculated? The base for a band is a movingaverage, and the band’s width is determined by volatility (see Figure 9-2).John Bollinger is a giant in today’s trading community. His BollingerBands sharpen the sensitivity of fixed indicators, allowing them to moreprecisely reflect a market’s volatility. By more accurately indicating theexisting market environment, they are seen by many as today’s standard—and most reliable—tool for plotting expected price action.Mr. John Bollinger notes the following characteristics of Bollingerbands:●
Sharp price changes tend to occur after the bands tighten and asvolatility lessens.
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When prices move outside the bands, a continuation of the currenttrend is implied.
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Bottoms and tops made outside the bands followed by bottoms andtops made inside the bands call for reversals in the trend.
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FIGURE 9-1 EUR/USD Daily Chart 2002–2003
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FIGURE 9-2 Bollinger Bands
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A move that originates at one band tends to go all the way to the otherband. (This observation is useful when projecting price targets.)
Bollinger bands are plotted at standard deviation levels above andbelow a moving average. Since standard deviation is a measure of volatility, the bands are self-adjusting—widening during volatile markets andcontracting during calmer periods. The bands bracket approximately 90percent of the market activity.The 10 percent outside the bands is most likely going to approximate areaswhere prices will return to within the bands. When the bands are flat and narrow, this indicates that price volatility is lower than in previous time periods.When the bands begin to flare, this indicates increased volatility andthe possible inception of a new, strong directional or trend move. Widebands are an indication of a very strong move.
DIRECTIONAL MOVEMENT INDEX (DMI)Developed by Welles Wilder, the DMI consists of two indicators: the average directional index (ADX) and the directional index (DI), which is bothpositive and negative (DI+ and DI−). Figure 9-3 illustrates the DMI.The ADX measures the strength of a prevailing trend, rising when thedirection is strong and falling when the prior confirmed trend or directionis weakening. The ADX is not a directional indicator. ADX attempts tomeasure the trending quality of the market, isolating those periods wherethe market is not trending.DI+ and DI− show direction. When DI+ rises above DI−, upward directionis confirmed. When DI− rises above DI+, downward direction is confirmed.When the move is strong, ADX is rising and DI+ and DI− remain apart.
STOCHASTIC INDICATORThe stochastic indicator identifies swings, tops, and bottoms. Popularizedby Dr. George C. Lane of Investment Educators, the stochastic indicatormeasures the position of a currency pair compared with its most recenttrading range (see Figure 9-4).You may have heard the stochastic indicator referred to as the “overbought” or “oversold” indicator. Specifically, it measures the relationshipbetween the closing price of a currency pair and its high and low during aspecific number of days or weeks.
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FIGURE 9-3 Directional Movement Index (DMI)
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FIGURE 9-4 Stochastic Indicator
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As the price of a currency pair rises, the closing price tends to be, onaverage, closer and closer to the extreme highs of the currency pair, and asprices fall, the closing price tends to fall, on average, closer and closer tothe extreme lows. This indicator tries to find a correlation between themoving closing price of a currency pair and its reversal tendencies. It doesa wonderful job and is used widely by most traders.Stochastic indicator points out overbought and oversold conditions andis considered a highly accurate method for picking tops and bottoms. Thestochastic indicator can be very useful as a timing aid in knowing when totake action in a currency pair, particularly when it is used in conjunctionwith other technical indicators. The stochastic indicator also may be usedwith industry groups or market indexes.
MOVING AVERAGES (SIMPLE, WEIGHTED, AND EXPONENTIAL)Moving averages are a very popular tool among traders because they are alagging indicator of price swings. Short- and long-term trends are easier toidentify. The averages are calculated on the user’s specifications and can beformatted to different styles of trading and time frames.For example, if you use an 89-time-frame moving average, the prices of thelast 89 time frames are added together and then divided by 89. As the newesttime frame ends, which appears at the end of the average line, the first one getsdropped, and the average line makes an upward, downward, or sideways move.Along with the different time frames a trader can use, the averages can becalculated based on the opening, high, low, or closing price. You also can usethe midpoint of the time frame, which is an average within itself. However,most traders prefer to use the closing price because it is the most important.There are three different types of moving averages:1.2.3.
The simple moving averageThe weighted moving averageThe exponentially smoothed moving average
SIMPLE MOVING AVERAGEA simple moving average is just what it says: The prices within time frames areadded and then divided by the number of time frames. For example, if you usea daily time frame chart and you are calculating a 10-day moving average, themost current day is added to the moving average and the last day is dropped.If the price is higher and moves the average higher than the precedingtime frame, the moving-average line will start moving upward and show anupward trend. Figure 9-5 provides an example of a 10- and 25-day movingaverage chart.
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FIGURE 9-5 Simple Moving Average
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WEIGHTED MOVING AVERAGEA weighted moving average consigns more weight to the most recent closing prices. Most traders argue that a weighted moving average is used moreoften on long-term charts because the recent prices get more emphasis, andnot as much attention is given to the last few time frames, which are stillpart of the moving average. Figure 9-6 presents two moving average linesthat compare a simple and a weighted moving average line.
EXPONENTIALLY SMOOTHED MOVING AVERAGEThe advantage of an exponentially smoothed moving average, unlike theweighted moving average, is that the chart is calculated gradually withless emphasis on prices in later time frames, and the last time frame isdropped. Exponentially smoothed averages assign different weights tothe previous prices.The further down the line the price is located, the less weight isassigned to it. Figure 9-7 provides an example of a 25-day moving-averagechart in which the solid line represents a simple moving average, the dottedline represents a weighted moving average, and the dashed line representsan exponentially smoothed moving average.Generally, you should use only two or three moving averages at onetime. You will need to experiment with time frames and the type of averagethat works best for the currency being traded. An advantage of using moving averages is the ability to back trade.Back trading is when you take a strategy such as a moving average andlook at a price chart. You then work backwards looking at the chart to see howmany times you would have entered and exited a trade using your strategy onpast performance. There are a lot of software programs out there that willallow you to back test your trading strategies. This is a very effective way tosee what might have happened using your respective trading strategy. Justremember that past performance may not always represent future success.By adding the moving averages, you can see how they have forecasted pasttrends, reversals, and entry or exit signals. By observing a shorter-term movingaverage across a longer-term average, a buy or sell signal can be identified.To avoid fake signals, it is advisable that the longer-term moving average is moving in the same direction as the short-term moving average.Another way to avoid fake signals is to use two moving averages for buyand sell signals and another one for long-term trends.If you feel comfortable using 10- and 25-day moving averages for entryand exits, perhaps an 89-day moving average, which is much respectedamong traders, should be used for a long-term trend. Figure 9-8 provides anexample of a 10-, 25-, and 89-day moving-average chart.
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FIGURE 9-6 Weighted Moving Average
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FIGURE 9-7 Moving Average Lines
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FIGURE 9-8 10-, 25-, 89-Day Moving Average Lines
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ENTERING A POSITION USING MOVING AVERAGES:Figure 9-9 shows how to use 10- and 25-day exponential moving averagesfor buy and sell signals with an 89-day moving average for long-term confirmation.By using the cross of a shorter-time-frame moving average over alonger-time-frame moving average, we are able to see a trend develop thatcould be very profitable. It is important to enter these trends at the crossonly when the long-term moving average confirms the trend.In this case, we are using an 89-day moving average as our confirmation line by only entering a long trade (buy) when the cross occursabove the line and a short trade (sell) below the confirmation line.The captions in Figure 9-9 point out the crosses between the 10- and25-day moving averages and point out entry points.The lag and possible sharp trend reversal could result in the loss of alot of profitable pips. The number of pips you allow your trade to recyclebefore closing out your trade largely will depend on your trading styleand the characteristics of the currency pair you are trading. Using goodmoney management will limit your risk and secure profits, always usestops and limits.
MOVING AVERAGE CONVERGENCE/DIVERGENCE (MAC/D)The MAC/D is the difference between a 26- and a 12-day exponential moving average. A 9-day exponential moving average, called the signal (or trigger) line, is plotted on top of the MAC/D to show buy/sell opportunities(see Figure 9-10).The MAC/D proves most effective in wide-swinging trading markets.There are three popular ways to use the MAC/D: crossover,overbought/oversold conditions, and divergences.The basic MAC/D trading rule is to sell when the MAC/D falls belowits signal line. Similarly, a buy signal occurs when the MAC/D rises aboveits signal line. It is also popular to buy/sell when the MAC/D goes above orbelow zero.The MAC/D is also useful as an overbought/oversold indicator. Whenthe shorter moving average pulls away dramatically from the longer moving average (the MAC/D rises), it is likely that the price is overextendingand will soon return to more realistic levels. MAC/D overbought and oversold conditions vary from currency pair to currency pair.
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FIGURE 9-9 Moving Average Lines with Buy and Sell Signals
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FIGURE 9-10 Moving Average Convergence/Divergence (MACD)
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An indication that an end to the current trend may be near occurs whenthe MAC/D diverges from the currency pair. A bearish divergence occurswhen the MAC/D is making new lows and the prices fail to reach those newlows. A bullish divergence occurs when the MAC/D is making new highsand the prices fail to reach those new highs. Both these divergences aremost significant when they occur at relatively overbought/oversold levels.
MOMENTUMMomentum is an oscillator designed to measure the rate of price change,not the actual price level. This oscillator consists of the net differencebetween the current closing price and the oldest closing price from a predetermined period (see Figure 9-11).In terms of time, the shorter the number of days included in the calculations, the more responsive the momentum will be to short-term fluctuations, and vice versa. The signal triggered by the crossing of the zero lineremains in effect. However, such signals should be followed only when theyare consistent with the ongoing trend.
RELATIVE STRENGTH INDEX (RSI)The relative strength index (RSI) is designed to indicate a market’s currentstrength or weakness, depending on where prices close during a givenperiod. It is based on the premise that higher closes indicate strong marketsand lower closes indicate weak markets (see Figure 9-12).The RSI is plotted on a 0 to 100 scale. Generally, a buy signal is generated when the RSI moves up through the lower band (band set to 30), and asell signal is generated when the RSI moves down through the upper band(band set to 70).The buy and sell levels will vary somewhat depending on the lengthyou choose for the RSI calculation. Once you are in a position, a warningsignal to close that position is indicated by values above 85, which indicatean overbought condition (selling signal), and values under 15, which indicate an oversold condition (buying signal).A shorter length time frame will result in the RSI being more volatile.A longer length time frame results in a less volatile RSI, which reachesextremes far less often. Different uses will result in slightly different levelsat which the price changes direction.
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FIGURE 9-11 Momentum
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FIGURE 9-12 Relative Strength Index (RSI)
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The band levels are usually close to each other. Most prices seem tochange direction at 30 and 70. It is important to note that this is not ahard-and-fast rule, and I recommend playing with the band levels untilyou find the best one for the issue you are looking at.
RATE OF CHANGE (ROC)ROC is another version of the momentum oscillator. The difference lies inthe formula. While the momentum oscillator’s formula is based on subtracting the oldest closing price from the most recent closing price, theROC formula is based on dividing the oldest closing price into the mostrecent closing price. Looking at both graphs for the same currency pair andprice period shows very little difference (see Figure 9-13).
VOLUMEThe volume indicator is used to show the strength of an up or down movement. A movement accompanied by increasing volume is likely to continuewith more strength than one accompanied by decreasing volume (see Figure 9-14).While many professionals use the volume indicator as their only tool intrading, others use it in conjunctions with price charts, economic news, andgeopolitical news. The volume indicator is a great source for confirmation,entry and exit signals, and overall decision making.You will find a few of the indicators discussed in this chapter with whichyou will feel comfortable, and you will learn to discern trends on differentcurrencies and time intervals that will help you to become a better trader.
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FIGURE 9-13 Rate of Change (ROC)
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FIGURE 9-14 Volume
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INTRODUCTIONLeonardo Fibonacci, a mathematician in the 1200s, created a numericalsequence of numbers. From left to right after the first two numbers, the val125Copyright © 2004 by The McGraw-Hill Companies, Inc. Click here for terms of use.
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ues increase successively, and each number, in turn, is determined by thesum of the previous two numbers. For example, in the Fibonacci sequence1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, to get the next number inthe series after 377, add 233 to 377 and arrive at 610.Many technicians use Fibonacci sequences in their technical analyseswhen attempting to determine support and resistance, and they commonlyuse 38.2, 50, and 61.8 percent retracements. It is commonly thought that a0.382 retracement from a trend tends to imply a continuation of the trend.A 0.618 retracement implies that a trend change may be in the making.Technicians have adopted many such rules.It is easier to see what is happening if we plot the ratios on a graph (seeFigure 10-1). As the figure shows, the ratio seems to be settling down to aparticular value. We call this value the golden ratio or the golden number. Ithas a value of approximately 1.61804.The other interesting relationship of this number sequence is that if wetake the ratio of two successive numbers in the Fibonacci series (i.e., wedivide each number by the number after it in the sequence), we will movetoward a particular constant value. This value is 0.6180345, which has beenreferred to as the golden ratio.
FIGURE 10-1 Fibonacci Graph
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If you also calculate the ratios using alternate numbers in the Fibonacciseries (i.e., do the same calculation but skip over a number), the resultingratio approaches 0.38196.
FIBONACCI RECTANGLES AND SHELL SPIRALSWe can make a picture showing the Fibonacci sequence 1, 1, 2, 3, 5, 8, 13,21 if we start with two small squares of size 1 next to each other. On top ofboth these small square, draw a square of size 2 (= 1 + 1). Now draw a newsquare—touching both a unit square and the latest square of side 2—having sides 3 units long; and then another touching both the square of size andthe square of size 3 (which has sides of 5 units).We can continue adding squares around the picture, each new squarehaving a side as long as the sum of the latest two squares’ sides. This set ofrectangles, whose sides are two successive Fibonacci numbers in lengthand which are composed of squares with sides that are Fibonacci numbers,we will call Fibonacci rectangles (see Figure 10-2).Figure 10-3 shows that we can draw a spiral by putting together quartercircles, one in each new square. This is a spiral (the Fibonacci spiral). Acurve that is similar to this occurs in nature as the shape of a snail shell orthe nautilus seashell.Whereas a Fibonacci spiral increases in size by a factor of phi (Phi isapproximately 1.618), in a quarter turn (i.e., a point a further quarter turnaround the curve is 1.618 times as far from the center, and this applies to allpoints on the curve) the nautilus spiral curve takes a whole turn beforepoints move a factor of 1.618 from the center. These spiral shapes are calledequiangular or logarithmic spirals.
FIGURE 10-2 FibonacciRectangles
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FIGURE 10-3 Fibonacci Shell Spirals
FIBONACCI RETRACEMENTSA Fibonacci retracement is tool used to measure the amount the markethas retraced compared with overall market movement. Fibonacciretracements give you support and resistance areas along with generaltarget prices.As shown in Figure 10-4, the lines start at the beginning of a wave andare dragged to the top of the same wave as prices retrace. A target entrypoint occurs when prices touch the 0.618 line and begin to return towardthe long-term trend.Fibonacci retracements commonly are drawn from the beginning ofwave 1, the zero point, to the top or bottom of wave 2 to find a target for thebeginning of wave 3. The default retracement percentages are 25, 38.2, 50,and 61.8 (see Figure 10-5).
FIBONACCI EXTENSIONSFibonacci extensions are used to measure the amount a market may extendcompared with overall movement. Fibonacci extensions give you generaltarget price areas.Fibonacci extensions are used most often to find the general area ofwave 5. You would click on the start of a wave 1 (the zero point), then clickon the top of wave 2, and then click one more time at the beginning of wave3. The default percentage extensions are 61.8, 100, 161.8, and 261.8 (seeFigures 10-6 and 10-7).
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FIGURE 10-4 Fibonacci Retracements
FIGURE 10-5 Fibonacci Retracements
FIBONACCI TIMEFibonacci time is a tool used between two price points to estimate a futureprice at a particular time. Clicking your mouse from one high to another willgive you an idea of when the third high should be expected. Figures 10-8 and10-9 provide an example.
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FIGURE 10-6 Fibonacci Retracements
FIGURE 10-7 Fibonacci Extension
FIBONACCI CIRCLESA Fibonacci circle is a combination of a Fibonacci retracement/extensionand Fibonacci time. By drawing a circle from the top to the bottom of thelast trend, we can identify potential support and resistance levels and timeframes in which to expect them.
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FIGURE 10-8 Fibonacci Time
FIGURE 10-9 Fibonacci Time
By clicking and dragging your mouse from the most recent highs orlows to the beginning of that trend, the Fibonacci circle can help you toidentify the immediate support, resistance, or trend reversals. In Figures10-10 through 10-12, the top of the trend is identified by Figure 10-10 andthe bottom by Figure 10-11.
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We can see in Figure 10-10 that the long-term trend is bullish. We alsocan see that the top is starting to flatten out and that a possible trend reversal is coming up in the near future. By drawing a circle, we can set out stoplimit orders a little below where the circle shows support.In Figure 10-11 an arrow points to our target support, and our stoplimit is slightly below that price level. Figure 10-12 shows how the 0.382line did act as strong support and that the trend continued in its bullishdirection.Figures 10-13 and 10-14 show how the currency pair broke though the0.382 line; however, the 0.618 line acted as strong resistance, and the pairtraded right along the rim of that resistance until it broke through. At thatpoint, the currency pair started a new trend, and a bullish pattern was beingdeveloped.We can conclude that the 0.382 line is the first support and resistanceline, and a bounce off that line signifies a continuance of the long-termtrend. However, the breaking of the 0.618 line usually indicates a new trendin the making.
FIGURE 10-10 Fibonacci Circle
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FIGURE 10-11 Fibonacci Circle
FIGURE 10-12 Fibonacci Circle
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FIGURE 10-13 Fibonacci Circle
FIGURE 10-14 Fibonacci Circle
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ELLIOT WAVESPractically all developments which result from (human) socialeconomic processes follow a law that causes them to repeat themselves in similar and constantly recurring serials of waves orimpulses of definite number and pattern.R. N. Elliott, in Nature’s Law: The Secret of theUniverse
R. N. Elliott discerned various types of wave patterns and labeled them. He discovered that there were two basic types of wave patterns: (1) waves that movein the direction of the main trend of the market, that is, impulse waves consisting of five smaller waves, and (2) waves that move counter to the market’s maindirection, that is, corrective waves consisting of three smaller waves.He further discovered that each wave, whether impulsive or corrective,subdivides into smaller waves and/or is part of a larger wave. Waves therefore can be analyzed in time periods ranging from a matter of minutes tomonths and years.The most difficult part of Elliott wave analysis is correctly labeling andcounting the waves. A correct wave count can lead the analyst to amazingaccuracy in forecasting the market. An incorrect wave count, of course, willhave the opposite result.Wave counting is quite subjective and usually will result in as many forecasts as there are Elliott wave forecasters. Because of this, it is often said byits harshest critics that Elliott wave analysis is useful only in hindsight, whichis to say that it is not very useful in predicting the future course of the market.I respectfully disagree. I have found that simplicity, proportionality, andflexibility in wave counting lead to the best results. Your ability is constantlychallenged by the market and is always evolving, hopefully to a higher level.Even if you are not interested in Elliott wave analysis as a trading technique for short-term profits, an understanding of Elliott waves still hasvalue because it brings to the investor a sense of historical perspective.Markets never go in one direction forever. Markets that go up eventually do come down. Unlike any other form of analysis that I know of, thesheer power of Elliott wave analysis as a forecasting tool creates a greatdeal of confusion and worry about the market.It goes without saying that the followers of this form of analysis believethat market timing is critical. It is up to you to decide whether market timingshould be a consideration when you make your own investment decisions.
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IMPULSE WAVESAn impulse wave is a wave that moves in the direction of the main trend ofthe market. It subdivides into five smaller waves. Waves 1, 3, and 5 movein the direction of the market’s main trend. Waves 2 and 4 move against themarket’s main trend. (They are called corrective waves.)Basic Five-Wave StructureWave 1. The currency pair makes its initial move upward. This is usually caused by a relatively small number of people who all of asudden feel that the previous price of the pair was cheap andtherefore the pair is worth buying, causing the price to go up.Wave 2. The currency pair is considered overvalued. At this point,enough people who were in the original wave consider the pairovervalued and start taking profits. This causes the price of thepair to go down.Wave 3. This is usually the longest and strongest wave. More peoplehave found out about the currency pair. More people want thepair, and they buy it for a higher and higher price. This wave usually exceeds the tops created at the end of wave 1.Wave 4. At this point, people again take profits because the currencypair is again considered expensive.Wave 5. This is the point where most people get on the currency pair,and the price is most driven by hysteria. People will come up withlots of reasons to buy the pair and won’t listen to reasons not to.This is the point where the pair becomes the most overpriced. Atthis point it will move into one of two patterns, either it will movetoward a correction (a-b-c) (see Figure 10-16) or it will start overagain with wave 1 (see Figure 10-15).Here are some additional terms that apply to impulse waves:Extended wave. A complex impulse wave in which one of the subwaves (either 1, 3, or 5) further subdivides into five waves.Failure. This occurs when the fifth subwave of an impulse wave failsto move beyond the end of the third subwave, indicating a strongand/or prolonged move in the opposite direction.Diagonal triangle. This is a terminal wave (often called a wedge),either a fifth wave or a c wave, in which the five subwaves subdivide into threes (a-b-c). On completion, there is usually a strongmove in the opposite direction.
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FIGURE 10-15 Elliott Impulse Wave
FIGURE 10-16 Elliott Corrective Wave
CORRECTIVE WAVESA corrective wave is a wave that moves counter to the direction of the maintrend of the market. It subdivides into three smaller waves (a-b-c). Waves aand c move against the market’s main trend. Wave b moves in the direction ofthe market’s main trend but subdivides into three waves (see Figure 10-16).
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Here are some additional terms that apply to corrective waves:Zigzag. A corrective wave (a-b-c) in which the b wave retraces only apart of wave a, and wave c moves beyond the terminal point ofwave a. Waves a and c subdivide into five waves and wave b intothree waves. (Double zigzags are two zigzags in succession connected by an x wave.)Flat. A corrective wave (a-b-c) in which the b wave retraces all ormore of wave a. Wave a subdivides into three waves, and wave cmay or may not terminate beyond the terminal point of wave a.Horizontal triangle. A corrective wave (a-b-c-d-e) that often developsafter a very strong move in the market with five subwaves, eachfurther subdividing into threes, that is, five successive correctivepatterns forming a sideways pattern in the market (more or less).Combination. A prolonged corrective wave that combines into onelarger corrective wave—two or three corrective waves that areconnected by one or two x waves. Two corrective waves connected by an x wave are called a double three. Three correctivepatterns each connected by an x wave are called a triple three. Thex wave, like other corrective waves in the direction of the maintrend, subdivides into three waves (a-b-c).
OTHER ELLIOTT WAVE CONCEPTSWave degree. Each five-wave and three-wave cycle can be found tosubdivide into waves of a smaller scale and/or be found to consistof a part of a wave of a larger scale. Waves can be labeled indegrees that last only a matter of minutes or as long as centuries.Parallel trendlines. Waves tend to channel between parallel trendlines.Depending on the time period analyzed, the market may channelbetween parallel trendlines on an arithmetic-scale chart or on as