URE 4.14 Dark Cloud Cover Pattern
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FIGURE 4.15 Dark Cloud Cover in GBP/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
REVERSAL PATTERNSFor candlestick aficionados, the candlestick’s ability to presage marketturns and quickly identify trend exhaustion is this tool’s greatest asset.There are numerous reversal patterns in candlestick theory, but for ourpurposes we will focus on the most common and popular formations.
The HaramiThe Harami candlestick (harami in Japanese means “pregnant”) is a twocandle formation that can flash either bullish or bearish signals dependingon the sequence of candles. In Figure 4.16 we see a bearish Harami reversal where a large white candle is followed by a small dark one. For thoseof you more familiar with technical analysis, the Harami is a classic example of an “inside” day where the price action of today is completely insidethe price range of the prior day. To Japanese traders, the formation lookedlike a baby (the small black candle) that came from the belly of themother (the large white candle)—thus the name “pregnant.” Regardless ofthe nomenclature, candlestick theory views the Harami as a reversal signal. The formation suggests that after a large up move that closes on the
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Harami
FIGURE 4.16 Harami Pattern
highs of the day bears are able to wrest control from the bulls, first bystymieing further momentum and then by driving prices to close belowthe day’s open.The Harami by itself is a relatively weak reversal signal as it could justas easily suggest consolidation rather than a trend change. Nevertheless,under certain circumstances, such as the example in Figure 4.17, it canlead to a trend change.
Hammer or Hanging ManThe shooting star/reverse hammer and the hammer/hanging man candlestick formations (see Figures 4.18 and 4.19) are the opposite sides of thesame coin, but taken together they represent some of the strongest reversal signals among candlestick patterns. In the shooting star or reversehammer candlestick, prices explore the upper end of the range and arequickly rejected. The end result is that prices not only fail to hold thehighs but actually end lower than where they opened. In the hammer orhanging man candlestick the exact opposite dynamic occurs as prices testthe lows and are instantly bid up by bargain-hunting bulls. Both the shooting star and the hammer are most effective if they appear after a large directional price move. These patterns provide a very powerful visualshorthand for trend exhaustion. Essentially what they are communicatingis that prices have reached a relative apex or nadir and these price levels
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FIGURE 4.17 Bullish Harami in EUR/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
Shooting star/reverse hammer
FIGURE 4.18 Shooting Star or Reverse Hammer
Hammer/hanging man
FIGURE 4.19 Hammer or Hanging Man
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have been deemed by the marketplace to be either too expensive or toocheap. Some experts believe that the longer the wick or shadow in thesepatterns, the higher the probability that they have signaled a swing bottom or top. Figure 4.20 demonstrates both the shooting star and the hammer in action.
Morning Star/Evening StarMorning star and evening star are simply more complex variations on theshooting star/hammer formations. In the morning star a long black candleis followed by a hammer, which in turn is followed by a long white candle(see Figure 4.21). The sequence is simply reversed and has a shooting starin the evening star formation (see Figure 4.22). What both of these candlestick patterns communicate, however, is the notion that control of theprice action is slowly changing from sellers to buyers in the morning starpattern and from buyers to sellers in the evening star pattern. Some candlestick analysts will argue that the deeper the third candle penetratesinto the first candle’s price range, the greater the likelihood that priceswill reverse. In effect, in both the evening and morning star formations the
FIGURE 4.20 Reversals in EUR/USD with Shooting Star and HammerSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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Morning star
FIGURE 4.21 Morning Star
Evening star
FIGURE 4.22 Evening Star
third candle is confirming the signals sent by the shooting star and thehammer and thus provides traders with more confidence to establish a position (see Figure 4.23).
Three Black Crows and Three AdvancingWhite SoldiersThese two candlestick formations are considered to be the rarest andtherefore the most powerful reversal patterns (see Figures 4.24 and4.25). Even the names have tremendous resonance, with “Three BlackCrows” sounding highly ominous and suggestive of carcasses and
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FIGURE 4.23 Evening Star in GBP/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
Three Black Crows
FIGURE 4.24 Three Black Crows
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Three Advancing White Soldiers
FIGURE 4.25 Three Advancing White Soldiers
death, while the name “Three Advancing White Soldiers” exudes confidence and strength.In the Three Black Crows pattern, the signal is most powerful if thefirst black candle in the formation closes below the preceding white candle’s body. This is the first clue to a trend reversal where today’s high islower than yesterday’s high and today’s low is below yesterday’s low.Two more long-bodied consecutive down days then ensue. On each ofthese days, it appears as if the price wants to retest former highs byopening higher than the previous day’s close, but by the end of each session the sellers regain control and prices drop to a new closing low (seeFigure 4.26).In the Three Advancing White Soldiers, the price dynamic is simplyflipped over as the virtuous cycle takes over and prices continuouslymake new highs with the bulls wrestling control from the bears.
FINAL WORD ON CANDLESTICKSThere is no doubt that candlesticks have become the preferred way fortechnically oriented traders to display chart data. One need only look atany trader’s desktop computer to find that an overwhelming majoritylook at price data through candlesticks even if most are not familiarwith many of the arcane formations. As I noted, the purpose of thischapter is not to provide a comprehensive accounting of every pattern.Many authors far more talented and erudite that yours truly have already
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FIGURE 4.26 Three Black Crows in EUR/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
done that. Rather, the idea here is to highlight the most important formations for day-to-day trading and to provide the basic understanding behind candlestick theory. Indeed, it is easy to see why candlesticks havebecome so popular. Their ability to visually compress and summarizethe key events in the battle between the bulls and the bears for any giventime frame is truly astounding. Nevertheless, as I noted before, taken bythemselves candlestick signals are almost useless and will fool tradersinto many false trades if they choose to utilize them exclusively. Onlywhen the candlestick patterns are placed into the broader context ofoverall price action as well as the supporting information from variousindicators (which we discuss later on) do they provide high-probabilityactionable setups.I hope that one point that this chapter has made is just how subjective some candlestick analysis is. Proper candlestick trading is far morea matter of art rather than science. It requires much screen time fortraders to become familiar with and quickly recognize key patterns,which in real life are never quite as precise as they appear in the book. Ifthere is one shorthand lesson to take away from candlestick analysis it’s
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this: The wick is the trick. By elegantly separating the price action of theopen and close from the highs and the lows, candles offer the trader aninstant view of the strength of the underlying trend. That is why doji candles with their long wicks suggesting hesitation and indecision are soclosely followed by many technical traders, as they provide a quickglimpse of actual price dynamics.
CHAPTER 5
Trend IsYour Friend?
E
verybody loves a trend. Almost every trading book repeats the dictum “the trend is your friend” ad nauseum. Furthermore, mosttraders are much more comfortable trading with the trend, ratherthan against it. In FX, where strong trends tend to develop often as majoreconomic themes seize the market for sometimes months at a time, trendtrading is the preferred strategy of choice.What is a trend? The basic, most common definition is higher lows foran uptrend or lower highs for a downtrend, both of which form stutterstep patterns in the price action. Note that trend is defined by the price action of the lows in a uptrend and highs in a downtrend, something thatmay appear at first to be counterintuitive but actually makes sense uponfurther reflection. Although most traders would define an uptrend as a series of higher highs, in fact prices can sometimes pause instead of rising.What makes an uptrend an uptrend is the failure of prices to go down;bulls overpower the bears and step up to buy every decline, which theyperceive as an opportunity to acquire tradable assets at discount prices.The ever-higher slope of higher lows is what forms the uptrend on thecharts. The process and the price dynamics work the exact same way except in reverse in downtrends.Of course, this is an idealized definition of trend because prices rarelycreate such perfect patterns. Even in the strongest uptrends and the mostvicious downtrends, prices will temporarily break below higher lows orabove lower highs. In real life, price action tends to correct, retrace, andgenerally follow a two steps forward, one step backward scenario thatcan shake traders out of their positions at the slightest indication of59
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change of trend. To combat this problem, technical traders have designedan array of tools to help them first determine if trend exists and then create strategies to stay in the trend for as long as possible.
TREND LINESPerhaps nothing is more controversial in technical analysis than trendlines. Ridiculed by some as useless subjective squiggles on a chart andhailed by others as indispensable tools, they are the simplest method fortrend determination in technical analysis. The rules for drawing trendlines vary, and therein lies the first problem. The premise behind the trendline is that in a uptrend the trader should draw a single straight line connecting the lowest swing low to the highest swing low and do the reversein the downtrend. The idea is that price will then respect these boundaries. One very serious problem with trend lines is to know exactly whereto draw them. Do you use the closing price or the highs and lows of theperiod? Do you adjust the slope for isolated spikes, or do you ignorethem? Do you change the trend line based on the scale of your chart?Note how in Figure 5.1 trend lines can have divergent slopes leadingto very different conclusions as to the status of price action.Proponents of trend lines argue that their true value is in capturingthe natural rhythms of buying and selling. A more sophisticated use of thetrend line is to design trend line channels that connect the lows of priceaction on one side and the highs on the other (see Figure 5.2). The classictechnical analysis strategy is then to purchase the instrument at or nearthe support trend line and then sell it at or near the resistance.The net effect is then to buy cheap and sell dear and be able to do soseveral times over as price progresses through time. This can be a veryprofitable strategy as long as price remains in the trend channel, but whathappens when it breaks through? First and foremost, careful speculatorsshould define clearly what constitutes a break of the trend line. Does apiercing of the line signify a break or must the price close through a trendline to be considered valid? How far must price extend beyond the trendline before it can be considered a legitimate break? More importantly, is atrendline break for only one price period enough?There are of course no absolute answers, but certain rules can be applied with relative assurance. Generally a simple intraperiod piercing of atrend line when prices extend beyond it in a rush of buying fury in thecase of a downtrend break, but then quickly retreat to close within the parameters of the line, is the weakest signal and for all intents and purposesis considered “noise” by most technicians. Understand that many profes-
Trend Is Your Friend?
FIGURE 5.1 Different Possible Trend Lines in EUR/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
FIGURE 5.2 Trend Line Channel in EUR/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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sional traders and dealers are well aware of these price channels, and theylove nothing more than to run prices to those levels to pick off many stopsclustered in that region. Because FX is the most leveraged market in theworld, it is also one where most participants trade with hard stops. Thefailure to do so at such high leverage would quickly annihilate most trading accounts. Nevertheless, the flip side of this fact is that stop running isperhaps more prevalent in FX than in any other market. For this reason,intraperiod piercings of trend lines cannot really be considered validbreaks. A close above the trend line may carry more meaning, as it indicates that in the case of down trend line the buyers have found enoughstrength to overwhelm the sellers, who have typically been beating themup for days. Yet what meaning does the trend line break really hold? Doesit predict change of trend? No, not at all. Certainly, sometimes a trend linebreak can mean that price action is ready to race the other way, but anyone who has traded for any period of time will attest that “V” bottoms and“Λ” tops are quite rare indeed. The best clue that can be gathered fromtrend line breaks is that the trend may be ending. What most frequentlyfollows the end of a trend is not a strong countertrend but rather consolidation, which will tend to frustrate both bulls and bears alike as price action will generate many false breakouts and breakdowns while remainingessentially in the same place.So what would provide the strongest evidence for a trend line break?First, price would have to close beyond, not just pierce, a particular trendline. In the case of a downtrend the close would have to be above the line.In the case of an uptrend the close would have to be below the line. Whysuch emphasis on the close? Because the basic premise of technical analysis is that the past matters, and the more recent, the more important itsvalue. Technical analysis is the study of past price behavior to ascertainfuture direction. If prices are actually able to close above or below the keytrend line, the assumption is that the consensus of the market may havematerially changed. Like tectonic plates underneath the earth’s surface,speculator sentiment may be shifting away from the present direction.Secondarily, if price over the next few periods is then able to stay abovethe trend line in case of a downtrend break, and vice versa for an uptrendbreak, then technicians would have stronger support for their thesis thatthe trend was changing. Finally, if prices return to the trend line but thenbounce off, that would provide a final clue that a turn may have occurred(see Figure 5.3).The fundamental principle of technical analysis is that once resistance is broken it becomes support, and once support is broken it becomes resistance. The common saying is that old support becomes newresistance and old resistance becomes new support. Why? The assumption behind this premise is that once traders have broken through a key
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FIGURE 5.3 Trend Line Break in EUR/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
level they will defend it vigorously. For example, in the case of an upsidebreak the trading dynamic behind the move suggests that the bulls havedecided that these particular prices represent true value for the currencypair as they overwhelm the bears and sweep away their stops. Now asprice moves upward the bulls are validated in their thesis. However, thebears, though weakened, may decide to regroup at higher levels and try topush the price back down. As price declines back to the levels of thebreakout the bulls may once again perceive value and decide to add totheir positions. Furthermore, other players who have missed the originalrun-up will join the bidding as they now have an opportunity to positionthemselves for another run-up.Does this work all the time? Of course not. New information can completely reconfigure the market’s perception of value. That’s why most successful technical traders also follow news. In surveys of various banktraders around the world, fundamental news is considered to be as criticalto professional trading as technical analysis. Currencies, after all, are national assets, and they can be greatly affected by geopolitical events. Totrade price action alone in a vacuum is to set yourself up for brutal shockswhen news overwhelms technical patterns. However, in the absence ofnews prices do tend to respect the technical boundaries set by trend lines.
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The reason is actually quite logical. When there is no news, the market isweighing the currently available information; therefore, prices thatseemed like a bargain a few days ago may remain so today since no newinformation has hit the market.William Gallacher in his famous antitechnical treatise Winner TakeAll (McGraw-Hill, 1993) noted that “trend lines cannot withstand seriouscritical scrutiny. It is born of geometric desire to suppose that bull andbear markets should proceed at a constant speed. It is ludicrous to try toconfirm the constant speed of markets by trend lines.” There is a lot oftruth to that statement, as traders should be cautious not to attach toomuch significance to trend lines. As noted earlier, markets rarely move inelegant straight lines. However, during trends, price behaviors tend to assume a certain rhythm. In an uptrend, selling is constantly met with morebuying and prices push ever higher as time moves forward. In a downtrend just the reverse occurs as every attempt to mark up prices is metwith waves upon waves of selling as bids give way. Because the marketsare a quintessential human activity, the dynamic is messy and oftenchaotic. Unlike machines that can spit out widgets with remarkable precision and complete detachment, human beings will overreact, panic, orbecome optimistic beyond all bounds. All of this behavior will be reflected in price action, which will faithfully record the madness of thecrowd. For this reason alone I believe that trend lines should be bestused as guidelines rather than some kind of inviolable vectors. Too oftentraders want the type of mathematical certainty with respect to trendlines that allows NASA scientists to point spacecraft on courses of thousands of miles away from earth and land them within inches of theirdestinations. That kind of attitude towards technical trading is only selfdefeating. When it comes to trend lines, they should be called guidelinesand used loosely to pinpoint the possible direction of price action. Ironically enough, trend lines may be of most value for traders who do nottake them too seriously.
MOVING AVERAGESA second method of identifying trend is the study of moving averages.Moving averages, unlike trend lines, provide far more definitive measures of support and resistance because they can be calculated mathematically with great precision. The most common form of movingaverage is the simple moving average (SMA), which is calculated bytaking the sum of the closing price values of the tradable asset and dividing it by a specific number of periods. For a 10-period simple moving
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average the trader would add each individual price close and divide thetotal by 10. As each new period is added, the oldest period is droppedoff and the average is recalculated. Simple moving averages are verymuch a lagging indicator, but they are very important to technical analysis nevertheless because they represent the consensus price of the market. By taking the average over a given period of time, traders canobtain an approximate idea of where the market believes the value lies.The most basic analysis states that if prices trade above a certain average they are in an uptrend and if they trade below they are in downtrend.Aside from the simple moving average calculation, technicians havedesigned a variety of flavors of moving averages over the years. Thenext most common moving average is the exponential moving average(EMA), which differs from the simple moving average by weighting themost recent price data samples more heavily than the data from periodsfurther back.This process tends to make the EMA more responsive to recent priceaction and therefore eliminates some of the lag of the SMA. The idea behind the EMA is one common to much of technical analysis work—namely that the most recent price action is more valuable than prior priceaction. This idea sometimes works well, but it can also distort the overalltone of price action by underweighting events further past that may havean important effect on future market movement.The exponential moving average is calculated as follows. Assumingthe same 10-period time sample we used for our simple moving average,the exponential moving average would have each period multiplied by anexponent first before all the values are summed and divided by 10. Onecommon formula is to have the EMA calculated by multiplying the mostrecent value by 10, the next most recent by 9, the one further back by 8,and so on, all divided by 10. You can clearly see that while the advantageof such a series is that it may respond faster to most recent price data, itdoes so at the expense of diminishing the value of the past data. While thistype of calculation may provide the trader with faster response, it mayalso send out far more false signals.I am of two minds about EMAs. On the one hand I can clearly seethe value of weighting most recent price action to offer a trader fasterclues to potential turns in price. On the other hand I feel that the function of stand-alone moving averages is to provide as accurate an approximation of price action as possible. By minimizing some parts ofthe sample while overemphasizing others, the price sample may become skewed and for this reason I prefer to use simple moving averages to get a true feel for direction. Ultimately the argument is reallyacademic over the shorter time frames such as 20 days. Note how in
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Figure 5.4 20-day SMA and 20-day EMA in the EUR/USD really do notdeviate much from each other. On longer time frames the situation isquite different. Looking at the 200 SMA and 200 EMA in Figure 5.5, thedivergence can be profound as the larger 200-period data sample withtypically far greater variability in price will generate a far differentreading in an SMA than in an EMA.There are numerous technical systems centered on moving averagesdesigned to help the technician to ascertain trend. The most basic andcommon way to utilize moving averages is to simply see if the currentprice is above or below a given moving average. Typically in an uptrend allprice action is contained by the 20-period SMA. Why is this so? There is noexact answer and my observation simply comes from watching thousandsupon thousands of chart patterns, but one logical explanation is that especially on a daily basis the number 20 represents a full month of tradingand therefore serves as a good sample of market sentiment. Moving averages are notorious, though, for providing false signals when price actionoscillates, so many traders create filters by designing moving averagecrossover systems. Typically these involve the use of a short-term movingaverage crossing a longer-term moving average to trigger a trade. If the
FIGURE 5.4 20 SMA versus 20 EMASource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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FIGURE 5.5 200 SMA versus 200 EMASource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
short-term average crosses the long-term average from the bottom, a buysignal is indicated. If it falls through the longer-term average from the top,this may signal further price weakness. The thinking behind these systemsis that when the short-term average price has dipped below the long-termaverage price, the market is discounting the tradable asset as sellers markdown the price below long-term value. The converse is true when theshort-term moving average moves above the long-term average. There areliterally thousands of permutations of this setup, with traders utilizingevery conceivable combination of averages to optimize their probabilityof success. Unfortunately, this methodology is just as vulnerable tochoppy price action as the simple “price through the moving average” approach. Furthermore, the actual moving average crossover point often occurs at the worst possible price entry to the trader. The reason is opticaldeception that shows up on the charts versus the dynamic of what is happening in real time.Rookie traders will often see a moving average crossover and perceive that the point of entry is at the intersection of the two moving averages. Seeing then how price action often follows in the direction of thecross they assume that this setup works well. In real life the actual moving
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average crossover occurs only after the price candle (i.e., the day’s trading) has completed its period. If, say, in the case of a downtrend the pricecandle is particularly steep, the real-life entry for the trader is at the bottom of the candle rather than at the point of the cross. On the upside theexact same dynamic occurs in reverse. The end result is that the movingaverage crossover will often force the trader to sell the bottoms or buy thetops. This is the prototypical mistake of trend chasing rather than trendtrading that frustrates so many traders using technical analysis techniques. Typically, after a severe move to the downside or a strong breakout to the upside, prices will pause and often retrace as short-term traderscover for profits while others fish for tops or bottoms. The net effect onthe inexperienced trader who trades the moving average crossover blindlyis to usually be in a losing trade from the moment of entry. While the tradeultimately may be correct, the disconcerting effect of instant losses willoften force a panic stop out of the position with vows that all moving average crossover systems are useless (see Figure 5.6). Yet, as with all technical analysis concepts, it’s the practitioner, not the tools, that determinessuccess.One interesting setup that uses moving averages is the triple movingaverage crossover. I like to use the 3-, 20-, and 65-period SMAs for my
FIGURE 5.6 Whipsaw Trades with Moving Average CrossoversSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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setup, but the specific value of moving averages is immaterial. In fact, focusing on specific periodicity of moving averages is a useless task. There isvery little difference between a 20-period and a 21-period or even 25-periodmoving average. Their variability is minuscule, and traders who spendtheir time trying to fine-tune just the right periodic average are engaging innothing but retrofitting of data. The value of the 3 SMA filter is not in theparticular time selection of averages, but in the fact that they are measuring the short-term, the intermediate-term, and the long-term directions ofprice. The idea behind this setup is that when the short-term average isabove the intermediate-term average and the intermediate-term average isabove the long-term average, prices are in an uptrend. When the positioning is reversed, with the intermediate-term below the long-term averageand the short-term below the intermediate-term average, prices are indowntrend.For the most part the value of the SMA setup is simply as an analysistool. It can quickly and very effectively tell the trader if prices are in atrend, but it cannot tell the trader if that trend will continue. More importantly, the setup’s primary value may be more as a negative filter ratherthan as a positive trigger. For example, a trend-oriented trader maychoose to stand aside if there is any conflict among the three moving averages. If the intermediate-term average is above the long-term average butthe short-term average has dipped below the intermediate-term average,the trend is unclear and the trend trader should look for a turn back up inprice action before determining that the uptrend remains in place. Thissimple pause can save traders from untold mistakes by paring down tradeselection to only the most consistent price patterns. Many traders oftenenter trades based on an outdated understanding of price action and thenstubbornly hang on to losing positions, unwilling to accept the reality thatprice action has changed. For trend traders, the 3 SMA setup offers a simple yet logical analytic tool to test their assumptions. Unlike trend lines,which can be configured differently based on each trader’s selection ofprice points, moving averages are completely objective in their readings(see Figure 5.7).Although the 3 SMA filter is simply a trend detection tool and by itselfcannot be used as an accurate trade trigger, there is one exception to therule that is worth exploring. When price action compresses, the threemoving averages will often begin to converge as the lack of volatility willmake the average short-term, intermediate-term, and long-term pricenearly identical. If at this point the three moving averages begin to fan outin proper alignment either up or down, as shown in Figure 5.8, then atrend trader should consider taking the price direction. The key reasonthat makes this particular variation of the setup so attractive is that thetrade carries little risk. Since all of the moving averages are extremely
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FIGURE 5.7 Support at Moving Averages in EUR/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
FIGURE 5.8 The Three Moving Average FilterSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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close to one another, it would not take a large adverse move in price totrigger a moving average crossover from the short-term average to the intermediate-term average and therefore indicate to the trader that thesetup has failed. In actuality what this type of setup is showing is a classicvolatility breakout. In times of market quiet when bulls and bears are ingeneral agreement on price, volatility will contract, but as one camp assumes dominance price will begin to move in that direction. The 3 SMA filter is an easy visual representation of this dynamic, which when it occurscan lead to very powerful profits if the trend sustains itself for a long time.
AVERAGE DIRECTIONAL INDEX/DIRECTIONALMOVEMENT INDEXOne very common technical trend detection indicator that I find absolutely worthless is the Average Directional Index (ADX)/Directional