Technical indicators (also called technicals, or TI's for short) are mathematical formulas, based on specific parameters, that focus on aspects of past price movements of a financial instrument (i.e. currency pairs in forex trading) and use the resulting information to make a prediction about future price movements.
In other words: a technical indicator looks at price developments in the past and based on that makes it easier to predict future price movements. A technical indicator (TI) does not look at the underlying fundamentals of a stock or financial instrument ― like employment data or inflation figures ― it only looks at price development. This makes TI's primarily interesting for short term traders, because fundamental factors have a significant impact on price development of stocks and financial instruments in the long term. That's not to say that a long term trader won't still use technical indicators to determine his entry and exit points ― just that they are likely to be more accurate in the short term.
There are many technical indicators and it goes beyond the scope of this book to cover them all, but some of the most important ones deserve some extra attention.
Moving Averages
The simplest way to say something meaningful about a price level is to look at its relative value, compared to other, earlier price levels. This can be done by calculating the Simple Moving Average, or SMA, of a price development.
The SMA is the result of the sum of the closing prices of a tradable instrument (in this case currency pairs), divided by the number of closing prices. For instance, to get a 10-period SMA you'd add the closing prices of 10 periods and divide that sum by 10. For every new closing price you add, you remove the oldest closing price. Plotting this 10-period SMA on an x-y axis would show the development of the average price for a given tradable instrument, during the last 10 periods.
The weak point of the SMA is that its lag, the distance from the reality of the moment, is rather big. Important SMA's, like the 100 SMA and the 200 SMA (looking at 100 and 200 periods respectively) take price levels into account from a long time ago. At the same time though, these SMA's paint a reasonably accurate picture of market consensus. They give you an idea of where the current price level is, relative to the long(er) term trend. If prices are above the SMA, they are said to be in an uptrend, if they are below it, they're in a downtrend. Simple, yes, but SMA's nevertheless have there uses.
SMA derivative indicators, methods
Several of the more accurate technical indicators are based on the idea of the SMA, such as the Exponential Moving Average and the 3 SMA filter.
Exponential Moving Average (EMA)
The Exponential Moving Average (EMA) works the same way as the SMA, only it gives greater importance to more recent price levels. The idea behind this is obvious: the more recent the price, the more relevant it is when looking at the (near) future. An example of an EMA calculation would be to multiply the most recent price level (for instance a period of 10 of 10) by 10, period 9 of 10 by 9, period 8 of 10 by 8 , etc. Add the number you get for each period and then divide the outcome by the number of multiplies (10+9+8+7 etc).
Naturally this enables the EMA to react to recent price developments faster than the SMA, but it also increases the margin of error, because the earlier periods are mostly excluded from the calculation. The difference between the SMA and EMA increases when increasing the number of periods measured (say 20, 40, 65 etc).
Moving Averages crossover systems
When the price moves back and forth within a narrow channel (known as oscillating) the margin of error for Moving Averages increases considerably. Remember that, like all technical indicators, Moving Averages are by definition a little bit behind the times (like all technical indicators) and when prices quickly move back and forth, Moving Average predictions of future price movements become less accurate.
Many traders therefore use filters made up of several Moving Averages, looking for situations where these different MA's cross each other. These are called Moving Averages crossover systems.
Traders primarily look for moments when a short-term moving average crosses a longer-term moving average. When the short-term MA crosses the longer-term MA from below, a buy signal is generated, while a crossing from above generates a sell signal. Because these are signals for a price development that is already under way, it's often not the right move to actually buy and sell at the crossovers themselves.
The reason for this is that the actual crossover normally only takes place after a considerable up or down swing. Such a swing is often followed by what is called a retracement move, which recaptures part of the ground covered by the swing. Retracements like this are often caused by traders closing profitable positions to take profit, while others are trying to get in at the top or bottom of the move, driving the price in the opposite direction. Getting in at that moment often means buying the top and selling the bottom.
What's the point then?
The value of these kind of Moving Average filters lies in being able to determine what kind of trend the price action is currently involved in. When the short-term MA is above the longer-term MA, the price action is in an uptrend (i.e. the more recent the period measured, the higher the price) and vice versa. The crossover points to a possible trend reversal. The 'tight to wide 3 SMA trade' explained below is an example of this.
3 SMA filter
One well known filter is the 3 SMA filter, which is made up of 3 SMA's of different periods. Frequently measured periods for the 3 SMA are 3, 20 and 65. When the short term SMA is above the medium term SMA, which in turn is above the long term SMA, the price is clearly in an uptrend. Simply put: measured over the longest period the average price is X, over the medium term the price is X+1 and over the shortest period it's X+2. So, the more recent the period that is measured the higher the price.
While the 3 SMA filter shows the current trend, it doesn't tell you whether or not the trend will continue. Nevertheless it's an important tool for traders focussed on trending movements. The 3 SMA filter's main function is showing when you should not get in a trade. Are the SMA's very close together, or not in line with each other (short above medium, medium above long configuration)? Then the trend trader knows it's not the right time to get in, because there's no clear trend.
Tight to Wide 3 SMA Trade
There is an exception to the rule that the 3 SMA filter shouldn't be used for generating an entry signal (only for determining what kind of market we're currently in, uptrend, downtrend or range). This is when the 3 SMA's are close together and then start to run wider apart in the right alignment. That right alignment would be short above medium, medium above long in an uptrend, and vice versa in a downtrend.
The most important reason for this is that getting in at this point carries little risk but has a lot of potential. Why is there so little risk? Because there is little price difference when the short Moving Average crosses the medium Moving Average (the 3 SMA's were close together, remember). So there is less chance of retracement and even if retracement does occur, it will be minimal.
Now, the argument not to get in on the crossover was because it will only show you where the big swing occurs after it has already happened, with the added risk that retracement will come into play around the time the crossover takes place. But when the SMA's are close together and then start to fan out, there is little to fear from retracement.
The signal that is created makes for a good moment to get in. For an uptrend, the signal would be short-term prices that are higher than medium-term prices, which are higher than long-term prices. If the SMA lines move closer together again, right after they started running further apart, it could be concluded the fanning out of the SMA's was a false signal.However, you would have limited your risk by putting in relatively tight stops.
Bollinger Bands
This is one of the most popular technical indicators. One of the reasons for it is that Bollinger Bands (BB's) instantly show you when the price is deviating from its 'normal' trading channel. A lot of traders habitually run BB's on their candlestick charts.
For many traders, nothing beats riding the wave of a trend for as long as possible, like surfing in the green room. Opening a position on a nascent trend and then simply enjoying the ride of The Long & Trending Road, making you richer with every pip. As a range trader, you can get the same feeling with a good range trade, only the length of the one-directional price movement is of course much shorter in that case.
But when do we speak of a trend? And how do you spot it as quickly as possible? That's where Bollinger Bands come in. Bollinger Bands are based on the fact that prices move within a certain bandwidth about 70 – 80 percent of the time. When prices start to move outside this bandwidth, this could signify the beginning of a trend.
Bollinger Bands measure the Standard Deviation (SD) of the price, compared to the 20-period Moving Average. When BB's are close together it means market volatility is low, because the difference between the two extremes – Standard Deviation on the upside and the downside ― is small.
In the next example, BB's are relatively far apart, meaning price volatility is high, making it harder to predict the market direction.
Using Bollinger Bands to open and close positions
To use Bollinger Bands successfully when trading on the forex, three questions are important:
1. Trend
detection -- when can we say a trend is emerging?
2. Entry point -- when to open a position?
3. Exit point -- when is the trend considered to have run its
course?
Of these three questions, the third is ― surprisingly perhaps ― the most important. The value of exit points is often underestimated by traders. Most traders are primarily concerned with entry points. Which stock, commodity or currency should I buy? When should I go long the euro? Of course it's important to pick a good moment to get in on a trade, but the reason most beginning traders are losing money is because they a) don't known how to limit their losses and b) don't know how to capitalize on their winning trades. Both a and b are determined by finding suitable exit points (note: we'll take a closer look at exit points later on in the book).
Trend detection -- when can we say a trend is emerging?
When using Bollinger Bands, a possible trend is said to be emerging when the candlestick closes above the upper BB or below the lower BB. Keep in mind however, that merely touching or crossing the band is not enough. A closing above / below the Band increases the chance of a possible definitive breach (as far as anything is ever definitive in financial trading).
Entry point -- when to open a position?
Even if the candle closes in the buy / sell zone (outside the BB channel) we still don't open a position right away. Why not? Because we're always looking for low-risk propositions. The difference between profitable and unprofitable traders is much less a case of being able to 'pick a winner' and much more one of cutting your losses and letting your profits run. That's why it's generally better to wait for prices to retrace, before getting in.
There is almost always some retracement following a rally. Even in a huge bull market, traders take profit while others get in on the opposite side because they think the price is bottoming/peaking. Successful traders often get in after a retracement. They don't try to cause trends (try the fashion industry if that's your thing) they try to follow them.
Getting in only after retracement has taken place can limit your risk exposure on a position considerably. If the price continues to move away from the high/low ― meaning the retracement doesn't stop, thus turning into a reversal ― there wasn't really a trend to begin with, saving you a stopped out position, (because you would only get in after retracement has taken place). Traders who opened a position immediately when the first candle closed in the buy / sell zone, no longer have that luxury. An added bonus is that if indeed there was retracement and the price returns to the buy/sell zone, your profit is greater if you get in after retracement has taken place. The only negative to this tactic is that every once in a while you'll miss a trade, because there is no retracement at all. Though this is obviously disappointing, it happens only rarely. Additionally, you should keep in mind that the goal of a successful trader is not getting in on every single profitable trade. The goal is ― or should be ― keeping Expected Value (EV) as high as possible and risk exposure as low as possible.
Therefore, we only open a position after the price momentarily returns inside the channel. If the candle closed substantially outside the buy / sell zone, the price only has to touch the BB when retracing, but either way we only get in when the price has temporarily retraced. This way, you'll limit losses in case the trend doesn't follow through, something which happens more often than not. You will also increase profits when a trend does form (because you got in at a better price).
On rare occasions, there will be hardly any retracement and the trend forms right away, causing you to miss a profitable trade. Not a very pleasant situation of course, but console yourself with the knowledge that in the long term, you will make more money by waiting for the retracement.
Exit point -- when is the trend considered to have run its course?
As said, this is the most important question, because it can both limit your losses and increase your profits. Many novice traders learn soon enough of the old adage, 'Cut your losses and let your profits run'. It's considered one of the golden rules of trading (another famous one: "Greed is good." ― Gordon Gekko in Wall Street). So, why are there so many losing traders if everybody knows this rule? The obvious answer -- because it's so hard to follow.
What is the greatest temptation after losing a lot of money in the casino or at the poker table? Increasing the stakes, to win back your losses. For most people, it's in their nature to do exactly the opposite of cutting losses and letting their profits run. Instead, they let their losses run and cut their profits short. Of course having difficulty accepting losses is very natural, as is the urge to want to lock in realized profits. After all, seeing realized profits being vaporized is a terrible thing, and seeing them turn into a loss is even worse.
The good news is that carefully considering and putting in place exit points can prevent this. As long as you stick to them of course….
The exit point when working with Bollinger Bands is usually when the price touches the opposite band. So in case of an uptrend, the touching of the lower Bollinger Band would create an exit signal. Why not the crossing of the Band or the closing of a candle below the Band? That's a matter of limiting risk exposure. A trend that's not strong enough to stay above the opposite Band can't really be called a trend and isn't worth taking any risk for anymore. (to use another saying, this one borrowed from the noble game of poker -- you should know when to release a shitty hand).
The correct use of Bollinger Bands not only increases the chance of spotting a trend and exploiting it successfully, but also forces one to think about exit points (both for taking profit and cutting losses). This helps foster a more planned approach to trading, which in turn increases the chances of developing a profitable trading strategy.
Relative Strength Index
This is a fairly simple, but much used technical indicator. The Relative Strength Index (RSI) measures the relative strength of a trend. The RSI helps to better estimate what to expect of a (possible) trend, increasing the chance of successfully getting in on one.
How the RSI works
The RSI measures the strength of a price development by comparing the number of times a currency pair closes higher to the number of times it closes lower. This is usually done over 14 periods, whereby the data is weighed through the use of exponential averages; in other words, the more recent the data, the more it counts.
The result is a number between 0 and 100. A rating above 70 indicates an overbought situation, while a rating below 30 indicates an oversold situation.
A rating above 70 or below 30 does not mean you have to spring into action right away; it only shows that the price has now entered an overbought/oversold situation, and that a change in this could signify a trend reversal.
How to use the Relative Strength Index
A much used method when using the RSI is to compare it with the actual price action. For instance, when prices keep making higher highs while the RSI does not, it signifies a trend reversal or possible consolidation. The same goes for down trends, when prices keep making lower lows but the RSI does not.
Divergence
Spotting the difference between price action and momentum is known as divergence. It is a method that works well with several technical indicators. At first sight, everything looks hunky dory with the trend, because prices keep trending higher (or lower, in case of a down trend), but the technical indicator shows that the trend is fact already weakening.
To quickly spot this kind of divergence, traders often use simple trend line analysis, connecting highs/lows directly on the RSI. When that RSI trend line is falling while the price itself is still rising, it's a strong indication that what is called trend line exhaustion is close-by. The next chart illustrates an example of trend line exhaustion.
The main advantage of the RSI is that it filters out market noise. Price developments can be hugely volatile, especially in the short term, making them very unpredictable. Because the RSI takes multiple periods into account and weighs recent periods more heavily than earlier ones, the chance of false signals is much smaller. The RSI can therefore help you find the right moment to open the position and increase your chance of a successful trade.
Stochastics
This is a somewhat older, but still popular technical indicator. The core idea of stochastics is that in an uptrend, the closing prices for each period are always close to the high ― because the bulls keep raising the price ― while the opposite is true for a downtrend, when the bears keep selling. It's an idea both simple and logical. What the stochastics formula does, is show how far along the trend probably is.
Range trading tool
As said, the price development of currency pairs is range-bound 70 to 80 percent of the time, meaning the price stays within a channel made up of resistance on the upside and support on the downside, going back and forth without much happening. For the real trend trader these are not the most exciting moments, but for those who know how to capitalize on it, range trading can be a goldmine. The main advantage of ranging prices is of course that the directional predictability is fairly high. This enables the range trader to work with tight stops, while the chance of success is high.
For example, let's say that the price moves in a range of 25 pips and you're getting in on the bottom side of the range and out on the top side. Do this 80 percent of the time and you could profit nicely. Suppose you execute 10 trades, using stops of 25 pips. You would earn 200 pips (8 x 25 pips) and lose only 50 pips (2 x 25). Deduct 10 x 2 pips for the spread (10 trades) and you would pocket a net profit of 130 pips, or 13 pips per trade on average. Not bad at all.
Determining approximately where you are in the range of the price action, is where Stochastics comes in. Keep in mind though that you should never trust Stochastics blindly (something that goes for all technical indicators) but merely use it as a hint, as another argument for putting on a trade, or for deciding against it.
Stochastics explained
Stochastics gets its core data from measuring the Moving Average level, usually over 14 periods. There are fast stochastics and slow stochastics.
Fast stochastics measures the price compared to the 14 period Moving Average, and rates it on a scale of 1 to 100. Slow stochastics is the 3 period average of the fast stochastics. The advantage of slow stochastics is that it filters out market noise even more than fast stochastics does. Unfortunately, it also shows more lag because of this.
Stochastics moves between a value of 1 and 100. The stochastics number for a given price therefore shows you at where the price is, compared to the 14 period Moving Average. So if the stochastics for a given price reads 50, it means the price is exactly in the middle of the 14 period Moving Average.
The basic rule states that when stochastics reads at 80 or above, prices are in an overbought phase (making a price decline more likely). Inversely, a reading of 20 or less indicates an oversold phase (making a price rise more likely).
That doesn't mean you should go short immediately after the stochastics reads over 80, or long when it's under 20. A high reading of 80 or above, or a low reading of less than 20, can easily persist for a longer period of time. The idea is to keep an eye on the indicator and wait for it to break the 80 or 20 line again, signaling a reversal.
In essence, stochastics is a momentum-meter. Used correctly ― as described above ― it will show you when a trend reversal has started.
Stochastics at its best: divergence
One of the best ways to use stochastics is by looking for a divergence situation ― during an overbought/oversold (80/20) phase ― when prices keep making higher highs/lower lows, while the Stochastics is already moving back to the 80/20 line but has not crossed it yet. In that case we would have a divergence between the price action and stochastics, which signals a possible trend exhaustion. With this method you would not be hindered by the indicator lagging behind real time action because the already falling/rising indicator predicts that the current trend might soon be over.
Again, no TI can ever give you 100 percent certainty about the future direction of a price development (nor can any fundamental analysis for that matter). The trick is to find low-risk possibilities, where you have a relatively small chance of a losing trade and a relatively high chance of a winning one. Succeeding at this can make you a lot of money in the long term.
Fibonacci
One of the most popular technical indicators, Fibonacci ratios are used by many traders. This makes it essential for you to know how they work. After all, markets are driven by people.
The Fibonacci sequence is the most esoteric technical indicator we look at in this book. It is esoteric in that it really has nothing to do with market movements as such and that there is no rational explanation for why the Fibonacci sequence should be applicable to the financial market. Devout supporters of the Fibonacci ratios ― of which there are many ― will nevertheless fervently deny the irrationality of its use. Due to their numbers, it is important that you know what all the hubbub is about.
That the Fibonacci sequence is often visible in price developments is doubtlessly true. Important resistance and support levels can often be predicted with the help of Fibonacci levels. The reasons for this are not born out of any mystical power however, but are much more mundane.
Everyone who is trying to predict the future (and as traders, we all are) risks losing himself in all kinds of holy grail stories about that one particle / being / astrological event / indicator that can explain all about people, the world and everything in it.
Perhaps you think I'm exaggerating about the methods traders use to try and predict future price developments, but some go much further than a little drooling over the Fibonacci sequence. They look for influences on human behavior in such things as tidal movements and sun spots that influence Earth's magnetic radiation (which in turn supposedly influences human behavior) and so on and so forth. It seems many people simply want to believe there is a higher order to everything that drives us.
The reason for this long introduction about the Fibonacci sequence ― which is definitely important for a trader to know about ― is because it is also the last technical indicator we'll discuss in this book, making for a good moment to emphasize once again not to overestimate the usability of TI's.
At the end of the day, markets are driven by human behavior. Everything that influences human behavior is important, including technical indicators ― even irrational technical indicators ― but at the same time no market is immune to substantial changes in the intrinsic values that underly market prices. When the American economy performs substantially worse than the economy of the Eurozone for a significant period of time, the value of the euro will rise compared to the US dollar. There are, after all, economic values at the core of the EUR/USD rate. Technical indicators can help you determine the strength of a price development, or predict the probable end of a trend, but in the long term the direction of a currency pair is determined by the economic values that underlie each currency.
It's also important to realize that many traders use technical indicators and fundamentals just to find good entry points, while successful trading only depends about 10% on being able to find good entry points. Exit points, position sizing (i.e. determining the maximum risk exposure for a trade) and expected value are much more important for trading profitably on the forex. All of which we will discuss this further on in the book.
So, Finally, What is the Fibonacci sequence
Leonardo of Pisa (1170 – 1250) better known as Fibonacci, discovered that a number sequence constructed with a certain formula – Fn = F(n+1) + F(n-2) – possesses interesting mathematical characteristics. The beginning of the sequence is as follows:
0,1,2,3,4,5,6,13,21,34,55,89,144,233,377,610,987,1597
The most interesting characteristic is that the ratio of neighboring numbers in the sequence is always 0,618. (though this is not the case for the smaller numbers by the way). This ratio is called phi, a.k.a the Golden Ratio. Another interesting fact is that the reversed ratio of the same neighboring numbers is 1,618; or 1 + phi.
Example:
144/233 = 0,618
233/144 = 1,618
To stress its importance, supporters of the Fibonacci sequence frequently point to the fact that the Golden Ratio is found everywhere in nature. Some traders seem to believe that something that plays such an important role as a natural ratio must also be a significant factor in the financial markets. (perhaps because the markets are driven by people ― who in turn are part of nature?).
Extra: in 2001, Donald Simanek, a physics professor at the University of Pennsylvania, published 'Science Askew', which invalidated a lot of the Fibonacci Ratio examples that were said to be found in nature. Among other things, he describes his examination of the supposed 'phi' ratio between someone's entire length and the length from a person's navel to their feet; a well-known phi ratio. What made Simanek's examination all the more interesting ― at least for 50 percent of us ― was that he used female swimsuit models for it. Simanek went on to prove two things with his 'phi ratio in swimsuit models' research:
1. The swimsuit models did not possess the well-known phi ratio.
2. Even physics professors can meet swimsuit models; they just need to find a good excuse for it.
How the Fibonacci sequence works in trading
In the FX market, traders concentrate on the following Fibonacci levels:
0,382 (1 – phi ratio 0,618)
0,5 (which, by the way, is not a real Fibonacci ratio!)
0,618 (phi)
1,382 (Fibonacci extension ratio)
1,618 (Fibonacci extension ratio)
Fibonacci support levels in an uptrend
The classic method to apply Fibonacci (Fib) ratios in technical analysis is by drawing a trend line from the lowest point to the highest point in an uptrend (opposite in a downtrend) and then place Fib lines on 38,2%, 50% and 61,8% of the total move. These Fib lines are said to represent strong support levels in case of a retracement from the highest point downward.
Fibonacci extension ratios
When there is a price breakout ― for instance beyond an ascending triangle (see chapter 12) ― Fibonacci extension ratios are used to determine how far the breakout will likely stretch. The trader calculates the vertical distance of the ascending triangle and then multiplies that with the Fibonacci extension ratios to determine possible exit points.
The most commonly used extension ratios are 138,2%, 161,8%, 261,8% and 423,6%. Most traders use Fibonacci extension levels in combination with other technical indicators and/or chart patterns, to get more input about good exit points.
Apart from Fibonacci, it's never a bad idea to split your position in two or three parts. You don't have to put on those two or three positions at the same time, but could instead opt to 'grow into' the entire position. The idea here is to open a second and possibly a third position when the price continues to move in your direction. This would prevent you from risking too much before the trend has proven itself a bit more.
Another advantage of growing into a position is that it also enables you to grow out of a position. You could, for instance, put in different exit points, with profit targets that are increasingly ambitious. Advice from professional traders frequently includes this idea of several exit points, which are sometimes based on Fibonacci extension ratios.
Why Fibonacci is important in FX trading
In part, the answer to this question is pretty obvious. Like every market, the forex is driven by human behavior. Even the automatic trading models you can build or buy are based on human suppositions. The human factor is everywhere and many, many traders are well aware of the Fibonacci levels. And whether or not they believe in them, they know that other traders are aware of them too, which increases their importance.
Many traders grow into their positions gradually, as described above, which can somewhat resemble the fib levels at 30% and 60% of the trend. When gradually growing into a trade, traders first wait until the move has started and then put on a relatively small position (half, or 1/3 of the desired position for instance) and then grow into a complete position if the move continues. Combined with multiple profit targets and stops, traders run less risk this way, while maximizing their chances of a decent profit.