Chapter 3: Beginner's Guide to Technical Analysis in Forex Trading

The most popular and successful method of making decisions in currency trading and analyzing FOREX markets in 2024 is technical analysis. Technical analysis is used by large and small traders alike. The difference between technical and fundamental analyses is that technical analysis ignores fundamental factors and is applied only to the price action of the market. Although fundamental data can often provide only a long-term forecast of exchange rate movements, technical analysis has become the primary tool to successfully analyze and trade shorter-term price movements, as well as to set profit targets and stop-loss safeguards because of its ability to generate price-specific information and forecasts.

Historically, technical analysis in the futures markets has focused on the six price fields available during any given period of time: open, high, low, close, volume, and open interest. Since the FOREX market has no central exchange, it is difficult to estimate the latter two fields, volume and open interest. In this chapter, we limit our analysis to the first four price fields.

Technical analysis consists primarily of a variety of technical studies, each of which can be interpreted to predict market direction or to generate buy and sell signals. Many technical studies share one common important tool: a pricetime chart that emphasizes selected characteristics in the price motion of the underlying security. One great advantage of technical analysis is its “visualness.” A picture is worth a thousand words.

Bar Charts

Bar charts are the most widely used type of chart in security market technical analysis and date back to the last decade of the nineteenth century. They are popular because they are easy to construct and understand. These charts are constructed by representing intraday, daily, weekly, or monthly activity as a vertical bar. Opening and closing prices are represented by horizontal marks to the left and right of the vertical bar respectively. Spotting both patterns and the trend of a market, two of the essentials of chart reading, is often easiest using bar charts. Bar charts present the data individually, without linking prices to neighboring prices. Each set of price fields is a single “island.”

Each vertical bar has the components shown in Figure 3.1

Figure 3.2 shows a daily bar chart for the EUR/USD currency pair for the month of June 2003. The vertical scale on the right represents the cost of one Euro in terms of U.S. Dollars. The horizontal legend at the bottom of the chart represents the day of week.

A common method of classifying the vertical bars is to show the relationships between the opening and closing prices within a single time interval as either bull or bear bars, as seen in Figure 3.3.

Graphically, an open/high/low/close (OHLC) bar chart is defined using the following algorithm:

One interesting variation to the standard OHLC bar chart was developed by author/trader Burton Pugh is the 1930s. His model involved connecting the previous set of quotes to the current set of quotes, which generates a continuous line representation of price movements. There are four basic formations between two adjacent vertical bars in Burton’s system. (See Figure 3.4.)

These are often called swing charts. 

Bar chart interpretation is one of the most fascinating and well-studied topics in the realm of technical analysis. Recurring bar chart formations have been labelled, categorized, and analyzed in detail. Common formations like tops, bottoms, head-and-shoulders, inverted head-and-shoulders, lines of support and resistance, reversals, and so forth, are examined in the following sections.

Trendlines

A trend can be up, down, or lateral and is represented by drawing a straight line above the daily highs in a downward trend and a straight line below the daily lows in an upward trend. See Figure 3.5.

A common trading technique involves the intersection of the trendline with the most recent prices. If the trendline for a downward trend crosses through the most recent prices, a buy signal is generated. Conversely, if the trendline for an upward trend passes through the most recent prices, then a sell signal is generated.

Support and Resistance

Support levels indicate the price at which most traders feel that prices will move higher. There is sufficient demand for a security to cause a halt in a downward trend and turn the trend up. You can spot support levels on the bar charts by looking for a sequence of daily lows that fluctuate only slightly along a horizontal line. When a support level is penetrated (the price drops below the support level) it often becomes a resistance level; this is because traders want to limit their losses and will sell later when prices approach the former level.

Like support levels, resistance levels are horizontal lines on the bar chart. They mark the upper level for trading or a price at which sellers typically outnumber buyers. When resistance levels are broken, the price moves above the resistance level, and often does so decisively. See Figure 3.6.

Many traders find lines of support and resistance useful in determining the placement of stop-loss and take-profit limit orders.

Recognizing Chart Patterns

Proper identification of an ongoing trend can be a tremendous asset to the trader. However, the trader must also learn to recognize recurring chart patterns that disrupt the continuity of trendlines. Broadly speaking, these chart patterns can be categorized as reversal patterns and continuation patterns.

Reversal Patterns

Reversal patterns are important because they inform the trader that a market entry point is unfolding or that it may be time to liquidate an open position. Figures 3.7 through 3.10 illustrate the most common reversal patterns.

Continuation Patterns

A continuation pattern implies that while a visible trend was in progress, it was temporarily interrupted, and then continued in the direction of the original trend. The most common continuation patterns are shown in Figures 3.11 through 3.15.
The proper identification of a continuation pattern may prevent the trader from prematurely liquidating an open position that still has profit potential.

These are some of the most common classical bar chart formations. Do they work? Sometimes. They worked more often in years gone by when fewer traders knew about them. Nowadays, everyone knows what a head and shoulders looks like. The result? Traders will begin to anticipate the second shoulder and sell before it forms. The result—often, no head and shoulders forms—just one shoulder and a head. This is how the market discounts information. Methods that work well initially become less and less effective over the years.

Candlestick Charts

These charts have found great popularity with currency traders. Candlestick charting is usually credited to the Japanese rice trader Munehisa Homma in the early eighteenth century, though many references indicate that this method of technical analysis probably existed as early as the 1600s. Steven Nison of Merrill Lynch is credited with popularizing candlestick charting in Western markets and has become recognized as the leading expert on their interpretation. See Figure 3.16.

The candlestick is the graphic representation of the price bar: the open, high, low, and closing price of the period. The algorithm to construct a candlestick chart follows.

The elements of a candlestick bar are shown in Figure 3.17.

Fig 3.16: Candlestick Chart

The nomenclature used to identify individual or consecutive combinations of candlesticks is rich in imagery: Hammer, hanging man, dark cloud cover, morning star, three black crows, three mountains, three advanced white soldiers, and spinning tops are only a few of the candlestick patterns that have been categorized and used in technical analysis.

Candlestick Chart Algorithm

•      Step 1—The candlestick is made up of a body and two shadows. •      Step 2—The body is depicted as a vertical column bounded by theopening price and the closing price. •      Step 3—The shadows are just vertical lines—a line above the body tothe high of the day (the upper shadow) and a line below the body to the low of the day (the lower shadow). •      Step 4—It is customary for the body to be empty if the close washigher than the open (a bull day) and filled if the close was lower than the open (a bear day).

A thorough description of how to interpret candlestick charts is given in Steven Nison’s books: Japanese Candlestick Charting Techniques (Hall, 1991) and Beyond Candlesticks: More Japanese Charting Techniques Revealed (John Wiley & Sons, 1994). 

Point and Figure Charts

The modern point and figure (P&F) chart was created in the late nineteenth century and is roughly 15 years older than the standard OHLC bar chart. This technique, also called the three-box reversal method, is probably the oldest Western method of charting prices still around today.

Its roots date back into trading lore, as it has been intimated that this method was successfully used by the legendary trader James R. Keene during the merger of U.S. Steel in 1901. Mr. Keene was employed by Andrew Carnegie to distribute the company shares, as Carnegie refused to take stock as payment for his equity interest in the company. Keene, using point and figure charting and tape readings, managed to promote the stock and get rid of Carnegie’s sizeable stake without causing the price to crash. This simple method of charting has stood the test of time and requires less time to construct and maintain than the traditional bar chart. See Figure 3.18.

The point and figure method derives its name from the fact that price is recorded using figures (Xs and Os) to represent a point, hence the name “Point and Figure.” Charles Dow, the original founder of the Wall Street Journal and the inventor of stock indexes, was rumored to be a point and figure user. Indeed, the practice of point and figure charting is alive and well today on the floor of all futures exchanges. The method’s simplicity in identifying price trends and support and resistance levels, as well as its ease of upkeep, has allowed it to endure the test of time, even in the age of web pages, personal computers, and the information explosion.

The elements of the point and figure anatomy are shown later in Figure 3.19.

Fig 3.18 Point and Figure Chart

Fig 3.19 Anatomy of Point and Figure Columns

Two user-defined variables are required to plot a point and figure chart, the first of which is called the box size. This is the minimum grid increment that the price must move in order to satisfy the plotting of a new X and O. The selection of the box size variable is usually based upon a multiple of the minimum tick size determined by the commodity exchange. If the box size is too small, then the point and figure chart will not filter out white noise, while too large a filter will not present enough detail in the chart to make it useful. I recommend initializing the box size for a FOREX P&F chart with the value of one or two pips in the underlying currency pair.

The second user-defined parameter necessary to plot a point and figure chart is called the reversal amount. If the price moves in the same direction as the existing trend, then only one box size is required to plot the continuation of the trend. However, in order to filter out small fluctuations in price movements (or lateral congestion), a reversal in trend cannot be plotted until it satisfies the reversal amount constraint. Typically, this value is set at three box sizes, though any value between one and seven is a plausible candidate. The daily limit imposed by most commodity exchanges can also influence the trader’s selection of the reversal amount variable.

The algorithm to construct a point and figure chart follows:

Point and Figure Algorithm

•      Upward trends are represented as a vertical column of Xs, while downward trends are displayed as an adjacent column of Os. •      New figures (Xs or Os) cannot be added to the current column unlessthe increase (or decrease) in price satisfies the minimum box size requirement. •      A reversal cannot be plotted in the subsequent column until the pricehas changed by the reversal amount times the box size.

Point and figure charts display the underlying supply and demand of prices. A column of Xs shows that demand is exceeding supply (a rally); a column of Os shows that supply is exceeding demand (a decline); and a series of short columns shows that supply and demand are relatively equal. There are several advantages to using P&F charts instead of the more traditional bar or candlestick charts.

Advantages of P&F Charts

P&F charts automatically: •      Eliminate the insignificant price movements that often make barcharts appear “noisy.” •      Remove the often-misleading effects of time from the analysis process(whipsawing). •      Make trendline recognition a “no-brainer.” •      Make recognizing support/ resistance levels much easier. Nearly all of the pattern formations discussed earlier have analogous patterns that appear when using a standard OHLC bar chart. Adjusting the two variables, box size and reversal amount, may cause these patterns to become more recognizable. P&F charts also: •      Are a viable online analytical tool in real time. They require only asheet of paper and pencil. •      Help you stay focused on the important long-term price developments.

The author uses a point and figure routine in which the reversal is not a number of boxes but a percentage of the previous column. This accommodates his Goodman Wave Theory method.

For a more detailed examination of this charting technique, Fineducke recommends Point & Figure Charting by Thomas J. Dorsey (John Wiley & Sons, 2001).

Charting Caveat—Prediction versus Description

Chart patterns always look impressive and convincing after the fact. The question is: Can they be predicted or are they simply descriptive? One simple method I learned from my mentor Charles B. Goodman for studying this idea is to take an old chart with an already well-formed chart pattern. Cover it with a sheet of blank, opaque paper. Move the paper slowly left-to-right to simulate real-time trading. Would you be able to predict the chart pattern in advance? You can easily see the patterns that work—seeing the ones that did not work is more difficult.

The author has written a program, Charlie’s CAT, to automate this procedure with computer charts.

Indicators and Oscillators

Beyond charting are various market indicators—calculations using the primary information of open, high, low, or close. Indicators can also be charted or graphed. Buy and sell signals and complete systems can be generated from a battery of indicators. The most popular indicators are: relative strength, moving averages, oscillators or momentum analysis (actually a superset of relative strength), and Bollinger bands.

TIP: Traders are fascinated by indicators. Numbers bring a sense of certainty. Be sure you know what an indicator is actually doing, measuring before using it.

Relative Strength Indicator

The relative strength indicator (RSI) shows whether a currency is overbought or oversold. Overbought indicates an upward market trend, because the financial operators are buying a currency in the hope of further rate increases. Sooner or later saturation will occur because the financial operators have already created a long position. They show restraint in making additional purchases and try to make a profit. The profits made can quickly lead to a change in the trend or at least a consolidation.

Oversold indicates that the market is showing downward trend conditions, because the operators are selling a currency in the hope of further rate falls. Over time saturation will occur because the financial operators have created short positions. They then limit their sales and try to compensate for the short positions with profits. This can rapidly lead to a change in the trend.

You cannot determine directly whether the market is overbought or oversold. This would suppose that you knew all of the foreign exchange positions of all the financial operators. However, experience shows that only speculative buying, which leads to an overbought situation, makes rapid rate rallies possible.

The RSI is a numerical indication of price fluctuations over a given period; it is expressed as a percentage.

RSI  sum of price rises/sum of all price fluctuations

To illustrate this, we have selected the daily closes (multiplied by 10,000) for the EUR/USD currency pair when it first appeared on the FOREX market in January 2002. The running time frame in this example is nine days. See Table 11.1.

An RSI between 30 percent and 70 percent is considered neutral. Below 25 percent indicates an oversold market; over 75 percent indicates an overbought market. The RSI should never be considered alone but in conjunction with other indicators and charts. Moreover, its interpretation depends largely on the period studied. The example in Table 11.1 is nine days. An RSI over 25 days would show, given a steady evolution of rates, fewer fluctuations. The advantage of obtaining more rapid signals for selling and buying (by using a smaller number of days) is counterbalanced by a greater risk of receiving the unconfirmed signals.

Momentum Analysis

Like the RSI, momentum measures the rate of change in trends over a given period. Unlike the RSI, which measures all the rate changes and fluctuations within a given period, momentum allows you to analyze only the rate variations between the start and end of the period studied.

The larger n is, the more the daily fluctuations tend to disappear. When momentum is above zero or its curve is rising, it indicates an uptrend. A signal to buy is given as soon as the momentum exceeds zero, and when it drops below zero, triggers the signal to sell.

Momentum  price on day (X )  price on day (X  n)

where n  number of days in the period studied.

The following example in Table 11.2 of momentum analysis uses the EUR/USD currency pair as the underlying security.

Examination of the nine-day momentum shows a clear downward trend. Momentum analysis should not be used as the sole criterion for market entry and exit timing, but in conjunction with other indicators and chart signals.

Moving Averages

The moving average (MA) is another instrument used to study trends and generate market entry and exit signals. It is the arithmetic average of closing prices over a given period. The longer the period studied, the weaker the magnitude of the moving average curve. The number of closes in the given period is called the moving average index.

Market signals are generated by calculating the residual value:

Residual  Price(X)  MA(X)

When the residual crosses into the positive area, a buy signal is generated. When the residual drops below zero, a sell signal is generated.

A significant refinement to this residual method (also called moving average convergence divergence, or MACD for short) is the use of two moving averages. When the MA with the shorter MA index (called the oscillating MA index) crosses above the MA with the longer MA index (called the basis MA index), a sell signal is generated.

Residual  Basis MA(X)  Oscillating MA(X)

Again we use the EUR/USD currency pair to illustrate the moving average method (see Table 3.3).

The reliability of the moving average residual method depends heavily on the MA indices chosen. Depending on market conditions, it is the shorter periods or longer periods that give the best results. When an ideal combination of moving averages is used, the results are comparatively good. The disadvantage is that the signals to buy and sell are indicated relatively late, after the maximum and minimum rates have been reached.

The residual method can be optimized by simple experimentation or by a software program. Keep in mind that when a large sample of daily closes is used, the indices will need to be adjusted as market conditions change.

TIP: For a simple trading method—at least to get started with understanding indicators—the new trader could do worse than a moving average and an oscillator. The moving average works best in trending markets; the oscillator, in trading or sideways markets. Try to come up with a limited set of rules to generate buy and sell signals. Use the moving average to identify the trend and the oscillator to avoid being whipsawed by sideways price movements.

Bollinger Bands

This indicator was developed by John Bollinger and is explained in detail in his opus called Bollinger on Bollinger Bands.The technique involves overlaying three bands (lines) on top of an OHLC bar chart (or a candlestick chart) of the underlying security.

The central band is a simple arithmetic moving average of the daily closes using a trader-selected moving average index. The upper and lower bands are the running standard deviation above and below the central moving average. Since the standard deviation is a measure of volatility, the bands are self-adjusting, widening during volatile markets and contracting during calmer periods. Bollinger recommends 10 days for short-term trading, 20 days for intermediateterm trading, and 50 days for longer-term trading. These values typically apply to stocks and bonds, thus shorter time periods will be preferred by commodity traders. See Figure 11.20.

Bollinger bands require two trader-selected input variables: the number of days in the moving average index and the number of standard deviations to plot above and below the moving average. More than 95 percent of all daily closes fall within three standard deviations from the mean of the time series. Typical values for the second parameter range from 1.5 to 2.5 standard deviations.

As with moving average envelopes, the basic interpretation of Bollinger bands is that prices tend to stay within the upper and lower band. The distinctive characteristic of Bollinger bands is that the spacing between the bands varies based on the volatility of the prices. During periods of extreme price changes (that is, high volatility), the bands widen to become more forgiving.

Fig 3.20: Bollinger Bands

During periods of stagnant pricing (that is, low volatility), the bands narrow to contain prices.

Bollinger notes the following characteristics of Bollinger bands:

• Sharp price changes tend to occur after the bands tighten, as volatilitylessens.
• When prices move outside the bands, a continuation of the currenttrend is implied.
• Bottoms and tops made outside the bands followed by bottoms andtops made inside the bands call for reversals in the trend.
• A move that originates at one band tends to go all the way to the otherband. This observation is useful when projecting price targets.

Bollinger bands do not generate buy and sell signals alone. They should be used with another indicator, usually the relative strength indicator. This is because when price touches one of the bands, it could indicate one of two things: a continuation of the trend or a reaction the other way. So Bollinger bands used by themselves do not provide all of what technicians need to know, which is when to buy and sell. MACD can be used in conjunction with Bollinger bands and RSI.

Indicator Caveat—Curve-Fit Data

Most indicators curve-fit data. You must define one or more price or time variables to calculate the indicator. In a moving average you must select how many time units to average. The indicator is said to be “curve-fit” to that data. The pre-Socratic philosopher Heraclitus said it best: “You cannot step twice into the same river”; and so it is with the FOREX markets. An instance variable that worked perfectly in one trading session can fail miserably in the next as the market environment changes. Opinions vary widely on this caveat. Indicators are immensely popular in FOREX. Co-author of the first edition Jim Bickford was a champion of them, whereas I believe they have limited value. At the least an indicator should be constructed in such a fashion that the instance variables are adjusted for the changes in market environment. Indicators that work well in trending markets (high directional movement and low volatility) fail in trading markets (low directional movement and high volatility) and vice versa. If you use a battery of indicators, be sure they are evenly divided between trading markets and trending markets for balance. For an excellent discussion of the classic trading versus trending concept, see Forex Patterns and Probabilities by Ed Ponsi (John Wiley & Sons, 2007).

Wave and Swing Analysis

Wave and swing analysis is one of those nebulous terms that means different things to different people. It is often associated with swing trading, which also harbors a variety of connotations (the swing trader usually keeps a trade open longer than the typical session or day trader).

Within the framework of this book, I define wave or swing analysis as the study of the distance between local peaks and troughs in the closing prices for the purpose of identifying recurring patterns and correlations. The swing chart, like its older sibling the point and figure chart, requires the use of a massaging algorithm that filters out lateral congestion (whipsawing) during periods of low volatility. For this purpose, a minimum box size must be selected. Within currency trading, this is almost always a single pip in the quote (second) currency of the currency pair. Additionally, a minimum reversal quantity must be selected. This is simply the number of pips (box sizes) required before a retracement can be drawn in the opposite direction (the continuation of an existing trend requires only one box size to plot the next point).

Unlike the P&F chart, the swing chart does not necessarily distort the time element. That is, swing charts are frequently overlaid directly on top of a vertical bar chart since both use the same numerical scaling for the x- and the yaxis. (See Figure 11.21.)

In Figure 11.21, it is clear that a swing chart is a sequence of alternating straight lines, called waves, which connect each peak with its succeeding trough and vice versa.

Fig 3. 21: Bar Chart with Swing Analysis Overlay

The swing analyst is particularly interested in retracement percentages. Market behavior is such that when a major trend does break out, there is a sequence of impulse waves in the direction of the trend with interceding retracement waves (also called corrective waves). The ratio of the corrective wave divided by the preceding impulse wave is referred to as the percentage of retracement. Famous analysts such as William D. Gann and Ralph N. Elliott have dedicated their lives to interpreting these ratios and estimating the length of the next wave in the time series.

Gann believed that market waves moved in patterns based on, among other things, the Fibonacci number series, which emphasizes the use of so-called magic numbers such as 38.2 percent, 50 percent, and 61.8 percent. Actually, there is no magic involved at all; they are simply proportions derived from the Golden Mean or Divine Ratio. This is a complete study unto itself and has many fascinating possibilities. Visit www.groups.dcs.st-and.ac.uk/~history/ Mathematicians/Fibonacci.html for more details on Fibonacci and his work.

In his analysis of stocks in the 1920s and 1930s, Elliott was able to identify and categorize nine levels of cycles (that is, a sequence of successive waves) over the same time period for a single bar chart. This entailed increasing the minimum reversal threshold in the filtering algorithm, which creates fewer but longer waves with each new iteration. He believed each major impulse wave was composed of five smaller waves while major corrective waves were composed of only three smaller waves. I refer interested readers to the web site www.elliottwave.com for more details on Elliott and his theories.

Cycle Analysis

Every market is composed of traders at different levels slugging it out. Scalpers, day traders, and position traders are all attempting to profit from price changes. Each group has a different time focus or horizon. Cycle theory believes these groups behave in cyclical fashion and that some composite of their behavior would parallel the market. If that composite were identified, the cyclical parameters could be run past today’s price into tomorrow’s, resulting in a forecast. I experimented with a cycle tool, the Expert Cycle System, not to predict the market but to examine the ways to find such a composite. (See Figure 11.22.)

Trading Systems

This chapter serves as a road map into the realm of technical analysis. It is a wondrous realm indeed, but it is easy to get lost there. Time series analysis is a complex and ever-changing discipline. Advanced studies include deviation analysis, retracement studies, statistical regressions, Fibonacci progressions, Fourier transforms, and the Box-Jenkins method, to name just a few. A separate realm is the attempt to transfer methods from other disciplines to market analysis such as data mining.

Fig 3.22: The Expert Cycle System

Many traders have developed more comprehensive systems for trading using technical analysis. FOREX traders may also wish to consider the technical analysis of Charles B. Goodman, including the Goodman Swing Count System (see Chapter 12, “A Trader’s Toolbox”) and the Goodman Cycle Count System—collectively Goodman Wave Theory. Joe DiNapoli’s DiNapoli Levels are popular and the basis of the educational course of Derek Ching’s HawaiiForex (www.HawaiiForex.com). Charles Drummond’s Point & Line Method has many ardent followers. Elliott Wave Theory is the granddaddy of them all and remains popular with FOREX traders.

The Technician’s Creed

All market fundamentals are depicted in the actual market data. So the actual market fundamentals need not be studied in detail.

The technician believes prices have memory—that past prices do influence future prices. If you get in a market you have to get out. History repeats itself, and therefore markets move in fairly predictable, or at least quantifiable, patterns. These patterns, generated by price movement, are the raw buy and sell signals. The goal in technical analysis is to uncover the signals exhibited 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. Trends occur at all price levels: tick, 5-minute, 1-hour, 1-day, weekly. What is a trend at the 1-minute level is obviously just a small blip on the radar on a weekly chart. The various price levels are interconnected in intricate and fascinating ways.

Never make a trading decision based solely on a single indicator or chart pattern. The eclectic approach of comparing several indicators and charts at the same time is the best strategy. Try to move from the most general conditions of a market to the most specific. Sift your technical tools finer and finer until they result in a trade.

As in all other aspects of trading, be disciplined when using technical analysis. Too often, a trader fails to sell or buy into a market even after it has reached a price that his technical studies have identified as an entry or exit point. This is money management and psychology, not technical analysis, and both are very important.

The basic types of technical analysis tools are charts, moving averages, oscillators, and momentum analysis. Chapter 12, “A Trader’s Toolbox,” puts forth a suggested program for developing your own technical analysis arsenal. Your analysis of the markets is only one of three components to successful trading—money management and psychology are the others.

Summary

The number of technical analysis charts, indicators, methods, and systems can fill a small library. The subject is fascinating but be objective and remember that your ultimate goal is to make money. Keep your technical analysis arsenal to a minimum. Remember that the most popular methods, such as bar chart formations and support and resistance, are used by many traders. The market gradually discounts chart patterns and indicator signals when used by many traders over a long period of time. Also, most traders do not succeed—draw your own conclusions.