Trend vs. No Trend
Which Technical Indicators to Use?
If "the trend is your friend," what happens when there is no trend? This is more than just a rhetorical question, since markets tend to move sideways much more frequently than they trend. For example, currency markets are particularly well known for long-term trends, which are in turn caused by long-term macro-economic trends, such as interest rate tightening or easing cycles. But even in currency markets, historical analysis reveals that trending periods only account for about 1/3 of price action over time, meaning that about two-thirds of the time there is no trend to catch.
By Brian DolanAs published in TRADERS' Magazine July 2005The Trend/No Trend ParadoxTo make matters worse, many traders typically utilize only one or two technical indicators to identify market direction and trade-timing. This one-size-fits-all approach leaves them exposed to the trend/no-trend paradox – an indicator that works well in trending markets can give disastrous results in sideways markets and vice versa. As a result, individual traders frequently find themselves exiting positions too early and missing out on larger moves as a bigger trend unfolds. Conversely, traders may end up holding onto a short-term position for too long following a reversal, believing they are "with the trend," when no trend exists.
To avoid getting caught in the paradox, this article will suggest using several technical tools in conjunction to determine whether or not a trend is in place. This will in turn dictate which technical indicators are best used to gauge entry/exit points as well as provide some risk management guidance. Rather than setting forth a list of concrete trading rules, this article seeks to outline a dynamic approach to the use of technical analysis to avoid getting caught in the trend/no-trend paradox.
Trend-friendly ToolsThe obvious starting point for this discussion is to define what is meant by a trend. In terms of technical analysis, a trend is a predictable price response at levels of support/resistance that change over time. For example, in an uptrend the defining feature is that prices rebound when they near support levels, ultimately establishing new highs. In a downtrend, the opposite is true – price increases will reverse as they near resistance levels, and new lows will be reached. This definition reveals the first of the tools used to identify whether a trend is in place or not – trendline analysis to establish support and resistance levels.
Trendline analysis is sometimes underestimated because it is perceived as overly subjective in nature. While this criticism has some truth, it overlooks the reality that trendlines help focus attention on the underlying price pattern, filtering out the noise of the market. For this reason, trendline analysis should be the first step in determining the existence of a trend. If trendline analysis does not reveal a discernible trend, it's probably because there isn't one. Trendline analysis will also help identify price formations that have their own predictive significance.
Trendline analysis is best employed starting with longer time frames (daily and weekly charts) first and then carrying them forward into shorter timeframes (hourly and 4-hourly) where shorter-term levels of support and resistance can then be identified. This approach has the advantage of highlighting the most significant levels of support/resistance first and minor levels next. This helps reduce the chances of following a short-term trendline break while a major long-term level is lurking nearby.
A more objective indicator of whether a market is trending is the directional movement indicator system (DMI). Using the DMI removes the guesswork involved with spotting trends and can also provide confirmation of trends identified by trendline analysis. The DMI system is comprised of the ADX (average directional movement index) and the DI+ and DI- lines. The ADX is used to determine whether or not a market is trending (regardless if it's up or down), with a reading over 25 indicating a trending market and a reading below 20 indicating no trend. The ADX is also a measure of the strength of a trend – the higher the ADX, the stronger the trend. Using the ADX, traders can determine whether or not there is a trend and thus whether or not to use a trend following system.
As its name would suggest, the DMI system is best employed using both components. The DI+ and DI- lines are used as trade entry signals. A buy signal is generated when the DI+ line crosses up through the DI- line; a sell signal is generated when the DI- line crosses up through the DI+ line. (Wilder suggests using the "extreme point rule" to govern the DI+/DI- crossover signal. The rule states that when the DI+/- lines cross, traders should note the extreme point for that period in the direction of the crossover (the high if DI+ crosses up over DI-; the low if DI- crosses up over DI+). Only if that extreme point is breached in the subsequent period is a trade signal confirmed.
The ADX can then be used as an early indicator of the end/pause in a trend. When the ADX begins to move lower from its highest level, the trend is either pausing or ending, signaling it is time to exit the current position and wait for a fresh signal from the DI+/DI- crossover.
Non-trend ToolsMomentum oscillators, such as RSI, stochastics, or MACD, are a favorite indicator of many traders and their utility is best applied to non-trending or sideways markets. The primary use of momentum indicators is to gauge whether a market is overbought or oversold relative to prior periods, potentially highlighting a price reversal before it actually occurs.
However, this application fails in the case of a trending market, as the price momentum can remain overbought/oversold for many periods while the price continues to move persistently higher/lower in line with the underlying trend. The practical result is that traders who rely solely on a momentum indicator might exit a profitable position too soon based on momentum having reached an extreme level, just as a larger trend movement is developing. Even worse, some might use overbought/oversold levels to initiate positions in the opposite direction, seeking to anticipate a price reversal based on extreme momentum levels.
The second use of momentum oscillators is to spot divergences between price and momentum. The rationale with divergences is that sustained price movements should be mirrored by the underlying momentum. For example, a new high in price should be matched by a new high in momentum if the price action is to be considered valid. If a new price high occurs without momentum reaching new highs, a divergence (in this case, a bearish divergence) is said to exist. Divergences frequently play out with the price action failing to sustain its direction and reversing course in line with the momentum.
In real life, though, divergences frequently appear in trending markets as momentum wanes (the rate of change of prices slows) but prices fail to reverse significantly, maintaining the trend. The practical result is that counter-trend trades are frequently initiated based on price/momentum divergences. If the market is trending, prices will maintain their direction, though their rate of change is slower. Eventually, prices will accelerate in line with the trend and momentum will reverse again in the direction of the trend, nullifying the observed divergence in the process. As such, divergences can create many false signals that mislead traders who fail to recognize when a trend is in place.
Putting the Tools to Work Let's look at some real-life trading examples to illustrate the application of the tools outlined above and see how they can be used to avoid the trend/no-trend paradox. For these examples, MACD (moving average convergence/divergence) will be used as the momentum oscillator, though other oscillators could be substituted according to individual preferences.
The first example (Figure1) illustrates 4-hour EUR/USD price action with MACD and the DMI system (ADX, DI+, DI-) as accompanying studies. Following the framework outlined above, trendline analysis reveals several multi-day price movements, identified by trendlines 1 and 2. Looking next at the ADX, it rises above the "trend" level of 25 at point A, indicating that a trend is taking hold and that momentum readings should be discounted. This is helpful, because if one looked only at the MACD at this point, it might be tempting to conclude that the upmove was stalling as the MACD begins to falter. Subsequent price action, however, sees the market move higher.
Along the way however, trendline 1 is broken and the ADX tops out and begins to move lower (point B). While the price action has been extremely volatile around this point, it should be noted that the ADX over 25 negated the premature crossover signal of MACD as well as the break of support on trendline 1. At point C, the ADX has fallen back below 25 and this suggests taking another look at the MACD, which is beginning to diverge bearishly, as new price highs are not matched by new MACD highs. A subsequent sharp downmove in price generates another negative crossover on the MACD, and since ADX is now below 25, a short position is taken at about 1.3060 (point D).
Following along with trendline 2 now, MACD is clearly weakening as prices move lower. The ADX initially continues to fall indicating the absence of any trend, but begins to turn up after a failed test of trendline resistance at point E. The focus remains on the MACD at this point as the ADX is still below 25. As price declines slow, MACD crosses upward indicating it is time to exit the position at around 1.2900 at point F. Subsequent price action is extremely whippy and the ADX again fails to signal an extended trend, confirming the decision to exit.
The above example showed the interplay between ADX and momentum (MACD), where the absence of a trend indicated traders should focus on the underlying momentum to gauge price direction. Let's now look at an example where a trend is present and it essentially cancels out signals given by momentum.
Figure 2 shows USD/CHF in an hourly format with DMI and MACD as the studies. Beginning with trendline analysis again, trendline resistance from previous highs is broken at point A. Momentum as shown by MACD has been moving higher and supports the break higher. The ADX also rises above 25, confirming the break higher and indicating a long position should be taken at approximately 1.1650. The trade entry could also have been signaled earlier by the crossover of DI+ over DI- and the application of Wilder's 'Extreme Point Rule.'
Subsequent price moves are modest initially, but the relevant feature to note is that the ADX remains well above 25, suggesting momentum signals should be disregarded. This is critical since the MACD quickly generates a signal to exit the trade at point B. Relying on the ADX alone at this point, however, the long position is maintained and subsequent price gains cause MACD to reverse higher again. ADX continues to rise with the price gains, which are also adhering to trendline support. MACD again generates a sell signal at point C, but this is ignored as the ADX approaches 50, suggesting a strong trend is now in place. Price gains become more explosive and the ADX goes on to register new highs. Contrast that with the MACD which is indicating a bearish divergence from point D onwards, even though the uptrend remains intact. The ADX also indicates a bearish divergence, implying trend intensity is fading. Only at point E are exit signals given by the break of trendline support and the decline of ADX below 25 at point E around 1.2000. In this example, a short-term trade was able to capitalize on a much larger move by employing the ADX in addition to the MACD. A strictly momentum based approach would have been caught in multiple whipsaws, or even a premature short based on bearish divergence.
Bottom lineFinancial markets are inherently dynamic environments. Nowhere is this more apparent than in the trend/no trend paradox. Trading rules or themes that apply one day might be obsolete by the next day. Carrying that notion over to technical analysis suggests traders need to employ dynamic technical tools to adapt to ever changing markets. An approach that utilizes trendline analysis, Wilder's DMI system, and momentum oscillators can yield far better results across varying market conditions than a single-indicator approach.
Saturday, November 17, 2007
Using Indicators to Identify Trends
Using Indicators to Identify Trends
Of the many market sayings thrown around by traders, perhaps none is more overused and less understood than the old adage 'the trend is your friend'. All too often, the phrase is used after a trader has taken a counter-trend position and subsequently been stopped out at a loss. Remorse sets in at this point and most traders kick themselves not only for having lost on a counter-trend trade, but also for not having caught the latest move in the trend itself.
To avoid this all too common scenario, we will suggest using several technical tools to identify whether or not a trend is in place and then use additional indicators to help maximize trading profits. Having a strategy in place to identify trends is essential to successful trading in any market, but especially so in the case of the forex markets. Currencies have a greater tendency to move in trending fashion due to the longer-term macroeconomic elements that drive exchange rates, such as interest rate cycles or global trade imbalances. Currencies are also pre-disposed to short-term, intra-day trends due to international capital flows reacting in unison to day-to-day economic and political news.Identifying the TrendIn its most basic sense, a trend is simply a prolonged market movement in one general direction, either up or down. From a traders' perspective, though, that simple definition is so broad as to be relatively meaningless. A more relevant definition of a trend would be one where a trend is defined as a predictable price response at levels of support/resistance that change over time. For example, in an uptrend the defining feature is that prices rebound when they near support levels, ultimately establishing new highs. In a downtrend, the opposite is true-price increases will reverse as they near resistance levels, and new lows will be reached. This definition reveals the first of the tools used to identify whether a trend is in place or not-trendline analysis to establish support and resistance levels.
Trendline analysis is often underestimated because it is perceived as overly subjective and retrospective in nature. While both criticisms have some truth, they overlook the reality that trendlines help focus attention on the underlying price pattern, filtering out the noise of the market. For this reason, trendline analysis should be the first step in determining the existence of a trend. If trendline analysis does not reveal a discernible trend, it's probably because there isn't one.
Trendline analysis is best employed starting with longer timeframes (daily or weekly charts) first and then carrying them forward into shorter timeframes (hourly or 4-hourly) where shorter-term levels of support and resistance can then be identified. This approach has the advantage of highlighting the most significant levels of support/resistance first and less important levels next. This helps reduce the chances of following a short-term trendline break while a major long-term level is lurking nearby.
Another technical tool that can be deployed to verify the existence of a trend is the directional movement indicator system (DMI), developed by J. Welles Wilder (see Wilder, New Concepts in Technical Trading Systems, c. 1978). Using the DMI removes the guesswork involved with spotting trends and can also provide confirmation of trends identified by trendline analysis. The DMI system is comprised of the ADX (average directional movement index) and the DI+ and DI- lines. The ADX is used to determine whether or not a market is trending (regardless if it's up or down), with a reading over 25 indicating a trending market and a reading below 20 indicating no trend. The ADX is also a measure of the strength of a trend--the higher the ADX, the stronger the trend. Using the ADX, traders can determine whether or not there is a trend and thus whether or not to use a trend following system.
As its name would suggest, the DMI system is best employed using both components. The DI+ and DI- lines are used as trade entry signals. A buy signal is generated when the DI+ line crosses up through the DI- line; a sell signal is generated when the DI- line crosses up through the DI+ line. (Wilder suggests using the "extreme point rule" to govern the DI+/DI- crossover signal. The rule states that when the DI+/- lines cross, traders should note the extreme point for that period in the direction of the crossover (the high if DI+ crosses up over DI-; the low if DI- crosses up over DI+). Only if that extreme point is breached in the subsequent period is a trade signal confirmed.
The ADX can then be used as an early indicator of the end/pause in a trend. When the ADX begins to move lower from its highest level, the trend is either pausing or ending, signaling it is time to exit the current position and wait for a fresh signal from the DI+/DI- crossover. CHART 1: JUMP IN AND HANG ON FOR THE RIDE. If you are an aggressive trader and entered a long position at Point A, and only exited your position at Point C, you would be pleased with the results. This can be achieved with a few simple indicators.
Let's look at recent long-term trend (chart 1) and put trendline analysis together with the DMI system to illustrate the utility of these tools when used in conjunction with each other. An aggressive trader might initiate a long position as the daily resistance line is breached on 11/12/03 (point A). A trader looking for confirmation might wait a day, when the DI+ crosses up through the DI- line, generating a buy signal. A conservative trader might wait for confirmation of the DI+/- crossover by waiting for the extreme point (high) to be exceeded, in line with Wilder's extreme point rule. This confirmation is given the following day (11/14/03). As the market begins to move higher, the support trendline drawn off the lows is tested, but holds, underscoring its validity to a nascent trend. Although the market has moved higher in line with the DI+/DI- crossover and trendline support, the ADX is still below 25 until 12/2/03 (point B), when a trend is finally confirmed. At this point, a trader should recognize that they are in a trending market and trend following systems can usefully be employed.
This brings us to the point of introducing some additional tools that can be used to maximize profit within a trending market. We have already suggested using the ADX as an early indicator of the end of a trend. Note that from point B, when it first registers above 25 indicating a trending market, the ADX continues to make new highs until 01/14/04 (point C) when it closes lower signaling a likely end to the uptrend and that it's time to exit the long position.
A second tool used to identify an exit point and possibly the end of a trend is the parabolic indicator. The parabolic indicator follows the price action but accelerates its own rate of increase over time and in response to the trend. The result is that the parabolic is continually closing in on the price, and only a steadily accelerating price rise (the essence of a trend) will prevent the price from falling below the parabolic, signaling an end to the trend. Chart 2 shows the parabolic indicator overlaid on the previous chart. Note that the parabolic gives an exit signal (point D) the day after the ADX experienced its first lower close. CHART 2: ADD A COUPLE MORE INDICATORS. Here, the parabolic indicator was used. The exit signal was given one day after the ADX gave its exit signal.
The very basic trendlines that are drawn also could have signaled the end to the uptrend. Note that the price accelerates above the upper channel line in the final extension of the uptrend, tests back to the break and then goes on to make new highs. The subsequent price decline back below the upper channel line would then signal the end of the up-move. As well, another support line similar to the parabolic could also be drawn, and its breach would have been the earliest signal of the end of the upmove.What About Short-term Trading?The same tools outlined above can be used for short-term decision making, even in markets that are trading sideways, or so-called trendless markets. While the market may not be trending in a long-term sense, there are multiple smaller, short-term movements taking place that can be exploited. (One caveat must be noted, though: traders need to be aware of what is happening in the bigger picture. If shorter term ADX readings indicate a trending market, traders must be circumspect in initiating trades that are counter to the larger, daily trend.)CHART 3: INTRADAY BASIS. On this hourly chart of the Australian dollar, the first entry signal was at point A. You could have held until point D, where you should have sold your position. The next entry signal was point AA (short) with a signal for covering that short position at point CC.
Let's then look at a short-term scenario using an hourly chart of the Australian dollar (chart 3). The first hint of a potential trading opportunity is the quick convergence of the DI+/DI- lines in the hour marked by point A. This is caused by the sharp bounce in price during that hour. The next hourly bar breaks through and closes above trendline resistance, precipitating DI+ crossing up through DI-. Following Wilder's extreme point rule, we wait for the previous high to be surpassed, which happens in the next hour at point B. At this point, we have several signals indicating a long position-the break of trendline resistance, crossover of DI+/DI-, extreme point rule satisfied, break of parabolic. As the market moves higher, the ADX begins to rise as well, peaking at point C and declining at point D, giving us our signal to exit the long. Basic trendline and parabolic supports are then broken several hours later setting the stage for the next potential move.
The next signal is given at point AA as the DI- crosses up through the DI+, generating a sell signal. This coincides with the price falling below recent hourly lows. The ADX begins to move up, indicating the possibility of a trend forming and eventually rises over 25 at point BB indicating a trend is in place and that the parabolic should be followed. Trendline and parabolic resistance are then breached and the ADX stalls at point CC, indicating an early, but profitable exit to the trade.The Trend is Your FriendProfiting from market trends is the essence of making the trend your friend. The first step to profiting from both short- and long-term trends is understanding what constitutes a trend and knowing how to identify them. The next step is employing a disciplined trading strategy that is specific to trends. A conscientious approach utilizing trendline analysis, the DMI system, and the parabolic indicator should help traders make more friends of market trends.
Authored by Brian Dolan & Kenneth AgostinoOriginally published in Technical Analysis of Stocks and Commodities, September 2004© 2004 GAIN Capital Group All rights reserved.
Of the many market sayings thrown around by traders, perhaps none is more overused and less understood than the old adage 'the trend is your friend'. All too often, the phrase is used after a trader has taken a counter-trend position and subsequently been stopped out at a loss. Remorse sets in at this point and most traders kick themselves not only for having lost on a counter-trend trade, but also for not having caught the latest move in the trend itself.
To avoid this all too common scenario, we will suggest using several technical tools to identify whether or not a trend is in place and then use additional indicators to help maximize trading profits. Having a strategy in place to identify trends is essential to successful trading in any market, but especially so in the case of the forex markets. Currencies have a greater tendency to move in trending fashion due to the longer-term macroeconomic elements that drive exchange rates, such as interest rate cycles or global trade imbalances. Currencies are also pre-disposed to short-term, intra-day trends due to international capital flows reacting in unison to day-to-day economic and political news.Identifying the TrendIn its most basic sense, a trend is simply a prolonged market movement in one general direction, either up or down. From a traders' perspective, though, that simple definition is so broad as to be relatively meaningless. A more relevant definition of a trend would be one where a trend is defined as a predictable price response at levels of support/resistance that change over time. For example, in an uptrend the defining feature is that prices rebound when they near support levels, ultimately establishing new highs. In a downtrend, the opposite is true-price increases will reverse as they near resistance levels, and new lows will be reached. This definition reveals the first of the tools used to identify whether a trend is in place or not-trendline analysis to establish support and resistance levels.
Trendline analysis is often underestimated because it is perceived as overly subjective and retrospective in nature. While both criticisms have some truth, they overlook the reality that trendlines help focus attention on the underlying price pattern, filtering out the noise of the market. For this reason, trendline analysis should be the first step in determining the existence of a trend. If trendline analysis does not reveal a discernible trend, it's probably because there isn't one.
Trendline analysis is best employed starting with longer timeframes (daily or weekly charts) first and then carrying them forward into shorter timeframes (hourly or 4-hourly) where shorter-term levels of support and resistance can then be identified. This approach has the advantage of highlighting the most significant levels of support/resistance first and less important levels next. This helps reduce the chances of following a short-term trendline break while a major long-term level is lurking nearby.
Another technical tool that can be deployed to verify the existence of a trend is the directional movement indicator system (DMI), developed by J. Welles Wilder (see Wilder, New Concepts in Technical Trading Systems, c. 1978). Using the DMI removes the guesswork involved with spotting trends and can also provide confirmation of trends identified by trendline analysis. The DMI system is comprised of the ADX (average directional movement index) and the DI+ and DI- lines. The ADX is used to determine whether or not a market is trending (regardless if it's up or down), with a reading over 25 indicating a trending market and a reading below 20 indicating no trend. The ADX is also a measure of the strength of a trend--the higher the ADX, the stronger the trend. Using the ADX, traders can determine whether or not there is a trend and thus whether or not to use a trend following system.
As its name would suggest, the DMI system is best employed using both components. The DI+ and DI- lines are used as trade entry signals. A buy signal is generated when the DI+ line crosses up through the DI- line; a sell signal is generated when the DI- line crosses up through the DI+ line. (Wilder suggests using the "extreme point rule" to govern the DI+/DI- crossover signal. The rule states that when the DI+/- lines cross, traders should note the extreme point for that period in the direction of the crossover (the high if DI+ crosses up over DI-; the low if DI- crosses up over DI+). Only if that extreme point is breached in the subsequent period is a trade signal confirmed.
The ADX can then be used as an early indicator of the end/pause in a trend. When the ADX begins to move lower from its highest level, the trend is either pausing or ending, signaling it is time to exit the current position and wait for a fresh signal from the DI+/DI- crossover. CHART 1: JUMP IN AND HANG ON FOR THE RIDE. If you are an aggressive trader and entered a long position at Point A, and only exited your position at Point C, you would be pleased with the results. This can be achieved with a few simple indicators.
Let's look at recent long-term trend (chart 1) and put trendline analysis together with the DMI system to illustrate the utility of these tools when used in conjunction with each other. An aggressive trader might initiate a long position as the daily resistance line is breached on 11/12/03 (point A). A trader looking for confirmation might wait a day, when the DI+ crosses up through the DI- line, generating a buy signal. A conservative trader might wait for confirmation of the DI+/- crossover by waiting for the extreme point (high) to be exceeded, in line with Wilder's extreme point rule. This confirmation is given the following day (11/14/03). As the market begins to move higher, the support trendline drawn off the lows is tested, but holds, underscoring its validity to a nascent trend. Although the market has moved higher in line with the DI+/DI- crossover and trendline support, the ADX is still below 25 until 12/2/03 (point B), when a trend is finally confirmed. At this point, a trader should recognize that they are in a trending market and trend following systems can usefully be employed.
This brings us to the point of introducing some additional tools that can be used to maximize profit within a trending market. We have already suggested using the ADX as an early indicator of the end of a trend. Note that from point B, when it first registers above 25 indicating a trending market, the ADX continues to make new highs until 01/14/04 (point C) when it closes lower signaling a likely end to the uptrend and that it's time to exit the long position.
A second tool used to identify an exit point and possibly the end of a trend is the parabolic indicator. The parabolic indicator follows the price action but accelerates its own rate of increase over time and in response to the trend. The result is that the parabolic is continually closing in on the price, and only a steadily accelerating price rise (the essence of a trend) will prevent the price from falling below the parabolic, signaling an end to the trend. Chart 2 shows the parabolic indicator overlaid on the previous chart. Note that the parabolic gives an exit signal (point D) the day after the ADX experienced its first lower close. CHART 2: ADD A COUPLE MORE INDICATORS. Here, the parabolic indicator was used. The exit signal was given one day after the ADX gave its exit signal.
The very basic trendlines that are drawn also could have signaled the end to the uptrend. Note that the price accelerates above the upper channel line in the final extension of the uptrend, tests back to the break and then goes on to make new highs. The subsequent price decline back below the upper channel line would then signal the end of the up-move. As well, another support line similar to the parabolic could also be drawn, and its breach would have been the earliest signal of the end of the upmove.What About Short-term Trading?The same tools outlined above can be used for short-term decision making, even in markets that are trading sideways, or so-called trendless markets. While the market may not be trending in a long-term sense, there are multiple smaller, short-term movements taking place that can be exploited. (One caveat must be noted, though: traders need to be aware of what is happening in the bigger picture. If shorter term ADX readings indicate a trending market, traders must be circumspect in initiating trades that are counter to the larger, daily trend.)CHART 3: INTRADAY BASIS. On this hourly chart of the Australian dollar, the first entry signal was at point A. You could have held until point D, where you should have sold your position. The next entry signal was point AA (short) with a signal for covering that short position at point CC.
Let's then look at a short-term scenario using an hourly chart of the Australian dollar (chart 3). The first hint of a potential trading opportunity is the quick convergence of the DI+/DI- lines in the hour marked by point A. This is caused by the sharp bounce in price during that hour. The next hourly bar breaks through and closes above trendline resistance, precipitating DI+ crossing up through DI-. Following Wilder's extreme point rule, we wait for the previous high to be surpassed, which happens in the next hour at point B. At this point, we have several signals indicating a long position-the break of trendline resistance, crossover of DI+/DI-, extreme point rule satisfied, break of parabolic. As the market moves higher, the ADX begins to rise as well, peaking at point C and declining at point D, giving us our signal to exit the long. Basic trendline and parabolic supports are then broken several hours later setting the stage for the next potential move.
The next signal is given at point AA as the DI- crosses up through the DI+, generating a sell signal. This coincides with the price falling below recent hourly lows. The ADX begins to move up, indicating the possibility of a trend forming and eventually rises over 25 at point BB indicating a trend is in place and that the parabolic should be followed. Trendline and parabolic resistance are then breached and the ADX stalls at point CC, indicating an early, but profitable exit to the trade.The Trend is Your FriendProfiting from market trends is the essence of making the trend your friend. The first step to profiting from both short- and long-term trends is understanding what constitutes a trend and knowing how to identify them. The next step is employing a disciplined trading strategy that is specific to trends. A conscientious approach utilizing trendline analysis, the DMI system, and the parabolic indicator should help traders make more friends of market trends.
Authored by Brian Dolan & Kenneth AgostinoOriginally published in Technical Analysis of Stocks and Commodities, September 2004© 2004 GAIN Capital Group All rights reserved.
Short-Term Currency Trends
Cashing in on Short-Term Currency Trends
Trends may be rarer than trading ranges, but that doesn't mean they can't be traded. This strategy uses two time frames to identify the trend, an overbought-oversold indicator to pinpoint entry and a trailing stop to protect gains on profitable trades.+
Many technical trading strategies revolve around the assumption that markets will hover within a given range — and with good reason. Seventy percent of the time markets will bounce back and forth between support and resistance levels, or fluctuate randomly. The rest of the time, market behavior is characterized by persistent price moves — trends — that shatter support and resistance levels.
Although these basic probabilities work against traders who try to exploit trends, the potential rewards can be worth the risk. It is possible to increase your ability to capitalize on trends by locating trend signals, identifying specific entry points within the trend and using risk management techniques to limit losses.
The following sections will explain how a trading system basedon these concepts works especially well in the foreign exchange (Forex), or currency, market, particularly with the "major" currencies — the U.S. dollar, Euro, Japanese yen, British pound, Swiss franc, Canadian dollar and Australian dollar. More than 85 percent of transactions in the $3.2 trillion per day Forex market involve the majors.
Tools and Rules
Stochastic RefresherThe stochastic oscillator consists of two lines: %K and a moving average of %K called %D.
The basic stochastic calculation compares the most recent close to the price range (high of the range - low of the range) over a particular period. A basic five-bar stochastic calculation is the difference between the most recent bar's close and the lowest low of the last five days divided by the difference between the highest high and the lowest low of the last five days. The result is multiplied by 100. The formula for this calculation, which is %K, is:%K = 100*{(Ct-Ln)/(Hn-Ln)}whereCt = the most recent bar's closing priceLn = the lowest price of the most recent n barsHn = the highest price of the most recent n bars(for a stochastic calculated on daily bars, the default is five days)
The second line, %D, is simply a three-period moving average of %K:
average(%K,3)
Because this basic "fast" stochastic calculation is very volatile, an additionally smoothed version of the indicator, where the original %D line becomes a new "slow" %K line and a three-period average of this line becomes the "slow"%D line, is more commonly used.
The stochastic can be made to reflect longer- or shorter-term price movementand to be less or more sensitive to small price fluctuations by increasing or decreasing the number of bars used to calculate %K and/or increasing or decreasing the length of the moving average used to calculate %D. For example, a stochastic using a 10-bar %K and a three-bar moving average for %D [stochastic(10,3)] would be shorter-term and more sensitive than a stochastic using a 20-bar %K and a five-bar moving average for %D [stochastic(20,5)].
The strategy uses two charts with different time periods (10-minute and hourly), along with two technical indicators: a 200-bar moving average and a 14-bar slow stochastic study (see "Stochastic refresher," right).
Step 1: Identify a trend. Compare the moving averages on the 10-minute and hourly charts. A trend is in effect when price is consistently above/below the moving averages on both charts.
Step 2: Pinpoint entry. Once you've identified a trend, look for the following two conditions at the same time on the 10-minute chart: 1) the market is no more than 20 points above (to buy) or 20 points below (to sell) the moving average; and 2) the fast stochastic line crosses above the slow stochastic line below 20 (to buy) or crosses below the slow stochastic line above 80 (to sell).
These conditions indicate: 1) the currency is currently in a short-term uptrend or downtrend; and 2) the currency has paused or pulled back (reflected by the higher low stochastic reading and the fact that price is within 20 points of the moving average) and is poised to turn (because the fast stochastic line is crossing back above or below the slow line).
Step 3: Ride the trend. Set a trailing stop after the initial trade entry. On a long position, enter a stop-loss order 10 points below the 200-period moving average on the 10-minute chart. In the case of a short position, place the initial stop 10 points above this moving average. As the trade goes in your favor, raise (for a long trade) or lower (for a short trade) the stop to protect profits. For simplicity's sake, the following examples use a trailing stop 25 points from each new top or bottom. The charts in the next section illustrate the application of this strategy in two currency pairs.
Trade Examples
The first example took place in the Euro currency-dollar (EUR/USD) currency pair during the fourth week of June 2002.
First, compare the hourly and 10- minute EUR/USD charts. Look for a time when price is above the 200-period moving averages on both charts. On the hourly chart (Figure 1 - Click here to view), the fact that price is almost exclusively above the 200-hour moving average indicates a persistent uptrend. On the 10-minute chart (Figure 2 - Click here to view), price moves (and remains above) the moving average in the last third of the chart. The next step is to pinpoint the entry zone — when the market is within 20 points of the moving average on the 10- minute chart and the stochastic lines cross.
The range between 1 p.m. and midnight on June 27 meets these requirements. The entry point occurs when the fast stochastic crosses above the slow stochastic when the indicator is below 20. A long position is entered at .9883 around 8 p.m., with an accompanying stop-loss at .9858 (10 points below the 200-bar moving average value of .9868). The stop is then trailed upward as the market makes new peaks. The EUR/USD tops out at .9992, so the stop scaled up to .9967, where the position was closed for an 84-point ($840) gain.
Figures 3 and 4 illustrate a similar example in the dollar-yen rate (USD/JPY). The hourly chart(Figure 3 - Click here to view) shows price was trading well below the 200-bar moving average after June 21. On the 10-minute chart (Figure 4 - Click here to view), price fell below the moving average after 10 a.m. on June 27, indicating a sell opportunity. Also, price was within 20 points of the moving average at this point. A short trade was opened around 5 p.m. at 119.57 when the fast stochastic line crossed below the slow stochastic line when the indicator was above 80.
The trade was protected with a stop-loss order at 119.86. In this case, the stop remained intact until the following day, when USD/JPY began to decline. After trailing the stop down as the market continued to decline, profits were taken at 118.58 (25 points off the 118.33 low), for a gain of 99 points.
Search and Exploit
This short-term trading method works well in the Forex market, but it is also applicable to others. Each step of the system helps identify areas where effective trades can be made. If at any point one of the criteria is not met, you'll instantly know not to make a trade. This model also gives you the freedom to experiment with different chart intervals. When you're equipped with a system that can help you catch the trend early, you can wait for the rest of the market to follow.
Quoting CurrenciesBecause currencies are quoted in a different manner than equities, reading a foreign exchange quote may seem a bit confusing at first. However, it's really quite simple if you remember two things: 1) The first currency listed first is the base currency and 2) the value of the base currency is always 1. For example, if you see a quote of USD/CAD 1.54825, that means that one U.S. dollar is equal to 1.54825 Canadian dollars. Likewise, USD/JPY 122.01 shows that one U.S. dollar is equal to 122.01 Japanese yen.
In every trade involving the U.S. dollar, the dollar will be the base currency, with three exceptions — the British pound (GBP), the Australian dollar (AUS) and the European currency unit, or Euro (EUR). In these cases, you might see a quote such as GBP/USD 1.4366, meaning that one British pound equals 1.4366 U.S. dollars.
Whenever the U.S. dollar is the base unit and a currency quote goes up, it means the dollar has appreciated in value and the other currency has weakened. If the USD/JPY quote we previously mentioned increases to 123.01, the dollar is stronger because it will now buy more yen than before.
However, in the three instances where the U.S. dollar is not the base rate, a rising quote means a weakening dollar, as it now takes more U.S. dollars to equal one pound, Euro or Australian dollar.
In other words, if a currency quote goes higher, that increases the value of the base currency. A lower quote means the base currency is weakening.
Trades that do not involve the U.S. dollar are called cross rates, but the premise is the same. A quote of GBP/CHF 2.4577 signifies that one British pound is equal to 2.4577 Swiss francs.
+ Placing contingent orders may not necessarily limit your losses.
Originally published in Active Trader, October 2002Authored by Timothy O'Sullivan
Trends may be rarer than trading ranges, but that doesn't mean they can't be traded. This strategy uses two time frames to identify the trend, an overbought-oversold indicator to pinpoint entry and a trailing stop to protect gains on profitable trades.+
Many technical trading strategies revolve around the assumption that markets will hover within a given range — and with good reason. Seventy percent of the time markets will bounce back and forth between support and resistance levels, or fluctuate randomly. The rest of the time, market behavior is characterized by persistent price moves — trends — that shatter support and resistance levels.
Although these basic probabilities work against traders who try to exploit trends, the potential rewards can be worth the risk. It is possible to increase your ability to capitalize on trends by locating trend signals, identifying specific entry points within the trend and using risk management techniques to limit losses.
The following sections will explain how a trading system basedon these concepts works especially well in the foreign exchange (Forex), or currency, market, particularly with the "major" currencies — the U.S. dollar, Euro, Japanese yen, British pound, Swiss franc, Canadian dollar and Australian dollar. More than 85 percent of transactions in the $3.2 trillion per day Forex market involve the majors.
Tools and Rules
Stochastic RefresherThe stochastic oscillator consists of two lines: %K and a moving average of %K called %D.
The basic stochastic calculation compares the most recent close to the price range (high of the range - low of the range) over a particular period. A basic five-bar stochastic calculation is the difference between the most recent bar's close and the lowest low of the last five days divided by the difference between the highest high and the lowest low of the last five days. The result is multiplied by 100. The formula for this calculation, which is %K, is:%K = 100*{(Ct-Ln)/(Hn-Ln)}whereCt = the most recent bar's closing priceLn = the lowest price of the most recent n barsHn = the highest price of the most recent n bars(for a stochastic calculated on daily bars, the default is five days)
The second line, %D, is simply a three-period moving average of %K:
average(%K,3)
Because this basic "fast" stochastic calculation is very volatile, an additionally smoothed version of the indicator, where the original %D line becomes a new "slow" %K line and a three-period average of this line becomes the "slow"%D line, is more commonly used.
The stochastic can be made to reflect longer- or shorter-term price movementand to be less or more sensitive to small price fluctuations by increasing or decreasing the number of bars used to calculate %K and/or increasing or decreasing the length of the moving average used to calculate %D. For example, a stochastic using a 10-bar %K and a three-bar moving average for %D [stochastic(10,3)] would be shorter-term and more sensitive than a stochastic using a 20-bar %K and a five-bar moving average for %D [stochastic(20,5)].
The strategy uses two charts with different time periods (10-minute and hourly), along with two technical indicators: a 200-bar moving average and a 14-bar slow stochastic study (see "Stochastic refresher," right).
Step 1: Identify a trend. Compare the moving averages on the 10-minute and hourly charts. A trend is in effect when price is consistently above/below the moving averages on both charts.
Step 2: Pinpoint entry. Once you've identified a trend, look for the following two conditions at the same time on the 10-minute chart: 1) the market is no more than 20 points above (to buy) or 20 points below (to sell) the moving average; and 2) the fast stochastic line crosses above the slow stochastic line below 20 (to buy) or crosses below the slow stochastic line above 80 (to sell).
These conditions indicate: 1) the currency is currently in a short-term uptrend or downtrend; and 2) the currency has paused or pulled back (reflected by the higher low stochastic reading and the fact that price is within 20 points of the moving average) and is poised to turn (because the fast stochastic line is crossing back above or below the slow line).
Step 3: Ride the trend. Set a trailing stop after the initial trade entry. On a long position, enter a stop-loss order 10 points below the 200-period moving average on the 10-minute chart. In the case of a short position, place the initial stop 10 points above this moving average. As the trade goes in your favor, raise (for a long trade) or lower (for a short trade) the stop to protect profits. For simplicity's sake, the following examples use a trailing stop 25 points from each new top or bottom. The charts in the next section illustrate the application of this strategy in two currency pairs.
Trade Examples
The first example took place in the Euro currency-dollar (EUR/USD) currency pair during the fourth week of June 2002.
First, compare the hourly and 10- minute EUR/USD charts. Look for a time when price is above the 200-period moving averages on both charts. On the hourly chart (Figure 1 - Click here to view), the fact that price is almost exclusively above the 200-hour moving average indicates a persistent uptrend. On the 10-minute chart (Figure 2 - Click here to view), price moves (and remains above) the moving average in the last third of the chart. The next step is to pinpoint the entry zone — when the market is within 20 points of the moving average on the 10- minute chart and the stochastic lines cross.
The range between 1 p.m. and midnight on June 27 meets these requirements. The entry point occurs when the fast stochastic crosses above the slow stochastic when the indicator is below 20. A long position is entered at .9883 around 8 p.m., with an accompanying stop-loss at .9858 (10 points below the 200-bar moving average value of .9868). The stop is then trailed upward as the market makes new peaks. The EUR/USD tops out at .9992, so the stop scaled up to .9967, where the position was closed for an 84-point ($840) gain.
Figures 3 and 4 illustrate a similar example in the dollar-yen rate (USD/JPY). The hourly chart(Figure 3 - Click here to view) shows price was trading well below the 200-bar moving average after June 21. On the 10-minute chart (Figure 4 - Click here to view), price fell below the moving average after 10 a.m. on June 27, indicating a sell opportunity. Also, price was within 20 points of the moving average at this point. A short trade was opened around 5 p.m. at 119.57 when the fast stochastic line crossed below the slow stochastic line when the indicator was above 80.
The trade was protected with a stop-loss order at 119.86. In this case, the stop remained intact until the following day, when USD/JPY began to decline. After trailing the stop down as the market continued to decline, profits were taken at 118.58 (25 points off the 118.33 low), for a gain of 99 points.
Search and Exploit
This short-term trading method works well in the Forex market, but it is also applicable to others. Each step of the system helps identify areas where effective trades can be made. If at any point one of the criteria is not met, you'll instantly know not to make a trade. This model also gives you the freedom to experiment with different chart intervals. When you're equipped with a system that can help you catch the trend early, you can wait for the rest of the market to follow.
Quoting CurrenciesBecause currencies are quoted in a different manner than equities, reading a foreign exchange quote may seem a bit confusing at first. However, it's really quite simple if you remember two things: 1) The first currency listed first is the base currency and 2) the value of the base currency is always 1. For example, if you see a quote of USD/CAD 1.54825, that means that one U.S. dollar is equal to 1.54825 Canadian dollars. Likewise, USD/JPY 122.01 shows that one U.S. dollar is equal to 122.01 Japanese yen.
In every trade involving the U.S. dollar, the dollar will be the base currency, with three exceptions — the British pound (GBP), the Australian dollar (AUS) and the European currency unit, or Euro (EUR). In these cases, you might see a quote such as GBP/USD 1.4366, meaning that one British pound equals 1.4366 U.S. dollars.
Whenever the U.S. dollar is the base unit and a currency quote goes up, it means the dollar has appreciated in value and the other currency has weakened. If the USD/JPY quote we previously mentioned increases to 123.01, the dollar is stronger because it will now buy more yen than before.
However, in the three instances where the U.S. dollar is not the base rate, a rising quote means a weakening dollar, as it now takes more U.S. dollars to equal one pound, Euro or Australian dollar.
In other words, if a currency quote goes higher, that increases the value of the base currency. A lower quote means the base currency is weakening.
Trades that do not involve the U.S. dollar are called cross rates, but the premise is the same. A quote of GBP/CHF 2.4577 signifies that one British pound is equal to 2.4577 Swiss francs.
+ Placing contingent orders may not necessarily limit your losses.
Originally published in Active Trader, October 2002Authored by Timothy O'Sullivan
Using Technical Indicators
Using Technical Indicators
A good understanding of the basic tenets of technical analysis can vastly improve one's trading skills.
When using technical analysis, price is the primary tool. Simply put, "everything is already in the rate." However, technical analysis involves a bit more than simply staring at price charts hoping to find a "yellow brick road" to a bonanza payday. Along with various methods of plotting price action on charts by using bars, candlesticks, and Xs and Os on point and figure charts, market technicians also employ many technical studies that help them to delve deeper into the data. By using these studies in conjunction with their price charts, traders are able to build much stronger cases to buy, sell or remain on the sidelines than they could by simply looking at price charts alone.
Here are descriptions of some of the more widely used and time-tested studies that technicians keep in their toolboxes:
Moving Averages Stochastics RSI Bollinger Bands MACD
Moving AveragesOne of the most basic and widely used indicators in a technical analyst's tool box, moving averages help traders verify existing trends, identify emerging trends, and view overextended trends about to reverse. Moving averages are lines overlaid on a chart indicating long term price trends with short term fluctuations smoothed out.
There are three basic types of moving averages:
Simple
Weighted
Exponential
A simple moving average gives equal weight to each price point over the specified period. The user defines whether the high, low, or close is used and these price points are added together and averaged. This average price point is then added to the existing string and a line is formed. With the addition of each new price point the sample set drops off the oldest point. The simple moving average is probably the most widely used moving average.
A weighted moving average gives more emphasis to the latest data. A weighted moving average multiplies each data point by a weighting factor which differs from day to day. These figures are added and divided by the sum of the weighting factors. A weighted moving average allows the user to successfully smooth out a curve while having the average more responsive to current price changes.
An exponential moving average is another way of "weighting" the more recent data. An exponential moving average multiplies a percentage of the most recent price by the previous period's average price. Defining the optimum moving average for a particular currency pair involves "curve fitting". Curve fitting is the process of selecting the right number of periods with the correct type of moving average to produce the results the user is trying to achieve. By trial and error, technicians work with the time periods to fit the price data.
Because the moving average is constantly changing based on the latest market data, many traders will use different "specified" time frames before they come up with a series of moving averages that are optimal for a particular currency.
For example, a trader might create a 5-day, a 15-day and a 30-day moving average for a currency and then plot them on his or her price chart. He might start out using simple moving averages and end up using weighted moving averages. In creating these moving averages, traders need to decide on the exact price data that will be used in this study; meaning closing prices vs. opening prices vs. high/low/close etc. After doing so, a series of lines are created that reflect the 5-day, 15-day and 30-day moving average of a currency.
Once the data is layered over a price chart, traders can determine how well these chosen periods keep track of the trend being followed. If, for example, a market is trending higher, you'd expect the 30-day moving average to be a very accurate trend line, providing a line of support for prices on their way higher. If prices seem too close under this 30-day moving average on several occasions without resulting in a halt in the up trend, a trader will simply adjust the time period to say a 45-day or 60-day moving average in order to optimize the average. In this way, the moving average will act as a trend line.
After determining the optimum moving average for a currency, this average price line can be used as a line of support in maintaining a long position or resistance in maintaining a short position. Breaches of this line can also be used as a signal that a currency is in the process of reversing course, in which case a trader will want to pare back an existing position or come up with entry levels for a new position. For example, if you determine that a 30-day moving average has shown itself to be a good support line for USD-JPY in an upward trending market, then market closes under this 30-day moving average line could be a signal that this trend could be running out of steam. However, it is important to wait for confirmation of these signals. One way to do this is to wait for another close below the level. On the second close under the average, you should begin to pare down your position. Another confirmation involves using other, shorter term moving averages.
While a longer term moving average can help to define and support a particular trend, shorter term moving averages can provide lead signals that a trend is ending before prices dip below your longer term moving average line. For this reason, most traders will plot several moving averages on the same chart. In a market that is trending higher, a shorter term moving average might signal a market reversal by turning down and crossing over the longer term moving average. For example, if you are using a 15-day and a 45-day moving average in a market that is in an up trend, and the 15-day moving average turns down and crosses over the 45-day moving average, this could be an early signal that the up trend is ending and it is probably time to begin to pare down your position.
StochasticsStochastic studies, or oscillators, are another useful tool for monitoring the expected sustainability of a trend. They provide a trader with information about the closing price in the current trading period relative to the prior performance of the instrument being analyzed.
Stochastics are measured and represented by two different lines, %K and %D and are plotted on a scale ranging from 0 to 100. Indications above 80 represent strong upward movement while level indications below 20 represent strong downward movements. The mathematics behind the studies are not as important as knowing what the stochastics are telling you. The %K line is the faster, more sensitive indicator while the %D line takes more time to turn. When the %K line crosses over the %D line, this could be an indication that a market is about to reverse course. Stochastic studies are not useful in choppy, sideways markets. At times when prices are fluctuating in a narrow range, the %K and %D lines might be crossing many different times and will be telling you nothing more than the market is moving sideways.
Stochastics are most useful in measuring the strength of a trend and as augurs of a coming reversal in prices. When prices are making new highs or lows and your stochastics are doing the same, you can be reasonably certain that the trend will continue. On the other hand, many traders finds that the best trading opportunity comes when their stochastic indicator is flattening out or moving in the opposite direction of prices. When these divergences occur, it's time to book profits and/or to establish a position in the opposite direction of the prior trend.
As should always be the case when using any technical tool, do not act on the first signal you see. Wait at least one or two trading sessions for confirmation of what the study is indicating before you commit to a position.
Relative Strength Index (RSI)RSI measures the momentum of price movements. It is also plotted on a scale ranging from 0 to 100. Traders will tend to look at RSI readings over 80 as an indicator of a market that is overbought or susceptible to a downturn, and readings under 20 as a market that is oversold or ready to turn higher.
This logic therefore implies that prices cannot rise or fall forever and that by using an RSI study, one can determine with a reasonable degree of certainty when a reversal will come about. However, be very wary of trading on RSI studies alone. In many instances, an RSI can remain at very lofty or sunken levels for quite a while without prices reversing course. At these times, the RSI is simply telling you that a market is quite strong or quite weak and shows no signs of changing course.
RSI studies can be adjusted to whatever time sensitivity a trader feels necessary for his or her particular style. For instance, a 5-day RSI will be very sensitive and will tend to give many more signals, not all of them sustainable, than say a 21-day RSI, which will tend to be less choppy. As with other studies, try a variety of time periods for the currency that you are trading based on your trading style. Longer term, position type traders, will tend to find that shorter time frames used for an RSI (or any other study for that matter) will give too many signals and will result in over-trading. On the other hand, shorter time frames will probably be ideal for day-traders trying to capture many shorter-term price fluctuations.
As with stochastics, look for divergences between prices and the RSI. If your RSI turns up in a slumping market or turns down during a bull run, this could be a good indication that a reversal is just around the corner. Wait for confirmation before you act on divergent indications from your RSI studies.
Bollinger BandsBollinger Bands are volatility curves used to identify extreme highs or lows in relation to price. Bollinger Bands establish trading parameters, or bands, based on the moving average of a particular instrument and a set number of standard deviations around this moving average.
For example, a trader might decide to use a 10-day moving average and 2 standard deviations to establish Bollinger Bands for a given currency. After doing so, a chart will appear with price bars capped by an upper boundary line based on price levels 2 standard deviations higher than the 10-day moving average and supported by a lower boundary line based on 2 standard deviations lower than the 10-day moving average. In the middle of these two boundary lines will be another line running somewhat close to the middle area depicting in this case, the 10-day moving average. Both the moving average and the number of standard deviations can be altered to best suit a particular currency.
Jon Bollinger, creator of Bollinger Bands recommends using a simple 20-day moving average and 2 standard deviations. Because standard deviation is a measure of volatility, Bollinger Bands are dynamic indicators that adjust themselves (widen and contract) based on the current levels of volatility in the market being studied. When prices hit the upper or lower boundaries of a given set of Bollinger Bands, this is not necessarily an indication of an imminent reversal in a trend. It simply means that prices have moved to the upper limits of the established parameters. Therefore, traders should use another study in conjunction with Bollinger Bands to help them determine the strength of a trend.
MACD - Moving Average Convergence DivergenceMACD is a more detailed method of using moving averages to find trading signals from price charts. Developed by Gerald Appel, the MACD plots the difference between a 26-day exponential moving average and a 12-day exponential moving average. A 9-day moving average is generally used as a trigger line, meaning when the MACD crosses below this trigger it is a bearish signal and when it crosses above it, it's a bullish signal.
As with other studies, traders will look to MACD studies to provide early signals or divergences between market prices and a technical indicator. If the MACD turns positive and makes higher lows while prices are still tanking, this could be a strong buy signal. Conversely, if the MACD makes lower highs while prices are making new highs, this could be a strong bearish divergence and a sell signal.
Fibonacci RetracementsFibonacci retracement levels are a sequence of numbers discovered by the noted mathematician Leonardo da Pisa during the twelfth century. These numbers describe cycles found throughout nature and when applied to technical analysis can be used to find pullbacks in the currency market.
Fibonacci retracement involves anticipating changes in trends as prices near the lines created by the Fibonacci studies. After a significant price move (either up or down), prices will often retrace a significant portion (if not all) of the original move. As prices retrace, support and resistance levels often occur at or near the Fibonacci Retracement levels.
In the currency markets, the commonly used sequence of ratios is 23.6 %, 38.2%, 50% and 61.8%. Fibonacci retracement levels can easily be displayed by connecting a trend line from a perceived high point to a perceived low point. By taking the difference between the high and low, the user can apply the % ratios to achieve the desired pullbacks.
One final word of advice: Don't get too caught up in the mathematics involved in putting together each study. It is much more important to understand how and why studies can and should be manipulated based on the time periods and sensitivities that you determine are ideal for the currency you are trading. These ideal levels can only be determined after applying several different parameters to each study until the charts and studies begin to reveal the "details behind the details."
A good understanding of the basic tenets of technical analysis can vastly improve one's trading skills.
When using technical analysis, price is the primary tool. Simply put, "everything is already in the rate." However, technical analysis involves a bit more than simply staring at price charts hoping to find a "yellow brick road" to a bonanza payday. Along with various methods of plotting price action on charts by using bars, candlesticks, and Xs and Os on point and figure charts, market technicians also employ many technical studies that help them to delve deeper into the data. By using these studies in conjunction with their price charts, traders are able to build much stronger cases to buy, sell or remain on the sidelines than they could by simply looking at price charts alone.
Here are descriptions of some of the more widely used and time-tested studies that technicians keep in their toolboxes:
Moving Averages Stochastics RSI Bollinger Bands MACD
Moving AveragesOne of the most basic and widely used indicators in a technical analyst's tool box, moving averages help traders verify existing trends, identify emerging trends, and view overextended trends about to reverse. Moving averages are lines overlaid on a chart indicating long term price trends with short term fluctuations smoothed out.
There are three basic types of moving averages:
Simple
Weighted
Exponential
A simple moving average gives equal weight to each price point over the specified period. The user defines whether the high, low, or close is used and these price points are added together and averaged. This average price point is then added to the existing string and a line is formed. With the addition of each new price point the sample set drops off the oldest point. The simple moving average is probably the most widely used moving average.
A weighted moving average gives more emphasis to the latest data. A weighted moving average multiplies each data point by a weighting factor which differs from day to day. These figures are added and divided by the sum of the weighting factors. A weighted moving average allows the user to successfully smooth out a curve while having the average more responsive to current price changes.
An exponential moving average is another way of "weighting" the more recent data. An exponential moving average multiplies a percentage of the most recent price by the previous period's average price. Defining the optimum moving average for a particular currency pair involves "curve fitting". Curve fitting is the process of selecting the right number of periods with the correct type of moving average to produce the results the user is trying to achieve. By trial and error, technicians work with the time periods to fit the price data.
Because the moving average is constantly changing based on the latest market data, many traders will use different "specified" time frames before they come up with a series of moving averages that are optimal for a particular currency.
For example, a trader might create a 5-day, a 15-day and a 30-day moving average for a currency and then plot them on his or her price chart. He might start out using simple moving averages and end up using weighted moving averages. In creating these moving averages, traders need to decide on the exact price data that will be used in this study; meaning closing prices vs. opening prices vs. high/low/close etc. After doing so, a series of lines are created that reflect the 5-day, 15-day and 30-day moving average of a currency.
Once the data is layered over a price chart, traders can determine how well these chosen periods keep track of the trend being followed. If, for example, a market is trending higher, you'd expect the 30-day moving average to be a very accurate trend line, providing a line of support for prices on their way higher. If prices seem too close under this 30-day moving average on several occasions without resulting in a halt in the up trend, a trader will simply adjust the time period to say a 45-day or 60-day moving average in order to optimize the average. In this way, the moving average will act as a trend line.
After determining the optimum moving average for a currency, this average price line can be used as a line of support in maintaining a long position or resistance in maintaining a short position. Breaches of this line can also be used as a signal that a currency is in the process of reversing course, in which case a trader will want to pare back an existing position or come up with entry levels for a new position. For example, if you determine that a 30-day moving average has shown itself to be a good support line for USD-JPY in an upward trending market, then market closes under this 30-day moving average line could be a signal that this trend could be running out of steam. However, it is important to wait for confirmation of these signals. One way to do this is to wait for another close below the level. On the second close under the average, you should begin to pare down your position. Another confirmation involves using other, shorter term moving averages.
While a longer term moving average can help to define and support a particular trend, shorter term moving averages can provide lead signals that a trend is ending before prices dip below your longer term moving average line. For this reason, most traders will plot several moving averages on the same chart. In a market that is trending higher, a shorter term moving average might signal a market reversal by turning down and crossing over the longer term moving average. For example, if you are using a 15-day and a 45-day moving average in a market that is in an up trend, and the 15-day moving average turns down and crosses over the 45-day moving average, this could be an early signal that the up trend is ending and it is probably time to begin to pare down your position.
StochasticsStochastic studies, or oscillators, are another useful tool for monitoring the expected sustainability of a trend. They provide a trader with information about the closing price in the current trading period relative to the prior performance of the instrument being analyzed.
Stochastics are measured and represented by two different lines, %K and %D and are plotted on a scale ranging from 0 to 100. Indications above 80 represent strong upward movement while level indications below 20 represent strong downward movements. The mathematics behind the studies are not as important as knowing what the stochastics are telling you. The %K line is the faster, more sensitive indicator while the %D line takes more time to turn. When the %K line crosses over the %D line, this could be an indication that a market is about to reverse course. Stochastic studies are not useful in choppy, sideways markets. At times when prices are fluctuating in a narrow range, the %K and %D lines might be crossing many different times and will be telling you nothing more than the market is moving sideways.
Stochastics are most useful in measuring the strength of a trend and as augurs of a coming reversal in prices. When prices are making new highs or lows and your stochastics are doing the same, you can be reasonably certain that the trend will continue. On the other hand, many traders finds that the best trading opportunity comes when their stochastic indicator is flattening out or moving in the opposite direction of prices. When these divergences occur, it's time to book profits and/or to establish a position in the opposite direction of the prior trend.
As should always be the case when using any technical tool, do not act on the first signal you see. Wait at least one or two trading sessions for confirmation of what the study is indicating before you commit to a position.
Relative Strength Index (RSI)RSI measures the momentum of price movements. It is also plotted on a scale ranging from 0 to 100. Traders will tend to look at RSI readings over 80 as an indicator of a market that is overbought or susceptible to a downturn, and readings under 20 as a market that is oversold or ready to turn higher.
This logic therefore implies that prices cannot rise or fall forever and that by using an RSI study, one can determine with a reasonable degree of certainty when a reversal will come about. However, be very wary of trading on RSI studies alone. In many instances, an RSI can remain at very lofty or sunken levels for quite a while without prices reversing course. At these times, the RSI is simply telling you that a market is quite strong or quite weak and shows no signs of changing course.
RSI studies can be adjusted to whatever time sensitivity a trader feels necessary for his or her particular style. For instance, a 5-day RSI will be very sensitive and will tend to give many more signals, not all of them sustainable, than say a 21-day RSI, which will tend to be less choppy. As with other studies, try a variety of time periods for the currency that you are trading based on your trading style. Longer term, position type traders, will tend to find that shorter time frames used for an RSI (or any other study for that matter) will give too many signals and will result in over-trading. On the other hand, shorter time frames will probably be ideal for day-traders trying to capture many shorter-term price fluctuations.
As with stochastics, look for divergences between prices and the RSI. If your RSI turns up in a slumping market or turns down during a bull run, this could be a good indication that a reversal is just around the corner. Wait for confirmation before you act on divergent indications from your RSI studies.
Bollinger BandsBollinger Bands are volatility curves used to identify extreme highs or lows in relation to price. Bollinger Bands establish trading parameters, or bands, based on the moving average of a particular instrument and a set number of standard deviations around this moving average.
For example, a trader might decide to use a 10-day moving average and 2 standard deviations to establish Bollinger Bands for a given currency. After doing so, a chart will appear with price bars capped by an upper boundary line based on price levels 2 standard deviations higher than the 10-day moving average and supported by a lower boundary line based on 2 standard deviations lower than the 10-day moving average. In the middle of these two boundary lines will be another line running somewhat close to the middle area depicting in this case, the 10-day moving average. Both the moving average and the number of standard deviations can be altered to best suit a particular currency.
Jon Bollinger, creator of Bollinger Bands recommends using a simple 20-day moving average and 2 standard deviations. Because standard deviation is a measure of volatility, Bollinger Bands are dynamic indicators that adjust themselves (widen and contract) based on the current levels of volatility in the market being studied. When prices hit the upper or lower boundaries of a given set of Bollinger Bands, this is not necessarily an indication of an imminent reversal in a trend. It simply means that prices have moved to the upper limits of the established parameters. Therefore, traders should use another study in conjunction with Bollinger Bands to help them determine the strength of a trend.
MACD - Moving Average Convergence DivergenceMACD is a more detailed method of using moving averages to find trading signals from price charts. Developed by Gerald Appel, the MACD plots the difference between a 26-day exponential moving average and a 12-day exponential moving average. A 9-day moving average is generally used as a trigger line, meaning when the MACD crosses below this trigger it is a bearish signal and when it crosses above it, it's a bullish signal.
As with other studies, traders will look to MACD studies to provide early signals or divergences between market prices and a technical indicator. If the MACD turns positive and makes higher lows while prices are still tanking, this could be a strong buy signal. Conversely, if the MACD makes lower highs while prices are making new highs, this could be a strong bearish divergence and a sell signal.
Fibonacci RetracementsFibonacci retracement levels are a sequence of numbers discovered by the noted mathematician Leonardo da Pisa during the twelfth century. These numbers describe cycles found throughout nature and when applied to technical analysis can be used to find pullbacks in the currency market.
Fibonacci retracement involves anticipating changes in trends as prices near the lines created by the Fibonacci studies. After a significant price move (either up or down), prices will often retrace a significant portion (if not all) of the original move. As prices retrace, support and resistance levels often occur at or near the Fibonacci Retracement levels.
In the currency markets, the commonly used sequence of ratios is 23.6 %, 38.2%, 50% and 61.8%. Fibonacci retracement levels can easily be displayed by connecting a trend line from a perceived high point to a perceived low point. By taking the difference between the high and low, the user can apply the % ratios to achieve the desired pullbacks.
One final word of advice: Don't get too caught up in the mathematics involved in putting together each study. It is much more important to understand how and why studies can and should be manipulated based on the time periods and sensitivities that you determine are ideal for the currency you are trading. These ideal levels can only be determined after applying several different parameters to each study until the charts and studies begin to reveal the "details behind the details."
Introduction to Technical Analysis
Introduction to Technical Analysis
Technical analysis is a method of forecasting price movements by looking at purely market-generated data. Price data from a particular market is most commonly the type of information analyzed by a technician, though most will also keep a close watch on volume and open interest in futures contracts. The bottom line when utilizing any type of analytical method, technical or otherwise, is to stick to the basics, which are methodologies with a proven track record over a long period. After finding a trading system that works for you, the more esoteric fields of study can then be incorporated into your trading toolbox. Almost every trader uses some form of technical analysis. Even the most reverent follower of market fundamentals is likely to glance at price charts before executing a trade. At their most basic level, these charts help traders determine ideal entry and exit points for a trade. They provide a visual representation of the historical price action of whatever is being studied. As such, traders can look at a chart and know if they are buying at a fair price (based on the price history of a particular market), selling at a cyclical top or perhaps throwing their capital into a choppy, sideways market. These are just a few market conditions that charts identify for a trader. Depending on their level of sophistication, charts can also help much more advanced studies of the markets. On the surface, it might appear that technicians ignore the fundamentals of the market while surrounding themselves with charts and data tables. However, a technical trader will tell you that all of the fundamentals are already represented in the price. They are not so much concerned that a natural disaster or an awful inflation number caused a recent spike in prices as much as how that price action fits into a pattern or trend. And much more to the point, how that pattern can be used to predict future prices. Technical analysis assumes that:
All market fundamentals are depicted in the actual market data. So the actual market fundamentals and various factors, such as the differing opinions, hopes, fears, and moods of market participants, need not be studied.
History repeats itself and therefore markets move in fairly predictable, or at least quantifiable, patterns. These patterns, generated by price movement, are called signals. The goal in technical analysis is to uncover the signals given off in a current market by examining past market signals.
Prices move in trends. Technicians typically do not believe that price fluctuations are random and unpredictable. Prices can move in one of three directions, up, down or sideways. Once a trend in any of these directions is established, it usually will continue for some period. The building blocks of any technical analysis system include price charts, volume charts, and a host of other mathematical representations of market patterns and behaviors. Most often called studies, these mathematical manipulations of various types of market data are used to determine the strength and sustainability of a particular trend. So, rather than simply relying on price charts to forecast future market values, technicians will also use a variety of other technical tools before entering a trade. As in all other aspects of trading, be very disciplined when using technical analysis. Too often, a trader will fail to sell or buy into a market even after it has reached a price that his or her technical studies identified as an entry or exit point. This is because it is hard to screen out the fundamental realities that led to the price movement in the first place. As an example, let's assume you are long USD vs. euro and have established your stop/loss 30 pips away from your entry point. However, if some unforeseen factor is responsible for pushing the USD through your stop/loss level you might be inclined to hold this position just a bit longer in the hopes that it turns back into a winner. It is very hard to make the decision to cut your losses and even harder to resist the temptation to book profits too early on a winning trade. This is called leaving money on the table. A common mistake is to ride a loser too long in the hopes it comes back and to cut a winner way too early. If you use technical analysis to establish entry and exit levels, be very disciplined in following through on your original trading plan. Price charts Chart patternsThere are a variety of charts that show price action. The most common are bar charts. Each bar will represent one period of time and that period can be anything from one minute to one month to several years. These charts will show distinct price patterns that develop over time. Candlestick patternsLike bar charts patterns, candlestick patterns can be used to forecast the market. Because of their colored bodies, candlesticks provide greater visual detail in their chart patterns than bar charts. Point & figure patternsPoint and figure patterns are essentially the same patterns found in bar charts but Xs and Os are used to market changes in price direction. In addition, point and figure charts make no use of time scales to indicate the particular day associated with certain price action. Technical Indicators Here are a few of the more common types of indicators used in technical analysis: Trend indicatorsTrend is a term used to describe the persistence of price movement in one direction over time. Trends move in three directions: up, down and sideways. Trend indicators smooth variable price data to create a composite of market direction. (Example: Moving Averages, Trend lines) Strength indicatorsMarket strength describes the intensity of market opinion with reference to a price by examining the market positions taken by various market participants. Volume or open interest are the basic ingredients of this indicator. Their signals are coincident or leading the market. (Example: Volume) Volatility indicatorsVolatility is a general term used to describe the magnitude, or size, of day-to-day price fluctuations independent of their direction. Generally, changes in volatility tend to lead changes in prices. (Example: Bollinger Bands) Cycle indicatorsA cycle is a term to indicate repeating patterns of market movement, specific to recurrent events, such as seasons, elections, etc. Many markets have a tendency to move in cyclical patterns. Cycle indicators determine the timing of a particular market patterns. (Example: Elliott Wave) Support/resistance indicatorsSupport and resistance describes the price levels where markets repeatedly rise or fall and then reverse. This phenomenon is attributed to basic supply and demand. (Example: Trend Lines) Momentum indicatorsMomentum is a general term used to describe the speed at which prices move over a given time period. Momentum indicators determine the strength or weakness of a trend as it progresses over time. Momentum is highest at the beginning of a trend and lowest at trend turning points. Any divergence of directions in price and momentum is a warning of weakness; if price extremes occur with weak momentum, it signals an end of movement in that direction. If momentum is trending strongly and prices are flat, it signals a potential change in price direction. (Example: Stochastic, MACD, RSI)
Technical analysis is a method of forecasting price movements by looking at purely market-generated data. Price data from a particular market is most commonly the type of information analyzed by a technician, though most will also keep a close watch on volume and open interest in futures contracts. The bottom line when utilizing any type of analytical method, technical or otherwise, is to stick to the basics, which are methodologies with a proven track record over a long period. After finding a trading system that works for you, the more esoteric fields of study can then be incorporated into your trading toolbox. Almost every trader uses some form of technical analysis. Even the most reverent follower of market fundamentals is likely to glance at price charts before executing a trade. At their most basic level, these charts help traders determine ideal entry and exit points for a trade. They provide a visual representation of the historical price action of whatever is being studied. As such, traders can look at a chart and know if they are buying at a fair price (based on the price history of a particular market), selling at a cyclical top or perhaps throwing their capital into a choppy, sideways market. These are just a few market conditions that charts identify for a trader. Depending on their level of sophistication, charts can also help much more advanced studies of the markets. On the surface, it might appear that technicians ignore the fundamentals of the market while surrounding themselves with charts and data tables. However, a technical trader will tell you that all of the fundamentals are already represented in the price. They are not so much concerned that a natural disaster or an awful inflation number caused a recent spike in prices as much as how that price action fits into a pattern or trend. And much more to the point, how that pattern can be used to predict future prices. Technical analysis assumes that:
All market fundamentals are depicted in the actual market data. So the actual market fundamentals and various factors, such as the differing opinions, hopes, fears, and moods of market participants, need not be studied.
History repeats itself and therefore markets move in fairly predictable, or at least quantifiable, patterns. These patterns, generated by price movement, are called signals. The goal in technical analysis is to uncover the signals given off in a current market by examining past market signals.
Prices move in trends. Technicians typically do not believe that price fluctuations are random and unpredictable. Prices can move in one of three directions, up, down or sideways. Once a trend in any of these directions is established, it usually will continue for some period. The building blocks of any technical analysis system include price charts, volume charts, and a host of other mathematical representations of market patterns and behaviors. Most often called studies, these mathematical manipulations of various types of market data are used to determine the strength and sustainability of a particular trend. So, rather than simply relying on price charts to forecast future market values, technicians will also use a variety of other technical tools before entering a trade. As in all other aspects of trading, be very disciplined when using technical analysis. Too often, a trader will fail to sell or buy into a market even after it has reached a price that his or her technical studies identified as an entry or exit point. This is because it is hard to screen out the fundamental realities that led to the price movement in the first place. As an example, let's assume you are long USD vs. euro and have established your stop/loss 30 pips away from your entry point. However, if some unforeseen factor is responsible for pushing the USD through your stop/loss level you might be inclined to hold this position just a bit longer in the hopes that it turns back into a winner. It is very hard to make the decision to cut your losses and even harder to resist the temptation to book profits too early on a winning trade. This is called leaving money on the table. A common mistake is to ride a loser too long in the hopes it comes back and to cut a winner way too early. If you use technical analysis to establish entry and exit levels, be very disciplined in following through on your original trading plan. Price charts Chart patternsThere are a variety of charts that show price action. The most common are bar charts. Each bar will represent one period of time and that period can be anything from one minute to one month to several years. These charts will show distinct price patterns that develop over time. Candlestick patternsLike bar charts patterns, candlestick patterns can be used to forecast the market. Because of their colored bodies, candlesticks provide greater visual detail in their chart patterns than bar charts. Point & figure patternsPoint and figure patterns are essentially the same patterns found in bar charts but Xs and Os are used to market changes in price direction. In addition, point and figure charts make no use of time scales to indicate the particular day associated with certain price action. Technical Indicators Here are a few of the more common types of indicators used in technical analysis: Trend indicatorsTrend is a term used to describe the persistence of price movement in one direction over time. Trends move in three directions: up, down and sideways. Trend indicators smooth variable price data to create a composite of market direction. (Example: Moving Averages, Trend lines) Strength indicatorsMarket strength describes the intensity of market opinion with reference to a price by examining the market positions taken by various market participants. Volume or open interest are the basic ingredients of this indicator. Their signals are coincident or leading the market. (Example: Volume) Volatility indicatorsVolatility is a general term used to describe the magnitude, or size, of day-to-day price fluctuations independent of their direction. Generally, changes in volatility tend to lead changes in prices. (Example: Bollinger Bands) Cycle indicatorsA cycle is a term to indicate repeating patterns of market movement, specific to recurrent events, such as seasons, elections, etc. Many markets have a tendency to move in cyclical patterns. Cycle indicators determine the timing of a particular market patterns. (Example: Elliott Wave) Support/resistance indicatorsSupport and resistance describes the price levels where markets repeatedly rise or fall and then reverse. This phenomenon is attributed to basic supply and demand. (Example: Trend Lines) Momentum indicatorsMomentum is a general term used to describe the speed at which prices move over a given time period. Momentum indicators determine the strength or weakness of a trend as it progresses over time. Momentum is highest at the beginning of a trend and lowest at trend turning points. Any divergence of directions in price and momentum is a warning of weakness; if price extremes occur with weak momentum, it signals an end of movement in that direction. If momentum is trending strongly and prices are flat, it signals a potential change in price direction. (Example: Stochastic, MACD, RSI)
Saturday, November 10, 2007
Calculating Profit and Loss
Calculating Profit and Loss
For ease of use, most online trading platforms automatically calculate the P&L of a traders' open positions. However, it is useful to understand how this calculation is derived.
To illustrate a typical FX trade, consider the following example.
The current bid/ask price for EUR/USD is 1.2320/23, meaning you can buy 1 euro with 1.2323 US dollars or sell 1 euro for 1.2320 US dollars.
Suppose you decide that the Euro is undervalued against the US dollar. To execute this strategy, you would buy Euros (simultaneously selling dollars), and then wait for the exchange rate to rise.
So you make the trade: to buy 100,000 euros you pay 123,230 dollars (100,000 x 1.2323). Remember, at 1% margin, your initial margin deposit would be $1,232 for this trade.
As you expected, Euro strengthens to 1.2395/98. Now, to realize your profits, you sell 100,000 euros at the current rate of 1.2395, and receive $123,950.
You bought 100k Euros at 1.2323, paying $123,230. You sold 100k Euros at 1.2395, receiving $123,950. That's a difference of 72 pips, or in dollar terms ($123,950 - $123,230 = $720).
Total profit = US $720
(TIP: When trading any USD counter currency pair, each pip is worth $10, per 100,000 trades).
For ease of use, most online trading platforms automatically calculate the P&L of a traders' open positions. However, it is useful to understand how this calculation is derived.
To illustrate a typical FX trade, consider the following example.
The current bid/ask price for EUR/USD is 1.2320/23, meaning you can buy 1 euro with 1.2323 US dollars or sell 1 euro for 1.2320 US dollars.
Suppose you decide that the Euro is undervalued against the US dollar. To execute this strategy, you would buy Euros (simultaneously selling dollars), and then wait for the exchange rate to rise.
So you make the trade: to buy 100,000 euros you pay 123,230 dollars (100,000 x 1.2323). Remember, at 1% margin, your initial margin deposit would be $1,232 for this trade.
As you expected, Euro strengthens to 1.2395/98. Now, to realize your profits, you sell 100,000 euros at the current rate of 1.2395, and receive $123,950.
You bought 100k Euros at 1.2323, paying $123,230. You sold 100k Euros at 1.2395, receiving $123,950. That's a difference of 72 pips, or in dollar terms ($123,950 - $123,230 = $720).
Total profit = US $720
(TIP: When trading any USD counter currency pair, each pip is worth $10, per 100,000 trades).
Leverage & Margin
Leverage & Margin
The leverage available in forex trading is one of main attractions of this market for many traders. Leveraged trading, or trading on margin, simply means that you are not required to put up the full value of the position.
Forex provides more leverage than stocks or futures. In forex trading, the amount of leverage available can be up to 200 times the value of your account.
FOREX.com: No Debit Balances At FOREX.com, your risk is only limited to funds on deposit. Because there are no margin calls in forex trading, for your protection we will automatically close out all of your open positions if your account equity falls below the required margin level. Think of this as a final, automatic stop. In fact, you'll never lose more money than you have in your account!
There are several reasons for the higher leverage that is offered in the forex market. On a daily basis, the volatility of the major currencies is less than 1%. This is much lower than an active stock, which can easily have a 5-10% move in a single day. With leverage, you can capture higher returns on a smaller market movement. More importantly, leverage allows traders to increase their buying power and utilize less capital to trade. Of course, increasing leverage increases risk.
Margin Trading: Stocks vs Forex
The word "margin" means something very different in forex than it does in stocks.
With stocks, trading on margin means that a trader can borrow up to 50% of a stock's value to buy that stock. This can be a costly move because the investor must pay interest to the brokerage firm on the amount borrowed. This is not the case in forex trading.
For example, at $400/share, 100 shares of Google are valued at $40,000 ($400 x 100 shares). To trade this stock on margin, the money required for the trade is 50%, or $20,000. The remaining $20,000 is borrowed and interest must be paid on that amount. Margin interest is different from broker to broker, but a good rule of thumb is typically Prime plus 1-3% or more.
In forex, margin is the minimum required balance to place a trade. When you open a forex trading account, the money you deposit acts as collateral for your trades. This deposit, called margin, is typically 1% of the value of the position.
For example, if you want to purchase $100,000 of USD/JPY at 100:1 leverage, the money required is 1%, or $1000. The other $99,000 is collateralized with your remaining account balance. You pay no interest.
It is very important to remember that increasing leverage increases risk. You should monitor your account balance on a regular basis and utilize stop-loss orders on every open position in an attempt to limit downside risk.
Here's a hypothetical example that demonstrates the upside of leverage:
With a US$5,000 balance in your account, you decide that the US Dollar (USD) is undervalued against the Swiss Franc (CHF).
To execute this strategy, you must buy Dollars (simultaneously selling Francs), and then wait for the exchange rate to rise.
The current bid/ask price for USD/CHF is 1.2322/1.2327 (meaning you can buy $1 US for 1.2327 Swiss Francs or sell $1 US for 1.2322 francs)
Your available leverage is 100:1 or 1%. You execute the trade, buying a one lot: buying 100,000 US dollars and selling 123,270 Swiss Francs. At 100:1 leverage, your initial margin deposit for this trade is $1,000.
As you expected, USD/CHF rises 50 pips to 1.2372/77. Since you're long dollars (and are short francs), you must now sell dollars and buy back the francs to realize any profit.
You close out the position, selling one lot (selling 100,000 US dollars and receiving 123,720 CHF) Since you originally sold (paid) 123,270 CHF, your profit is 450 CHF.
To calculate your P&L in terms of US dollars, simply divide 450 by the current USD/CHF rate of 1.2372. Your profit on this trade is $364.3
SUMMARY
Initial Investment:
$1000
Profit:
$364.31
Return on investment:
36%
If you had executed this trade without using leverage, your return on investment would be less than 1%.
The leverage available in forex trading is one of main attractions of this market for many traders. Leveraged trading, or trading on margin, simply means that you are not required to put up the full value of the position.
Forex provides more leverage than stocks or futures. In forex trading, the amount of leverage available can be up to 200 times the value of your account.
FOREX.com: No Debit Balances At FOREX.com, your risk is only limited to funds on deposit. Because there are no margin calls in forex trading, for your protection we will automatically close out all of your open positions if your account equity falls below the required margin level. Think of this as a final, automatic stop. In fact, you'll never lose more money than you have in your account!
There are several reasons for the higher leverage that is offered in the forex market. On a daily basis, the volatility of the major currencies is less than 1%. This is much lower than an active stock, which can easily have a 5-10% move in a single day. With leverage, you can capture higher returns on a smaller market movement. More importantly, leverage allows traders to increase their buying power and utilize less capital to trade. Of course, increasing leverage increases risk.
Margin Trading: Stocks vs Forex
The word "margin" means something very different in forex than it does in stocks.
With stocks, trading on margin means that a trader can borrow up to 50% of a stock's value to buy that stock. This can be a costly move because the investor must pay interest to the brokerage firm on the amount borrowed. This is not the case in forex trading.
For example, at $400/share, 100 shares of Google are valued at $40,000 ($400 x 100 shares). To trade this stock on margin, the money required for the trade is 50%, or $20,000. The remaining $20,000 is borrowed and interest must be paid on that amount. Margin interest is different from broker to broker, but a good rule of thumb is typically Prime plus 1-3% or more.
In forex, margin is the minimum required balance to place a trade. When you open a forex trading account, the money you deposit acts as collateral for your trades. This deposit, called margin, is typically 1% of the value of the position.
For example, if you want to purchase $100,000 of USD/JPY at 100:1 leverage, the money required is 1%, or $1000. The other $99,000 is collateralized with your remaining account balance. You pay no interest.
It is very important to remember that increasing leverage increases risk. You should monitor your account balance on a regular basis and utilize stop-loss orders on every open position in an attempt to limit downside risk.
Here's a hypothetical example that demonstrates the upside of leverage:
With a US$5,000 balance in your account, you decide that the US Dollar (USD) is undervalued against the Swiss Franc (CHF).
To execute this strategy, you must buy Dollars (simultaneously selling Francs), and then wait for the exchange rate to rise.
The current bid/ask price for USD/CHF is 1.2322/1.2327 (meaning you can buy $1 US for 1.2327 Swiss Francs or sell $1 US for 1.2322 francs)
Your available leverage is 100:1 or 1%. You execute the trade, buying a one lot: buying 100,000 US dollars and selling 123,270 Swiss Francs. At 100:1 leverage, your initial margin deposit for this trade is $1,000.
As you expected, USD/CHF rises 50 pips to 1.2372/77. Since you're long dollars (and are short francs), you must now sell dollars and buy back the francs to realize any profit.
You close out the position, selling one lot (selling 100,000 US dollars and receiving 123,720 CHF) Since you originally sold (paid) 123,270 CHF, your profit is 450 CHF.
To calculate your P&L in terms of US dollars, simply divide 450 by the current USD/CHF rate of 1.2372. Your profit on this trade is $364.3
SUMMARY
Initial Investment:
$1000
Profit:
$364.31
Return on investment:
36%
If you had executed this trade without using leverage, your return on investment would be less than 1%.
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