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Mastering the Currency Market sell-offs or price breaks. It is this dynamic occurrence, or behavioral change, that experienced traders can see. This often is referred to as “feeling” a market, as in “that last leg up didn’t feel right to me.” Even without seeing the volume histogram at the bottom of the chart, experienced traders notice when a market is starting to waver at minor resistance levels or drops faster than it had been dropping on reactions. Head and shoulders formations are great times to notice these subtle changes in price behavior because, like triple tops and triple bottoms, they take time to play out, giving us time to observe and understand the changing dynamics. Figure 6-16 Head and Shoulders Top 148 C h a rt Pat t e r n s Figure 6-16 shows a head and shoulders top in the U.S. stock market that played out in 2007 and 2008. We can see from the volume pattern on the chart how trader participation dried up for the last leg up to create the head and then picked up as the market sold off in November. By the time price penetrated the neckline, there was little doubt about who was in control of this market from the price action and volume: the bears. After a climactic sell-off in January, the market snapped back and retested the original breakout area. Rising and Falling Wedges A rising wedge is a bearish formation that usually is seen as a reversal pattern but also can be a continuation pattern. Here we will focus on reversal patterns. A rising wedge can be seen on the charts as an up move with a wide shape that gradually narrows as it rises, giving it a cone shape. It can be tricky to identify as being bearish because it exhibits the higher lows and higher highs that are the hallmark of an uptrend. What helps us identify it as a reversal formation is the decreasing volume on each successive rally. Regardless of whether we see it as a bearish development, by following basic trendline analysis we will be able to see when the formation breaks out, or down, by the way it penetrates the support line that helps identify it. Figure 6-17 shows a rising wedge on the weekly USDCAD chart that built up through the second half of 2001 and culminated with a major reversal in early 2002. A falling wedge is a bullish formation that usually is seen as a reversal pattern but also can be a continuation pattern. Here we will focus on reversal patterns. It can be seen on the 149 Mastering the Currency Market Figure 6-17 Rising Wedge charts as a down move with a wide shape that gradually narrows as it falls, giving it a cone shape. Like a rising wedge, it can be tricky to identify as being bullish because of the lower highs and lower lows. Again, what helps us identify it as a reversal formation is the decreasing volume on each successive sell-off. By following trendline analysis, we should be able to identify the breakout or point of reversal when it penetrates the resistance line that borders its upper range. There is no way to project a price objective for this formation. Figure 6-18 shows a falling wedge on a weekly EURJPY chart 150 C h a rt Pat t e r n s Figure 6-18 Falling Wedge that culminates with a double bottom in the fourth quarter of 2000 just before a powerful reversal and rally. The pattern-recognition techniques we’ve outlined can come in handy in analyzing and trading the financial markets. When taken in the context of the candlestick charts, support and resistance levels, and trendlines we have studied, the prospect of forecasting market movement should start to seem like a very real possibility. Knowing that we are likely to see price continuation patterns more often than actual price reversal 151 Mastering the Currency Market patterns should give us an edge over less educated analysts and traders. In summary, we can say that basic price patterns and volume indicators are essential in the study of technical analysis and will bring us closer to melding market analysis with our intuition. 152 C H A P T E R 7 Technical Indicators A myriad of technical tools, studies, and overlays are available to analysts and traders, and it is our goal to define those which are readily available on most charting packages and those which we use or know are used by other professionals in the trading community. In this section we will cover only those indicators which are derived from price. A technical indicator is a tool that uses a series of data points and various mathematical formulas to define a perspective on market behavior. The primary data points used are an individual period’s open, high, low, and closing price. Despite what most analysts believe, technical indicators were not designed to predict future price movement as much as to define current price movement. Each type of indicator has a different formula and varies in its degree of sophistication. It is believed by most experienced money managers and traders that the simplest formulas often lead to the most successful trading. 153 Mastering the Currency Market Leading and Lagging Indicators The term leading indicator is somewhat of a misnomer in that there is no tool that can predict what will happen in the future. Previous and current price behaviors are generally the only determinants in technical analysis. For the sake of analysis, however, technical indicators can be divided into two types: leading indicators and lagging indicators. A leading indicator gives us an indication or signal before an actual price reversal; a lagging indicator gives us an indication or signal after a new trend has started. The first thing one needs to understand about this concept is that trades that are based on a leading indicator probably are going to have a higher losing percentage because the indicator is anticipating price behavior. In contrast, with a lagging indicator we wait for behavior that indicates that a reversal has occurred, and that new trend is already under way before we commit to a trade. Most leading indicators measure momentum, or the degree of the slope of a current price movement—i.e., the speed of the trend—and are called momentum oscillators. Momentum in markets ebbs and flows, and an indicator that lets us know whether the speed of the market is accelerating or slowing is a handy tool to have because larger price changes usually are accompanied by higher price momentum. A market can be making lower lows and lower highs and be in an obvious downtrend, but if the rate of its descent is slowing and we have a position that is going with the trend, we may want to pay closer attention to price. We would take additional confirmation from individual candle behavior and support lines. Similarly, if the rate of acceleration is increasing in our favor, we would be more inclined to maintain our position. 154 T e c h n i c a l I n d i c at o r s Direction constitutes important information, but measuring momentum, particularly as a market approaches support or resistance, has predictive value. Leading indicators include stochastics, the Relative Strength Index (RSI), and the Commodity Channel Index (CCI). Most trend-following indicators, or “overlays,” such as moving averages and moving average crosses, are considered lagging indicators as they are giving us the price’s previous and current direction. Indicators based on previous price action cannot alert us to a change of direction until after the market has experienced it. An advantage of this is that we are inclined to stay with positions longer. It is thought by many experienced traders that the most important skill a trader can have and the one that is the hardest to achieve is the ability to “let a profit run,” or stay in a position longer and maximize profits. Two of the main reasons for this are emotions, generally nervousness, and leading indicators. Trend traders need to be comfortable with lagging indicators. Lagging indicators other then moving averages include moving average convergence/divergence (MACD) and Bollinger bands. Lagging Indicators Moving Averages and Crosses: Simple and Exponential Moving averages are lagging indicators that are overlaid on the price chart and are used primarily to help traders identify a trend’s direction, provide support or resistance, and generate trade signals. A simple moving average (SMA) is a chart overlay that provides a smoothed average of the closing prices or opening prices for a particular period. A simple moving 155 Mastering the Currency Market average is calculated by adding together a specific number of bars’ or candles’ closing prices and dividing that sum by the total number of time periods to get an average price. The formula for a five-period moving average is SMA ⫽ (C1 ⫹ C2 ⫹ C3 ⫹ C4 ⫹ C5) ⫼ 5 Figure 7-1 shows a five-period simple moving average taken for EURUSD in summer 2008. As each candle is completed on the chart, a new average point is plotted so that over time the average moves forward, following price. The shorter-term the time frame covered by the moving average is, the more sensitive the moving average becomes and the choppier the line becomes. The longer-term the moving average is, the more Figure 7-1 Five-Period Simple Moving Average 156 T e c h n i c a l I n d i c at o r s desensitized it becomes and the smoother the line becomes. The moving average is used to smooth out actual price action in an effort to make the trend easier to spot. When price is trading above the moving average points, the trend is said to be higher, whereas price trading below the moving average indicates that the trend is lower. Some analysts use longer-term moving averages such as 100-period and 200-period averages as support or resistance. Longer-term averages also are used to generate signals in several ways. If the close is above or below a particular moving average, a buy or sell signal may be generated. A moving average cross is formed by using two separate averages that are based on two different time frames that then are used both to confirm trending price action and to generate trade signals. Figure 7-2 is a chart of the S&P 500 stock index futures contract from the fourth quarter of 2007 through Figure 7-2 Fifty-Period and 200-Period Simple Moving Average 157