Technical Analysis - Introduction to Candlesticks

Japanese candlesticks give us a better understanding of value, or more precisely, the interpretation of value given to any instrument by investors and traders than any other type of chart. They also help us have a better understanding of the psychology of traders and investors driven by fear, greed and hope, since all these characteristics are represented in price movements.

Before going through candlesticks patterns and how to trade based on them, we should first understand what different candlesticks represent by themselves.

Long candlesticks 

Long candlesticks describe strong buying/selling pressure. Price had a sharp advance/decline from the open price (traders were aggressive).

When we talk about “long” candlesticks, we are referring to the body of the candlestick.

But, long compared to what?

We know it is long when we compare the action of any candlestick with the length of previous candlesticks. A “long” candlestick must be clearly identified in order to be a valid pattern, should there be any doubt, it is probable that the candlestick is not long “enough”.

Short candlesticks 

Short candlesticks could represent two things: not much volume or periods of indecision (demand meets supply.)

Short candlesticks are also compared to previous action to assess the validity of the candlestick.

Marubozu 

Marubozu candlesticks are strong candles. They have no shadows, this means that the open price equals the low/high of the period and the closing price equals the high/low of the period.

The interpretation of this kind of candlesticks varies depending on where it was formed. If a bullish marubozu appears in a downtrend, it could signal a short-term reversal (bulls took control of the situation from the first minute to the last.) If a bullish marubozu appears at the top the range, it could signal a final push up, it all depends on preceding candlesticks. The same is true for a bearish marubozu.

If the marubozu breaks through an important support or resistance level, the market is likely to continue on the way of the “break through”.

Doji candlesticks 

Doji candlesticks represent periods of indecision, or fierce battle between bulls and bears.

Doji candlesticks are formed when the open price and the close price are virtually the same (or very close). Ideally, the open and close prices should be equal, but remember, the important thing to capture here is the essence of the candlestick.

For instance, when the close and open price is similar, it shows us that as the price went up, sellers took control of the situation, and when prices went down, the buyers the control of prices.

Doji candlesticks alone are considered neutral, but should be a warning. If for instance, in a downtrend a doji candlestick is preceded by a long bull candlestick, then it could mean a possible reversal.

Spinning tops/bottoms

Spinning tops and bottoms have small bodies and long shadows usually larger than its body.

Spinning tops/bottoms, as dojis, represent periods of indecision and intensive action between bulls and bears, with no clear domination.

Spinning tops/bottoms are considered neutral until a long bull/bear candlestick appears after them.

Long-legged doji

Long upper and lower shadows, open and close prices are virtually the same.

These candlesticks also represent intensive action between bulls and bears, and no one was being able to take control over prices.

Dragonfly and Gravestone doji´s are Long-legged doji´s.

Dragonfly doji

Long lower shadow with open and closing prices near the top of the range. Bears took control first, but then bulls were attracted by cheaper prices then taking control of prices.

This candlestick is more bullish than bearish since the bears were not able to drive prices lower because bulls took control over prices, pushing them up.

Gravestone doji

Long upper shadow with open and closing prices near the bottom of the range. Bulls took control of prices at the beginning, but then bears resurfaced gaining control taking the price near the low (and open) of the range.

This candlestick is slightly more bearish than bullish since bulls tried to take control over prices driving them higher first, but then the bears took control over them driving them back down.

Technical Analysis Trends and Range bound Conditions

Trend

One of the basic principles of technical analysis, as we have already discussed, is that the price (or market) trends. But what exactly does that mean? Or more importantly, when is the market trending?

It is said that the market is trending when price action reaches –

UPTRENDING - successive higher highs and higher lows on its way up

DOWNTRENDING - lower lows and lower highs on its way down.

Here is a chart trending up

And here is a chart trending down

Chart 1 and 2 are clear examples of trending markets.

Another important question traders should answer is, when is the market not considered to be trending?

That leads us to the next concept...

Range Bound and Ranging Markets

The market is not trending when it is not following a clear direction (up or down). This is condition is also called as sideways or trendless markets.

Now, the market could be ranging in two different ways: when there are well defined extreme levels (support and resistance zones are well established) or when the market has no defined extreme levels.

Here is a sideway market with no well defined extremes.

As you can see, the market is not following any direction. It keeps ranging back and forth, making higher highs but also lower lows with no consistent pattern. When the market is ranging like this it is very difficult to trade.

Here is a ranging market with well defined extremes:

When the market is ranging this way, trading it is relatively easier, traders tend to buy around the support zone and sell around the resistance zone.

Trendlines

Trendlines are very important tools for trend identification, confirmation and to measure the intensity of the trend.

Trendlines are lines connecting two or more important points when price has bottomed or topped and then it is extended to the future where it is expected to act again as a support or resistance zone. So we can say trendlines are support and resistance lines with either and upward (uptrends) or downward (downtrends) slope.

Let’s take a look at some charts.

Uptrend trendline: two or more higher lows connected (upward slope), identifying an uptrend.

There are four points (higher lows) connecting this up-trendline. As long as the market keeps trading above the trendline the uptrend is intact. If a sustained break below the trendline happened, a reversal, a correction or a consolidation period (range) is plausible. 

Downtrend trendline:

                      two or more lower highs connected (downward slope).

Here we have a downtrend trendline; it suggests that the demand for the given instrument is decreasing even when the prices are falling. Four points (lower highs) connect the trendline indicating a downtrend. As long as the price stays below the trendline, the trend stays intact. But as we see, the trendline is violated indicating that the market will reverse, consolidate or have a correction.

Two more points:

- The intensity of the trend is measured by the slope of the trendline. The steeper the trendline the stronger the trend is and the more likely prices are to react at extreme levels.

- The significance of trendlines depends on how many times price has bounced off from it: the more times the price has bounced from the trendline, the more significance the trendline has and the more likely it is to hold the price from breaking it.

At the beginning of this section we mentioned trendlines are like support and resistance zones, and it’s true because the same rules apply for both of them:

- A sustained break above/below the trendline need to happen before the trendline gets violated.

- When the market approaches to the trendline, we should think the market will get rejected from it.

- Once a trendline gets violated, it could become a resistance if it was a support and vice versa.

- Some times it can be difficult to find a trendline even when the markets are trending

- Trendlines should be part of the analysis and not the tool to make the final decision to get in or out the market. It will produce better results when used in combination with other technical tools.

Forex Trading, Technical Analysis - Support and Resistance

Establishing well-defined support and resistance zones is a key element that will help us have better trading results. Here are a few questions and answers that will help you gain a better understanding of the use of support and resistance zones.

Is there an exact level where support and resistance levels should be placed? 

No, as we have already seen, support and resistance are more like “zones” rather than “levels”. It is common however to place resistance zones just above price action and support zones just below price action, but some traders put them at or near price action. At times, it is difficult to find the exact level of support or resistance; in these cases it is valid to place support and resistance zones near price action (like we did in charts 1 and 2). 

What different methods exist to define support and resistance zones?

Based on Previous highs or lows –

                                                  When ever the market approaches to previous highs or lows it has the potential to act as a resistance or support (you will see this in the next lesson on chart patterns). 

Round Numbers –

                                    Many experts and bank traders put their orders at round numbers (entry orders or take profit orders) because there are so many orders around these levels that the market sometimes has some trouble getting through them. These levels tend to have a psychological support and resistance zones. Round numbers are 1.4500 or 1.0000, etc. 

Based on Moving Averages –

                                                A moving average is a technical indicator that could be useful to determine support and resistance areas (we will see MA in more detail in the following lessons). 

Based on other technical indicators –

                                               Other technical indicators can also be used to determine possible support or resistance areas, en example would be Fibonacci Retracements.

From the methods above, which one is more effective?

There is no correct answer for that question. Sometimes one methodology forecast support and resistance levels better than the other ones. What I recommend you is to see what is the market’s feel each day of trading, and see what is working for that particular day (i.e. there is no case to use round numbers as support or resistance if the market is not taking them in consideration).

What are false breaks?

Take a look at the chart below:

This chart is the same one as Chart 2, take a close look at what happen in the red oval, the market actually traded above the support zone but it bounced back. This is what we call a false break: the market fails to trade consistently above/below a resistance or support zone.

Whenever the market approaches to a support or resistance zone, what should I do?

That depends in your situation. Here are a few scenarios:

- If you have no open positions and intend to go long, if the market approaches to a support zone, try to find a long signal.

- If you have no open positions and intend to go short, if the market approaches to a resistance zone, try to find a short signal.

- If you have a long position and the market approaches a resistance level, try to find an exit signal.

- If you have a short position and the market approaches to a support level, try to find an exit signal.

Technical Analysis - Support and Resistance

These two are probably the most important concepts in technical analysis. Basically, support and resistance are points or levels where forces of supply and demand meet.

As the prices go down, the demand for one given instrument tends to increase, because it attracts buyers interested in cheaper prices. At some point, the demand for the given instrument will outperform the supply for it, making the price bounce back up from certain zone (support). This makes the price go up again, but there is again a certain zone in which the price is so high that it attracts more sellers interested in selling high. At this point, the supply for that instrument will outperform the demand for it, making prices to bounce back down again (resistance).

Every one of us (at least must of us) have seen a demand curve back in our school and college days, so it will probably be a good idea to illustrate these two concepts with the famous curve.

Take a look at the following image.

Imagine that curve is the demand for EURUSD, as the price goes down it will attract:

- Buyers interested in low prices (buying low to sell high), and

- Traders already short looking to take profits on their short positions.

Those two forces will make the market to go back up again because the demand for it will increase, that zone is what we call “support”.

As the prices go up again, it will attract:

- More sellers interested in high prices (to sell high and buy back at low prices), and

- Traders already long looking to take profits on their long positions.

Those two forces will make the price go down again, that zone is what we call “resistance”.

And what happens when the market breaks one support or resistance? Ahh Sharp eye... we will get to that. But for now, here is a brain feeder for you.

How do you think the market behaves when the supply for one currency meets the demand for it over a considerable period of time?

Remember, support and resistance are more like “zones” rather than “levels”. So even if we refer to “support and resistance levels”, from now on they are really zones.

Now let’s get to some real life examples.

Support Zone

A support is a price level or zone in which the demand for one given instrument outperforms its supply, preventing prices from falling below this zone. It “supports” the price from falling below it. 

In this chart, the support zone is marked by the black line. There were several points where the market was stopped from falling below. At this level, the buyers (bulls) outperformed the sellers (bears) and the buying becomes so strong that it prevents the price from falling further.

Resistance Zone

A resistance is a price zone in which the supply for a given instrument is greater than the demand for it. This prevents prices from going above this level. The price “resists” going higher. 

In the chart above, the level at which the bears outperformed the bulls is clearly seen and it’s market with a black line. At this level, the selling (product of traders attracted by the high prices and traders closing long positions thus selling back their trade) is so strong that it prevents the price from reaching higher levels. At this zone bears outperform bulls.

NOTE: Support and resistance levels are only considered to be broken when there is a sustained break, otherwise the level is considered intact, so when prices break through any important level and bounces back quickly (like the third peak on chart 2), the important level is still considered valid.

This takes us to our next concept...

Sustained Breaks

A sustained break happens when the prices are traded above the resistance or below the support zone for several periods. Should this happen, the old resistance now becomes an important support (in the case of a break “up”) or the old support becomes an important resistance (in a break “down”).

Below are two examples that picture these scenarios

Support zone becomes a resistance.

The support zone is clearly seen at the left hand side of the chart, the price is rejected from that zone at least two times. Once the market breaks the support zone and continues to trade below the support zone it is considered a sustained break. The market goes down and retraces again to the support zone which is now a resistance zone. The price action gets rejected once, and on the last part of the chart, the market approached again to the resistance zone and it should be rejected again as it is now a resistance zone.

In the next chart, a resistance zone becomes a support.

 

Here the sustained break happened when the market traded continuously above the resistance zone, as we can see the resistance zone became a support zone preventing the market from falling below it. This creates a possible buying opportunity.

When the price of a certain market breaks the support or resistance level, the balance between supply and demand has changed. When the price breaks an important support level, what investors thought to be a low price, now becomes a high price. When the price breaks an important resistance level, what was thought to be a high price, becomes a low price.

In terms of the demand curve this is what happens when there is a break of a resistance zone:

There is a shift to the right in the demand curve when there is a break of an important level. “The balance between demand and supply changes”, what was once considered “high”, is now considered “low”.

We just saw what would happen to the demand curve once the market breaks a resistance zone, but what would happen if the market breaks a support zone?

Technical Analysis - Types of Forex Charts

Charts are prices, plotted over one specific timeframe. Vertical axes represent the price of one given instrument, while the horizontal axis represents the time horizon.

The most common types of charts used by technical analysts are:

• Line chart
• Bar chart
• Candlestick chart

Line Chart

The line chart consists of dots connected by a line. These dots usually record the closing prices of currencies on one determined timeframe. 

The line charts are commonly used by traders whose main focus is to study only closing prices.

Bar Chart

The bar chart gives us more information regarding price at any given moment. It records the high, low, open and close price of one security during any given period.

The high and the low are represented by the top (high) and the bottom (low) of the vertical line. The open price is represented by the short horizontal line on the left, while the close price is represented by the short horizontal line on the right

On the chart above, every bar represents 30 minutes of price action. The top and bottom of each bar represent the highest and the lowest price of every period (30 minutes). The horizontal lines represent the open and the close of each 30 minutes bar

Candlestick Charts

Candlestick charts are very similar to the bar charts, they also record the open, close, high and low price of every period. The only difference is that candlesticks have a body on each bar.

Every “white” (or hollow) candlestick indicates that the price closed higher than where it opened. Thus the open price is the bottom of the body (not the whole candlestick), and the close price is the top of the body. In contrast, every black candlestick indicates that the price closed lower than where it opened. Thus the open price is the top of the body and the close price is at the bottom of the body.

The wicks above and below the body of the candlestick are called “shadows” or “wicks”, they represent the highest (upper wick) and the lowest (lower wick) price printed for each period. 

Candlestick charting has become very popular for traders. The main reason for this is because it is easier to read and study the relationship of prices (and investor’s psychology) on this type of charting.

Later in our courses we will see more about candlesticks, we will learn what each one of them represent as well as other patterns that could help us make a better trading decision. We will get to that!

Technical Analysis

As we have already stated in the previous lesson, technical analysis tries to determine the future performance of any financial instrument based in the study of historic prices (price behavior).

By studying the price behavior and technical analysis we are actually analyzing the behavior of all traders involved in a certain market. Traders and investors are behind every price movement; after all, they all drove the price to a certain level. The price moves based on traders’ expectations; on what they think the future price of any given instrument should be.

Most of the time traders are driven by their emotions (fear, greed, hope, etc.) and these emotions are visible on the charts as repetitive price patterns. The outcome of these specific patterns is what technical analysis tries to forecast.

Technical analysis is based on the Dow Theory which has three main principles:

Price Discounts Everything - All information available is already reflected in price, it reflects the knowledge of everyone involved, including fundamentalists.

Price Behavior is not Random - Although there are periods of trendless or random behavior, the price tends to trend. Our job as technicians is to identify those periods where the price is trending and profit from them.

The “What” (or “Where”) Question is more Important than “Why” - The “What question” refers to where is price and what is its historical behavior. Those questions are to be answered by technical analysts. Why is price at certain level? This one is of concern of fundamental analysts; they look for reasons behind certain price movements.

And here we go with Technical Analysis...

This will be  in the following way:

   

1-Types of Charts - We will review the most common types of charts used by technical analysts.

2-Support and Resistance - We will review one of the most important concepts of trading; we will see what makes support and resistance and how to identify them.

3-Support and Resistance FAQ’s – Here you will find common questions about support and resistance zones. 

4-Trends and Range Bound Conditions - How to identify a trend and a range market. We will also see how to measure its intensity through trendlines.

5-Candlesticks Intro - We will review the most popular type of charting used by technical analysts.

Some Thought on News and Event Trading

News and event trading has become a very popular trading style in these days. The reason behind it lies in the huge profit potential made in just a few minutes - with no effort at all.

Take for instance the first Friday of the month, when the non-farm payrolls report is released. The price of the EUR/USD can move around 150 pips in less than 10 minutes. That is US$1,500 (trade based in only one standard lot).

What traders fail to realize are all the risks involved in such practices. What if those 150 pips go against you? Even with a stop loss order, sometimes your broker won’t be able to honor it, because the price gaps (values between prices are not printed). In these cases, your broker won’t take the loss, so he will give you the closest printed price, meaning 70, 100, or 150 pips against you. That amount of pips could mean a margin call or a huge loss. In how much time again? …10 minutes.

The important thing here is that your job as a trader is to make sure you are going to be able to trade the next day, week, and years to come. Taking these kinds of risks won’t help much.

Other traders instead of using market orders to get in the market use stop and limit orders. But the same happens there, it is too risky, the market could again gap and your broker won’t be able to honor your stop. Traders that use this kind of strategy are taking uncalculated risks, risks that could cost them their trading account, and probably their trading careers.

Also, price movements are not always steady in one direction. It could go up and trigger some orders just to go back to the other extreme, then trigger the other side orders and then come back to where it all started.

The truth is, there is no possible way to forecast price movements in such circumstances. As we already know, the price moves based on traders and investors expectations. This is the combination of all traders perceptions on where price should be. To possibly know where the price is heading we need to ask every single trader and investor around the world what their intentions are during such announcements (something impossible to do). To go a little further, sometimes as the news report comes out, nothing happens, or worse, the price goes against the fundamentals.

Take for instance a day of interest rate announcement. It is rumored that there will be an interest rate cut. In this case, the currency will go short before the actual decision. Once the interest cut is announced, it is possible that the currency will be bought back, as all traders that could have shorted the currency, had already been short days or weeks ago. So there is no one else to short the currency. In this case, the price could be pushed up, against the fundamentals.

The point I want to make here is, trading itself is risky, and there are risks that you just cannot avoid, like the possibility to lose one trade. There are however some other risks that traders must avoid, as in event trading. The more you control your risks, the better results you will have. Take care of your risks; your profits will take care of themselves.

We consider trading the news announcements to be very risky.

Is there a system based solely on fundamental trading?

I am sure there is. But as with every system, it should have rules and setups that have to be present in order to get in the market, as well as money management controls etc.

Common Practices Used by Fundamentalists

Figure Deviation

A common practice used by short term fundamental traders (or more accurately news and event traders) is trading based on the deviation of an economic indicator actual figure vs. the expected figure.

When economic figures are to be announced, usually 3 numbers are shown:

Previous, expected (also called consensus or forecast) and actual figures.

Previous Figure:

                        The actual figure of the previous period (usually the previous month).

Expected Figure: 

                       What experts think the figure should come out as. Usually and average is made between say forecasts of 20 experts on the field.

Actual Figure: 

                     The actual number of the figure.

What news and event traders focus on is on the last two figures: the expected and the actual figure. The more the deviation the actual figure has from the expected value the more the impact it should have in the exchange rate.

Carry Trades

Most fundamentalists trade the currency market for the long term. This is because most of the time changes in supply and demand take longer to be reflected in the charts.

Carry Trades or Rolling over is a common practice that consists of taking advantage of the interest rate differentials between two currency pairs. Most of these trades have a long-term span. Aside from taking advantage in the currency pair movements, they also benefit from buying a high yield currency and simultaneously selling a low yield currency or selling a low yield currency and simultaneously buying a high yield currency. This way, traders are paid an interest or roll over.

Equity Market Correlation

When a given equity market offers greater returns than other equity markets, it is common that fundamentalists buy the currency of the equity market that offers greater returns.

This is because investors around the world will see benefits by investing in that country. As the sentiment gets better, that currency will increase its demand, pushing its price up.

Gold and Oil and it's relationship with the Forex market

Gold and Oil have an important relationship with the Forex market. Often these two commodities are used as a leading indicator in making trading decisions in the Forex market.

Gold

Ok, before going through some analysis let’s take a look at the following table:

Gold Production by Country

[Table 2]

Why would gold have a negative or inverse relationship with the USD if United States is the second larger producer of Gold (out-placed Australia in 2006)?

The answer is simple (or maybe not)...

The obvious reason behind this inverse relationship is that gold is always priced against the USD: naturally a strong dollar will buy more ounces of gold (and a weak dollar will buy less ounces of gold).

But there is also another less evident reason of this inverse relationship: decades ago, during periods of uncertainty investors tend to migrate away their capital from USD to gold as a safe-haven.

Ok, to check some numbers: The USD has fallen to historic lows against some currencies including: EUR, CHF and CAD while gold (XAUUSD) has reached all time highs.

Majors that have a positive or direct relationship with gold are the Canadian dollar and the Australian dollar.

AUD - Australia is the third largest producer of gold in the world and as a result, the correlation coefficient of the AUD and Gold prices is close to 80%. So the AUD always benefits from rising gold prices and it also decreases when gold prices decline.

CAD - Canada is the third world largest exporter of the commodity. This makes the CAD and Gold move in the same direction, although its correlation coefficient isn’t as large as the AUD and Gold.

What would be the case for the EUR or other major currencies where there is no relationship (at least not a clear one)?

Other majors will have a direct relationship with gold because both of them (majors and gold) are priced in USD.

Oil Prices

Generally speaking an increase in the price of oil results in increasing costs of transportation, utility and heating costs as well as the cost of practically every finished product (particularly in oil-dependent economies such as the US, China India and other developed countries).

Arguments in favor of an indirect relationship between oil and the USD:

• US accounts for only 5% of the world’s population but it consumes 25% of the world's fossil fuel-based energy.
• US imports about 75% of its oil, but owns only 2 percent of world reserves.

Because of this dependency on both oil and foreign suppliers, any increases in price or supply disruptions will negatively influence the US economy (hence the USD) to a greater degree than any other nation.

Canada is one of the few developed countries who are net exporters of energy (i.e. oil). Canada has the second largest oil reserves in the world (only behind Saudi Arabia). For this reason the Canadian dollar has a very tight positive relationship with oil prices.

Where is oil heading?

Oil experts adopted Hubbert’s Curve to forecast oil production for the following decades:

[Image 1]

According to their prediction, world oil production was to peak sometime around the second half between 2000 and 2010 (like now?). Right now the oil barrel is pretty close to US$100, but what could happen to if this prediction is true? It will probably keep going that way for a few more hundreds...

Brain Feeder 4 – Recently a few presidents from large oil producer countries have announced their concerns about the weak US dollar and have declared they would be willing to change the oil pricing in Euros instead of US dollars. What to you think could happen to the USD if they price their oil barrels in Euros instead of US dollars?