exhibit short-term memory. Thisis because markets are made up of all the information held by the people with positionsin the market that intuitively remember the short-term past. This is why long-term backtesting, while at first intuitive, can result in overoptimization and curve fitting.
Market InefficienciesIt should be obvious that finding trading rules that are able to be profitable is alwaysan ongoing commitment. Remember, you are competing against traders who most likelyhave far more experience, capital, and research to back up their trades. Finding thosemarket inefficiencies and capitalizing on them with trading rules can be challenging, butthere is certainly plenty of market inefficiency to drive huge proprietary trading teamsat investment banks, thousands of hedge funds, and many individual traders like you topost double-digit returns year in and year out.
Back-Testing for Risk ManagementBanks, hedge funds, and savvy traders also use back-testing for risk management.Managing risk is accomplished by measuring and planning for loss. Even if your trading
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ideas are sound, not having enough capital for the long-term execution of that tradingidea will keep you from realizing maximum success. Standard risk measures includedrawdown, value-at-risk (VaR), leverage, and historical volatility. Maximum drawdowntells you the maximum amount, in currency, of your biggest losing streak. This is calculated based on when your trading system or idea would have had a position in themarket. VaR is quite different in that it measures, statistically, the 95 percent or 99 percent maximum volatility (movement) in an instrument over a given period of time. This isa far more sophisticated measure of risk because you can compare across portfolios andasset classes (types of instruments). Also, you have a single number that you can applyto many different trading systems for a given market. Back-testing for risk managementis probably the most overlooked important piece in a trader’s tool kit.
CONCLUSIONAt this point we have reviewed the major components of technical analysis, which include support and resistance, trend lines, and volatility. The dimensions of analysis provide a map of what the price is doing. Any technical indicator that is used falls into thesecategories. But technical analysis is not complete without looking at the patterns that theprices produce. We explore these in the next section.
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C H A P T E R 13
Chart Formations andPrice Patterns YouShould Know
he price itself is perhaps the most powerful indicator of all, because when price patterns form the experienced trader gains a strong alert to prepare to trade. Patternsform, appear, and reappear because the forex market in particular is not random innature. When prices congeal into a pattern, it reflects market sentiment.Recognizing patterns in fact is the basis of how learning occurs in all fields. A childlearns to talk after listening to adults speaking for about nine months to one year becausethe human brain has the capacity to differentiate patterns in spoken language and thatcapability makes speech possible. Similarly, when a child tries to walk but falls first, thebrain learns which pattern of steps results in successful walking. Every kind of skill canbe learned by identifying the patterns that are associated with the successful applicationof that skill. Ultimately, what intelligent trading is all about is pattern recognition.The challenge to the new trader in forex is to build a database of experiences intrading patterns. The beginning trader lacks a history of trading. The trader with years oftrades accumulated is able to match the pattern he sees with his successful experiencewith that pattern in the past. The question often arises: How long will it take to become asuccessful trader? The answer is not one of time duration but one of trades. After accumulating an experience base of 10 trades, there is almost no basis for generalizing aboutfuture success. After accumulating an experience base of 100 trades, traders will be ableto detect patterns not only in the market but in their own trading. The critical path tosuccess in forex trading is a constant application of pattern-based trading andknowledge.
T
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EMOTIONAL CONTAGION AND PATTERNS FORTRADING FOREXThe first step in learning how to recognize patterns is to understand that the prices reflect market psychology. The trades are signatures of human decisions that move pricesin response to market conditions. Trades, however, do not occur in isolation. Traders,whether they are alone at their desktop or in a trading room, are really part of a virtual neighborhood and as a result are influenced directly and indirectly. The result is thepresence of market psychology and the phenomenon of market memory.Patterns in the past influence patterns in the future, because they are behavioral innature. Observing past patterns actually helps form the next pattern. Therefore, marketpsychology is about group behavior and the dynamics of how trades reflect group psychology. Market moves are often described as herding behavior because they are similarto how herds of animals, swarms of insects, flocks of birds, and schools of fishes respond to environmental stimuli. In all of these cases there is no real central intelligenceleading the group. Instead, patterns of behavior emerge from uncoordinated decisionsof numerous single agents. Descriptions such as emotional contagion, crowd-mind, andcellular automaton behavior (www.automatatrading.com) are indicative forms of multiagent behavior. The field of behavioral finance has recently emerged to study these formsof conduct (see Table 13.1).It is conventional wisdom that the market reflects an interaction between fear andgreed. This is simplistic because emotional responses include a much deeper gradientof emotions. For example, there are different forms of fear. There is fear of increasedlosses and fear of losing profits gained; there is fear of being left out of moves leading togreater gains. There may be fear of spousal disapproval of trading!
TABLE 13.1
Patterns that Reﬂect Emotions
Emotion
Pattern
Trader Response
Hesitation
Doji
Greed or mania
Parabolic path
SurpriseConsensus
Spike and gapsChannel patternThree-line trendsNarrow rangeWide rangeHugging/Sliding on theextreme Bollingerbands
If the doji is at a support/resistancepoint, look for reversalWait for price angle to reach 90degreesStay away; let market recoverTrade signals oﬀ channelTrade in direction trendBreakout comingRange trading scalpingEnter into trend
BoredomAnxiety/UncertaintyDetermination/Enthusiasm/Despair
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Now let’s look at greed. Greed emerges in several forms when there is a significantincrease in buyers. This generates a sharp move up. Uncertainty and anxiety result ina reluctance to trade, and therefore generate narrowing of ranges. Market enthusiasmtakes a path of trend continuation. When there is sentiment of consensus about a currency pair, one result is a channel pattern where we see the emergence of equilibriumbetween buyers and sellers. These are only some of the corresponding patterns that areassociated with each of these emotions. Once they are recognized, there are appropriatetrading strategies that can be used. Let’s explore them.The doji is perhaps the most famous of the candlestick patterns. It means hesitation.The interpretation of hesitation results from the fact that the opening price is the same asthe closing price. This means visually there is no body, and the appearance of a doji candle means that the sentiment battle between the buyers and the sellers resulted duringthat candle period in no clear winner. When hesitation occurs at a key support or resistance area, it is a sign of weakness. A trader seeing a doji near a lower Bollinger bandwould be reluctant to enter into a sell order. Stronger sentiment for sellers would putshow up as a candle probing the lower Bollinger band with a range around the Bollinger.The opposite is true of doji at resistance. A stronger bull sentiment would not result inhesitation. The market would push the price above the top of the Bollinger band. Severalconsecutive dojis provide greater confirmation of hesitation. We can see the doji at thebottom of the Bollinger band in Figure 13.1.When the market is determined to continue a trend direction, a good pattern to tradeoff is called “hugging the band.” We can see this in Figure 13.2. When candles are notreversing after probing a Bollinger band, the trader should not wait for a retracement
FIGURE 13.1 Doji Touches Lower Bollinger Band before Price Moves Up.Source: www.tradesignal.com.
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FIGURE 13.2 Hugging the Band.Source: www.tradesignal.com.
but should consider going along with the pattern by selling (sliding along the path) or bybuying (riding the climb up).
SURPRISE, GREED, AND EXHAUSTIONWhen you see prices follow a parabolic path, trades will follow. The parabolic path is ageneral phenomenon of energy transfer. Figure 13.3 shows the general equation for whatis called a “cubical parabolic hyperbola.” This equation closely models the path oftentaken by forex prices. This should not be a surprise because parabolic patterns are aboutenergy flow and its subsequent loss. When you throw a ball, it follows a parabolic pathas it loses energy.Parabolic paths of forex prices are patterns that show many emotions. First is surprise when the price has a quick and big move. Then there is greed as traders rush into take a ride on the move and take the path to altitudes approaching 90 degrees. It isunsustainable. At the apex, the trader can anticipate a sell-off. The parabolic is not necessarily a reversal indicator, but it is an indicator of exhaustion. Often, the sell-off workswithin the Fibonacci levels and the prepared trader can look to trade in the direction ofthe original move—after the price stops at the Fib level. Look what happened in Figure13.4 to the euro–U.S. dollar (EURUSD) parabolic and Fib combination.
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Chart Formations and Price Patterns You Should Know
y(x)10y(x) = (x – 3)2(x + 1)
y(x) = (x – 1)2(x – 2)
8642
–2
2
4
x
–2–4
FIGURE 13.3 Parabolic Curves.Source: Eric W. Weisstein, “Cubical Parabolic Hyperbola.” From MathWorld—A Wolfram Web Resource,http://mathworld.wolfram.com/CubicalParabolicHyperbola.html.
FIGURE 13.4 Parabolic Showing Sell Oﬀ in EURUSD.Source: www.tradesignal.com.
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FIGURE 13.5 Parabolic in USDCAD Followed by Sideways Action.Source: www.tradesignal.com.
Figure 13.5 shows a U.S. dollar–Canadian dollar (USDCAD) 90-minute chart with aclassic parabolic followed by a sideways sell-off and then a downward parabolic.
FRUSTRATION IN THE CHARTSWhen sentiment can’t find a release, the price compresses and waits for a break. Thesignature of such compression, frustration, and impending explosion of a breakout arethe triangles. Triangles can be equilateral where the angles are all equal or shaped in anascending or descending pattern. Figure 13.6 shows an ascending pattern because thelargest side is trending up. The range is getting narrower, and there is no room for theenergy to go. There must be a break. The strength of the break is not known in advance.But the trader seeing a triangle can anticipate that a break will occur.In the EURCAD cross-pair, an equilateral triangle is spotted, providing an anticipation of a breakout (see Figure 13.7).
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FIGURE 13.6 Compression and Then Breakdown in EURUSD 1-Hour.Source: www.tradesignal.com.
FIGURE 13.7 Classic Triangle.Source: www.tradesignal.com.
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WavelengthBeltWidthRifflesPool
FIGURE 13.8 Wave Equation of Channel Pattern.
STABILITY: THE CHANNEL PATTERNPatterns that endure over time through 20 or more candles demonstrate sentiment stability. The best visualization of this is the channel pattern. Channels can be sideways ortilted downward or upward. It is called a channel pattern because the patterns are similarto a river channel, and, in fact, the geometry and energy flow of water in a river channelis very similar to the movements prices make when forming a channel pattern. Channelpatterns in forex trading are examples of traders using the language of another field ofscience as a metaphor to describe what they see the price doing (see Figures 13.8 and13.9). The trader perceiving a channel can decide on several ways of trading it.The first strategy is to trade in the direction of the channel and, in a downward channel, wait for the price to retest the upper bank. For an upward channel, the best locationof the next trade is for the price to sell off and bounce off the lower channel. Channeltrading permits countertrend trading because the market is showing persistence in thepattern. The width of the channel should permit trading. This means that the trader needsroom for entry off the top or bottom, and assuming that such a cushion requires about 10pips each, it is reasonable to assume that channels of 30 pips or more are the best size.Four-hour charts provide a very good source of channels.The channel formation occurs in almost every time interval. Its robustness can express itself even at the most micro levels of price movement. The 1-minute pattern canshow a channel and therefore reveal the inherent stability of the sentiment as we see inthe 1-minute U.S. dollar–Japanese yen (USDJPY) chart channel in Figure 13.10.Most recently, as the EURUSD pair reached historic levels, it formed a clearly identifiable channel pattern (see Figure 13.11).
TIME AS A TOOL OF ANALYSIS: MULTIPLETIME FRAMESOnce you become familiar with trading setups, using time as a variable of analysisis appropriate. In a real sense, the forex trader is a time traveler moving from the
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FIGURE 13.9 Mississippi River Channel Pattern.Source: www.tradesignal.com.
FIGURE 13.10 USDJPY Showing 1-Minute Downward Channel.
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FIGURE 13.11 EURUSD Channel.
intrahour chart worlds to the outer reaches of weekly and monthly charts. The questionoften arises: Which time interval frame is the best to use to put on the trade?The answer is that each time interval generates trade-offs that the trader has toconsider. A short time interval such as a 5-minute or 15-minute chart provides lessrisk exposure to wider moves, but also involves the risk that the pattern traded is notreliable and has more noise than information in it. A longer time frame such as a 4hour or day chart generates a much wider price range and great potential for largerpip profits.At the same time, it is also associated with risk of larger losses since a wider rangeincreases volatility. The proper way to utilize time is to compare and align different timeframes. This allows time itself to be a confirming indicator, increasing confidence in thedecision made by the trader to put on the trade.
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SUMMARYTechnical analysis, when applied to trading forex, must also include recognition of pricepatterns. When forex prices form patterns, they represent a variety of emotions. Understanding patterns and whether they are stable is a key milestone in evolving into aknowledgeable and skilled trader.
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C H A P T E R 14
Trading Stylesand Setups
ne of the major reasons that forex trading has such a wide appeal is the presenceof different trading styles that can be applied. Those traders looking for very quickmoves can adapt scalping strategies and tactics. A great portion of forex tradersput on trades that have moderate-size intraday durations that allow the currency pair tomove through a range. These traders go for 10 to 30 pip moves. Multiple day trades allowfor larger profit objectives of 100 pips or more. Forex trading can also include the goalof trading for income. This goal is featured in carry trades and is a dominant strategyof large hedge funds and institutions. But carry trades are also possible for the averageretail trader.The beginning trader should explore many of these styles and strategies by creatingtrading setups that use a combination of technical indicators, and chart patterns to pinpoint conditions for a trade. Table 14.1 provides a matrix for grouping the strategies andthe appropriate technical analysis tools to implement them.As we can see, there is no single style of trading, nor any one technical indicatoror methodology that will be sufficient. Successful trading of forex is a combination offundamental knowledge, technical tactics, and experience in pattern recognition. Whilethere are many paths to success once you choose a particular style, there are setups thathave proven successful for each style as summarized in the matrix above. Let’s discusseach one with some illustrations of their application. The order of these styles does notreflect any priority. All the styles are valid for use in forex trading.
O
143
144Proﬁt Goal
5–10 pips
5–9 pip scalp on newsbreakout15 pip moves15–30 pips
20–40 pips
Scalp
15–50 Pips
30–150 pips3–5% per month returnon equity
Scalper
News trader
Post news traderIntraday trader
Bounce trader
Reversal trader
Trend trader
Set and forget
Carry trader
Several months
2 hours to several days
15 minutes to 2 hours
Monthly and weekly trend lines
Variety of setups
Fib breakdownStochastic turnBollinger band huggingSTARC channel break
Trend linesChannelpatternsChannelpatterns
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30 minutes4 hours
Sidewayschannel
Fib linesFib lines
Parabolic
Best Pattern
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15 minutes to 2 hours
Bollinger bandsFib linesStochasticsRelative strength indicatorMoving average convergencedivergenceSetup enhancements:Linear regressionBollinger bandsStochastic turnMarket structures
Use basic setups:
5-Minute Trend-Line ChartsRenko 1-minute chartsThree-line break chartsPivot points + renko charting
Tech Tools And Tactics
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15 minutes to 2 hours1–2 hours
5 minutes to 2 hours
15 minutes or less
Duration of Trade
Trading Styles and Associated Setups
Style of Trader
TABLE 14.1
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BOUNCE TRADERThe bounce trader waits for prices to enter into sideways ranges. The price could becoming from an uptrend or a downtrend, but there are likely to be pauses along the way.The bounce trader will select a direction to trade and then wait for either the failure ofthe price to penetrate resistance or support. The price could in fact close above resistance or support but then proceed to fall back. Using a setup to confirm the reversal thebounce trader is looking for a 15+ pip move. In the U.S. dollar–Japanese yen (USDJPY)15-minute chart shown in Figure 14.1, we see a set up with standard Bollinger bands, slowstochastics (5, 3, 3) and moving average convergence divergence (MACD) histogram orForest version. These indicators are all lined up and provide a high confidence that thesetup for the trade is reasonable. The setup aligned itself for several bounces off the topand bottom trades. Important to note in the setup is the convergence of the upper channel line with the upper Bollinger band. The range is about 40 pips. This means the tradehas to conserve slippage and trade off the top or bottom.
FIGURE 14.1 15-Minute USDJPY Forms Bounce Pattern.Source: www.tradesignal.com.
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INTRADAY TRADERThe intraday trader has more patience and wants to go for a bigger move than the averagegoal of 15 pips. This requires trading off larger time intervals such as the 30-minute and4-hour charts. The intraday trader is looking for wider ranges of 60 pips or more to locatea trade preferable near support or resistance. This trade requires a “sniper” mind-set towait for the right pattern.
TREND TRADERThe trend trader (slide or hug trader) isn’t looking for reversals but wants to go alongwith the crowd. When a pattern confirms trend continuation, this trader enters into thetrade. Many times, one hardly needs any indicators at all to recognize that a trend continuation pattern is intact. This occurred in a classic way on February 27, when the USDJPYpair proceeded to enter into a downtrend with increasing momentum (Figure 14.2). The
FIGURE 14.2 30-Minute USDJPY Forms Multiple Trend Lines.Source: www.tradesignal.com.
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chart reveals several shifts in the trend line, creating a fan of outer to inner trend. Trendpatterns such as this one are irresistible, and entering into the trend is a high probabletrade provided stops are placed above the trend lines.The pattern shows crowd behavior, as there are very few corrective moves up. Thisusually occurs when the price is sliding down the Bollinger band or hugging the band onan upward move. The major technical tactic is using the trend line to confirm where thetrend reversal would occur. Also, determine if an oscillator is appropriately aligned inthe direction of the trend (see Figure 14.3).Let’s look at how the trader would use renko blocks to determine whether to getout after going into a slide trade. We see a very clear hugging-the-band situation in theUSDJPY 15-minute chart (Figure 14.4). Assume the trade was put on at 8:00 after seeingthe price stick right on the band. The question is: Should the trader get out? By using
FIGURE 14.3 Trendline Provides Resistence.Source: www.tradesignal.com.
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FIGURE 14.4 USDJPY 15-Minute Shows Hugging-the-Band Pattern.Source: www.tradesignal.com.
trend lines and renko blocks, the trader gets the answer. If the trader sees that the renkoblocks are staying in a selling sentiment (red), as we see in Figure 14.5 and also that theprice is below the trend line, it is a good idea to stay in for the ride and not get out onsmall countermoves up.
SCALPERThe scalper has the goal of a quick trade for small but leveraged profits. The scalperprefers to trade frequently for small moves instead of working for larger moves. Thescalper focuses on the goal of taking profits quickly from the market and trades in avery limited time frame. Scalpers focus on the most recent price action and on smalltime intervals, from 10-minute candles to 1-minute candles. The trader seeing a highprobable trade can decide to put on multiple lots and then attempt to obtain 5 to10 pips or more. Parabolic patterns are excellent conditions for a scalp. After a parabolicmove up, the probability of a fading of the sentiment is great. The scalper has to minimize the risk of a whipsaw. There is no perfect strategy, but the use of renko blocks
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FIGURE 14.5 Renko Blocks Showing Initiation of Bear Sentiment.Source: www.tradesignal.com.
will clarify more precisely than candlesticks when to get in and out of a scalp. Figure14.6 shows the situation facing the euro–U.S. dollar (EURUSD). There was a parabolicmove up, indicating a potential reversal. The question was when to get in and out fora scalp.Let’s see how a renko scenario would have worked. Mr. Ashkan Balour is a professional forex scalper trader who focuses on capturing moves like a hawk looking for prey.It takes experience in pattern recognition, but Ash is an example that forex trading canbecome a profitable endeavor. Figure 14.7 is an example of one trade he did; his owndescription of it follows. Ash is quite a good trader and was able to pick off 15 pips without 1-minute candles. Compare his candlestick view with renko. The newcomer to forexscalping should use renko to help out. (See Figure 14.8.)
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FIGURE 14.6 Parabolic Move Up on EURUSD.Source: www.tradesignal.com.
FIGURE 14.7 Scalp Setup.Source: www.tradesignal.com.
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FIGURE 14.8 Renko Signal for Scalp.
I just finished this trade. The dollar has been weak all day. It came down from thetop of about 1.9673. It did one wave down to around 1.9645, then started to forma pendant and went lower. I was looking to go long the whole time. I waited till itdid a three-wave sequence down under the pendant. On the third wave, it enteredan area of support in the 1.9630 area. I read a comment that there were buyershere around 1.9630, which is not my reason to trade this area but gives you someconfidence. On the first up candle I was long, 1.9636; I waited until the first redcandle and bagged 15 pips easily. Most trades aren’t this quick and easy.
SET-AND-FORGET TRADERThe set-and-forget trader is playing fundamental direction and is seeking very largemoves of 150 to 300 pips. This trader doesn’t want to sit and watch the screen butplay the longer moves and forces behind forex. This requires trading off 4-hour, daily,and even weekly charts and setting with risk control to target a 3-to-1 ratio of pipprofits over losses. Trading cross-pairs such as the euro–Japanese yen (EURJPY),
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FIGURE 14.9 Bounce Oﬀ Channel Line.Source: www.tradesignal.com.
Australian dollar–Japanese yen (AUDJPY), and euro–Canadian dollar (EURCAD) provide wide ranges. One disadvantage is psychological. Set-and-forget trades are slow andtake a long time to complete. In contrast, an advantage is that all it takes is three out ofseven wins to be profitable.The trader wants to enter on the side of the predominant trend, put on the trade withproper limits and targets. Channel patterns fit this style. In Figure 14.9, we can see theEURUS