technique of manuallydrawing horizontal support and resistance lines at market turns.In the case of breakouts, the logic is equally simple. The reasoning is that price should respect previously established support and
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EXHIBIT 5.6
Manually Drawn Horizontal Lines
Source: FX Solutions – FX AccuCharts
resistance levels under normal circumstances, but if there is a strongenough catalyst for pushing price to break a given level, that breachshould carry enough momentum to take price to the next further support/resistance level. If the breakout level in question is avery-long-term or all-time high or low, where a further establishedsupport/resistance level does not exist, the assumption is that pricewill subsequently make new highs/lows somewhere significantlybeyond the broken level. As we saw in the case of false breakouts,however, this assumption does not always hold true.Besides the technique of manually drawn horizontal lines fordenoting support and resistance levels, there are also several other
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EXHIBIT 5.7
Trendline Break
Source: FX Solutions – FX AccuCharts
methods available that can be used in breakout trading. Theseother methods, however, will usually yield different price levels thanthe horizontal line technique. They include: dynamic trendlines(as illustrated in Exhibit 5.7), chart patterns (described later in thischapter), pivot points and Fibonacci retracements (also describedlater in this chapter), and moving averages.However support and resistance are measured, the concept oftrading breakouts is straightforward. A trader customarily entersthe breakout trade beyond the actual breakout point, balancing thegoal of avoiding a false breakout with the goal of getting in as earlyas possible for a larger profit potential. A hard stop loss is generally
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placed right before the breakout point where, if it is hit, the pricemove will have proven itself to be a false or premature breakout. Thisstraightforward stop loss placement is one of the primary strengths ofbreakout trading, as it ensures tightly controlled downside risk, whileboosting the potential reward-to-risk profile of the trade.One very important and common variation on the traditionalbreakout is called the pullback/throwback. These phenomena occurwhen momentum on a breakout wanes shortly after the break, resulting in an extra move. See Exhibit 5.8 for an illustration of typicalpullback and throwback moves. A throwback is simply a return to thepoint of breakout after an upward break. A pullback is a return tothe point of breakdown after a downward break. In either direction,if the break is true (which means it carries real directional momentum) price should hit and bounce off the point of breakout, and thensurpass the point at which breakout momentum waned and priceturned. On a true break, price should then continue in the breakout
EXHIBIT 5.8
Pullback and ThrowbackThrowback
Breakout level
PullbackBreakout level
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direction as if the pullback or throwback never occurred. Someprudent breakout traders will wait for a pullback/throwback beforegetting in on a breakout trade. Traders who do so may miss somepotential trading opportunities (as many breakouts do not have pullbacks or throwbacks), but that extra patience often pays off in betterpositioned breakout trades with somewhat reduced risk.Like range trading, breakout trading is a very popular strategyfor approaching forex. Breakouts occur frequently on currencycharts. Whether these breakouts are real or false, however, is the difficulty in implementing this methodology. But since the nature ofbreakout trading inherently possesses an extremely straightforwardand beneficial method for setting optimal risk management controls(stop losses), trading in this manner can be a very high probabilitymethod for approaching the foreign exchange markets.
EXECUTIVE INSIGHT
Ed PonsiEd Ponsi, president of FXEducator.com and author of ForexPatterns and Probabilities, is well-known in the industry as atop trader, money manager, and forex trading educator. He hasadvised hedge funds, institutional traders, and individual tradersof all levels of skill and experience, and has become one of themost sought-after lecturers in the financial world.Ponsi states:“Regarding technique, I’m primarily a trend trader. I lookfor situations where the technicals mesh with the fundamentals—if there is a clear trend in place, and if the
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EXECUTIVE INSIGHT (CONTINUED)fundamentals confirm what I see on the chart, I’m goingto try to grab a chunk of that trend.One thing I’m very cautious about is trading thebreakout—if the trend is moving upwards, I want to golong but I don’t want to buy a currency as it’s hittingnew highs. Because there are so many false breakoutsin forex trading, my strategy is to try to catch the pullbacks. That way, even if the currency pair fails to breakthrough, there is still some potential for profit when thepair reaches resistance.One of my favorite situations is a false breakout thatmoves against the trend. These types of breakouts havea high failure rate, and they also set the stage for a ‘slingshot’ trade in the opposite direction. It’s a great setup,and I’m constantly looking for it.If the trend is strong enough, I might not use a target at all; instead, I’ll trail a stop. I like to trail stopsmanually, moving them strategically instead of automatically. That way, I can keep my stop beneath a trend lineor moving average, instead of moving it to an arbitrarylocation—which is often exactly what happens when weuse automatic trailing stops.”
P attern Trading — Playing with ShapesAs mentioned in the previous section, pattern trading may be considered one form of breakout trading, depending upon which typeof chart pattern one might be referring to. There are essentially twogeneral types of chart patterns. First are the several multibar shapesthat together constitute one of the pillars of Western-style technicalanalysis. These formations generally represent price consolidation, and
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include triangles, flags, pennants, wedges, rectangles, and head-andshoulders, among others. Many of the most important of these patterns are illustrated and described in detail in Chapter 3. For the mostpart, all of these patterns are generally traded when a breakout of onetype or another occurs. Conversely, the second type of chart pattern—candlestick patterns (also described in Chapter 3)—are not tied asclosely with breakout trading.When speaking of pattern breakouts, it is helpful to delineatewhich patterns are more often considered continuation patternsand which ones are more often considered reversal patterns. Thesedelineations are far from rules, as any pattern could act as a continuation pattern or a reversal pattern, or neither (e.g., prolongedconsolidation after breakout). Traditionally, though, most patternshave fulfilled certain roles that historically have been somewhat reliable to a certain extent. A continuation pattern is simply a consolidation formation where price exits, or breaks out of, the patternin the direction of the trend that prevailed prior to the formation.Conversely, a reversal pattern is a consolidation formation whereprice exits, or breaks out of, the pattern in the opposite direction ofthe trend that prevailed prior to the formation.As indicated in Chapter 3, of the most common patterns foundon currency charts, those that are generally considered reversal formations include double tops/bottoms, triple tops/bottoms, and headand-shoulders tops/bottoms. Those that are most often consideredcontinuation patterns include flags, pennants, triangles, wedges, andrectangles, among others.When a continuation pattern approaches breakout on the sideof the pattern that would denote a continuation, technical traders
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wait patiently for a break. At this point, it is treated as a breakouttrade with a similar type of entry and stop-loss placement as withstandard support/resistance breakout trades. The same holds true forreversal patterns when price approaches breakout on the side of thepattern that would denote a reversal. But in actuality, any type ofbreakout of these patterns, whether in the direction of continuationor reversal, is an eagerly watched and traded event.One added benefit of trading pattern breakouts lies in the precise structuring of profit targets. Most patterns have a built-in profittarget after breakout. A good example is the well-known headand-shoulders pattern. As shown in Exhibit 5.9, after price breaksthe neckline, the traditional signal for a trade, the target is derivedby measuring the height of the pattern from the top of the headto the neckline, and then projecting that height from the necklinebreak down for the profit target. Similarly, for a rectangle consolidation pattern, the height of the rectangle is projected up or down toderive a profit target after breakout. Triangles, flags, pennants, andother chart patterns also have convenient, built-in targets.EXHIBIT 5.9
Head-and-Shoulders Profit TargetHead and Shoulders Profit Target
Neckline
Profit Target
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In contrast with Western-style chart patterns, Japanese-stylecandlestick patterns (the most important of which are described inChapter 3) are generally smaller chart formations that are not usually considered self-sufficient trading signals. Rather, candlestickpatterns are more often utilized as important trade confirmationtools that are used in conjunction with other analytical methods.For example, a hammer candle that occurs after a steep, well-defineddowntrend should not be taken by itself as a reversal signal to buy atthe low. But if this candle occurs right at a well-established supportlevel, the hammer can certainly represent a strong confirmation thata potential long trade may be in order.Pattern trading is very similar to general support/resistance breakout trading in terms of entries and exits, but with the added benefitof clear-cut profit targets. Patterns appear very frequently on foreign currency charts, and can be found on all charting timeframes.Through diligent chart-watching practice, any foreign exchangetrader can learn to spot even the most comprehensive pattern trading opportunities at a glance.
F ibonacci and Pivot Point Trading — MagicNumbers and Self - Fulfilling PropheciesAlso sharing some similar characteristics with general support/resistance trading, the use of Fibonacci levels and pivot points areoften considered by their adherents as complete, self-contained trading strategies. The origins of these two methodologies are far fromintertwined with each other, but they are grouped together herebecause they are commonly traded and analyzed in a similar fashion.
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The horizontal price levels that are generated through Fibonacciand pivot points are calculated using different methods, but theyboth produce mathematically derived support and resistance levels that traders may use either as indicators of possible retracementturns or as zones to watch for breakouts.A substantial component of what makes these tools work surprisingly well under diverse market conditions is the simple factthat many traders, both large and small, utilize both Fibonacci andpivot points in their trading. Therefore, the levels derived from thesepopular tools become a sort of self-fulfilling prophecy. This is wheresignificant price action often occurs around these levels due tothe simple fact that many traders are watching and reacting to theseprice levels. This phenomenon contributes to their frequent effectiveness and accuracy in describing market movement.As discussed in Chapter 3 on technical analysis tools, the mathematical theory now generally known as Fibonacci Theory is widely considered to have originated from a 13th century Italian mathematicianappropriately named, Leonardo Fibonacci. He calculated a sequence ofnumbers that led to the discovery of the Golden Ratio, 1.618, which isa proportion that advocates say can be found in nature, science, music,and even financial markets. Derived from this ratio and its inverse of0.618 are the Fibonacci percentages commonly used in technical analysis today. There are several modern charting tools based on these percentages that have been created expressly for analyzing price charts, ofwhich the most popular is the standard Fibonacci retracement tool.The most common Fibonacci retracement percentages, as shownin Exhibit 5.10, include 23.6%, 38.2%, 50%, and 61.8%. Of these,the latter three are perhaps the most closely followed by traders and
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EXHIBIT 5.10
Fibonacci Retracements
Source: FX Solutions – FX AccuCharts
analysts. Very often, one will read commentary from an analyst inthe financial news proclaiming that price is approaching the 38.2%retracement level, and that something important, like a turn, couldoccur at this key level. Such is the widespread popularity of Fibonacciretracements.As mentioned earlier, Fibonacci retracements are customarily tradedin one of two ways—either as a breakout opportunity or as a retracement turn (a bounce). Both are viable methods of trading forex thathave built-in and clear-cut locations for stop-loss placement, much likeall support/resistance trading techniques. In addition, Fibonacci levelscan also be used as profit targets for existing open trades.
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Similar to Fibonacci retracements in both look and functionalityare pivot points. As described in Chapter 3, pivot points originatedlong ago in other financial markets. They are derived mathematically from the previous day’s key data points, including the high, low,and close. The main pivot point price level, labeled “PP,” is calculated by taking the mean (average) of the high, low, and close fromthe prior day’s price action. From the PP, four other primary pivotpoints are calculated, two above and two below the main PP. Thelevels above are R1 and R2, where “R” stands for resistance.The levels below are S1 and S2, where “S” stands for support. Often,this pivot point structure is extended even further to R3 and S3.Following are the calculations for the most common daily pivotpoints. Although a pivot point calculator may readily be found online,and is also a standard component of many charting software packages, it is still useful to know how these important levels are derived.Beginning with the middle Pivot Point that is calculated from theprevious day’s key price points, as per the following calculations,the resulting support and resistance levels are subsequently derived.R3 (Resistance 3)  Yesterday’s High  2(PP  Yesterday’s Low)R2 (Resistance 2)  PP  (RI  SI)R1 (Resistance 1)  2  PP  Yesterday’s LowPP (Pivot Point)  (Yesterday’s High  Yesterday’s Low Yesterday’s Close)  3S1 (Support 1)  2  PP - Yesterday’s HighS2 (Support 2)  PP  (R1  S1)S3 (Support 3)  Yesterday’s Low  2(Yesterday’s High  PP)
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EXHIBIT 5.11
Pivot Points
Source: FX Solutions – FX AccuCharts
Traders can calculate the current day’s relevant pivot pointsusing these calculations, based upon the previous day’s price data,and then plot the levels using horizontal lines on a currency pricechart. Exhibit 5.11 illustrates the calculated levels plotted on a chart.Once these levels are calculated and plotted, they are used in muchthe same way as Fibonacci retracements. Breakouts or bouncesmay be traded, and they are often also used as profit targets. Tradersalso use pivot points as reference levels to provide guidance as towhether the current price is relatively low or relatively high withinits expected range for the day. If price is near the day’s S2, for example, traders may look for long trading opportunities with the view
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that price should reasonably move towards equilibrium around themain PP level.Both Fibonacci retracements and pivot points are excellent technical tools that often encompass entire trading disciplines in themselves. Mostly based on breakouts or bounces (whether the bounce isup off support or down off resistance), these strategic trading methodologies can also lend very valuable confirmation to other currencytrading strategies. Both known for their large following of adherents,Fibonacci retracements and pivot points are frequently effective forjust that reason—traders actually trade off of these levels. This factalone makes these tools a valuable component of any trader’s technical trading arsenal.
E lliott Wave Trading — Two Steps Forward,One Step BackRelated to Fibonacci Theory, Elliott Wave Theory also claims anenormous following of practitioners. As briefly discussed in Chapter 3,Elliott Wave is named after Ralph Nelson Elliott, who asserted thatprice movement is predictable and can be classified into a series ofidentifiable waves. The basic structure is five waves comprising thetrend movement and three waves comprising the corrective (orcountertrend) movement. Furthermore, within each of these wavesis a smaller sub-wave structure that also adheres to the 5/3 pattern,depending upon whether the wave is with the larger trend or againstit. So the basic 5/3 wave pattern remains intact on every magnitude, from the longest-term to the shortest-term, and each wave
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EXHIBIT 5.12
Comprehensive Elliott Wave StructureElliott Wave Structure(5)(B)(3)(A)(1)5B
(4)
(C)
31
A4
C(2)
2
pattern exists within the context of a larger wave pattern while alsoencompassing many smaller wave patterns. Perhaps the best way tounderstand this principle is through a visual representation. Exhibit5.12 provides an illustration of a comprehensive Elliott Wave structure.There are three primary guidelines of a trend pattern in ElliottWave, according to its founder. Within the context of the 5-wavetrend cycle, as shown in Exhibit 5.12, Wave 2 never moves beyondthe beginning of Wave 1, Wave 3 is never the shortest of the fivewaves, and Wave 4 never enters the price span of Wave 1. Beyondthese strictly observed principles, there are numerous nuances surrounding Elliott Wave theory that are well beyond the scope ofthis book. An explanation of how practitioners view the real-worldimplications of each wave, though, should help illustrate how ElliottWave traders approach the foreign exchange markets.
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IN THE REAL WORLD
Elliott Wave TradingIn practice, trading according to Elliott Wave principles is primarily about identifying market turns, whether those turns are merelyminor retracements within a dominant trend or if they are major market reversals. Within a typical 5-wave dominant trend pattern, eachwave represents a certain market psychology. The same is true ofeach wave within the 3-wave corrective pattern. Following is a description of each wave’s significance within the more readily identifiable 5wave trend. This particular description will depict a dominant UPtrend.The same principles apply, but in reverse, for dominant DOWNtrends.Wave 1: Within the context of a brand new uptrend, the currencypair in question is still considered by the majority of market participants and analysts to be entrenched in the previously prevailing downtrend. Therefore, at the time that the trend reversaloccurs, it can often be extremely difficult to identify the fact thata new trend is indeed beginning. At this point, buying activityis only a trickle, as contrarian traders begin accumulating inexpensively at or near the lows. This initial move within the newuptrend later turns out to be a significant push that becomesprogressively more obvious as the first wave ends.Wave 2: After the initial push in the new direction, this secondwave constitutes, among other actions, profit-taking by thosewho participated in the first wave. This correction should not,however, reach past the beginning of the first wave. Not onlydoes this second wave represent profit-taking, but this corrective move is also partly caused by the many traders who areacting on their belief that the market is still embedded withinthe previous downtrend.Wave 3: This wave usually constitutes the strongest and largestmove within the 5-wave pattern. At the very least, it shouldnever be the shortest. Throughout this wave, traders, analysts,
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IN THE REAL WORLD (CONTINUED)and the media become progressively more bullish and committed to the new trend in the currency pair. By the end of thisthird wave, a buying frenzy among the masses may have developed, generally pushing the pair to new heights in a swift andsteep manner. This wave should extend well past the end ofthe first wave.Wave 4: Representing a corrective pullback move before the finalpush, this wave is generally not as strong as the other waves,and often tends to move in a sideways, consolidative fashion.Many Elliott Wave practitioners consider the end of this wave asan ideal place to enter a position on a pullback (or “dip”). Thistrade setup would be a long trade, in the direction of both thefinal wave and the dominant trend. One primary rule is that thiswave should never enter the price region of the first wave.Wave 5: This is the final push in the direction of the maintrend. At this point, bullish sentiment on the currency pairis approaching a peak. Analysts, traders, and the media aregenerally extremely positive, fueling even more buying activity.During the middle of this wave, novice traders get carried awaywith all of this bullishness and begin joining the buying crowdat this late stage, if they have not done so already. Duringthis last wave, only contrarians quietly begin to take profitson their long positions and start to short-sell. This processgains momentum to culminate in a peak high, and ultimatelythe beginnings of a corrective 3-wave pattern.
Elliott Wave trading is one of the more difficult strategies tomaster, as it requires a great deal of practice and experience in orderto be able to identify waves effectively under different market conditions. As many professional Elliott Wave traders will agree, however, learning to trade these waves can potentially be very rewarding.169
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D ivergence Trading — Separate PathsAlso an effective analytical tool if used in the correct manner, priceoscillator divergences have long been acknowledged by technicaltraders and analysts as a solid indicator of potential impending pricereversals. Of course, by no means should it be inferred in any way thatdivergences will always predict a reversal, or even that they are correcta majority of the time. But well-defined price-oscillator divergences,especially on longer-term charts, can be surprisingly accurate in manyinstances. Furthermore, catching a major price reversal at the correcttime can be so potentially profitable that only a few accurate divergences are needed to offset the inevitable false signals.Price-oscillator divergence can be spotted with just two elementson a price chart. The first element is price, while the second element isan oscillator that runs either above or below price.This second elementcould be Stochastics, RSI, MACD or any similar oscillator as describedin Chapter 3. A divergence occurs when there is an imbalance betweenthe price element and the oscillator element. They begin to go separate ways and start telling opposite stories. This is when the oscillator isproviding a strong hint that price may be losing its current momentum,and a change in price direction may therefore be impending.So, for example, bearish divergence (which hints at an impending reversal back down) occurs when price hits a higher high whilethe oscillator hits a corresponding lower high. Exhibit 5.13 displaysa typical instance of bearish divergence.The indication after a clear bearish divergence signal is thatprice may soon turn and go back down as the higher high in priceloses its upward momentum and begins falling.
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EXHIBIT 5.13
Bearish Divergence
Source: FX Solutions – FX AccuCharts
Bullish divergence (which hints at an impending reversal backup) occurs when price hits a lower low while the oscillator hits acorresponding higher low. Exhibit 5.14 displays a typical instance ofbullish divergence.The indication after a clear bullish divergence signal is that pricemay soon turn and go back up as the lower low in price loses itsdownward momentum and begins rising.Divergences are often used as hints, or early indications, of possible turns and reversals. Much less often are they employed exclusively as a full-fledged, self-sufficient trading strategy. But used in
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EXHIBIT 5.14
Bullish Divergence
Source: FX Solutions – FX AccuCharts
conjunction with other trading tools, divergences can often be aremarkably effective method for helping to time major market turns.
M ultiple Timeframe Trading — Timing IsEverythingA trading method used very extensively by many foreign exchangetraders involves the use of multiple timeframes. To trade in thismanner, a trader might first look at a long-term timeframe like amonthly or weekly chart to determine the overall direction of thetrend, if any. If a decisive long-term trend is in place, the tradershould only trade in this direction.
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Then, the trader may drill down to a shorter timeframe like thedaily or 4-hour chart to look for dips, or pullbacks, in the trend.As mentioned in the section on trend trading, these are countertrend moves that provide an advantageous location to enter in thedirection of the trend. For example, in a strong long-term uptrend,a minor downward retracement would represent a potential highprobability entry to get in on the trend at a good price.Finally, the trader may drill down even further to an even shortertimeframe like the 30-minute or 15-minute chart to pinpoint and timeexact entries. For example, if a retracement in an uptrend is identifiedon the 4-hour chart, the trader could go down to the 15-minute chartto wait for a resistance breakout in the direction of the trend beforefinally entering into a long position.What makes multiple timeframe trading so powerful is that it putstraders on the right side of the market while also pinpointing the highest probability entries available. Perhaps the best manifestation of multiple timeframe trading can be found in Dr. Alexander Elder’s TripleScreen, as described in the following Tips & Techniques section.
TIPS AND TECHNIQUES
The Triple ScreenDr. Alexander Elder, a psychiatrist by trade and an expert in technical analysis, is one of the world’s foremost authorities on trading.Among other prominent books, Elder wrote the international bestselling classic, Trading for a Living, and the comprehensive tradingtome, Come Into My Trading Room: A Complete Guide to Trading.
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TIPS AND TECHNIQUES (CONTINUED)In both of these classics, he writes about one of his mostwell-known trading strategies based upon the multiple timeframeapproach. It is called the “Triple Screen.”In Come Into My Trading Room: A Complete Guide to Trading(John Wiley & Sons, 2002), Elder writes,“Triple Screen resolves contradictions between indicators and timeframes. It reaches strategic decisions onlong-term charts, using trend-following indicators—this isthe first screen. It proceeds to make tactical decisionsabout entries and exits on the intermediate charts, usingoscillators—this is the second screen.