Welcome to my Masterclass.
In this lesson you will learn what the foreign exchange market is all about and how we are able to take advantage of the worlds biggest exchange.
Leading of lagging?
Indicators are tools that use mathematical formulas to metamorphose price-action into another visual form on a chart or oscillator. Indicators use the same open, close, high and low candlestick data that you see on the chart itself. Indicators are formulas that look for more complex relationships within the data than most traders will get out of a chart.
Indicators such as moving averages and MACD, are used by traders to analyse historical prices to signal deceleration, acceleration or reversal in trend and predict future prices or direction. Since indicators use historical data, inherently indicators are lagging to pure price action.
The data that indicators use is pure price-action. So any debate about which is better, price-action or indicators, is pure nonsense. Price action is king and indicators are used as confirmation. As a result we use them both, and so should you. Indicators help build a case of evidence when we analyse and prepare trade a trade setup.
There are basically 2 types of indicators:
All of our strategies are trend based as you will learn in this course. Our charts are not cluttered with dozens of indicators. We use price action in combination with just three trend based indicators: Moving Averages, MACD and the ADX. Although we do not trade in range-bound markets, it is good to have a basic understanding of how these markets behave and which indicators are being used by the industry, as you will probably hear many other traders use them. And, as you will learn in the next chapter "multi-time-frame analyses", even range-bound markets are trending if you zoom into them.
But first let's discuss trend based indicators.
With trend indicators you want to identify a trend, specifically you want to know:
the beginning of a trend
the strength of a trend
the end of a trend
But how do you know the trend using only price-action?
- Uptrends consist of higher highs and higher lows
- Downtrends consist of lower highs and lower lows
- Ranging markets move sideways between horizontal levels
Below an example of ranging price action:
Below an example of uptrending price action:
Below an example of downtrending price action:
As you can see in case of a sideways ranging market, this is not always “easy” to see on a naked chart. So which indicators do we use to measure the trend?
Moving Averages (MA)
In the lesson about trendlines we already mentioned the use of moving averages as dynamic support and resistance lines in trends. In this lesson we will talk about moving averages from a trend-indicator point of view.
A moving average is plotted as a line on your chart. It is an average over a previous period. This makes it a “lagging” indicator. It works best in a trending market, hence it’s use as a trend-indicator.
In an uptrend price is above the MA
In a downtrend price is below the MA
In uptrends the MA slopes upwards
In downtrends the MA slopes downwards
The longer the MA period, the longer the trend
It is very important to know that the slope of the MA signals the momentum of the trend. The steeper the MA, the more strength the trend has. When price is above the MA this also signifies (upwards) strength, the higher above it, the more (upwards) strength (in a downtrend vice versa).
Look at the chart below (for AUDJPY - Aussie/Yen). The orange line - closest to price - is the 12 EMA, the red line is the 50 EMA and the blue line is the 200 EMA.
Let's take the 12 EMA as an example, the position of the 12 EMA is calculated using the price of the previous 12 candles. For the 50 EMA the line is calculated using the data of the previous 50 candles and so forth. The 200 EMA is just added to the chart to show you what it looks like. We do not use the 200 EMA for our strategies, just the 12 EMA and 50 EMA.
As you can see, when price is trending, the more candles in the past are used to calculate the moving average, the smoother the line is and the longer a trend seems to continue.
In our case we only use the 12 and the 50 EMA. An EMA is one of many types of MA's (Moving Averages). Where a normal (or simple) 12 MA for example calculates its position using price of the previous 12 candles and weighing price at each candle as 1/12 of the outcome, an EMA is calculated differently. The 'E' in EMA stands for Exponential. In the formula, the recent price is weighted exponentially more heavily than price in the past.
Just as a reference; below you can see how a simple MA, Weighted MA and Exponential MA are calculated.
You don't really have to know the exact formula of how an EMA is calculated. Just know that there are several types of MA's and we use the EMA for our strategies. The 12 EMA and the 50 EMA are respected the most out of all types and periods of MA's.
MACD is an acronym for Moving Average Convergence Divergence. Many traders use this indicator as a tool to identify a new trend (both bullish or bearish). However we do not use the MACD for this reason. The only signal we take from the MACD is the Convergence and Divergence part. What does this mean? First let me explain how the MACD indicator works.
With an MACD chart, you will usually see three numbers that are used for its settings.
The first is the number of periods that is used to calculate the faster-moving average.
The second is the number of periods that is used in the slower moving average.
And the third is the number of bars that is used to calculate the moving average of the difference between the faster and slower moving averages.
For example, if you were to see “12, 26, 9” as the MACD parameters (which is usually the default setting for most charting software), this is how you would interpret it:
The 12 represents the previous 12 bars of the faster moving average.
The 26 represents the previous 26 bars of the slower moving average.
The 9 represents the previous 9 bars of the difference between the two moving averages. This is plotted by vertical lines called a histogram (the purple vertical lines in the chart below).
In the image below you can see the MACD plotted in a separate window under price. The MACD consists out of two lines (blue for the MACD line and orange for the SIGNAL line) and a histogram (purple).
There is a common misconception when it comes to the lines of the MACD. The two lines that are drawn are NOT moving averages of the price. Instead, they are the moving averages of the DIFFERENCE between two moving averages. In our example above, the faster moving average is the moving average of the difference between the 12 and 26-period moving averages.
The slower moving average plots the average of the previous MACD line. Once again, from our example above, this would be a 9-period moving average. This means that we are taking the average of the last 9 periods of the faster MACD line and plotting it as our slower moving average. This smoothens out the original line even more, which gives us a more accurate line. To top it off, when the MACD and signal line are below "0" were are in a downtrend and when the MACD is above "0", we are in an uptrend. Remember MACD, as all indicators are, is lagging to price action.
The histogram simply plots the difference between the fast and slow moving average.
If you look at our chart above, you can see that, as the two moving averages separate, the histogram gets bigger. This is called divergence because the faster moving average is “diverging” or moving away from the slower moving average.
As the moving averages get closer to each other, the histogram gets smaller. This is called convergence because the faster moving average is “converging”, or getting closer to the slower moving average. And that, my friend, is how you get the name, Moving Average Convergence Divergence!
However this is not how we use MACD to our favor. Simply by looking at price action and the EMA's we use on our chart we can see if price is impulsing, pulling back or is being corrective. We don't need the lagging MACD to tell us that. What we do use the MACD for, is so called "hidden divergence". For this we only need to look at the MACD (blue) line. The signal line and the histogram are not important to us.
Hidden divergence shows us something that is hard to see for an untrained eye. Namely, if a trend is slowing down or not. If price in a downtrend for instance, is making lower lows and lower highs, but the MACD line (blue) is making higher highs and higher lows - at the same swing high and lows - this is an indication that momentum is slowing down and that a possible (temporary) trend reversal might be imminent.
Take a look at the chart below:
For the MACD indicator, we deselected the signal line and the histogram, and are left with only the blue MACD line. Price is in a downtrend for some time now as price is still printing lower lows and lower highs. However after severals of these swing lows and highs, you can clearly see that the MACD line is printing higher lows where price is making lower lows.
When you connect the last three swing lows of price you can see that price is still sloping down (red arrow). When you connect the three swing lows of the MACD, you can clearly see that the MACD is sloping up (green arrow). This means that there is a high probability that price will reverse at some point. This might be a full reversal in price, or just a temporary small pullback.
Don't ever trust MACD by itself. MACD divergence is just one (but the least important) tool in providing a case of evidence when we examine a possible trade setup. Is only tells us that price movement has slowed down compared to previous price action. Is does not have to mean that the trend is about to reverse. However when combined with for instance a head-and-shoulder pattern, where the left shoulder is lower than the head - but MACD prints a lower high on the head - this is a solid piece of evidence that the head-and-shoulder pattern could play out more often than not. See this example below.
You can clearly see that price has made a higher high on the price chart, and that MACD has made a lower high. So when the right head forms, you are one step ahead knowing that there is a high probability that price will fall from the right head, potentially below the neck-line (which it did). We use the MACD indicator to make predictions about the future in combination with chart patterns. So that when the chart pattern takes form, there is an added layer of confluence that it will play out in our favor.
The last indicator we use on our chart is the ADX or Average Directional Index. Trading in the direction of a strong trend reduces risk and increases profit potential. The average directional index (ADX) is used to determine when the price is trending strongly. In many cases, it is the ultimate trend indicator. After all, the trend is your friend, and it helps to know who your friends are. In this chapter, we'll explain what the ADX does and how we use it as a trend strength indicator.
ADX is used to quantify trend strength. ADX calculations are based on a moving average of price range expansion over a given period of time. The default setting is 14 bars, although other time periods can be used (which is not advisable). ADX can be used on any trading asset such as stocks, mutual funds, exchange-traded funds, futures and of course the currency market.
The ADX is plotted as a single line with values ranging from a low of zero to a high of 100. ADX is non-directional; it registers trend strength whether price is trending up or down. The indicator is usually plotted in the same window as the two directional movement indicator (DMI) lines, from which ADX is derived.
Below you see an image where the ADX indicator is in a separate window below price. The ADX is the black line, the +DMI is the green line and the -DMI is the red line. A level of '25' has been set by a blue horizontal line
When the +DMI is above the -DMI, prices are moving up and the ADX measures the strength of the uptrend. When the -DMI is above the +DMI, prices are moving down and the ADX measures the strength of the downtrend. The chart above is an example of an uptrend reversing to a downtrend. Notice how the ADX rose during the uptrend when +DMI was above -DMI. When price flattened the -DMI crossed above the +DMI, and ADX declined below the 25 level.
If price were to reverse, what would happen? Let's take a look:
As you can see on the left side of the chart, price was trending down nicely and the ADX picked up on the trend. +DI was above -DI and the ADX itself (black line) was almost at 80 indicating a very strong trend. As price was struggling to impulse down from the high on the 5th of August, thus decelerating, price formed an inverse head-and-shoulders pattern. But even before price was unable to impulse down from its last swing low, the ADX already showed weakness in the bearish trend and ducked below the blue "25" level. Also the +DI and the -DI converged and reversed positions. A clear indication that the trend might be over.
At the time price was forming the inverse head-and-shoulders pattern, the ADX, +DI and -DI were just moving sideways, not doing much. Once the right shoulder was broken to the upside, and the reversal in trend was confirmed by the break of the neckline, price started to trend upwards. The ADX climbed back above 25 and the DI's were converging once more, but this time with the +DI above the -DI.
Quantifying Trend Strength
ADX values help traders identify the strongest and most profitable trends to trade. The values are also important for distinguishing between trending and non-trending conditions. Many traders will use ADX readings above 25 to suggest that the trend is strong enough for trend-trading strategies. Conversely, when ADX is below 25, many will avoid trend-trading strategies.
ADX Value Trend Strength
0-25 => Absent or Weak Trend
25-50 => Strong Trend
50-75 => Very Strong Trend
75-100 => Extremely Strong Trend
Low ADX is usually a sign of accumulation or distribution. When ADX is below 25 for more than 30 bars, price enters range-bound conditions, and price patterns are often easier to identify. Price then moves up and down between resistance and support to find selling and buying interest, respectively. From low ADX conditions, price will eventually break out into a trend.
The direction of the ADX line is important for reading trend strength. When the ADX line is rising, trend strength is increasing, and the price moves in the direction of the trend. When the line is falling, trend strength is decreasing, and the price enters a period of retracement or consolidation.
A common misperception is that a falling ADX line means the trend is reversing. A falling ADX line only means that the trend strength is weakening, but it usually does not mean the trend is reversing, unless there has been a price climax, such as a double top/bottom or a head-and-shoulders pattern. As long as the ADX is above 25, it is best to think of a falling ADX line as simply a trend that is weakening. When the ADX is below 25, the trend is weak. When ADX is above 25 and rising, the trend is strong. When the ADX is above 25 and falling, the trend is less strong.
Like we said, we do not use any of these indicators on our chart as we do not need them. They will only over-complicate things and most of the time contradict our trading decisions. Most bounded indicators are “oscillators”. Oscillators are one of the most common indicator types. As you will see, the most common signals these indicators produce are crossovers and divergences.
The RSI is such an “oscillator”, it is contained between 0 and 100. Therefore it provides us with some different information than the MACD. The RSI indicator is a momentum indicator and thus measures the strength of the market, “Relative Strength Index”.
One of the hardest things (trend and pullback) traders need to do, is to detect if a move down is a small retrace or an actual end of a trend. Momentum can help with this.
In physics momentum is mass x velocity. In trading momentum is just measure over past price change and there is no such thing as mass. A good approach is maybe to add volume to the momentum indicator (MFI indicator) as a replacement for mass. But the main difference is that in trading, psychology plays a big role too. A panic drop can’t really be foreseen, that’s why it causes such panic and thus momentum.
So the RSI measure price changes. RSI is calculated over a lookback period, default this is 14 period. The longer this lookback period, the smoother the indicator line. The shorter, the closer it follows price. Even though the RSI follows price like a MA, it is not a trend indicator. When price drops lower or jumps higher, it just does so at a faster speed, creating the same move on the momentum indicator. When the market goes sideways, the speed at which price changes often changes much less, so the RSI also stays flat also.A smoother line may visually look better, but a faster line responds better to price changes. But a fast RSI can cause more “whipsaw”.
As said the RSI is an “oscillator” type, bounded indicator, its value goes from 0 to 100.
In reality it rarely touches 0 or 100, but more often turns at the 30 and 70 levels. Above 70 is called “overbought” and below 30 is called “oversold”. Many traders use these as buy or sell signals. But this is dangerous, as price can actually go much higher or lower or stay above 70 or below 30 longer than you are willing to hold a losing position. Trust me! It can stay there for months while price is not reversing.
These days traders use momentum indicators like the RSI a lot. Some even base their trading decisions solely on momentum. Traders call the RSI a leading indicator. This might seem confusing, as the RSI is also based on past prices. RSI is no “holy grail”, it’s just measuring the speed and strength of the market. Most of the time the market is already losing steam, before the end of the trend is visible in price. RSI measures this rate of change. As many people trade according to the RSI values, it also has a self-fulfilling nature.
In the next example you see 2 price swings. Both lasted the same amount of time, but swing A made a bigger move obviously. This is how momentum is calculated: the amount that price moved in a particular period.
Especially in strong trends, RSI can remain in overbought/ oversold territory, while price reaches much further. But it is often true that price reverses to the downside, once it enters “overbought” territory and vice versa.
There are many other indicators that are used by the masses and that you should at least know the existence off, such as:
ATR: Average True Range
The “Stochastics” indicator is a popular member of the “Oscillator” family of technical indicators. George Lane created the Stochastics oscillator when he observed that, as markets reach a peak, the closing prices tend to approach the daily highs, and vice-versa. Lane, over the course of numerous interviews, has said that the stochastic oscillator does not follow price or volume or anything similar. He indicates that the oscillator follows the speed or momentum of price. Lane also reveals in interviews that, as a rule, the momentum or speed of the price of an asset changes before the price changes itself. In this way, the stochastic oscillator can be used to foreshadow reversals when the indicator reveals bullish or bearish divergences. This signal is the first, and arguably the most important trading signal Lane identified.
What Does The Stochastic Oscillator Tell You?
The Stochastics indicator is classified as an “oscillator” since the values fluctuate between zero and “100”. The indicator chart typically has lines drawn at both the “20” and “80” values as warning signals. Values exceeding “80” are interpreted as a strong overbought condition, or “selling” signal, and if the curve dips below “20”, a strong oversold condition, or “buying” signal, is generated. However, these are not always indicative of impending reversal; very strong trends can maintain overbought or oversold conditions for an extended period. Instead, traders should look for changes in the stochastic oscillator with regards to clues about future trend shifts.
Stochastic oscillator charting generally consists of two lines: one reflecting the actual value of the oscillator for each session, and one reflecting its three-day simple moving average. Because price is thought to follow momentum, intersection of these two lines is considered to be a signal that a reversal may be in the works, as it indicates a large shift in momentum from day to day.
Divergence between the stochastic oscillator and trending price action is also seen as an important reversal signal. For example, when a bearish trend reaches a new lower low, but the oscillator prints a higher low, it may be an indicator that bears are exhausting their momentum and a bullish reversal is brewing.
The stochastic oscillator presents the location of the closing price of an asset in relation to the high and low range of the price of that asset over a period of time, typically a 14-day period.
Example Of How To Use The Stochastic Oscillator
The stochastic oscillator is included in most charting platforms and can be easily employed in practice. The standard time period used is 14 days, though this can be adjusted to meet specific analytical needs. The stochastic oscillator is calculated by subtracting the low for the period from the current closing price, dividing by the total range for the period and multiplying by 100. As a hypothetical example, if the 14-day high is $150, the low is $125 and the current close is $145, then the reading for the current session would be: (145-125)/(150-125)*100, or 80.
By comparing current price to the range over time, the stochastic oscillator reflects the consistency with which price closes near its recent high or low. A reading of 80 would indicate that the asset is on the verge of being overbought.
The Difference Between The Relative Strength Index (RSI) and The Stochastic Oscillator
The relative strength index (RSI) and stochastic oscillator are both price momentum oscillators that are widely used in technical analysis. While often used in tandem, they each have different underlying theories and methods. The stochastic oscillator is predicated on the assumption that closing prices should close near the same direction as the current trend. Meanwhile, the RSI tracks overbought and oversold levels by measuring the velocity of price movements. In other words, the RSI was designed to measure the speed of price movements, while the stochastic oscillator formula works best in consistent trading ranges.
In general, the RSI is more useful during trending markets, and stochastics more so in sideways range-bound or choppy markets.
Bollinger Bands are among the most reliable and potent trading indicators traders can choose from. They can be used to read the trend strength, to time entries during range markets and to find potential market tops. The indicator is also not a lagging indicator because it always adjusts to price action in real time and uses volatility to adjust to the current environment.
As the name implies, Bollinger Bands are price channels (bands) that are plotted above and below price. The outer Bollinger Bands are based on price volatility, which means that they expand when the price fluctuates and trends strongly, and the Bands contract during sideways consolidations and low momentum trends.
By default, the Bollinger Bands are set to 2.0 Standard deviations which means that, from a statistical perspective, 95% of all the price action happens in between the channels. A move close to the, or outside of the outer Bollinger Bands shows a significant price move – more on that later.
In the center of the Bollinger Bands, is the 20-period moving average and the perfect addition to the volatility based outer bands. We can use the Bollinger Bands to analyse the strength of trends and get a lot of important information this way. There are just a few things you need to pay attention to when it comes to using Bollinger Bands to analyse trend strength:
During strong trends, price stays close to the outer band. If price pulls away from the outer band as the trend continues, it shows fading momentum. Repeated pushes into the outer bands that don’t actually reach the band show a lack of power.
The Average True Range (ATR) indicator is unlike any other trading indicator that measure momentum, trend direction, overbought levels, and etc. The ATR indicator is something entirely different. And if used correctly, the Average True Range is one of the most powerful indicators you’ll come across.
It’s developed by J. Welles Wilder and was first mentioned in his book, New Concepts in Technical Analysis Systems (in 1978).
This is how the ATR is calculated:
Method 1: Current high less the current low
Method 2: Current high less the previous close
Method 3: Current low less the previous close
See the image below:
As you can see:
Example A: The current candle’s range is larger than the previous candle, we use method.
Example B: The current candle closes higher than the previous candle, we use method.
Example C: The current candle closes lower than the previous candle, we use method 3.
This is what is comes down to: The larger the range of the candles, the greater the ATR value (and vice versa). The ATR indicator is NOT a trending indicator. A mistake traders make is to assume that volatility and trend go in the same direction. This is not the case. A trend can continue for a long time on low volume. The Average True Range indicator measures the volatility of the market. This means volatility can be low while the market is trending higher (and vice versa).
As you can see price is volatile during the first part of the day (big candles up and down) and once price stabilizes, price movement is reduced and the ATR slopes down.
This concludes this chapter on Indicators. Although there are thousands to choose from, remember we only use the four we laid out in the beginning of this chapter (12 EMA, 50 EMA, MACD and the ADX).