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Bollinger bands require two trader-selected input variablesBollinger 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 selfadjusting, widening during volatile markets and contracting during calmer periods. Bollinger recommends 10 days for short-term trading, 20 days for intermediate-term 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. 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. Over 95 percent of all the 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. 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 volatility lessens. When prices move outside the bands, a continuation of the current trend is implied. Bottoms and tops made outside the bands followed by bottoms and tops 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 other band. 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 index. This is because when price touches one of the bands, it could indicate one of two things: a continuation of the trend or it could indicate 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 CaveatCurve-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 may 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 very 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. Swing Analysis 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 will define 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 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 y-axis. 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. 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 upon, 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 http://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. Once that composite were identified, the cyclical parameters could be run past todays price into tomorrows, 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. Advanced Studies This chapter serves as a road map into the realm of technical analysis. It is a wondrous realm indeed, but it is very 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. FOREX traders may also wish to consider the technical analysis of Charles B. Goodman, including the Goodman Swing Count System (see Chapter 12) and the Goodman Cycle Count System. Joe DiNapolis DiNapoli Levels are popular and the basis of the educational course of Derek Chings HawaiiForex (www.HawaiiForex.com). Charles Drummonds Point & Line Method has many ardent followers. As previously mentioned, there are also those using techniques from other disciplines to analyze the markets. Michael Duane Archer has deeply explored the use of Cellular Automata and other complexity theory models to forecast FOREX prices. See Chapter 20, The Final Frontiers. The Technicians Creed All market fundamentals are depicted in the actual market data. So the actual market fundamentals need not be studied in detail. 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 exhibited in a current market by examining past market signals. Prices move in trends. Technicians typically do not believe that price fluctuations are tandom 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. Curiously, the various price levels are interconnected. Never make a trading decision based solely on a single indicator. The electric approach of comparing several indicators and charts at the same time is the best strategy. As in all other aspects of trading, be very 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. Do you understand the differences between fundamental analysis and technical analysis? The basic types of technical analysis tools are charts, moving averages, oscillators, and momentum analysis. Chapter 12, The Toolbox Approach, will put forth a suggested program for developing your own technical analysis arsenal. Your analysis of the markets is only one of three components to successful tradingmoney management and psychology are the others. Summary Keep your technical analysis aresenal to a minimum. Remember that the most popular methods, such as bar chart formations and support and resistance, are used by many traders. Most traders do not succeeddraw your own conclusions. Your analysis of the markets is only one component of your trading system. In fact, two other components are more important, in the opinion of the authors: money management and psychology (discussed in detail in later chapters). Most traders who fail (and most traders do fail) tend to spend all their energies on developing a trading system at the expense of money management and trading psychology. Dont be like them! The Toolbox Approach While fundamentals almost certainly drive the long-term trends of currencies, trading is a very short-term affair. Most traders do not even hold a position from one eight-hour session to another. If U.S. interest rates go up, then the USD will risethis is true in some cases, false in others. (There are so many other factors determining currency prices that a very accurate observation one time may even be incorrect the next.) But even if one knew a statement to be correct, how does that help a trader in the short term? Leverage is the name of the game, and no one wants a $10,000 loss while waiting for a fundamental factor to kick in. Ergo, I strongly recommend the new trader develop a simple technical analysis toolbox to trade currencies. You may add to the toolbox later or make adjustments. But start your FOREX career by keeping it simple. For a look at the Codex approach to trade program development see, Getting Started in Forex Trading Strategies (John Wiley & Sons, 2008) by Michael D. Archer. General Principles As you select technical analysis tools keep in mind: 1. Many traders use similar tools, and I know in fact the majority almost always loses. 2. Be certain you know what a technical tool is doing, what it is measuring, before adding it to your toolbox. 3. Seek synergy. Does your tool add to and or complement your other selections? 4. Avoid overkill. Keep it simple! This shows prices depicted as a bar chart on the top and a relative strength indicator (see Chapter 11) on the bottom. Functionally Relative Strength measures the slope of a line (trend). Does the Relative Strength indicator below add anything that you cannot see on the bar chart? It is quite often possible to eliminate indicators because you can more easily see the same information on a chart. This is the thesis of Charles Goodmans Market Environment (ME) charting technique. See Chapter 16 for more on ME. A KIS Toolbox This toolbox is only an example of how to select a few basic tools for trading. Survey the fieldit is hugeand pick wisely. I recommend a toolbox consisting of: 1. A chart interpretation technique 2. At the most three Indicators . A noncomplementary check tool (one that is substantially different from your primary trading tools; i.e., if you use indicators to trade, a simple bar chart would be a noncomplementary tool) 4. A heuristic for analyzing a market with your tools The Goodman Swing Count System The Goodman Swing Count System (GSCS) was developed by commodity trader Charles B. Goodman and used by him until his death in 1984. Michael D. Archer, whom he mentored, further developed the system. GSCS is a method for interpreting charts. You may use bar, swing, or point and figure; bar charts are the easiest and most common. Like all chart interpretation techniques, it is not applicable to all charts all the time. Not every chart forms a pennant or a head and shoulders, and not every chart forms a Goodman Wave. But the variety in FOREX is rich enough that you will find many trading opportunities. I can only introduce GSCS here. For a deeper look please consult the companion volume, Getting Started in Forex Trading Strategies (John Wiley & Sons, 2007), by Michael D. Archer and www.fxpraxis.com. GSCS Rules The 50 Percent Rule This rule is almost as old as the market itself. It states simply that at the 50 percent retracement of a trend, prices find at least a temporary equilibrium. The logic is that in the aggregate all the traders who participated in the initial trend are at a break-even point. More specifically: half the buyers have losses, half have profits; half the sellers have losses, half have profits. The price value of trend or swing B is 50 percent of A. Charles Goodman called this A-B-C formation a matrix and considered it the primary market formation. It is a subset of the Pugh Bull or Bear formations, discussed below. As seen in Figure 12.3, The price value of trend or swing C is the same as A and twice B. The Wave Propagation Rule One of Goodmans most useful discoveries was that prices often form or build as a series of propagating matrices or measured moves. Each matrix becomes a trend in the propagation of successively larger matrices. This is a distinct difference and, in my opinion, improvement over Elliott Wave Theory. As seen in Figure 12.4, the price value of D is 50 percent of A-B-C. The matrix A-B-C is now considered itself as a single trend in GSCS theory. Trend E is anticipated to be of the net price value of A-B-C. The complete formation of A-B-C-D-E is a Goodman Wave. Though it may look similar to an Elliott Wave, the Return Trend and how it is calculated makes an enormous difference. Compare to the Flat-Complex, Figure 12.8 for the same concept from a different viewpoint. The 3C Rule This was the most astonishing discovery Mr. Goodman made about the markets. It says that if the 50 percent objective is not perfectly met, the over or under of the measurement will be made on the measured move. In Figure 12.5 the 50 percent measurement missed by one price unit (the value of B is three instead of four units) and is made up by the full measured move measurement in the third trend. The 3C Rule states that whatever price value is missed on the 50 percent move will be made up on the measured move. Calculations are done in this way: (1) Calculate the value missed (either over or under the 50 percent move); (2) begin counting from the 50 percent price point in the direction of trend A; (3) calculate the final price point as if the 50 percent move had been in effect; and (4) add or subtract the value in Step 1 to find the anticipated adjusted price points for trend C. 3C Stands for Carryover, Compensation, and Cancellation There are a number of other GSCS rules and principles but these three will suffice for getting started. The three most useful Goodman formations are the Double Intersection Trade, Trading the Return D Swing, and the Flat/Complex Trade. The Double Intersection This is the most useful chart formation I have ever used. It occurs when the 50 Percent Rule intersects or cancels at two price points. If one 50 percent move represents equilibrium, two represents even stronger equilibrium. Prices very often react sharply from these double intersections. Although this is not factually correct, it is useful to think of traders at different price levels or matrices. Like irrational numbers, they may not in truth exist, but they are useful for analysis. In the Double Intersection the traders in matrix A-B-C have the same equilibrium point as the traders in B1-B2-B3. The 50 percent move of A-B (1,2,3) meets the measured move of B1-B2-B3. There are several Double Intersection templates using the various combinations of the 50 Percent Rule and Measured Move Rule at different points of a matrix. The Return Trend or Swing Refer again to the Wave Propagation. When most traders see the D trend or swing on a chart they think in terms of Elliott Wave Theory where D is simply related to C. In GSCS D is in fact the Return or Propagation Wave, representing a 50 percent return of the entire A-B-C matrix. It almost always has a longer price duration than A, B, or C, and price reversals may be powerful. Such behavior is very tradable. TIP: Watch for charts where trend D digs into the marked spot intersecting B and C. This spot often offers strong support and resistance, and can be a good point to watch to enter for a trend E in the direction of A and C. The Flat/Complex Trade A flat trend is one consisting of no other components. A complex trend is itself an A-B-C matrix. This is a trading technique because it allows you to sometimes anticipate price behavior. It states that if the first primary trend or swing (A) of a matrix is flat, the second primary trend (C) will be complex. In Figure 12.8, the A wave is a flat followed by a complex. The B wave is a complex followed by a flat. If you spot a flat trend A that makes a 50 percent return swing, you can anticipateand visually map on your charta complex swing C. TIP: Given a flat swing A and a 50 percent measured move B, the swing C will stop momentarily just above the highest price of A to conform with the Flat/Complex Rule. You will find many examples of this trade on FOREX charts! GSCS is a price-based system. Mr. Goodman also developed a time-based counting system, the Goodman Cycle Count System. For information, go to www.fxpraxis.com in the Currency Codex section. I have concluded that GSCS complements two other trading ideas very well: Nofris Congestion Phase and Pugh Formations. The Nofri Congestion Phase Method This simple but useful idea was presented by Eugene Nofri in Success in Commodities (Success Publishing, 1975). It is out of print but sometimes available on www.eBay.com or www.abebooks.com. Nofri was a floor trader in the corn market, but like most technical trading ideas this one is applicable to FOREX. There are 32 total formations, but the simplest one is to watch for two trading units when price goes up or down followed by two trading units when prices go down or up but remain inside the range formed by the first two units. The prediction is that the fifth price unit will be in the direction of the first two units. Pugh Swing Chart Formations This is a simple but effective method. The basic formations were identified by Burton Pugh, a famous grain trader of the 1930s and 1940s. There are only four basic chart formations: Bull, Bear, Inside, and Outside. Highs and lows are always referenced to the previous data unit.A Pugh formation is always in reference to the preceding formations high and low. A. Bull Formation Higher high and higher low from preceding formation B. Bear Formation Lower low and lower high from preceding formation C. Outside Formation Higher high and lower low from preceding formation D. Inside Formation Lower high and higher low from preceding formation Trends tend to be series of Bull Formations (up trend) and Bear Formations (down trend). Consolidations tend to be combinations of Inside and Outside formations. The famous Head and Shoulders Top and Bottom is actually two sequential Bull (or Bear) Formations followed by a Bear (or Bull) Formation. In fact all conventional bar chart formations shown in Chapter 11 can be reduced to a Pugh series. I keep a running notation of Pugh Formations and look for patterns in the series. You may use 1, 2, 3, 4 for the four formations. I use 1 for a Bull, 0 for a Bear, 11 for an Outside, and 00 for an Inside. A vertical line | is used to separate them. You might also use brackets [ ]. A Moving Average and Oscillator Battery This would be a good noncomplementary tool. Almost all trading platforms offer moving averages and oscillators. A moving average typically works when a market is trending in one direction or another. An oscillator is most effective when a market is moving sideways. Look for points where either: 1. A market is above the Moving Average line but the oscillator is falling sharply or below the zero line. This may indicate that a market is still in an up trend but in a buying range because it has lost some downward velocity, at least temporarily. 2. A market is below the Moving Average line but the oscillator is rising sharply or above the zero line. This may indicate that a market is still in a down trend but in a selling range because it has lost some of the downward velocity, at least temporarily. TIP: Remember, trends and trading ranges are relative to the price scale you are using. A trend on an hourly chart is probably made up of a number of 5-minute minitrends and trading areas. Use scales for your moving averages and oscillators in harmony with the scale of the price chart you are watching. Dont use a 10-day moving average on a 10-minute chart; you will see essentially nothing but a straight line. Table 12.1 shows some recommended moving average and oscillator scales. You can use them for other indicators, as well. Some trading platforms do the work for you: Indicators are pre-scaled in definable units based on the price scale. Indicator Scaling Scalper Day Trader Position Trader 5-Second 5-Minute 5-Minute 1-Hour 1-Minute 15-Minute 1-Hour 3-Hour 5-Minute 1-Hour 3-Hour 1-Day Contrary Opinion At the old Peavey commodity office, around 1975, I befriended a trader who successfully traded using nothing but a Moving Average-Oscillator tool in conjunction with contrary opinion. Contrary opinion states that if a large majority of traders think a market will rise, it will fall. If a large majority think it will fall, it will rise. The reasoning is that if everyone thinks a market will go up, they have already bought, and there is no more buying power to maintain the trend. R. Earl Hadady wrote a book on Contrary Opinion. Again, it was for the futures markets, but it would be a good read for any FOREX trader. Take a look at Contrary Opinion (Hadady Publications, 1983). If everyone believes a market will go up, it will go down. If everyone believes a market will go upit will go down. This is the basic premise of Contrary Opinion theory. While well developed and quantified in futures, it is less so in FOREX. Jay Meislers www.global-view.com does a weekly trader poll. Archers www.fxpraxis.com will soon offer a FOREX contrary opinion tool. More on Contrary Opinion in Chapter 16, Tactics and Strategy. Two exceptionally useful toolsvolume and open interestare not cur rently available to the FOREX trader, although commodity futures traders do have them at their disposal. Without a central clearinghouse it is impossible to collect this information. Volume Volume is the number of transactions, both to enter a market and to exit a market, over a given period of time. In futures the standard unit is daily. Open Interest Open interest is the number of open commitments in a market. It is essentially a cumulative number of all open tradestrades that have not been offset. I am currently working on methods for creating synthetic FOREX volume and open interest; stay tuned. Heuristics Every chess player worth his salt uses a heuristic with every turn to move. A heuristic is typically a set of ordered questions that must be answered before making a move. A heuristic can be very simple or extremely complex. The FOREX trader would be advised to develop a simple heuristic for every contemplated trade. The more involved your trading method, the longer will be your heuristic. I recommend simplicity and clarity in all aspects of trading. Your final heuristic should include both money management and psychology parameters. For the previously mentioned KIS trading program a bare-bones heuristic might look like this: Is there a GSCS formation worth considering? If yes, which one? What are the Pugh formations and series? Is there a Nofri formation? Do all of these occur in the same tie and price zone? Does the Moving Average-Oscillator battery confirm the trade or anticipated price direction? Begin with your primary tool and work through the others. Optimally each will identify a trade or potential trade at the same price and time level. Summary As the late Jim Bickford liked to say, You can torture the numbers, but you cant make them talk! No matter how involved your trading method is, remember the markets can only go up, down, or sideways. And sideways doesnt count unless you are trading options. For a more comprehensive discussion of developing both a toolbox and a trading program see the sequel to this volume, Getting Started in Forex Trading Strategies (John Wiley & Sons, 2007) by Michael D. Archer. There are many books on technical analysis. Appendix H lists some that I have found of value, beyond those mentioned in this chapter. As I have said before, your trading method is only one of the three components to marshalling a successful FOREX campaign. The others, psychology and money management, are actually more important. These are covered in Chapter 14, Psychology of Trading and Chapter 15, Money Management Made Simple. Sadly, trading techniques get the most publicity; perhaps because they are easier to communicate. Traders have hundred of tools to trade from, and almost every trader uses a different set of tools. But almost all successful traders share the same psychological attributes and basic money management rules. |
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