Determining The End Of The Trend

Transcription

1 Access to foreign exchange trading has opened up exciting trading options for the retail trader. You can now trade alongside corporations and institutions in a highly liquid market that is global, traded around the clock, and highly leveraged. Before jumping into this market, however, we must understand the factors that affect the forex market. With that in mind, STOCKS & COMMODITIES has introduced Forex Focus to better prepare the retail trader to participate in the currency market. Determining The End Of The Trend One of the keys to doing well in the forex market is to apply reversal pattern and indicator tools to know when the trend is over and when the next one is starting. Here s how. W ould you like to be able to target the end of a sequence so you don t end up holding the bag? Or would you rather continue to do what most novice traders pretend not to do, which is to buy highs and sell lows? In the 90s, Ralph Nelson Elliott discovered that stock markets traded in repetitive cycles that were actually a reflection of the emotions of investors. By understanding Elliott s contributions depicting the psychological structure of market behavior and combining it with other patterns and indicators, we will be able to plan for the future and develop a framework for establishing positions before the market turns. In this article, we assume we have the following basic knowledge of Elliott wave theory, which is that markets move in impulsive five-wave sequences in the direction of trend and correct in one or more three-wave patterns in the opposite direction before resuming the trend. THE END OF THE TREND CHECKLIST Several techniques are used to pinpoint the end of a trend. We will present a checklist of six confirming methods, which when combined will impart the necessary confidence to plan the trade and trade the plan. The checklist includes: Channeling to target the end of a sequence The channeling technique is a useful tool for projecting the end of a trend-defining five-wave sequence. Elliott noted that trend moves are usually contained within parallel lines or by Jody Samuels EUR/USD, WEEKLY ( wk. 0 yr) (Nov. 00 Dec. 006) channels. This channeling methodology is often used to delineate exhaustion zones, after which we would expect to see a trend reversal as long as the other confirmation signals are also present. It serves as an optimal timing guide, giving the trader a competitive edge. Channeling with four reference points Step : Connect the bottoms of waves and. Step : Draw a parallel line off the top of wave to project wave. Step : Draw the parallel line off the top of wave and 0% between and to project wave. Using all three channels actually gives a price zone targeting the end of wave (Figure ). Channeling with three reference points There are some variations to this technique that have gathered attention, one of which is to start drawing the Target zone. Connect bottoms of and. Draw parallel line off top of. Draw parallel line off top of. Draw 0% between and to target end of sequence //0 //06 /7/06 6//06 8//06 0/6/06 //06 //07 FIGURE : CHANNELING. Channeling to target the end of a sequence puts us in the ballpark of the completion of the trend move. INTELLICHARTS

2 channel with only three reference points (waves,, and ). Step : Connect the tops of waves and. Step : Draw a parallel line off the bottom of wave to project wave. This provides the initial wave boundary. Step : Wait until wave is complete, and redraw the channel by connecting the bottoms of waves and. Step : Draw a parallel line off the tops of each of waves and. Wave should fall within this channel target zone. Fibonacci price projections Fibonacci, the nickname for a th-century Italian mathematician, developed a sequence of numbers now known as the Fibonacci sequence. By taking the ratio of successive terms in the sequence, the user calculates a value of 0.68, referred to as the golden mean or section, and denoted by the Greek letter phi. Also called the divine proportion, the golden section is regarded as the reason for aesthetically pleasing, harmonious proportions in nature, architecture, art, and music. There are other properties of these numbers worth noting. For example, /phi is the inverse of 0.68, or.68, calculated by taking the ratio of any number to its next lower number. These ratios among others derived from the sequence are all used in targeting retracements and projections of market moves (Figure ). Now how do we apply these Fibonacci price projections to target the end of a move? In a five-wave sequence, wave is a multiple of wave. It is also a multiple of the beginning of wave to the end of wave. The probable targets for wave are: Equality with wave, where the length of wave equals the length of wave 0.68 times the length of wave.7 times the length of wave.68 times the length of wave, and 0.68 times the length of the start of wave to the end of wave. By channeling a trend move and calculating the projections for the end of the sequence within a target range, we have a good idea as to where the move will end. At this point, we can refine our analysis even further by looking at four more confirmation signals. Remember, the more confirmations we have, the higher the probable trade setup for a reversal (Figure ). EUR/USD, WEEKLY ( wk. 0 yr) (Nov. 00 Dec. 006) Fibonacci price projections Actual price:.70 00% of :.70 7.% of :.7 6.8% of :.07 Number Divided by Ratio Number Divided by Ratio FIGURE : FIBONACCI PRICE PROJECTIONS. Here are Fibonacci price projection calculations using the Fibonacci sequence. Target zone Channeling to target end of sequence. Connect bottoms of and. Draw parallel line off tops of and. Draw 0% line between and //0 //06 /7/06 6//06 8//06 0/6/06 //06 //07 FIGURE : FIBONACCI AND CHANNELS. Using Fibonacci price projections in combination with channeling adds precision to the end of the move. Actual price of.70 is pips from the 7.% targeted projection. Divergence and change in the direction of current momentum Another way to identify the end of a trend is to look for divergence in an oscillator and a change in momentum. My favorite chart setup uses Bill Williams s oscillator or a // moving average convergence/divergence (MACD), a momentum indicator that takes a five-period and -period simple moving average, plotted in a histogram with between 00 0 bars or candlesticks on the screen. This indicator is always measuring an Elliott wave of some degree. If the trend move under consideration occupies fewer than 00 bars, the MACD will be measuring the Elliott wave of a larger degree. If the wave sequence occupies more than 0 bars, the MACD will be measuring an Elliott wave of a smaller degree. You can also use a standard MACD in any charting package and change the settings to // to conform to the oscillator. This indicator identifies the following: a The top or bottom of wave. Because all oscillators are lagging indicators, the top or bottom of wave will be the highest or lowest price that occurs between one and five periods on the oscillator prior to the top or bottom of the oscillator.

3 EUR/USD, WEEKLY ( wk. 0 yr) (Nov. 00 Dec. 006) CAO Signal line Signal line: Buy above and sell below FIGURE : CHANGE IN DIRECTION OF CURRENT MOMENTUM. This chart illustrates divergence in the market, which signals at least a corrective move in the opposite direction. b The end of wave, or when its minimum requirements have been met. This is evident when the histogram comes all the way back to the zero line. Assuming a downtrend immediately after the bottom of wave, we note the histogram moving above the signal line. (The signal line is the five-period average of the oscillator itself.) This indicates that momentum is running out of steam and we are due for a fourth-wave correction. If short, you may choose to hold on through wave or you may decide to take profits and wait until the histogram comes all the way back to the zero line, signifying that the minimum requirements for the wave have been met and we are now due for the final wave move. c The top or bottom of wave. In any trend move, if the price makes a new high (low) in the case of an uptrend (downtrend) and the oscillator does not, this is a bearish (bullish) divergence. In an uptrend, if the bulls are losing control of the market we soon see a significant price reversal. In the case of a strong trend, we might even see double and triple divergences on the chart. When we see divergence in the oscillator, it also warns us we are in a wave versus a wave, or the end of the move. In a downtrend, when the wave price makes a new low below the wave price but the oscillator does not, it indicates that the entire five-wave sequence is running out of steam and a reversal is in order. d A change in direction of the current momentum. At its most basic level, momentum assesses the relative amounts of greed or fear in the market at a given point in time. In a fivewave trend move, the market surges ahead during waves,, and and retreats during the corrective phases and. The Williams oscillator signals the immediate direction of the Divergence and change in direction of the current momentum Bearish divergence in an uptrend between waves and //0 /6/06 //06 //06 7/7/06 9//06 //06 //07 Zero line current momentum by looking at the relative position between the / histogram of the oscillator and the signal line, which is a five-bar simple moving average of the / oscillator. It actually tracks the ebb and flow of the five-wave sequence. Therefore, in the case of an uptrend move, if the histogram is below the signal line, the current momentum is down, and if above, the momentum is up (Figure ). Reversal chart patterns Chart patterns fall into two categories: reversal and continuation. Since we are looking for confirmation signals depicting the end of the trend, we must brush up on classical technical analysis reversal chart pattern skills. Because markets are fractal in nature, chart patterns, which are graphical representations of historical prices, form repeating arrangements or shapes in any time frame. By (correctly) identifying these patterns, we can determine future trading opportunities with greater predictability. Chart patterns portray the trading psychology, or the collection of trading emotions driving buying and selling behavior at any given time. Reversal chart pattern recognition helps traders determine a change in market sentiment as well as time entries and exits. Elliott s interpretation of chart patterns parallels the classical use of these designs but with added precision. To apply Elliott wave analysis accurately, we need to look for the chart patterns in the price data and understand that they can be explained by the wave principle. Elliott wave theory places such reversal patterns as rising and falling wedges, head & shoulder formations, and double and triple tops and bottoms into perspective (Figure ). Let s take them one by one. The first reversal chart pattern is the rising or falling wedge, which in Elliott wave terminology is equivalent to a diagonal triangle. In a rising (falling) wedge pattern, the trendlines enclose the wedge and when complete, price breaks down (up) once the supporting (resisting) trendline is broken. The classic head & shoulders pattern is another reversal pattern that traces out the end of a move and ensuing trend in the opposite direction. Imagine completing a five-wave sequence, with waves,, and forming the left shoulder and head, followed by an a-b-c corrective sequence, forming the right shoulder and neckline break. We are currently playing this pattern out on the GBP/JPY weekly chart (Figure 6). A double top and bottom is similar to a failed fifth wave where wave fails to go above wave or wave and where corrects the full length of. A triple top and bottom has an equivalent Elliott wave pattern, which signifies a strong resistance (support) area and impending trend reversal.

4 Chart pattern Elliott wave pattern Rising or falling wedge Diagonal triangle GBP/JPY, WEEKLY ( wk. 0 yr) Head & shoulder Waves ---A-B-C Double tops and bottoms Failed th or - Triple tops and bottoms --- Chart pattern: B FIGURE : REVERSAL CHART PATTERNS. This table Head & shoulders formation summarizes some of the classical chart patterns and what Elliott waves,,, A, B, and C their equivalents would be using Elliott wave terminology. We have now looked at four tools to substantiate the end of a trend and have two more to go. When used in combination as confirmation signals, high-probability trade setups become apparent. The eight-, -, -, and -period Fibonacci EMA filter How does a Fibonacci sequence of exponential moving averages (EMAs) point to the end of a trend? The answer is the most efficient tools are related to trends, and using a Fibonacci sequence EMA filter is a great way to exit a position after a trend move. For some review, every five-wave sequence has waves moving with the trend and waves moving against the trend. Waves,, and move in the direction of trend, while waves and move countertrend. Picture yourself sitting on the beach, watching the waves move out to sea and into shore. Try meditating on that visualization of: Taking profits as the waves crash into shore in a trend-defining sequence, and Repositioning for the trend during the corrective cycle of moving out to sea. If you observe enough charts of varying time frames, especially the hourly and -minute varieties, you will become familiar with the wave start of the trend, the wave impulsive thrust of the trend, and the wave completion of the trend, with (of course) the corrective pauses in between. This description holds true for every five-wave sequence in any time frame. In fact, taking apart trends will become intuitive after a while. As presented, one simple and efficient tool to use to analyze the end of a trend is the // MACD or the Bill Williams s oscillator. A second simple and effective tool that complements the /6/06 /7/06 7/7/06 0/6/06 //07 /6/07 7/6/07 9/7/07 A Neckline breakout point Head and shoulders measuring objective from head to neckline C? //08 FIGURE 6: HEAD & SHOULDERS PATTERN. This weekly GBP/JPY chart illustrates the formation of a head & shoulders pattern that has just broken through the neckline. Notice price stays below the EMAs during waves,, and USD/JPY, -HOUR The 8,, and -period Fibonacci EMA Filter When the trend is complete, the 8-period EMA crosses above the -, -, and -period EMAs Divergence FIGURE 7: FIBONACCI EMA FILTER. The price action hugs the Fibonacci EMA filter during the trend moves and crosses above during the corrective sequences. MACD applies a combination of eight-, -, -, and -period EMAs. These EMAs are part of the Fibonacci sequence, as are the moving averages in the MACD. The smallest EMA, the eight-period, is the most volatile and creates market whipsaws as it hugs the price action, whereas the -period is the least volatile of this EMA series (Figure 7). Some observations in a downtrend: When the eight-period EMA is pierced by a candle that closes below the EMA, it acts as a warning of a hesitation in the trend.

5 BULLISH PATTERNS Bullish reversal patterns form in a downtrend at a price low Morning star Bullish three-candle pattern at swing lows Candle has a tall red real body Candle has a small red or blue real body (that would gap below the first real body in a market other than forex) Candle closes at least 0% into the first real body and is a tall blue candle Bullish engulfing Market is in a definable downtrend Candle has a small red real body Candle reverses where the blue body completely engulfs the previous day s red body A stronger signal occurs when the blue reversal candle body engulfs two or more bodies Tweezer bottom Good reversal signal Two or more candlesticks with matching bottoms The real bodies or the wicks must be at the same level BEARISH PATTERNS Bearish reversal patterns form in an uptrend at a price peak Evening star Bearish three-candle pattern at swing highs Candle has a tall blue real body Candle has a small red or blue real body (that gaps above the first real body in a nonforex market) Candle closes at least 0% into the first real body and is a tall red candle Bearish engulfing Market is in a definable uptrend, not in a sideways consolidation Candle is characterized by a small blue real body in an uptrend Candle reverses where the red body completely engulfs the previous day s blue body Tweezer top Good reversal signal Two or more candlesticks with matching tops The real bodies or the wicks must be at the same level Other examples Piercing line Hammer Inverted hammer Bullish harami Doji star Tri-star Harami cross Other examples Dark cloud cover Hanging man Shooting star FIGURE 8: CANDLESTICK REVERSAL PATTERNS. Here are some common bullish and bearish candlestick patterns. Bearish harami Doji star Tri-star Harami cross If the candle close is above the - and -period EMAs, it s a signal that an eventual pullback or reversal may be imminent. At this point, the eightperiod EMA might cross above the other averages and you will see convergence and crossover. This is exactly the time to exit a position, signaling the end of a trend move. At the end of a trend sequence, the price action hugs and then moves away from the averages. This is the traders emotional desire to stay with the trend, even if there are warning signs that the trend may be ending. What you see next is that price always comes back to the averages. There is little value in entering a short position at this stage of the game, as price will revert to the mean a few candles later. When the price comes back to the EMAs without piercing them, another move in the trend direction is pending. These resting points or consolidations are the real catalysts of a trend s strength. As long as they continue, the current wave is not complete, even though the move may seem extended at a certain stage. Again, when this is used in combination with the other tools, we are able to pinpoint the end of the trend so that we can call for the start of the new trend. 6 Candlestick reversal patterns The Japanese have used candlesticks as a charting and analysis technique for centuries. Candlestick analyst Steve Nison says that candle signals should not be used in isolation. Because they mostly help pick tops and bottoms, candles are most powerful when they confirm a western indicator. A Japanese candle pattern is a psychological imprint of what traders are thinking at any given time. Candles form both continuation and reversal patterns just like with classic chart patterns. Whenever a reversal pattern is bullish, an inversely related pattern is bearish. When a pair of patterns work in both bullish and bearish cases, they tend to use the same name, though not always. There are approximately 0 reversal candle patterns that vary from single candlesticks to groupings of up to five candlesticks. Using candlestick signals creates tremendous profit-making advantages because it allows the trader to make a quick decision. Combined with oscillator divergence, reversal chart patterns, and the Fibonacci EMA filter, candlestick patterns provide reliable entry points. Because the forex markets operate hours a day, very rarely do we see gaps, and certainly not intraday. Gaps are found in other traded markets where the open of the second candle does not equal the close of the first candle. However, we can still use candlestick patterns without gaps, and the

6 examples in Figure 8 account for the uniqueness of the forex market. A COMPLETE TOOLKIT You now have a complete toolkit of trend-ending indicators and reversal patterns that will take you a long way in your analysis. There are several methods of determining the end of a trend. When used in combination with one another, highprobability trades setups can be planned and traded. To summarize: Complete the checklist to determine how many of the six items corroborate the end of the trend. If at least four tools indicate reversal, then consider it a high-probability trade setup. Plan the trade by determining entry points and stoploss levels. Use money management. Wait for the market to turn and then place the trade, rather than picking a top or bottom. Now trade the plan, set a few different profit targets, and enjoy the fruits of your analysis. As for entry and exit strategies and money management, those are the subjects for another article. Jody Samuels ( is a leading coach for successful traders and the creator of the FX Trader s EDGE program. Samuels trading expertise spans the financial, currency, and commodity markets as a trading professional for a US global investment bank and sales professional for an energy company. She currently works with program members in private coaching sessions, teaches an Elliott wave course, and manages a daily online trading room. She may be reached at jody@fxtradersedge.com. SUGGESTED READING Frost, A.J., and Robert Prechter [98]. Elliott Wave Principle, New Classics Library. Williams, Bill [99]. Trading Chaos, John Wiley & Sons. IntelliCharts S&C