Bollinger Bands

An indicator that allows users to compare volatility and relative price levels over a period of time. The Bollinger Bands are envelopes based on a moving average and a standard deviation which makes the bands widen or narrow relative to the current market volatility. 95% of price action will take place within the Bollinger bands and thus the bands act as strong areas of support and resistance when the Forex market is without trend. It is possible at times like this to successfully trade the price rising or falling from one Bollinger line to the other. When a trend begins and the volatility of the market increases, the spacing of the Bollinger Bands will widen, and as the trend slows down the Bollinger bands will narrow.

Moving Average Convergence Divergence

This is an indicator that follows the difference between a pair of moving averages. Developed by Gerald Appel, MACD (moving average convergence divergence) is a trend following momentum indicator that shows the relationship between two moving averages of prices.

Calculation

In order to calculate the MACD, subtract the 26-day exponential moving average (EMA) from a 12-day EMA. A 9-day dotted EMA of the MACD called the signal line is then plotted on top of the MACD. Other lengths of average can be used, but 9-12-26 is the most common "standard" setting.

Function

MACD measures the difference between two moving averages. A positive MACD indicates that the 12-day EMA is trading above the 26-day EMA. A negative MACD indicates that the 12-day EMA is trading below the 26-day EMA. If MACD is positive and rising, then the gap between the 12-day EMA and the 26-day EMA is widening. This indicates that the rate-of-change for the faster moving average is higher than the rate-of-change for the slower moving average. Positive momentum is increasing and this would be considered bullish. If MACD is negative and declining further, then the negative gap between the faster moving average and the slower moving average is expanding. Downward momentum is accelerating and this would be considered bearish.

Application

There are 3 common methods to interpret the MACD:

• Crossovers - When the MACD falls below the signal line it is a signal to sell. Vice versa when the MACD rises above the signal line it is a signal to buy.
• Divergence - When the security diverges from the MACD it may signal the end of the current trend. For instance, price may continue to make higher highs while MACD makes lower highs. This is an example of bearish or negative divergence and a warning that the up trend may soon be finished.
• Oversold - When the MACD rises dramatically (shorter moving average pulling away from longer term moving average) it is a signal the security is overbought and will soon return to normal levels.

Momentum

The impetus of a directional movement, or a technical indicator used to measure directional impetus. Also described as a Forex style, where one looks for increased impetus as an entry signal. Momentum can refer to a number of things in regard to trading. Firstly it can refer to 'momentum' as the impetus, or increased activity of an item - such as a stock or index. This can be referred to as gaining momentum or losing momentum. Secondly it is a type of indicator that can be added to a chart as part of technical analysis - this is a momentum indicator, which measures the amount of impetus or activity in a stock or index and shows it growing or waning. There are also other types of momentum indicators such as the Relative Strength Index or the Stochastic Momentum Indicator. Thirdly it can refer to a type of trading or investing, where traders look for an increase in the momentum of a stock or index as an entry point for their trade.

Moving Averages

An average of price, or some other data value, plotted over time. A moving average is referred as such because it is recalculated at each consecutive point in time. Moving averages are used in technical analysis, the effect is to produce a line that smoothes out fluctuations in the original data. Types of Moving Averages Simple Moving Average (SMA) The average (mean) of the previous n data points in the time series. For example, a 10-day simple moving average closing price is the mean of the previous 10 days' closing prices. The larger the value of n, the greater the smoothing effect and the more the MA line is displaced from the original data. Weighted Moving Average (WMA) The weighted mean of the previous n data points in the time series. The weighting is generally (but not necessarily always) linear. That means a relative weight of 1 is assigned to time period t, with each previous period's value assigned a lower weight on down to a relative weight of 1/n assigned to time period t-n. The WMA is more responsive to recent movements than the SMA. Exponential Moving Average (EMA) An exponentially weighted mean of previous data points. The parameter of a EWMA can be expressed as a proportional percentage. For example, a 10% EMA has each time period assigned a weight that is 90% of the weight assigned to the next more recent time period.

Relative Strength Index

RSI is an extremely useful, reliable indicator which is a favourite of many Forex traders.

Calculation

The RSI is generally calculated using a 14 day time period, which is generally the default setting of many trading software packages. However, other time periods can be used, such a 9 day for a faster setting and 25 day for a slower setting. The RSI is calculated by taking a number of days (N), for example 14 days, and using the equation:

Where p = (the average gain of N days /average loss of N days)

Application

In general terms the RSI is an overbought/oversold indicator. In practice below 30 is considered an oversold indication and when the RSI crosses 30 to go up, it is a buy signal. At the other end of the scale, a value above 70 is considered overbought, and when the RSI crosses to go below this it is a sell signal.

It should be noted that the RSI will form chart patterns similar to those found on the main chart (such as a double top, head and shoulders, etc.) which may not show up in the stock/indices price, but which will give an indication as to pending change ahead.

The RSI will also form support and resistance levels, just like the main chart, and it may also diverge from the main chart direction indicating change. For example, the stock/index may make a new high, but the RSI doesn't - that's a bearish indicator. Conversely, the stock/index may make a drop to a new low, but the RSI moves sideways or upwards - that's a bullish indicator. In these cases the price will usually follow the direction the RSI has just shown.

Stochastic Oscillator

The stochastic is a momentum indicator devised by George Lane in the 1950s. It gives overbought or oversold signals depending on its position relative to the 0 level. The stochastic can also be used to give convergence and divergence indications; such as when a stock/index price makes a new low but the stochastic does not - this is a bullish divergence. Conversely, when the stock/index price makes a new high but the stochastic does not, or moves horizontally- this is a bearish divergence and the price of the stock/index will soon follow the stochastic.

In general terms a stochastic level below 20 would be considered oversold, whereas a level above 80 would be considered overbought. However, Lane did not believe that a reading above 80 was necessarily bearish or a reading below 20 bullish. A buy or sell signal can be generated by the stochastic when the indicator passes back above the 20 level for a buy signal or below the 80 level for a sell signal.

There are different types of stochastic oscillators and reference may be made to a fast stochastic or a slow stochastic. These are generated by using different settings, as detailed in the calculation below. The fast stochastic can be useful for quick trades made in short time frames. The slow stochastic is more smoothed and loses a lot of 'noise' that can lead to confusion with the fast stochastic.

Forex Line Charts

The most basic of the four charts is the line chart because it represents only the closing prices over a set period of time. The line is formed by connecting the closing prices over the time frame. Line charts do not provide visual information of the trading range for the individual points such as the high, low, and opening prices. However, the closing price is often considered to be the most important price in currency data compared to the high and low for the day, and this is why it is the only value used in line charts.

Forex Bar Charts

The bar chart expands on the line chart by adding several more key pieces of information to each data point. The chart is made up of a series of vertical lines that represent each data point. This vertical line represents the high and low for the trading period, along with the closing price. The close and open are represented on the vertical line by a horizontal dash. The opening price on a bar chart is illustrated by the dash that is located on the left side of the vertical bar. Conversely, the close is represented by the dash on the right. Generally, if the left dash (open) is lower than the right dash (close) then the bar will be shaded black, representing an up period for the currency, which means it has gained value. A bar that is coloured red signals that the currency has gone down in value over that period. When this is the case, the dash on the right (close) is lower than the dash on the left (open).

Forex Candlestick Charts

The candlestick chart is similar to a bar chart, but it differs in the way that it is visually constructed. Similar to the bar chart, the candlestick also has a thin vertical line showing the period's trading range. The difference comes in the formation of a wide bar on the vertical line, which illustrates the difference between the open and close. And, like bar charts, candlesticks also rely heavily on the use of colours to explain what has happened during the trading period. However, a major problem with the candlestick colour configuration is that different sites use different standards; therefore, it is important to understand the candlestick configuration used at the chart site you are working with. There are two colour constructs for days up and one for days that the price falls. When the price of the currency is up and closes above the opening trade, the candlestick will usually be white or clear. If the currency has traded down for the period, then the candlestick will usually be red or black, depending on the site. If the currencies price has closed above the previous day's close but below the day's open, the candlestick will be black or filled with the colour that is used to indicate an up day.

Point and Figure Charts

The point and figure chart is not well known or used by the average investor but it has had a long history of use dating back to the first technical traders. This type of chart reflects price movements and is not as concerned about time and volume in the formulation of the points. The point and figure chart removes the noise, or insignificant price movements, in a currency, which can distort traders' views of the price trends. These types of charts also try to neutralize the skewing effect that time has on chart analysis.



When first looking at a point and figure chart, you will notice a series of Xs and Os. The Xs represent upward price trends and the Os represent downward price trends. There are also numbers and letters in the chart; these represent months, and give investors an idea of the date. Each box on the chart represents the price scale, which adjusts depending on the price of a currency pair: the higher the currency pairs price the more each box represents. On most charts where the price is between $20 and $100, a box represents $1, or 1 point for the stock. The other critical point of a point and figure chart is the reversal criteria. This is usually set at three but it can also be set according to the chartist's discretion. The reversal criteria set how much the price has to move away from the high or low in the price trend to create a new trend or, in other words, how much the price has to move in order for a column of Xs to become a column of Os, or vice versa. When the price trend has moved from one trend to another, it shifts to the right, signalling a trend change.

Forex Trend Lines

A trend line is basically a line drawn joining consecutive lows or highs in a trend pattern. The basis for drawing trend lines onto charts is probably one of the most basic to do and master, yet it is one of the more powerful and reliable indicators used to determine a change in trend. Trend lines can be applied to many different indicators but we will be using closing price data. When viewing most charts a pattern of the price formation is usually visible to the naked eye. This pattern is called a trend and these trends have three distinct patterns.

Up Trend: Prices increasing

Down Trend: Prices decreasing

Holding Pattern or Flat Line: Prices stagnant or small trading range

An up trend with trend line drawn in - Draw a line connecting the lowest points on a chart in an up trend.



A down trend with trend line drawn in - Draw a line connecting the highest points on a chart in a down trend.


Holding pattern with both lines drawn in – Draw a line connecting both highs and lows on a chart in a holding pattern.

Support Line

A support line is a line drawn joining all the lows of a price pattern together. These lines are a low point on the chart on which the price bounces off consistently when reached. Many traders would elect to buy when the price reaches this point. Experienced chartists believe that the market likes to test support lines more than once, and will only look for buy signals after a second or third testing of this line. If a support line is broken, the current trend is said to be broken or in a down trend and the market will look for a lower price to set up a new support level.

Resistance Line

A resistance line is a line drawn joining all the tops of a price pattern together. It is basically the exact opposite of the support line; it is a series of highs on a chart where the market continually rejects the price, thus not allowing it to go any higher. Many traders would elect to sell when the price reaches this point. Experienced chartists believe that the market likes to test resistance lines more than once, and will only look for sell signals after a second or third testing of this line.

The resistance line is drawn in red and the support line is drawn in green. The same applies for resistance in that it is a powerful level and one should think seriously about taking profit at this level.

Breakouts

We have now established what trend lines are and how to draw them. When one of these lines is breached, it is called a breakout. If a breakout occurs on a resistance line, many traders will class this as a buy signal, and act accordingly. If a breakout occurs on a support line, many traders will class it as a sell signal, and act accordingly.

Resistance Broken


Note that the old resistance line will now become the support line.

Price Patterns

A price pattern is a distinct formation on a currency chart that creates a trading signal, or a sign of future price movements. Chartists use these patterns to identify current trends and trend reversals, and to trigger buy and sell signals. Remember the third underlying principle of technical analysis; history repeats itself. The theory behind price patterns is based on this assumption. The idea is that certain patterns are seen many times, and that these patterns signal a certain high probability move in a currency pair. Based on the historic trend of a price pattern setting up a certain price movement, chartists look for these patterns to identify trading opportunities.

Price Patterns

So far we have covered the most commonly used price patterns. We will now learn about price pattern theories. The two most common theories used in the currency markets are Fibonacci and Elliot Wave.

There are different types of stochastic oscillators and reference may be made to a fast stochastic or a slow stochastic. These are generated by using different settings, as detailed in the calculation below. The fast stochastic can be useful for quick trades made in short time frames. The slow stochastic is more smoothed and loses a lot of 'noise' that can lead to confusion with the fast stochastic.

Fibonacci

Leonardo Fibonacci was an Italian mathematician born in the 12th century. While tackling a problem involving the prediction of rabbit population growth, he discovered the "Fibonacci numbers," which are a sequence of numbers where each successive number is the sum of the two previous numbers.

e.g. 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc.

As far as trading is concerned, this sequence is not that important; rather, it is the quotient of the adjacent terms (e.g. 144/89) that possesses an amazing proportion: roughly 1.618, or its inverse 0.618. This proportion is known by many names, including: the golden ratio, the golden mean, phi and the divine proportion. So, why is this number so important? Well, almost everything in nature has dimensional properties that adhere to the ratio of 1.618, so it seems to have a fundamental function or presence. Therefore it would not be unimaginable for Fibonacci ratios to have some bearing on the market.

Application

Interpretation of the Fibonacci numbers in technical analysis anticipates changes in trends as prices approach lines created by the Fibonacci studies. When used in technical analysis, the golden ratio is typically translated into three percentages: 38.2%, 50% and 61.8%. However, more multiples can be used if needed, such as 23.6%, 161.8%, 423% and so on.
There are four primary methods for applying the Fibonacci sequence to finance:

• Retracements / Extensions
• Arcs
• Fans
• Time Zones

Fibonacci Retracements

Fibonacci retracements use horizontal lines to indicate areas of support or resistance. They are calculated by first locating the high and low of the chart. Then five lines are drawn: the first at 100% (the high on the chart), the second at 61.8%, the third at 50%, the fourth at 38.2%, and the last one at 0% (the low on the chart). After a significant price movement up or down, the new support and resistance levels are often at or near these lines. Levels above 100%, such as 161.8% can also be used to predict price extensions following the break of a significant high or low.

Fibonacci Arcs

Finding the high and low of a chart is the first step to composing Fibonacci arcs. Then, with a compass-like movement, three curved lines are drawn at 38.2%, 50% and 61.8%, from the desired point. These lines anticipate the support and resistance levels, and areas of ranging.

Fibonacci Fans

Fibonacci fans are composed of diagonal lines. After the high and low of the chart is located, an invisible vertical line is drawn though the rightmost point. This invisible line is then divided into 38.2%, 50% and 61.8%, and lines are drawn from the leftmost point through each of these points. These lines indicate areas of support and resistance.

Unlike the other Fibonacci methods, time zones are a series of vertical lines. They are composed by dividing a chart into segments with vertical lines spaced apart in increments that conform to the Fibonacci sequence (1, 1, 2, 3, 5, 8, 13, etc.). These lines indicate areas in which major price movement can be expected.

Elliot Wave

Elliot Wave theory was initiated in the 1930s by Ralph Nelson Elliot. His basic theory was that crowd behaviour, the basis for market activity, tends to operate in recognizable phases; and as such, price movements can be anticipated to some degree.

During his early studies, using stock market data for his analysis, Elliot isolated thirteen examples of patterns – or waves – that are repetitive in their form only, and that the time and amplitude of the waves need not necessarily be repetitive. To demonstrate what he learned, Elliot named, defined and illustrated each pattern, showing how several small patterns could be brought together to create one larger example of the same form, which would in turn merge into another, larger version of the "wave".

Elliot Wave theory is a collection of these patterns, and a set of guidelines regarding as to where and when the patterns may occur in the financial markets. These patterns allow the Elliot Wave trader to understand market action, and possibly predict future trends. These patterns are now known throughout the industry as the “Elliot Wave Principle”.

Application

It is easier to grasp the concept of Elliot Wave if we demonstrate the theory in pictures, rather than words. The basic format is shown below.


There are two distinct parts to each wave: the numbered phase, and the lettered phase. In the numbered phase, waves 1, 3 and 5 are called "impulse" waves - minor upwards moves in an otherwise bullish trend. Waves 2 and 4 are the smaller, less powerful "corrective" waves. Greater volume on impulses than corrections helps confirm the pattern. In the lettered phase, waves A and C are the stronger impulse waves down, with wave B – the bull wave – being the weaker move.

Head and Shoulder Pattern

This is one of the most popular and reliable chart patterns in technical analysis. Head and shoulders is a reversal chart pattern that, when formed, signals that the currency pair is likely to move against the previous trend. As you can see in Figure 1, there are two versions of the head and shoulders chart pattern. Head and shoulders top (shown on the left) is a chart pattern that is formed at the high of an upward movement and signals that the upward trend is about to end. Head and shoulders bottom, also known as inverse head and shoulders (shown on the right), is the lesser known of the two but is used to signal a reversal in a downtrend.



Head and shoulders bottom, or inverse head and shoulders, is shown on the right. Both of these head and shoulders patterns are similar in that there are four main parts: two shoulders, a head and a neckline. Also, each individual head and shoulders is comprised of a high and a low. For example, in the head and shoulders top image shown on the left side in Figure 11, the left shoulder is made up of a high followed by a low. In this pattern, the neckline is a level of support or resistance. Remember that an upward trend is a period of successive rising highs and rising lows. Therefore, the head and shoulders chart pattern illustrates a weakening in a trend by showing the deterioration in the successive movements of the highs and lows.

Double Tops and Bottoms

This chart pattern is another well-known pattern that signals a trend reversal. It is considered to be one of the most reliable and is commonly used. These patterns are formed after a sustained trend, and signal to chartists that the trend is about to reverse. The pattern is created when a price movement tests support or resistance levels twice and is unable to break through. This pattern is often used to signal intermediate and long-term trend reversals.



In the case of the double top pattern in Figure 12, the price movement has twice tried to move above a certain price level. After two unsuccessful attempts at pushing the price higher, the trend reverses and the price heads lower. In the case of a double bottom (shown on the right), the price movement has twice tried to go lower, but has found support each time. After the second bounce off of the support, the security enters a new trend and heads upward.

Flag and Pennant

These two short-term chart patterns are continuation patterns that are formed when there is a sharp price movement followed by a generally sideways price movement. This pattern is then completed upon another sharp price movement in the same direction as the move that started the trend. The patterns are generally thought to last from one to three weeks.



As you can see in Figure 14, there is little difference between a pennant and a flag. The main difference between these price movements can be seen in the middle section of the chart pattern. In a pennant, the middle section is characterized by converging trend lines, much like what is seen in a symmetrical triangle. The middle section on the flag pattern, on the other hand, shows a channel pattern with no convergence between the trend lines. In both cases, the trend is expected to continue when the price moves above the upper trend line.

Triangles

Triangles are some of the most well-known chart patterns used in technical analysis. The three types of triangles, which vary in construct and implication, are: the symmetrical triangle, the ascending (rising) triangle and the descending (falling) triangle. These chart patterns are considered to last anywhere from a couple of weeks to several months.



The symmetrical triangle in Figure 13 is a pattern in which two trend lines converge toward each other. This pattern is neutral in that a breakout to the upside or downside is a confirmation of a trend in that direction. In an ascending triangle, the upper trend line is flat, while the bottom trend line is upward sloping. This is generally thought of as a bullish pattern in which chartists look for an upside breakout. In a descending triangle, the lower trend line is flat and the upper trend line is descending. This is generally seen as a bearish pattern where chartists look for a downside breakout.

Wedge

The wedge chart pattern can be either a continuation or a reversal pattern. It is similar to a symmetrical triangle except that the wedge pattern slants in an upward or downward direction, while the symmetrical triangle generally shows a sideways movement. The other difference is that wedges tend to form over longer periods, usually between three and six months.



The fact that wedges are classified as both continuation and reversal patterns can make reading signals confusing. However, at the most basic level, a falling wedge is bullish and a rising wedge is bearish. In Figure 15, we have a falling wedge in which two trend lines are converging in a downward direction. If the price was to rise above the upper trend line, it would form a continuation pattern, while a move below the lower trend line would signal a reversal pattern.

Waves within Waves

Elliot theorized that the wave above was a small wave, embedded within an overall larger wave, and that each larger wave was in turn simply part of an even larger wave. This can be difficult to imagine, but if we look at the example below, we can see exactly what he meant:



We can see that waves 1 through 5 and waves A through C - as shown in the first chart above - form part of an overall impulse wave 3 - as shown in the second chart above.

Cycles

Elliot believed that there were many cycles of both impulse and corrective waves, and he named each cycle to fit in with his theory that the waves were based around the Fibonacci series of numbers – 1, 2, 3, 5, 8, 13, etc. The names are:

• Grand Super Cycle
• Super Cycle
• Cycle
• Primary
• Intermediate
• Minor
• Minute
• Minuette
• Sub-Minuette

Elliot provided several varieties of the main wave, and placed particular relevance on the Fibonacci value of 0.618 as the most common level for a retracement to occur. The examples shown are perfect definitions of the Elliot Wave theory. In the real world, things tend not to be quite so clear. The price action shown in the chart below is taken from the NASDAQ Composite Index, during the later part of 2003. The waves are still there, but somewhat harder to spot to the untrained eye.

NB: Wave 1 continues down of the bottom left of the chart so that it's start is lower than the low of wave 2.