Introduction
Fundamental analysis and technical analysis are very different. Some people will stay loyal to either fundamental or technical analysis methods during their trading lives, but others dabble with both. As you already know, I am in this latter category. I will explain how I use technical analysis in my trading.
I do not intend to tell you the very basics, so you will need a grasp of these before you begin. It will be useful to have some knowledge of bar charts, candlestick charts and price patterns as I will be using these in my examples.
If you do not have this knowledge at present then there are hundreds, if not thousands, of books and websites that can give you a run-down of the basics of technical analysis. I recommend John Murphy’s website Stock Charts (stockcharts.com) and also Barbara Rockefeller’s Technical Analysis for Dummies, as both give great overviews.
Before we begin I’ll share with you my personal (and troubled) history with technical analysis. When I first started working in a foreign exchange dealing room grasping the fundamentals and trying to figure out what nonfarm payrolls meant for the dollar was more than enough for me to chew on. However, I was aware that there was a group of traders who didn’t really bother with fundamentals. They spent their days concentrating on prices and charts, charts and prices. Sometimes their trading strategies would do incredibly well. As a firm believer of learning from others, I asked them what they were doing, which turned out to be my first foray into technical analysis (TA).
I have to say, my initial look into TA didn’t last long. I couldn’t see the patterns that other practitioners could and to be honest I preferred fundamental analysis and the way it used real data, from real events, like central bank decisions, economic data releases, etc., to assess the market. I failed to read the TA books I was recommended and that was it for me and TA in the beginning – a short and confused relationship.
Back then I was working for BP, which traded huge amounts of foreign exchange, some with long time horizons. This type of time frame and flow is much more conducive to fundamental analysis in my opinion. It was not until I ventured into the retail forex market that I finally realised how essential technical analysis is to the retail trader.
A potted history
The modern form of technical analysis originates from Dow Theory – this isn’t some complicated trading theory or algorithm, rather it is derived from the writings of Charles Dow and his op-eds at the Wall Street Journal, the paper he founded.
Technical analysis is derived from Dow’s observations of looking at asset prices and seeing how things traded – essentially trying to find method in the madness of financial markets. He followed prices and felt that all the information you needed to know was recorded in the price of an asset. From the price you could determine if the market was bullish, bearish or neutral.
What started with Charles Dow now has hundreds of thousands, if not millions, of devoted followers across the world and if you type “technical analysis” into an internet search engine you get millions of results. Likewise, there are hundreds of thousands of videos on the internet telling you how to master technical analysis based on looking at charts and prices, and trying to define patterns, trend lines, triggers, etc. But since no two human beings see exactly the same things, technical analysis can be just as subjective as fundamental analysis.
The key thing to remember is that technical analysis is a huge field and anyone claiming to have mastered it and have the ultimate knowledge can’t be telling the truth. Like prices themselves, technical analysis is always evolving, so there is no end of the line for TA – if you practice it you are in a perpetual cycle of learning.
The dinner party explanation
Have you ever planned a dinner party menu based on what you have cooked before? The answer may be yes if you wanted your dinner party to be a success.
Let’s say that you have cooked tomato soup, roast lamb and apple pie many times, and have been pleased with the result. You have a dinner party coming up on Saturday and so you decide to do these dishes because:
Technical analysis is a bit like this. For some traders technical analysis can be a fail-safe way to trade the markets. Essentially, it is based on using past price data and patterns to predict future prices. Let’s substitute roast lamb for EURUSD to explain this in more detail.
You observe the price patterns of EURUSD over the last 12 months. You notice that this cross tends to rise or fall by 50 pips on a normal day when there are no economic data surprises or breaking news. Also it tends to respect certain levels like 1.3000 or 1.5000. These observations give you the confidence to trade EURUSD. So, just like at the dinner party, you use what you know has worked in the past to try and get the best possible future results.
This is illustrated in Figure 2.1, where the horizontal line indicates 1.3000. This can be a sticky level for EURUSD and you can see how the pair traded around this level for a prolonged period.
Figure 2.1: EURUSD with a resistance line at 1.3000
How to use TA
My chief aim when using technical analysis is to determine trends in the FX market. You may have heard that the trend is your friend – it is certainly mine. A trend is constant, it is unlikely to throw up surprises and if I am confident in the strength of the trend then it can help me to make profits.
Technical analysis helps me to find out all of these things, including when a trend is starting, when it is ending and how strong it is. Put together, this information should tell me whether or not I should trade with the trend.
To determine where a price will go next I need to know what the market is thinking: is it bullish or bearish on a currency, is the market changing its mind and will the trend change? Technical analysis helps me to answer these questions.
There are thousands of technical indicators that I could look at, but I prefer to limit the number of indictors that I use. Here is my personal technical analysis toolkit:
The first four are useful to determine direction; the last two are momentum indicators and can be useful in determining changes in trends.
I like these six indicators for two key reasons. Firstly, because I find them less subjective than other technical indicators, thus I have greater trust in the signals that they produce.
Secondly, these signals are popular and commonly used in the analysis of the forex market. Technical analysis is about knowing what the herd is thinking and where it might go next, so it’s important to use indicators that are widely used in order that I know what other traders are up to.
Charts
The best technical analysts that I know are very particular about their charts and how they look. To use technical analysis in your trading you need a good charting package. Check with your broker as they may offer one on their platforms, or alternatively there are also some very sophisticated charting packages that you can buy.
The first thing I do is ensure that the size of my chart is large enough to see chart patterns and price action. I put tool bars and anything else that gets in the way of the body of the chart to one side so that I get the largest possible area to look at the price action. I tend to put tool bars at the top of the chart, including time frames (so that I can toggle between them) and drawing tools, etc.
Next, choose if you are going to use bar, line or candlesticks for your chart. I tend to use candlesticks as I find they are the best way for me to see prices and there are some simple candlestick patterns that are extremely easy to spot. This is good for me, since I am not that adept at spotting some of the more complicated patterns.
I find that candlestick charts work best for hourly or daily charts. For shorter time periods they can be less effective. You will see that most of the charts I look at are hourly or daily time frames. Scalping and using 1, 5 and 10 minute charts is not for me as it requires a good deal of luck (which I find sometimes to be not that forthcoming when I trade).
The last thing to set up is indicators. Some, like Ichimoku clouds and moving averages sit in the body of the chart, others like the momentum indicators MACD and RSI have a chart of their own that sits directly below the main chart. These second charts can be fairly small in size so that they don’t compromise your view of the price action.
Figure 2.2 is an example of how my charts look on my desktop computer, mobile phone and laptop (they would also look like this on a tablet if I had one, but I don’t).
Figure 2.2: EURUSD daily: how my charts look with candlesticks, moving averages and MACD
Now it is time to move on to how I put my technical analysis toolkit to use. Rather than break this down into separate sections for each of the technical indicators, I use a series of real-life examples to show how I use the indicators in practice to try to trade with the trend.
Trading with trends
The whole point of my technical analysis is to try to spot trends. The most basic definition of an uptrend is when you get a series of higher highs and higher lows; the opposite is true for a downtrend. So that’s what I’m looking for.
If the market likes a currency and it is rising (the street calls this bullish) the currency is in an uptrend (see Figure 2.3), when it doesn’t like a currency and it is falling (bearish) the currency is in a downtrend (see Figure 2.4). Usually I want to buy strong currencies and sell weak ones – so buy into an uptrend and sell in a downtrend.
Figure 2.3: EURUSD in uptrend
Figure 2.4: EURUSD in downtrend
I will look at uptrends and downtrends in turn here.
Uptrend
Here are three methods I use to determine an uptrend:
1. Moving averages
Moving averages are used to smooth out price action as they show the average price over a certain time frame. Exponential moving averages and simple moving averages are the most popular and I use simple moving averages (SMAs) myself.
SMAs come in different time frames – I tend to look at 21, 55, 100 and 200 day SMAs. As I mentioned above technical analysis can be very subjective and this is definitely the case with SMAs; I originally chose to use these particular time frame SMAs because one of my old bosses did. They have worked for me so they have stuck.
In an uptrend the SMAs should be pointing upwards. If you want to trade a healthy uptrend then you should look for a nice, steady upward sloping moving average. This suggests a low volatility trend that you could trade.
But moving averages get really interesting when trends start to change. For example, if you see the short-term moving average cross above the long-term SMA then you should sit up and notice. Shorter-term moving averages are more reactionary to changes in market direction, so when the shorter-term SMA starts to move in a different direction to the longer-term SMA then it is a sign that things are changing for that currency pair.
At the start of an uptrend you should look out for the short-term SMA (say the 21-period or 55-period) crossing above the 200-period or 100-period SMA. Looking at Figure 2.5, when the 21-day SMA crossed over the 55-day SMA in August it marked the low for this pair.
Figure 2.5: EURUSD daily with moving averages
2. Ichimoku clouds
The Ichimoku cloud technique was devised by a Japanese business journalist in the 1960s. It is particularly useful when trading the yen. It is also based on the principles of moving averages, except rather than using single lines it defines areas known as clouds that determine if a currency is in an uptrend or a downtrend.
This is one of my favourite indicators because its signals are so simple to read: anything above the cloud is a technical uptrend, while anything below the cloud is a technical downtrend. Figure 2.6 shows USDJPY attempting to break above the cloud for the first time in six months (circled area). This is a significant break and could be the start of a powerful uptrend.
Figure 2.6: USDJPY – the price action is above the cloud, indicating the start of an uptrend
3. Chart patterns
There are literally thousands of chart patterns in technical analysis. Unless you have a photographic memory then you don’t stand much chance of remembering them all and spotting them in time to jump on the back of a new trend. I find it best to master a few patterns that will help me to determine if the market is in, or is about to embark on, a trend. Hence when it comes to pattern analysis I stick firstly to patterns I can recognise easily and secondly reversal and continuation patterns, as these tend to be the most accurate in my opinion.
Inverted hammer
In an uptrend, the first pattern I am looking for is called the inverted hammer. This is very easy to spot as the candlestick has a small lower body and a long upper wick. It shows that the bears may be starting to tire and there is some buying interest in the market to push the cross higher. It suggests that the bulls are rising out of their slumber and are about to take control of the bears. It is typically associated with the end of a downtrend and the start of an uptrend.
The inverted hammer pattern is a signal that the downtrend may be about to end, but it does not mean that the market will turn at that moment. As you can see in Figure 2.7, it took about two weeks for the market to decisively break out of the downtrend and start on a trajectory higher after the inverted hammer pattern occurred (circled area).
Figure 2.7: EURUSD: inverted hammer pattern signalling the end of the downtrend
Bullish engulfing candle
Another key pattern that indicates a shift to an uptrend is the bullish engulfing candle. As shown in Figure 2.8, it is a series of two candles – the first candle is negative, and the second candle is positive and completely engulfs the first.
The second candle opened lower than the first, but it closed higher, suggesting that the battle between the bulls and the bears was decisively won by the bulls; this is another sign that a downtrend could be weakening.
Figure 2.8: EURUSD: bullish engulfing candlestick
Downtrend
Most of the indicators that can be used to spot an uptrend can be used in reverse to signify a downtrend. For example, when a price falls below the Ichimoku cloud that signifies a downtrend. Likewise, there are a couple of chart patterns that also signify the end of an uptrend. One of my favourites is the tweezer top.
Tweezer top
The tweezer top looks just like (yep, you have guessed it) a pair of tweezers, with two identical sized candles with small upper wicks. This suggests that a near-term top has been put in place and the price may be headed lower from there. Figure 2.9 shows an instance where a tweezer top signalled a top in the price of EURUSD.
Figure 2.9: EURUSD with tweezer top
Bearish engulfing candlestick
The second pattern I watch for is the bearish engulfing candlestick. This is when a negative candle with a black body completely engulfs the candle immediately before it. An example of this is shown in the circled area of Figure 2.10.
Figure 2.10: EURUSD with bearish engulfing candlestick
Moving averages
The final indicator I look at to determine a downtrend is moving averages. If the short-term SMA crosses below the long-term SMA this is a key bearish signal that suggests the price action could be headed lower.
Confirming the trend
Sometimes clouds and candlesticks are not enough and I need to find a way to confirm if there is an uptrend or downtrend. This is where the relative strength index (RSI) comes in handy.
The relative strength index is a measure of momentum in the market and is the rate of the rise or fall in an asset’s price. It is the ratio of higher closes to lower closes, and is typically significant in the range 20 to 80.
The RSI is useful for two reasons. Firstly, it can help to confirm the start of an uptrend; typically this happens if the index is particularly oversold and hovering around the 20 mark. The second use for the RSI is that it can show when the market is overbought; at this point the index is hovering around the 80 mark.
Figure 2.11 shows how the RSI can be used to tell when a currency cross is overbought or oversold. On two occasions, once in September and once in December, the RSI moved into overbought territory (above 80), which was followed by a sell-off in EURUSD.
Figure 2.11: EURUSD and RSI
During a trend
The biggest threat when trend-following is that the trend will end unexpectedly. A trader needs to know the difference between when a trend is merely pausing for breath (also known as the pullback), or when a trend is ending and reversing.
The pullback
Sometimes a change in direction does not signal a change in trend. One of the key things I try to remember is that the market does not go up or down in a straight line. Instead it can experience pullbacks or trade sideways for a while before trending once more.
Figure 2.12 shows EURUSD in a downtrend, but you can see periodic bouts of strength (pullbacks) in the circled areas. The market starts to move counter to the prevailing trend and then reverses and continues the trend once more.
Figure 2.12: EURUSD in a downtrend
Imagine this scenario – one day the market is trending upwards as I expected, but the next day it starts to decline. What should I do? Don’t panic. This could be just a normal pullback.
So how can a pullback be identified?
I find that the best way to identify a pullback is to use channels. Figure 2.13 shows a downward channel and an upward channel. During a trend the price tends to move within the upper and lower boundaries of these channels. Price action is not perfect, and on both of these examples price action has popped outside of the channel boundaries, but only for short periods of time.
Figure 2.13: Pullbacks within channels
In a downtrend you may see prices occasionally start to rise to the upper channel, thus breaking with the prevailing price action of lower highs. Likewise, in an uptrend you may see prices start to move to the lower channel. Don’t be concerned; as long as prices stay roughly within these boundaries then the trend prevails.
Pullbacks happen because different types of traders have different trading plans; some people may take profit after a couple of days, some after a couple of weeks, and some hold positions for years. Thus, although the overall bias may be an uptrend (or downtrend) there will always be people selling the currency throughout an uptrend (and buying the currency in a downtrend).
Continuation patterns
Sometimes prices can move sideways in the middle of a trend, which can also be the market just taking a breather before it continues in its prior trend. You can spot this by looking for continuation patterns. A couple of continuation patterns that I use are ascending and descending triangles.
Ascending triangles
Ascending triangles can occur during an uptrend when the price action fails to make higher highs; as we mention above a series of higher highs is one of the key determinants of an uptrend. But, the difference between a continuation pattern and the end of an uptrend is that the price will still be making higher lows. So although the price is not making any more traction on the upside, it is not falling either. Eventually this triangle gets so narrow that the price breaks out to the upside, as shown in Figure 2.14.
Figure 2.14: Ascending triangle
Descending triangles
The descending triangle is the exact opposite of an ascending triangle. The price stops making lower lows, but neither is it making higher highs, suggesting that a breakout to the downside will eventually occur. The descending triangle pattern is shown in Figure 2.15.
Figure 2.15: Descending triangle
I find these triangle patterns are useful for two reasons:
When a trend ends
Once I have determined that a trend is in place and have entered a trade to take advantage of this, I am then on the lookout for signals that the trend is going to end. There tends to be two main reasons why trends cease and the market changes direction:
Here is a checklist that I use to help me determine when a trend is about to end:
Focusing just on the top point in this list, I have described some candlestick patterns below that I use to identify when a trend is coming to an end.
Bearish harami
In an uptrend you may see a bearish harami pattern, which indicates future bearish price action. The bulls have one last push higher and then the bears pile in, suggesting that a top has been put in place. See the circled area in Figure 2.16.
Figure 2.16: Bearish harami pattern
Doji candlestick
Sometimes a change in trend can take a while to materialise, but if a trend is starting to tire there are a couple of signals that can be detected in price action. One example is the doji candlestick pattern.
A doji is when the opening and closing prices are at the same level and the upper and lower wicks are approximately the same length. This suggests indecision in the market with neither the bulls nor the bears willing to take the lead. Sometimes a doji occurs when the market is pausing for breath, at other times it is a warning signal that a trend is coming to an end.
In Figure 2.17 the doji pattern is followed by a tweezer top (circled), which is another reversal pattern and can be used to draw the conclusion that the uptrend is coming to an end.
Figure 2.17: GBPUSD showing a doji followed by a tweezer top
A note on volume data
In other markets, such as equities, you can look at volume-based indicators (the numbers of buyers and sellers) to determine the strength of a trend or if a trend is coming to an end. For example, when a trend is ending volume tends to fall off, and at the start of a new trend it tends to pick up.
There is no definitive volume indicator for the FX market because there is no central exchange. You can get volume data for the FX futures and ETC (exchange-traded currency) markets; the volume of FX futures trading is published by the Commodities Futures Trading Commission (CFTC) each week.
However, it is worth noting that this represents a small fraction of the market. Although futures traders can be fairly active participants in the FX market, the volume data needs to be approached with caution.
What happens when markets don’t trend?
Considering how many times I include the word trend in this section you may think that markets are in a perpetual trend, but in fact this is not the case. It is said that markets only trend 30% of the time and for the rest of the time they are trading within a range (range-trading).
Throughout my career I have found that many traders label themselves – they only trade break-outs, they only follow Ichimoku, etc. I don’t restrict myself in this way. If markets aren’t breaking out or changing trend then you could be twiddling your thumbs for some while if you have told yourself that you don’t trade at these times.
The best traders are dynamic and alter their technique according to the situation they find themselves in. This is more realistic in my view since trading styles can change with time.
An example where the break-out trader would have found the markets extremely frustrating was the first quarter of 2012, when EURUSD stayed in a range from January to May.
The upside was capped at 1.35, which was the high from November 2011. Try as it might, this pair just couldn’t break above this level. However, rather than trigger another leg lower in the single currency, the cross found good support at 1.30. This pair was stuck in a range between 1.30 and 1.35 for almost four months.
Thus, EURUSD traders were forced to adapt to these range-trading conditions. Interestingly, once you have done some fairly simple legwork range trading can be surprisingly easy, as you can see in the following example.
Range trading: a real-life example
Step 1: Identify the range
Let’s use the example of EURUSD for January to May 2012. As you can see in Figure 2.18, this cross tended to move higher when it touched 1.30 and sell off when it reached 1.35. A support level tends to protect a currency’s downside when it sells off and resistance can thwart the upside. Thus, by looking at the chart I have identified support and resistance levels.
Figure 2.18: range-trading step 1 – establish a range is in place
More often than not you can tell by eye that a market is range trading, however sometimes momentum indicators can also give you confirmation. When markets are stuck in a range the MACD and RSI tend to flat line, showing no direction to the upside or the downside. To illustrate this, Figure 2.19 shows USDJPY in 2012 – for most of June, July August and September it was stuck in a very tight range. At the same time the RSI and MACD had both flattened out, suggesting that there was no prevailing trend in place.
Figure 2.19: USDJPY and RSI, MACD
Step 2: Use this information to place a trade
Now I need to know what trade to place. As you can see in Figure 2.20 there are some good reversal signals in place at 1.35 – including a triple top candlestick pattern (circled). This suggests that the market is willing to test this level but not move above it.
Likewise, there are bullish engulfing candlestick patterns when this cross reaches 1.30 (circled), suggesting that this level attracts buying interest. I mentioned above that range trading can be simple and it is. These patterns essentially present buy and sell levels on a plate. In fact, if I wanted to hold this position for the long term then I could leave a sell order with my broker just above 1.35 for a long trade, and a buy order just below 1.30 for a short trade.
Figure 2.20: range-trading step 2 – place a trade
Step 3: Identify when a range is over
If the price breaks the support or resistance then the range no longer exists. One point to remember is that markets don’t trade in neat support and resistance levels, so I need to leave myself a margin of error, in this example 50 to 100 pips either side should be enough. Thus, if I see EURUSD break above 1.3550 then the range would be over and the market would be entering an uptrend. Likewise, if it broke below 1.2950 a downtrend has started.
As you can see in Figure 2.21, EURUSD eventually broke to the downside in May 2012. There were signs that a downside break was on the cards. For example, EURUSD made a series of lower highs (the tell-tale sign of a downtrend) even when it was within its range. Also, after hitting 1.30 in mid-April the bulls only made a tentative effort to push the cross higher and there were multiple doji patterns forming at this time, suggesting indecision was gripping the market (see circled area).
Figure 2.21: range-trading step 3 – identify when the range is broken
Technical analysis wrap-up
There are a few things you should take away from this chapter: