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Monday, February 24, 2014

Technical Analysis, Technical Indicators, Fibonacci Retracements

Developed by Leonardo Fibonacci in the 12th century and then popularized by Ralph Elliot. The main purpose of this technique is to forecast possible reaction levels (support or resistance) as the price pulls back down or up.

The Fibonacci numbers are: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 611...
The interesting thing about these numbers is that the sum of each consecutive number results in the next Fibonacci number (i.e. 13+21=34, 2+3=5). In addition, the ratio of any number and the next higher number (after the first five numbers of the series) approximates to 0.618.
The inverse number of 0.618 is 1.618, which is commonly referred as the golden mean. The golden mean is related to almost every natural phenomena (in the family tree of cows, rabbits and bees, the number of branches in a tree, petals on flowers). The series is even present in the proportions of the Egyptian pyramids.
It is not relevant studying why these Fibonacci numbers are present in nature, what is important to answer is how could this information help me? Take for instance, you buy a pair of rabbits, wouldn’t it be good to know that at the end of the sixth month you will need to clear some space for 13 pairs of rabbits?

Fibonacci Retracement Usage
Back to trading, the most common usage of the Fibonacci numbers is to forecast reaction levels after a major advance or decline in price. The most important levels are 61.8%, 50% and 38% of the initial decline or advance. These levels are used based in a major move of 100% trough to peak or peak to trough.
In a major advance if a pullback is to happen, it is likely that it will find support first at the 38% retracement level, then the 50% level and lastly at the 61.8% level. When the market bounces off from these levels, the market is more likely to continue its uptrend. If it breaks these levels, on the other hand, a probable reversal might be in place. The opposite is true for a decline.

Fibonacci levels as support
Fibonnacci Retracements
[Chart 28]
We measure the total movement (from 1 to 100%) where we want to calculate possible retracements. In the chart above the market retraced all the way to the last retracement level 62.8%. It played an important support role preventing the market from falling below such level.

Fibonacci levels as resistance.
Fibonacci Retracemenets
[Chart 29]
The market reacts at the 61.8 retracement. Traders will look for short opportunities around that retracement level. If on the other hand the market gets past the 61.8% retracement, the market is likely to reverse.
As with other technical factors, this indicator gives better results when used in combination with other technical tools.
Remember, some indicators work better under trending market conditions and some other during sideways conditions. For this reason, we need to choose different indicators for different market conditions. For instance, we could us an oscillator to forecast tops and bottoms during a sideways market, but once the range is broken and a trend is present, we could use the CCI and take the signals when the readings reach extreme levels in direction of the trend.

It is important to understand the market changes, and it is impossible to use one indicator for every market condition.
Relying on one sole indicator is risky. We should adopt different indicators for different market conditions, preferably different concepts.
For instance using oscillators in combination with candlestick patterns to get the trading signals. The other extreme, using many indicators, is not good either. You could end up with a complicated system that is really hard to follow.
For now, study each indicator , see which one fits you better or what combination is better for you.

Tuesday, February 18, 2014

Technical Analysis, Technical Indicators, Average Directional Index (ADX)

The ADX was developed by Welles Wilder. He created it as an attempt to determine the strength of the current trend (be it up or down).
The ADX reading derives from two other indicators created also by Welles Wilder called Positive Directional Indicator (+DI) and the Negative Directional Indicator (-DI).
The +DI measures the force of the up moves while the –DI measures the force of the down moves.
The ADX does not recognize between an uptrend and a downtrend, it only assess the strength of the current trend. +DI and -DI can be used to determine whether the trend is up or down.

ADX Usage
Usage No. 1 – Strength of the Trend. The ADX is an oscillator that fluctuates between 1 and 100. When the readings are above 30, the market is considered to be in a strong trend, when the readings are below 20 the market is considered to be sideways, while readings between 20 are 30 are undefined.
ADX to measure the strength of the Trend

[Chart 26]
ADX – Black Line
+DI – Blue Dotted line
-DI – Red Dotted Line
It is said that when the blue line (+DI) is above the red line (-DI) the market is in an uptrend, and when the red line (-DI) is above the blue line (+DI) the market is in an uptrend.
In the chart above, strong trends are marked when the ADX reading go above 30.

Usage No 2 – Determine potential changes in the market trend. To use this indicator to determine changes in the market trend we need to identify divergences. When the divergence is present near the top indicates the trend is weakening, when it is present near the bottom it indicates the trend is strengthening.
Weakening trend

Weakening Trend

[Chart 27]
In the chart above, the divergence is present near the top indicating a weakening trend.

Sunday, February 16, 2014

Technical Analysis, technical indicators,Bollinger Bands (BB)

Indicator was developed by John Bollinger. This indicator consists of three different components:
- A simple moving average in the middle
- An upper band, which is calculated by adding 2 standard deviations to the middle MA
- A lower band, which is calculated by subtracting 2 standard deviations to the middle MA.
The principal objective of this indicator is to measure the volatility at any given moment relative to historical volatility of any given currency pair.

Bollinger Bands Usage

Usage No 1
Volatility. When the upper and lower bands expand it indicates more volatility relative to previous periods. When the bands get narrower it indicates the volatility at the moment is lower than the volatility of previous periods.
Bollinger Bands to measure volatility
[Chart 24]

Usage No 2
- Bands as support and resistance. Sometimes the extreme bands can act as important support and resistance levels.
Thus, we can take trades as the price bounces off the bands, as prices break out the bands, etc. This type of trading is recommended on pullbacks or retracements and during trendless conditions (to scalp). Of course, with the help of other technical indicators the signals will increase their accuracy.
Bollinger Bands as Support and Resistance
[Chart 25]
The signals that are taken in direction of the trend offer much better accuracy than those taken against the trend.
The psychology behind this signal is that most of the time the market will be inside both bands. When the market reaches either band, it will tend to retrace or switch directions to the other side as “it has reached its normal deviation”.

Wednesday, February 12, 2014

Technical Analysis, technical indicators,Momentum (MOM)

This indicator compares the price of any given instrument to the price over a selected number of preceding periods.
This represents the rate of change over the chosen periods. In other words, it lets you see where is the price located relative to the historical data selected.

Momentum Usage
Usage No 1 - Trend indication. When the momentum reading is above 100 and rising, it indicates a strong move up. When the reading is below the 100 level and falling further, it indicates a strong downtrend.
Momentum as a Trend Identification Tool
[Chart 21]
It’s important to remember that we need to choose larger periods to use this indicator as a trend indication.

Usage No 2 - Overbought/oversold conditions. When the indicator reaches extreme levels and bounces back from these levels - the signals are given.
Momentum as an oscillator
[Chart 22]
The problem with using momentum to forecast overbought and overbought conditions is that there are no pre-defined values for the indicator to be overbought or oversold. They are relative to previous indicator action.

Usage No 3 - Divergence trading. This indicator is also used to find points of divergence between the indicator and the price action.
Momentum to trade Divergence
[Chart 23]
Here is once more the same chart used with STC and RSI, the divergence is also present with momentum. From the three indicators used, in the MOM and RSI the divergence is clearer.

Friday, February 7, 2014

Technical Analysis, technical indicators,Stochastics (STC)

Developed by George Lane in the 50´s. Stochastics compare the last closing price relative to its trading range over the chosen periods. The values of the stochastic oscillator range between 0 and 1, or more precisely between 0% and 100%.
When the reading of the oscillator is near zero, it indicates that the last period closing price closed near the bottom of the n-period range. A reading close to 1 indicates that the last period closing price closed near the top of the n-period range.
A 9 period stochastic will measure the last close relative to the last 9 periods low and high range.
There are three types of stochastics: fast, slow and full stochastics. The slow stochastic is simply a smoother (less whipsaws but less sensitive to price fluctuations) version of the fast stochastic. The full stochastic adds an additional parameter which makes it even smother than the slow stochastic.

Stochastic Usage
Usage No 1 - Overbought/oversold conditions. Stochastics are probably the most used indicator for these purposes. A buy signal is given when the readings are below 20% and rises above this level (buy signal – oversold condition). A sell signal occurs when the reading is above 80% and falls back down below that level (sell signal - overbought condition). When the market is trending, it is advised to take only those signals that are in direction of the trend.

Stochastics as an Oscillator
[Chart 19]
As we already mentioned, stochastics are probably the indicator that gives overbought and oversold signals more accurately. The signal is triggered when the indicator returns to the neutral territory from an oversold or overbought condition.

Usage No 2 - Divergence trading. As other indicators, stochastics also give divergence signals.
Stochastics to trade Divergence
[Chart 20]
This is the same chart we used for the RSI divergence. As you can see the RSI works better and signals a clearer divergence. Either way, the divergence is present.

Thursday, February 6, 2014

Technical Analysis, technical indicators, Relative Strength Index (RSI)

RSI is an extremely popular oscillator developed by Welles Wilder in 1978. It measures the strength in which the market trends up or down (the ratio of up and down candlesticks for a chosen period of time). The values of the RSI oscillate between 0 and 100. A value close to 100 indicates the market has been trending up sharply, while values close to zero indicate the market has been trending down.
As the RSI approaches to extreme levels, the indicator becomes less sensitive to price fluctuations, making the indicator to go back to neutral levels.

RSI Usage

Usage No 1
- Overbought/oversold conditions. Values above 80 are considered overbought and values below 20 are considered oversold. As the market reaches higher levels, there is a possibility that every bull interested in the instrument has already taken a position (this took the RSI above the 80 level). At this point weak longs start taking profits and closing out positions. This gives the market a chance to retrace, letting the RSI get back to neutral levels, breaking back down the 80 level as the price sells off. The same is true for a downside move, as the RSI reaches the oversold territory (below zero), bears start to take profits, giving the RSI the strength needed to get back to neutral levels, making the price rally.
RSI as an oscillator
[Chart 16]
Remember overbought and oversold signals are triggered then the indicators returns to neutral territory from an overbought or oversold condition. These types of signals tend to work better when the market is ranging.

Usage No 2 Divergence. Like other indicators, the RSI is also used for divergence trades but probably the RTI is the best indicator to measure and trade off divergences. When prices reach new levels and the indicator fails to make comparable highs/lows, divergence is present.
RSI to trade Divergence
[Chart 17]
In this chart we clearly see how the market reaches lower lows while the indicator is unable to replicate those lower lows (it makes higher highs). This indicates that the market isn’t as strong as it was at the beginning. As other trading signals, when the divergence is present it could signal a trend reversal, retracement or a consolidation period.

Usage No 3 - Trend indicator. When the values of the RSI are above 50 it indicates that the average gains are greater than the average loses (uptrend). Readings below 50 indicate that the average loses are greater than the average gains (downtrend).
RSI as a Trend Indicator
[Chart 18]
The basic rule would be: when the RSI is above 50 the market is to be considered in an uptrend, when the RSI is below 50 the market is considered to be in a downtrend.
It is important to mention that when using the RSI in this way, it is advisable to choose longer periods [i.e. RSI(40) or RSI(80)] .

Tuesday, February 4, 2014

Technical Analysis, Technical Indicator, Commodity Channel Index (CCI)

The CCI measures the difference between the last typical price [(high + low + close)/3] and the average of the means over a chosen period of time. The result is then compared to the average difference over a chosen period of time and multiplied by a factor.
Remember it is not important to understand the formula, what is important to understand is the CCI behavior over different scenarios and how we could use it in order to get better results.
About 80% of the time the CCI stays between the +100 and - 100 values (varies depending on the number of periods chosen). A move above or below this levels indicates a strong move.

Usage of CCI

Usage No 1 - As almost all oscillators, it indicates overbought/oversold conditions. When the CCI reaches levels above +100 (overbought) or below -100 (oversold) and crosses back to the neutral zone (between +100 and - 100) a signal is given.
CCI as an Oscilator Indicator
[Chart 11]
In this case we used a CCI of 50 periods: CCI(50). We need to remember that overbought and oversold conditions should only be applied in direction of the trend (when the market is trending.) For instance, we could use an EMA to determine the trend, if the market is in an uptrend, then we only take the oversold signals and vice versa. Also, remember the overbought and oversold signals are triggered when the market goes back to the neutral territory (between -100 and +100 in the CCI).

Usage No 2
- Extreme levels. This signal was the main purpose of Lambert’s CCI, as explained before, the CCI stays in neutral territory (+/-100) 80% of the time so eventual breaks of these levels could indicate a strong move in the same direction. A move above +100 is a buy signal and a move below -100 is a short signal.
CCI as a Momentum Indicator
[Chart 12]
We got around three signals in this chart. Two of them are long and one to go short. How could we have avoided the last signal?

Usage No 3
- Divergence. When the price reaches new highs and the CCI fails to do the same , the CCI gives a short signal, the same is also true when the indicator reaches new highs and the price fails to do so. It is also utilized for bear markets.
Divergences indicate that although the trend is still intact, it is not as strong as it was before. A possible short-term reversal might be ahead.
CCI to trade Divergence
[Chart 13]
In the chart above the CCI fails to make a peak similar to that created by the market indicating a possible retracement, reversal or consolidation period.
Usage No 4 - Trendline breaks. Like basic trendline breakouts, the CCI also generates peaks and bottoms. When two or more successive peaks or bottoms are formed by the indicator they could be connected to form a trendline. If the indicator reading breaks such trendline, it signals a trade in direction of the break out.
CCI Trandline Breaks
[Chart 14]
At the chart above the CCI trendline break is clearly seen. These types of signals sometimes are irrelevant as what we really care about are “market levels” not “indicator levels”.

Combination of CCI Signals
Probably the best combination for these signals could be the following:
Combination of CCI Signals
[Chart 15]
When trading the extreme levels of CCI it is also advised to trade only those signals that are in the direction of the prevailing trend. Every yellow triangle indicates a valid long or short signal, red triangles indicate false signals (and are to be ignored). The rule is, take only signals in direction of the trend measured by the position of the market in relation to the EMA. 
In the first triangle the CCI reached extreme levels but the market was just below the MA invalidating the signal. This one would have been profitable but we need to be sure the market is ready to reverse, so we need to see more movement in the suggested direction. The second red triangle was a short signal when the market is clearly up trending. All other signals are valid.