Section I: Introduction
In this Lesson, we will review the most important technical indicators used to trade the Forex market.
Technical indicators are no more than a series of data points plotted in a chart that are derived from a mathematical formula applied to the price of any given instrument. In other words, indicators are just a different way in which price movements can be represented over specified periods of time (they offer us a different perspective).
Some technical indicators are used to confirm price action (lagging indicators), others are used to predict price action while some others are used as an alert or warning of a possible break on price action.
Lagging indicators - These indicators follow the price action, in other words they confirm what the price just did. The signals that come out of this type of technical indicators usually happen after the change in price begins. These types of indicators are also called trend-following indicators and work best during trending markets, where they allow traders to catch most of the move. During trendless conditions (sideways or ranging market) these types of indicators give many false signals.
Leading indicators - These indicators try to predict future price movements. They give signals before the actual price movement begins. These kinds of indicators work best during consolidation periods or trendless markets. During trending conditions, only signals in direction of the existing trend are advised to be taken. During up-trending conditions, leading indicators help us identify oversold conditions (price has falling enough and it is ready to continue its trend). During downtrending conditions, they help us identify overbought conditions (price has rallied enough, and now it is ready to continue its trend).
When using leading indicators it is also advisable to wait for the actual price movements before taking the indicator signal.
Most important lagging indicators: Moving Averages (MA) and Moving Average Convergence-Divergence (MACD).*
Most important leading indicators: Relative Strength Index (RSI), Stochastics, Commodity Channel Index (CCI) and Momentum.*
*Some of these indicators can be used both as a lagging indicator and as a leading indicator.
Sensitivity vs. Consistency
Before going through all the indicators it is important to understand the relationship between these two concepts. Every indicator represents price movements over a chosen period. Each indicator gives you the option to decide on how many periods you want to go back over to do the calculation. If we shorten the period, we will get more and earlier signals, but at the same time, the percentage of false signals will also increase. If we increase the number of periods, false signals will decrease, but the signal will get us in a trade later, giving up some profits.
It is up to the trader to select the approach that best suits his or her trading personality, trading style and objectives.
In this lesson we will cover the following topics:
Section II: Moving Averages - In this section, we will review moving averages, what they tell you, common uses, etc.
Section III: Moving Average Convergence-Divergence (MACD) – MACD is a popular indicator that can be used in several ways to our benefit.
Section IV: Commodity Channel Index (CCI) – The CCI is an indicators that quickly reacts to the price action.
Section V: Relative Strength Index (RSI) – This indicator measures the ration of bull and bear candlesticks, the information is then plotted and can tell us several market conditions.
Section VI: Stochastics (STC) – We will review the best overbought/oversold indicator.
Section VII: Momentum (MOM) – Trying to measure the strength/momentum of the market can help us take better decision.
Section VIII: Bollinger Bands (BB) – This volatility indicator developed by Bollinger shows us how far the market could go during “normal conditions”.
Section IX: Average Directional Index (ADX) – The ADX is an indicator that measures the strength of the trend in any market.
Section X: Fibonacci Retracements – Once the market has retraced, the Fibonacci retracements can help us determine where could the retracement could end.
Section XI: Pivot Points (PP) – PP is a popular technique that shows us the sentiment of the market and other useful information.
Section XII: Important Considerations about Technical Indicators – What’s inside indicators, how should we use them? Do they generate accurate signals?
Section XIII: Time-Frames – The combination of time-frames is critical to have good results.
Section II: Moving Averages (MA)
MA’s measure the average price of the previous n-periods. For instance, a MA(5) measures the average price of the last 5 bars. However, as the name implies, the average changes as when a new period is added the last period is dropped. So it is always the MA of the last 5 periods.
As in any other indicator, the period selected is a critical element. The shorter the period the more sensitive the MA is to price movements and is less consistent, and the larger the period chosen, the more consistent it is, but at the same time less sensitive to price fluctuations.
The moving average explained above is called simple moving average (SMA). However, there are also other popular types of moving averages: exponential moving average (EMA) and weighted moving average (WMA). The only difference between the SMA and the other two approaches is the weight assigned to each period. EMA´s and WMA´s assign more weight to the periods that are closer to the current price, while in SMA all periods are equally weighted.
[Chart 1]
Let’s concentrate on the yellow box. The green line is a 10 period exponential moving average (EMA) while the red one is a 10 period simple moving average (SMA). At the beginning of the yellow box there is a small period of consolidation where moving averages are pretty close to each other, there is nothing to be noticed. But once the market starts moving, you will see the EMA(10) lifts up first, then the SMA(10). This is because the EMA gives more weight to periods closer to the market action than SMA’s. This means that EMA’s will always be closer to the current market action than SMA.
Which one to use?
We prefer to use EMA since they give more value to more recent price fluctuations, and reflect what is happening at any given time with more accuracy. However, there are traders that prefer to use SMA.
Usage of Moving Averages
Usage No. 1 - As stated before, MA´s are trend following indicators. They smooth out price fluctuations and make it easier to identify a trend. There are several ways in which this indicator can be used to identify the trend:
1 - Location of the MA in relation to price action. If the MA is above the price, it indicates a downtrend is in place. If the moving average is below the price then it is considered an uptrend.
2 - With the slope of the MA. When the MA is sloping up, the market is considered to be in an uptrend. When it is sloping down the market is considered to be in a downtrend. When there is no slope (close to a flat line), then the market is trendless or sideways
[Chart 2]
The chart above shows both ways to identify a trend. When the price breaks the EMA(21), a significant change in trend could be imminent (or at least a retracement or consolidation period). Also the slope of the EMA(21) keeps good track of the trend. There are also periods of indecision (when the market breaks the MA back and forth). During these periods, the EMA(21) could lead us to take false conclusions about the market condition [when the EMA(21) is almost flat.]
For this reason it is always advised to use a second MA. This allows us to keep track of the location of one MA relative to the other. When the short period MA is above the longer period MA the trend is considered an uptrend, and when the short period moving average is below the larger period MA, the trend is considered to be a downtrend.
[Chart 3]
In this case we added an EMA(75) [red line]. When the EMA(21) [green line] is above the EMA(75) [red line] the trend is considered an uptrend (which is the case for the chart above). On the other hand, when the EMA(21) is below the EMA(75) then the trend is considered to be a downtrend.
Usage No. 2 - MA as support and resistance. Some MA’s are used to establish levels of support and resistance. The most common periods used in MA for this kind of usage are: 50, 100, 200, 144, 89, and 34.
[Chart 4]
In this chart we used an EMA(144) [notice it is the same chart we used for the other MA’s examples]. As you can see this moving average is a very powerful price level in the chart. Almost all the time, something happens when the price action approaches to this EMA, either it bounces off from it or makes a wild break out. This EMA(144) is significant on all charts and all time frames, we personally use it a lot as a very important level of support and resistance.
Usage No. 3 - Moving averages as cross-over signals. Perhaps the most common and easy trading system is this one. It consists in plotting a short period moving average and a larger period moving average. When the short period moving average crosses above the large period moving average, it signals a buy signal. When the short period MA crosses down the larger period moving average, it indicates a sell signal.
[Chart 5]
In the chart above we used an EMA(21) as the short period MA (red line) and an EMA(34) as the longer period MA (green line). There are a total of 5 cross-over signals: 3 buy and 2 sell signals. The three buy signals are generated when the short period MA crosses above the long period MA while the 2 short signals are generated when the short period MA crosses below the long period MA.
Combination of Moving Averages Signals
During trending conditions these types of systems work very well, getting you in the market early and letting you catch most of the move. But during consolidation periods, a moving average crossover gives many false signals.
For this reason is important to determine ahead of time the trend on each trading possibility. If there is an existing trend, then we use a system that works during trending conditions, if there is no trend, then we use a system that works under ranging conditions.
Let’s try to filter signals on the crossover above with a longer period moving average that will be of use to us as trend identification.
[Chart 5]
What we are trying to accomplish with this new large period MA is to filter out signals against the trend. We are using the new EMA(75) as a trend identification – position of the market in relation to the MA. According to this new rule, most of the time the market stays above the EMA(75) indicating an uptrend. What we are going to do now is to validate all long signals and ignore all short signals as they are against the direction of the trend and we know this system works best during trending conditions taking trades in direction of the trend. So we filter out all short signals and go ahead only with long signals. This produces better results than taking every single signal.
Remember also that the signals given by a MA crossover are very sensitive to the number of periods chosen for the MA´s. If short periods of MA´s are chosen, then the system is going to get you in the market early but also will give you many false signals. On the other hand, if larger periods are chosen, the system will get you in the market later, (giving up some profits) but will give you more accurate signals.
Section III: Moving Average Convergence-Divergence (MACD)
The MACD charts the difference between two exponential moving averages (a longer period EMA subtracted to a short period MA). The most common settings applied to MACD are 26 periods EMA and a 12 period EMA.
The MACD is positive when the EMA(12) is above the EMA(26) indicating that the rate of change of the shorter period MA is higher than the longer period MA and this indicates positive momentum. On the other hand, it is negative when the EMA(12) is below the EMA(26), the rate of change of the shorter period MA is lower than the longer period MA indicating negative momentum. These values are then plotted in a histogram.
MACD Usage
Usage No. 1 - As an oscillator indicating overbought/oversold conditions.
An overbought condition indicates that the instrument has been bought all the way up, and a probable short term reversal is very likely to happen. An oversold condition indicates that bears have been selling an instrument all the way down at a certain point that it is very likely that buyers start taking command of prices attracted by cheap prices (short-term reversal).
[Chart 7]
Every time the MACD gets overbought or oversold the market tends to change direction. But what is considered overbought or oversold with the MACD? Good question... it is relative to the previous highs or lows as there are not “set levels” for the MACD to be considered overbought or oversold. This is one of the weak points if the MACD for this usage.
Although this MACD usage is not very common, there are still traders that use the MACD in this way.
Usage No. 2 - Centerline crossover. When the MACD crosses from negative territory to positive territory, it is called a bullish crossover and indicates positive momentum. On the other hand, when the MACD crosses from positive territory to negative territory it is called a bearish crossover ant it indicates negative momentum.
[Chart 8]
When the histogram crosses from the negative territory to the positive territory it means that the market is gaining positive momentum signaling a long trade.
Usage No 3 - Divergence trading. A divergence occurs when the price behavior differs from the indicator behavior. Theoretically, when the price reaches new highs, the indicator should also reach new highs and the opposite is also true for a bear market. Therefore, when the price makes new highs and the indicator fails to do the same, or when the indicator reaches new highs and the price fails to do the same, a divergence is present. The same is true when the indicator reaches new lows and the price fails to do so or when the price reaches new lows and the indicator fails to do the same.
[Chart 9]
The second low created by the market is clearly at lower levels than the first low. The MACD fails to make a similar low and creates a higher low instead.
This creates a divergence signaling the market isn’t as bearish as it used to be.
Combination of MACD Signals
Please take a look at the following chart and try to determine what we are using to generate the signal (yellow triangle).
[Chart 10]
In this chart we used the divergence signal coupled with the centerline crossover signal as a confirmation. Once the market created the divergence we need the MACD to cross below zero to confirm the signal. Of course we could add the support line break out also (blue horizontal line).
Section IV: 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.
[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.
[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.
[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.
[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:
[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.
Section V: 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.
[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.
[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).
[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
Section VI: 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.
[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.
[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.
Section VII: 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.
[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.
[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.
[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.
Section VIII: 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.
[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.
[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”.
Section IX: 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.
[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
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
[Chart 27]
In the chart above, the divergence is present near the top indicating a weakening trend.
Section X: 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
[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.
[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 reviewed in this lesson, see which one fits you better or what combination is better for you.
Section XI: Pivot Points
In a few words, a pivot point (PP) is a level in which the sentiment of traders and investors changes from bull to bear or vice versa.
Why PP works?
They work simply because many traders and investors (including bank and institutional traders) use and trust them. It is known by every trader that the pivot point is an important measure of strength or weakness of any market.
There are several ways to calculate the pivot point. The method we found to have the most accurate results is calculated by taking the average of the high, low and close of a previous period (or session).
Warning – some pretty boring maths ahead. The good news is that almost all charting platforms will automatically calculate this for you and draw the lines on in whatever pretty colour you like. But as this is the ADVANCED course we think you should have a basic idea of how they are calculated.
Pivot point (PP) = (High + Low + Close) / 3
Take for instance the following EUR/USD information from the previous session:
Open: 1.2386
High: 1.2474
Low: 1.2376
Close: 1.2458
The PP would be,
PP = (1.2474 + 1.2376 + 1.2458) / 3 = 1.2436
So, what does this number tell us? It simply tells us that if the market is trading above 1.2439, Bulls are winning the battle pushing the prices higher. In addition, if the market is trading below this 1.2439 the bears are winning the battle pulling prices lower. In both cases this condition is likely to sustain until the next session.
Since the Forex market is a 24hr market (no close or open from day to day) there has been an ongoing battle deciding at what times we should take the open, close, high and low from each session. From our point of view, the times that produce more accurate predictions is taking the open at 00:00 GMT and the close at 23:59 GMT (obviously the high and low in between those hours).
Besides the calculation of the PP, there are other support and resistance levels that are calculated using the PP as a reference.
Support 1 (S1) = (PP * 2) – H
Resistance 1 (R1) = (PP * 2) - L
Support 2 (S2) = PP – (R1 – S1)
Resistance 2 (R2 ) = R1 + (PP – S1)
Where, H is the High of the previous period
L is the low of the previous period
Continuing with the example above, PP = 1.2436
S1 = (1.2436 * 2) - 1.2474 = 1.2398
R1 = (1.2436 * 2) – 1.2376 = 1.2496
R2 = 1.2496 + (1.2436 – 1.2398) = 1.2338
S2 = 1.2436 – (1.2496 – 1.2398) = 1.2534
These levels are supposed to mark support and resistance levels for the current session.
In the next chart we have calculated the PP and the support and resistance levels for September 5th.
S2 = 1.2616
S1 = 1.2579
PP = 1.2545
R1 = 1.2508
R2 = 1.2474
[Chart 1]
Vertical lines separate sessions (4th and 5th of September). As we can see, the market went rapidly below the PP level. From that point on, we should be careful with longs, and start thinking on shorts, because the sentiment of traders and investors is turning to “net short”.
Notice how the PP represents a resistance on early September 5th. Notice also S1 rejected twice the price as it approached the S1 level representing good trading opportunities. Finally, S2 marked a good support, this indicates weakness on current bears, which tells us that the sentiment is not as strong as it was at the beginning of the trading session.
On the example above, the PP was calculated using information of the previous session (previous day). This way we could see possible intraday resistance and support levels. But it can also be calculated using the previous weekly or monthly data to determine such levels. By doing so, we are able to see the sentiment over longer periods of time. In addition, we can see possible levels that might offer support and resistance throughout the week or month. Calculating the weekly or monthly pivot point is mostly used by long term traders, and as we said, it gives us a good idea about the longer term trend.
Got it? Good - there will be questions on this in the quiz later…
As mentioned; all these mapping indicators are available on a point and click basis on almost all charting packages as they are so commonly used (therefore have such intrinsic power). We prefer and choose to use MetaTrader 4 and will go into more detail about that package later.
Section XII: Important Consideration about Technical Indicators
Remember that some indicators work best during trending markets while others generate best results under ranging or trendless conditions.
For this reason it is important to choose different indicators for different market conditions. For instance, we could use one oscillator to forecast tops and bottoms when the market is ranging, but once either the top or bottom is broken, we could use the CCI to take signals based on extreme levels.
To trade based only on one indicator could be risky, we need to adapt our strategy to the different market conditions, and combine preferably indicators of different nature, for example, use oscillators in combination with candlestick reversal patterns to get our trading signals.
The other extreme is not good either, using a lot of indicators could complicate trading decisions and we could end up with a system that is hardly tradable.
For now, get familiar with each indicator and pattern studied in these past three lessons. Try to see which one of them fits you better and what combination of technical tools could help you achieve better results.
Section XIII: Time-Frames
There are different periods in which a currency pair could be charted: monthly, weekly, daily, hourly, 30-minute, 5-minute, etc.
Each timeframe has its unique trend; this is the reason why there is no absolute trend for any currency, take the following charts for example.
EURUSD Hourly Chart
[Chart 30]
EURUSD Daily Chart
[Chart 31]
In these charts, a swing trader focusing in the 1H chart could assess: well there is no trend (ranging market) right now for the EURUSD while a long-term trader could assess: the trend for the EURUSD is clearly up. Which trader is wrong? No one, both of them are correct. Both of them have effectively determined the trend in the timeframe they are focusing on.
Of course, the market condition in the 1H chart is most likely to continue for the next couple of days while the market condition in the daily chart is likely to continue for the next month or so.
The same goes when we use indicators. Sometimes the same indicator could be signalling the opposite signals on the same currency pair on different time frames.
Take for instance the following charts:
GBPJPY 15 Minute
[Chart 32]
GBPJPY 4H
[Chart 33]
On the first chart (15min) the stochastics are in an oversold situation however, at the same time, in the 4H chart the stochastics did give a sell signal (crossing from the overbought territory to the neutral territory). The reason for this simple, remember all indicators go back n-periods to make a calculation, in this particular case, the 7 period stochastics in the 15 min chart went back 8 candlesticks to complete its calculation (1.75 hours). The stochastics in the 4H chart also represent 8 candlesticks but those 21 candles represent around 1.5 days worth of data. The market conditions are completely different during those periods.
Obviously, it is better to trade when many timeframes indicate the same market condition (i.e. both, the 15 min and the 4H chart indicate an oversold condition). When this happens, the probability of success of the given signal increases enormously.
Is important to realize that the longer the timeframe the more impact it will have in the market. For instance, an oversold condition in the 4H chart is more important than an overbought condition in the 15 min chart. More important because the “signaled market condition” will last for a greater time in longer time frames than in the shorter time frames.
Which timeframe should I use?
When trying to decide which timeframe to trade in we must take in consideration two important factors: the time dedicated to your trading and your personality.
How much time a day/week are we going to dedicate to our trading? Obviously if you have a day job and do not have the possibility to monitor your trades, then it would be better to focus on the 4H or 1H chart, and even daily charts can work out. If there is a possibility to monitor your trades then you can use the 30 min charts.
On the other hand, if you are a full time trader, then you have the possibility to trade shorter timeframes such as the 5 or 15 min charts.
However, we must almost consider that when you are a full time trader there is a chance that trading shorter timeframes does not fit your personality. The same goes for traders with a day job, there is a possibility that trading the longer term just will not work. I have a friend who started trading the FX market using the 1min chart. His trading wasn’t going the way he expected so he moved to the 15 min, then to the 30 min and finally to the 1H charts, where he felt most comfortable trading (and of course profits also increased).
So to summarize, you should use the time frames that better fit your personality and time requirements, and the best way to know which one fits you better is by trading as many time frames as possible, then choose the one you felt most comfortable with.
Summary Report
Ok, now that you have read the lesson material and taken the quiz, please make sure you completely understand and/or do the following:
- Review each technical indicator, put them in your charts and identify which indicator or indicators you feel more comfortable trading with, try different indicators and remember each one of them could be used in different ways, some for trend identification, trigger signal, etc. This exercise is important because you will probably be using one or two of them (trade confirmation, or trend identification, etc) when developing your system.
- It’s also very important to understand all aspects of technical indicators and what must be considered in their use (please refer to section 11).
- Identify the relationship between timeframes.
I know this lesson is probably the largest and most technical of all, so you are going to need more time here (2 or 3 days) to complete the job. It is important you do it thoroughly and comprehensively!
Good luck!
