close).Interest represents another potential cost of trading, althoughtraders may also earn interest on their trading positions. Dependingon the specific currency pair and the direction in which it is traded(long or short), interest can either represent a significant expense onpositions that are held overnight, or a way to generate daily incomefrom holding open trades.Finally, hedging is a more advanced topic that involves the simultaneous buying and selling of the same currency pair at the same
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Chapter Summary
time.When implemented, this creates a situation where any exchangerate movement will not affect the profit/loss picture, since one sideof the hedge profits as the other side loses by an equal amount.After this discussion on basic foreign exchange trading mechanics, the next logical step is to explore the features and functionalities of a currency trading platform. This can be accomplished at nocost simply by signing up for a free demo practice account with anyreputable online forex broker. The best part about this is that a forextrader can test-drive a trading platform in an extremely thoroughmanner, secure in the knowledge that all losses in a practice accountare not only free-of-charge, but also highly educational.
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CHAPTER 3
Technical Analysis—Tools for TradingForeign Exchange
After reading this chapter, you will beable to:●
Apply the primary tools used by technical traders toanalyze the foreign exchange markets.
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Understand the purposes and mechanics of the mostimportant functional elements of currency charts.
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Delve into the most practical aspects of technical analysis, including pattern recognition, drawing trendlines,and identifying support and resistance.
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I ntroduction to Technical Analysis —Interpreting Price ActionTechnical analysis is the most popular discipline, or school of financial analysis, for trading the foreign exchange markets. Simply put,technical analysis is often defined as the systematic study of priceaction, which is ultimately derived from the effects of mass marketbehavior.While fundamental analysis may concern itself with the myriad reasons why price moves, technical analysis is single-mindedlyfocused on how price moves, and the ways in which that might affectfuture price movement. Technical analysis consists of a broad methodology through which traders can make all of their most importanttrading decisions. This includes entries, exits, stop-loss placement,profit target placement, trade-sizing, risk management, and more.The primary toolbox used by foreign exchange technical analysts in analyzing and interpreting price action is the versatile currency chart. As we shall soon see, there are several styles of thesetoolboxes, including bar charts, candlestick charts, and point & figure charts.Furthermore, within each of these toolboxes is quite a diverse setof tools. These tools can range anywhere from a simple trendline toan elaborate chart pattern to a mathematically derived oscillator to acomplex algorithmic trading system. For the purposes of this book,however, we will stick to the essentials.When a beginner is first introduced to using technical analysis for analyzing and trading the foreign exchange markets, thereare invariably several buzzwords and phrases that are heard most
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frequently. These include such common terms as trend, support/resistance, moving averages, head-and-shoulders pattern, Fibonacci,Elliott Wave, and so on. All of these terms, and much more, will beaddressed further on in this chapter.In the actual practice of technical analysis, however, generally itis better to keep all of these countless chart elements to a manageable minimum in order to avoid the very common beginner’s epidemic of “paralysis by analysis.” This is where traders clutter theircharts with so many lines and indicators that they become utterlyunable to conduct any useful analysis or to act on any bonafide signals from their charts. In the world of technical analysis, too muchof a good thing is just as bad as the opposite extreme of not enough.To avoid paralysis by analysis, traders should ideally mastera handful of chart elements and become an expert on how pricereacts to these elements. For example, a trader may study in-depthhow a certain currency pair reacts over time in relation to the outerbands of the popular Bollinger Bands indicator. Or another tradermay wish to become an expert on price behavior around the keyFibonacci retracement levels.Yet another trader may choose to workexclusively with trendlines, trading bounces and breakouts of thesedynamic support/resistance levels. There is virtually no end to howa technical analyst may specialize to become a master of one (or afew), rather than an unfocused Jack of all Trades.The primary advantages of technical analysis for the foreignexchange trader are manifold. This includes the exceptionally precise trade entries and exits afforded by chart analysis, sensible riskmanagement through the use of technically derived stop levels, theability to backtest technical strategies using past price action, and
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the unambiguous, rule-based nature of many technical tradingsystems. These concepts will all be covered in this chapter and inChapter 5, which covers trading methods and strategies.While technical analysis can be a powerful method for analyzing foreign exchange price movement, it can also be both timeconsuming and incredibly frustrating. This is often the case whenindicators or lines that traders rely upon to provide them with profitable trading signals give false signals, conflicting signals, or justplain don’t work. But this should not be a valid reason to abandonthe entire discipline of technical analysis altogether. As alluded topreviously, there is no lack of foreign exchange traders who, throughuntiring study and experience, have managed to build successfultrading careers from specializing in just a handful of technical methods that work well for them.Therefore, patience and the careful study of technical tools andmethods clearly comprise the path to mastery of technical analysis.In turn, the mastery of technical analysis may well provide the roadto consistent profitability in the foreign exchange markets.
B asics of Bars and CandlesticksBars and candlesticks are the primary building blocks of technical analysis charting. There are several other methods of depictingprice action visually in the foreign exchange markets, includingolder techniques that enjoy significant followings like point & figurecharts (which will be touched on later in this chapter), but bars andcandlesticks have assumed their vital roles as the main workhorses ofpresent-day technical analysis.
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Basics of Bars and Candlesticks
Bar charts and candlestick charts share close similarities in thatthey both represent the most salient data points available in priceaction analysis. Within a given time period, this includes the openprice, the high price, the low price, and the close price. For example, a daily chart, where each bar or candlestick represents one fulltrading day, will depict the price levels at which a given day openedand closed, as well as the high and low that were reached duringthat day. In the foreign exchange markets, incidentally, a trading daywould consist of a full 24 hours. Exhibit 3.1 shows an example ofboth a bar and a candlestick.As shown in Exhibit 3.1, a bar opens at the level of the left horizontal arm and closes at the level of the right horizontal arm. Thetop of the vertical bar represents that period’s high, while the bottom represents the low.In contrast, a candlestick places much heavier emphasis on theopen and close of a particular period by making the space betweenEXHIBIT 3.1
Bar and Candlestick DiagramHighest price during time periodPeriod close price (on bar right)BarPeriod open price (on bar left)Lowest price during time period
Candlestick
Highest price during time periodPeriod open or close priceReal body is white (or green) ifcurrency closed higher and black(or red) if it closed lowerPeriod open or close priceLowest price during time period
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the open and close exceptionally prominent. This space is called the“real body.” The vertical lines above and below are called “shadows”or “wicks.” If the real body is white (or green), it means that it was abullish candle, and that price opened at the bottom of the real bodyand closed at the top of the real body. If, on the other hand, the realEXECUTIVE INSIGHT
Steve NisonThe most authoritative voice on the subject of candlesticks wouldcertainly be Steve Nison, CMT. But besides having introduced theentire concept of Japanese candlesticks to the English-speakingworld, Nison has also been a renowned expert on Western-styletechnical analysis for over three decades. Therefore, he bringsa unique perspective that straddles both Eastern and Westernmethods of charting. Widely quoted in the major financial pressas one of the world’s foremost technical analysts, Nison authoredthe definitive book on the subject of candlesticks, JapaneseCandlestick Charting Techniques, and is the founder and Presidentof CandleCharts.com.Nison states:“Warren Buffett said he would be a bum in the street witha tin cup if the markets were always efficient. And whyaren’t the markets efficient? It’s because of human emotions such as fear, greed, and hope. And the only way togauge the emotional and psychological aspects of marketparticipants is technical analysis. Bernard Baruch, oneof most famous economists of the 20th century stated,‘It’s not the news itself, but it is the market’s reaction tothe news that’s important.’ And for those who watch theforex market we know that many times an ounce of emotion can be worth a pound of facts.
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EXECUTIVE INSIGHT (CONTINUED)The reason I’m spending time on the importance ofmarket psychology is that the candlesticks—which I referto as candles—is one of the best methods to get a quickvisual grasp of who’s winning in the ongoing battle of thebulls versus the bears. While very easy to construct,the candles provide an x-ray into the supply/demandsituation. As the Japanese proverb states, ‘Look at theoutside and know the inside.’ Think about the candleline. A tall white real body means the bulls are in chargeduring that session—whether it’s an intraday, daily,or weekly. A long black real body hints the bears are inforce. A doji (where the open and close are the same)clearly reflects a market in balance between the bulls andbears. And if a doji emerges during a rally, it increasesthe chances of a turn. A hammer, with its extended longlower shadow, is visually proving the market is rejecting lower levels. So on this one session it means thatthe bears are getting less confident because the marketcan’t hold the lows into the close, while the bulls are getting more optimistic. In essence, the candlestick line isdrawn based on the psychological underpinning of currentmarket activity. And by reading the candles correctly youare reading the market’s message.As the author mentions in this chapter, I recommend using candles as just one of the tools in a tradingarsenal. However, after you gain the knowledge of howto correctly and fully harness the insight of the candlesyou’ll find that they will become one of your most important tools. At my live seminars, where I have taught thousands of retail and institutional traders, I often ask at theconclusion, ‘Who would ever go back to a bar chart?’ Noone has ever raised a hand.”
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body is black (or red), it means that it was a bearish candle, and thatprice opened at the top of the real body and closed at the bottom ofthe real body.In both the U.S. equities and futures markets, bar charts havetraditionally been the primary mode of representing price actionfor technical analysis purposes. Only in the past decade or so havecandlestick charts come into popular usage in the Western world,largely through the efforts of Steve Nison, who introduced thisancient charting method to America from its humble rice-tradingroots in Japan.The main difference between bars and candlesticks lies in theirdiffering visual portrayals of identical price data points. Therefore,although both charting methodologies utilize the same data, whichincludes the open, high, low, and close price of a given time period,the manner in which this information is represented differs significantly between the two.While bars may reveal all of the usual support/resistance indications and chart patterns that Western technical analystsnormally look for, candlesticks go a step further by including all of thisrelevant information plus providing a unique visual interpretation ofthe struggle between bulls (buyers) and bears (sellers).Furthermore, while there are numerous popular chart patternsthat are commonly associated with bar charts (e.g., head-and-shoulder,double tops, triangles, flags, and pennants, among many others), candlestick charts include all of these formations, plus incorporate anadditional library of imaginatively named chart patterns like “morning star,” “hammer,” and “hanging man,” among many others. All ofthese patterns for both bar and candlestick charts will be explainedlater in this chapter.
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Keeping Time with Char t Timeframes
K eeping Time with Chart TimeframesWhile the structures of bars and candlesticks are relatively straightforward, these stick shapes would mean very little from an analyticalperspective without the vital element of time. On both bar and candlestick charts, the vertical y-axis represents the price of one currencyin a pair against the other, while the horizontal x-axis represents timemoving forward from left to right. This is illustrated in Exhibit 3.2.Point & figure (p&f ) charts are the notable exception to this prevailing axis structure, as they do not include the time element. Butthese unique p&f charts will be touched upon in more detail lateron in this chapter.EXHIBIT 3.2
Chart with Labeled x-axis and y-axis
Source: FX Solutions – FX AccuCharts
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Most charting software allows traders to choose from a widevariety of timeframes for bar and candlestick charts. This choiceis critical for numerous reasons. Most importantly, it dictates howmuch time is contained in each bar or candlestick. For example,in a daily chart, each bar has a duration of exactly one day, or 24hours. A five-minute candlestick, on the other hand, has a durationof exactly five minutes. It is crucial for traders to know exactly whattimeframe is being viewed at all times, as there are differing strategies for long-term, medium-term, and short-term trading.Another reason that the timeframe holds so much importance isthat it determines how much price action can practically be viewedat one time. Longer-term charts like daily, weekly, and monthlytimeframes can comfortably include price action visuals going backmany years or decades. Displaying price action spanning more thana few days for one- or five-minute charts, on the other hand, wouldquickly become unwieldy.Yet another reason timeframes are so critical lies in the verynature of technical analysis itself. It is certainly true that chart patterns are generally fractal, which means that these patterns can befound on all chart timeframes. But from a practical trading perspective, trends and patterns are usually much more reliable on longerterm charts like daily and higher, rather than shorter-term chartslike the intraday hourly and minute charts. This is partly due to thefact that directionless volatility, or noise, that usually defies all technical analysis efforts, is much more prevalent on shorter-term charts.Chart timeframes should therefore be chosen with a great dealof care. Of course, many traders choose to view and analyze multiple
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Support for Resistance (and Support)
timeframes simultaneously in order to identify trend confirmationsand/or conflicts. This type of trading approach will be discussed inChapter 5, which covers trading methods and strategies.Popular timeframes used by foreign exchange traders include(in ascending order of duration): 1-minute, 5-minute, 10-minute,15-minute, 30-minute, 1-hour, 2-hour, 3-hour, 4-hour, 12-hour, daily,weekly, and monthly. There are also multitick timeframes, whereeach bar or candlestick contains a certain number of ticks (minimum incremental movements in price), but these are not nearly aspopular as the abovementioned standard duration timeframes.
S uppor t for Resistance (and Support)Now that basic chart structure has been established, the real “meatand potatoes” of technical analysis can be discussed, and there is nobetter place to begin than with support and resistance. Besides thenotion of trend, which will be discussed in the next section,the twin concepts of support and resistance are at the core of technical analysis. Their explanation is rather simple, yet their significance is far-reaching.Support and resistance are two parts of one whole. They canalso be considered polar opposites. Support is simply defined as therecurring upward price “pressure” found at relatively lower prices,while resistance is the recurring downward price “pressure” found atrelatively higher prices. These upward and downward pressures havea number of hypothetical causes, many of which are purported torelate closely with mass trader psychology.
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Without delving into the theoretical underpinnings of the collective trader psyche, however, the concepts of support and resistance are often considered simply to stem from market participants’price memory, among other factors. This idea will be exploredbriefly here.From a price memory perspective, sustainable support and resistance levels will occur because traders remember specific price levels, and will base their trading decisions on whether they considerthese levels as relatively high or relatively low. The most basic tendency is for traders to buy at price levels they consider relativelylow (support) and to sell at price levels they consider relatively high(resistance).When a majority of traders collectively believe that a certainprice level or region is relatively low, buying pressure will often resultand the price should generally go up, thereby creating a “bounce upoff support.” Conversely, when a majority of traders believe that acertain price level or region is relatively high, selling pressure willoften result and the price should generally go down, thereby creatinga “bounce down off resistance.”For an example of resistance, if the price region surrounding1.6000 on the EUR/USD is considered collectively by traders tobe relatively high (which, as of this writing, is the case), traderswithout positions in the market may wish to sell short the pair ifthis level is reached, with the intention to profit by buying back(or covering) later at a lower price. By the same token, traders withexisting long positions in the pair may also wish to sell at this level,effectively closing their positions and taking their profits. All ofthis selling activity places downward pressure at this 1.6000 level,
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thereby creating significant resistance in the form of a “ceiling” onprice action. The expectation, then, is that when price reaches asignificant resistance level, it will turn and go back down at thatlevel.If, on the other hand, the price region surrounding 95.00 on theUSD/JPY is considered collectively by traders to be relatively low,traders without positions in the market may wish to buy the pairif this level is reached, with the intention to profit by selling theirpositions later at a higher price. And traders with existing short positions in the pair may also wish to buy back (or cover) at this level,effectively closing their positions and taking their profits. All of thisbuying activity places upward pressure at this 95.00 level, therebycreating significant support in the form of a “floor” on price action.The expectation, then, is that when price reaches a significant support level, it will turn and go back up at that level.Sideways price action between both a support floor and a resistance ceiling is called a trading range, as displayed in Exhibit 3.3.These occur quite often in the foreign exchange markets. Manycurrency traders exploit breakouts or breakdowns of low volatilitytrading ranges as one of their primary trade entry tactics. This willbe discussed further in Chapter 5, which covers trading methodsand strategies.The simple fact that support and resistance levels are oftenrespected by price numerous times before ultimately being brokenis, in itself, a remarkable phenomenon that can contribute a greatdeal to any foreign exchange trader’s strategy. Therefore, wheneverprice nears historically significant support or resistance levels, traders and analysts will invariably begin paying close attention to the
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EXHIBIT 3.3
Trading Range Support and Resistance
Source: FX Solutions – FX AccuCharts
action, waiting for the level in question either to be respected orbroken. These traders and analysts will then act accordingly.Another important aspect of traders’ collective price memory asit relates to the concept of support and resistance lies in the extraordinary tendency for a support/resistance level to transform into theopposite, once broken. For example, when price breaks out above aprevious resistance level, technical analysts and traders would thenconsider that broken resistance level as a new support level. By thesame token, when price breaks down below a previous support level,technical analysts and traders would then consider that broken support level as a new resistance level.
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The most plausible reason for this phenomenon, from a technical analysis perspective, is that once a currency pair breaks asupport/resistance level in a convincing manner, traders begin tobelieve that the pair has reached a whole new plateau of price activity. Therefore, mass trader momentum will move away from the previous price level, towards equilibrium at this new norm. The borderbetween the old plateau and the new one is the broken support/resistance zone, and it will therefore be expected to act as a futureprice barrier.For example, if the GBP/USD breaks out and remains above ahighly significant resistance level that represents a multidecade high,say at 2.1160 (as of this writing), traders will begin to believe thatthe pair will continue to move within this new, higher plateau. This isbecause it would be such a technically rare feat to break this lofty levelthat price must be trending up with extremely strong momentum. Sowhen the level is finally broken, if price ever subsequently went backdown to revisit that broken resistance line around 2.1160, it wouldsignal a relatively low price, and therefore a good place to buy at support. And when a lot of major market participants all decide to buy atsupport, it can be manifested in price action as a bounce up off support. This phenomenon can be seen in Exhibit 3.4.Of course, as with every aspect of technical analysis (or any otheranalysis, for that matter), this tendency does not always work outas expected. But the phenomenon is realized frequently enough inthe foreign exchange markets to warrant serious consideration. Theexpectation that support becomes resistance, and resistance becomessupport, is one of the central themes of the support/resistance concept, as well as of technical analysis as a whole.
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EXHIBIT 3.4
Resistance Becomes Support
Source: FX Solutions – FX AccuCharts
T he Trend Will Set You FreeEven more important to the practice of technical analysis than support and resistance is the concept of trend. Knowing the trend atany given time is absolutely essential to analyzing charts effectively.Though this may appear to be a simple thing, there are plenty ofnuances in identifying trends that make it an art unto itself.One of the major complexities involved in determining whetherthe trend is up or down has to do with timeframes, as presentedearlier in this chapter. On a long-term monthly bar chart of AUD/USD, for example, where each bar is the equivalent of one monthof price action, the prevailing trend may be unmistakably up. At the
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same time, the medium-term daily chart might show that the current trend is down. In turn, the short-term hourly chart may beindicating an uptrend. And the ultra-short-term minute chart maybe hinting at a downtrend. Up-down-up-down—which timeframeis indicating the correct trend direction for the currency pair?The answer depends entirely upon which timeframe(s) a particular trader is accustomed to trading. It may well be true that thelonger timeframes offer more reliable trend indications, as shortertimeframes tend to include a lot of market noise, or minor pricefluctuations that have very little to do with the overall trend. Atthe same time, however, a short-term intraday trader might wellbe advised to ignore price action on the weekly chart entirely. Thelong-term trend is virtually irrelevant to the shortest-term intradaytrader. Likewise, a long-term position trader can certainly ignore theintraday price movements on a 5-minute chart.A potential method that can be used for dealing with trends andtimeframes is to concentrate on the trend indicated by a timeframe4–6 times longer than the one traded. For example, if a trader isaccustomed to analyzing a 1-hour chart for trades, the 4-hour chart(4 times the length of the 1-hour chart) would be used to indicatethe trend. And if a trader is accustomed to analyzing a 4-hour chartfor trades, the daily chart (6 times the length of the 4-hour chart)would be used to indicate the trend. Finally, if a trader is accustomedto analyzing a daily chart for trades, the weekly chart (5 times thelength of the daily chart) would be used to indicate the trend.Once the overall, longer-term trend is identified, many foreignexchange traders wisely follow the oft-repeated dictum that all tradesshould always be in the direction of the prevailing trend. Although
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there are certainly a substantial number of successful countertrendtechnical traders in the foreign exchange markets, there are arguablymore successful traders that are of the trend-following persuasion.Besides the issue of timeframe-compatibility in identifyingtrends, the larger question remains as to how a trend is inherentlydefined. If price movement consisted of a straight line either up ordown, identifying a trend would obviously be too simple. In reality,currency prices move around incessantly, often denying the technical analyst an easy trend read.There are primarily three modes of price movement that can bereadily identified.They are uptrend mode, downtrend mode, and nontrending (sideways) mode. Remember that in the foreign exchangemarkets, an uptrend is simultaneously an uptrend for the base currency (first currency in the pair) and a downtrend for the quotecurrency (second currency in the pair). Conversely, a downtrend fora currency pair is simultaneously a downtrend for the base currencyand an uptrend for the quote currency. Because nontrending mode,by definition, is not an integral part of a discussion on trends, it willbe disregarded here.Ideally, an uptrend is characterized by progressively higher lowsand higher highs in price. An ideal downtrend, conversely, is characterized by progressively lower highs and lower lows. A low is considered a point of reversal between a downmove and an upmove.A high is considered a point of reversal between an upmove and adownmove.Trends can be measured and evaluated with a number of tools,including trendlines, trend channels, moving averages, AverageDirectional Index (ADX), Directional Movement Index (DMI),
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Elliott Wave, and others. These will all be discussed later in thischapter.Although there are certainly idealistic conditions for the formation of uptrends and downtrends, in practice it can be difficult tofind sustained trends that conform perfectly to these requirements(higher lows and highs for uptrends, and lower highs and lows fordowntrends). Much more frequently, traders and analysts find ontheir charts uptrends that are only required to hit higher lows, anddowntrends that are only required to hit lower highs. Thus, we havethe terms, uptrend support and downtrend resistance. By definition, these two concepts comprise the technical analysis supertoolfor evaluating trends—the trendline. In turn, the trendline compriseshalf of another vitally important tool in trend analysis—the paralleltrend channel.
H ow Trendy — Lines and ChannelsBesides the ubiquitous horizontal support and resistance linestouched upon earlier in this chapter, trendlines and channels remainamong the most utilized weapons in the technical analysis arsenal.There are almost as many ways to draw trendlines as there are traders using them in their analysis. Over time, there have also emergedcountless new methodologies for drawing and interpreting theselines. But the traditional manner of constructing trendlines remainsclear and focused. One would connect progressively higher lows (atleast two, but preferably more) for an uptrend, as in Exhibit 3.5. Ina similar manner, one would connect progressively lower highs (atleast two, but preferably more) for a downtrend, as in Exhibit 3.6.
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EXHIBIT 3.5
Uptrend Line
Source: FX Solutions – FX AccuCharts
The practical applications of trendlines can be enormously usefulfor the foreign exchange trader. In fact, there is a whole contingentof traders that prefers to use trendline analysis almost exclusively indictating trading decisions. Trendlines can be used to pinpoint breakout entries, pullback entries, prudent stoplosses, and optimal profittargets. Though there can often be excessive subjectivity in theirconstruction and interpretation, trendlines have withstood the test oftime as an integral component of many of the most profitable tradingstrategies. These will be discussed in more detail in Chapter 5.If a trendline supplies just the floor for an uptrend, the paralleluptrend channel provides the ceiling as well. By the same token, if a
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