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A common trading technique involves the intersection of the trend line with the most recent pricesTechnical Analysis Overview Probably the most popular and successful method of making decisions and analyzing FOREX markets is technical analysis. 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. While 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 very difficult to estimate the latter two fields, volume and open interest. In this chapter, we therefore 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 price-time chart that emphasizes selected characteristics in the price motion of the underlying security. One great advantage of technical analysis is its visualness. 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 11.1. Figure 11.2 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. Graphically, an open/high/low/close (OHLC) bar chart is defined using the following algorithm: OHLC Bar Chart Algorithm Step 1One vertical rectangle whose upper boundary represents the high for the day and whose lower boundary represents the low for the given time period. Step 2One horizontal rectangle to the left of the high-low rectangle whose central value represents the opening price for the given period. Step 3One horizontal rectangle to the right of the high-low rectangle whose central value represents the closing price for the given period. 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 Burtons system. (See Figure 11.4.) 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 labeled, 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. Trend Lines 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. A common trading technique involves the intersection of the trend line with the most recent prices. If the trend line for a downward trend crosses through the most recent prices, a buy signal is generated. Conversely, if the trend line 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. 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 trend lines. 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. 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 . The proper identification of a continuation pattern may prevent the trader from prematurely liquidating an open position that still has profit potential. Candlestick Charts 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 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 11.17. 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 1The candlestick is made up of a body and two shadows. Step 2The body is depicted as a vertical column bounded by the opening price and the closing price. Step 3The shadows are just vertical linesa line above the body to the high of the day (the upper shadow) and a line below the body to the low of the day (the lower shadow). Step 4It is customary for the body to be empty if the close was higher 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 Nisons books: Japanese Candlestick Charting Techniques, Hall, 1991, and Beyond Candlesticks: More Japanese Charting Techniques Revealed, Wiley, 1994. A summary of the different candlestick patterns can also be found at www.hotcandle. com/candle.htm. 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 Carnegies 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. 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 methods 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 on Figure 11.19. 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 traders 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 unless the increase (or decrease) in price satisfies the minimum box size requirement. A reversal cannot be plotted in the subsequent column until the price has 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. P&F charts automatically: Advantages of P&F Charts Eliminate the insignificant price movements that often make bar charts appear noisy. Remove the often misleading effects of time from the analysis process (whipsawing). Make trend line recognition a no-brainer. Make recognizing support/resistance levels much easier. Nearly all of the pattern formations discussed above 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 a sheet of paper and pencil. Help you stay focused on the important long-term price developments. For a more detailed examination of this charting technique, we recommend Point & Figure Charting by Thomas J. Dorsey. Charting CaveatPrediction 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 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 to simulate real-time trading. Would you be able to predict the chart pattern in advance? Indicators and Oscillators Beyond charting are various market indicatorscalculations using the primary information of open, high, low, or close. Indicators may also be charted or graphed. Buy and sell signals and complete systems may 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. Relative Strength Indicator The relative strength indicator (RSI) shows whether a currency is overbought or oversold. Overbought indicates an upward market trend, since 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 very quickly lead to a change in the trend or at least a consolidation. Oversold indicates that the market is showing downward trend conditions, since 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 very 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 of 2002. The running time frame in this example is nine days. An RSI between 30 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. 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. |
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