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Forex is driven by global interest rates, politics, and economic cycles. Consequently, currencies trend over long periods of time, making trend lines particularly relevant.
Draw a line between at least two high points, or two low points, and you have a trend line. What could be easier? Horizontal trend lines provide particularly valuable insight into support and resistance levels.
Support is the price at which buying pressure is greater than selling pressure. Resistance is the price at which selling pressure outweighs buying pressure. When a market breaks above key resistance and holds, the bears liquidate and the market surges higher with considerable momentum. The old resistance becomes the support. Why? Because the bears who held out tend to liquidate as prices pullback toward their breakeven point. Meanwhile, the bulls add to positions at the entry point that previously proved profitable. Of course, the same hold true in reverse for support lines, which then become resistance when breached.
In Forex, Support and Resistance gravitates towards double-zero price levels (i.e. 122.00, 1.4900, 0.9400).
Moving Averages
Moving Averages are probably the most commonly used analysis tool of all. And moving average crossover systems are among the most common strategies. That said, if you’re going to employ moving averages be smart about it. Stay away from the numbers every Forex trader is looking at, like 18, 20, 50, 100 and 200. I’ve found the 22-day Exponential Moving Average particularly effective for Forex. So, that’s a good place to start.
A crossover system generates a buy or sell signal every time a short-term moving average crosses over a longer-term moving average… or some combination of multiple moving averages. The centerline of our Bollinger Bands is a 22-day EMA. Trying to incorporate additional short-term moving averages into the entry signals would probably just complicate matters. However, using a long-term MA as a trend filter may be beneficial. There are many systems that respect the 100-day MA and 200-day MA as an ultimate boundary… taking buy signals when above the long term MA, and sell signals when below.
Now, I’ll be first to agree that you should only trade a trend-following system in one direction at a time. Otherwise, the first time there’s a choppy trend reversal, you’ll find yourself getting whipsawed into a devastating string of losses. I don’t like to clutter my charts up with too many lines. So, I click over to weekly charts and make sure price is above the 22-week EMA, to take a long TD trade, and price is below the 22-week EMA to take a short TD trade.
Oscillators
Oscillators are designed to illustrate short-term market cycles of overbought and oversold conditions. In some markets, you can simply buy when the oscillator turns up from an oversold condition. And sell when the indicator turns down from an overbought condition. But this strategy really isn’t very reliable in Forex.
With Forex, you’re better off watching for a divergence between price trend and the indicator’s trend. When price continues to make new highs (lows) but the oscillator does not, this usually indicates the trend is weakening.
Relative Strength Index (RSI)
The RSI scales ranges from 0 to 100. Generally, values over 70 indicate overbought, and values below 30 are oversold. The internal calculation is a variation of 14-day EMA in which you average the Up-days and Down-days separately.
U = (Sum of Up-Day (close – open)) / 14
D = (Sum of Down-Day (open – close)) / 14
RS = U/D_
RSI = 100 – (100/(1+RS))
The resulting RSI is a smoothed momentum oscillator, less affected by “noise” in the market.
Stochastic
The Stochastic plots two lines, on a scale of 0-100, illustrating the rate of change in the daily CLOSE relative to the HIGH, and LOW. The concept being, as prices move higher, the daily closes will be closer to the high of the daily range, (vice versa in a down trend).
Three calculations are required: the Raw Value, %K, and %D (a smoothed 3-day moving average of %K). When the Raw Value and %K are plotted on the same chart, the result is “Fast Stochastic”, which shows many up and down swings in a very short period of time. When %K and %D are used, you have “Slow Stochastic”, which is smoother and eliminates numerous false signals.
Moving Average Convergence/Divergence (MACD)
The MACD indicator has two parts. The first part is comprised of the MACD itself, and a 9-day EMA of the MACD. To calculate the MACD, you simply find the difference between the 26-day EMA and the 12-day EMA. The second part is a histogram representing when the MACD was higher than its 9-day EMA and when it was lower. The histogram can give the trader a feel for the speed of price movement, and is therefore a popular way to gauge momentum.
Average Directional Index (ADX)
ADX measures the strength of an existing trend. Unlike oscillators, the ADX rises whenever a market is trending, either up or down. Once the ADX line climbs above 40 and then turns down, it’s a signal to take profits. While the ADX might signal the end of an existing trend, a move in the opposite direction is not necessarily predicted. Price might enter a consolidation phase. As ADX slips below 25 it’s a good time for range bound strategies. When ADX drops to 10 you can expect a breakout soon. ADX works well following a sideways period, but is unreliable after a “V” bottom or top, (common in Forex).
If price climbs and then falls off sharply, the higher and lower prices cancel each other out. As a result, there is a window of data for which ADX does not detect any net directional movement, causing the indicator to lag badly. Therefore, when there’s an abrupt trend reversal, the ADX line will continue to decline for quite some while, even though a significant new trend is underway.
Fibonacci Retracements and Extensions
Since prices are influenced by changes in mass human psychology, and humans are subject to the same rules that govern the universe, it seems logical to assume that market activity would fall under the same rule.
Hence the popularity of using Fibonacci numbers to anticipate areas of support and resistance. The Fibonacci number series, discovered in the thirteenth-century by Leonardo Fibonacci, is created as follows: Start with the number 1 and then add the previous two numbers in the series to get the third number… 0+1=1, 1+1=2, 1+2=3, 2+3=5, 3+5=8, and so on.
The resulting series: 1,1,2,3,5,8,13,21,34,55,89,144, etcetera occurs throughout nature… ripples in a pond, spirals in a seashell, even flowers tend to have Fibonacci number of petals.
By the way, in Chinese Feng Shui, the number 8 is regarded as a wealth symbol. And in Forex the market often stalls after an 8-bar move. What happens next is even more intriguing. Once you get past the first 3 numbers, any Fibonacci number divided by the previous number in the sequence equals approximately 1.618, the Golden Number, or what the ancient Greeks calls Phi.
You’ll find the Golden Ratio pops up absolutely everywhere; take your hand for instance. The longest bone in your finger is 1.618 times longer than the middle bone and the middle bone is 1.618 times as long as the shortest bone. Same deal with your arms and legs. It is the inverse, and variations thereof, on which traders mostly rely… Divide any Fibonacci number into the previous number for the key Fibonacci ratio of .618. Before the Golden Ratio kicks in, we have 1 ÷ 2=.50, the final Fibonacci ratio for defining support – The Square Root of .618, which is .786, is also used, but to a lesser degree.
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