Introduction – Why Trade Forex?
Basically, there are two types of investors in the world. There are investors who primarily like to invest in foreign exchange market and then there are people who would rather prefer the stock market. If you search online, there has been a never-ending debate between the advantages and disadvantages of both these trading markets. The fact of the matter is that both are popular trading markets and hundreds of millions of people take part in both these market activities worldwide. At the same time, however, foreign exchange trade is usually considered to be more profitable by many investors. There are various reasons behind this claim and some of the important points are discussed below.
Forex trading is undoubtedly a highly profitable option. One of the core reasons lies in the simplicity of foreign exchange trading. In the stock market, traders can have many hundreds and even thousands of options to choose from. Presence of thousands of options makes decision-making slower and technical analysis more difficult.
On the other hand, there are only a handful small number of currency pairs to choose in Forex, such as EUR/USD or GBP/USD. All the currency pairs are in fact combinations of basic 7 currency pairs. Hence, any developments may be easier to follow and analysis becomes sound which ultimately leads to better decision making.
Round the Clock
Secondly, round the clock trading practice makes Forex trading more attractive trading market. Forex markets operate 24 hours and this is one of the most important and well-known advantage of this market. The fact is often deemed unimportant or neglected by the supporters of stock market. In reality, however, it can have huge potential implications for Forex investors. With the exception of weekends, there is no gap between the actual events taking place and their information being spread.
A devoted Forex trader would quickly know about the latest happenings and he or she can make better informed and more-timely decisions. This means reduction of risk and more profits by better decision making and minimizing risks.
On the other hand, less working hours in stock market may delay the decisions and the opportunity to exploit any latest information may be lost. Therefore, stock market can be riskier without providing any additional profitable benefit.
High Costs in Stock Market
It is one of the simplest rules of any business that high costs reduce profit. This factor is often neglected in the discussion of Forex VS Stock trading; however it can be a very crucial factor. The overall cost of trading in stock market includes commission of stock brokers, their spread and fees paid to the stock exchange. On the other hand, the only cost is in Forex market is the spread paid to broker as their fees. A detailed comparison of these costs would show that even if stock trading becomes profitable at some point, the overall cost is likely to considerably reduce the extra profit. Whereas no huge cost involved in Forex trading, hence improving the overall profit.
Leverage is another important concept in context of both Forex and stock trading. There is a huge difference between the leverages in both these trading. The leverage is usually much higher in Forex trading if compared with stock trading. Leverage of 2:1 provided in the stock market is much less than the leverage of 100:1 provided in the Forex market.
These are usually the common leverages and may vary in different situations but Forex will also provide higher leverage. While it may not be directly related to profit maximization, it is still considered as an important advantage of foreign exchange trading.
Level of Risk Involved
Stock trading is obviously more risky than foreign currency trading. Price fluctuations are very minimal in currency rates and while it reduces the margin per unit of currency, it also reduces the risk of potential loss. Investors can easily increase their profit by buying large quantities of currency stocks. On the other hand, stock market is prone to rapid change in prices and huge fluctuations. Such fluctuations can result in huge losses. While there is also an opportunity to earn substantial profits, it is very rare in reality. Only the most educated investors with better luck along with appropriate technical analysis and calculated decision-making are usually able to take advantage of such favorable events.
Above were some of the important points which make Forex an attractive trading market for worldwide traders and investors. Trading is foreign exchange market is simpler, less costly, highly flexible and less risky. A huge portion of experts, commentators and investors also believe Forex to be better profitable due to these (and few other) obvious reasons.
However, the choice of either of these trading options can depend on personal preferences, individual circumstances and risk appetite.
Chapter 1: What Is Forex?
- Transactions between market participants do not occur in one exchange trade office, but instead, transactions occur globally and directly between them. This is the reason why there is no true volume information available for the Forex market, there are so many places where currencies are traded thus it is not possible to identify the real volume that takes place.
- The Forex market is opened 24 hours per day during the working days of the week. It opens the week late Sunday and closes the week late Friday European time. The reason that 24-hour trading is possible is because it is a decentralized marketplace. If the banks in New York are closed, no problem, the banks in Sydney and Tokyo are open so you can trade with them.
All of us are in some way part of this huge currency market. Whether you are going to a vacation in another country, or you are buying something from abroad you are participating in this market because you need the other country’s currency. You can see from here how currency fluctuations can have important implications on the life of the general population. If the domestic currency loses value for example, then sooner or later imported products will become more expensive.
Big international companies also can have issues with currency fluctuations as they conduct a lot of business with partners from foreign lands. There are many famous cases where corporations lost billions because of currency fluctuations. To eliminate such risks, corporation hedge currencies in the futures market, which is a way to agree on a price for an asset ahead of time thus the spot price of the asset doesn’t matter. Mismanaging currency risks has the potential to bankrupt a business.
The foreign exchange market is the most liquid financial market in the world, a lot bigger than the stock or any other financial market. It is an attractive opportunity to profit for many investors. Some of the biggest participants in Forex market include:
- Central banks аim to provide a stable currency and economy. They have huge financial power as they are the masters of the money that circulate in the economy. They control the printing press for the currency and if the conditions require they can print as much money as they need.
- Retail banks are the marketplace for the Forex market, also called the interbank market. Transactions occur between them, they profit on the spread, but will also speculate when they spot an opportunity to make money.
- Investment companies like hedge funds and to some extend mutual funds also have huge capital under their disposal and as such can be big market drivers. Their only goal is the same as that of the retail trader, which is to make profits on price fluctuations. Hedge funds are also widely known as the most aggressive speculators in financial markets.
- Retail traders seldom are important market players in Forex, though a flood of small orders in the same price area can cause sharp moves on a currency pair.
To analyze financial markets there are two most famous ways and they are also used for Forex. Those are technical and fundamental analysis.
- Technical analysts look at charts of a currency pair and they only focus on the price and the formations on the chart that price has drawn. Through those so-called “price patterns”, the traders aim to determine his entry and exit levels for a trade.
- Fundamental analysts look at economic reports and other events that can impact the market like politics. In the case of currencies following the state of the economy of the currency’s country is the main task for fundamental traders. Major market moving reports for the Forex market include employment, GDP, inflation, PMI, retail sales, etc.
In the past 10 – 15 years, Forex trading has become easily accessible to the retail trader and many do jump on the opportunity to profit from the everyday price fluctuations. For new traders it’s important they make sure that they know the risks of trading Forex and they understand how the Forex market works. Nothing can beat good education and the time spent to learn to better analyze and profit from the Forex market is time well spent. In the long term, continued education pays off.
Chapter 2: Spread, Swap & Market Hours
What Is Spread
The spread is the basic way that brokers make money from providing financial services, and the spread is the main cost for traders. Every Forex pair has a buy and sell price listed on the broker’s platform and the difference between those two is the spread.
For example, if on EUR/USD the listed bid (sell) price is 1.1302 and the ask (buy) price is 1.1304. Then, the difference is 2 pips. Therefore, the spread is two pips. This is the cost that the trader will pay on the opening of any new position on the pair. Spreads vary greatly between different brokers and different pairs. Forex brokers offer fixed and variable spreads.
What Is An Overnight Swap Rate
As the name suggests, the overnight swap rate is a fee that is paid for positions held overnight, after New York’s close. Usually, the traders pay this fee, but sometimes even brokers pay to the traders. Who pays the fee depends on the base interest rates of the currencies which are set by their respective central banks.
To better illustrate this, we will take a Forex pair with one currency with a very low interest rate Euro (0.0%) and the other with a high interest rate like the New Zealand dollar (2.25%). If the trader buys EURNZD (long Euro), then he will pay a fee to the broker because the Euro has a lower interest rate then the NZD. If he sells the pair (long NZD) then the broker will pay a fee to the trader. Note here, that for the same pair, the fee that the broker pays to the trader is smaller than the fee that the trader pays to the broker.
Forex Market Hours
The Forex market is opened 24 hours a day, Monday to Friday. However, it doesn’t necessarily mean that you will get the same opportunities by trading at any time. In fact, there is a widespread belief that better trading opportunities exist during the most active time of the market, which are the London and New York sessions, and especially the overlap of those 2 sessions.
On the other hand, trading during the Asian session (also called Tokyo and Sydney sessions) is considered less attractive.
Chapter 3: Leverage, Margin, Lot & Pip
Aside from the stop loss a big role in risk management also have leverage, margin, lot size, and pip value. Understanding them well and how different combinations between them can have very different implications for your account is absolutely critical for your long term success in Forex trading. Let’s get into each and explain them:
Margin and leverage are always tied to each other, you can’t have one without the other.
Leverage in Forex trading refers to the option traders have to borrow money from the broker in order to open positions. Usually, brokers offer several hundred times borrowed money than what the trader has to put in the position which is known as the margin. For example with a 500:1 leverage the trader can open a position of 1 lot ($100,000) with just $200 of his own money. The other $99,800 are borrowed from the broker.
The $200 that the trader must have in order to open a position of 1 lot is called the margin, and the other $99 800 are the leverage on the margin, 200 * 500 = $100,000.
Leverage is known as the notorious killer of Forex traders, and because of this it is restricted in some countries, for example in the USA Forex brokers can provide a maximum of 50:1 leverage to their customers. Now, the truth is that really leverage by itself can not harm you. It is not understanding how to use it correctly that really does the damage to traders. It’s critical to understand that leverage works against you as much as it works for you.
A margin call is something that you don’t want to have in your trading career. It basically means you’ve lost a lot of money and in some cases of very high leverage it can mean you’ve lost all the money in your account.
To better understand how a margin call occurs, first, let’s see what is free margin. To use our example above, let’s say that the trader has a $1,000 in his account. With his position of 1 lot and a margin of $200 he has $800 free for other trades, which is known as the free margin.
Free margin is important because you only get a margin call when your free margin reaches 0, at which point your broker automatically closes some or all of your open positions. After this, you are left with only as much money as your used margin was.
So, free margin is calculated by subtracting the used margin from the account equity, not the account balance, although it may seem more natural. In this regard, you can see how your equity has to be dropping in order to receive a margin call. If your trades are profitable you will not receive a margin call. However, by using very large leverage even with a very small market move you can receive a margin call because the leverage will multiply your losses.
The lot size determines how much money you put at stake in each trade. Most commonly forex brokers offer 3 types of lot sizes to trade with.
• 1 lot = 100,000 units of the base currency
• 1 mini lot = 0.1 lot = 10,000 units of the base currency
• 1 micro lot = 0.01 lot = 1,000 units of the base currency
Sometimes you may also find nano lots:
• 1 nano lot = 0.001 lot = 100 units of the base currency
The base currency is always the fist quoted currency, for example for EURUSD the base currency is the EUR and in the case of GBPCHF, the base currency is the GBP. This is good to know because you are always opening your positions in the base currency, thus, any profits or losses you incur are calculated in the base currency.
So, depending on which type of lot you use you will be exposing your account to a different magnitude of risk.
Pip value is another thing to keep an eye on. Most traders don’t understand this correctly, and it can be confusing, but basically what you need to know is that each currency pair has its own pip value which is calculated by the quoted currency, or the second one in the quotation like the dollar in EURUSD, GBPUSD, and AUDUSD.
For pairs where the greenback is the quoted currency, the pip value is always $1. However for other pairs with a different quoted currency, the pip value is calculated in that currency. For example for EURGBP, the pip value is calculated in GBP and for the size of 1 standard lot, the pip value will be 10 GBP.
Chapter 4: Basics Of Risk & Money Management
If you have some experience with trading or maybe other ways of financial investing, you have probably heard that risk management is one of the most important ingredients to long-term sustainable profits.
Placing a protective stop loss order on all of your trades is critical to whether or not you will ultimately succeed in Forex trading, especially in the beginning of your trading journey.
Sometimes in the market, there can be sudden sharp moves in one or both directions. Not using a stop loss in such extreme cases literally exposes you to lose all or a huge part of your invested capital. In contrast, always using a stop loss generally accounts for early exits on losing positions, and the trader loses much less in the end than if he didn’t use a stop at all.
Now, let’s look at two ways traders generally use to place stops.
A not so good way to decide the size of your stop loss is having a fixed pip stop loss, that is using the same predefined number of pips as the size of the stop loss. This is seldom a good strategy to place a protective stop because it’s not based on anything other than your willingness to risk a certain amount of money or your pain threshold. Trading according to your emotions is always wrong and the same is true for stop placing because the market doesn’t care what you feel and how much you are prepared to lose. Instead, it will always go where it wants to and by how many pips it wants to. You can not affect the market in any way, therefore knowing this you can see that using a fixed stop simply doesn’t make much sense because it’s based on YOU rather than the MARKET.
In contrast, a much better strategy is to always consider your POSITION SIZE before taking a trade. Your position size for each trade should be determined based on the size of the stop loss that your strategy suggest is appropriate.
As an example, consider a trade according to your trading strategy where the size of your stop loss should be 50 pips and on different trade the stop loss should be 100 pips. This automatically means that on the second trade your risk is twice as big compared to the risk of the first trade. To make the risks equal for both trades you carefully use position size to adjust for the risks determined by the market environment. In this case, if you entered the first trade with 0.5 lots, then for the second trade the appropriate position size for you is 0.25 lots.
Position sizing is the ultimate biggest factor that determines your risk with every trade. Understanding all the implications of increasing a position’s size is crucial to correctly understand the risks you are involving yourself with. Just to illustrate with an example, consider you have one opened trade in your account with a position size of 1 lot. A size of 1 lot usually translates to a 10 dollar value for every one pip move in the market. This means that a 100 pips move will equal a $1000 loss or gain in your account only because of this one trade.
On the other hand, consider you have 10 opened trades in your account all with a position size of 0.1 lots. Although this is a much more flexible strategy than having everything in one basket, you are holding a total market exposure of 1 lot.
Finally, the risk:reward ratio is the last piece that determines your risks when trading forex. In essence, it poses the question of how much is your possible gain on the trade, and is it worth risking a certain amount of money to have the possibility to win the gain?
Most often it is recommended to have at least a 1:2 or sometimes a 1:1 risk-reward on any one of your trades. Of course, the higher the reward compared to the risk the better it gets. Risking as much as you may gain, or a 1:1 risk:reward ratio is absolutely the bare minimum for taking a trade. Always be careful to consider the risk-reward of each trade before you TAKE the trade, or otherwise, you may find yourself in a trade where you are risking more to gain less which is both unprofitable and ultimately stupid.
Now, keep in mind that as you develop your trading skills and you gain more experience, depending on market conditions you will likely be able to judge which trades are higher probability than others and thus sometimes you will be sure in taking trades with a 1:1 risk-reward ratio and other times you will be reluctant in taking a trade with a 1:3 risk-reward ratio.
Chapter 5: Candlestick Patterns
If you are reading this article, you surely know about most of the basic concepts related to foreign exchange trading. Basic knowledge can be very helpful in understanding candlestick patterns. These patterns can form an integral part of overall technical analysis and are used to predict future market movements. A candlestick chart is used to graphically depict the current price movements for a particular period of time and to show the future movements as well. The history of use of candlestick patterns can be traced back to late 18th century.
Candlestick patterns are obviously important tool to have in your arsenal for successful trading. However, precaution should be taken as the patterns can be very subjective. This is because of the fact that candlestick patterns fundamentally rely on predefined set of rules. Currently, at least 40 different such patterns are recognized and these patterns can range from very simple patterns to fundamentally complex patterns. Appropriate and careful selection of particular candlestick patterns are shown to have extraordinary favorable results. Big Black Candle, Three Black Crows, Long Legged Doji, Engulfing Bullish Line, Engulfing Bearish Line and Three White Soldiers are some of the famous candlestick patterns. Some of these patterns are further discussed below. However, before we move any further, it should be noted here that all of the candlestick patterns work well in their particular context of surrounding and limitations, including certain time limitations.
Before we go any further, let us incorporate the concept of price action trading, previously discussed in another article. Price action trading is known to increase the overall profitability of trade and is closely related with the concept of candlestick patterns.
First of all, we are going to discuss the pin bar price action pattern. Pin bar is specifically known to be highly accurate in trending markets. It has an obvious long tail and it may look like Pinocchio’s nose. Pin bars at certain support and resistance levels are often considered to be most accurate. Two simple and easy rules are often recommended in order to maximize one’s profit. Always buy above bullish pin bar (rejected support level) and sell below bearish pin bar (rejected resistance level).
Like pin bar and inside bar, fakey bar can also be an important part of price action strategy. In any market, rejection of any important level can be easily indicated with the help of fakey bar. It is a common observation that market often seems to move in a single direction for a certain period of time and then suddenly reverses back. Such a situation can wipe out all market amateurs, leaving some experienced professionals with large sums of money. The fakey bar setup can be used to set off big and important moves in a foreign exchange market.
Another important tool is the inside bar. It can be used as a trend continuation signal as well as an important turning point signal. As a beginner, a trader should focus on its use as a continuation signal as other uses can be more sophisticated. Inside bars are most effective in daily as well as weekly charts and are often famous for minimizing risks and maximizing reward. Inside bars should not be used in any time frame less than a single day. In its graphical representation, an inside bar usually stays within the range of its immediate earlier bar. It can also be explained in these words that the second bar is likely to have a higher low and a lower high. Inside bar can be a great tool but it must be used with reasonable care. It is often recommended to place only a single order (sell or buy) according to the prevailing trend.
Another important term related to this topic includes bullish engulfing and bearish engulfing. A bullish engulfing pattern is formed when a large bullish candlestick follows a small bearish candlestick. The small candlestick has small shadow (or tail), allowing the larger candlestick to cover the previous day’s entire candlestick. On the other hand, bearish engulfing pattern is the opposite. A large bearish candlestick follows a shorter bullish candlestick.
Bullish engulfing pattern usually means a declining security trend. It is recommended to take account of preceding and the following day’s price into consideration in order to make decisions. On the other hand, Bearish engulfing pattern suggests that bears are in control of the security. What it means is that an uptrend and peak is expected. However, similar recommendation of considering preceding and following day’s price is still applicable.
Both these engulfing patterns are seen with skepticism but these patterns have survived over the centuries and have helped millions of investors in making better decisions and trades. These candlestick patterns are specifically popular in Japan and many Japanese traders consider them as the most convincing tool when it comes to statistical analysis.
Chapter 6: Chart Patterns
Just like any other venture, various tools are available in order to successfully trade in any foreign exchange market. However, chart patterns are considered as one of the most important and fundamental tool for every potential investor in this market. Chart patterns can be compared with land mine detectors just to make things funny as both are crucial in spotting explosions before they actually happen. Movements are spotted before they actually happen with the help of various chart patterns. It saves investors from likely explosions and helps them in maximizing their profit.
Real life Forex market condition can depend on various different factors and predicting future with 100% accuracy is usually not possible. At the same time, however, chart patterns are widely considered to be relatively accurate indicators. One of the important things these patterns do is to help understand whether the current price trends will carry on in the same direction or whether the trends would reverse.
The importance of chart patterns cannot be neglected but care must be taken when choosing any particular pattern. An appropriate choice of chart pattern can save considerable amount of time and effort and can provide better results. Double Top, Double Bottom and Head and Shoulders are often the most common chart patterns and are discussed below.
It is an important part of an investor’s overall technical analysis of the market. At the most basic level, it helps in identifying a trend’s rise and the drop which follows and another rise and another drop at the same level. A double top pattern can be indicated at the upward trend peaks. It can be used as an important indicator as it implies a weakening upward trend. Moreover, it shows that buyers have lost interest. The trend is then reversed once the double top pattern is completed.
In its graphical representation, a double top pattern may look like the letter “M”. Resistance level is considered at the two upper point of this “M”. The double top pattern is usually completed in two stages. During an upward trend, a new high is created in the first stage. At its peak, it faces resistance and ultimately reaches a support level. In the next stage, price moves towards the resistance level once again, similar to the previous stage. The same process is repeated as price once again sells off to support level.
Finally, the price of the security breaks down and falls below the support level; hence completing the pattern.
Understanding of the double bottom pattern is closely related to the knowledge of double top pattern (discussed earlier). In fact, both are considered to be opposite to each other. The double bottom chart pattern indicates a downtrend reversal and forms a “W” like shape on chart.
As opposed to the double top pattern, a new low price movement in a downtrend makes the double bottom chart pattern. Support level is ultimately found by the downward move. It no longer moves further downward from this point and instead it will go on to find a new high level. At this new high, the security finds resistance and once again starts a downwards journey going back to its previous low. The two bottom points of “W” indicate the two support levels. The pattern is considered to be completed once the security moves above the resistance level.
Many rules associated with double bottom can also be applicable in the double top chart pattern and vice versa.
Head & Shoulders
Head & shoulders is another commonly used chart pattern in Forex trading. Working of the head & shoulders chart pattern can be described in three steps. In the first step, price reaches a peak and then declines. In the second step, the price rises again to a new (and higher) peak and ultimately declines. Finally in the third and the last step, the price rises once more (below the previous peak) and then declines to complete the chart pattern. Hence, the second peak is the highest; while first and third peaks remain below this peak. The middle (second) peak is called the head; whereas the other two peaks (first and third) are called shoulders; hence completing the head and shoulders pattern on the chart.
Head and Shoulders pattern is one of those few chart patterns which are very easy to spot on various time frames. A potential trade should be planned beforehand. However, a trader must be patient in order for the pattern to complete. Broken neckline is usually the common entry point for trade.
No pattern can be perfect but the head and shoulders have shown relatively better results. However, it still cannot work at all times and precaution must be taken when making practical decisions. One of the most important tips is to wait for the pattern to fully develop.
Chapter 7: Support & Resistance
Understanding Support and Resistance is another essential Forex trading methods that helps you making a successful technical analysis using trading charts. Learn how to identify these major price levels, and you will know enough to build a good strategy to trade Forex.
Support is the important price area where demand starts to rise higher that it stops the value from further decline. It is the area where buyers consider joining market and starting buying.
Resistance is another level where supply begins to rise that it prevents the value from further growth. It is the area where sellers find the opportunity to enter market and sell heavily.
Ways to Find Horizontal Support and Resistance
There is no particular custom indicator to recognize of these values on trading charts. These two conditions could be recognized by several different ways on trading charts.
The most familiar condition is horizontal price value as support or resistance. You can recognize it just by looking into a price history on your chart and finding the level where the price stop its most significant moves.
Strength of These Technical Areas
Your chart could be based on different time-frame. You can make use of different time periods as you want, for example: 15 minutes, 30 minutes, 1 hour, weekly, and so. You can easy find these horizontal levels on any time-frame.
So, you must identify levels that are stronger and useful than others but of course it is very simple as well. Prices from a weekly time-frame are more significant than daily period, and these are stronger points than prices from a 15-minute intraday period used by short term day traders.
These Levels Can Be Broken
Nothing is forever. The same applies to Support and Resistance levels. Thus, any of these levels can be broken. However, such a break can be a great opportunity for executing a trade. Such break of these levels changes whole summary and view of traders and so it usually leads to huge liquidation of old positions and execution of new positions in market.
Keep in mind, these simple significant rules for your analysis and strategy:
- Broken support is the new resistance area
- Broken resistance is now the new support area
How to Trade Support and Resistance
Now that you are familiar with the basics of support and resistance, it is time to make use of these basic but very helpful technical tools in your trading. As we want to make things simple and easy to understand, we have divided the idea of trading support and resistance levels into two categories: the Bounce and the Break.
Now, we will learn how to trade support and resistance using the Bounce. As the name suggests, it is a technique of trading horizontal support and resistance levels just after the bounce.
A lot of retail Forex traders make the mistake of executing their orders straight on support and resistance areas and then simply wait for their trade to happen. This kind of method may work at times but in a long run, this kind of method supposes that a support or resistance level will grasp without price actually getting there yet.
You might be asking yourself, ‘Why don’t I simply set an entry order exactly on the line? This is how I am confident the best potential price’.
However, you must know that when playing the bounce with support and resistance you need to tilt the odds in your favor and identify some sort of confirmation that the support or resistance will hold.
Rather than buying or selling right off the bat, wait for it to bounce first before executing your trades. By doing this, you can easily avoid those moments when price changes very fast and break through support and resistance levels.
In Forex trading market, we could easily jump in and out whenever price hits those key support and resistance levels and generate enough profit. But, reality of the matter is that these levels break… frequently.
Therefore, it is not sufficient to just play bounces. You should also follow break points to identify the best opportunity to execute your trades.
In Forex trading, support and resistance method is a significant part of trends as it can be applied to help make trading decisions and recognize when a trend may be turning around. These levels can often facilitate a trader to determine when to enter market and make profits. Support and resistance levels are methods every trader that utilizes technical analysis should follow and observe. After practicing for some time, you will be able to identify possible forex support and resistance levels very easily.
Chapter 8: Trendlines & Channels
Trendlines and channels are very simple, yet very effective trading tools that really any trader should know how to properly use. Look around and you will see that all professional and successful traders use these 2 tools when making trading decisions. Deemed classic technical analysis, they are one of the oldest tools in use and have proven their value over so many years, and continue to do so, even in today’s ever-changing markets.
First things first, there can exist an upward, or bullish trendline, and a downward, or bearish trendline. An upward trendline is called support and a downward one is viewed as resistance.
Let’s talk about trendlines first:
The most basic definition of an upward trendline is a line that connects 2 swing lows on the chart. Conversely, for a downward trendline, it is a line that connects 2 swing highs. You can red more about this on EA Builder Review.
A swing low is a point on the chart, where the immediately preceding low and the immediately following low are higher than this point, marked with blue in the chart below.
A swing high is the reverse thing and is shown in orange in the chart.
Now, take any 2 swing lows or swing highs on the chart and connect them. There will be a simple trendline.
Note that you cannot connect a low and high to form a trendline. The line must connect a low with a low, or a high with a high.
Now, let’s talk about the more practical part. For a trendline to carry more significance, we need at least 3 points connected before we can considering it for a trade. And this is because of a simple rule in technical analysis:
The more times a trendline is touched the more significant it becomes, and the harder it is for the market to break it.
From experience, this is absolutely true.
And once such a strong trendline is broken, usually a nasty and sharp retracement follows.
But, just having a trendline that has been touched at least 3 times, does not mean we can jump into the market right away! Of course, we are going to look for confirmation from other signals like support/resistance levels and candlestick patterns before we take a trade.
On this GBPNZD chart above, you can see how you can find good entry points using trendlines in combination with prior support/resistance and candlestick patterns. The yellow circles are valid entry points for this trend. The stop would be placed below the low of the candlestick patterns. It’s really amazing how often reversals come with a candlestick pattern.
Now, what are channels?
They are just 2 parallel trendlines acting as both support and resistance.
Like in trendlines, there are upward (bullish) and downward (bearish) channels. The upper trendline is always acting as resistance and the lower trendline is always acting as support.
Channels, by definition, provide more information about the state of the market than trendlines alone do because when there is a channel, you automatically have a profit target as well as entry levels.
The other advantage that channels provide is that you do not have to wait for the second line to be touched 2 or 3 times. Once one of the trendlines has been established you can just draw a parallel line and that will be the valid trendline.
On the AUDUSD chart above, a downward channel is shown. Valid entry points are marked with yellow. On the left side of the chart, normally, there are no entry points because the channel setup was not established yet. After point 3, of the upper trendline, formed, we can draw the lower trendline from the swing low on the left.
Let’s look at the entry points:
Entry point A – A morning star candlestick pattern signals the reversal
Entry point B – An evening star candlestick pattern signals the end of the rally
Entry point C – A previous support zone is present, accompanied by a bullish piercing candlestick pattern
Entry point D – A previous resistance area is present. The reversal comes after a nice bearish engulfing candlestick pattern with a very long wick.
So, one of the goals of this article is to show you how much more successful your trading can be when a combination of signals, which are all pointing in the same direction, is present on the chart.
And lastly, go to your charts and look for trendlines and channels yourself. Test strategies, and combine signals to achieve higher probability trades. Always strive to improve your skills.
Chapter 9: Fibonacci
The Fibonacci levels are a very popular and successful technical trading tool, that is extensively applied in trading the currency market. Because of the very high liquidity of the Forex market, these Fibonacci levels work extremely well on all major currency pairs. Whole trading methods have been created based solely on these levels. There is one specific branch of Fibonacci analysis, called Harmonic Trading, which uses a combination of these ratios to form unique price patterns that give very high probability reversal signals.
The Fibonacci levels provide several important advantages like:
Revealing, in advance, where turning points may exist.
No need for previous support or resistance to exist, Fibonacci retracements and extensions can be calculated anywhere and anytime on the chart. All you need is to find a swing in the market, pull out the Fibonacci tool on your trading platform and it will draw your levels.
Multiple Fibonacci levels can be used to look for a confluence area.
So, what are these fascinating Fibonacci levels?
These are mathematical relationships or ratios, that exist literally everywhere around us. Most natural progressions and growth, occur in harmony with these Fibonacci relationships. They were named after the man who discovered them, genius 13th-century It
Fibonacci ratios that are used in trading are:
- Retracements: 0.146, 0.236, 0.382, 0.50, 0.618, 0.702, 0.764, 0.786, 0.886.
- Extensions: 1.128, 1.272, 1.382, 1.414, 1.618, 2.0, 2.24, 2.618, 3.14 (Pi), 3.618, 4.618
Note that, it is highly inconvenient to use all of them on the chart because that will completely confuse you. It is advisable for you to open up your charts and see which of these levels work best for you. Place them all on past price data and test them. Adapt them to your other trading strategies and choose the ones that help you to see the market clearer.
It is always a good idea to practise and backtest any strategy which you would want to execute on your live trading account.
However, keep in mind that out of all these levels that are listed, most significant ones for trading are:
- 0.382 or (38.2%) – A modest retracement, mainly found in trending markets. Usually, price will respect this level, even if it is just a quick pause in the move.
- 0.50 (50%) – Half way of a swing. Important psychological level.
- 0.618 (61.8%) – Somewhat deep retracement. This is the golden ratio – retracement level. Price will definitely respect it in some way, and even completely reverse from it.
- 1.618 (161.8%) – The golden ratio – extension level. It i most often used for determining where a market swing will end, usually looking for a good place to take profit.
- 2.618 (261.8%) – An extreme extension level. It is not used very often because the market rarely moves in such large swings.
So what are the most important and best ways to use Fibonacci ratios in your technical analysis?
If there is any general truth in technical analysis, it will be a confluence of signals which provides the best trading results. The more technical signals exist at the same level the better the chances are for you to make a profit.
Find out where classical support and resistance exist and see if any Fibonacci levels happen to be in the same area. If so, this is a much better trade than if only one of them was in place.
And this is true for fundamentals too. Always look for confirmation from as many indicators and sources as possible before deciding on taking a trade.
In this regard, you can also look for multiple Fibonacci levels converging in the same area. A single Fibonacci level can be significant, but when 2 or 3 converge in the same area that is surely more significant.
On the chart above, we have the AB downswing. We apply the Fibonacci tool with the retracement levels. See how the market respected, first, the 38.2% level by not closing above it. Then after taking it out, the market had trouble with the 50% level, before finally just touching the 61.8% level, and completely crushing down. Additionally, there is classic resistance, shown with the blue lines. This is just to show you how powerful are the Fibonacci levels, especially when combined with other tools, like support and resistance.
Lastly, understand that the Fibonacci levels alone are not a directional indicator, meaning they do not reveal which direction you should enter the market. You need to use other indicators for that purpose, or even better fundamental analysis. But, what it does show, is good levels which the market will have difficulty breaking, and where the chances of a trend reversal are higher.
Indicators are the vision mechanisms for traders and today we are going to look at 4 very important types of indicators. Each of them provides valuable information to traders that often has a direct impact on his/her output account balance.
Chapter 10: Types Of Indicators
Indicators are the vision mechanisms for traders and today we are going to look at 4 very important types of indicators. Each of them provides valuable information to traders that often has a direct impact on his/her output account balance.
If you are going to trade the Forex market, you need to have at least one good trend indicator that will provide you with information about the current trend in the market. Trading without a trend indicator would be similar to driving with your eyes closed hoping to stay on the road.
There are many trend indicators developed, most of which, will show you the direction of the trend (up or down) and the strength of that trend.
The most popular and the most used trend indicators are, unsurprisingly, Moving Averages (MA). Many variations of moving averages can be created. However, keep in mind that the ones that most professional traders pay attention to are the 50, 100 and 200-day moving averages. That means the moving averages are calculated based on daily closes on the daily chart. The basic implication behind these 3 is simple. If price is above the moving average then the trend is up and if price is below it then the trend is down.
Other very popular trend indicators include MACD, ADX and Parabolic SAR.
They are designed to measure the rate of change of price, or with other words the acceleration or deceleration of price.
The basic concept behind why they work is that price tends to accelerate at the beginning of a trend and they will decelerate towards the end of the trend, right before a reversal takes place. Momentum oscillators show this by flattening or turning before price changes direction.
The other things oscillators are used extensively for is:
- Determining overbought and oversold levels of a currency pair. An overbought oscillator indicates that a market top may be forming. Conversely, oversold levels on the indicator signals a market that is unlikely to continue moving further down. One very important thing to keep in mind is that oscillators are only Mathematical formulas derived from price and they do not reflect the real order flow from in market.
- Divergence between price and the oscillator. If the price makes a swing higher but the oscillator swing is lower than its previous swing high, then that is called bearish divergence and it indicates a market top. On the flipside, a bullish divergence is when price makes a lower swing and the indicator fails to do so.
Volume shows the number of orders for a given trading period. This can be used to interpret the size behind a move in the market. For this purpose, indicators derived from volume and price have been developed to make it easier for traders to understand all the data.
Volume and volume indicators are usually used as a confirmation tool because any price move on large volume is more likely to be a genuine move. Whereas a thin low liquidity market usually produces choppy small price moves, which are useless to technical traders.
Examples of volume indicators include the Price and Volume Trend, Chaikin Money Flow, the Klinger Volume Oscillator, Ease Of Movement and the Money Flow Index.
Volatility indicators are a very valuable component to any Forex trading strategy. It is crucial that you as a trader pay attention to volatility. Chart patterns and trading tactics work differently under different market volatility. Low and high volatility market environments require different position size management. Also, when deciding on the price level of your stop loss, you have to take volatility into account, because otherwise there is a higher chance to be stopped out in a fakeout.
So here are some good tools to help you judge volatility:
Bollinger bands are a wonderful trading tool because they indicate extremely well where price will trade for a given period. This can help you decide on where to enter and where to exit a trade. It also shows when price has reached an extreme level, thus you know whether it is a good time to enter a trade or it is better to hold on.
Average True Range (ATR) is a simple indicator that shows the average number of pips that a pair has moved. When the ATR is going up, it means that volatility is increasing and when the indicator is down then there is a so-called “quiet” market.
So try out the different types of indicators and see what works for you. It is always a sound strategy to learn and understand these indicators, and also, to be aware of the signals these indicators are generating.
Chapter 11: Divergence
Divergence is an important leading sign of a trend reversal. Highly accurate reversal signals can be generated in combination with other trading tools.
In technical analysis, the most common divergence used is that of price and one of the momentum oscillators (usually used are Stochastic, MACD or RSI).
When the price is making higher highs, in order for the move to be viewed as a genuine uptrend, it needs to be backed up by increasing bullish momentum, which is indicated by an oscillator that is also making higher highs. In a downtrend, it is just the opposite. Price makes lower lows and the momentum oscillator should do the same.
The price and momentum oscillators will usually mimic each other and normally are moving in the same direction. Thus, we generally have a convergence of price and momentum oscillators.
A divergence, on the other hand, occurs when price makes a higher swing, but the momentum oscillator fails to do the same and instead stays flat or even turns down. This indicates that the last swing high of the uptrend didnâ€™t have the same strong momentum as before and this, in turn, is seen as a sign of weakness in the ongoing trend. This is called normal, or regular divergence.
In the first purple circle, you can see how price made a lower low, but the Stochastic oscillator failed to make a lower low, and instead made a higher low (shown with the upward blue line). This is a classic bullish divergence and in this case, it was accompanied by support from the previous low. When a combination like this occurs, the chances of a price reversal are significantly increased.
In the second purple circle, the opposite, a bearish divergence is shown. Here, price managed to make a higher swing high, but the oscillator’s reading made a lower high. As you can see price reversed from here as well.
Another, trickier, less known type of divergence is hidden divergence. This is, in a way, the opposite of regular divergence. It occurs when the oscillator makes a higher high and price makes a lower high. However, the difference is, in that, unlike regular divergence, hidden divergence is a signal for trend continuation instead of a trend reversal.
On this EUR/USD chart above, you can see how hidden bullish divergence can be a sign of trend continuation. In the first case on the left, the price was in an uptrend and then started to retrace down, finishing at point 2. This retracement was small, however, the Stochastic oscillator made a lower low on this swing low than the low at point 1. This is marked with the declining navy-blue line. The divergence between the oscillator and price was a sign that the uptrend will make another swing higher.
In the second case on the right, hidden bearish divergence signalled the continuation of the new downtrend. Price slowly declined, making lower highs, but the oscillator raised higher than the first high, at point 1. This was a good opportunity to sell the pair.
How To Trade Divergence
As we said, in the beginning, you can use any momentum oscillator to spot divergences. It is best to use one that you are comfortable with and works best for you. If do not have a favorite oscillator yet, try the 3 most popular oscillators (MACD, Stochastic and RSI).
The most important thing you need to be aware of is, that, like everything in trading, a divergence signal is not correct a 100% of the time. In fact, whenever you spot a divergence on the chart, you must have confirmation from other signals or tools before entering a trade. That is why you need to analyze your charts in context and look at the bigger picture. Check what is happening on the higher timeframes. Is divergence occurring at a support or resistance zone? Is a strong Fibonacci level nearby? Any confirmation signal will increase the probabilities for a profitable trade.
Another way to confirm the trade is to wait for the oscillator lines to crossover (does not apply for RSI). If you spot a bullish divergence with the MACD for example, you do not have to enter immediately but instead, wait for the MACD lines to crossover to the upside, and then enter. The downside of this method is that you will enter a little later and part of the profits will be left on the table.
So, go on and practice your newly learned skills to strengthen and solidify them. As with all skills, here too, practice makes perfect.
Chapter 12: Forex Strategies
Like in any business, to succeed in Forex trading you need to implement successful strategies. Many Forex strategies exist today, some of them are bad, some are mediocre and a lot of them are good. The key is finding strategies that are in line with your own goals and personality and therefore because it will suit your trading style, you will take the maximum advantage out of them.
Now, let’s look at three Forex trading strategies that have historically proven to be successful.
Range trading is a strategy which traders use to exploit the periods in the market when price oscillates between two points, where the lower one is known as support and the upper point is called resistance. Most often, range trading refers to a horizontal box range. However, this doesn’t necessarily have to be the case. Range trading strategies can be used in any shape that is clearly enclosed by a support and by a resistance line.
It’s a fact that the Forex market spends 70% to 80% of the time trading in ranges. Hence, the large number of opportunities to profit from such trading strategies.
The basic logic behind most of the range trading strategies is that you buy the Forex pair at the support level and you sell it at the resistance level. The more additional signals confirm the trade at those critical support or resistance levels, the better it is. Because more trading signals pointing in the same direction mean a higher probability of making a winning trade.
Some general principles to keep in mind when trying to range trade the market:
- The overbought/oversold indicators like the Stochastic, RSI and Bolinger Bands have proven to work much better in a ranging market environment than a trending market. Hence, it’s advised that you make full use of such indicators during those times the market spends in a range and avoid them during strong trends.
- On the flipside, trend indicators like moving averages and the MACD give a lot of false signals when the market is not trending, so it’s recommended to ignore their signals when using a range trading strategy.
Breakout trading is a strategy that can be used in times after the price breaks out of a tightly constrained range. Here traders assume that the price will continue to move in the direction of the breakout, however, this doesn’t happen in a straight line and very often false breakouts occur. In fact, as much as 50% of the time, the initial direction of the breakout turns out to be the wrong direction in the end.
Luckily there are some reliable ways to avoid getting tricked in a false breakout:
- As a basic way to confirm a true breakout, look for price to close outside of the range. So, if the range is on the daily chart then wait for the daily candle (bar) to close outside of the range.
- An even better way to trade a breakout is to wait for the price to retrace back to the border of the range and retest it. An additional benefit of this strategy is that you get to use a very tight stop. You might be surprised but very often exactly this happens, and in fact most of the true breakouts come after a retest of the range. It’s really a highly reliable way to trade breakouts, tremendously reducing the chances of being trapped in a false breakout.
Fakey trading is a strategy, or more precisely a chart pattern, by which traders take advantage of a specific kind of fake breakout. These false breakouts are very often designed to trick ordinary, retail traders into taking the wrong side of the trade. With the fakey pattern, the ordinary trader has a way to combat these deliberately created, false scenarios and use them to his advantage instead.
The fakey pattern can occur only after an inside bar, or a series of inside bars, have formed. Then, the price needs to break out of the large candle (known as the mother bar) range. For the fakey pattern to complete, it’s required that the price fails to close outside of the mother bar range and instead it returns inside of it. Once it does so, a signal is generated to enter the market in the opposite direction than that of the breakout.
- It’s advised to look for the fakey pattern on higher timeframes, like the daily and weekly, simply because it’s much more reliable.
- Like with all technical analysis, more signals converging in the same area mean a higher probability of success. Look for the fakey pattern near key support or resistance zones.
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