ROIX FOREX - RISK OVER REGRET

2.2   TREND CONTINUATION PATTERNS

2.2.1 TRIANGLES

Triangles are among the most popular chart patterns used in technical analysis since they occur frequently compared to other patterns. The three most common types of triangles are Symmetrical Triangles, Ascending Triangles, and Descending Triangles. These chart patterns can last anywhere from a couple weeks to several months.

2.2.1.1    SYMMETRICAL TRIANGLES

Symmetrical triangles occur when two trend lines converge toward each other and signal only that a breakout is likely to occur – not the direction. Ascending triangles are characterized by a flat upper trend line and rising lower trend line and suggest a breakout higher is likely, while descending triangles have a flat lower trend line and descending upper trend line that suggests a breakdown is likely to occur. The magnitude of the breakouts or breakdowns is typically the same as the height of the left vertical side of the triangle (see fig 2.8). A symmetrical triangle is generally regarded as a period of consolidation before the price moves beyond one of the identified trend lines. A break below the lower trend line is used by technical traders to signal a move lower, while a break above the upper trend line signals the beginning of a move upward. As you can see from the chart fig 2.8, technical traders use a sharp increase in volume or any other available technical indicator to confirm a breakout beyond one of the trend lines.

2.2.1.2   ASCENDING TRIANGLE

An ascending triangle is generally considered to be a continuation pattern, meaning that it is usually found amid a period of consolidation within an uptrend. Once the breakout occurs, buyers will aggressively send the price of the asset higher, usually on high volume. The most common price target is generally set to be equal to the entry plus the vertical height of the triangle (see fig 2.9).

2.2.1.3    DESCENDING TRIANGLE

This is a very popular tool among traders because it clearly shows that the demand for an asset is weakening, and when the price breaks below the lower support, it is a clear indication that downside momentum is likely to continue or become stronger. Descending Triangles give technical traders the opportunity to make substantial profits over a brief period of time. The most common price targets are generally set to equal the entry minus the vertical height between the two trend lines.

A descending triangle is the bearish counterpart of an ascending triangle (see fig 2.10).

2.2.2    FLAGS & PENNANT

The flag and pennant patterns are two continuation patterns that closely resemble each other, differing only in their shape during the pattern’s consolidation period. This is the reason the terms flag and pennant are often used interchangeably. A flag is a rectangle shape, while the pennant looks more like a triangle.

These two patterns are formed when there is a sharp price movement followed by generally sideways price movement, which is the flag or pennant. The pattern is complete when there is a price breakout in the same direction of the initial sharp price movement. The following move will see a similarly sharp move in the same direction as the prior sharp move. The complete move of the chart pattern – from the first sharp move to the last sharp move – is referred to as the flag pole.

2.2.2.1    THE PENNANT

The pennant forms what looks like a symmetrical triangle, where the support and resistance trend lines converge towards each other. The pennant pattern does not need to follow the same rules found in triangles, where they should test each support or resistance line several times. Also, the direction of the pennant is not as important as it is in the flag; however, the pennant is generally flat (see fig 2.11).

2.2.2.2    THE FLAG

The flag pattern forms what looks like a rectangle. The rectangle is formed by two parallel trend lines that act as support and resistance for the price until the price breaks out. In general, the flag will not be perfectly flat but will have its trend lines sloping. The buy or sell signal is formed once the price breaks through the support or resistance level, with the trend continuing in the prior direction. This breakthrough should be on heavier volume to improve the signal of the chart pattern (see fig 2.12).

2.2.3    WEDGES

2.2.3.1    RISING WEDGE

A rising wedge is formed when price consolidates between upward sloping support and resistance lines. Here, the slope of the support line is steeper than that of the resistance. This indicates that Higher Lows are being formed faster than Higher Highs. This leads to a wedge-like formation, which is exactly where the chart pattern gets its name from!

With prices consolidating, we know that a big splash is coming, so we can expect a breakout to either the top or bottom.
If the rising wedge forms after an uptrend, it’s usually a bearish reversal pattern. On the other hand, if it forms during a downtrend, it could signal a continuation of the down move.

Either way, the important thing is that, when you spot this Forex trading chart pattern, you are ready with your entry orders. Again, the price movement is bounded by the two converging trend lines. As the price moves towards the apex of the pattern, momentum is weakening. A move below the lower support would be viewed by traders as a reversal in the upward trend.

As the strength of the buyers weakens (exhibited by their inability to take the price higher), the sellers start to gain momentum. The pattern is complete, with the sellers taking control of the security, when the price falls below the supporting trend line. (See fig 2.13).

2.2.3.2    FALLING WEDGE

The falling wedge is a generally bullish pattern signalling that one will likely see the price break upwards through the wedge and move into an uptrend. The trend lines of this pattern converge, with both being slanted in a downward direction as the price is trading in a downtrend.

Another thing to look at in the falling wedge is that the upper (or resistance) trend line should have a sharper slope than the support level in the wedge construction. When the lower (or support) trend line is clearly flatter as the pattern forms, it signals that selling pressure is waning, as sellers have trouble pushing the price down further each time the security is under pressure. (See fig 2.14).

2.2.4    RECTANGLES

The rectangle formation reflects a consolidation period. Upon breakout, it is likely to continue the original trend. Its failure will change it from a continuation to a reversal pattern. This pattern is easy to spot, as it can be considered a minor side-ways trend. If it occurs within an up-trend and the breakout occurs on the upside, it is called a bullish rectangle (See Fig 2.15). The price objective is the height of the rectangle. As Fig 2.15 shows, the currency moves between well-defined, flat support and resistance levels. A valid breakout may occur on either side from this consolidation period. The price target (GH) is equal to the height of the rectangle (G’H), measured from the breakout point H.

3.0      TRADING INDICATORS

Many investors and active traders use technical trading indicators to help identify high probability trade entry and exit points. Hundreds of indicators are available on most trading platforms; therefore, it is easy to use too many indicators or to use them inefficiently. This article will explain how to select multiple indicators, how to avoid information overload and how to optimize indicators to most effectively take advantage of these technical analysis tools.

Technical indicators are mathematical calculations based on a trading instrument’s past and current price and/or volume activity. Technical analysts use this information to evaluate historical performance and to predict future prices. Indicators do not specifically provide any buy and sell signals; a trader must interpret the signals to determine trade entry and exit points that conform to his or her own unique trading style. Several different types of indicators exist, including those that interpret trend, momentum, volatility and volume.

3.1   MOVING AVERAGES

3.1.1    WHAT IS A “MOVING AVERAGE -MA”?

A widely used indicator in technical analysis that helps smooth out price action by filtering out the “noise” from random price fluctuations. A moving average (MA) is a trend-following or lagging indicator because it is based on past prices. The two basic and commonly used MAs are the Simple Moving Average (SMA), which is the simple average of a security over a defined number of time periods, and the Exponential Moving Average (EMA), which gives bigger weight to more recent prices. The most applications of MAs are to identify the trend direction and to determine support and resistance levels. While MAs are useful enough on their own, they also form the basis for other indicators such as the Moving Average Convergence Divergence (MACD).

Why use a Moving Average?

A Moving Average can help cut down the amount of “noise” on a price chart. Look at the direction of the moving average to get a basic idea of which way the price is moving. Angled up and the price is moving up (or was recently) overall, angled down and the price is moving down overall, moving sideways and the price is likely in a range.

    Trend Identification

The same signals can be generated using simple or exponential moving averages. As noted above, the preference depends on each individual. These examples below will use both simple and exponential moving averages. The term “moving average” applies to both simple and exponential moving averages.

The direction of the moving average conveys important information about prices. A rising moving average shows that prices are generally increasing. A falling moving average indicates that prices, on average, are falling. A rising long-term moving average reflects a long-term uptrend. A falling long-term moving average reflects a long-term downtrend (see fig 3.0).

3.1.2    EXPONENTIAL MOVING AVERAGE CALCULATION, EMA

Exponential moving average reduce the lag by applying more weight to recent prices. The weighting applied to the most recent price depends on the number of periods in the moving average. There are three steps to calculating an exponential moving average. First, calculate the simple moving average. An exponential moving average (EMA) has to start somewhere so a simple moving average is used as the previous period’s EMA in the first calculation. Second, calculate the weighting multiplier. Third, calculate the exponential moving average.

3.2   FIBONACCI EXTENSIONS AND CHANNELS

Fibonacci retracement is a very popular tool among technical traders and is based on the key numbers identified by mathematician Leonardo Fibonacci in the thirteenth century. However, Fibonacci’s sequence of numbers is not as important as the mathematical relationships, expressed as ratios, between the numbers in the series.

In technical analysis, Fibonacci retracement is created by taking two extreme points (usually a major peak and trough) on a Forex chart and dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%. Once these levels are identified, horizontal lines are drawn and used to identify possible support and resistance levels. Before we can understand why these ratios were chosen, we need to have a better understanding of the Fibonacci number series. (For a more indepth discussion of this subject, google Fibonacci and the golden ratio.)

The Fibonacci sequence of numbers is as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc.

Each term in this sequence is simply the sum of the two preceding terms and the sequence continues infinitely.

One of the remarkable characteristics of this numerical sequence is that each number is approximately 1.618 times greater than the preceding number. This common relationship between every number in the series is the foundation of the common ratios used in retracement studies.

The key Fibo ratio of 61.8% – also referred to as “the golden ratio” or “the golden mean” – is found by dividing one number in the series by the number that follows it. For example: 8/13=0.6153, and 55/89=0.6179.

The 38.2% ratio is found by dividing one number in the series by the number that is found two places to the right. For example: 55/144=0.3819.

The 23.6% ratio is found by dividing one number in the series by the number that is three places to the right. For example: 8/34=0.2352.

For reason that are unclear, these ratios seem to play an important role in the Foreign Exchange market, just as they do in nature, and can be used to determined critical points that cause an asset’s price to reverse. The direction of the prior trend is likely to continue once the price of the asset has retraced to one of the ratios listed above. The following chart illustrates how Fibonacci retracement can be used. Notice how the price changes direction as it approaches the support/resistance levels. (Draw the Fibo lines from the yesterday’s high to the yesterday’s low price if the chart is trending down. I use the time frame H4 to repair yesterday’s high and low price to draw my fibo lines.) See fig 3.1.

3.3   BOLLINGER BANDS

A Bollinger Band, developed by famous technical trader John Bollinger, is plotted two standard deviations away from a simple moving average. Bollinger bands are a powerful technical indicator. Some traders will swear that solely trading a Bollinger bands strategy is the key to their success. Bollinger bands encapsulate the price movement of a stock. It provides relative boundaries of highs and lows.

The crux of the Bollinger band indicator is based on a moving average that defines the intermediate-term “trend” of the stock based on the trading time frame you are viewing.

This trend indicator is known as the middle band. Most Forex charting applications use a 20-period moving average for the default Bollinger bands settings.

The upper and lower bands are then a measure of volatility to the upside and downside. They are calculated as two standard deviations from the middle band (see fig 3.2).

3.4   STOCHASTIC (OVERBOUGHT vs OVERSOLD)

The stochastic oscillator is a momentum indicator comparing the closing price of a security to the range of its prices over a certain period of time. The sensitivity of the oscillator to market movements is reducible by adjusting that time period or by taking a moving average of the result. The general theory serving as the foundation for this indicator is that in a market trending upward, prices will close near the high, and in a market trending downward, prices close near the low (see fig 3.3).

Lane also expressed the important role the stochastic oscillator can play in identifying overbought and oversold levels, because it is range bound. This range – from 0 to 100 – will remain constant, no matter how quickly or slowly a security advances or declines. Considering the most traditional settings for the oscillator, 20 is typically considered the oversold threshold and 80 is considered the overbought threshold. However, the levels are adjustable to fit security characteristics and analytical needs. Readings above 80 indicate a security is trading near the top of its high-low range; reading below 20 indicate the security is trading near the bottom of its high-low range.

3.5   MACD

What is the “Moving Average Convergence Divergence – MACD”? Moving Average Convergence Divergence (MACD) is a trend-following momentum indicator that shows the relationship between two moving averages of prices. The MACD is calculated by subtracting the 26-day exponential moving average EMA from the 12-day EMA. A nine-day EMA of the MACD, called the “signal line”, is then plotted on top of the MACD, functioning as a trigger for buy and sell signals.

The MACD can be used well in trending or ranging markets due to its use of moving averages provide a vital display of changes in momentum. After you have identified the market environment as either ranging or trading, there are two things you want to look for to derive signals from this indicator.

First you want to recognize the lines in relation to the zero line which identify a crossover or cross under of the MACD line (red) to the signal line (bleu) for a buy or sell trade, respectively. (See fig 3.4).

Like all indicators, the MACD is best coupled with an identified trend or rangebound market. Once you’ve identified the trend, it is best to take crossovers of the MACD line in the direction of the trend. When you’ve entered the trade, you can set stops below the recent price extreme before the crossover, and set a trade limit at twice the amount you are risking.

3.6   ICHIMOKU INDICATOR

The Ichimoku Kinko Hyo (or simply – Ichimoku) indicator is appointed to determine simultaneously a market trend direction, support and resistance levels and to trigger buy and sell signals. Such a way, this indicator unites in itself a number of other indicators as well as different approaches concerning with the price movement prediction.

CONGRATULATIONS! YOU HAVE COMPLETED CHAPTER 3!

AS A FOREX TRADER, YOU CAN TRADE WITHOUT INDICATORS AND STILL BE PROFITABLE BUT YOU CAN NEVER TRADE WITHOUT MEMORIZING THE CHART PATTERNS, POPULAR CANDLESTICK PATTERNS AND BECOME PROFITABLE! NO WAY!!

NOW IT IS TIME FOR YOU TO CHOOSE MAXIMUM 4 CURRENCY PAIRS AS A BEGINNER AND START IDENTIFYING THE PATTERNS YOU HAVE LEARNT IN THIS CHAPTER, PLEASE DO IT!