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.