Technical Analysis for FX Options
What is Technical Analysis? Technical analysis, also known as charting, is an attempt to predict future prices, by studying the trading history of a traded security (currencies, equities, commodities, etc.). Technical analysts evaluate securities by analyzing the statistics generated by market activity, such as past prices and volume, and use charts and other tools to identify patterns that can suggest future activity.
Using Technical Analysis Technical analysis assumes that, at any given time, the currency s price reflects everything that has or could affect the currency - including fundamental factors, along with broader economic factors and market psychology are all priced in, removing the need to actually consider these factors separately. This only leaves the analysis of price movement, which the chartists view as a product of the supply and demand. Although there are many different methods and tools used in technical analysis, all of them rely on the assumption that price patterns and trends exist in markets, and they can be identified and exploited.
Interpretation of Technical Analysis The underlying assumptions of technical analysis can be described in three ways. The market discounts everything. Over a period of time price reflects all information impacting the currency, and its future potential direction. Price tends to trend or form patterns. Most technical trading strategies are based on this assumption. This means that after a trend has been established, the future price movement is more likely to be in the same direction as the trend than to be against it. History tends to repeat itself. Price trends occur and reoccur in patterns that are fairly predictable. The repetitive nature of price movements is attributed to market psychology.
Candlestick Charts Candlestick charts are one of the most popular graphical charts. They provide a variety of information about the current market prices, and they are relatively easy to read and understand. Candlestick charts are used by short and long term traders alike, and are used by many different trading systems. There are only two groups of people in the market - buyers and sellers. One can use the candles to figure out which group is in control of the price action.
This image shows how candlesticks are constructed. The highs and lows of the time period are called the "wicks" and the open and close form the "body". The candle itself is the "range". When the currency closes at the bottom of the range we conclude that the sellers are in control. When currencies close at the top of the range we conclude that buyers are in control.
Trends In any given chart, one can notice that price does not tend to move in a straight line in any direction, but rather in a series of highs and lows. In technical analysis, it is the movement of these highs and lows that constitute a trend. Trends can also be divided into three separate stages: Primary or major trend. It is the most important trend to investors who want to buy and hold currencies for a longer time Secondary trends are counter trend movements in the direction of the major trend. These counter movements cause price to correct back to a more realistic price value. Once these counter trends are over the primary trend is resumed. Intermediate trends are that part when price swings both, in the direction and against the direction of the primary trend. The intermediate trends are important to investors to spot the best price level to enter the primary trend or to add to their positions. Minor trends. The day to day price fluctuations within these moves are called minor trends. These minor trends are important to day traders who want to exit trade after the end of the day.
Types of Trends It is important to be able to understand and identify trends so that you can trade with rather than against them. Two important sayings in technical analysis are "the trend is your friend" and "don't buck the trend," which shows how important trend analysis is for technical traders. There are three types of trend Uptrend - when each successive peak and trough of the price movement is higher, it's referred to as an upward trend. Downtrend - If the peaks and troughs are getting lower, it's a downtrend. Sideways/Horizontal trends - When there is little movement up or down in the peaks and troughs, it's a sideways or horizontal trend. One can say that a sideways trend is actually not a trend on its own, but a lack of a well-defined trend in either direction.
Trend Lines A trend line is a simple charting technique that adds a line to a chart to represent the trend in the market. These lines are used to clearly show the trend and are also used in the identification of trend reversals. An upward trend line is drawn at the lows of an upward trend. This line represents the support that price forms every time it moves from a high to a low. This type of trend line helps traders to anticipate the point at which price will begin moving upwards again. A break of this trend line is the simplest indication of a change of trend towards the downside. Similarly, a downward trend line is drawn at the highs of the downward trend. This line represents the resistance level that price faces every time it moves from a low to a high. Likewise a break of this trend line is the simplest indication of a change of trend towards the upside.
Support and Resistance The support and resistance levels are important in terms of market psychology and supply and demand. These are the levels at which a lot of traders are willing to buy the currency (in the case of a support) or sell it (in the case of resistance). When these levels are broken, the supply and demand and the psychology behind the price movement is thought to have shifted, in which case new levels of support and resistance will likely be established. Once a resistance or support level is broken, its role is reversed. If the price falls below a support level, that level will become resistance. If the price rises above a resistance level, it will often become support. For a true reversal to occur, however, it is important that the price make a strong move through either the support or resistance.
Indicators Indicators are calculations based on the price of the currency that measure such things as trends, volatility and momentum. Indicators are used as a secondary measure to the actual price movements and add additional information to the analysis. They can be used in two main ways: to confirm price movement & chart patterns, and to form buy and sell signals.
Moving Averages Most chart patterns show a lot of variation in price movement. This can make it difficult for traders to get an idea of the currency's overall trend. One simple method traders use to combat this is to apply Moving Averages. A moving average is the average price of the currency over a set amount of time. By plotting the currency's average price, the price movement is smoothed out. Once the day-to-day fluctuations are removed, traders are better able to identify the true trend and increase the probability that it will work in their favor. Since moving averages rely on historical data for calculation, they have a lagging effect. The drawback of moving averages is these lags which can delay buying and selling decisions. Therefore averaging is typical choice between desired level of smoothing and the percentage of lag that a trader is willing to tolerate.
Types of Moving Averages Three types of moving averages exist. These are Simple moving averages (SMA) Weighted moving averages (WMA) Exponential moving averages (EMA). Each of these averages should be judged upon its own merits. There are also time periods when any of these is an appropriate choice.
Use of Moving Averages Moving averages can be used to quickly identify whether the currency is moving in an uptrend or a downtrend depending on the direction of the moving average. When a moving average is heading upward and the price is above it, the currency is in an uptrend. Conversely, a downward sloping moving average with the price below can be used to signal a downtrend.
Another method of determining momentum is to use a pair of moving averages. When a short-term average is above a longer-term average, the trend is up. On the other hand, a long-term average above a shorter-term average signals a downward movement in the trend.
Another major way moving averages are used is to identify support and resistance levels. It is not uncommon to see a currency that has been falling, stop its decline and reverse direction once it hits the support of a major moving average. And a move through a major moving average is often used as a signal by technical traders that the trend is reversing.
The Stochastic Oscillator The Stochastic Oscillator was developed by George Lane, and is a momentum indicator that measures the price of a currency, relative to the high/low range over a set period of time. The indicator oscillates between 0 and 100, with readings below 20 considered oversold and readings above 80 considered overbought. The stochastic method relies on the principle that prices tend to close near the upper part of the trading range during an uptrend and near the lower part of the trading range in a downtrend. As a trend approaches a turning point, the price closes further away from the extremes.(that is, further away from the highs in a rising market and further away from the lows in a declining market.) The objective of the slow stochastic is to identify these points in the trend since this indicates a reversal may be at hand.
Interpretation of the Slow Stochastic The basic interpretation of this indicator, would be 1. A stochastic value above 80 indicates an overbought market, while a stochastic below 20 indicates an oversold market. 2. The crossing of the %K and %D lines generates buy and sell signals. But they are more effective when the stochastic has been overbought or oversold and then moved out of the zone. This is especially important in a strong trend as the stochastic will remain in the overbought/oversold zone and give false crossovers. 3. Stochastic can show divergence, when the stochastic values are moving in one direction and the price values are moving in the opposite direction.
Drawback of the Slow Stochastic The basic drawback of this indicator is that it looses its effectiveness in trending markets. While it is one of the most effective indicators for ranging markets, it should not be relied upon when the market is in a trend. This is because the stochastic lines tend to remain in the extreme zones during a trend, giving false crossover signals. To overcome this drawback during trends, take signals only in the direction of the trend and never go long when stochastic is overbought, nor short when oversold. And as mentioned earlier, wait for the lines to move out of the extreme zone.
The Relative Strength Index (RSI) The Relative Strength Index (RSI) is one of the most widely used technical indicators by traders. It is used primarily to help identify overbought or oversold conditions in a particular currency, as it is formulated to fluctuate between 0 and 100, enabling fixed overbought and oversold levels. It does this by confirming changes in momentum which signals an imminent change in price direction or trend for the particular currency. The advantage of the RSI over other oscillators such as the Momentum or Rate of Change oscillators, is that it is smoother and is not as susceptible to distortion from unusually high or low prices
Interpretation of the RSI If used properly, the RSI is a very valuable tool in interpreting chart movement. Its two basic functions to interpret price movement are the overbought/oversold levels, and divergence. It also identifies price movement by forming patterns such as a double top/bottom, head & shoulders etc, when the same would not be clearly visible in the price movement. Similarly areas of support/resistance found on the RSI, prove to be more effective. It would generate more precise signals when the market is in a range bound state. Here, the overbought/oversold levels as well as divergences show up more accurately on the RSI. When price is trending, it would give false signals since it remains in the overbought/oversold state for an extended period of time.
Bollinger Bands Developed by John Bollinger, Bollinger Bands is an indicator that allows users to compare volatility and relative price levels over a period time. In short, the Bollinger Bands provide a relative definition of high and low. The indicator consists of three bands which usually to encompasses the majority of price action. A simple moving average in the middle An upper band (SMA plus 2 standard deviations) A lower band (SMA minus 2 standard deviations
Interpretation of the Bollinger Bands The basic interpretation of Bollinger Bands is that prices tend to stay within the upper and lower band. Because standard deviation is a measure of volatility, the bands adjust themselves to the market conditions. When the markets become more volatile, the bands widen (move further away from the average), and during less volatile periods, the bands contract (move closer to the average). The tightening of the bands is often used by technical traders as an early indication that the volatility is about to increase sharply.
Characteristics of Bollinger Bands 85% of the price action is contained within the bands. Sharp price changes tend to occur after the bands tighten, as volatility lessens. When prices move outside the bands, a continuation of the current trend is implied. Bottoms and tops made outside the bands followed by bottoms and tops made inside the bands call for reversals in the trend. A move that originates at one band tends to go all the way to the other band. This observation is useful when projecting price targets.
Fibonacci Ratios Fibonacci ratios are a very popular tool among technical traders and are based on a particular series of numbers identified by mathematician Leonardo Fibonacci in the thirteenth century. The Fibonacci sequence of numbers is as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc. Each term in this sequence is simply the sum of the two preceding terms and sequence continues infinitely. However, the sequence of numbers is not as important as the mathematical relationships, expressed as ratios, between the numbers in the series. One of the remarkable characteristics of this numerical sequence is that each number is approximately 1.618 times greater than the preceding number. This common relationship between every number in the series is the foundation of the common ratios used in retracement studies. The key Fibonacci ratio of 61.8% - also referred to as "the golden ratio" or "the golden mean" - is found by dividing one number in the series by the number that follows it. For example: 8/13 = 0.6153, and 55/89 = 0.6179.
Using Fibonacci Ratios For some reason, these ratios seem to play an important role in the financial markets, just as they do in nature, and can be used to determine critical points that cause price to reverse. Price has an uncanny way of respecting Fibonacci ratio s, often quite precisely. Hence one can use these ratios to ascertain the correct technical levels. Fibonacci retracements. In technical analysis, the Fibonacci retracement is calculated by taking two extreme points (usually a swing high and swing low) on the price movement and dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%. Once these levels are identified, horizontal lines are drawn and used to identify possible support and resistance levels. The direction of the prior trend is likely to continue once the price has retraced to any of the ratios.
The Pivot Point The Pivot point system is a technique developed by floor traders, to help ascertain where the price is relative to previous market action. The Pivot point in a very basic sense can be defined as a turning point. It can be classified as a technical indicator derived by calculating the numerical average of the high, low and closing prices, of any currency / index / stock etc. One can say that it is a level at which the sentiment of the market changes. It can tell us where the sentiment of traders and investors changes, from bull to bear or vice versa. Pivot points work best on highly liquid markets, like the spot currency market, but they can be used in other markets as well. The main advantage of this technique is that it is price-based as opposed to indicator-based. By the time most indicators generate a signal, the move is already well under way. By following this system, one can get into a trade before the indicator-following traders, and be well into the trend when a signal is just being generated on a stochastic or other oscillator.
Interpretation In its basic interpretation, we can say that if the market breaks the Pivot level up, then the sentiment is said to be a bull market and it is likely to continue its way up, on the other hand if the market breaks this level down, then the sentiment is bearish, and is expected to continue its way down. The pivot point can thus be used as a predictive indicator. If the following day's market price falls below the pivot point, it may be used as a new resistance level. Conversely, if the market price rises above the pivot point, it may act as the new support level.
Calculating the Pivot Levels There are different methods for calculating pivot points, the most common of which is the five-point system. This system uses the previous day's high, low and close, to derive the pivot point along with two support levels and two resistance levels (totaling five levels) The equations are as follows: R2 = P + (R1 - S1) R1 = (P x 2) - L P = (H + L + C) / 3 S1 = (P x 2) - H S2 = P -(R1 -S1) Here, "P" represents the pivot point, "S" the support levels, "R" the resistance levels and "H", "L" and "C" represent the High, Low and Close respectively. These levels form the support and resistance levels for the current session.
Chart Patterns A chart pattern is a distinct formation on a chart that creates a trading signal, or a sign of future price movements. Chartists use these patterns to identify current trends and trend reversals and to trigger buy and sell signals. There are two types of patterns within this area of technical analysis, Reversal and Continuation. A reversal pattern signals that a prior trend will reverse upon completion of the pattern. A continuation pattern, on the other hand, signals that a trend will continue once the pattern is complete. These patterns can be found over charts of any time frame. The most commonly used chart patterns are the Head & Shoulders, Double top/bottom, Flag formations, Triangles, 123 pattern etc.
Using Multiple Technical Indicators Technical analysis is used for predicting price action in the financial markets. This is just another factor to put the odds in favor of the trader to increase the probability of a successful trade. Since the forex is a very liquid market and the currencies tend to trend well, we should try and ascertain a trend at its early stage, and a confirmation of 2 different factors gives the edge for a successful trade. But relying on any single indicator to provide signals for a trade is not advisable. If we have another factor confirming the same signal, the probability of a successful trade is increased. Using multiple sources of confirmation helps to avoid the potential false signals, and preserve our capital for only those situations that provide us with the most favorable risk to reward scenarios. The confirming factor could another indicator, but ideally price action should confirm the signals shown by the indicator. Hence a combination of an indicator with a chart formation can give better results.
Example of Using Multiple Technical Indicators For using multiple indicators, one must use indicators which are non-correlated. Most indicators tend to give similar inferences & one must understand the advantages & drawbacks of each to achieve an effective result. In the following example we have used the Moving average crossover method along with the slow stochastic indicator. In the trend as indicated by the moving averages, we identify overbought / oversold situations by the slow stochastic. We are thus using the characteristics of both to give us a better trade setup.
Thank you Sunil Mangwani