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Mastering the Currency Market the most reliable trade signals is the combination trendline break and stochastic cross. In the last section we talked about what happens when a trend reverses and how the order of operation for the technical indicators plays out. Right at the top of the list was the trendline break and the stochastic cross. The combination of these two occurrences is always noteworthy because a shift in the trend cannot occur without them. Because of the simplicity and reliability of this signal, it is one of the first trade signals we will be covering. We see an example of these signals in Figure 9-5, where we have the signals marked by vertical lines that show the candles that gave us the signals. The vertical line on the left side of the Figure 9-5 Combination Stochastic and Trendline Trade Signal 212 T y i n g t h e T e c h n i c a l I n d i c at o r s T o g e t h e r chart marks a sell signal given by the combination of the price closing below a short-term up trendline and the stochastic crossing below the oversold line. The vertical line on the right marks a buy signal marked by a close above the bear trendline combined with the stochastic moving higher above the oversold line. The trendline drawn is intermediate-term in length as it is between 15 and 60 candles. Also note how the MACD supports both the sell signal and the buy signal. To take a sell signal, we prefer to see that the MACD histogram has stair-stepped lower at least once, which tells us that there is a shift in momentum in favor of the signal. For the buy signal on the right side of the chart, we see that although MACD is below zero, the MACD histogram is stairstepping in the direction of the trigger. When we use the trendline and stochastic cross signal, we don’t need the MACD histogram for confirmation, but we want it to confirm within the next couple of candles. A rule of thumb is that if we are considering a trade signal and the MACD histogram is moving opposite to the signal, we know we are very likely to be entering a countertrend trade and should be even more active in monitoring the trade. Preferably, we want at least the MACD histogram starting to stair-step in favor of the trade. Figure 9-6 provides two more examples of trade signals given by the trendline and stochastic combination. In the first case the MACD does not confirm, and in the second it does. For the first buy signal on the left side of the chart in Figure 9-6, we see that the signal did help identify a bottom, but the trader would have had to sit through a drawdown on his or her position and a retest of that low. The reason for this 213 Mastering the Currency Market Figure 9-6 MACD Confirms Trade Signal is that the momentum of the down move was too strong, as marked by the increased slope of the sell-off. When we see momentum that strong before a signal, we may decide that it does not warrant the risk of taking the trade. When a price move is marked by a nearly parabolic candle like this one, it is best to stick with signals in the same direction as the momentum or just not trade. The MACD confirms our decision not to take the signal as it is below both the zero line and the trigger line. Eventually the market gave us a rounded bottom, and the next buy signal on the right side of the chart provided a nice trade as the intermediate-term trendline was penetrated. At the time of this signal the MACD confirmed by crossing above the trigger line to give us a countertrend buy signal. 214 T y i n g t h e T e c h n i c a l I n d i c at o r s T o g e t h e r The next signal we are going to cover is a close above a bullish doji and a close below a bearish doji. When the market gives us a doji or, more specifically, a shooting star doji at or near resistance and then has a close below the low of that doji, this is a sell signal. The shooting star candle tells us the market is indecisive, and the candle that closes below that low would be a change-of-direction candle by definition because it closes below the low of the doji. We can take this combination of candles as a sell trigger. On the October 2008 GBPJPY chart shown in Figure 9-7 we see a pair of sell signals created by a shooting star dojis followed immediately by change-of-direction candles that closed below the low of the dojis. The change-of-direction candle is often going to provide a signal because by definition Figure 9-7 Candlestick Trade Signals 215 Mastering the Currency Market Figure 9-8 Candlestick Buy Signals it is breaking the previous pattern of price action, and it also is very likely to create a short-term trendline break. In her 1996 book Trading with the Odds, Cynthia Kase describes how she often uses this signal to exit trades. Figure 9-8 shows examples of hammer dojis followed by change-of-direction candles in the summer of 2007 that marked a secondary low in GBPJPY. Trending and Countertrending Behavior In Chapter 4 we touched on the difference between trending and countertrending markets by pointing out that elongated candles extending up or down identify trending, or impulsive price action, whereas shorter candles with smaller bodies 216 T y i n g t h e T e c h n i c a l I n d i c at o r s T o g e t h e r indicate countertrending price action, or reactive trading. This is an important distinction for a trader because although our indicators and overlays remain the same, our trading strategy will differ slightly with the type of market we are in. A trending market is one in which the directional bias is obvious and can be seen on the chart by a pattern of highs, lows, and closes moving in the same direction. A countertrending market is one in which there is no obvious direction other than sideways. Trending markets call for making quick decisions upon entering a trade but showing more patience once one is in the market, whereas countertrending markets give the trader more time in taking a trade but require less time in the trade and speed in exiting. Trending markets by definition are impulsive and move easily in one direction, whereas countertrend markets are reactive by nature and exhibit indecisive price action. We can define a trend trade as a position taken in the same direction as the overall pattern of highs, lows, and closing prices. A countertrend trade is one in which the trader is going against, or fading, the overall direction of the market in anticipation of a correction or a reversal or a trade in which the objective is to take advantage of a sideways market by selling near the top of the current price range and buying near the bottom. Beginning traders often are attracted to countertrend trading because of the perceived level of risk. To someone with a small account, buying a market at a support level after a sharp price drop and then placing a tight stop-loss order can seem like a better choice than waiting for a market to correct or retrace and then turn before entering the trade and then placing a stop-loss order some distance away, below the last swing high. We believe a 217 Mastering the Currency Market trader is better off recognizing the environment she is in by seeing the overall pattern of highs and lows and gauging the momentum before making the decision to go with a trending strategy in which once she is in the trade, she may use a lagging indicator and plan to allow the trend to develop. Or a trader can decide to employ a countertrend strategy in which he uses support and resistance, individual candle behavior, and/or a leading indicator to get in and out of trades faster. In the long run, trend traders will be rewarded more because they will be taking advantage of the market’s tendency to trend. Countertrend trading strategies can be successful but require more diligence and create higher transaction costs because of the higher frequency of trading. To enter any trade, whether in a trending or a countertrending environment, we generally prefer to use a signal generated by a leading indicator coupled with a short-term trendline break. In a countertrending environment, though, we can speed up our entry process by using the closing price beyond a doji or inside candles on existing support or resistance as the trigger. In countertrending markets we want to get in our position as close to the top or bottom of the range as we can. In a trending environment, in contrast, we want the market to give us more of an indication that it is turning rather than just a pause in support or resistance. In a strong trending market it is best to pass on countertrending signals unless you have the time and skill to trade on a lower time frame. Something to know and remember about markets is that they exhibit fractal geometry. What this means is that price 218 T y i n g t h e T e c h n i c a l I n d i c at o r s T o g e t h e r behavior on the higher time frames is mimicked by price behavior on the lower time frames. If we are seeing pronounced trending behavior on the daily chart, we can expect trending behavior on the intraday charts. This does not mean that the intraday movement will always be in the same direction as the primary trend; it means that the candles will be longer, which can seem counterintuitive to untrained traders. Similarly, if the market is in a narrow sideways range over an extended period on the daily chart, we would expect similar reactive behavior on an intraday basis. A very important difference between a trending market and a countertrending market is that in a trending market the higher time frames will dictate price movement and direction, whereas in a countertrending environment the lower time frame charts can dictate direction. This means that in a trending market you do not want to go against the trend on the next higher time frame. In a countertrending market you are taking signals on the lower time frames routinely regardless of the previous direction on the higher time frames. We titled this section “Trending and Countertrending Behavior” instead of “Trending versus Countertrending Behavior” because to be a complete trader, you must do both. The easiest way to define whether you are in a trending or a countertrending market is to define the trends on the different time frames and see if they are in agreement, which would mean a trending market, or are conflicting, which would mean a countertrending market. We are going to teach you how to do that in the next section. 219 Mastering the Currency Market Higher Time Frame Confirmation and Quantifying the Trend In this section we consider the words intermediate and secondary, with the words long-term and primary interchangeable. We generally refer to a market movement as secondary and describe the trend that constitutes that movement to be intermediate-term. Similarly, we measure a primary move by identifying the long-term trend. Knowing how to use a higher time frame chart to confirm a price signal on a lower time frame is a skill that can reward a trader greatly. Many students will become impatient and take a trade that is coordinated on the lower time frames, not on the higher time frames. This is a mistake and often a waste of time, energy, and, more important, money. Although you may not always have all the time frames line up, there will be times when this happens. More often than not, though, if you are trading an intraday chart and have the current trend on the daily chart lined up in the same direction, you are going to have the wind at your back. If you have the knowledge to identify markets in which the intraday trends are moving in the same direction as the daily and weekly trends, you are going to put yourself in a position to reap a reward. Here are the time frames we analyze and trade from: Monthly   weekly   daily   240 minutes   60 minutes   15 minutes   5 minutes The different time frames we use must remain three to six increments apart to maintain continuity: 220 T y i n g t h e T e c h n i c a l I n d i c at o r s T o g e t h e r Monthly/4 Weekly/5 Daily/6 240/4 60/4 15/3 ⫽ weekly chart ⫽ daily chart ⫽ 240-minute chart ⫽ 60-minute chart ⫽ 15-minute chart ⫽ 5-minute chart In analyzing a market we never skip over a time frame. If we are trading off a 60-minute chart, we look to our 240-minute chart for confirmation. We never jump time frames because we would lose continuity. If we see a signal on the daily chart, we look to the trend on the weekly chart for confirmation. If we see a signal or setup on the 15-minute chart, we look to the 60-minute chart for confirmation. It is paramount to maintain this continuity. The collage of charts in Figure 9-9, with the long-term on the left, the intermediate-term on the lower right, and the short-term on the upper right, provides an excellent perspective from which to analyze and trade markets. (For this example we are using the monthly chart for the long term, the weekly chart for the intermediate term, and the daily chart for the short term.) Here we see the market’s stance, with the higher time frame charts encompassing all the activity on the lower time frame charts. We’ve overlaid most of the significant support and resistance levels and trendlines on the charts, along with the MACD, stochastic, and RSI at the bottom. (For ease of viewing we have omitted the RSI on the lower time frame charts.) We should always take direction and identify a trade setup from our intermediate-term chart, in this case the weekly chart. We can look to the long-term chart for confirmation or support—though this is not a prerequisite, particularly if one is day trading—and use the short-term chart to hasten our entry and exit signals. 221