Introduction to Technical Analysis

Technical analysis is a method of forecasting price movements by looking at purely market-generated

data. Price data from a particular market is most commonly the type of information analyzed by a
technician, though most will also keep a close watch on volume and open interest in futures contracts.
The bottom line when utilizing any type of analytical method, technical or otherwise, is to stick to the
basics, which are methodologies with a proven track record over a long period. After finding a trading
system that works for you, the more esoteric fields of study can then be incorporated into your trading
toolbox.

Almost every trader uses some form of technical analysis. Even the most reverent follower of market
fundamentals is likely to glance at price charts before executing a trade. At their most basic level, these
charts help traders determine ideal entry and exit points for a trade. They provide a visual
representation of the historical price action of whatever is being studied. As such, traders can look at a
chart and know if they are buying at a fair price (based on the price history of a particular market),
selling at a cyclical top or perhaps throwing their capital into a choppy, sideways market. These are
just a few market conditions that charts identify for a trader. Depending on their level of sophistication,
charts can also help much more advanced studies of the markets.

On the surface, it might appear that technicians ignore the fundamentals of the market while
surrounding themselves with charts and data tables. However, a technical trader will tell you that all of
the fundamentals are already represented in the price. They are not so much concerned that a natural
disaster or an awful inflation number caused a recent spike in prices as much as how that price action
fits into a pattern or trend. And much more to the point, how that pattern can be used to predict future
prices.

Technical analysis assumes that:

• All market fundamentals are depicted in the actual market data. So the actual market
fundamentals and various factors, such as the differing opinions, hopes, fears, and moods of
market participants, need not be studied.

• History repeats itself and therefore markets move in fairly predictable, or at least quantifiable,
patterns. These patterns, generated by price movement, are called signals. The goal in technical
analysis is to uncover the signals given off in a current market by examining past market
signals.
• Prices move in trends. Technicians typically do not believe that price fluctuations are random
and unpredictable. Prices can move in one of three directions, up, down or sideways. Once a
trend in any of these directions is established, it usually will continue for some period.

The building blocks of any technical analysis system include price charts, volume charts, and a host of
other mathematical representations of market patterns and behaviors. Most often called studies, these
mathematical manipulations of various types of market data are used to determine the strength and
sustainability of a particular trend. So, rather than simply relying on price charts to forecast future
market values, technicians will also use a variety of other technical tools before entering a trade.

As in all other aspects of trading, be very disciplined when using technical analysis. Too often, a trader
will fail to sell or buy into a market even after it has reached a price that his or her technical studies
identified as an entry or exit point. This is because it is hard to screen out the fundamental realities that
led to the price movement in the first place.

As an example, let's assume you are long USD vs. euro and have established your stop/loss 30 pips
away from your entry point. However, if some unforeseen factor is responsible for pushing the USD
through your stop/loss level you might be inclined to hold this position just a bit longer in the hopes
that it turns back into a winner. It is very hard to make the decision to cut your losses and even harder
to resist the temptation to book profits too early on a winning trade. This is called leaving money on
the table. A common mistake is to ride a loser too long in the hopes it comes back and to cut a winner
way too early. If you use technical analysis to establish entry and exit levels, be very disciplined in
following through on your original trading plan.

Price charts
Chart patterns
There are a variety of charts that show price action. The most common are bar charts. Each bar will
represent one period of time and that period can be anything from one minute to one month to several
years. These charts will show distinct price patterns that develop over time.

Candlestick patterns
Like bar charts patterns, candlestick patterns can be used to forecast the market. Because of their
colored bodies, candlesticks provide greater visual detail in their chart patterns than bar charts.

Point & figure patterns

Point and figure patterns are essentially the same patterns found in bar charts but Xs and Os are used to
market changes in price direction. In addition, point and figure charts make no use of time scales to
indicate the particular day associated with certain price action.

Technical Indicators
Here are a few of the more common types of indicators used in technical analysis:

Trend indicators
Trend is a term used to describe the persistence of price movement in one direction over time. Trends
move in three directions: up, down and sideways. Trend indicators smooth variable price data to create
a composite of market direction. (Example: Moving Averages, Trend lines)
Strength indicators
Market strength describes the intensity of market opinion with reference to a price by examining the
market positions taken by various market participants. Volume or open interest are the basic
ingredients of this indicator. Their signals are coincident or leading the market. (Example: Volume)

Volatility indicators
Volatility is a general term used to describe the magnitude, or size, of day-to-day price fluctuations
independent of their direction. Generally, changes in volatility tend to lead changes in prices.
(Example: Bollinger Bands)

Cycle indicators
A cycle is a term to indicate repeating patterns of market movement, specific to recurrent events, such
as seasons, elections, etc. Many markets have a tendency to move in cyclical patterns. Cycle indicators
determine the timing of a particular market patterns. (Example: Elliott Wave)

Support/resistance indicators
Support and resistance describes the price levels where markets repeatedly rise or fall and then reverse.
This phenomenon is attributed to basic supply and demand. (Example: Trend Lines)

Momentum indicators
Momentum is a general term used to describe the speed at which prices move over a given time period.
Momentum indicators determine the strength or weakness of a trend as it progresses over time.
Momentum is highest at the beginning of a trend and lowest at trend turning points. Any divergence of
directions in price and momentum is a warning of weakness; if price extremes occur with weak
momentum, it signals an end of movement in that direction. If momentum is trending strongly and
prices are flat, it signals a potential change in price direction. (Example: Stochastic, MACD, RSI)
 Using Technical Indicators
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."
 Trend vs. No Trend
Which Technical Indicators to Use?

If "the trend is your friend," what happens when there is no trend? This is more than just a rhetorical
question, since markets tend to move sideways much more frequently than they trend. For example,
currency markets are particularly well known for long-term trends, which are in turn caused by long-
term macro-economic trends, such as interest rate tightening or easing cycles. But even in currency
markets, historical analysis reveals that trending periods only account for about 1/3 of price action
over time, meaning that about two-thirds of the time there is no trend to catch.

The Trend/No Trend Paradox

To make matters worse, many traders typically utilize only one or two technical indicators to identify
market direction and trade-timing. This one-size-fits-all approach leaves them exposed to the trend/no-
trend paradox – an indicator that works well in trending markets can give disastrous results in
sideways markets and vice versa. As a result, individual traders frequently find themselves exiting
positions too early and missing out on larger moves as a bigger trend unfolds. Conversely, traders may
end up holding onto a short-term position for too long following a reversal, believing they are "with
the trend," when no trend exists.

To avoid getting caught in the paradox, this article will suggest using several technical tools in
conjunction to determine whether or not a trend is in place. This will in turn dictate which technical
indicators are best used to gauge entry/exit points as well as provide some risk management guidance.
Rather than setting forth a list of concrete trading rules, this article seeks to outline a dynamic
approach to the use of technical analysis to avoid getting caught in the trend/no-trend paradox.

Trend-friendly Tools
The obvious starting point for this discussion is to define what is meant by a trend. In terms of
technical analysis, a trend is a predictable price response at levels of support/resistance that change
over time. For example, in an uptrend the defining feature is that prices rebound when they near
support levels, ultimately establishing new highs. In a downtrend, the opposite is true – price increases
will reverse as they near resistance levels, and new lows will be reached. This definition reveals the
first of the tools used to identify whether a trend is in place or not – trendline analysis to establish
support and resistance levels.

Trendline analysis is sometimes underestimated because it is perceived as overly subjective in nature.

While this criticism has some truth, it overlooks the reality that trendlines help focus attention on the
underlying price pattern, filtering out the noise of the market. For this reason, trendline analysis should
be the first step in determining the existence of a trend. If trendline analysis does not reveal a
discernible trend, it's probably because there isn't one. Trendline analysis will also help identify price
formations that have their own predictive significance.
Trendline analysis is best employed starting with longer time frames (daily and weekly charts) first
and then carrying them forward into shorter timeframes (hourly and 4-hourly) where shorter-term
levels of support and resistance can then be identified. This approach has the advantage of highlighting
the most significant levels of support/resistance first and minor levels next. This helps reduce the
chances of following a short-term trendline break while a major long-term level is lurking nearby.

A more objective indicator of whether a market is trending is the directional movement indicator
system (DMI). Using the DMI removes the guesswork involved with spotting trends and can also
provide confirmation of trends identified by trendline analysis. The DMI system is comprised of the
ADX (average directional movement index) and the DI+ and DI- lines. The ADX is used to determine
whether or not a market is trending (regardless if it's up or down), with a reading over 25 indicating a
trending market and a reading below 20 indicating no trend. The ADX is also a measure of the strength
of a trend – the higher the ADX, the stronger the trend. Using the ADX, traders can determine whether
or not there is a trend and thus whether or not to use a trend following system.

As its name would suggest, the DMI system is best employed using both components. The DI+ and
DI- lines are used as trade entry signals. A buy signal is generated when the DI+ line crosses up
through the DI- line; a sell signal is generated when the DI- line crosses up through the DI+ line.
(Wilder suggests using the "extreme point rule" to govern the DI+/DI- crossover signal. The rule states
that when the DI+/- lines cross, traders should note the extreme point for that period in the direction of
the crossover (the high if DI+ crosses up over DI-; the low if DI- crosses up over DI+). Only if that
extreme point is breached in the subsequent period is a trade signal confirmed.

The ADX can then be used as an early indicator of the end/pause in a trend. When the ADX begins to
move lower from its highest level, the trend is either pausing or ending, signaling it is time to exit the
current position and wait for a fresh signal from the DI+/DI- crossover.

Non-trend Tools
Momentum oscillators, such as RSI, stochastics, or MACD, are a favorite indicator of many traders
and their utility is best applied to non-trending or sideways markets. The primary use of momentum
indicators is to gauge whether a market is overbought or oversold relative to prior periods, potentially
highlighting a price reversal before it actually occurs.

However, this application fails in the case of a trending market, as the price momentum can remain
overbought/oversold for many periods while the price continues to move persistently higher/lower in
line with the underlying trend. The practical result is that traders who rely solely on a momentum
indicator might exit a profitable position too soon based on momentum having reached an extreme
level, just as a larger trend movement is developing. Even worse, some might use overbought/oversold
levels to initiate positions in the opposite direction, seeking to anticipate a price reversal based on
extreme momentum levels.
The second use of momentum oscillators is to spot divergences between price and momentum. The
rationale with divergences is that sustained price movements should be mirrored by the underlying
momentum. For example, a new high in price should be matched by a new high in momentum if the
price action is to be considered valid. If a new price high occurs without momentum reaching new
highs, a divergence (in this case, a bearish divergence) is said to exist. Divergences frequently play out
with the price action failing to sustain its direction and reversing course in line with the momentum.

In real life, though, divergences frequently appear in trending markets as momentum wanes (the rate of
change of prices slows) but prices fail to reverse significantly, maintaining the trend. The practical
result is that counter-trend trades are frequently initiated based on price/momentum divergences. If the
market is trending, prices will maintain their direction, though their rate of change is slower.
Eventually, prices will accelerate in line with the trend and momentum will reverse again in the
direction of the trend, nullifying the observed divergence in the process. As such, divergences can
create many false signals that mislead traders who fail to recognize when a trend is in place.

Putting the Tools to Work

Let's look at some real-life trading examples to illustrate the application of the tools outlined above and
see how they can be used to avoid the trend/no-trend paradox. For these examples, MACD (moving
average convergence/divergence) will be used as the momentum oscillator, though other oscillators
could be substituted according to individual preferences.
The first example (Figure1) illustrates 4-hour EUR/USD price action with MACD and the DMI system
(ADX, DI+, DI-) as accompanying studies. Following the framework outlined above, trendline
analysis reveals several multi-day price movements, identified by trendlines 1 and 2. Looking next at
the ADX, it rises above the "trend" level of 25 at point A, indicating that a trend is taking hold and that
momentum readings should be discounted. This is helpful, because if one looked only at the MACD at
this point, it might be tempting to conclude that the upmove was stalling as the MACD begins to falter.
Subsequent price action, however, sees the market move higher.

Along the way however, trendline 1 is broken and the ADX tops out and begins to move lower (point
B). While the price action has been extremely volatile around this point, it should be noted that the
ADX over 25 negated the premature crossover signal of MACD as well as the break of support on
trendline 1. At point C, the ADX has fallen back below 25 and this suggests taking another look at the
MACD, which is beginning to diverge bearishly, as new price highs are not matched by new MACD
highs. A subsequent sharp downmove in price generates another negative crossover on the MACD,
and since ADX is now below 25, a short position is taken at about 1.3060 (point D).

Following along with trendline 2 now, MACD is clearly weakening as prices move lower. The ADX
initially continues to fall indicating the absence of any trend, but begins to turn up after a failed test of
trendline resistance at point E. The focus remains on the MACD at this point as the ADX is still below
25. As price declines slow, MACD crosses upward indicating it is time to exit the position at around
1.2900 at point F. Subsequent price action is extremely whippy and the ADX again fails to signal an
extended trend, confirming the decision to exit.

The above example showed the interplay between ADX and momentum (MACD), where the absence
of a trend indicated traders should focus on the underlying momentum to gauge price direction. Let's
now look at an example where a trend is present and it essentially cancels out signals given by
momentum.

Figure 2 shows USD/CHF in an hourly format with DMI and MACD as the studies. Beginning with
trendline analysis again, trendline resistance from previous highs is broken at point A. Momentum as
shown by MACD has been moving higher and supports the break higher. The ADX also rises above
25, confirming the break higher and indicating a long position should be taken at approximately
1.1650. The trade entry could also have been signaled earlier by the crossover of DI+ over DI- and the
application of Wilder's 'Extreme Point Rule.'
Subsequent price moves are modest initially, but the relevant feature to note is that the ADX remains
well above 25, suggesting momentum signals should be disregarded. This is critical since the MACD
quickly generates a signal to exit the trade at point B. Relying on the ADX alone at this point,
however, the long position is maintained and subsequent price gains cause MACD to reverse higher
again. ADX continues to rise with the price gains, which are also adhering to trendline support.
MACD again generates a sell signal at point C, but this is ignored as the ADX approaches 50,
suggesting a strong trend is now in place. Price gains become more explosive and the ADX goes on to
register new highs. Contrast that with the MACD which is indicating a bearish divergence from point
D onwards, even though the uptrend remains intact. The ADX also indicates a bearish divergence,
implying trend intensity is fading. Only at point E are exit signals given by the break of trendline
support and the decline of ADX below 25 at point E around 1.2000. In this example, a short-term trade
was able to capitalize on a much larger move by employing the ADX in addition to the MACD. A
strictly momentum based approach would have been caught in multiple whipsaws, or even a premature
short based on bearish divergence.

Bottom line
Financial markets are inherently dynamic environments. Nowhere is this more apparent than in the
trend/no trend paradox. Trading rules or themes that apply one day might be obsolete by the next day.
Carrying that notion over to technical analysis suggests traders need to employ dynamic technical tools
to adapt to ever changing markets. An approach that utilizes trendline analysis, Wilder's DMI system,
and momentum oscillators can yield far better results across varying market conditions than a single-
indicator approach.
 Using Indicators to Identify Trends
Of the many market sayings thrown around by traders, perhaps none is more overused and less
understood than the old adage 'the trend is your friend'. All too often, the phrase is used after a trader
has taken a counter-trend position and subsequently been stopped out at a loss. Remorse sets in at this
point and most traders kick themselves not only for having lost on a counter-trend trade, but also for
not having caught the latest move in the trend itself.

To avoid this all too common scenario, we will suggest using several technical tools to identify
whether or not a trend is in place and then use additional indicators to help maximize trading profits.
Having a strategy in place to identify trends is essential to successful trading in any market, but
especially so in the case of the forex markets. Currencies have a greater tendency to move in trending
fashion due to the longer-term macroeconomic elements that drive exchange rates, such as interest rate
cycles or global trade imbalances. Currencies are also pre-disposed to short-term, intra-day trends due
to international capital flows reacting in unison to day-to-day economic and political news.

Identifying the Trend

In its most basic sense, a trend is simply a prolonged market movement in one general direction, either
up or down. From a traders' perspective, though, that simple definition is so broad as to be relatively
meaningless. A more relevant definition of a trend would be one where a trend is defined as a
predictable price response at levels of support/resistance that change over time. For example, in an
uptrend the defining feature is that prices rebound when they near support levels, ultimately
establishing new highs. In a downtrend, the opposite is true-price increases will reverse as they near
resistance levels, and new lows will be reached. This definition reveals the first of the tools used to
identify whether a trend is in place or not-trendline analysis to establish support and resistance levels.

Trendline analysis is often underestimated because it is perceived as overly subjective and

retrospective in nature. While both criticisms have some truth, they overlook the reality that trendlines
help focus attention on the underlying price pattern, filtering out the noise of the market. For this
reason, trendline analysis should be the first step in determining the existence of a trend. If trendline
analysis does not reveal a discernible trend, it's probably because there isn't one.

Trendline analysis is best employed starting with longer timeframes (daily or weekly charts) first and
then carrying them forward into shorter timeframes (hourly or 4-hourly) where shorter-term levels of
support and resistance can then be identified. This approach has the advantage of highlighting the most
significant levels of support/resistance first and less important levels next. This helps reduce the
chances of following a short-term trendline break while a major long-term level is lurking nearby.

Another technical tool that can be deployed to verify the existence of a trend is the directional
movement indicator system (DMI), developed by J. Welles Wilder (see Wilder, New Concepts in
Technical Trading Systems, c. 1978). Using the DMI removes the guesswork involved with spotting
trends and can also provide confirmation of trends identified by trendline analysis. The DMI system is
comprised of the ADX (average directional movement index) and the DI+ and DI- lines. The ADX is
used to determine whether or not a market is trending (regardless if it's up or down), with a reading
over 25 indicating a trending market and a reading below 20 indicating no trend. The ADX is also a
measure of the strength of a trend--the higher the ADX, the stronger the trend. Using the ADX, traders
can determine whether or not there is a trend and thus whether or not to use a trend following system.

As its name would suggest, the DMI system is best employed using both components. The DI+ and
DI- lines are used as trade entry signals. A buy signal is generated when the DI+ line crosses up
through the DI- line; a sell signal is generated when the DI- line crosses up through the DI+ line.
(Wilder suggests using the "extreme point rule" to govern the DI+/DI- crossover signal. The rule states
that when the DI+/- lines cross, traders should note the extreme point for that period in the direction of
the crossover (the high if DI+ crosses up over DI-; the low if DI- crosses up over DI+). Only if that
extreme point is breached in the subsequent period is a trade signal confirmed.

The ADX can then be used as an early indicator of the end/pause in a trend. When the ADX begins to
move lower from its highest level, the trend is either pausing or ending, signaling it is time to exit the
current position and wait for a fresh signal from the DI+/DI- crossover.

CHART 1: JUMP IN AND HANG ON FOR THE RIDE. If you are an aggressive trader and
entered a long position at Point A, and only exited your position at Point C, you would be pleased with
the results. This can be achieved with a few simple indicators.

Let's look at recent long-term trend (chart 1) and put trendline analysis together with the DMI system
to illustrate the utility of these tools when used in conjunction with each other. An aggressive trader
might initiate a long position as the daily resistance line is breached on 11/12/03 (point A). A trader
looking for confirmation might wait a day, when the DI+ crosses up through the DI- line, generating a
buy signal. A conservative trader might wait for confirmation of the DI+/- crossover by waiting for the
extreme point (high) to be exceeded, in line with Wilder's extreme point rule. This confirmation is
given the following day (11/14/03). As the market begins to move higher, the support trendline drawn
off the lows is tested, but holds, underscoring its validity to a nascent trend. Although the market has
moved higher in line with the DI+/DI- crossover and trendline support, the ADX is still below 25 until
12/2/03 (point B), when a trend is finally confirmed. At this point, a trader should recognize that they
are in a trending market and trend following systems can usefully be employed.

This brings us to the point of introducing some additional tools that can be used to maximize profit
within a trending market. We have already suggested using the ADX as an early indicator of the end of
a trend. Note that from point B, when it first registers above 25 indicating a trending market, the ADX
continues to make new highs until 01/14/04 (point C) when it closes lower signaling a likely end to the
uptrend and that it's time to exit the long position.

A second tool used to identify an exit point and possibly the end of a trend is the parabolic indicator.
The parabolic indicator follows the price action but accelerates its own rate of increase over time and
in response to the trend. The result is that the parabolic is continually closing in on the price, and only
a steadily accelerating price rise (the essence of a trend) will prevent the price from falling below the
parabolic, signaling an end to the trend. Chart 2 shows the parabolic indicator overlaid on the previous
chart. Note that the parabolic gives an exit signal (point D) the day after the ADX experienced its first
lower close.

CHART 2: ADD A COUPLE MORE INDICATORS. Here, the parabolic indicator was used. The
exit signal was given one day after the ADX gave its exit signal.

The very basic trendlines that are drawn also could have signaled the end to the uptrend. Note that the
price accelerates above the upper channel line in the final extension of the uptrend, tests back to the
break and then goes on to make new highs. The subsequent price decline back below the upper channel
line would then signal the end of the up-move. As well, another support line similar to the parabolic
could also be drawn, and its breach would have been the earliest signal of the end of the upmove.

What About Short-term Trading?

The same tools outlined above can be used for short-term decision making, even in markets that are
trading sideways, or so-called trendless markets. While the market may not be trending in a long-term
sense, there are multiple smaller, short-term movements taking place that can be exploited. (One
caveat must be noted, though: traders need to be aware of what is happening in the bigger picture. If
shorter term ADX readings indicate a trending market, traders must be circumspect in initiating trades
that are counter to the larger, daily trend.)

CHART 3: INTRADAY BASIS. On this hourly chart of the Australian dollar, the first entry signal
was at point A. You could have held until point D, where you should have sold your position. The next
entry signal was point AA (short) with a signal for covering that short position at point CC.

Let's then look at a short-term scenario using an hourly chart of the Australian dollar (chart 3). The
first hint of a potential trading opportunity is the quick convergence of the DI+/DI- lines in the hour
marked by point A. This is caused by the sharp bounce in price during that hour. The next hourly bar
breaks through and closes above trendline resistance, precipitating DI+ crossing up through DI-.
Following Wilder's extreme point rule, we wait for the previous high to be surpassed, which happens
in the next hour at point B. At this point, we have several signals indicating a long position-the break
of trendline resistance, crossover of DI+/DI-, extreme point rule satisfied, break of parabolic. As the
market moves higher, the ADX begins to rise as well, peaking at point C and declining at point D,
giving us our signal to exit the long. Basic trendline and parabolic supports are then broken several
hours later setting the stage for the next potential move.
The next signal is given at point AA as the DI- crosses up through the DI+, generating a sell signal.
This coincides with the price falling below recent hourly lows. The ADX begins to move up,
indicating the possibility of a trend forming and eventually rises over 25 at point BB indicating a trend
is in place and that the parabolic should be followed. Trendline and parabolic resistance are then
breached and the ADX stalls at point CC, indicating an early, but profitable exit to the trade.

The Trend is Your Friend

Profiting from market trends is the essence of making the trend your friend. The first step to profiting
from both short- and long-term trends is understanding what constitutes a trend and knowing how to
identify them. The next step is employing a disciplined trading strategy that is specific to trends. A
conscientious approach utilizing trendline analysis, the DMI system, and the parabolic indicator should
help traders make more friends of market trends.
 Cashing in on Short-Term Currency Trends
Trends may be rarer than trading ranges, but that doesn't mean they can't be traded. This strategy uses
two time frames to identify the trend, an overbought-oversold indicator to pinpoint entry and a trailing
stop to protect gains on profitable trades.

Many technical trading strategies revolve around the assumption that markets will hover within a given
range — and with good reason. Seventy percent of the time markets will bounce back and forth
between support and resistance levels, or fluctuate randomly. The rest of the time, market behavior is
characterized by persistent price moves — trends — that shatter support and resistance levels.

Although these basic probabilities work against traders who try to exploit trends, the potential rewards
can be worth the risk. It is possible to increase your ability to capitalize on trends by locating trend
signals, identifying specific entry points within the trend and using risk management techniques to
limit losses.

The following sections will explain how a trading system basedon these concepts works especially
well in the foreign exchange (Forex), or currency, market, particularly with the "major" currencies —
the U.S. dollar, Euro, Japanese yen, British pound, Swiss franc, Canadian dollar and Australian dollar.
More than 85 percent of transactions in the $1 trillion per day Forex market involve the majors.

Tools and Rules

The strategy uses two charts with different time periods (10-minute and hourly), along with two
technical indicators: a 200-bar moving average and a 14-bar slow stochastic study (see "Stochastic
refresher," right).

Step 1: Identify a trend. Compare the moving averages on the 10-minute and hourly charts. A trend is
in effect when price is consistently above/below the moving averages on both charts.

Step 2: Pinpoint entry. Once you've identified a trend, look for the following two conditions at the
same time on the 10-minute chart: 1) the market is no more than 20 points above (to buy) or 20 points
below (to sell) the moving average; and 2) the fast stochastic line crosses above the slow stochastic
line below 20 (to buy) or crosses below the slow stochastic line above 80 (to sell).

These conditions indicate: 1) the currency is currently in a short-term uptrend or downtrend; and 2) the
currency has paused or pulled back (reflected by the higher low stochastic reading and the fact that
price is within 20 points of the moving average) and is poised to turn (because the fast stochastic line
is crossing back above or below the slow line).

Step 3: Ride the trend. Set a trailing stop after the initial trade entry. On a long position, enter a stop-
loss order 10 points below the 200-period moving average on the 10-minute chart. In the case of a
short position, place the initial stop 10 points above this moving average. As the trade goes in your
favor, raise (for a long trade) or lower (for a short trade) the stop to protect profits. For simplicity's
sake, the following examples use a trailing stop 25 points from each new top or bottom. The charts in
the next section illustrate the application of this strategy in two currency pairs.

Trade Examples

The first example took place in the Euro currency-dollar (EUR/USD) currency pair during the fourth
week of June 2002.

First, compare the hourly and 10- minute EUR/USD charts. Look for a time when price is above the
200-period moving averages on both charts. On the hourly chart (Figure 1 - Click here to view), the
fact that price is almost exclusively above the 200-hour moving average indicates a persistent uptrend.
On the 10-minute chart (Figure 2 - Click here to view), price moves (and remains above) the moving
average in the last third of the chart. The next step is to pinpoint the entry zone — when the market is
within 20 points of the moving average on the 10- minute chart and the stochastic lines cross.

The range between 1 p.m. and midnight on June 27 meets these requirements. The entry point occurs
when the fast stochastic crosses above the slow stochastic when the indicator is below 20. A long
position is entered at .9883 around 8 p.m., with an accompanying stop-loss at .9858 (10 points below
the 200-bar moving average value of .9868). The stop is then trailed upward as the market makes new
peaks. The EUR/USD tops out at .9992, so the stop scaled up to .9967, where the position was closed
for an 84-point ($840) gain.

Figures 3 and 4 illustrate a similar example in the dollar-yen rate (USD/JPY). The hourly chart
(Figure 3 - Click here to view) shows price was trading well below the 200-bar moving average after
June 21. On the 10-minute chart (Figure 4 - Click here to view), price fell below the moving average
after 10 a.m. on June 27, indicating a sell opportunity. Also, price was within 20 points of the moving
average at this point. A short trade was opened around 5 p.m. at 119.57 when the fast stochastic line
crossed below the slow stochastic line when the indicator was above 80.

The trade was protected with a stop-loss order at 119.86. In this case, the stop remained intact until the
following day, when USD/JPY began to decline. After trailing the stop down as the market continued
to decline, profits were taken at 118.58 (25 points off the 118.33 low), for a gain of 99 points.

Search and Exploit

This short-term trading method works well in the Forex market, but it is also applicable to others. Each
step of the system helps identify areas where effective trades can be made. If at any point one of the
criteria is not met, you'll instantly know not to make a trade. This model also gives you the freedom to
experiment with different chart intervals. When you're equipped with a system that can help you catch
the trend early, you can wait for the rest of the market to follow.
 Forex Market Drivers

How Interest Rate Increases Drive Currency Spikes

A common way to think about U.S. interest rates is how much it’s going to cost to borrow money,
whether for our mortgages or how much we’ll earn on our bond and money market investments.
Currency traders think bigger. Interest rate policy is actually a key driver of currency prices and a great
“starter” strategy for new currency traders.
Fundamentally, if a country raises its interest rates, the currency of that country will strengthen
because the higher interest rates attract more foreign investors. When foreign investors invest in U.S.
treasuries, they must sell their own currency and buy U.S. Dollars in order to purchase the bonds.If
you believe U.S. interest rates will continue to rise, you could express that view by going long U.S.
Dollars.
If you believe that the Fed has finished raising rates for the time being, you could capitalize on that
view by buying a currency with a higher interest rate, or at least the prospect of relatively higher rates.
For example, U.S. rates may be higher than those of Euroland now but the prospect of higher rates in
Euroland, albeit still lower than the U.S., may drive investors to purchase Euros.
Capitalize on Rising Gold Prices with Currencies
It’s not hard to understand why we’ve experienced a run-up in gold prices lately. In the US, we’re
dealing with the threat of inflation and a lot of geo-political tension. Historically, gold is a country-
neutral alternative to the U.S. dollar. So given the inverse relationship between gold and the U.S.
Dollar, currency traders can take advantage of volatility in gold prices in innovative ways.
For example, if gold breaks an important price level, one would expect gold to move higher in coming
periods. With this in mind, forex traders would look to sell dollars and buy Euros, for example, as a
proxy for higher gold prices. Moreover, higher gold prices frequently have a positive impact on the
currencies of major gold producers. For example, Australia is the world's third largest exporter of gold,
and Canada is the world's third largest producer of gold. Therefore, if you believe the price of gold will
continue to rise you could establish long positions in Australian Dollar or the Canadian Dollar - or
even position to be long those currencies against other major countries like the UK or Japan.
Translating Rising Oil Prices to Profitable Currency Moves
Equity investors already know that higher oil prices negatively impact the stock prices of companies
that are highly dependent on oil such as airlines, since more expensive oil means higher expenses and
lower profits for those companies.
In much the same way, a country's dependency on oil determines how its currency will be impacted by
a change in oil prices. The US’s massive foreign dependence on oil makes the US dollar more
sensitive to oil prices than other countries. Therefore, any sharp increase in oil prices is typically
dollar-negative.
If you believe the price of oil will continue to increase for the near term, you could express that
viewpoint in the currency markets by once again favoring commodity-based economies like Australia
and Canada or selling other energy-dependent countries like Japan.