FX Tango

A Journey to Master Forex Trading (FX Trader from Singapore)

Showing posts with label Theory. Show all posts
Showing posts with label Theory. Show all posts

Saturday, December 6, 2008

Technical Analysis: Principles

Reprinted from: http://www.alpari.co.uk/en/market-analysis-guide/technical-analysis/overview.html

Technical Analysis: Principles

History

Among various methods financial analysts utilize for forecasting the markets, the two most common methods are fundamental and technical analyses.

All in all, different technical theories can be viewed as puzzle stones, the combination of which should lead us to the ultimate goal of technical analysis - the set-up of the highest probability scenario for a specific market direction.

The roots of modern-day technical analysis stem from the Dow Theory, developed around 1900 by Charles H. Dow (1851-1902). His famous market philosophy, price action analysis and other techniques have been around for almost 100 years, yet even in today's volatile and technology-driven markets, the basic components of Dow Theory still remain useful.

In a series of stunning editorials for the Wall Street Journal at the turn of the century, Dow laid out the foundations of his own theory on the market. Among them were:

  • The market is always considered as having three movements, all occuring at the same time - primary, secondary and intraday.
  • Averages discount everything.
  • The market reflects all available information.

Everything there is to know is already reflected the markets through price. Prices represent the total sum of hopes, fears and expectations of all participants. Interest rate movements, earnings expectations, revenue projections, presidential elections, product initiatives and everything else is already priced into the market. The unexpected occurs, but usually this affects only the short-term trend. The primary trend remains unaffected.

Dow developed a conception of confirmation which is now better known as a divergence. Traders use it to compare price movements to oscillator movements to define the strength of the prevailing trend.

Dow placed the emphasis on the importance of trading volume to predict price rebounds and trend direction. For example, if the market is oversold, selling will be accompanied by low volume, whereas a rally will result in an increasing volume.

Robert Rhea spent a lot of time on market statistics. He was the first technical analyst who defined that divergence should have the narrowest range so, that it could be considered as a well-defined secondary movement.

Richard Schabacker (1902-1938) is considered to be a grandfather of technical analysis who laid the foundations for modern pattern analysis.

He classified tools which helped technical analysts not only to forecast future market movements, but also to foresee when the prevailing trend would finish.

He was the first to classify common charts patterns, develop the theory of price gaps, formalise the use of trend lines and prove the importance of support and resistance levels.

Richard Schabacker�s most popular tool is Bar charts. The vast majority of chart patterns fall into two main groups: reversal and continuation. Reversal patterns indicate the trend may change and may be broken down into top and bottom formations. Continuation patterns indicate that the trend takes a pause and resumes its previous direction after a while.

Richard Wyckoff traded stocks and bonds in the early and mid 1900's. His subject of interest was logic matters behind market actions. He developed a methodology which concentrated on the Volume-Price, Point and Figure and the process of sifting and ranking analyses. He developed such patterns as "Swing" and "Upthrust" which provide a trader with the key touch points as they describe test levels and false breakouts, which are produced when the price fluctuates within a trading range. Richard Wyckoff also introduced index comprised of five selected shares (the most sensitive ones) to predict market reversals on the early stages.

The next logical step of the Dow Theory was Elliott Wave Theory, which was proposed in the early 1930s by R.N. Elliot (1871-1948).

Principles of Technical Analysis

Technical analysis predominantly uses charts to forecast future price movements. Nowadays it is not necessary to draw charts on paper as the process is automated by specially designed computer programs. If you want to get more information on one of such trading platforms, please refer to the page about MetaTrader 4.

There are three sources for the technical analysis: price, volume and open interest (only for the future contracts).

Principles of technical analysis are the following:

  • Price discounts everything. Price is affected by economic, political and other factors, and all information is already reflected in it. Technical analysis utilizes the information captured by the price to interpret what the market is saying with the purpose of forming a view on the future.
  • Price movements are not totally random, or prices trend. The main purpose of the charts is to define a trend at an early stage and to trade in accordance with its direction.
  • History repeats itself. The techniques which were effective in the past can be still effective to forecast future price movements.
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Thursday, December 4, 2008

Elliott Wave Theory

Elliott Wave Theory

Back in the old school days during the 1920-30s, there was this mad genius named Ralph Nelson Elliott. Elliott discovered that stock markets, thought to behave in a somewhat chaotic manner, actually, did not.

They traded in repetitive cycles, which he pointed out were the emotions of investors and traders caused by outside influences (ahem, CNBC) or the predominant psychology of the masses at the time.

Elliott explained that the upward and downward swings of the mass psychology always showed up in the same repetitive patterns, which were then divided into patterns he called "waves". He needed to claim this observation and so he came up with a super original name: The Elliott Wave Theory.

The 5 – 3 Wave Patterns

Mr. Elliott showed that a trending market moves in what he calls a 5-3 wave pattern. The first 5-wave pattern is called impulse waves and the last 3-wave pattern is called corrective waves.

Let’s first take a look at the 5-wave impulse pattern. It’s easier if you see it as a picture:

Elliott Wave Theory

That still looks kind of confusing. Let’s splash some color on this bad boy.

Elliot Wave

Ah magnefico! Me likes colors. It’s so pretty! I’ve color-coded each wave along with its wave count.

Here is a short description of what happens during each wave. I am going to use stocks for my example since stocks is what Mr. Elliott used but it really doesn’t matter what it is. It can easily be currencies, bonds, gold, oil, or Tickle Me Elmo dolls. The important thing is the Elliott Wave Theory can also be applied to the foreign exchange market.

Wave 1
The stock makes its initial move upwards. This is usually caused by a relatively small number of people that all of the sudden (for a variety of reasons real or imagined) feel that the price of the stock is cheap so it’s a perfect time to buy. This causes the price to rise.

Wave 2
At this point enough people who were in the original wave consider the stock overvalued and take profits. This causes the stock to go down. However, the stock will not make it to its previous lows before the stock is considered a bargain again.

Wave 3
This is usually the longest and strongest wave. The stock has caught the attention of the mass public. More people find out about the stock and want to buy it. This causes the stock’s price to go higher and higher. This wave usually exceeds the high created at the end of wave 1.

Wave 4
People take profits because the stock is considered expensive again. This wave tends to be weak because there are usually more people that are still bullish on the stock and are waiting to “buy on the dips”.

Wave 5
This is the point that most people get on the stock, and is most driven by hysteria. You usually start seeing the CEO of the company on the front page of major magazines as the Person of the Year. People start coming up with ridiculous reasons to buy the stock and try to choke you when you disagree with them. This is when the stock becomes the most overpriced. Contrarians start shorting the stock which starts the ABC pattern.


ABC Correction

The 5-wave trends are then corrected and reversed by 3-wave countertrends. Letters are used instead of numbers to track the correction. Check out this example of smokin’ hot 3-wave corrective wave pattern!

Just because I’ve been using a bull market as my primary example doesn’t mean the Elliott Wave theory doesn’t work on bear markets. The same 5 – 3 wave pattern can look like this:

Waves within a Wave

The other important thing you have to know about the Elliot Wave Theory is that a wave is made of sub-waves? Huh? Let me show you another picture. Pictures are great aren't they? Yee-haw!

Do you see how Wave 1 is made up of a smaller 5-wave impulse pattern and Wave 2 is made up of smaller 3-wave corrective pattern? Each wave is always comprised of smaller wave patterns.

Okay, let’s look at a real example.

As you can see, waves aren’t shaped perfectly in real life. You’ll also learn its sometimes difficult to label waves. But the more you stare at charts the better you’ll get.

Okay, that’s all you need to know about the Elliott Wave Theory. Remember the market moves in waves. Now when you hear somebody say “Wave 2 is complete.” You’ll know what the heck he is talking about.

If you wish to become an Elliott Wave Theory guru, you can learn more about it at www.elliottwave.com.

Summary

  • According to the Elliott Wave Theory, the market moves in repetitive patterns called waves.
  • A trending market moves in a 5-3 wave pattern. The first 5-wave pattern are called impulse waves. The second 3-wave pattern are called corrective waves.
  • If you look hard enough at a chart, you'll see that the market really does move in waves.
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Japanese Candlesticks

What is a Candlestick?

While we briefly covered candlestick charts in the previous lesson, we’ll now dig in a little and discuss them more in detail. First let’s do a quick review.

What is a Candlestick?

Back in the day when Godzilla was still a cute little lizard, the Japanese created their own old school version of technical analysis to trade rice. A westerner by the name of Steve Nison “discovered” this secret technique on how to read charts from a fellow Japanese broker and Japanese candlesticks lived happily ever after. Steve researched, studied, lived, breathed, ate candlesticks, began writing about it and slowly grew in popularity in 90s. To make a long story short, without Steve Nison, candle charts might have remained a buried secret. Steve Nison is Mr. Candlestick.

Okay so what the heck are candlesticks?

The best way to explain is by using a picture:

Forex candlestick anatomy

Candlesticks are formed using the open, high, low and close.

  • If the close is above the open, then a hollow candlestick (usually displayed as white) is drawn.
  • If the close is below the open, then a filled candlestick (usually displayed as black) is drawn.
  • The hollow or filled section of the candlestick is called the “real body” or body.
  • The thin lines poking above and below the body display the high/low range and are called shadows.
  • The top of the upper shadow is the “high”.
  • The bottom of the lower shadow is the “low”.

Sexy Bodies and Strange Shadows

Sexy Bodies

Just like humans, candlesticks have different body sizes. And when it comes to forex trading, there’s nothing naughtier than checking out the bodies of candlesticks!

Long bodies indicate strong buying or selling. The longer the body is, the more intense the buying or selling pressure.

Short bodies imply very little buying or selling activity. In street forex lingo, bulls mean buyers and bears mean sellers.

Long candlestick body versus short candlestick body

Long white candlesticks show strong buying pressure. The longer the white candlestick, the further the close is above the open. This indicates that prices increased considerably from open to close and buyers were aggressive. In other words, the bulls are kicking the bears’ butts big time!

Long black (filled) candlesticks show strong selling pressure. The longer the black candlestick, the further the close is below the open. This indicates that prices fell a great deal from the open and sellers were aggressive. In other words, the bears were grabbing the bulls by their horns and body slamming them.

Mysterious Shadows

The upper and lower shadows on candlesticks provide important clues about the trading session.

Upper shadows signify the session high. Lower shadows signify the session low.

Candlesticks with long shadows show that trading action occurred well past the open and close.

Candlesticks with short shadows indicate that most of the trading action was confined near the open and close.

Long shadows

If a candlestick has a long upper shadow and short lower shadow, this means that buyers flexed their muscles and bid prices higher, but for one reason or another, sellers came in and drove prices back down to end the session back near its open price.

If a candlestick has a long lower shadow and short upper shadow, this means that sellers flashed their washboard abs and forced price lower, but for one reason or another, buyers came in and drove prices back up to end the session back near its open price.

Basic Candlestick Patterns

Spinning Tops

Candlesticks with a long upper shadow, long lower shadow and small real bodies are called spinning tops. The color of the real body is not very important.

The pattern indicates the indecision between the buyers and sellers

Spinning Tops

The small real body (whether hollow or filled) shows little movement from open to close, and the shadows indicate that both buyers and sellers were fighting but nobody could gain the upper hand.

Even though the session opened and closed with little change, prices moved significantly higher and lower in the meantime. Neither buyers nor sellers could gain the upper hand, and the result was a standoff.

If a spinning top forms during an uptrend, this usually means there aren’t many buyers left and a possible reversal in direction could occur.

If a spinning top forms during a downtrend, this usually means there aren’t many sellers left and a possible reversal in direction could occur.

Marubozu

Sounds like some kind of voodoo magic huh? "I will cast the evil spell of the Marubozu on you!" Fortunately, that's not what it means. Marubozu means there are no shadows from the bodies. Depending on whether the candlestick’s body is filled or hollow, the high and low are the same as it’s open or close. If you look at the picture below, there are two types of Marubozus.

Marubozu

A White Marubozu contains a long white body with no shadows. The open price equals the low price and the close price equals the high price. This is a very bullish candle as it shows that buyers were in control the whole entire session. It usually becomes the first part of a bullish continuation or a bullish reversal pattern.

A Black Marubozu contains a long black body with no shadows. The open equals the high and the close equals the low. This is a very bearish candle as it shows that sellers controlled the price action the whole entire session. It usually implies bearish continuation or bearish reversal.

Doji

Doji candlesticks have the same open and close price or at least their bodies are extremely short. The doji should have a very small body that appears as a thin line.

Doji suggest indecision or a struggle for turf positioning between buyers and sellers. Prices move above and below the open price during the session, but close at or very near the open price.

Neither buyers nor sellers were able to gain control and the result was essentially a draw.

There are four special types of Doji lines. The length of the upper and lower shadows can vary and the resulting candlestick looks like a cross, inverted cross or plus sign. The word "Doji" refers to both the singular and plural form.

/school/images/doji-examples.gif

When a doji forms on your chart, pay special attention to the preceding candlesticks.

If a doji forms after a series of candlesticks with long hollow bodies (like white marubozus), the doji signals that the buyers are becoming exhausted and weakening. In order for price to continue rising, more buyers are needed but there aren’t anymore! Sellers are licking their chops and are looking to come in and drive the price back down.

Long Doji

Keep in mind that even after a doji forms, this doesn’t mean to automatically short. Confirmation is still needed. Wait for a bearish candlestick to close below the long white candlestick’s open.

If a doji forms after a series of candlesticks with long filled bodies (like black marubozus), the doji signals that sellers are becoming exhausted and weakening. In order for price to continue falling, more sellers are needed but sellers are all tapped out! Buyers are foaming in the mouth for a chance to get in cheap.

Black Doji

While the decline is sputtering due to lack of new sellers, further buying strength is required to confirm any reversal. Look for a white candlestick to close above the long black candlestick’s open.

Reversal Patterns

Prior Trend

For a pattern to qualify as a reversal pattern, there should be a prior trend to reverse. Bullish reversals require a preceding downtrend and bearish reversals require a prior uptrend. The direction of the trend can be determined using trendlines, moving averages, or other aspects of technical analysis.

Hammer and Hanging Man

The hammer and hanging man look exactly alike but have totally different meaning depending on past price action. Both have cute little bodies (black or white), long lower shadows and short or absent upper shadows.

Hammer and Hanging Man


Hanging Man

The hammer is a bullish reversal pattern that forms during a downtrend. It is named because the market is hammering out a bottom.

When price is falling, hammers signal that the bottom is near and price will start rising again. The long lower shadow indicates that sellers pushed prices lower, but buyers were able to overcome this selling pressure and closed near the open.

Word to the wise… just because you see a hammer form in a downtrend doesn’t mean you automatically place a buy order! More bullish confirmation is needed before it’s safe to pull the trigger. A good confirmation example would be to wait for a white candlestick to close above the open of the candlestick on the left side of the hammer.

Recognition Criteria:

  • The long shadow is about two or three times of the real body.
  • Little or no upper shadow.
  • The real body is at the upper end of the trading range.
  • The color of the real body is not important.

The hanging man is a bearish reversal pattern that can also mark a top or strong resistance level. When price is rising, the formation of a hanging man indicates that sellers are beginning to outnumber buyers. The long lower shadow shows that sellers pushed prices lower during the session. Buyers were able to push the price back up some but only near the open. This should set off alarms since this tells us that there are no buyers left to provide the necessary momentum to keep raising the price. .

Recognition Criteria:

  • A long lower shadow which is about two or three times of the real body.
  • Little or no upper shadow.
  • The real body is at the upper end of the trading range.
  • The color of the body is not important, though a black body is more bearish than a white body.

Inverted Hammer and Shooting Star

The inverted hammer and shooting star also look identical. The only difference between them is whether you’re in a downtrend or uptrend. Both candlesticks have petite little bodies (filled or hollow), long upper shadows and small or absent lower shadows.

Inverted Hammer

Shooting Star

The inverted hammer occurs when price has been falling suggests the possibility of a reversal. Its long upper shadow shows that buyers tried to bid the price higher. However, sellers saw what the buyers were doing, said “oh hell no” and attempted to push the price back down. Fortunately, the buyers had eaten enough of their Wheaties for breakfast and still managed to close the session near the open. Since the sellers weren’t able to close the price any lower, this is a good indication that everybody who wants to sell has already sold. And if there’s no more sellers, who is left? Buyers.

The shooting star is a bearish reversal pattern that looks identical to the inverted hammer but occurs when price has been rising. Its shape indicates that the price opened at its low, rallied, but pulled back to the bottom. This means that buyers attempted to push the price up, but sellers came in and overpowered them. A definite bearish sign since there are no more buyers left because they’ve all been murdered.

Summary

Candlesticks are formed using the open, high, low and close.

  • If the close is above the open, then a hollow candlestick (usually displayed as white) is drawn.
  • If the close is below the open, then a filled candlestick (usually displayed as black) is drawn.
  • The hollow or filled section of the candlestick is called the “real body” or body.
  • The thin lines poking above and below the body display the high/low range and are called shadows.
  • The top of the upper shadow is the “high”.
  • The bottom of the lower shadow is the “low”.

Long bodies indicate strong buying or selling. The longer the body is, the more intense the buying or selling pressure.

Short bodies imply very little buying or selling activity. In street forex lingo, bulls mean buyers and bears mean sellers.

Upper shadows signify the session high.

Lower shadows signify the session low.

Candlesticks with a long upper shadow, long lower shadow and small real bodies are called spinning tops. The pattern indicates the indecision between the buyers and sellers

Marubozu means there are no shadows from the bodies. Depending on whether the candlestick’s body is filled or hollow, the high and low are the same as it’s open or close.

Doji candlesticks have the same open and close price or at least their bodies are extremely short.

The hammer is a bullish reversal pattern that forms during a downtrend. It is named because the market is hammering out a bottom.

The hanging man is a bearish reversal pattern that can also mark a top or strong resistance level.

The inverted hammer occurs when price has been falling suggests the possibility of a reversal.

The shooting star is a bearish reversal pattern that looks identical to the inverted hammer but occurs when price has been rising.


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