sellers who are now deep in loss territory will beginto cover as they realize that they are on the wrong side of the market.This reaction will only fuel prices higher and then Johnny-come-latelybuyers will jump on the trend bandwagon, believing that prices will continue their linear progression. At this point most of the players whowanted to buy have already established their positions and the rate ofnew highs slows. The early buyers who have now amassed substantialprofits begin to liquidate their positions as they see prices level off. Allof this jockeying translates into one simple fact: Velocity has slowedmarkedly. If at the beginning of the trend it took only five minutes tomove prices higher by 50 points, now it may take several hours to movethem only 2 or 3 points higher, or worse yet they may actually begin todecline as early winners take profits while there are no additional buyersto absorb their sells.The MACD histogram is a very sensitive measure of price velocity andas such is a very useful tool in one of my favorite setups—the MACD turn.The MACD turn essentially trades the MACD histogram rather than theprice action itself. A buy signal is generated once the MACD histogrammakes a peak. In the case of a long signal the MACD histogram wouldneed to record a higher low on one of its bars. The trader would then assume a long position (see Figure 6.8 for a sell signal). Note that very frequently the price will continue to decline even as the MACD histogramposts higher lows. Most traders will panic at this point and will stop themselves out, typically just at absolute price lows. This is almost always acritical mistake. One of the key tenets of trading with indicators is that thetrader should stay with the logic of his setup. If the entry was based on anindicator signal, then the stop-exit should be based on the indicator aswell. In the MACD turn example I would stop myself out of the trade onlyif the MACD value made a new swing low. In the MACD turn trade thetrick is to trade the indicator, not the price.Many novice technical traders will enter on an indicator signal butwill exit on some predetermined price. This in fact is the trading equiva-
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FIGURE 6.8 Trading the MACD Histogram in AUD/CADSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
lent of comparing apples and oranges. There is little logic in such asetup and it will frequently fail as result. Little wonder, then, that manytraders who experiment with indicators quickly give up in frustrationand proclaim that technical analysis “does not work.” That certainly istrue; any set of tools utilized incorrectly will fail at their intended task.However, the most difficult notion to understand about a technicalanalysis tool like MACD is that even when they are used properly theycan fail as well.The basis of technical analysis is that momentum precedes price.That means failure in momentum will occur before failure in price. In adeclining market, momentum will usually taper off before price willstop decreasing. Generally, this is a very high-probability bet. On someoccasions, however, momentum will send a fake signal. Note in Figure6.9 how the MACD initially turns upward suggesting that momentum isincreasing but then quickly reverts back. At that point it is critical forthe trader to stop himself out because his key criterion—positive momentum in the form of an ever-increasing MACD histogram slope—hasbeen negated.
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FIGURE 6.9 Stopping Out of a Short as MACD Turns PositiveSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
COMMODITY CHANNEL INDEXThe Commodity Channel Index (CCI), invented by Donald Lambert in1980, was originally designed to solve engineering problems regarding signals. The indicator was adapted for trading of commodities and later popularized by Ken Wood, who used it to trade a variety of financialinstruments, including currency futures.Donald Lambert’s intent in developing the CCI was to manufacturean indicator that would try to normalize momentum readings. Like stochastics and RSI, the prime focus of the CCI is to measure the deviationof the price of the tradable from its statistical average. The CCI uses several sophisticated tricks to achieve its goal. Instead of simply taking theclosing price reading over a specific period, the formula for the CCI calculates what Lambert calls the typical price, which is in fact the averageof the high, low, and close. The net effect of that calculation is that thetypical price is more representative of the whole array of the prices during that period rather than just the close. The typical price then subtractsthe average of typical prices over a number of periods—usually 14. This
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numerator is then divided by the mean deviation of this result multipliedby a constant 0.15.Mathematically the formula looks like this:1. Calculate the last period’s typical price (TP) = (H + L + C)/3 where H =
high, L = low, and C = close.2. Calculate the 20-period simple moving average of the typical price(SMATP).3. Calculate the mean deviation. First, calculate the absolute value ofthe difference between the last period’s SMATP and the typical pricefor each of the past 20 periods. Add all of these absolute values together and divide by 20 to find the mean deviation.4. The final step is to apply the typical price (TP), the simple moving average of the typical price (SMATP), a constant (0.015), and the meandeviation to the following formula:CCI = Typical Price −
SMATP× Mean Deviation0.015
In essence, the CCI is simply a measure of divergence from the SMA,which is constantly normalized in relation to the volatility of price flow.The CCI, like the MACD, generates positive and negative values. The assumption behind its design is that between 70 to 80 percent of all priceswill fall between CCI readings of +100 and –100. The classic way to readthe CCI is that prices become overbought when they exceed +100 andoversold when they decline below –100. However, the standard way totrade the CCI is not to fade price flow when those readings are reachedbut to actually go with it. Traders should buy the currency when the CCIbreaks above +100 and sell it when it falls below –100. For traders wishingto fade price flow, the recommendation is to wait until the price leaves the+100 zone to initiate sells (see Figure 6.10), and the reverse—to wait untilit pokes above the –100 zone—to initiate buys. Much like with stochasticsand RSI, the process of fading strength and weakness is twofold: First theprice must create overbought or oversold conditions by piercing the+/–100 zones and then it must leave them. The drawback of such an approach is that the trader is frequently late to the turn. Because the CCIcontinuously produces its reading from what is essentially a derivative ofa derivative (moving average of a moving average), the signal will almostalways be triggered after the price has made part of its move. However,the value of this more cautious approach is that traders do not put themselves into the position of shorting an ever-rising market or buying an
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FIGURE 6.10 Trading with CCI in GBP/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
ever-falling one, as CCI values could remain in highly overbought or oversold states for a long period of time.Like all moving average–derived indicators, the CCI of course is subject to whipsaw risk as it can dart in and out of the +/–100 zones severaltimes before settling on direction. For this reason many traders prefer touse the CCI as a divergence indicator. If the price continues to makehigher highs but the CCI makes lower highs within the +100 zone, a tradermay consider initiating a short position and maintain that short positioneven if the price continues to make newer highs as long as the CCI doesnot exceed its prior highs (see Figure 6.11). The setup of course works exactly the same way in reverse with the CCI making higher lows while theprice proceeds to decline.One novel way of trading the CCI has emerged from Ken Wood, universally known as Woodie to his many legions of fans and fellow traders.Woodie hosts more than 10 separate trading chat groups on the Internetwhere he and his followers trade a variety of financial instruments including currency futures in the EUR/USD using the CCI exclusively as their indicator of choice.In an interview with SFO magazine Ken Wood stated, “Many yearsago, right after the CCI article appeared, I was doing work on momentum—because I always found that for some reason momentum gave a
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FIGURE 6.11 Trading CCI Divergence in EUR/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
little bit of a warning ahead of time of what was going to happen. Andthe CCI is classified as a momentum indicator. I began using the CCI andstarted to develop patterns on it about 13 to 14 years ago; I noticed thatthese particular patterns were continuously showing up on daily charts atthat time—all the time. And so, that’s when I started developing the patterns on the CCI and not on the price bars.” That indeed was Woodie’sgreat insight and contribution to technical analysis. Instead of tradingprice charts, Woodie trades the classic technical patterns that form on theCCI. Since the CCI is specifically designed to normalize price data, thismethod protects Woodie from the random market noise of pure price action. Woodie in fact sets up his charts without any price axis whatsoeverso that he can simply concentrate on the patterns formed by the CCI andnot be swayed by the price action itself. That’s an act of mental disciplinefew traders could practice, but the underlying core of his philosophy—trade the indicator, not the price—has been a tremendous insight and helpto many technically oriented traders. Indeed, I borrowed this concept indesigning my MACD turn setup.Among Woodie’s most popular CCI setups are the ghost, the trend linebreak, and the zero line reject patterns. The ghost pattern, though rare,can be a very powerful trade. The ghost is simply the head and shoulderspattern on the CCI itself, which suggests that momentum has made a peak
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and a price reversal may soon follow. It is especially useful in timing aturn in price after a long trend period. Note in Figure 6.12 how the ghostsetup warned traders of an impending trend change in the EUR/USD afterthe price had climbed 1,000 points.The trend line break simply uses a break of trend line on the CCIrather than price to trigger a trade. The trend line break can be a verypowerful setup, especially if it is combined with the cross of the zero line.Again, because the CCI normalizes the price data, its peaks and valleyswill be smoother and less random than the price itself; therefore, a breakof trend as mapped by the CCI will have more meaning and accuracy thantrend line breaks on price charts alone.Finally, one other common setup of Woodie’s is the zero line reject,where the CCI approaches the zero line (though many traders use the0–50 zone for more flexibility) and then begins to turn away. The traderwould quickly buy the currency pair in the case of a positive zero line reject trade and sell it in the case of a negative zero line reject trade (seeFigure 6.13). The exit for the trade would occur when the CCI reading exceeded 100 or –100. This in effect is a classic retracement trade where thetrader buys weakness in the uptrend and sells strength in a downtrend,and then quickly exits at the extremes. The difference is that using the
FIGURE 6.12 Trading CCI “Ghost” in EUR/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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FIGURE 6.13 Trading CCI Zero Line Reject in GBP/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
CCI provides the trader with a very precise framework to execute thisstrategy.
CONCLUSIONUltimately all oscillators simply measure the rate of change in price action. Their formulas may differ and their readings may have slight variability, but their primary usefulness to a technician is to spot divergencebetween momentum and price. Does a break in momentum always predict a turn in price? Of course not. In fact, such primitive application ofoscillators is precisely the reason why many novice traders are unable tobenefit from technical analysis. One of the principal tenets of successfultechnical trading is to maintain a logical structure to one’s trading setups.Traders should trade either indicators or price action but not mix the two.Indicator signals are only clues, not guarantees about future price direction. Those technical traders who focus strictly on analyzing and trading indicators will have a much greater degree of success because theirtrade setups will possess an inherent logical structure.
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Like all rules in life, the one I just stated needs to be broken occasionally. All technical indicators by definition lag price action becausethey are composed of past price history. Furthermore, because many oscillators normalize the price data, their signals may be even further delayed. In case of extraordinary volatility, trading strictly off indicatorsmay create highly damaging and perhaps even fatal drawdowns to account equity. Traders always need to have a disaster response scenariobefore they put on a trade that requires a hard money stop, regardless ofwhat indicators say.Oscillators are the primary tools of technical analysis because mosttechnical analysis is centered on the concept of divergence betweenmomentum and price. They, like all tools in technical analysis, are notby any scientific means precise. However, used properly they can offera critical edge to the trader, and in a business where one needs to beonly 51 percent correct on an even risk/reward basis, that is a valuableservice indeed.
CHAPTER 7
Fibs Don’t Fib
L
eonardo of Pisa, who lived from 1170 to 1250 and is better knownas Fibonacci, is the most popular mathematician in trading, morefamous even than Fischer Black and Myron Scholes, who inventedthe Black-Scholes formula, which is the foundation for all modern pricing of options. Fibonacci’s contribution was far less complex than theBlack-Scholes option pricing model. He is best known to traders for discovering the sequence of numbers that carries his name. The sequenceproceeds like this: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610,987, 1597, and so on. The series is constructed by choosing the first twonumbers, known as the seeds, and then constructing the next numberfrom the sum of the two prior numbers. The Fibonacci sequence obeysthe formula P(n) = P(n – 1) + P(n – 2) and is an example of many suchsequences in mathematics known as recursion relations.The Fibonacci sequence has several neat mathematical properties,including:1. If you take any three adjacent numbers, then square the middle num-
ber and multiply the two outside numbers, the difference betweenthose two values will always be 1.2. If you take any four adjacent numbers, then multiply the two outsidenumbers and multiply the two inside numbers, the product of the twooutside numbers will always be 1 more or 1 less than the product ofthe inside numbers.
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3. Finally, the sum of any 10 adjacent numbers will always be equal to
the value of multiplying the seventh number of that sequence by 11.While these tricks are mildly amusing, in trading the Fibonacci sequence is revered for the fact that the ratio of adjacent numbers converges to a constant value of 0.618. Note this not the case for the smallernumbers—as for example 2:3 is equal to 0.66 and 5:8 is equal to 0.625—butas numbers progress, especially as the sequence exceeds about 55 numbers, the ratio of each adjacent number begins to equal 0.618 all the wayto the tenth decimal point. This ratio is often referred to as “phi.” Theother quite interesting aspect of the Fibonacci sequence is that the reciprocal of that ratio is equal to 1.618 or 1 + phi. In other words, 144/233 =0.618 and 233/144 = 1.618. This remarkable property is consistent throughout the sequence.Is the Fibonacci sequence unique? Not at all. As mentioned, it’s part ofa family of mathematical series called recursive relations. Another famousseries is called the Lucas sequence, after French mathematician EdouardLucas (1842–1891), which is “seeded” with 1 and 3 instead of 0 and 1. TheLucas sequence has the following string: 1, 3, 4, 7, 11, 18, 29, 47, and so on.As its numbers increase, its ratio also approaches phi. No other sequence,though, with different seed numbers and different summation rules willconverge to phi. For example, a sequence with seed values 0, 1, 1 and thesummary rules changed so that P(n) = P(n – 2) + P(n – 3) will generate theseries 0, 1, 1, 2, 2, 3, 4, 5, 7, 9, and so on. The ratio of the two adjacent numbers will converge to 0.754, and the reciprocal value will be 1.32—quitedifferent from Fibonacci values. However, the one property that all ofthese recursive series share is that the ratios of their adjacent numbersquickly converge to nearly constant values. After about 30 generations theratio numbers become constant to 10 decimal points.So what’s all the fuss about? Why are Fibonacci ratios so important?To their proponents “Fibs” hold almost mystical values. Petals of flowers,planetary orbits, and human physiology all adhere to this ratio. If the Fibonacci sequence and its ratio are so widespread in nature, then they reason it should have powerful application to the financial markets, which,after all, are a reflection of natural human behavior. Like many traders, Iused to accept this line of reasoning without question until I came acrossa critique of the whole Fibonacci philosophy by Donald Simanek, a professor at Lock Haven University of Pennsylvania and author of ScienceAskew (Institute of Physics Publishing, 2001). Professor Simanek eviscerates the whole “Fibonacci is the key to natural order” argument by pointing out the inconsistencies in the adherents’ positions. For example, onthe matter of flowers the proponents argue that petals follow the Fibonacci sequence. Table 7.1 lists all such flowers.
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TABLE 7.1 Petal Numbers That Are “Fibs”Flower
Number of Petals
Lily
3
Violet
5
Delphinium
8
Mayweed
13
Aster
21
Pyrethrum
34
Helenium
55
Michaelmas Daisy
89
The problem is that this list is selective. There are plenty of flowerswhose petals are not Fibonacci numbers. Professor Simanek points outjust a few such examples in Table 7.2.Similarly, the orbital rotations of Uranus, Saturn, Jupiter, and Marshappen to follow the Fibonacci ratio when a planet’s period is comparedto the planet adjacent to it. However, as Professor Simanek points out, theorbits of Pluto, Neptune, Venus, and Earth do not, making the wholeprocess rather subjective and arbitrary.Finally on the question of human physiology many Fibonacci adherents claim that perfect human features both on the face and on the bodywill follow the Fib ratio. One very often quoted Fib concept is that the perfect human body will have a “phi” relationship between the height of theperson’s navel as measured from the floor relative to the person’s fullheight. Professor Simanek actually tested this assertion by measuring alarge sample of swimsuit models deemed beautiful by most standards and
TABLE 7.2 Petal Numbers That AreNot “Fibs”Flower
Number of Petals
Mustard
4
Dame’s Rocket
4
Hyacinth
6
Corn Lily
6
Solomon’s Seal
6
Starﬂower
7
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TECHNICAL ANALYSIS OF THE CURRENCY MARKET
arrived at an average of 0.58 with a variance of only +/–.01 versus the phiratio of 0.62.So where does all of this leave us? Are the claims of Fib proponentsthat this sequence has critical value to understanding the order of the universe complete nonsense? Absolutely. Are Fibonacci ratios therefore completely useless when applied to currency trading? Absolutely not.In the FX markets Fibonacci ratios are keenly observed. The key Fibonacci levels that most traders follow are 0.382 percent (1 minus “phi”ratio of 0.618), 50 percent (which is not a true Fibonacci ratio and alreadyshows a perversion of the dogma), and phi itself (0.618). Additionally,traders also key in on what are called Fibonacci extension ratios—1.382and 1.618. The classic way to apply the Fib ratios in technical analysis isto draw a trend line from the absolute swing low to the absolute swinghigh in an uptrend (reverse in a downtrend) and then to attach Fib lines at38.2 percent, 50 percent, and 61.8 percent levels of the move. The idea isthat prices will correct by these amounts in any type of trend as these arenatural support and resistance levels (see Figures 7.1 and 7.2).For Fib extensions the process also relies on marking the near-termlength of the trend but then simply multiplying that value by 1.382 and1.618 to project the key levels that prices are likely to reach (see Figure
FIGURE 7.1 Finding Support with Fibonacci in EUR/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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FIGURE 7.2 Determining Resistance with Fibonacci in EUR/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
7.3). For example, in the case of an uptrend in EUR/USD from a swing lowof 1.2000 to a swing high of 1.2100 a Fibonacci-based trader would demarcate the length of the trend as 100 points and would project 1.2138 as hisfirst point of exit and 1.2162 as his second profit target.Why use Fibonacci ratios at all in trading if they are of dubious meritscientifically? Part of the reason is that almost everyone in the FX market—from the smallest speculator in Spokane, Washington, to the largesthedge fund trader in Greenwich, Connecticut—is aware of these levels.The process is only reinforced by the financial press, which disseminatesthe information on Fib levels through almost every FX web site on the Internet. The fact that these numbers are well known and that market participants follow them avidly makes Fib levels a useful reference tool.However, ultimately I think this is a weak argument in the vein of “Well Idid it because everyone was doing it, too.”There is, I believe, a better and more logical reason for why Fib levelswork quite well in the currency market. Stripped of their mystical nonsense, the Fib ratios basically represent proportions of about one-thirdand two-thirds of the total value of the move. To understand why these arenatural retrenchment levels for currencies we need to examine the basicdynamics of trading. In a trending market, when prices find direction FX
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FIGURE 7.3 Fibonacci Extensions in EUR/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
dealers can typically be found on the opposite side of the move. This result is the natural outcome of the dealers’ function as market makers.When customers come to buy they must be willing to sell in order to provide liquidity to the market. Unlike customers, dealers almost never puton their whole position at once. Instead they continuously scale in and outof their positions, riding the price charts, absorbing and removing inventory much like a fast elevator in a high-rise building. As prices continue tomove in one direction, dealers and other short-term market speculatorsmay begin to parabolically scale into their positions. Simply put, they maystart not just to average up but to double up at each new high or low. Thismethod may appear to be financially suicidal, and for most speculatorswith limited capital it certainly would be. But for large-scale traders withaccess to enormous credit lines and seasoned experience with risk, thisstrategy can be highly efficient. Let’s just look at a hypothetical exampleto see the real dynamic at play.Imagine that EUR/USD is trading at 1.2000. Dealer X as part of hismarket making duties sells 100 million euros to his customers. An unexpected piece of news hits the market and the EUR/USD jumps to 1.2100.Most market participants on the wrong side of that trade may choose tocover for a loss and get out at that point. But remember our Dealer X hasspent only a fraction of his total available capital on that position and
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may decide to stay with the position. At 1.2100 he will sell 200 millioneuros more into the market. The EUR/USD rally, however, continues tobuild steam and the pair now trades at 1.2200. At this point even themost steely-eyed short-term speculator is likely to cover as the pain ofthe loss becomes nearly unbearable. Our Dealer X, however, still hasplenty of capital in reserve and chooses to sell once again—this time 400million euros at 1.2200. As prices move uninterrupted for 200 points inone direction the early winners from this trade—the longs who havebeen in since 1.2000—may decide to cash in some of their positions. Focus, however, on our friend Dealer X. What has he really done? Essentially he has lowered his break-even point by two-thirds of the amplitudeof the move. Or put differently, prices have to retrace by only one-thirdin order for Dealer X’s position to become profitable: (100 million ×1.2000) + (200 million × 1.2100) + (400 million × 1.2200) = average priceof 1.12142.In parabolic averaging, where the trader always doubles up his positions at any given interval, the break-even point will be one-third of thelength of the move. Of course, the preceding is an idealized example. Nobody continuously doubles up their positions ad infinitum. Such a systemwould be simply nothing but a version of the martingale technique wherethe gambler repeatedly doubles his bet until he can recoup his originalcapital. All martingale systems are doomed to fail eventually. However,unlike what you may have read in trading books, in real life professionaltraders often double down on their positions in a modified version of themartingale technique. There are two key differences between the pros andthe amateurs. First, professionals almost never spend all of their risk capital on a single entry. Note that in our example Dealer X may have had asmuch as a billion euros of credit available to him, and even with all of thedoubling his total trade allocation was only 700 million euros. Second,professionals always set an exit point for a trade gone wrong even if it’s avery wide emergency stop hundreds of points away. Unlike the amateurmartingale gamblers who tempt fate once too often and will inevitablylose all of their capital, pros always cut their losses at a small percentageof their overall capital.Is it any wonder, then, that the 38.2 percent Fib level seems to resonate in currency trading? This is the first zone at which traders trappedon the wrong side of the move are able to get out of their positions atbreak-even or better. As prices approach these levels, these players wouldbecome natural sellers if the original move was a downtrend or naturalbuyers if it was an uptrend. Therefore, just as the early speculators on theright side of the trend who wanted to cash out their winnings presented anatural barrier to any further directional move, so, too, these countertrend traders now present a natural cap to any retracement.
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Is it the mysterious power of Fibonacci or is it simply the natural ebband flow of the markets that makes the main Fibonacci retracement levelsso valuable in FX trading? I would strongly argue that it’s the latter. Butyou may wonder, why care either way? After all, if Fib levels work in FX,why not simply use them profitably regardless of the reasons for their efficacy? Because it’s important not to accord too much meaning to Fibonacci numbers. Very rarely do prices make an exact 38.2 percentretracement and then immediately turn back.The Fib retracement ratiosare not some precise mathematical calculations that allow the trader toanticipate support and resistance levels with the same degree of certaintythat allows NASA engineers to land a spaceship on the moon. On the contrary, traders who try to anticipate the Fibonacci retracement level are often disappointed as prices run over their positions before finally making aturn. Although on occasion it may be quite profitable to simply put in alimit order at the 38.2 percent or 61.8 percent level, catch the absolute bottom of the retracement, and then watch as prices bounce right off thatlevel to resume their original direction, in real life such setups have a verylow probability of success. Far better for most traders to observe price action as it actually meets Fibonacci levels. Typically if the Fib support isreal, the velocity of the move will slow down and prices may spend several periods consolidating in that region. If prices then resume the originaltrend, the trader may have more confidence that the Fib support level isgenuine, and his trade, though far from certain, would have a higher probability of success (see Figure 7.4).Fib levels are not static, rigid lines that serve as inviolable supportfor any given trend; rather, they are more like elastic rubber bands thatdynamically absorb price action in a broad zone before the price resumesits original move. Dennis Gartman, who writes the eponymous newsletter that covers the currency, stock, bond, and commodity markets and isread the world over by most institutional traders, uses what he calls the“box” to gauge retracement levels in a trend. The box is simply the 50percent to 61.8 percent zone of any given trend (see Figure 7.5). Gartmanlikes to see how prices react when they enter into the box; if they stall hewill often place a trade in the direction of the original trend, betting thatthe retracement is over. Note that instead of relying on specific numericallines, Gartman uses a wide area of price action as his measure of support.Fibonacci levels become important not in their ability to pinpoint specificretracement levels, but rather in the utility to point out the broad generalareas