Developing Trading Discipline

No matter which trading style you decide to pursue, you need an organized trading plan, or you won’t get very far. The difference between making money and losing money in the forex market can be as simple as trading with a plan or trading without one. A trading plan is an organized approach to executing a trade strategy that you‘ve developed based on your market analysis and outlook.

Here are the key components of any trading plan:

ü  Determining position size: How large a position will you take for each trade strategy? Position size is half the equation for determining how much money is at stake in each trade.

ü  Deciding where to enter the position: Exactly where will you try to open the desired position? What happens if your entry level is not reached?

ü  Setting stop-loss and take-profit levels: Exactly where will you exit the position, both if it's a winning position (take profit) and if it's a losing position (stop loss)? Stop-loss and take-profit levels are the second half of the equation that determines how much money is at stake in each trade.

That’s it - just three simple components. But it’s amazing how many traders, experienced and beginner alike, open positions without ever having fully thought through exactly what their game plan is. Of course, you need to consider numerous finer points when constructing a trading plan, but for now, I just want to drive home the point that trading without an organized plan is like flying an airplane blindfolded - you may be able to get off the ground, but how will you land?

And no matter how good your trading plan is, it won‘t work if you don’t follow it. Sometimes emotions bubble up and distract traders from their trade plans. Other times, an unexpected piece of news or price movement causes traders to abandon their trade strategy in midstream, or midtrade, as the case may be. Either way, when this happens, it‘s the same as never having had a trade plan in the first place.

Developing a trade plan and sticking to it are the two main ingredients of trading discipline. If we were to name the one defining characteristic of successful traders, it wouldn’t be technical analysis skill, gut instinct, or aggressiveness - though they’re all important. Nope, it would be trading discipline. Traders who follow a disciplined approach are the ones who survive year after year and market cycle after market cycle. They can even be wrong more often than right and still make money because they follow a disciplined approach. Yet establishing and maintaining trading discipline is an elusive goal for many traders.

Taking the emotion out of trading

If the key to successful trading is a disciplined approach - developing a trading plan and sticking to it - why is it so hard for many traders to practice trading discipline? The answer is complex, but it usually boils down to a simple case of human emotions getting the better of them.

I remember an episode of the TV sitcom M *A *S *H, in which Hawkeye Pierce (Alan Alda) observes that the three basic human emotions are greed, fear, and greed. Certainly, that’s the case in financial market trading. When it comes to trading in any market, don’t underestimate the power of emotions to distract and disrupt.

So exactly how do you take the emotion out of trading? The simple answer is: You can’t. As long as your heart is pumping and your synapses are firing, emotions are going to be flowing. And truth be told, the emotional highs of trading are one of the reasons people are drawn to it in the first place. There’s no rush quite like putting on a successful trade and taking some money out of the market. So just accept that you’re going to be experiencing some pretty intense emotions when you’re trading.

The longer answer is that because you can’t block out the emotions, the best you can hope to achieve is understanding where the emotions are coming from, recognizing them when they hit, and limiting their impact on your trading. It's a lot easier said than done, but keep in mind some of the following, and you may find you’re better able to keep your emotions in check:

ü  Focus on the pips and not the dollars and cents. Don’t be distracted by the exact amount of money won or lost in a trade. Instead, focus on where prices are and how they’re behaving. The market has no idea what your trade size is and how much you’re making or losing, but it does know where the current price is.

ü  It’s not about being right or wrong; it’s about making money. At the end of the day, the market doesn’t care if you were right or wrong, and neither should you. The only true way of measuring trading success is in dollars and cents.

ü  You’re going to lose in a fair number of trades. No trader is right 100% of the time. Taking losses is as much a part of the routine as taking profits. You can still be successful over time with a solid risk-management plan.

ü  The market is not out to get you. The market is going to do what it does whether you’re involved in it or not, so don’t take your trading results personally. Interpret them professionally, just as you would the results of any other business venture.

Managing your expectations

Currency trading is a relatively new opportunity for individual traders, and a lot of people have no frame of reference about what to expect when it comes to price movements. A frequent question asked by newcomers is “How much can I expect to make on this trade?” Whoa, Nelly. Talk about a loaded question.

Financial markets are not bank ATMs, and the forex market is certainly no exception. There are a lot of people speculating on which way various currency pairs are going to move; some of those people are going to be right, and some are going to be wrong. Some may also be right for a moment but suddenly end up on the wrong side of equation. Trading can play out in many different ways, but at the end of the day it all comes down to making money or losing money.

Before you get involved with trading currencies, you need to have a healthy sense of what to expect when it comes to trading outcomes. Many people choose to focus on only the upside prospects of currency trading, like the view expressed in that loaded question earlier. But losses are part of trading, too. Even the biggest and best traders have losing trades on a regular basis.

One of the keys to establishing trading discipline is to first accept that losses are inevitable. The second step is to dedicate yourself to keeping those losses as small as possible. Most experienced traders will tell you the hardest part of trading is keeping the money you've made and not giving it back to the market.

Imagining realistic profit-and-loss scenarios

The trading style that you decide to pursue will dictate the relative size of profits and losses that you can expect to experience. If you’re trading on a short- to medium-term basis, look at average daily trading ranges to get a good idea of what to expect.

The average daily trading range is a mathematical average of each day's trading range (high to low) over a specified period. Keep in mind that this figure is just a statistical average - there will be days with larger ranges and days with narrower ranges. Also, average daily ranges will vary significantly by currency pair.

But the average daily trading range covers a full 24-hour trading session and tends to overstate what short- and medium-term traders can expect from intraday trading ranges. Generally speaking, you’re better off anticipating more modest price movements of 30 to 80 pips rather than aiming for the homerun ball.

And no matter what any infomercial tells you, you’re not going to retire based on any single trade. The key is to hit singles and stay in the game.

Balancing risk versus reward

Trading is all about taking on risk to generate profits. So one question is frequently posed: “How much should I risk in any given trade?” There is no easy answer to that question. Some trading books advise people to use a risk/reward ratio, like 2:1, meaning that if you risk $100 on a trade, you should aim to make $200 to justify the risk. Others counsel to never risk more than a fixed percentage of your trading account on any single trade. It's all a bit formulaic, if you ask me, and it also has no relation to the reality of the markets.

A better way to think about risk and reward is to look at each trade opportunity on its own and assess the outcomes based on technical analysis. This approach has the virtue of being as dynamic as the market, allowing you to exploit trade opportunities according to prevailing market conditions.

Another factor to consider in balancing risk and reward is the use of leverage. In online currency trading, generous leverage ratios of 100:1.1 or 200:1 are typically available. The higher the leverage ratio, the larger position you can trade based on your margin. But leverage is a double-edged sword because it also amplifies profits and losses.

The key here is to limit your overall leverage utilization so you’re not putting all your eggs in one basket. If you open the largest position available based on your margin, you’l1 have very little cushion left in case of adverse price movements. It may seem sexy to trade as large a position as possible, but whoever said prudent, risk-aware trading was supposed to be sexy? Keep your feet on the ground, and don’t lose your head in the clouds of leverage.

Keeping your ammunition dry

The margin you’re required to post with your forex broker is the basis for all your trading. The amount of margin you put up will determine how large a position you can hold and for how long (in pips) if the market moves against you. Unless you just won the lottery, your margin collateral is a precious, finite resource, so you have to use it sparingly.

If Hamlet were alive today and trading currencies, his famous soliloquy might begin “To trade or not to trade?” One of the biggest mistakes traders make is known as overtrading. Overtrading typically refers to trading too often in the market or trading too many positions at once. Both forms suggest a lack of discipline, and sound more like throwing darts at a board and hoping something sticks.

Keeping your ammunition dry refers to staying out of the market, watching and waiting, and picking your trades more selectively.

Opportunity lost or opportunity cost?

One of the more popular market aphorisms is “You've got to be in it to win it." Though it’s obviously a truism, we would counter that trading discretion is the better part of trading valor. Holding open positions not only exposes you to market risk, but can also cost you market opportunities.

After you enter a position, your available margin is reduced, which in turn lowers the amount of available positions you can establish. If you’re routinely involved in the market because you don’t want to miss out on the next big move, you actually run the risk of missing out on the next big move because you may not have enough available margin to support a position for the big move.

Don’t be afraid about missing out on some trade opportunities. No one ever catches all the moves. Instead, focus on your market analysis and pinpoint the next well-defined trading opportunity.

Thinking clearly while you can

Another virtue of trading less frequently is that your market outlook is not skewed by any of the emotional entanglements that come with open positions. If you ask a trader who’s long EUR/USD What he thinks of EUR/USD, surprise, surprise - he’s going to tell you he thinks it’s going up. That’s called talking your book.

But being out of the market, or being square, allows you to step back and analyze market developments with a fresh perspective. That’s when you can spot opportunities more clearly and develop an effective trade strategy to exploit them. All too soon, you‘ll be on to your next trade, and the emotional roller coaster will start all over again. 

Different Strokes for Different Folks

After you’ve given some thought to the time and resources you‘re able to devote to currency trading and which approach you favor (technical, fundamental, or a blend), the next step is to settle on a trading style that best fits those choices.

There are as many different trading styles and market approaches in FX as there are individuals in the market. But most of them can be grouped into three main categories that boil down to varying degrees of exposure to market risk. The two main elements of market risk are time and relative price movements. The longer you hold a position, the more risk you‘re exposed to. The more of a price change you’re anticipating, the more risk you‘re exposed to.

In this post, I detail three main trading styles and what they really mean for individual traders. My aim here is not to advocate for any particular trading style. (Styles frequently overlap, and you can adopt different styles for different trade opportunities or different market conditions.) Instead, my goal is to give you an idea of the various approaches used by forex market professionals so you can understand the basis of each style. I think this information will help you settle on a style that best fits your personality and individual circumstances. Equally important, you’ll be able to recognize whether your style is drifting and generally maintain a more disciplined approach to the market.

Short-term, high-frequency day trading

Short-term trading in currencies is unlike short-term trading in most other markets. A short-term trade in stocks or commodities usually means holding a position for a day to several days at least. But because of the liquidity and narrow bid/offer spreads in currencies, prices are constantly fluctuating in small increments. The steady and fluid price action in currencies allows for extremely short-term trading by speculators intent on capturing just a few pips on each trade.

Short-term trading in forex typically involves holding a position for only a few seconds or minutes and rarely longer than an hour. But the time element is not the defining feature of short-term currency trading. Instead, the pip fluctuations are what's important. Traders who follow a short-term trading style are seeking to profit by repeatedly opening and closing positions after gaining just a few pips, frequently as little as 1 or 2 pips.

Jobbing the market pip by pip

In the interbank market, extremely short-term, in-and-out trading is referred to as jobbing the market; online currency traders call it scalping. (I use the terms interchangeably.) Traders who follow this style have to be among the fastest and most disciplined of traders because they're out to capture only a few pips on each trade. In terms of speed, rapid reaction and instantaneous decision - making are essential to successfully jobbing the market.

When it comes to discipline, scalpers must be absolutely ruthless in both taking profits and losses. If you’re in it to make only a few pips on each trade, you can’t afford to lose much more than a few pips on each trade. The overall strategy is obviously based on being right more often than being wrong, but the key is not risking more than a few pips on each trade. The essential motto is “Take the money and run” - repeated a few dozen times a day.

Jobbing the market requires an intuitive feel for the market. (Some practitioners refer to it as rhythm trading.) Scalpers don’t worry about the fundamentals too much. If you were to ask a scalper for her opinion of a particular currency pair, she would be likely to respond along the lines of “it feels bid” or “it feels offered” (meaning, she senses an underlying buying or selling bias in the market - but only at that moment). If you ask her again a few minutes later, she may respond in the opposite direction.

Successful scalpers have absolutely no allegiance to any single position. They couldn’t care less if the currency pair goes up or down. They’re strictly focused on the next few pips. Their position is either working for them, or, they’re out of it faster than you can blink an eye. All they need is volatility and liquidity.

Adapting jobbing to online currency trading

Jobbing is a popular trading style in the interbank market because institutional traders have the ability to bid and offer in the market as well as pay offers and hit bids. This enables them to minimize the trading spreads they’re exposed to and maximize the pips gained. If the market feels bid (buying bias), a trader may get long by buying at the 18 offer and then immediately offer to sell that position at 19 or 20. If his offer isn’t paid (bought by someone else) quickly enough, he may have to hit the 17 or 18 bid to exit and try again.

Retail traders are typically faced with bid/offer spreads of between 2 and 5 pips. Although this makes jobbing slightly more difficult, it doesn't mean you can't still engage in short-term trading - it just means you’ll need to adjust the risk parameters of the style. Instead of looking to make l to 2 pips on each trade, you need to aim for a pip gain at least as large as the spread you’re dealing with in each currency pair. The other basic rules of taking only minimal losses and not hanging on to a position for too long still apply.

Here are some other important guidelines to keep in mind when following a short-term trading strategy:

ü  Trade only the most liquid currency pairs, such as EUR/USD, USD/JPY, EUR/GBP, EUR/JPY, and EUR/CHF. The most liquid pairs will have the tightest trading spreads and will be subject to fewer sudden price jumps.

ü  Trade only during times of peak liquidity and market interest. Consistent liquidity and fluid market interest are essential to short-term trading strategies. Market liquidity is deepest during the European session when Asian and North American trading centers overlap with European time zones - about 2 am to noon eastern time (ET). Trading in other sessions can leave you with far fewer and less predictable short-term price movements to take advantage of.

ü  Focus your trading on only one pair at a time. It you’re aiming to capture second-by-second or minute-by-minute price movements, you‘ll need to fully concentrate on one pair at a time. It’ll also improve your feel for the pair if that pair is all you’re watching.

ü  Preset your default trade size so you don’t have to keep specifying it on each deal.

ü  Look for a brokerage firm that offers click-and-deal trading so you’re not subject to execution delays or requotes.

ü  Adjust your risk and reward expectations to reflect the dealing spread of the currency pair you’re trading. With 2- to 5- pip spreads on most major pairs, you probably need to capture 3 to 10 pips per trade to offset losses if the market moves against you.

ü  Avoid trading around data releases. Carrying a short-term position into a data release is very risky because prices can gap sharply after the release, blowing a short-term strategy out of the water. Markets are also prone to quick price adjustments in the 15 to 30 minutes ahead of major data releases as nearby orders are triggered. This can lead to a quick shift against your position that may not be resolved before the data comes out.

Keeping sight of the forest while you’re in the trees

Trading a short-term strategy online also requires individual traders to invest more time and effort in analyzing the overall market, especially from the technical perspective.

If you pursue a short-term trading strategy online, where dealing spreads can equal profit targets, you need to be right by a larger margin. To give yourself a better chance of capturing slightly larger short-term moves, always know where you stand in longer charting timeframes. By all means, use tick, one minute, and five-minute charts to refine your trade timing, entry, and exit. But be aware of the larger picture suggested by 30-minute, hourly, and multi-hour charts, because they’re going to hold the keys to the larger directional movements.

Medium-term directional trading

If you thought short-term time frames were exceptionally brief, medium-term time frames aren’t much longer Medium-term positions are typically held for periods ranging anywhere from a few minutes to a few hours, but usually not much longer than a day. Just as with short-term trading, the key distinction for medium-term trading is not the length of time the position is open, but the amount of pips you’re seeking/risking.

Where short-term trading looks to profit from the routine noise of minor price fluctuations, almost without regard for the overall direction of the market, medium-term trading seeks to get the overall direction right and profit from more significant currency rate moves. By the same token, medium-term traders recognize that markets rarely move in one direction for too long, so they approach the market with well-defined trade entry and exit strategies.

Almost as many currency speculators fall into the medium-term category (sometimes referred to as momentum trading and swing trading) as fall into the short-term trading category. Medium-term trading requires many of the same skills as short-term trading, especially when it comes to entering/exiting positions, but it also demands a broader perspective, greater analytical effort, and a lot more patience. We classify ourselves as medium-term traders. Short-term traders love the noise of moment-to-moment price changes; directional traders have to suffer through it to see how their view will play out.

           

Capturing intraday price moves for maximum effect

The essence of medium-term trading is determining where a currency pair is likely to go over the next several hours or days and constructing a trading strategy to exploit that view. Medium-term traders typically pursue one of the following overall approaches, but there’s also plenty of room to combine strategies:

ü  Trading a view: Having a fundamental-based opinion on which way a currency pair is likely to move. View trades are typically based on prevailing market themes, like interest rate expectations or economic growth trends. View traders still need to be aware of technical levels as part of an overall trading plan.

ü  Trading the technicals: Basing your market outlook on chart patterns, trend lines, support and resistance levels, and momentum studies. Technical traders typically spot a trade opportunity on their charts, but they still need to be aware of fundamental events, because they’re the catalysts for many breaks of technical levels.

ü  Trading events and data: Basing positions on expected outcomes of events, like a central bank rate decision or a G7 meeting, or individual data reports. Event/data traders typically open positions well in advance of events and close them when the outcome is known.

ü  Trading with the flow: Trading based on overall market direction (trend) or information of major buying and selling (flows). To trade on flow information, look for a broker that offers market flow commentary, like that found in FOREX.com‘s Forex Insider (www forex.com/forex_research.html). Flow traders tend to stay out of short-term range-bound markets and jump in only when a market move is under way.

When is a trend not a trend?

When it's a range. A trading range or a range-bound market is a market that remains confined within a relatively narrow range of prices. ln currency pairs, a short-term (over the next few hours) trading range may be 20 to 50 pips wide, while a longer-term (over the next few days to weeks) range can be 200 to 400 pips wide.

For all the hype that trends get in various market literature, the reality is that most markets trend no more than a third of the time. The rest of the time they’re bouncing around in ranges, consolidating, and trading sideways.

If markets reflect all the currently known information that’s available, they’re going to experience major trends or shifts only when truly new and unexpected information hits the market. On a day-to-day basis, incoming economic data and events usually result in an adjustment of prices only within a prevailing range, rather than a breakout, but that’s enough for medium-term traders to take advantage of the opportunity.

Taking what you get from the market

Medium-term traders recognize that sizeable price movements and trends are more the exception than the rule. So rather than selling and holding in the case of a downtrend, for example, they're looking to capitalize on the 50- to 150- point price declines that make up the overall downtrend. The key here is that medium-term traders will take profit frequently and step back to reassess market conditions before getting back in.

Although medium-term traders are normally looking to capture larger relative price movements - say, 50 to 100 pips or more - they're also quick to take smaller profits on the basis of short-term price behavior. For instance, if a break of a technical resistance level suggests a targeted price move of 80 pips higher to the next resistance level, the medium-term trader is going to be more than happy capturing 70% to 80% of the expected price move. They’re not going to hold on to the position looking for the exact price target to be hit. It goes without saying that it’s better to catch 75 % of something than 100% of nothing.

Long-term macroeconomic trading

Long-term trading in currencies is generally reserved for hedge funds and other institutional types with deep pockets. Long-term trading in currencies can involve holding positions for weeks, months, and potentially years at a time. Holding positions for that long necessarily involves being exposed to significant short-term volatility that can quickly overwhelm margin trading accounts.

With proper risk management, individual margin traders can seek to capture longer-term trends. The key is to hold a small enough position relative to your margin that you can withstand volatility of as much as 5% or more. Mini accounts, which trade in lot sizes of 10,000 currency units, are a good vehicle to take advantage of longer-term price trends.

For example, let's say you’re of the view that the U.S. dollar is going to weaken and that USD/JPY, currently at 120.00, is headed for 110.00 or lower. But if USD/JPY rises above 125.00, you think the downside scenario is over, and you want to be out of the trade. In this case, you would be risking 500 pips to make 1,000 pips. For a 10,000 USD/JPY trade size, that translates into a risk of losing $400 according to the trade parameters (10,000 × 500 JPY pips = JPY 50,000 ÷ 125.00 = $400) or making a gain of over $900 (10,000 × 1,000 JPY pips = JPY 100,000 + 110.00 = $909.09).

Identifying the macro elements that lead to long-term trends

Long-term trading seeks to capitalize on major price trends, which are in turn the result of long-term macroeconomic factors. Before you embark on long-term speculation, you want to see how some of the following macroeconomic chips stack up:

ü  Interest rate cycles: Where are the two currencies’ relative interest rates, and where are they likely to go in the coming months? Narrower interest-rate differentials will tend to help the lower-yielding currency and hurt the higher-yielding currency; wider interest rate differentials will help the higher-yielding currency and hurt the lower-yielding one.

ü  Economic growth cycles: What‘s the outlook for relative growth over the next several months? An economy that is in an expansionary phase of growth is likely to see higher interest rates in the future, which would support that currency. An economy that is showing signs of slowing may see interest rate expectations lowered, hurting the currency in the process.

ü  Currency policies: Are the currencies considered to be excessively overvalued or undervalued by the major global trading powers? Are the G7 or the national governments of the currencies agitating for changes in the currency’s relative value?

ü  Structural deficits or surpluses: Do the currencies have any major structural issues that tend to see currencies weaken or strengthen, such as fiscal deficits/surpluses or trade deficits/surpluses?

Trading around a core position

Just because you’re trading with a long-term view doesn't mean you can‘t take advantage of significant price changes when they're in your favor in the medium term. Trading around a core position refers to taking profit on a portion of your overall position after favorable price changes. You continue to hold a portion of your original position - the core position - and look to re-establish the full position on subsequent market corrections. Remember: It never hurts to take some money off the table when you’re winning.

Taking partial profit on a long-term position works best when the currency pair you’re trading is reaching significant technical levels, such as multiday or multiweek highs. If the trend of the currency pair you‘re holding is displaying a channel on the charts, taking partial profit near the top of the channel in an uptrend or near the channel bottom in a downtrend is one way of judging when to take partial profit.

The risk with trading around a core position is that the trend may not correct after you’ve taken partial profit, never giving you the chance to re-establish your desired full position. But you’re still holding the core of your position, and because the market hasn’t corrected, it means your core position is doing just fine.

Carry trade strategies

A carry trade happens when you buy a high-yielding currency and sell a relatively lower-yielding currency. The strategy profits in two ways:

ü  By being long the higher-yielding currency and short the lower-yielding currency, you can earn the interest-rate differential between the two currencies, known as the carry. If you have the opposite position - long the low-yielder and short the high-yielder - the interest-rate differential is against you, and it is known as the cost of carry.

ü  Spot prices appreciate in the direction of the interest-rate differential. Currency pairs with significant interest-rate differentials tend to move in favor of the higher-yielding currency as traders who are long the high yielder are rewarded, increasing buying interest, and traders who are short the high yielder are penalized, reducing selling interest.

So let me get this straight, you may be thinking: All I have to do is buy the higher-yielding currency/sell the lower-yielding currency, sit back, earn the carry, and watch the spot price move higher? What's the catch?

Right you are. There is a catch, and the catch is that downside spot price volatility can quickly swamp any gains from the carry trade‘s interest-rate differential. The risk can be compounded by excessive market positioning in favor of the carry trade, meaning a carry trade has become so popular that everyone gets in on it. When everyone who wants to buy has bought, why should the price continue to move higher? Even more daunting, if the price begins to reverse against the carry trade, it may trigger a panic exodus out of the trade, accelerating the price plunge. Take a look at Figure below to get an idea of the trends that can develop around carry trades as well as the sharp setbacks that can happen along the way.

NZD/JPY  trends higher in line with carry trade fundamentals (New Zealand's interest rates are much higher than japan's), but it meets sharp setbacks along the way)

Carry trades usually work best in low-volatility environments, meaning when financial markets are relatively stable and investors are forced to chase yield. Keep in mind that carry trades need to have a significant interest-rate differential between the two currencies (typically more than 2%) to make them attractive. And carry trades are definitely a long-term strategy, because depending on when you get in, you may get caught in a downdraft that could take several days or weeks to unwind before the trade becomes profitable again.

Finding the Right Trading Style for You

The question that frequently asked, “What’s the best way to trade the forex market?” For starters, that’s a loaded question that seems to imply there’s a right way and a wrong way to trade currencies. It also suggests that there’s some magic formula out there, and if you can just find out what it is, you’ll be guaranteed trading success. Unfortunately, there is no easy answer. Better put, there is no standard answer - one that applies to everyone.

The forex market’s trading characteristics have something to offer every trading style (long-term, medium-term, or short-term) and approach (technical, fundamental, or a blend). So in terms of deciding what style or approach is best suited to currencies, the starting point is not the forex market itself, but your own individual circumstances and way of thinking.

Real-world and lifestyle considerations

Before you can begin to identify a trading style and approach that works best , for you, you need to give some serious thought to what resources you have available to support your trading. As with many of life’s endeavors, when it comes to financial market trading, there are two main resources that people never seem to have enough of: time and money. Deciding how, much of each you can devote to currency trading will help to establish how you pursue your trading goals.

If you’re a full-time trader, you have lots of time to devote to market analysis and actually trading the market. But because currencies trade around the clock, you still have to be mindful of which session you’re trading, and of the daily peaks and troughs of activity and liquidity. Just because the market is always open doesn’t mean it’s necessarily always a good time to trade.

If you have a full-time job, your boss may not appreciate your taking time to catch up on the charts or economic data reports while you're at work. That means you’ll have to use your free time to do your market research. Be realistic when you think about how much time you'll be able to devote on a regular basis, keeping in mind family obligations and other personal circumstances.

When it comes to money, I can’t stress enough that trading capital has to be risk capital and that you should never risk any money that you can’t afford to lose. The standard definition of risk capital is money that, if lost, will not materially affect your standard of living. It goes without saying that borrowed money is not risk capital - you should never use borrowed money for speculative trading.

When you determine how much risk capital you have available for trading, you’ll have a better idea of what size account you can trade and what position size you can handle. Most online trading platforms typically offer generous leverage ratios that allow you to control a larger position with less required margin. But just because they offer high leverage doesn’t mean you have to fully utilize it.

              

Making time for market analysis

Before this, I write about the amount of data and news that flows through the forex market on a daily basis - and it can be truly overwhelming. That's one reason the major banks that are active in the forex market employ teams of economists, strategists, technical ana1ysts,"and traders. So how can an individual trader possibly keep up with all the data and news?

The keg is to develop an efficient daily routine of market analysis. Thanks to the Internet and online currency brokerages, independent traders can access a variety of daily and intraday market reports, covering both technical and fundamental perspectives. Your daily regimen of market analysis should focus on:

ü  Overnight forex market developments: Who said what, which data came out, and how the currency pairs reacted. 

ü  Daily updates of other major market movements over the prior 24 hours and the stories behind them: If oil prices or U.S. Treasury yields rose or fell substantially, find out why.

ü  Data releases and market events (for example, the retail sales report, Fed speeches, central bank rate announcements) expected for that day: Ideally, you’ll monitor data and event calendars one week in advance, so you can be anticipating the outcomes along with the rest of the market.

ü  Multiple-time-frame technical analysis of major currency pairs: There is nothing like the visual image of price action to fill in the blanks of how data and news affected individual currency pairs.

ü  Current events and geopolitical themes: Stay abreast on issues of major elections, political scandals, military conflicts, and policy initiatives in the major currency nations.

Establishing a research routine will take some time at first. You’ll have to read many different news stories and analysts’ reports before you get a handle on which sources provide the best overnight summaries, which fundamental analysts are most focused on the forex market, and which technical analysts are focused on actionable short term trade strategies. Most traders tend to focus on the mainstream financial news media, such as Bloomberg.com, Reuters.com, and MarketWatch.com.

Technical versus fundamental analysis

I write about fundamental analysis and technical analysis in greater depth in "Getting Down and Dirty with Fundamental Data" and "The Philosophy of Technical Analysis". I include them here as elements to consider as you develop your overall approach to the market. Ask yourself on what basis you‘ll make your trading decisions - fundamental analysis or technical analysis?

Followers of each discipline have always debated which approach works better. Rather than take sides, I suggest following an approach that blends the two disciplines. In my experience, macroeconomic factors such as interest rates, relative growth rates, and market sentiment determine the big picture direction of currency rates. But currencies rarely move in a straight line, which means there are plenty of short-term price fluctuations to take advantage of and some of them can be substantial.

Technical analysis can provide the guideposts along the route of the bigger price move, allowing traders to more accurately predict the direction and scope of future price changes. Most important, technical analysis is the key to constructing a well-defined trading strategy. For example, your fundamental analysis, data expectations, or plain old gut instinct may lead you to conclude that USD/JPY is going lower. But where exactly do you get short? Where do you take profit, and where do you cut your losses? You can use technical analysis to refine trade entry and exit points, and to decide whether and where to add to positions or reduce them. 

Sometimes forex markets seem to be more driven by fundamental factors, such as current economic data or comments from a central bank official. In those times, fundamentals provide the catalysts for technical breakouts and reversals. At other times, technical developments seem to be leading the charge - a break of trend-line support may trigger stop-loss selling by market longs and bring in model systems that are selling based on the break of support. Subsequent economic reports may run counter to the directional breakout, but data be damned - the support is gone, and the market is selling.

Fundamental data and events are only one piece of the puzzle. Be aware that forex markets frequently ignore the fundamentals and do their own thing.

Approaching the market with a blend of fundamental and technical analysis will improve your chances of both spotting trade opportunities and managing your trades more effectively. You’ll also be better prepared to handle markets that are alternately reacting to fundamental and technical developments or some combination of the two.

The Science of Technical Analysis

Relax. Nothing is especially scientific or particularly complicated about technical analysis. Many in the market use the term science to describe the mechanics of various technical tools, but in my opinion technical analysis is far more art than science.

Each tool in technical analysis has a number of concrete elements that we need to outline before you can start interpreting what they mean. Unless you’re developing your own systematic trading model, you don’t need to get too caught up in the math or the calculations behind various indicators. Far more important is understanding what the indicators are measuring and what their signals mean and don’t mean.

Momentum oscillators and studies

Momentum refers to the speed at which prices are moving, either up or down. Momentum is an important technical measurement of the strength of the buying or selling interest behind a movement in prices. The higher the momentum in a down move, for example, the greater the selling interest is thought to be. The slower the momentum, the weaker the selling interest.

Currency traders use momentum indicators to gauge whether a price movement will be sustained, potentially developing into a trend, or whether a directional move has run its course and is now more likely to reverse direction. If momentum is positive and rising, it means prices are advancing, suggesting that active buying is taking place. If momentum begins to slow, it means prices are advancing more slowly, suggesting that buying interest is beginning to weaken. If buying interest is drying up, selling interest may increase.

Momentum takes on added significance in currencies because no viable way of assessing trading volume on a real-time basis exists. In equity and futures markets, volume data is an important indicator of the significance of a price move. For example, a sharp price movement on high volume is considered legitimate and likely to be sustained while a similarly sharp move on low volume is discounted and viewed as more likely to reverse.

Momentum indicators fall into a group of technical studies known as oscillators, because the mathematical representations of momentum are plotted on a scale that sees momentum rise and fall, or oscillate, depending on the relative speed of the price movements. A variety of different momentum oscillators exist, each calculated by various formulas, but they’re all based on the relationship of the current price to preceding prices over a defined period of time.

Momentum oscillators are typically displayed in a small window at the bottom of charting systems, with the price chart displayed above, so you can readily compare the price action with its underlying momentum.

Overbought and oversold

Momentum oscillators have extreme levels at the upper and lower ends of the oscillator’s scale, where the upper level is referred to as overbought and the lower level is referred to oversold. No hard definitions of overbought and oversold exist, because they’re relative terms describing how fast prices have changed relative to prior price changes. The best way to think of overbought and oversold is that prices have gone up or down too fast relative to prior periods.

Many momentum indicators suggest trading rules based on the indicator reaching overbought or oversold levels. For example, if a momentum study enters overbought or oversold territory, and subsequently turns down or up and moves out of the overbought or oversold zone, it may be considered a sell or buy signal.

Just because a momentum indicator has reached an overbought or oversold level does not mean that prices have to reverse direction. After all, the essence of a trend is a sustained directional price movement, which could see momentum remain in overbought or oversold territory for a long period of time as prices continue to advance or decline in the trend. Momentum is only an indicator. The key is to wait for confirmation from prices that the prior direction or trend has, in fact, changed.

Divergences between price and momentum

Another useful way to interpret momentum indicators is by comparing them to corresponding price changes. In most cases, momentum studies and price changes should move in the same direction. If prices are rising, for example, you would expect to see momentum rising as well. By the same token, if momentum begins to stall and eventually turn down, you would expect to see prices turn lower, too. But relatively frequently, especially in shorter, intraday timeframes (15 minutes, 1 hour, or 4 hours), prices diverge from momentum (meaning, prices may continue to rise even though momentum has started to move lower).

When prices move in the opposite direction of momentum, it’s called a divergence. Divergences are relatively easy to spot - new price highs are not matched by new highs in the momentum indicator, or new price lows are not matched by new lows in the momentum study. When a new price high or low is made, and momentum fails to make a similar new high or low, the price action is not confirmed by the momentum, suggesting that the price move is false and will not be sustained. The expectation, then, is that the price will change direction and eventually follow the momentum.

When prices make new highs, and momentum is falling or not making new highs, it’s called a bearish divergence (meaning, prices are expected to shift lower - move bearishly - in line with the underlying momentum). When prices are making new lows, but momentum is rising or not making new lows, it’s called a bullish divergence (meaning, prices are expected to turn higher - bullish - in line with momentum).

Divergences are great alerts that something may be out of kilter between prices and the underlying strength or momentum of the price move. Whenever you spot a divergence between price and momentum, you should start looking more closely at what's happening to prices. Are stop-loss levels being run in thin liquidity conditions? Or has some important news just come out that has sent prices moving sharply, and momentum will eventually catch up?

In a trending environment, prices may continue to move in the direction of the trend (that’s what a trend is), but at a slower pace, causing momentum to diverge. To know for certain, you need to wait for confirmation from prices before you enter a trade based on a divergence.

Using momentum in ranges and trends

Momentum indicators work best in range environments, where price movements are relatively constrained. As buying drives prices toward the upper end of a range, for example, selling interest comes in, slowing the price advance and turning momentum lower. As the buyers turn around, the selling interest increases and momentum begins to accelerate lower, confirming the change in direction. At the bottom of the range, the same thing happens, but in the opposite direction.

Momentum studies frequently give off incorrect signals during breakouts and trending markets. This is especially the case when using shorter timeframes, such as hourly and shorter study periods. The key to understanding why this happens is to recognize that momentum studies are backward-looking indicators. All they can do is quantify the change in current prices relative to what has come before. They have little predictive capacity, which is why you always need to wait for confirmation from prices before trading based on a momentum signal.

Some of the most extreme price moves typically occur when momentum readings are in overbought or oversold territory. Divergences in shorter time frames also appear frequently, especially during breakouts, where rapid price moves are not reflected quickly enough in momentum studies. By the time the momentum indicator has caught up with the price breakout, prices may already have peaked or bottomed, again causing momentum to signal a divergence. Just because momentum is overbought or oversold doesn’t mean prices can’t continue to move higher or lower.

Most technical studies analyze prior price action over specified time periods. The period refers to the time frame in which you’re viewing the technical study, such as 15 minutes, an hour, or days. If you’re looking at a technical study in the hourly time frame, for example, and the study is using 9 and 14 as the two time periods, it means the study is looking at the price action over the last 9- and 14-hour periods for its price data. If you switch to a 15-minute timeframe, the data is drawn from the last nine and fourteen 15-minute periods. The shorter the period (the lower the number), the more sensitive the indicator will be to current prices. The longer the period (the higher the number), the more slowly the study will respond to current price moves. As a result, shorter-period studies tend to be more volatile and generate more signals than longer-period studies. Charting systems typically supply preset default periods, or parameters, for each study, based on the developer of the study or common market usage.

Here are the main momentum oscillators used by currency traders: -

ü  Relative Strength Index (RS1): A single-line oscillator plotted on a scale from 0 to 100, based on closing prices over a user-defined period. Common RSI periods are 9, 14, and 21. RSI compares the strength of up periods to the weakness of down periods - hence, the label relative strength. RSI readings over 75 are considered overbought; readings below 25 are considered oversold. RSI signals are given when the indicator leaves overbought or oversold territory and on divergences with price.

ü  Stochastic: A two-line oscillator plotted on a scale oi 0 to 100. The two lines are known as %K (fast stochastic) and %D (slow stochastic). Stochastics are also based on closing prices of prior periods. The basic theory behind stochastics is that the strength of a directional move can be measured by how near the close is to the extreme of a period. In an uptrend, a close near the highs for the period signifies strong momentum; a close in the middle or below signals that momentum is weakening. In a downtrend, the close of a period should be nearer to the lows for momentum to strengthen. As momentum shifts, the %K line will cross over the slower-moving %D line. Crossovers in overbought or oversold territory are considered sell or buy signals. Overbought is above 80, and oversold is below 20.

ü  Moving Average Convergence/Divergence (MACD): Not really a momentum oscillator, but a complex series of moving averages. (It functions very similarly to momentum studies, so I include it here.) MACD fluctuates on either side of a zero line and has no fixed scale, so overbought or oversold are judged relative to prior extremes. MACD also consists of two lines: the MACD line (based on two moving averages) and the signal line (a moving average of the MACD line). Trading signals are generated if the MACD line crosses up over the signal line while below the zero line (buy) or crosses clown below the signal line while above the zero line (sell). MACD tends to generate signals more slowly than RSI or stochastics due to the longer periods typically used and the slower nature of moving averages. The result is that it takes longer for MACD to crossover, generally preventing fewer false signals.

Trend-identifying indicators

One of the market’s favorite sayings is “The trend is your friend.” The idea is that if you trade in the direction of the prevailing trend, you're more likely to experience success than you are if you trade against the trend. Now, how can you argue with logic like that?

The hard part for us mortals is to determine whether there’s a trend in the first place. The question becomes more complex when you look at multiple time frames, because trends can exist in any timeframe. On a daily time frame, the market may be largely range bound. But in a shorter time frame, such as hourly or 30 minutes, there may be a trending movement that presents a trading opportunity.

Determining whether a trend is in place is also important when it comes to deciding whether to follow the signals given by momentum indicators. Momentum studies are great in relatively range-bound markets, but they tend to give off bad signals during trends and breakouts. The key is to determine whether a trend is in place. In the following, we look at a few technical studies you can use to identify whether a trend is in place and how strong it may be.

Directional Movement Indicator system

The Directional Movement indicator (DMI) system is a set of quantitative tools designed to determine whether a market is trending. The DMI was developed by J. Welles Wilder (author of New Concepts in Technical Trading Systems), who also developed the MACD indicator. Using the DMI removes the guesswork involved with spotting trends and can also provide confirmation of trends identified by trend-line analysis.

The DMI is based on the idea that when a market is trending, each period’s price extremes should exceed the prior price extremes in the direction of the trend. For example, in an uptrend, each successive high should be higher than the prior period‘s high. In a downtrend, the opposite is the case: Each new low should be lower than the prior period's low.

The DMI system is comprised of the ADX line (the average directional movement index) and the Dl+ and Dl- lines (which refer to the directional indicators for up periods [+] and down periods [-]). The ADX is used to determine whether a market is trending (regardless if it’s up or down), with a reading over 25 indicating a trending market and a reading below 20 indicating no trend. The ADX is also a measure of the strength of a trend - the higher the ADX, the stronger the trend. Using the ADX, traders can determine whether a trend is operative and decide whether to use a trend-following system or to rely on momentum oscillator signals.

As its name would suggest, the DMI system is best employed using both components. The Dl+ and Dl- lines are used as trade-entry signals. A buy signal is generated when the Dl+ line crosses up through the Dl- line; a sell signal is generated when the Dl- line crosses up through the Dl+ line. Wilder suggests using the extreme-point rule to govern the Dl+/Dl- crossover signal. The rule states that when the DI+/Dl- lines cross, you should note the extreme point for that period in the direction of the crossover (the high if Dl+ crosses up over Dl-; the low if Dl- crosses up over Dl+). If that extreme point is exceeded in the next period, the Dl+/DI- crossover is considered a valid trade signal. If the extreme point is not surpassed, the signal is not confirmed.

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

Moving averages

One of the more basic and widely used indicators in technical analysis, moving averages can verify existing trends, identify emerging trends, and generate trading signals. Moving averages are simply an average of prior prices over a user-defined time period displayed as a line overlaid on a price chart. There are two main types of moving averages:

ü  Simple moving average gives equal weight to each price point over the specified period.

ü  Exponential moving average gives greater weight to more recent price data, with the aim of capturing directional price changes more quickly than the simple moving average.

In terms of defining a trend, when prices are above the moving average, an uptrend is in place; when prices are below the moving average, a downtrend is in place.

Traders like to experiment with different periods for moving averages, but a few are more commonly used in the market than others, and they're worth keeping an eye on. The main moving average periods to focus on are 21, 55, 100, and 200. Shorter-term traders may consider looking at the 9- and 14- period moving averages.

Another way moving averages are used is by combining two or more moving averages and using the crossovers of the moving averages as buy or sell signals based on the direction of the crossover. For example, using a 9- and 2- period moving average, you would buy when the faster-moving 9-period average crosses up over the slower-moving 21-period average, and vice versa for a crossover to the downside.

Don’t follow any single technical study blindly. Get used to looking at several 41-different studies in conjunction with one another. Use them to assist you and to serve as early warning signals of potential changes in price direction, pending confirmation from prices, such as breaks of trend lines or spike reversals. Also, the time frame of your study directly relates to its timing implications for the future - a very short time frame carries meaning for the relatively brief future, while a daily study will carry implications for several days ahead.

The Art of Technical Analysis

Chart analysis is at the heart of technical analysis. Don’t become reliant on all the fancy indicators and technical studies on your charting system. The most powerful technical indicators you have are your eyes and what’s behind them. I will try to show you the basics of drawing trend lines and look at some of the most common, yet significant, price patterns you’l1 encounter over and over again in your trading.

Bar charts and candlestick charts

There are 2 main types of chart you’ll likely be using as you pursue your own technical analysis.

Measuring markets with price bars

Most charting systems are set to default to show bar charts, probably the most widely used form of charting among Western traders. Bar charts are composed of price bars, which encompass the key points of each trading period - namely, the open, high, low, and close. Each bar is displayed as a vertical line with a tick mark on each side of the bar. The tick mark on the left side of the price bar represents the open of the period; the tick mark on the right side is the close of the period; and the upper and lower levels of the bar are the period's highs and lows.

You can use bar charts to draw trend lines, measure retracement levels, and gauge overall price volatility. Each bar represents the trading range for the period; the larger the bar, the greater the range and the higher the volatility (and vice versa for smaller bars). You can set bar charts to display in any time period you want, from five minutes to hours to days and beyond. Bar charts are best suited to relatively basic analysis, such as getting a handle on an overall trend.

Lighting the way with candlesticks

I put my favoritism right out front for everyone to see: I love using candlestick charts to spot trade setups, especially impending price reversals. I think candlesticks are among the more powerful predictive tools in the trader’s arsenal, and I strongly recommend that you study them further.

In particular, I highly recommend reading Steve Nison’s Japanese Candlestick Charting Techniques, 2nd Edition. Nison literally wrote the book on candlesticks and is credited with introducing the popular Japanese form of market analysis to Western audiences.

Candlestick charts are among the earliest known forms of technical analysis, dating back to trading in the Japanese rice markets in the 18th century. Candlestick charts, or just candles for short, provide a more visually intuitive representation of price action than you get from simple bar charts. They do this through the use of color and by more clearly breaking out the key price points of each trading day - open, close, high, and low.

Figure below shows the components of two candlesticks. Immediately, you can see that one candle is light, and the other is dark. What does that mean? Think of yin and yang, good and bad, up and down. The light candlestick indicates that the close was higher than the open - it was an up day. The dark candle indicates that the close was lower than the open a down day.

The light dark portion in the middle of the candle is called the real body or just body; it displays the difference between the open and the close. The lines above and below the body are called tails (the term we‘ll use going forward), shadows or wicks; these lines represent the high and low of the period.

Figure 1: Candlesticks provide a highly intuitive visual representation of price movements.

Drawing trend lines

Probably no exercise in technical analysis is more individualistic than identifying and drawing trend lines. Very often, it comes down to a matter of beauty being in the eye of the beholder. But in the case of chart analysis, beauty is order, and the trend lines you draw are the outlines of that order. Ultimately, drawing trend lines is not that complicated - with a bit of practice, you’ll get the hang of it pretty quickly.

What is a trend line? Basically, a trend line is a line that connects significant price points over a visually defined time period on a price chart. The significant price points are usually the highs and lows of bars or candles, though in the case of candles you can also use the open or close levels of the candle’s real body.

Connecting the dots

The starting point in drawing trend lines is looking at the overall price chart in front of you. What do you see? If it’s your first time looking at a price chart, it probably looks like a jumble of meaningless bars or candles. The key is to turn that jumble into a meaningful visualization of what’s happening to prices.

Scan the chart from left to right, starting in the past and looking into the present. What are prices doing? Are they moving up, down, or a little of bit of both? (If you’re looking at a currency chart, you can bet they’re doing a little bit of both.) Draw your first trend lines to connect the highest highs (you need only two points to form a line) and the lowest lows, to capture the overall range in the observed period. Always use the extreme points of the price bars or candles when connecting price points (lows with lows, highs with highs).

Look at what’s happening between those two trend lines. You’ll invariably see a number of smaller, distinct price movements making up the whole. You can draw trend lines to connect the highs of price moves down and the lows of price moves up. Be sure to extend your trend lines all the way to the right edge of the chart, regardless of other bars or candles that later break it. Look for evenness, whether it’s horizontal, sloping down, shooting steeply higher or anything in between. Eventually, that evenness will be broken by price moves that break through the trend lines.

Your ultimate focus will be on the prices on the right side of the chart, because that’s the most recent price action, and beyond it lie future price developments. The idea is to winnow out trend lines from the past that appear to have little relevance (they’re frequently broken), and keep the trend lines that have the most relevance (prices reverse course when they’re hit, and they’re largely unbroken) and extend them into the future. Those trend lines are going to act as support and resistance just as they did in the past and provide you with guidance going forward.

Looking for symmetry

When you’re drawing trend lines, be alert for symmetrical patterns, such as parallel channels, sloping up or down, or simply horizontal. Look for horizontal tops and bottoms to be made where prior high and lows were reached. Note that a rising trend line may be heading for a falling trend line, forming a triangle. The two lines are set to intersect at some point in the future, and one of them will be broken, sparking a price reaction.

Charting systems usually have a trend-line function that allows you to draw a line parallel to another line, or copy an existing line and move it to a parallel position. Experiment with that tool, and you’ll be surprised how frequently price points match up to it.

Recognizing chart formations

Pattern recognition, or the identification of chart formations, is another form of technical analysis that helps traders get a handle on what’s happening in the market. In the following sections, we cover some of the most widely observed chart formations and what they mean from a trading standpoint. While you‘re looking through them, keep in mind that the formations can occur in different charting timeframes (for example, 15 minutes, hourly, daily).

The key to trading on chart formations is to recognize the time period in which they‘re apparent and to factor that into your trade strategy. A reversal pattern that occurs on an hourly chart, for example, may constitute a reversal that lasts for only a few hours or a day and retrace a relatively smaller pip distance. A reversal pattern on a daily chart, in contrast, could signal a significant multi-week reversal spanning several hundred pips. Keep the formations you observe in the proper time-frame perspective.

Basic chart formations

Chart formations are part and parcel of trends. They’re generally grouped into categories that reflect what they mean in the context of a trend. The two most common types of chart patterns are:

ü  Reversal patterns: A reversal pattern indicates that the prior directional price movement is coming to an end. it does not necessarily mean that prices will actually begin to move in the opposite direction, though in many cases they will.

ü  Consolidation and continuation patterns: Consolidation and continuation patterns represent pauses in directional price moves, where prices undergo a period of back-and-forth consolidation before the overall trend continues.

Double tops and double bottoms

Double tops and double bottoms are typically considered among the most powerful chart formations indicating a reversal in the direction of an overall trend. Double tops form in an uptrend, and double bottoms form in a downtrend. Figure 2 below shows a double-top pattern on a daily EUR/USD chart.

    Figure 2: A double top formations suggest that the prior trend higher may reverse.

In terms of market psychology, the idea behind both is that a directional trend (up or down) will make a high or low at some point. After a period of consolidation, the market will move again to test the prior high or low for the trend. If the trend is still intact, the market should be able to make a new high or low beyond the prior one. But if the market is unable to surpass the prior high or low, it’s taken as a signal that the trend is over, and trend followers begin to exit, generating the reversal.

As with most chart formations, double tops and bottoms rarely form perfectly. The second high or low may come up short of the prior high or low; that inability even to retest the prior high or low can create a more rapid and volatile reversal. Other times, the first high may be surpassed by a brief amount and for a brief time (possibly due to stops at the prior high being triggered), as in Figure 2 above, only to be rejected, leading to the reversal.

Head and shoulders and inverted head and shoulders

Head-and-shoulders (H&S) formations are another form of reversal pattern, sometimes referred to as a triple top. Figure 3 below shows an example of a H&S top formation. The H&S formation develops after an uptrend, and the inverted H&S comes after a downtrend. In the case of an uptrend, a high is made at some stage followed by a pullback lower, creating the left shoulder. A subsequent new high is made, generating the head, followed by yet another correction lower. A third attempt to move higher fails to reach the second or highest high and may surpass, equal, or fall short of the left shoulder. Failure to reach the prior high typically triggers selling, and confirmation of a reversal is received when prices fall below the neckline, which is formed by connecting the lows seen after each pullback from the shoulder and the head.

The standard measured move objective (the price move suggested by a chart pattern) in an H&S pattern is the distance from the top of the head to the neckline. When the neckline is broken, prices should subsequently move that distance.

Figure 3: A head-and-shoulders formation in EUR/GBP signals that attempts to move higher are about to reverse.

Flags

Flags are consolidation patterns that typically form in a counter-trend direction. For example, if prices have vaulted higher (the trend is up) and run into resistance above, in order for a flag to form, prices will begin to consolidate in a downward (counter-trend) channel. The formation suggests that the flag consolidation channel will eventually break out in the direction of the prior trend, and the directional trend will resume. Perhaps somewhat confusingly, a bull flag actually slopes downward, but it’s called a bull flag because after it breaks, the bullish trend resumes. A bear flag slopes upward, but after it breaks to the downside, the bearish trend continues.

Flags have a measured move objective based on the flagpole, or the distance of the prior move that ultimately stalled, resulting in the formation of the flag. When the flag is broken, the price target is usually equal to the length of the flagpole, as shown in Figure 4 below.

Figure 4: A break of a bull-flag consolidation pattern on an hourly chart of USD/CHF signals that the up move is resuming.

Triangles

Triangles are another type of consolidation pattern, and they come in a few different forms:

ü  Symmetrical triangles: These formations have downward-sloping upper edges and upward-sloping lower edges, resulting in a triangle pointing horizontally. Symmetrical triangles are mostly neutral in what they suggest about the direction of the ultimate breakout.

ü  Ascending triangles: These formations have a flat or horizontal top and an upward-sloping lower edge (see Figure 5). Ascending triangles typically break out to the upside after resistance on the top is overcome. The rising lower edge signifies that buyers keep coming back at ever higher levels to push through the horizontal top. The minimum measured move objective on a breakout is equal to the distance between the rising bottom and where the flat top is first reached.

ü  Descending triangles: These formations are the inverse of ascending triangles, where the horizontal edge and the expected direction of the breakout are to the downside.

Figure 5: The break of the flat top in an ascending triangle formation signals an upside breakout.

Candlestick patterns

Candlestick patterns are some of the most powerful predictors of future price direction. Candlesticks have little predictive capacity when it comes to the size of future price movements, so you need to look at other forms of technical analysis to gauge the extent of subsequent price moves. But if you can get the direction right, you’re more than halfway there.

Candlestick formations come in two main forms:

ü Reversal patterns: Where a preceding directional move stops and changes direction

ü Continuation patterns: Where a prior directional move resumes its course after a period of consolidation

I like to look at candlestick patterns primarily for reversal signals because they’re among the most reliable of the candlestick patterns.

The key to interpreting a candle formation as a reversal indicator is that there has to be an identifiable directional move in the clays preceding the candles. If the prior day‘s direction was sideways, as evidenced by small real bodies, a candlestick reversal pattern holds less significance. The directional price move may be part of an extended uptrend or downtrend, or simply a day or two of a clear directional move higher or lower, as shown by relatively large real bodies.

Literally dozens of different candlestick reversal patterns exist, but I focus on the most common patterns. Keep in mind that some candle reversal formations consist of a single candle, while others depend on two or three candles to constitute the pattern. Look closely, and you'll see that many of them are variations on the same theme (namely that a directional move is losing force, increasing the potential for a price reversal). 

Doji

Doji are probably the most significant of the candlestick patterns, because their basic shape forms the basis for many other candlestick patterns. A doji occurs when the close is the same as the open, generating a candlestick with no real body - simply a vertical line with a cross on it, as shown in Figure 6 below.

Figure 6: A doji with long tails on a dily USD/JPY charts suggest that the up move may be set to reverse.

On days when the close is only a few points apart from the open, generating a candle with an extremely small real body, you can take a bit of artistic license and consider it a potential doji depending on the preceding candles. If the prior days’ candles were composed of long real bodies, that increases the likelihood that the very small real body should be viewed as a doji. Whenever you spot a doji after a daily close, you should take note of it and begin looking for signs of a reversal.

Doji are significant because they represent indecision and uncertainty. By looking at a doji, you can see that both buyers and sellers had a pretty good at it, but they ended up finishing the day essentially unchanged, meaning neither side is dominating. Figure above shows a classic doji, where the open and close are the same and about in the middle of the day’s trading range. The longer the upper and lower tails are in a doji, the greater the sense of uncertainty displayed by the market and the more likely the prior trend is to be ending.

A double doji occurs when two doji appear in successive periods. The increased uncertainty associated with a double doji tends to signal that the subsequent price move will be more significant after the market’s indecision is resolved.

On its own, a doji is considered neutral. You need to wait for subsequent price action, such as a trend-line break, to confirm that the doji is signalling a reversal.

Hammer and hanging man

A hammer and hanging man are single-candle formations that indicate that a reversal is likely taking place. Both candles have the same form - a small real body at the upper end of the candle, with a long lower tail (at least twice the height of the real body) and little or no upper tail. The color of the candle can be either light or dark. The pattern is called a hammer when it appears after a down move (shown in figure 7) and is a bullish reversal signal. The formation is called a hanging man (refer to Figure 8) after an uptrend and is a bearish reversal pattern.

Figure 7: A hammer formation signals a downside move is likely set to reverse higher

Figure 8: A bearish harami cross (followed by a hanging man in this case suggest an up move is set to reverse lower.

A hammer has a long lower tail, and the real body is at the upper end of the range, which are both bullish signs after a downtrend. You can trade a hammer without confirmation. A hanging man, on the other hand, requires confirmation by the next candle because the long lower shadow and the real body at the top of the range in an uptrend are generally bullish signs. Look for prices on the next candle to open below the real body of the hanging man, or close below it, to signal confirmation.

Harami and harami crosses

Harami and harami crosses are two-candlestick formations that indicate a reversal - a bearish harami occurs after an uptrend (shown in Figure 8), and a bullish harami comes after a downtrend. The formation is called a harami cross if the second candle is a doji (the cross) or a candle with a very small real body. A harami cross is considered a more powerful signal of a reversal than a regular harami due to the doji.

Also, the formation usually requires that the body of the second candle be completely overlapped by the body of the first candle. But because currencies typically open where they closed (in most cases), the ideal overlap may not occur. Instead, look for a small real body at the extreme end of the second candle.

ü  Bullish harami: A long-bodied dark candle followed by a relatively short candle with a small real body of either color. If the second candle is a doji, or nearly so, the potential for an upside reversal is higher.

ü  Bearish harami: A long-bodied light candle followed by a shorter candle with a small real body of either color. If the second candle is a doji, or nearly so, as in Figure 8, the potential for a downside reversal is greater.

Spinning tops

Spinning tops (see Figure 9) are single-candle formations that have a small real body and typically short upper and lower tails, though the size of the tails is secondary. The formation gets its name because it resembles a child’s toy top. The significance of a spinning top is that it has a small real body, which represents a drop in directional momentum after a series of up or down candles.

Spinning tops can be seen in other reversal formations, such as harami and hammer or hanging man, and can be thought of as resembling a fatter doji as well. Spinning tops require confirmation by subsequent candles, but be on alert for potential reversals if you spot a spinning top.

 Figure 9: Spinning tops are similar to doji both in shape and in that they suggest a potential reversal of the prior directional move. The example shown here could also be viewed as a double doji.

Engulfing lines

Engulfing lines are two-candlestick patterns that can be either bullish or bearish, depending on whether they come after a down move or an up move:

ü  Bullish engulfing line: The first candle is dark, followed by a large light candle, the body of which completely engulfs the body of the dark candle. The smaller the body of the first candle (think spinning top), the more significant the reversal signals. Also, because currencies generally open where they closed, the second candle may not completely engulf the body of the first but only match the high.

ü  Bearish engulfing line: The first candle is light, followed by a long dark colored candle that engulfs the body of the first candle, as shown in Figure 10. Again, the body of the second candle may not completely engulf the first but only match the high.

Figure 10: A bearish engulfing line signals the end of the prior uptrend and later goes on to make a double top. This is a good example of candles and traditional chart formations being used together.

Tweezers taps and tweezers bottoms

Tweezers formations are two-candlestick patterns that get their name because they resemble the pincer end of a pair of tweezers. Tweezers tops (shown in Figure 11) and bottoms correspond to double tops and bottoms in traditional chart analysis, and they mean the same thing - a reversal after failing to make new highs or lows.

ü  Tweezers top: The first candle is long and light-colored, while the size and color of the second candle do not matter. What matters is that they have the same highs, or nearly so, as indicated by the upper tails.

Tweezers bottom: The first candle is dark with a long real body, followed by a second candle that has the same, or nearly the same, low. The color and size of the second candle do not matter.

Figure 11: A tweezers topformation signals that an up move is set to reverse. Note the doji in the prior day suggesting that upside sentiments was uncertain.

Fibonacci retracements

A-retracement is a price movement in the opposite direction of the preceding price move. For instance, if EUR/USD rises by 150 pips over the course of two days and declines by 75 pips on the third day, prices are said to have retraced half the move higher, or made a 50% retracement of the move up. (50% is not technically a Fibonacci retracement, but I include it here because many traders watch it, too, because of its clean, halfway demarcation.)

Fibonacci retracements come from the ratios between the numbers in the Fibonacci sequence, a nearly magical numerical series that appears in the natural world and mathematics with regularity. The most important Fibonacci retracement percentages are 38.2 % and 61.8 %, with 23.6% and 76.4% as secondary, but still important levels.

Most charting systems contain an automatic Fibonacci retracement drawing tool. All you need to do is click the starting point of a directional price move (the low for an up move; the high for a down move) and drag the cursor to the finishing point of the movement. The charting system will then display lines that correspond to 23.6%, 38.2%, 50%, 61.8%, 76.4%, and 100%.

Fibonacci retracements form the basis of many of the price expectations contained in the Elliott wave principle of price movements, a relatively complex method of viewing trends as a series of related price waves. (For more on Elliott waves, I recommend A. J. Frost and Robert R. Prechter, Jr.’s book Elliott Wave Principle.

Beyond Elliott wave, currency traders routinely calculate Fibonacci retracement levels to determine support and resistance levels, and Fibonacci retracement levels are strong examples of self-fulfilling prophecies in technical analysis. Figure 12 provides a good illustration of how Fibonacci retracement levels can act as resistance in a correction higher following a price decline.

Figure 12: You can identify future support levels and resistance levels (shown here) by drawing Fibonacci retracement of prior directional price moves on your charting systems.