Chapter 11

Cutting the Fog with Technical Analysis

In This Chapter

Understanding what technical analysis is and isn’t

Identifying support and resistance

Using momentum the right way

Spotting important chart patterns

Saying that there is a lot of information to absorb in the forex market is an understatement of major proportions. To help make sense of all the information, a lot of which can be just noise — the fog of the market — professional traders focus on the one piece of information that is not subject to dispute or opinion: price.

The field of technical analysis is huge, and there’s no way we can cover it in its entirety in this single chapter. Literally hundreds of books have been written on technical analysis in general, as well as on specific approaches (such as the Elliott wave principle or candlestick analysis). In Chapter 19, we suggest several of our favorite books on technical analysis as additional reading. We strongly urge you to supplement the material in this chapter with further in-depth study.

In this chapter, we give you as rich a slice of the technical cake as possible, covering the main elements of technical analysis as they apply to the forex market. What’s more, we approach it from a trader’s perspective, focusing on the technical tools and approaches that we’ve found most useful in our own currency trading, as well as what it means for trade strategies and spotting trade setups. That approach may get us in trouble with some technical purists out there, but, hey, that’s what makes a market — a difference of opinion.

The Philosophy of Technical Analysis

Calling technical analysis a philosophy is probably a bit of a stretch, but plenty of technical traders are almost cultish in their devotion to it. More than anything, technical analysis is a subjective approach aimed at bringing a sense of order to seemingly random price movements.

Traders use technical analysis to identify trade opportunities, refine their trading strategies (entry and exit levels), and manage their market risk.

Personally, we like to use fundamentals to guide our overall view of market direction, and refine that with technical analysis to identify entry and exit points for specific trades. But not infrequently, technical analysis will suggest a trade opportunity all by itself, even though it may be counter to our fundamental outlook (see the Tips in the “Candlestick patterns” section later in this chapter for more).

What is technical analysis?

In a nutshell, technical analysis is the study of historical price movements to predict future price movements. You’re probably familiar with the standard disclaimer that “past performance is no guarantee of future results,” a statement that tends to call into question the validity of using past price data to forecast future price developments.

But technical analysis is able to get beyond those concerns based on two main considerations:

• Markets are made up of humans. Human psychology and investing behavior haven’t changed very much over the years, whether it’s the Dutch tulip frenzy of the 1600s, the dot-com bubble of the 1990s, or the real estate bubbles of the last decade. The emotional forces that dictate buying and selling decisions are reflected in historical price patterns that appear over and over in all manner of financial markets. As long as humans are still making the decisions (or are writing the programs for the computers that make the decisions), you’ll be able to look at past behavior as a guide to what is likely to happen in the future.
• Technical analysis is widely practiced in all markets. This is the self-fulfilling-prophecy aspect of technical analysis. The greater the number of traders who focus on technical analysis, the more likely their actions will reflect the interpretations of technical analysis, reinforcing the impact of that analysis. Believe us when we say that professional currency traders who do not practice some form of technical analysis are a rarity.

What technical analysis is not

Despite its name, technical analysis is not some engineer-designed, surefire, guaranteed method of market analysis. There are no such methods, period. Technical analysis involves a high degree of subjectivity where individual interpretations can vary significantly. Two technical traders looking at the same currency chart could reach opposite conclusions about the course of future prices. What’s more, they could both be right, depending on their timing and specific strategies.

Technical analysis requires a great deal of patience, practice, and experimentation based on individual preferences and circumstances. Short-term traders focusing on the next few minutes and hours find certain tools and approaches more helpful than long-term traders do. Longer-term traders looking at multiday or multiweek trades use other tools and indicators entirely. Certain technical approaches work better in some currency pairs than others. Overall market conditions of volatility and liquidity also influence which technical approach works best. The key is to develop your own approach based on your particular circumstances — time frame, risk appetite, discipline (see Chapter 10 for more on this).

No single, magical technical indicator or approach always works. Be careful about becoming too reliant on any single indicator. A particular indicator may yield excellent signals in certain market environments but fail when market conditions begin to change. We suggest becoming familiar with several different approaches and indicators, using them to cross-check each other depending on market conditions. (We look at this idea in the “Waiting for confirmation” section, later in this chapter.)

Forms of technical analysis

Technical analysis can be broken down into three main approaches:

• Chart analysis: Visual inspection of price charts to identify price trends, ranges, support, and resistance levels. (We look at chart analysis in “The Art of Technical Analysis,” later in this chapter.)
• Pattern recognition: Identifies chart formations or patterns that provide specific predictive signals, such as a reversal or a breakout. (We show you some of the most common traditional chart patterns and candlestick formations in the “Recognizing chart formations” section, later in this chapter.)
• Momentum and trend analysis: Looks at the rate of change of prices for indications of market sentiment regarding the price movement. Trend indicators seek to determine the presence of a trend and its strength. (We look at these indicators in “The Science of Technical Analysis,” later in this chapter.)

Finding support and resistance

One of the basic building blocks of technical analysis is the concept of support and resistance:

• Support: A price level where buying interest overwhelms selling interest, causing a price decline to stop, bottom out, or pause. Think of support as a floor for prices in a downmove.
• Resistance: The opposite of support. Resistance is where selling interest materializes and slows or overpowers buying interest, causing prices to peak, stall, or pause in a price rally. Think of resistance as the ceiling in a price advance.

Support and resistance levels are identified based on prior price action, such as highs and lows and short-term (minutes to hours) consolidation or congestion zones (where prices get all stopped up and can’t move one way or the other for a period of time). Support and resistance can also be determined by drawing trend lines. Still other forms of support and resistance come from Fibonacci retracement levels, Ichimoku lines, and moving averages, which we save for later in this chapter. Figure 11-1 shows some basic support and resistance levels from sloping and horizontal trend lines drawn off key highs and lows.

One of the key concepts of support and resistance is that after a support or resistance level is broken, it shifts direction. In other words, after a support level is broken in a move to the downside, it becomes resistance in subsequent price attempts to rally. After a resistance level is broken to the upside, it may later act as support for further price gains.

Not all support and resistance are created equal

Support and resistance come in all shapes and sizes. Some support or resistance levels are stronger or weaker than others, and technical analysts typically refer to support as either minor or major. But those terms are subjective and difficult to quantify with any precision.

The best way to get a handle on the relative strength of a support or resistance level is to view it in the context of time and price significance.

• The longer the time frame of the price point, the greater its significance. A weekly high/low is more important than a daily high/low, which is more important than an hourly high/low, and so on, down the time scale.
• Trend-line strength is also a function of time frame and durability. A trend line based on daily charts tends to be stronger than a trend line based on hourly prices. A trend line that dates back six months has greater significance than one that’s only a week or two old. Also, the more often a trend line is tested (meaning, prices touch the trend line but do not break through it, or break through it only very briefly and by small amounts), the more valid it is.
• The strength of support or resistance levels during a retracement depends on the strength of the support or resistance during the prior directional move. A retracement refers to a price movement in the opposite direction of a previous price advance or decline. The distance that prices reverse, or retrace, is called a retracement. For example, trend lines that were support in a downmove will act as resistance in any retracement higher. The strength of the trend-line support on the way down, such as how many attempts were needed to break below it, will give a good indication of its likely strength as resistance in the retracement.

Support and resistance are made to be broken

We don’t want to leave you with the impression that support and resistance levels are immutable forces in the market that are never challenged or broken. Just the opposite: Forex markets spend much of the time testing support or resistance levels, looking for the weak side in which to push prices.

Different trading styles focus on different types of support and resistance:

• Tests and breaks of short-term support or resistance levels are the meat and potatoes of intraday trading. Short-term traders focus on the nearest support or resistance levels (for example, 5- or 15-minute or hourly highs/lows and trend lines) as guides to the immediate direction of prices.
• Tests and breaks of longer-term support and resistance levels are the fuel that fires longer-term trends or defines medium-term ranges. Medium- to longer-term traders typically focus on longer-term support or resistance levels, such as daily/weekly highs/lows, and trend lines drawn off them, to guide their trading.

One of the keys to assessing the significance of a break of support or resistance levels is the strength of follow-through that occurs after the level is broken. Follow-through is the price action that takes place after technical support or resistance is broken. After resistance is broken, for example, prices should accelerate higher as shorts who sold in front of the resistance buy back their positions and new buyers enter the market, because resistance has been surpassed. The amount of follow-through buying or selling that materializes, or fails to materialize, after the break of a technical support or resistance level is an important indication of the strength of the underlying move.

Waiting for confirmation

We were tempted to title this section “Looking for confirmation,” but we thought that sounded too proactive in the sense that if you go looking for something on a chart, odds are you can find it and rationalize it as confirmation. The more disciplined approach involves waiting for confirmation, letting market prices provide you with unambiguous signs of a change in direction or break of a chart pattern.

Confirmation refers to price movements that verify, or confirm, a technical observation that suggests a particular outcome. For example, certain chart patterns are useful predictors of a potential reversal in price direction. But note that the starting point in this case is that prices are moving in a trend or steady direction. Blindly following a pattern that suggests that a trend is about to end is very risky. After all, the trend is your friend, so why would you take the risk of going against the trend?

If you’re patient and wait for price action to provide you with confirmation that a directional move or trend is indeed reversing, essentially confirming that the observed chart pattern is playing out as you expected, you’re reducing the risks of being wrong-sided or premature in your trade. The trade-off is that you may sacrifice a better entry level for a higher degree of certainty in the overall trade setup. Looked at the other way around, you’re reducing the risks of getting into a trade setup too soon and being wrong if the setup doesn’t play out as you expected. The difference is not making as much money as possible or losing money outright. Which would you prefer?

Technical-based observations provide you with a heads-up alert that a price shift may soon take place — for example, prices may be stalling in a move higher, potentially setting up a reversal lower. Confirmation comes when prices break an established trend line, prior high or low, or other key technical levels of support or resistance. Be careful about looking for confirmation from multiple technical indicators, because they may be measuring the same thing, just in slightly different formats. Price is the key element of confirmation.

The Art of Technical Analysis

Chart analysis is at the heart of technical analysis. Don’t become reliant on all the fancy indicators and technical studies on your charting system. The most powerful technical indicators you have are your eyes and what’s behind them.

In this section, we show you the basics of drawing trend lines and look at some of the most common, yet significant, price patterns you’ll encounter over and over again in your trading. In Chapter 12, we go into greater detail and suggest practical approaches to drawing and applying trend lines on a regular basis, as well as how to trade the chart formations you observe.

Bar charts and candlestick charts

In this section, we introduce the two main types of charts you’ll likely be using as you pursue your own technical analysis.

Measuring markets with price bars

Most charting systems are set to default to show bar charts, probably the most widely used form of charting among Western traders. Bar charts are composed of price bars, which encompass the key points of each trading period — namely, the open, high, low, and close. A period is the time interval you’ve selected to analyze, such as 5 or 15 minutes for short-term traders, and 1 hour, 4 hours daily, or weekly for longer-term traders (though short-term traders need to be aware of the longer periods, too). Each bar is displayed as a vertical line with a tick mark on each side of the bar. The tick mark on the left side of the price bar represents the open of the period; the tick mark on the right side is the close of the period; and the upper and lower levels of the bar are the period’s highs and lows. For example, Figure 11-1 is a bar chart.

You can use bar charts to draw trend lines, measure retracement levels, and gauge overall price volatility. Each bar represents the trading range for the period; the larger the bar, the greater the range and the higher the volatility (and vice versa for smaller bars). Bar charts are best suited to relatively basic analysis, such as getting a handle on an overall trend.

Lighting the way with candlesticks

We put our favoritism right out front for everyone to see: We love using candlestick charts to spot trade setups, especially impending price reversals. We think candlesticks are among the more powerful predictive tools in the trader’s arsenal, and we strongly recommend that you study them further. In particular, we highly recommend reading Steve Nison’s Japanese Candlestick Charting Techniques, 2nd Edition (see Chapter 19 for more on Nison’s book).

Candlestick charts are among the earliest known forms of technical analysis, dating back to trading in the Japanese rice markets in the 18th century. Candlestick charts, or just candles for short, provide a more visually intuitive representation of price action than you get from simple bar charts. They do this through the use of color and by more clearly breaking out the key price points of each trading day — open, close, high, and low.

Figure 11-2 shows the components of two candlesticks. Immediately, you can see that one candle is light, and the other is dark. What does that mean? Think of yin and yang, good and bad, up and down. The light candlestick indicates that the close was higher than the open — it was an up day. The dark candle indicates that the close was lower than the open — a down day.

The light/dark portion in the middle of the candle is called the real body or just body; it displays the difference between the open and the close. The lines above and below the body are called tails (the term we use going forward), shadows, or wicks; these lines represent the high and low of the period. (We look more at candlesticks in the “Candlestick patterns” section, later in this chapter.)

Candlestick charts are best analyzed using daily or weekly periods rather than intraday periods like 1 hour or 30 minutes. The philosophy behind candlestick analysis is that a full day or week of trading is needed before the market has rendered a verdict, potentially offering signals about future direction.

Drawing trend lines

Probably no exercise in technical analysis is more individualistic than identifying and drawing trend lines. Very often, it comes down to a matter of beauty being in the eye of the beholder. But in the case of chart analysis, beauty is order, and the trend lines you draw are the outlines of that order. Ultimately, drawing trend lines is not that complicated — with a bit of practice, you’ll get the hang of it pretty quickly.

What is a trend line? Basically, a trend line is a line that connects significant price points over a defined time period on a price chart. The significant price points are usually the highs and lows of bars or candles, though in the case of candles you can also use the open or close levels of the candle’s real body.

Connecting the dots

The starting point in drawing trend lines is looking at the overall price chart in front of you. What do you see? If it’s your first time looking at a price chart, it probably looks like a jumble of meaningless bars or candles. The key is to turn that jumble into a meaningful visualization of what’s happening to prices. (We offer several graphical representations of trend lines throughout Chapter 12.)

Scan the chart from left to right, starting in the past and looking into the present. What are prices doing? Are they moving up, down, or a little of both? (If you’re looking at a currency chart, you can bet they’re doing a little bit of both.) Draw your first trend lines to connect the highest highs (you need only two points to form a line) and the lowest lows, to capture the overall range in the observed period. Always use the extreme points of the price bars or candles when connecting price points (lows with lows, highs with highs).

Look at what’s happening between those two trend lines. You’ll invariably see a number of smaller, distinct price movements making up the whole. You can draw trend lines to connect the highs of price moves down and the lows of price moves up. Be sure to extend your trend lines all the way to the right edge of the chart, regardless of other bars or candles that later break it. Look for evenness, whether it’s horizontal, sloping down, shooting steeply higher, or anything in between. Eventually, that evenness will be broken by price moves that break through the trend lines.

Your ultimate focus will be on the prices on the right side of the chart, because that’s the most recent price action, and beyond lies future price developments. The idea is to winnow out trend lines from the past that appear to have little relevance (they’re frequently broken), and keep the trend lines that have the most relevance (prices reverse course when they’re hit, and they’re largely unbroken) and extend them into the future. Those trend lines are going to act as support and resistance just as they did in the past and provide you with guidance going forward.

Looking for symmetry

When you’re drawing trend lines, be alert for symmetrical patterns, such as parallel channels, sloping up or down, or simply horizontal. Look for horizontal tops and bottoms to be made where prior high and lows were reached. Note that a rising trend line may be heading for a falling trend line, forming a triangle. The two lines are set to intersect at some point in the future, and one of them will be broken, sparking a price reaction.

Charting systems usually have a trend-line function that allows you to draw a line parallel to another line, or copy an existing line and move it to a parallel position. Experiment with that tool, and you’ll be surprised how frequently price points match up to it.

Recognizing chart formations

Pattern recognition, or the identification of chart formations, is another form of technical analysis that helps traders get a handle on what’s happening in the market. In the following sections, we cover some of the most widely observed chart formations and what they mean from a trading standpoint. While you’re looking through them, keep in mind that the formations can occur in different charting time frames (for example, 15 minutes, hourly, daily).

The key to trading on chart formations is to recognize the time period in which they’re apparent and to factor that into your trade strategy. A reversal pattern that occurs on an hourly chart, for example, may constitute a reversal that lasts for only a few hours or a day and retrace a relatively smaller pip distance. A reversal pattern on a daily chart, in contrast, could signal a significant multiweek reversal spanning several hundred pips. Keep the formations you observe in the proper time-frame perspective.

Basic chart formations

Chart formations are part and parcel of trends. They’re generally grouped into categories that reflect what they mean in the context of a trend. The two most common types of chart patterns are

• Reversal patterns: A reversal pattern indicates that the prior directional price movement is coming to an end. It does not necessarily mean that prices will actually begin to move in the opposite direction, though in many cases they will.
• Consolidation and continuation patterns: Consolidation and continuation patterns represent pauses in directional price moves, where prices undergo a period of back-and-forth consolidation before the overall trend continues.

Double tops and double bottoms

Double tops and double bottoms are typically considered among the most powerful chart formations indicating a reversal in the direction of an overall trend. Double tops form in an uptrend, and double bottoms form in a downtrend. Figure 11-3 shows a double-bottom pattern on a daily AUD/USD chart, and Figure 11-1 shows a double top on a four-hour AUD/USD chart (not labeled, but you can see the two highs).

In terms of market dynamics, the idea behind both is that a directional move (up or down) will make a high or low at some point. After a period of consolidation, the market will frequently test the prior high or low for the trend. If the trend is still intact, the market should be able to make a new high or low beyond the prior one. But if the market is unable to surpass the prior high or low, it’s taken as a signal that the trend is over, and trend followers begin to exit, generating the reversal.

As with most chart formations, double tops and bottoms rarely form perfectly. The second high or low may come up short of the prior high/low; that inability even to retest the prior high/low can create a more rapid and volatile reversal. Other times, the first low may be surpassed by a brief amount and for a brief time (possibly due to stops at the prior low being triggered), as in Figure 10-3, only to be rejected, leading to the reversal.

Head and shoulders and inverted head and shoulders

Head-and-shoulders (H&S) formations are another form of reversal pattern, sometimes referred to as a triple top. The H&S top formation develops after an uptrend, and an inverted H&S comes after a downtrend. Figure 11-4 shows a classic example of an inverted H&S formation, signaling the end of the EUR’s decline after the Eurozone debt crisis. In the case of an uptrend, a high is made at some stage followed by a pullback lower, creating the left shoulder. A subsequent new high is made, generating the head, followed by yet another correction lower. A third attempt to move higher fails to reach the second or highest high and may surpass, equal, or fall short of the left shoulder. Failure to reach the prior high typically triggers selling, and confirmation of a reversal is received when prices fall below the neckline, which is formed by connecting the lows seen after each pullback from the shoulder and the head.

The standard measured move objective (the price move suggested by a chart pattern) in an H&S pattern is the distance from the top of the head to the neckline. When the neckline is broken, prices should subsequently move that distance.

Flags

Flags are consolidation patterns that typically form in a counter-trend direction. For example, if prices have moved higher (the trend is up) and run into resistance above, for a flag to form, prices will begin to consolidate in a downward (counter-trend) channel. The formation suggests that the flag consolidation channel will eventually break out in the direction of the prior trend, and the directional move will resume. Perhaps somewhat confusingly, a bull flag actually slopes downward, but it’s called a bull flag because after it breaks, the bullish trend resumes. A bear flag slopes upward, but after it breaks to the downside, the bearish trend resumes.

If the opposite side of the flag channel is broken (the lower end of a bull flag/upper end of a bear flag), the pattern is invalidated and it may signal a larger reversal.

Flags have a measured move objective based on the flagpole, or the distance of the prior move that ultimately stalled, resulting in the formation of the flag. When the flag is broken, the price target is usually equal to the length of the flagpole projected from the flag break, as shown in Figure 11-5.

Triangles

Triangles are another type of consolidation pattern, and they come in a few different forms:

• Symmetrical triangles: These formations have downward-sloping upper edges and upward-sloping lower edges, resulting in a triangle pointing horizontally. Symmetrical triangles are mostly neutral for the direction of the ultimate breakout, but they have a slightly greater tendency to break out in the direction in which they entered the triangle consolidation, meaning the trend is resuming.
• Ascending triangles: These formations have a flat or horizontal top and an upward-sloping lower edge (see Figure 11-6). Ascending triangles typically break out to the upside after resistance on the top is overcome. The rising lower edge signifies that buyers keep coming back at ever-higher levels to push through the horizontal top. The minimum measured move objective on a breakout is equal to the distance between the rising bottom and where the flat top is first reached.
• Descending triangles: These formations are the inverse of ascending triangles, where the horizontal edge and the expected direction of the breakout are to the downside.

Candlestick patterns

Candlestick patterns are some of the most powerful predictors of future price direction. Candlesticks have little predictive capacity when it comes to the size of future price movements, so you need to look at other forms of technical analysis to gauge the extent of subsequent price moves. But if you can get the direction right, you’re more than halfway there. (We look more at using candles to develop trade strategies in Chapter 12.)

Candlestick formations come in two main forms:

• Reversal patterns: Where a preceding directional move stops and changes direction
• Continuation patterns: Where a prior directional move resumes its course after a period of consolidation

We like to look at candlestick patterns primarily for reversal signals because they’re among the most reliable of the candlestick patterns.

The key to interpreting a candle formation as a reversal indicator is that there has to be an identifiable directional move in the preceding days. The directional price move may be part of an extended uptrend or downtrend, or simply a day or two of a clear directional move higher or lower, as shown by relatively large real bodies.

Literally dozens of different candlestick reversal patterns exist, but we focus on the most common patterns in the following sections. Keep in mind that some candle reversal formations consist of a single candle, whereas others depend on two or three candles to constitute the pattern. Look closely, and you’ll see that many of them are variations on the same theme (namely that a directional move is losing force, increasing the potential for a price reversal). A good source of candlestick reference can be found for free at www.candlesticker.com.

Doji

Doji are among the most significant of the candlestick patterns because their basic shape forms the basis for many other candlestick patterns. A doji occurs when the close is the same as the open, generating a candlestick with no real body — simply a vertical line with a cross on it.

On days when the close is only a few points apart from the open, generating a candle with an extremely small real body, you can take some artistic license and consider it a potential doji depending on the preceding candles. If the prior days’ candles were composed of long real bodies, that increases the likelihood that the very small real body should be viewed as a doji (or a spinning top, which we cover later in this section). Figure 11-7 is a good example of this — the open and close were only 5 pips apart. Whenever you spot a doji after a daily close, you should note it and consider that the preceding directional move may be ending or set for a reversal.

Doji are significant because they represent indecision and uncertainty. When viewing a doji, think of buyers and sellers fighting to a draw. In the case of a preceding decline lower, for example, it signals that sellers are losing power and buyers have emerged. Figure 11-7 shows a classic doji, where the open and close are the same and about in the middle of the day’s trading range. The longer the upper and lower tails are in a doji, the greater the sense of uncertainty displayed by the market and the more likely the prior trend is to be ending.

A double doji occurs when two doji appear in successive periods. The increased uncertainty associated with a double doji tends to signal that the subsequent price move will be more significant after the market’s indecision is resolved. A long-legged doji, one with larger tails, is another indication that the market’s uncertainty may resolve with a more pronounced move.

On its own, a doji is considered neutral. You need to wait for subsequent price action, such as a trend-line break, to confirm that the doji is signaling a reversal.

Hammers and shooting stars

Hammers and shooting stars are single-candle formations that indicate a reversal may be in store. Hammers appear after a decline and are notable for a long lower tail (at least twice the height of the real body) and a small real body at the upper end of the candle (akin to a doji or spinning top). A shooting star is the mirror image after a move higher — a long upper tail and a small real body at the bottom of the day’s range. The color of the candle can be either light or dark. In both cases the market dynamic is the same: After a price rise, in the case of a shooting star, buyers attempted to extend the advance, but by the end of the day were beaten back by sellers, and vice versa with hammers.

The size of the tails is an important indication of the strength of the signal — the larger the tail, the greater the opposing force to the prior move and the more likely prices are to reverse course. Figure 11-8 shows a shooting star signaling recent gains may be set to reverse. (See Figure 11-10 for a hammer as part of another candle pattern.)

Hammers and shooting stars are one of our major alerts for price reversals. They’re a signal to exit or at least reduce positions in the direction of the prior trend, and a good basis to establish a position in the opposite direction. If the high of a shooting star or the low of a hammer is exceeded, then the signal is negated and you have to get out. (See more in Chapter 12 for trading tactics using candles.)

Spinning tops

A spinning top (see Figure 11-9) is a single-candle formation that has a small real body and typically short tails, sort of like a fatter version of a doji, but with larger tails. (Larger tails may signify a greater potential price move; however, the size of the tails is secondary.) The formation gets its name because it resembles a child’s toy top. A spinning top frequently appears in pairs, similar to a double doji. The significance of a spinning top is that it has a small real body, which represents a drop in directional momentum after a series of up or down candles, which may signal a directional move is stalling and is ripe for a correction. Spinning tops require confirmation by subsequent candles, but be on alert for potential reversals if you spot a spinning top.

Engulfing lines

Engulfing lines are two-candlestick patterns that can be either bullish or bearish, depending on whether they come after a downmove or an upmove:

• Bullish engulfing line: The first candle is dark, followed by a large light candle, the body of which completely engulfs the body of the dark candle, seen in Figure 11-8. The smaller the body of the first candle (think spinning top — see the preceding section), the more significant the reversal signals.
• Bearish engulfing line: The first candle is light, followed by a long dark-colored candle that engulfs the body of the first candle, as shown in Figure 11-10 as part of another candle pattern.

Engulfing lines also rank among our favorite candlestick patterns and are a sufficient basis to establish a position in the opposite direction of the preceding price move. If the high/low of the candle preceding the engulfing candle is exceeded, the pattern is negated and you need to exit.

Tweezer tops and tweezer bottoms

Tweezers formations are two-candlestick patterns that get their name because they resemble the pincer end of a pair of tweezers. Tweezer tops and bottoms (shown in Figure 11-10) correspond to double tops and bottoms in traditional chart analysis, and they mean the same thing — a reversal after failing to make new highs or lows. Tweezer tops and bottoms are characterized by long tails on the bottom after a move down, similar to a hammer, and long tails above after a move higher, like shooting stars. The extremes of the tails should ideally be equal, but if the tails are sufficiently long, we’d take notice.

Hopefully you noticed that many of the candlestick patterns we discuss have two things in common — long tails and small bodies. As part of your technical analysis routine (see Chapter 12), we strongly suggest reviewing daily candle charts after each day’s close (5 p.m. ET), and on the weekends for weekly candles, to see if any patterns are evident. They can be powerful signals about where prices are heading in the next trading day or week.

Fibonacci retracements

A retracement is a price movement in the opposite direction of the preceding price move. For instance, if EUR/USD rises by 150 pips over the course of two days and declines by 75 pips on the third day, prices are said to have retraced half the move higher, or made a 50 percent retracement of the move up. (Fifty percent is not technically a Fibonacci retracement, but we include it here because many traders watch it, too, because of its clean, halfway demarcation.)

Fibonacci retracements come from the ratios between the numbers in the Fibonacci sequence, a nearly magical numerical series that appears in the natural world and mathematics with regularity. The most important Fibonacci retracement percentages are 38.2 percent and 61.8 percent, with 76.4 percent as a secondary, but still important, level.

Most charting systems contain an automatic Fibonacci retracement drawing tool. All you need to do is click the starting point of a directional price move (the low for an upmove; the high for a downmove) and drag the cursor to the finishing point of the movement. The charting system will then display lines that correspond to 38.2 percent, 50 percent, 61.8 percent, 76.4 percent, and 100 percent.

Currency traders routinely calculate Fibonacci retracement levels to determine support and resistance levels, and Fibonacci retracement levels are strong examples of self-fulfilling prophecies in technical analysis. Figure 11-11 provides a good illustration of how Fibonacci retracement levels can act as resistance in a correction higher following a price decline. You can see the 38.2 percent retracement level put up a pretty good fight for a while, but after it broke above, prices blew right past the 50 percent point and quickly moved to the 61.8 percent level, even exceeding it briefly before a pullback. That pullback was nicely contained by the 38.2 percent level. Prices went on to surpass the 61.8 percent level and then tested 76.4 percent, which also held for a time and sent prices back to the 61.8 percent point. From there they rallied higher and finally broke the 76.4 percent level, setting up potential for a 100 percent retracement of the prior decline.

The Science of Technical Analysis

Relax. Nothing is especially scientific or particularly complicated about technical analysis. Many in the market use the term science to describe the mechanics of various technical tools, but in our opinion technical analysis is far more art than science.

Each tool in technical analysis has a number of concrete elements that we need to outline before you can start interpreting what they mean. Unless you’re developing your own systematic trading model, you don’t need to get too caught up in the math or the calculations behind various indicators. Far more important is understanding what the indicators are measuring and what their signals mean and don’t mean.

Momentum oscillators and studies

Momentum refers to the speed at which prices are moving, either up or down. Momentum is an important technical measurement of the strength of the buying or selling interest behind a movement in prices. The higher the momentum in a downmove, for example, the greater the selling interest is thought to be. The slower the momentum, the weaker the selling interest.

Currency traders use momentum indicators to gauge whether a price movement will be sustained, potentially developing into a trend, or whether a directional move has run its course and is now more likely to reverse direction. If momentum is positive and rising, it means prices are advancing, suggesting that active buying is taking place. If momentum begins to slow, it means prices are advancing more slowly, suggesting that buying interest is beginning to weaken. If buying interest is drying up, selling interest may increase.

Momentum takes on added significance in currencies because there’s no viable way of assessing trading volume on a real-time basis. In stock and futures markets, volume data is an important indicator of the significance of a price move. For example, a sharp price movement on high volume is considered legitimate and likely to be sustained, while a similarly sharp move on low volume is discounted and viewed as more likely to reverse.

Momentum indicators fall into a group of technical studies known as oscillators, because the mathematical representations of momentum are plotted on a scale that sees momentum rise and fall, or oscillate, depending on the relative speed of the price movements. A variety of different momentum oscillators exist, each calculated by various formulas, but they’re all based on the relationship of the current price to preceding prices over a defined period of time.

Momentum oscillators are typically displayed in a small window at the bottom of charting systems, with the price chart displayed above, so you can readily compare the price action with its underlying momentum.

Overbought and oversold

Momentum oscillators have extreme levels at the upper and lower ends of the oscillator’s scale, where the upper level is referred to as overbought and the lower level is referred to oversold. No hard definitions of overbought and oversold exist, because they’re relative terms describing how fast prices have changed relative to prior price changes. The best way to think of overbought and oversold is that prices have gone up or down too fast relative to prior periods.

Many momentum indicators suggest trading rules based on the indicator reaching overbought or oversold levels. For example, if a momentum study enters overbought or oversold territory, and subsequently turns down or up and moves out of the overbought or oversold zone, it may be considered a sell or buy signal.

Just because a momentum indicator has reached an overbought or oversold level does not mean that prices have to reverse direction. After all, the essence of a trend is a sustained directional price movement, which could see momentum remain in overbought or oversold territory for a long period of time as prices continue to advance or decline in the trend. Breaking news or data may be behind the price move, lending a fundamental urgency to price adjustments that defy momentum analysis. Momentum is only an indicator. The key is to wait for confirmation from prices that the prior direction or trend has, in fact, changed.

Divergences between price and momentum

Another useful way to interpret momentum indicators is by comparing them to corresponding price changes. In most cases, momentum studies and price changes should move in the same direction. If prices are rising, for example, you would expect to see momentum indicators rising as well. By the same token, if momentum begins to stall and eventually turn down, you would expect to see prices turn lower, too. But relatively frequently, especially in shorter, intraday time frames (15 minutes, 1 hour, or 4 hours), prices diverge from momentum (meaning, prices may continue to rise even though momentum has started to move lower).

When prices move in the opposite direction of momentum, it’s called a divergence. Divergences are relatively easy to spot — new price highs are not matched by new highs in the momentum indicator, or new price lows are not matched by new lows in the momentum study. When a new price high or low is made, and momentum fails to make a similar new high or low, the price action is not confirmed by the momentum, suggesting that the price move is false and will not be sustained. The expectation, then, is that the price will change direction and eventually follow the momentum.

When prices make new highs, and momentum is falling or not making new highs, it’s called a bearish divergence (meaning, prices are expected to shift lower — move bearishly — in line with the underlying momentum). When prices are making new lows, but momentum is rising or not making new lows, it’s called a bullish divergence (meaning, prices are expected to turn higher — bullish — in line with momentum). (In Chapter 12, we show an example of a bearish divergence.)

Divergences are great alerts that something may be out of kilter between prices and the underlying strength or momentum of the price move. Whenever you spot a divergence between price and momentum, you should start looking more closely at what’s happening to prices. Are stop-loss levels being run in thin liquidity conditions? Or has some important news just come out that has sent prices moving sharply, and momentum will eventually catch up?

In a trending environment, prices may continue to move in the direction of the trend (that’s what a trend is), but at a slower pace, causing momentum to diverge. To know for certain, you need to wait for confirmation from prices before you enter a trade based on a divergence.

Using momentum in ranges and trends

Momentum indicators work best in range environments, where price movements are relatively constrained and no trend is evident or has moved into consolidation. As buying drives prices toward the upper end of a range, for example, selling interest comes in, slowing the price advance and turning momentum lower. As the buyers turn around, the selling interest increases and momentum begins to accelerate lower, confirming the change in direction. At the bottom of the range, the same thing happens, but in the opposite direction.

Momentum studies frequently give off incorrect signals during breakouts and trending markets. This is especially the case when using shorter time frames, such as hourly and shorter periods. The key to understanding why this happens is to recognize that momentum studies are backward-looking indicators. All they can do is quantify the change in current prices relative to what has come before. They have little predictive capacity, which is why you always need to wait for confirmation from prices before trading based on a momentum signal.

Some of the most extreme price moves typically occur when momentum readings are in overbought or oversold territory. Divergences in shorter time frames also appear frequently, especially during breakouts, where rapid price moves are not reflected quickly enough in momentum studies. By the time the momentum indicator has caught up with the price breakout, prices may already have peaked or bottomed, again causing momentum to signal a divergence. Just because momentum is overbought or oversold doesn’t mean prices can’t continue to move higher or lower.

Here are the main momentum oscillators used by currency traders:

• Relative Strength Index (RSI): A single-line oscillator plotted on a scale from 0 to 100, based on closing prices over a user-defined period. Common RSI periods are 9, 14, and 21. RSI compares the strength of up periods to the weakness of down periods — hence, the label relative strength. RSI readings over 75 are considered overbought; readings below 25 are considered oversold. RSI signals are given when the indicator leaves overbought or oversold territory and on divergences with price.
• Stochastic: A two-line oscillator plotted on a scale of 0 to 100. The two lines are known as %K (fast stochastic) and %D (slow stochastic). Stochastics are also based on closing prices of prior periods. The basic theory behind stochastics is that the strength of a directional move can be measured by how near the close is to the extreme of a period. In an uptrend, a close near the highs for the period signifies strong momentum; a close in the middle or below signals that momentum is weakening. In a downtrend, the close of a period should be nearer to the lows for momentum to strengthen. As momentum shifts, the %K line will cross over the slower-moving %D line. Crossovers in overbought or oversold territory are considered sell or buy signals. Overbought is above 80, and oversold is below 20.
• Moving Average Convergence/Divergence (MACD): Not really a momentum oscillator, but a complex series of moving averages. (It functions similarly to momentum studies, so we include it here.) MACD fluctuates on either side of a zero line and has no fixed scale, so overbought or oversold are judged relative to prior extremes. MACD also consists of two lines: the MACD line (based on two moving averages) and the signal line (a moving average of the MACD line). Trading signals are generated if the MACD line crosses up over the signal line while below the zero line (buy) or crosses down below the signal line while above the zero line (sell). MACD tends to generate signals more slowly than RSI or stochastics due to the longer periods typically used and the slower nature of moving averages. The result is that it takes longer for MACD to cross over, generally preventing fewer false signals.

Trend-identifying indicators

One of the market’s favorite sayings is “The trend is your friend.” The idea is that if you trade in the direction of the prevailing trend, you’re more likely to experience success than if you trade against the trend. Now, how can you argue with logic like that?

The hard part for us mortals is to determine whether there’s a trend in the first place. The question becomes more complex when you look at multiple time frames, because trends can exist in any time frame. On a daily time frame, the market may be largely range bound. But in a shorter time frame, such as hourly or 30 minutes, there may be a trending movement that presents an opportunity for short-term traders.

Determining whether a trend is in place is also important when it comes to deciding whether to follow the signals given by momentum indicators. Momentum studies are great in relatively range-bound markets, but they tend to give off bad signals during trends and breakouts. The key is to determine whether a trend is in place.

In the following sections, we look at a few technical studies you can use to identify whether a trend is in place and how strong it may be.

Directional Movement Indicator system

The Directional Movement Indicator (DMI) system is a set of quantitative tools designed to determine whether a market is trending. The DMI is based on the idea that when a market is trending, each period’s price extremes should exceed the prior price extremes in the direction of the trend. For example, in an uptrend, each successive high should be higher than the prior period’s high. In a downtrend, the opposite is the case: Each new low should be lower than the prior period’s low. That’s the essence of a trend.

The DMI system is comprised of the ADX line (the average directional movement index) and the DI+ and DI– lines (which refer to the directional indicators for up periods [+] and down periods [–]). The ADX is used to determine whether a market is trending (regardless if it’s up or down), with a reading over 25 indicating a trending market and a reading below indicating no trend. The ADX is also a measure of the strength of a trend — the higher the ADX, the stronger the trend. Using the ADX, traders can determine whether a trend is operative and decide whether to use a trend-following system or to rely on momentum oscillator signals.

As its name would suggest, the DMI system is best employed using both components. The DI+ and DI– lines are used as trade-entry signals. A buy signal is generated when the DI+ line crosses up through the DI– line; a sell signal is generated when the DI– line crosses up through the DI+ line. Wilder suggests using the extreme-point rule to govern the DI+/DI– crossover signal. The rule states that when the DI+/DI– lines cross, you should note the extreme point for that period in the direction of the crossover (the high if DI+ crosses up over DI–; the low if DI– crosses up over DI+). If that extreme point is exceeded in the next period, the DI+/DI– crossover is considered a valid trade signal. If the extreme point is not surpassed, the signal is not confirmed.

The ADX can also be used as an early indicator of the end or pause in a trend. When the ADX begins to move lower from its highest level, the trend is either pausing or ending, signaling that it’s time to exit the current position and wait for a fresh signal from the DI+/DI– crossover.

Moving averages

One of the more basic and widely used indicators in technical analysis, moving averages can verify existing trends, identify emerging trends, and generate trading signals. Moving averages are simply an average of prior prices over a user-defined time period displayed as a line overlaid on a price chart. There are two main types of moving averages:

• Simple moving average gives equal weight to each historical price point over the specified period.
• Exponential moving average gives greater weight to more recent price data, with the aim of capturing directional price changes more quickly than the simple moving average.

In terms of defining a trend, when prices are above the moving average, an uptrend is in place; when prices are below the moving average, a downtrend is in place.

Traders like to experiment with different periods for moving averages, but a few are more commonly used in the market than others, and they’re worth keeping an eye on. The main moving average periods to focus on are 21, 55, 100, and 200. Shorter-term traders may consider looking at the 9- and 14-period moving averages.

Another way moving averages are used is by combining two or more moving averages and using the crossovers of the moving averages as buy or sell signals based on the direction of the crossover. For example, using a 9- and 21-period moving average, you would buy when the faster-moving 9-period average crosses up over the slower-moving 21-period average, and vice versa for a crossover to the downside.

Trading with clouds — Ichimoku charts

Ichimoku Kinko Hyo, or “one-glance equilibrium,” charts are another technical analysis approach imported from Japan that is gaining widespread popularity in forex (and other financial) markets. Often referred to as cloud charts because of the central feature of the system (the cloud, or kumo in Japanese), Ichimoku is basically a trend-following system. But Ichimoku lines can also define significant support and resistance levels not identified by more traditional technical approaches.

The key components of Ichimoku charts are five lines shown in Figure 11-12:

• Tenkan line: The faster moving average based on the average of the high and low of the prior nine days.
• Kijun line: The slower moving average based on the average of the high and low from the prior 26 days.
• Senkou span A (leading span A): The average of the Tenkan and Kijun lines from the prior 26 days, projected 26 days into the future.
• Senkou span B (leading span B): The average of the high and low of the prior 52 days projected 26 days into the future. The cloud is the space between the two leading spans.
• Chikou span (lagging span): Today’s closing price reflected 26 days into the past.

A few points to note here: Ichimoku is a daily-based chart approach (weekly views can also be used), making it a tool for longer-term traders. Most importantly, intraday breaks of Ichimoku lines are relatively common, but it’s only the daily close that matters, reinforcing it as a medium/longer-term trading tool.

Ichimoku trading signals are based on the position of the current price relative to the lines as well as crossovers of the lines themselves. In the simplest form, the trend is up when prices are above the cloud and down when prices are below. Buying and selling signals also come from crossovers of the Tenkan and Kijun lines, but the strength of the signal depends on the position of price relative to the cloud. A crossover of the Tenkan below the Kijun line (bearish crossover) with price above the cloud is a weak sell signal. If price is inside the cloud, it’s a medium strength sell signal. If prices are below the cloud, it’s a strong sell signal. The same applies in bullish crossovers, but in reverse. The Chikou span is also used to gauge the validity of the trade signals, based on where current prices are relative to prior periods. The idea is that if an uptrend is in place, for example, current price should be above those of prior periods, as seen by the lagging span.

Earlier we indicate that intraday breaks of Ichimoku lines are common, but they also have an uncanny way of acting as formidable support and resistance, too. In particular, the slower moving Kijun line can be used as a level to re-enter a prevailing trend, buying a downside retracement in an uptrend or selling rebounds higher in a downtrend. We always make a point of noting the Ichimoku levels as part of our daily technical analysis routine.