USING
TECHNICAL INDICATORS
A good understanding of the
basic tenets of technical analysis can vastly improve one's
trading skills.
When
using technical analysis, price is the primary tool. Simply
put, "everything is already in the rate." However,
technical analysis involves a bit more than simply staring at
price charts hoping to find a "yellow brick road" to
a bonanza payday. Along with various methods of plotting price
action on charts by using bars, candlesticks, and Xs and Os on
point and figure charts, market technicians also employ many
technical studies that help them to delve deeper into the
data. By using these studies in conjunction with their price
charts, traders are able to build much stronger cases to buy,
sell or remain on the sidelines than they could by simply
looking at price charts alone.
Here
are descriptions of some of the more widely used and
timetested studies that technicians keep in their toolboxes:
Indicators
Moving
Averages
One of the most basic and widely used indicators in a technical
analyst's tool box, moving averages help traders verify existing
trends, identify emerging trends, and view overextended trends
about to reverse. Moving averages are lines overlaid on a chart
indicating long term price trends with short term fluctuations
smoothed out.
There
are three basic types of moving averages:

Simple

Weighted

Exponential
A simple
moving average gives equal weight to each price point
over the specified period. The user defines whether the high,
low, or close is used and these price points are added together
and averaged. This average price point is then added to the
existing string and a line is formed. With the addition of each
new price point the sample set drops off the oldest point. The
simple moving average is probably the most widely used moving
average.
A weighted
moving average gives more emphasis to the latest
data. A weighted moving average multiplies each data point by a
weighting factor which differs from day to day. These figures
are added and divided by the sum of the weighting factors. A
weighted moving average allows the user to successfully smooth
out a curve while having the average more responsive to current
price changes.
An exponential
moving average is another way of
"weighting" the more recent data. An exponential
moving average multiplies a percentage of the most recent price
by the previous period's average price. Defining the optimum
moving average for a particular currency pair involves
"curve fitting". Curve fitting is the process of
selecting the right number of periods with the correct type of
moving average to produce the results the user is trying to
achieve. By trial and error, technicians work with the time
periods to fit the price data.
Because the moving
average is constantly changing based on the latest market data,
many traders will use different "specified" time
frames before they come up with a series of moving averages that
are optimal for a particular currency.
For example, a
trader might create a 5day, a 15day and a 30day moving
average for a currency and then plot them on his or her price
chart. He might start out using simple moving averages and end
up using weighted moving averages. In creating these moving
averages, traders need to decide on the exact price data that
will be used in this study; meaning closing prices vs. opening
prices vs. high/low/close etc. After doing so, a series of lines
are created that reflect the 5day, 15day and 30day moving
average of a currency.
Once the data is
layered over a price chart, traders can determine how well these
chosen periods keep track of the trend being followed. If, for
example, a market is trending higher, you'd expect the 30day
moving average to be a very accurate trend line, providing a
line of support for prices on their way higher. If prices seem
too close under this 30day moving average on several occasions
without resulting in a halt in the up trend, a trader will
simply adjust the time period to say a 45day or 60day moving
average in order to optimize the average. In this way, the
moving average will act as a trend line.
After determining
the optimum moving average for a currency, this average price
line can be used as a line of support in maintaining a long
position or resistance in maintaining a short position. Breaches
of this line can also be used as a signal that a currency is in
the process of reversing course, in which case a trader will
want to pare back an existing position or come up with entry
levels for a new position. For example, if you determine that a
30day moving average has shown itself to be a good support line
for USDJPY in an upward trending market, then market closes
under this 30day moving average line could be a signal that
this trend could be running out of steam. However, it is
important to wait for confirmation of these signals. One way to
do this is to wait for another close below the level. On the
second close under the average, you should begin to pare down
your position. Another confirmation involves using other,
shorter term moving averages.
While a longer term
moving average can help to define and support a particular
trend, shorter term moving averages can provide lead signals
that a trend is ending before prices dip below your longer term
moving average line. For this reason, most traders will plot
several moving averages on the same chart. In a market that is
trending higher, a shorter term moving average might signal a
market reversal by turning down and crossing over the longer
term moving average. For example, if you are using a 15day and
a 45day moving average in a market that is in an up trend, and
the 15day moving average turns down and crosses over the 45day
moving average, this could be an early signal that the up trend
is ending and it is probably time to begin to pare down your
position. (Back
to Indicators)
Stochastics
Stochastic studies, or oscillators, are another useful tool for
monitoring the expected sustainability of a trend. They provide
a trader with information about the closing price in the current
trading period relative to the prior performance of the
instrument being analyzed.
Stochastics are
measured and represented by two different lines, %K and %D and
are plotted on a scale ranging from 0 to 100. Indications above
80 represent strong upward movement while level indications
below 20 represent strong downward movements. The mathematics
behind the studies are not as important as knowing what the
stochastics are telling you. The %K line is the faster, more
sensitive indicator while the %D line takes more time to turn.
When the %K line crosses over the %D line, this could be an
indication that a market is about to reverse course. Stochastic
studies are not useful in choppy, sideways markets. At times
when prices are fluctuating in a narrow range, the %K and %D
lines might be crossing many different times and will be telling
you nothing more than the market is moving sideways.
Stochastics are most
useful in measuring the strength of a trend and as augurs of a
coming reversal in prices. When prices are making new highs or
lows and your stochastics are doing the same, you can be
reasonably certain that the trend will continue. On the other
hand, many traders finds that the best trading opportunity comes
when their stochastic indicator is flattening out or moving in
the opposite direction of prices. When these divergences occur,
it's time to book profits and/or to establish a position in the
opposite direction of the prior trend.
As should always be
the case when using any technical tool, do not act on the first
signal you see. Wait at least one or two trading sessions for
confirmation of what the study is indicating before you commit
to a position. (Back
to Indicators)
Relative
Strength Index (RSI)
RSI measures the momentum of price movements. It is also plotted
on a scale ranging from 0 to 100. Traders will tend to look at
RSI readings over 80 as an indicator of a market that is
overbought or susceptible to a downturn, and readings under 20
as a market that is oversold or ready to turn higher.
This logic therefore
implies that prices cannot rise or fall forever and that by
using an RSI study, one can determine with a reasonable degree
of certainty when a reversal will come about. However, be very
wary of trading on RSI studies alone. In many instances, an RSI
can remain at very lofty or sunken levels for quite a while
without prices reversing course. At these times, the RSI is
simply telling you that a market is quite strong or quite weak
and shows no signs of changing course.
RSI studies can be
adjusted to whatever time sensitivity a trader feels necessary
for his or her particular style. For instance, a 5day RSI will
be very sensitive and will tend to give many more signals, not
all of them sustainable, than say a 21day RSI, which will tend
to be less choppy. As with other studies, try a variety of time
periods for the currency that you are trading based on your
trading style. Longer term, position type traders, will tend to
find that shorter time frames used for an RSI (or any other
study for that matter) will give too many signals and will
result in overtrading. On the other hand, shorter time frames
will probably be ideal for daytraders trying to capture many
shorterterm price fluctuations.
As with stochastics,
look for divergences between prices and the RSI. If your RSI
turns up in a slumping market or turns down during a bull run,
this could be a good indication that a reversal is just around
the corner. Wait for confirmation before you act on divergent
indications from your RSI studies. (Back
to Indicators)
Bollinger
Bands
Bollinger Bands are volatility curves used to identify extreme
highs or lows in relation to price. Bollinger Bands establish
trading parameters, or bands, based on the moving average of a
particular instrument and a set number of standard deviations
around this moving average.
For example, a
trader might decide to use a 10day moving average and 2
standard deviations to establish Bollinger Bands for a given
currency. After doing so, a chart will appear with price bars
capped by an upper boundary line based on price levels 2
standard deviations higher than the 10day moving average and
supported by a lower boundary line based on 2 standard
deviations lower than the 10day moving average. In the middle
of these two boundary lines will be another line running
somewhat close to the middle area depicting in this case, the
10day moving average. Both the moving average and the number of
standard deviations can be altered to best suit a particular
currency.
Jon Bollinger,
creator of Bollinger Bands recommends using a simple 20day
moving average and 2 standard deviations. Because standard
deviation is a measure of volatility, Bollinger Bands are
dynamic indicators that adjust themselves (widen and contract)
based on the current levels of volatility in the market being
studied. When prices hit the upper or lower boundaries of a
given set of Bollinger Bands, this is not necessarily an
indication of an imminent reversal in a trend. It simply means
that prices have moved to the upper limits of the established
parameters. Therefore, traders should use another study in
conjunction with Bollinger Bands to help them determine the
strength of a trend. (Back
to Indicators)
MACD
 Moving Average Convergence Divergence
MACD is a more detailed method of using moving averages to find
trading signals from price charts. Developed by Gerald Appel,
the MACD plots the difference between a 26day exponential
moving average and a 12day exponential moving average. A 9day
moving average is generally used as a trigger line, meaning when
the MACD crosses below this trigger it is a bearish signal and
when it crosses above it, it's a bullish signal.
As with other
studies, traders will look to MACD studies to provide early
signals or divergences between market prices and a technical
indicator. If the MACD turns positive and makes higher lows
while prices are still tanking, this could be a strong buy
signal. Conversely, if the MACD makes lower highs while prices
are making new highs, this could be a strong bearish divergence
and a sell signal. (Back
to Indicators)
Fibonacci
Retracements
Fibonacci retracement levels are a sequence of numbers
discovered by the noted mathematician Leonardo da Pisa during
the twelfth century. These numbers describe cycles found
throughout nature and when applied to technical analysis can be
used to find pullbacks in the currency market.
Fibonacci
retracement involves anticipating changes in trends as prices
near the lines created by the Fibonacci studies. After a
significant price move (either up or down), prices will often
retrace a significant portion (if not all) of the original move.
As prices retrace, support and resistance levels often occur at
or near the Fibonacci Retracement levels.
In the currency
markets, the commonly used sequence of ratios is 23.6 %, 38.2%,
50% and 61.8%. Fibonacci retracement levels can easily be
displayed by connecting a trend line from a perceived high point
to a perceived low point. By taking the difference between the
high and low, the user can apply the % ratios to achieve the
desired pullbacks.
One
final word of advice: Don't get too caught up in the
mathematics involved in putting together each study. It is much
more important to understand how and why studies can and should
be manipulated based on the time periods and sensitivities that
you determine are ideal for the currency you are trading. These
ideal levels can only be determined after applying several
different parameters to each study until the charts and studies
begin to reveal the "details behind the
details."
(Back
to Indicators)
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