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A good understanding of the basic tenets of technical analysis
can vastly improve one's trading skills.
 When
using technical analysis, price is the primary tool. Simply put,
"everything is already in the rate." However, technical
analysis involves a bit more than simply staring at price charts
hoping to find a "yellow brick road" to a bonanza payday.
Along with various methods of plotting price action on charts
by using bars, candlesticks, and Xs and Os on point and figure
charts, market technicians also employ many technical studies
that help them to delve deeper into the data. By using these studies
in conjunction with their price charts, traders are able to build
much stronger cases to buy, sell or remain on the sidelines than
they could by simply looking at price charts alone.
Here are descriptions of some of the
more widely used and time-tested studies that technicians keep
in their toolboxes:
Moving Averages
One of the most basic and widely used indicators in a technical
analyst's tool box, moving averages help traders verify existing
trends, identify emerging trends, and view overextended trends
about to reverse. Moving averages are lines overlaid on a chart
indicating long term price trends with short term fluctuations
smoothed out.
There are three basic types of moving
averages:
- Simple
- Weighted
- Exponential
A simple moving average
gives equal weight to each price point over the specified period.
The user defines whether the high, low, or close is used and these
price points are added together and averaged. This average price
point is then added to the existing string and a line is formed.
With the addition of each new price point the sample set drops
off the oldest point. The simple moving average is probably the
most widely used moving average.
A weighted moving average
gives more emphasis to the latest data. A weighted moving average
multiplies each data point by a weighting factor which differs
from day to day. These figures are added and divided by the sum
of the weighting factors. A weighted moving average allows the
user to successfully smooth out a curve while having the average
more responsive to current price changes.
An exponential moving average
is another way of "weighting" the more recent data.
An exponential moving average multiplies a percentage of the most
recent price by the previous period's average price. Defining
the optimum moving average for a particular currency pair involves
"curve fitting". Curve fitting is the process of selecting
the right number of periods with the correct type of moving average
to produce the results the user is trying to achieve. By trial
and error, technicians work with the time periods to fit the price
data.
Because the moving average is constantly changing based on the
latest market data, many traders will use different "specified"
time frames before they come up with a series of moving averages
that are optimal for a particular currency.
For example, a trader might create a 5-day, a 15-day and a 30-day
moving average for a currency and then plot them on his or her
price chart. He might start out using simple moving averages and
end up using weighted moving averages. In creating these moving
averages, traders need to decide on the exact price data that
will be used in this study; meaning closing prices vs. opening
prices vs. high/low/close etc. After doing so, a series of lines
are created that reflect the 5-day, 15-day and 30-day moving average
of a currency.
Once the data is layered over a price chart, traders can determine
how well these chosen periods keep track of the trend being followed.
If, for example, a market is trending higher, you'd expect the
30-day moving average to be a very accurate trend line, providing
a line of support for prices on their way higher. If prices seem
too close under this 30-day moving average on several occasions
without resulting in a halt in the up trend, a trader will simply
adjust the time period to say a 45-day or 60-day moving average
in order to optimize the average. In this way, the moving average
will act as a trend line.
After determining the optimum moving average for a currency,
this average price line can be used as a line of support in maintaining
a long position or resistance in maintaining a short position.
Breaches of this line can also be used as a signal that a currency
is in the process of reversing course, in which case a trader
will want to pare back an existing position or come up with entry
levels for a new position. For example, if you determine that
a 30-day moving average has shown itself to be a good support
line for USD-JPY in an upward trending market, then market closes
under this 30-day moving average line could be a signal that this
trend could be running out of steam. However, it is important
to wait for confirmation of these signals. One way to do this
is to wait for another close below the level. On the second close
under the average, you should begin to pare down your position.
Another confirmation involves using other, shorter term moving
averages.
While a longer term moving average can help to define and support
a particular trend, shorter term moving averages can provide lead
signals that a trend is ending before prices dip below your longer
term moving average line. For this reason, most traders will plot
several moving averages on the same chart. In a market that is
trending higher, a shorter term moving average might signal a
market reversal by turning down and crossing over the longer term
moving average. For example, if you are using a 15-day and a 45-day
moving average in a market that is in an up trend, and the 15-day
moving average turns down and crosses over the 45-day moving average,
this could be an early signal that the up trend is ending and
it is probably time to begin to pare down your position.
Stochastics
Stochastic studies, or oscillators, are another useful tool for
monitoring the expected sustainability of a trend. They provide
a trader with information about the closing price in the current
trading period relative to the prior performance of the instrument
being analyzed.
Stochastics are measured and represented by two different lines,
%K and %D and are plotted on a scale ranging from 0 to 100. Indications
above 80 represent strong upward movement while level indications
below 20 represent strong downward movements. The mathematics
behind the studies are not as important as knowing what the stochastics
are telling you. The %K line is the faster, more sensitive indicator
while the %D line takes more time to turn. When the %K line crosses
over the %D line, this could be an indication that a market is
about to reverse course. Stochastic studies are not useful in
choppy, sideways markets. At times when prices are fluctuating
in a narrow range, the %K and %D lines might be crossing many
different times and will be telling you nothing more than the
market is moving sideways.
Stochastics are most useful in measuring the strength of a trend
and as augurs of a coming reversal in prices. When prices are
making new highs or lows and your stochastics are doing the same,
you can be reasonably certain that the trend will continue. On
the other hand, many traders finds that the best trading opportunity
comes when their stochastic indicator is flattening out or moving
in the opposite direction of prices. When these divergences occur,
it's time to book profits and/or to establish a position in the
opposite direction of the prior trend.
As should always be the case when using any technical tool, do
not act on the first signal you see. Wait at least one or two
trading sessions for confirmation of what the study is indicating
before you commit to a position.
Relative Strength Index
(RSI)
RSI measures the momentum of price movements. It is also plotted
on a scale ranging from 0 to 100. Traders will tend to look at
RSI readings over 80 as an indicator of a market that is overbought
or susceptible to a downturn, and readings under 20 as a market
that is oversold or ready to turn higher.
This logic therefore implies that prices cannot rise or fall
forever and that by using an RSI study, one can determine with
a reasonable degree of certainty when a reversal will come about.
However, be very wary of trading on RSI studies alone. In many
instances, an RSI can remain at very lofty or sunken levels for
quite a while without prices reversing course. At these times,
the RSI is simply telling you that a market is quite strong or
quite weak and shows no signs of changing course.
RSI studies can be adjusted to whatever time sensitivity a trader
feels necessary for his or her particular style. For instance,
a 5-day RSI will be very sensitive and will tend to give many
more signals, not all of them sustainable, than say a 21-day RSI,
which will tend to be less choppy. As with other studies, try
a variety of time periods for the currency that you are trading
based on your trading style. Longer term, position type traders,
will tend to find that shorter time frames used for an RSI (or
any other study for that matter) will give too many signals and
will result in over-trading. On the other hand, shorter time frames
will probably be ideal for day-traders trying to capture many
shorter-term price fluctuations.
As with stochastics, look for divergences between prices and
the RSI. If your RSI turns up in a slumping market or turns down
during a bull run, this could be a good indication that a reversal
is just around the corner. Wait for confirmation before you act
on divergent indications from your RSI studies.
Bollinger Bands
Bollinger Bands are volatility curves used to identify extreme
highs or lows in relation to price. Bollinger Bands establish
trading parameters, or bands, based on the moving average of a
particular instrument and a set number of standard deviations
around this moving average.
For example, a trader might decide to use a 10-day moving average
and 2 standard deviations to establish Bollinger Bands for a given
currency. After doing so, a chart will appear with price bars
capped by an upper boundary line based on price levels 2 standard
deviations higher than the 10-day moving average and supported
by a lower boundary line based on 2 standard deviations lower
than the 10-day moving average. In the middle of these two boundary
lines will be another line running somewhat close to the middle
area depicting in this case, the 10-day moving average. Both the
moving average and the number of standard deviations can be altered
to best suit a particular currency.
Jon Bollinger, creator of Bollinger Bands recommends using a
simple 20-day moving average and 2 standard deviations. Because
standard deviation is a measure of volatility, Bollinger Bands
are dynamic indicators that adjust themselves (widen and contract)
based on the current levels of volatility in the market being
studied. When prices hit the upper or lower boundaries of a given
set of Bollinger Bands, this is not necessarily an indication
of an imminent reversal in a trend. It simply means that prices
have moved to the upper limits of the established parameters.
Therefore, traders should use another study in conjunction with
Bollinger Bands to help them determine the strength of a trend.
MACD - Moving Average
Convergence Divergence
MACD is a more detailed method of using moving averages to find
trading signals from price charts. Developed by Gerald Appel,
the MACD plots the difference between a 26-day exponential moving
average and a 12-day exponential moving average. A 9-day moving
average is generally used as a trigger line, meaning when the
MACD crosses below this trigger it is a bearish signal and when
it crosses above it, it's a bullish signal.
As with other studies, traders will look to MACD studies to provide
early signals or divergences between market prices and a technical
indicator. If the MACD turns positive and makes higher lows while
prices are still tanking, this could be a strong buy signal. Conversely,
if the MACD makes lower highs while prices are making new highs,
this could be a strong bearish divergence and a sell signal.
Fibonacci Retracements
Fibonacci retracement levels are a sequence of numbers discovered
by the noted mathematician Leonardo da Pisa during the twelfth
century. These numbers describe cycles found throughout nature
and when applied to technical analysis can be used to find pullbacks
in the currency market.
Fibonacci retracement involves anticipating changes in trends
as prices near the lines created by the Fibonacci studies. After
a significant price move (either up or down), prices will often
retrace a significant portion (if not all) of the original move.
As prices retrace, support and resistance levels often occur at
or near the Fibonacci Retracement levels.
In the currency markets, the commonly used sequence of ratios
is 23.6 %, 38.2%, 50% and 61.8%. Fibonacci retracement levels
can easily be displayed by connecting a trend line from a perceived
high point to a perceived low point. By taking the difference
between the high and low, the user can apply the % ratios to achieve
the desired pullbacks.
One final word of advice:
Don't get too caught up in the mathematics involved in putting
together each study. It is much more important to understand how
and why studies can and should be manipulated based on the time
periods and sensitivities that you determine are ideal for the
currency you are trading. These ideal levels can only be determined
after applying several different parameters to each study until
the charts and studies begin to reveal the "details behind
the details."
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