Forex Knowledge hub PART-2
Commission Free Trading
You know what’s great about trading currencies? You pay NO commissions! Because you deal directly with the market maker via a purely electronic online exchange, you eliminate both ticket costs and middleman brokerage fees. There is still a cost to initiating any trade,
but that cost is reflected in the bid/ask spread that is also present in futures or equities trading. Brokers are compensated for their services through the bid-ask spread instead of via commissions.
Price Certainty When trading Forex, you get rapid execution and price certainty under normal market
conditions. In contrast, the futures and equities markets do not offer price certainty or instant trade execution. Even with the advent of electronic trading and limited guarantees
of execution speed, the prices for fills for futures and equities on market orders are far from certain. The prices quoted by brokers often represent the LAST trade, not necessarily the price for which the contract will be filled.
Guaranteed Limited Risk
Traders must have position limits for the purpose of risk management. This number is set relative to the money in a trader’s account. Risk is minimized in the spot FX market because the online capabilities of the trading platform will automatically generate a
margin call if the required margin amount exceeds the available trading capital in your account. All open positions will be closed immediately, regardless of the size or the nature of positions held within the account. In the futures market, your position may be liquidated at a loss, and you will be liable for any resulting deficit in the account. That sucks.
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Impress Your Date with Your Forex Lingo
As in any new skill that you learn, you need to learn the lingo...especially if you wish to woo your love's heart. You, the newbie, must know certain terms like the back of your
hand before making your first trade. Some of these terms you've already learned, but it never hurts to have a little review.
Major and Minor Currencies
The eight most frequently traded currencies (USD, EUR, JPY, GBP, CHF, CAD, NZD and AUD) are called the major currencies. All other currencies are referred to as minor
currencies. Do not worry about the minor currencies, they are for professionals only. Actually, on this site we'll mostly cover what we call the Fab Five (USD, EUR, JPY, GBP, and
CHF). These pairs are the most liquid and the most sexy.
Base Currency
The base currency is the first currency in any currency pair. It shows how much the base currency is worth as measured against the second currency. For example, if the USD/CHF
rate equals 1.6350, then one USD is worth CHF 1.6350. In the Forex markets, the U.S. dollar is normally considered the “base” currency for quotes, meaning that quotes are expressed as a unit of $1 USD per the other currency quoted in the pair. The primary exceptions to this rule are the British pound, the Euro, and the Australian and New
Zealand dollar.
Quote Currency
The quote currency is the second currency in any currency pair. This is frequently called
the pip currency and any unrealized profit or loss is expressed in this currency.
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Pip
A pip is the smallest unit of price for any currency. Nearly all currency pairs consist of five
significant digits and most pairs have the decimal point immediately after the first digit,
that is, EUR/USD equals 1.2538. In this instance, a single pip equals the smallest change in
the fourth decimal place - that is, 0.0001. Therefore, if the quote currency in any pair is
USD, then one pip always equal 1/100 of a cent.
One notable exception is the USD/JPY pair where a pip equals $0.01.
Bid Price
The bid is the price at which the market is prepared to buy a specific currency pair in the
Forex market. At this price, the trader can sell the base currency. It is shown on the left side of the quotation.
For example, in the quote GBP/USD 1.8812/15, the bid price is 1.8812. This means you sell
one British pound for 1.8812 U.S. dollars.
Ask Price
The ask is the price at which the market is prepared to sell a specific currency pair in the
Forex market. At this price, you can buy the base currency. It is shown on the right side of
the quotation.
For example, in the quote EUR/USD 1.2812/15, the ask price is 1.2815. This means you
can buy one Euro for 1.2815 U.S. dollars. The ask price is also called the offer price.
Bid/Ask Spread
The spread is the difference between the bid and ask price. The “big figure quote” is the
dealer expression referring to the first few digits of an exchange rate. These digits are often omitted in dealer quotes. For example, the USD/JPY rate might be 118.30/118.34,
but would be quoted verbally without the first three digits as “30/34”.
Quote Convention
Exchange rates in the Forex market are expressed using the following format:
Base currency / Quote currency Bid / Ask
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Transaction Cost
The critical characteristic of the bid/ask spread is that it is also the transaction cost for a
round-turn trade. Round-turn means both a buy (or sell) trade and an offsetting sell (or
buy) trade of the same size in the same currency pair. For example, in the case of the
EUR/USD rate of 1.2812/15, the transaction cost is three pips.
The formula for calculating the transaction cost is:
Transaction cost = Ask Price – Bid Price
Cross Currency
A cross currency is any pair in which neither currency is the U.S. dollar. These pairs exhibit
erratic price behavior since the trader has, in effect, initiated two USD trades. For
example, initiating a long (buy) EUR/GBP is equivalent to buying a EUR/USD currency pair and selling a GBP/USD. Cross currency pairs frequently carry a higher transaction cost. Margin
When you open a new margin account with a Forex broker, you must deposit a minimum
amount with that broker. This minimum varies from broker to broker and can be as low as
$100 to as high as $100,000.
Each time you execute a new trade, a certain percentage of the account balance in the
margin account will be set aside as the initial margin requirement for the new trade
based upon the underlying currency pair, its current price, and the number of units (or
lots) traded. The lot size always refers to the base currency.
For example, let's say you open a mini account which provides a 200:1 leverage or .5%
margin. Mini accounts trade mini lots. Let's say one mini lot equals $10,000. If you were to open one mini-lot, instead of having to provide the full $10,000, you would only need $50
($10,000 x .5 = $50).
Leverage
Leverage is the ratio of the amount capital used in a transaction to the required security
deposit (margin). It is the ability to control large dollar amounts of a security with a
relatively small amount of capital. Leveraging varies dramatically with different brokers,
ranging from 2:1 to 400:1.
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Margin + Leverage = Possible Deadly Combination
Trading currencies on margin lets you increase your buying power. Meaning that if you
have $5,000 cash in a margin account that allows 100:1 leverage, you could purchase up
to $500,000 worth of currency because you only have to post one percent of the purchase price as collateral. Another way of saying this is that you have $500,000 in buying power. With more buying power, you can increase your total return on investment with less cash
outlay. But be careful, trading on margin magnifies your profits AND losses.
Margin Call
All traders fear the dreaded margin call. This occurs when your broker notifies you that
your margin deposits have fallen below the required minimum level because an open
position has moved against you.
While trading on margin can be a profitable investment strategy, it is important that you
take the time to understand the risks. Make sure you fully understand how your margin
account works, and be sure to read the margin agreement between you and your broker. Always ask any questions if there is anything unclear to you in the agreement. Your positions could be partially or totally liquidated should the available margin in your
account fall below a predetermined threshold. You may not receive a margin call before your positions are liquidated (the ultimate unexpected birthday gift). Margin calls can be effectively avoided by monitoring your account balance on a very regular basis and by utilizing stop-loss orders (discussed later) on every open position to
limit risk. Protect Yo Self Before You Wreck Yo Self
Before we go any further we are going to be 100% honest with you and tell you the following before you consider trading currencies:
1. All forex traders, and we mean all traders LOSE money on trades.
Ninety percent of traders lose money, largely due to lack of planning and training
and having poor money management rules. Also, if you hate to lose or are a super
perfectionist, you'll probably have a hard time adjusting to trading.
2. Trading forex is not for the unemployed, those on low incomes, or who can't
afford to pay their electricity bill or afford to eat.
You should have at least $10,000 of trading capital (in a mini account) that you can
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afford to lose. Don’t expect to start an account with a few hundred dollars and
expect to become a kazillionaire.
The Forex market is one of the most popular markets for speculation, due to its enormous
size, liquidity and tendency for currencies to move in strong trends. You would think
traders all over the world would make a killing, but success has been limited to very small
percentage of traders.
Many traders come with the misguided hope of making a gazillion bucks, but in reality, lack the discipline required for trading. Most people usually lack the discipline to stick to a
diet or to go to the gym three times a week. If you can't even do that, how do you think you're going to succeed trading?
Short term trading IS NOT for amateurs, and it is rarely the path to “get rich quick”. You can't make gigantic profits without taking gigantic risks. A trading strategy that involves
taking a massive degree of risk means suffering inconsistent trading performance and often suffering large loss. A trader who does this probably doesn’t even have a trading
strategy - unless you call gambling a trading strategy!
Forex Trading is not a Get-Rich-Quick Scheme!
Forex trading is a SKILL that takes TIME to learn.
Skilled traders can and do make money in this field. However, like any other occupation or career, success doesn’t just happen overnight.
Forex trading isn’t a piece of cake (as some people would like you to believe). Think about it, if it was, everyone trading would already be millionaires. The truth is that even expert
traders with years of experience still encounter periodic losses.
Drill this in your head: there are NO shortcuts to Forex trading. It takes lots and lots of TIME to master.
There is no substitute for hard work and diligence. Practice trading on a DEMO ACCOUNT and pretend the virtual money is your own real money.
Do NOT open a live trading account until you are trading PROFITABLY on a demo account.
If you can't wait until you're profitable on a demo account, at least demo trade for 2 months. Hey, at least you were able to hold off losing all your money for two months
right? If you can't hold out for 2 months, cut your hands off.
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Concentrate on ONE major currency pair.
It gets far too complicated to keep tabs on more than one currency pair when you first
start trading. Stick with one of the majors because they are the most liquid which makes
their spreads cheap.
You can be a winner at currency trading, but as in all other aspects of life, it will take hard work, dedication, a little luck, a lot of common sense, and a whole lot of good judgment.
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Types of Trading
Congratulations! You’ve gotten through the Pre-School and are ready to begin your first day of class. You did go through the Pre-School right? By now you’ve learned some history
about the Forex, how it works, what affects the prices, blah blah blah.
We know what you’re thinking…BORING! SHOW ME HOW TO MAKE MONEY ALREADY! Well, say no more my friend; because here is where your journey as a Forex trader begins…
This is your last chance to turn back… Take the red pill, and we take you back to where you were and you will forget all about this. You can go back to living your average life in
your 9-5 job and work for someone else for the rest of your life.
OR
You can take the green pill (green for money! Yeah!) And learn how you can make money
for yourself in the most active market in the world, simply by using a little brain power. Just remember, your education will never stop. Even after you you must constantly pursue as much knowledge as you can, so that you can become a true FOREX MASTER! Now pop that green pill in, wash it down with some chocolate milk, and grab your lunchbox…School of Pipsology is now in session! Note: the green pill was made with a brainwashing serum. You will now obey everything
that we tell you to do! Mwuahahaha! <--evil laugh
Two Types of Trading
There are 2 basic types of analysis you can take when approaching the forex:
1. Fundamental analysis
2. Technical analysis.
There has always been a constant debate as to which analysis is better, but to tell you the
truth, you need to know a little bit of both. So let’s break each one down and then come
back and put them together.
Fundamental Analysis
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Fundamental analysis is a way of looking at the market through economic, social and
political forces that affect supply and demand. (Yada yada yada.) In other words, you look
at whose economy is doing well, and whose economy sucks. The idea behind this type of
analysis is that if a country’s economy is doing well, their currency will also be doing well.
This is because the better a country’s economy, the more trust other countries have in that currency.For example, the U.S. dollar has been gaining strength because the U.S. economy is gaining strength. As the economy gets better, interest rates get higher to control inflation
and as a result, the value of the dollar continues to increase. In a nutshell, that is basically what fundamental analysis is.
Later on in the course you will learn which specific news events drive currency prices the most. For now, just know that the fundamental analysis of the Forex is a way of analyzing
a currency through the strength of that country’s economy.
Technical Analysis
Technical analysis is the study of price movement. In one word, technical analysis =
charts. The idea is that a person can look at historical price movements, and, based on
the price action, can determine at some level where the price will go. By looking at charts,
you can identify trends and patterns which can help you find good trading opportunities.
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The most IMPORTANT thing you will ever learn in technical analysis is the trend! Many, many, many, many, many, many people have a saying that goes, “The trend is your
friend”. The reason for this is that you are much more likely to make money when you can find a trend and trade in the same direction. Technical analysis can help you identify
these trends in its earliest stages and therefore provide you with very profitable trading
opportunities.
Now I know you’re thinking to yourself, “Geez, these guys are smart. They use crazy
words like "technical" and "fundamental" analysis. I can never learn this stuff!” Don't
worry yourself too much. After you're done with the School of Pipsology, you too will be
just as....uhmmm..."smart?" as us.
By the way, do you feel that green pill kicking in yet? Bark like a dog!
So which type of analysis is better?
Ahh, the million dollar question. Throughout your journey as an aspiring Forex trader you will find strong advocates for both fundamental and technical trading. You will have those
who argue that it is the fundamentals alone that drive the market and that any patterns found on a chart are simply coincidence. On the other hand, there will be those who argue
that it is the technicals that traders pay attention to and because traders pay attention to it, common market patterns can be found to help predict future price movements.
Do not be fooled by these one sided extremists! One is not better than the other...
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In order to become a true Forex master you will need to know how to effectively use both
types of analysis. Don't believe me? Let me give you an example of how focusing on only
one type of analysis can turn into a disaster.
• Let’s say that you’re looking at your charts and you find a good trading opportunity. You
get all excited thinking about the money that’s going to be raining down from the sky. You
say to yourself, “Man, I’ve never seen a more perfect trading opportunity. I love my
charts.”
• You then proceed to enter your trade with a big fat smile on your face (the kind where all
your teeth are showing).
• But wait! All of a sudden the trade makes a 30 pip move in the OTHER DIRECTION! Little
did you know that there was an interest rate decrease for your currency and now
everyone is trading in the opposite direction.
• Your big fat smile turns into mush and you start getting angry at your charts. You throw
your computer on the ground and begin to pulverize it. You just lost a bunch of money,
and now your computer is broken. And it’s all because you completely ignored
fundamental analysis.
(Note: This was not based on a real story. This did not happen to me. I was never this
naive. I was always a smart trader.... From the overused sarcasm, I think you get the
picture)
Ok, ok, so the story was a little over-dramatized, but you get the point.
The Forex is like a big flowing ball of energy, and within that ball is a balance between
fundamental and technical factors that play a part in determining where the market will
go.
Remember how your mother or father used to
tell you as a kid that too much of anything is
never good? Well you might've thought that
was just hogwash back then but in the Forex,
the same applies when deciding which type of
analysis to use. Don't rely on just one. Instead,
you must learn to balance the use of both of
them, because it is only then that you can
really get the most out of your trading.
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Types of Charts
Let’s take a look at the three most popular types of charts:
1. Line chart
2. Bar chart
3. Candlestick chart
Line Charts
A simple line chart draws a line from one closing price to the next closing price. When
strung together with a line, we can see the general price movement of a currency pair
over a period of time.
Here is an example of a line chart for EUR/USD:
Bar Charts
A bar chart also shows closing prices, while simultaneously showing opening prices, as
well as the highs and lows. The bottom of the vertical bar indicates the lowest traded price
for that time period, while the top of the bar indicates the highest price paid. So, the
vertical bar indicates the currency pair’s trading range as a whole. The horizontal hash on
the left side of the bar is the opening price, and the right-side horizontal hash is the
closing price.
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Here is an example of a bar chart for EUR/USD:
NOTE: Throughout our lessons, you will see the word “bar” in reference to a single piece
of data on a chart. A bar is simply one segment of time, whether it is one day, one week,
or one hour. When you see the word ‘bar’ going forward, be sure to understand what
time frame it is referencing.
Bar charts are also called “OHLC” charts, because they indicate the Open, the High, the
Low, and the Close for that particular currency. Here’s an example of a price bar:
Open: The little horizontal line on the left is the
opening price
High: The top of the vertical line defines the highest
price of the time period
Low: The bottom of the vertical line defines the
lowest price of the time period
Close: The little horizontal line on the right is the
closing price
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Candlestick Charts
Candlestick charts show the same information as a bar chart, but in a prettier, graphic
format.
Candlestick bars still indicate the high-to-low range with a vertical line. However, in
candlestick charting, the larger block in the middle indicates the range between the
opening and closing prices. Traditionally, if the block in the middle is filled or colored in,
then the currency closed lower than it opened.
In the following example, the ‘filled color’ is black. For our ‘filled’ blocks, the top of the
block is the opening price, and the bottom of the block is the closing price. If the closing
price is higher than the opening price, then the block in the middle will be “white” or
hollow or unfilled.
We don’t like to use the traditional black and white candlesticks. We feel it’s easier to look
at a chart that’s colored. A color television is much better than a black and white television, so why not in candlestick charts?
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We simply substituted green instead of white, and red instead of black. This means that if
the price closed higher than it opened, the candlestick would be green. If the price closed
lower than it opened, the candlestick would be red. In our later lessons, you will see how
using green and red candles will allow you to “see” things on the charts much faster, such
as uptrend/downtrends and possible reversal points.
For now, just remember that we use red and green candlesticks instead of black and white
and we will be using these colors from now on.
Check out these candlesticks…BabyPips.com style! Awww yeeaaah! You know you like that!
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Here is an example of a candlestick chart for EUR/USD. Isn’t it pretty?
The purpose of candlestick charting is strictly to serve as a visual aid, since the exact same
information appears on an OHLC bar chart. The advantages of candlestick charting are:
• Candlesticks are easy to interpret, and are a good place for a beginner to start figuring out
chart analysis.
• Candlesticks are easy to use. Your eyes adapt almost immediately to the information in
the bar notation.
• Candlesticks and candlestick patterns have cool names such as the shooting star, which
helps you to remember what the pattern means.
• Candlesticks are good at identifying marketing turning points – reversals from an uptrend
to a downtrend or a downtrend to an uptrend. You will learn more about this later.
Now that you know why candlesticks are so cool, it’s time to let you know that we will be
using candlestick charts for most, if not all of chart examples on this site.
Summary
Types of Trading:
• There are 2 types of analysis: Fundamental and Technical
• Fundamental analysis is the analysis of a market through the strength of its
economy. (i.e. the dollar gets stronger because the US economy is getting
stronger)
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• Technical analysis is the analysis of price movements. Technical analysis = charts.
• Technical analysis also helps us identify trends which can help us find profitable
trading opportunities.
• To become a successful trader, you must always incorporate both types of analysis.
Types of Charts:
• There are three types of charts:
1. Line charts
2. Bar charts
3. Candlestick charts
• We will be using candlesticks from now on
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What is a Candlestick?
While we briefly covered candlestick charts in the previous lesson, we’ll now dig in a little
and discuss them more in detail. First let’s do a quick review.
What is a Candlestick?
Back in the day when Godzilla was still a cute little lizard, the Japanese created their own
old school version of technical analysis to trade rice. A westerner by the name of Steve
Nison “discovered” this secret technique on how to read charts from a fellow Japanese
broker and Japanese candlesticks lived happily ever after. Steve researched, studied, lived,
breathed, ate candlesticks, began writing about it and slowly grew in popularity in 90s. To
make a long story short, without Steve Nison, candle charts might have remained a buried
secret. Steve Nison is Mr. Candlestick.
Okay so what the heck are candlesticks?
The best way to explain is by using a picture:
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Candlesticks are formed using the open, high, low and close.
• If the close is above the open, then a hollow candlestick (usually displayed as white) is
drawn.
• If the close is below the open, then a filled candlestick (usually displayed as black) is
drawn.
• The hollow or filled section of the candlestick is called the “real body” or body.
• The thin lines poking above and below the body display the high/low range and are called
shadows.
• The top of the upper shadow is the “high”.
• The bottom of the lower shadow is the “low”.
Sexy Bodies and Strange Shadows
Sexy Bodies
Just like humans, candlesticks have different body sizes. And when it comes to forex
trading, there’s nothing naughtier than checking out the bodies of candlesticks!
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Long bodies indicate strong buying or selling. The longer the body is, the more intense the
buying or selling pressure.
Short bodies imply very little buying or selling activity. In street forex lingo, bulls mean
buyers and bears mean sellers.
Long white candlesticks show strong
buying pressure. The longer the white
candlestick, the further the close is above
the open. This indicates that prices
increased considerably from open to close
and buyers were aggressive. In other
words, the bulls are kicking the bears’
butts big time!
Long black (filled) candlesticks show strong
selling pressure. The longer the black
candlestick, the further the close is below
the open. This indicates that prices fell a great deal from the open and sellers were
aggressive. In other words, the bears were grabbing the bulls by their horns and body
slamming them.
Mysterious Shadows
The upper and lower shadows on candlesticks provide important clues about the trading session.
Upper shadows signify the session high. Lower shadows signify the session low.
Candlesticks with long shadows show that trading action occurred well past the open and close.
Candlesticks with short shadows indicate that most of the trading action was confined near the open and close.
If a candlestick has a long upper shadow
and short lower shadow, this means that
buyers flexed their muscles and bided
prices higher, but for one reason or
another, sellers came in and drove prices
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back down to end the session back near its open price.
If a candlestick has a long lower shadow and short upper shadow, this means that sellers
flashed their washboard abs and forced price lower, but for one reason or another, buyers
came in and drove prices back up to end the session back near its open price.
Basic Candlestick Patterns
Spinning Tops Candlesticks with a long upper shadow, long lower shadow and small real bodies are
called spinning tops. The color of the real body is not very important.
The pattern indicates the indecision between the buyers and sellers
The small real body (whether hollow or
filled) shows little movement from open to
close, and the shadows indicate that both
buyers and sellers were fighting but
nobody could gain the upper hand.
Even though the session opened and
closed with little change, prices moved
significantly higher and lower in the
meantime. Neither buyers nor sellers
could gain the upper hand, and the result
was a standoff. If a spinning top forms during an uptrend, this usually means there aren’t many buyers left
and a possible reversal in direction could occur.
If a spinning top forms during a downtrend, this usually means there aren’t many sellers left and a possible reversal in direction could occur.
Marubozu
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Sounds like some kind of voodoo magic huh? "I will cast the evil spell of the Marubozu on
you!" Fortunately, that's not what it means. Marubozu means there are no shadows from
the bodies. Depending on whether the candlestick’s body is filled or hollow, the high and
low are the same as it’s open or close. If you look at the picture below, there are two
types of Marubozus.
A White Marubozu contains a long white
body with no shadows. The open price
equals the low price and the close price
equals the high price. This is a very bullish
candle as it shows that buyers were in
control the whole entire session. It usually
becomes the first part of a bullish
continuation or a bullish reversal pattern.
A Black Marubozu contains a long black
body with no shadows. The open equals
the high and the close equals the low. This
is a very bearish candle as it shows that
sellers controlled the price action the
whole entire session. It usually implies bearish continuation or bearish reversal. Doji
Doji candlesticks have the same open and close price or at least their bodies are extremely
short. The doji should have a very small body that appears as a thin line.
Doji suggest indecision or a struggle for turf positioning between buyers and sellers. Prices move above and below the open price during the session, but close at or very near the open price.
Neither buyers nor sellers were able to gain control and the result was essentially a draw.
There are four special types of Doji lines. The length of the upper and lower shadows can vary and the resulting candlestick looks like a cross, inverted cross or plus sign. The word
"Doji" refers to both the singular and plural form.
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When a doji forms on your chart, pay special attention to the preceding candlesticks.
If a doji forms after a series of candlesticks with long filled bodies (like white marubozus),
the doji signals that the buyers are becoming exhausted and weakening. In order for price
to continue rising, more buyers are needed but there aren’t anymore! Sellers are licking their chops and are looking to come in and drive the price back down. Keep in mind that even after a doji forms,
this doesn’t mean to automatically short.
Confirmation is still needed. Wait for a
bearish candlestick to close below the long
white candlestick’s open.
If a doji forms after a series of candlesticks
with long hollow bodies (like black
marubozus), the doji signals that sellers
are becoming exhausted and weakening.
In order for price to continue falling, more
sellers are needed but sellers are all
tapped out! Buyers are foaming in the
mouth for a chance to get in cheap.
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While the decline is sputtering due to lack
of new sellers, further buying strength is
required to confirm any reversal. Look for
a white candlestick to close above the long
black candlestick’s open.
Reversal Patterns
Prior Trend
For a pattern to qualify as a reversal pattern, there should be a prior trend to reverse.
Bullish reversals require a preceding downtrend and bearish reversals require a prior
uptrend. The direction of the trend can be determined using trendlines, moving averages,
or other aspects of technical analysis.
Hammer and Hanging Man
The hammer and hanging man look exactly alike but have totally different meaning
depending on past price action. Both have cute little bodies (black or white), long lower
shadows and short or absent upper shadows.
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The hammer is a bullish reversal pattern that forms during a downtrend. It is named
because the market is hammering out a bottom.
When price is falling, hammers signal that the bottom is near and price will start rising
again. The long lower shadow indicates that sellers pushed prices lower, but buyers were
able to overcome this selling pressure and closed near the open.
Word to the wise… just because you see a hammer form in a downtrend doesn’t mean
you automatically place a buy order! More bullish confirmation is needed before it’s safe
to pull the trigger. A good confirmation example would be to wait for a white candlestick
to close above the open of the candlestick on the left side of the hammer.
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Recognition Criteria:
• The long shadow is about two or three times of the real body.
• Little or no upper shadow.
• The real body is at the upper end of the trading range.
• The color of the real body is not important.
The hanging man is a bearish reversal pattern that can also mark a top or strong
resistance level. When price is rising, the formation of a hanging man indicates that sellers
are beginning to outnumber buyers. The long lower shadow shows that sellers pushed
prices lower during the session. Buyers were able to push the price back up some but only
near the open. This should set off alarms since this tells us that there are no buyers left to
provide the necessary momentum to keep raising the price. .
Recognition Criteria:
• A long lower shadow which is about two or three times of the real body.
• Little or no upper shadow.
• The real body is at the upper end of the trading range.
• The color of the body is not important, though a black body is more bearish than a white
body.
Inverted Hammer and Shooting Star
The inverted hammer and shooting star also look identical. The only difference between
them is whether you’re in a downtrend or uptrend. Both candlesticks have petite little
bodies (filled or hollow), long upper shadows and small or absent lower shadows.
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The inverted hammer occurs when price has been falling suggests the possibility of a reversal. Its long upper shadow shows that buyers tried to bid the price higher. However,
sellers saw what the buyers were doing, said “oh hell no” and attempted to push the price back down. Fortunately, the buyers had eaten enough of their Wheaties for breakfast and
still managed to close the session near the open. Since the sellers weren’t able to close the price any lower, this is a good indication that everybody who wants to sell has already sold. And if there’s no more sellers, who is left? Buyers. The shooting star is a bearish reversal pattern that looks identical to the inverted hammer
but occurs when price has been rising. Its shape indicates that the price opened at its low, rallied, but pulled back to the bottom. This means that buyers attempted to push the price
up, but sellers came in and overpowered them. A definite bearish sign since there are no
more buyers left because they’ve all been murdered.
Summary
Candlesticks are formed using the open, high, low and close.
• If the close is above the open, then a hollow candlestick (usually displayed as white) is drawn.
• If the close is below the open, then a filled candlestick (usually displayed as black) is drawn.
• The hollow or filled section of the candlestick is called the “real body” or body.
• The thin lines poking above and below the body display the high/low range and are called shadows.
• The top of the upper shadow is the “high”.
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• The bottom of the lower shadow is the “low”.
Long bodies indicate strong buying or selling. The longer the body is, the more intense the buying or selling pressure.
Short bodies imply very little buying or selling activity. In street forex lingo, bulls mean buyers and bears mean sellers.
Upper shadows signify the session high.
Lower shadows signify the session low.
Candlesticks with a long upper shadow, long lower shadow and small real bodies are
called spinning tops. The pattern indicates the indecision between the buyers and sellers
Marubozu means there are no shadows from the bodies. Depending on whether the
candlestick’s body is filled or hollow, the high and low are the same as it’s open or close.
Doji candlesticks have the same open and close price or at least their bodies are extremely short.
The hammer is a bullish reversal pattern that forms during a downtrend. It is named because the market is hammering out a bottom.
The hanging man is a bearish reversal pattern that can also mark a top or strong resistance level.
The inverted hammer occurs when price has been falling suggests the possibility of a reversal.
The shooting star is a bearish reversal pattern that looks identical to the inverted hammer
but occurs when price has been rising.
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Support and Resistance
Support and resistance is one of the most widely used concepts in trading. Strangely
enough, everyone seems to have their own idea on how you should measure support and resistance.
Let’s just take a look at the basics first.
Look at the diagram above. As you can see, this zigzag pattern is making its way up (bull market). When the market moves up and then pulls back, the highest point reached
before it pulled back is now resistance.
As the market continues up again, the lowest point reached before it started back is now
support. In this way resistance and support are continually formed as the market oscillates
over time. The reverse of course is true of the downtrend.
Plotting Support and Resistance
One thing to remember is that support and resistance levels are not exact numbers. Often times you will see a support or resistance level that appears broken, but soon after find
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out that the market was just testing it. With candlestick charts, these "tests" of support
and resistance are usually represented by the candlestick shadows.
Notice how the shadows of the candles tested the 2500 resistance level. At those times it
seemed like the market was "breaking" resistance. However, in hindsight we can see that
the market was merely testing that level.
So how do we truly know if support or resistance is broken?
There is no definite answer to this question. Some argue that a support or resistance level is broken if the market can actually close past that level. However, you will find that this is
not always the case. Let's take our same example from above and see what happened
when the price actually closed past the 2500 resistance level.
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In this case, the price had closed twice above the 2500 resistance level but both times ended up falling back down below it. If you had believed that these were real breakouts
and bought this pair, you would've been seriously hurtin! Looking at the chart now, you can visually see and come to the conclusion that the resistance was not actually broken;
and that it is still very much in tact and now even stronger.
So to help you filter out these false breakouts, you should think of support and resistance
more of as "zones" rather than concrete numbers. One way to help you find these zones is
to plot support and resistance on a line chart rather than a candlestick chart. The reason is
that line charts only show you the closing price while candlesticks add the extreme highs
and lows to the picture. These highs and lows can be misleading because often times they
are just the "knee-jerk" reactions of the market. It's like when someone is doing something really strange, but when asked about it, they simply reply, "Sorry, it's just a reflex."
When plotting support and resistance, you don't want the reflexes of the market. You only
want to plot its intentional movements.
Looking at the line chart, you want to plot your support and resistance lines around areas
where you can see the price forming several peaks or valleys.
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Other interesting tidbits about support and resistance:
1. When the market passes through resistance, that resistance now becomes support.
2. The more often price tests a level of resistance or support without breaking it the stronger
the area of resistance or support is.
Trend Lines
Trend lines are probably the most common form of technical analysis used today. They
are probably one of the most underutilized as well.
If drawn correctly, they can be as accurate as any other method. Unfortunately, most
traders don’t draw them correctly or they try to make the line fit the market instead of the
other way around.
In their most basic form, an uptrend line is drawn along the bottom of easily identifiable support areas (valleys). In a downtrend, the trend line is drawn along the top of easily
identifiable resistance areas (peaks).
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Channels
If we take this trend line theory one step further and draw a parallel line at the same angle
of the uptrend or downtrend, we will have created a channel.
To create an up (ascending) channel, simply draw a parallel line at the same angle as an
uptrend line and then move that line to position where it touches the most recent peak.
This should be done at the same time you create the trend line.
To create a down (descending) channel, simple draw a parallel line at the same angle as
the downtrend line and then move that line to a position where it touches the most recent valley. This should be done at the same time you created the trend line. When prices hit the bottom trend line this may be used as a buying area. When prices hit
the upper trend line this may be used as a selling area.
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Summary
When the market moves up and then pulls back, the highest point reached before it
pulled back is now resistance.
As the market continues up again, the lowest point reached before it started back is now
support.
In their most basic form, an uptrend line is drawn along the bottom of easily identifiable
support areas (valleys). In a downtrend, the trend line is drawn along the top of easily
identifiable resistance areas (peaks).
To create an up (ascending) channel, simply draw a parallel line at the same angle as an
uptrend line and then move that line to position where it touches the most recent peak.
To create a down (descending) channel, simple draw a parallel line at the same angle as
the downtrend line and then move that line to a position where it touches the most
recent valley.
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Fibonacci Who?
We will be using Fibonacci ratios a lot in our trading so you better learn it and love it like your mother. Fibonacci is a huge subject and there are many different studies of Fibonacci
with weird names but we’re going to stick to two: retracement and extension.
Let me first start by introducing you to the Fib man himself…Leonard Fibonacci.
Leonard Fibonacci was a famous Italian mathematician, also called a super duper uber geek, who had an “aha!” moment and discovered a simple series of numbers that created
ratios describing the natural proportions of things in the universe
The ratios arise from the following number series: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144
……
This series of numbers is derived by starting with 1 followed by 2 and then adding 1 + 2 to
get 3, the third number. Then, adding 2 + 3 to get 5, the fourth number, and so on.
After the first few numbers in the sequence, if you measure the ratio of any number to
that of the next higher number you get .618. For example, 34 divided by 55 equals 0.618.
If you measure the ratio between alternate numbers you get .382. For example, 34
divided by 89 = 0.382 and that’s as far as into the explanation as we’ll go.
These ratios are called the “golden mean.” Okay that’s enough mumbo jumbo. Even I’m
about to fall asleep with all these numbers. I'll just cut to the chase; these are the ratios
you have to know:
Fibonacci Retracement Levels
0.236, 0.382, 0.500, 0.618, 0.764
Fibonacci Extension Levels
0, 0.382, 0.618, 1.000, 1.382, 1.618
You won’t really need to know how to calculate all of this. Your charting software will do all the work for you. But it’s always good to be familiar with the basic theory behind the indicator so you’ll have knowledge to impress your date. Traders use the Fibonacci retracement levels as support and resistance levels. Since so many traders watch these same levels and place buy and sell orders on them to enter
trades or place stops, the support and resistance levels become a self-fulfilling
expectation.
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Traders use the Fibonacci extension levels as profit taking levels. Again, since so many traders are watching these levels and placing buy and sell orders to take profits, this tool
usually works due self-fulfilling expectations.
Most charting software includes both Fibonacci retracement levels and extension level
tools. In order to apply Fibonacci levels to your charts, you’ll need to identify Swing High
and Swing Low points.
A Swing High is a candlestick with at least two lower highs on both the left and right of itself.
A Swing Low is a candlestick with at least two higher lows on both the left and right of itself.
Let's take a closer look at Fibonacci retracement levels...
Fibonacci Retracement
In an uptrend, the general idea is to go long the market on a retracement to a Fibonacci
support level. In order to find the retracement levels, you would click on a significant
Swing Low and drag the cursor to the most recent Swing High. This will display each of the
Retracement Levels showing both the ratio and corresponding price level. Let’s take a look
at some examples of markets in an uptrend.
Watch how to draw Fibonacci retracement levels on a chart
This is an hourly chart of USD/JPY. Here we plotted the Fibonacci Retracement Levels by
clicking on the Swing Low at 110.78 on 07/12/05 and dragging the cursor to the Swing
High at 112.27 on 07/13/05. You can see the levels plotted by the software. The
Retracement Levels were 111.92 (0.236), 111.70 (0.382), 111.52 (0.500), and 111.35
(0.618). Now the expectation is that if USD/JPY retraces from this high, it will find support
at one of the Fibonacci Levels because traders will be placing buy orders at these levels as
the market pulls back.
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Now let’s look at what actually happened after the Swing High occurred. The market
pulled back right through the 0.236 level and continued the next day piercing the 0.382
level but never actually closing below it. Later on that day, the market resumed its
upward move. Clearly buying at the 0.382 level would have been a good short term trade.
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Now let’s see how we would use Fibonacci Retracement Levels during a downtrend. This is
an hourly chart for EUR/USD. As you can see, we found our Swing High at 1.3278 on
02/28/05 and our Swing Low at 1.3169 a couple hours later. The Retracement Levels were
1.3236 (0.618), 1.3224 (0.500), 1.3211 (0.382), and 1.3195 (.236). The expectation for a
downtrend is if it retraces from this high, it will encounter resistance at one of the
Fibonacci Levels because traders will be placing sell orders at these levels as the market
attempts to rally.
Let’s check out what happened next. Now isn’t that a thing of beauty! The market did try
to rally but it barely past the 0.500 level spiking to a high 1.3227 and it actually closed
below it. After that bar, you can see that the rally reversed and the downward move
continued. You would have made some nice dough selling at the 0.382 level.
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Here’s another example. This is an hourly chart for GBP/USD. We had a Swing High of
1.7438 on 07/26/05 and a Swing Low of 1.7336 the next day. So our Retracement Levels
are: 1.7399 (0.618), 1.7387 (0.500), 1.7375 (0.382), and 1.7360 (0.236). Looking at the
chart, the market looks like it tried to break the 0.500 level on several occasions, but try as
it may, it failed. So would putting a sell order at the 0.500 level be a good trade?
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If you did, you would have lost some serious cheddar! Take a look at what happened. The
Swing Low looked to be the bottom for this downtrend as the market rallied above the
Swing High point.
You can see from these examples the market usually finds at least temporary support
(during an uptrend) or resistance (during a downtrend) at the Fibonacci Retracements
Levels. It’s apparent that there a few problems to deal with here. There’s no way of
knowing which level will provide support. The 0.236 seems to provide the weakest
support/resistance, while the other levels provide support/resistance at about the same
frequency. Even though the charts above show the market usually only retracing to the
0.382 level, it doesn’t mean the price will hit that level every time and reverse. Sometimes
it’ll hit the 0.500 and reverse, other times it’ll hit the 0.618 and reverse, and other times
the price will totally ignore Mr. Fibonacci and blow past all the levels like similar to the
way Allen Iverson blows past his defenders with his nasty first step. Remember, the
market will not always resume its uptrend after finding temporary support, but instead
continue to decline below the last Swing Low. Same thing for a downtrend. The market
may instead decide to continue above the last Swing High.
The placement of stops is a challenge. It’s probably best to place stops below the last
Swing Low (on an uptrend) or above the Swing High (on a downtrend), but this requires
taking a high level of risk in proportion to the likely profit potential in the trade. This is
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called reward-to-risk ratio. In a later lesson, you will learn more money management and
risk control and how you would only take trades with certain reward-to-risk ratios.
Another problem is determining which Swing Low and Swing High points to start from to
create the Fibonacci Retracement Levels. People look at charts differently and so will have
their own version of where the Swing High and Swing Low points should be. The point is,
there is no one right away to do it, but the bad thing is sometimes it becomes a guessing
game.
Fibonacci Extension
The next use of Fibonacci you will be applying is that of targets. Let’s start with an
example in an uptrend.
In an uptrend, the general idea is to take profits on a long trade at a Fibonacci Price
Extension Level. You determine the Fibonacci extension levels by using three mouse clicks.
First, click on a significant Swing Low, then drag your cursor and click on the most recent
Swing High. Finally, drag your cursor back down and click on the retracement Swing Low.
This will display each of the Price Extension Levels showing both the ratio and
corresponding price levels.
Watch how to draw Fibonacci extension levels on a chart
On this 1-hour USD/CHF chart, we plotted the Fibonacci extension levels by clicking on the
Swing Low at 1.2447 on 08/14/05 and dragged the cursor to the Swing High at 1.2593 on
08/15/15 and then down to the retracement Swing Low of 1.2541 on 08/15/05. The
following Fibonacci extension levels created are 1.2597 (0.382), 1.2631 (0.618), 1.2687
(1.000), 1.2743 (1.382), 1.2760 (1.500), and 1.2777 (1.618).
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Now let’s look at what actually happened after the retracement Swing Low occurred.
• The market rallied to the 0.500 level
• fell back to the retracement Swing Low
• then rallied back up to the 0.500 level
• fell back slightly
• rallied to the 0.618 level
• fell back to the 0.382 level which acted as support
• then rallied all the way to the 1.382 level
• consolidated a bit
• then rallied to the 1.500 level
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You can see from these examples that the market often finds at least temporary
resistance at the Fibonacci extension levels - not always, but often. As in the examples of
the retracement levels, it should be apparent that there are a few problems to deal with
here as well. First, there is no way of knowing which level will provide resistance. The
0.500 level was a good level to cover any long trades in the above example since the
market retraced back to its original level, but if you didn’t get back in the trade, you would
have left a lot of profits on the table.
Another problem is determining which Swing Low to start from in creating the Fibonacci
Extension Levels. One way is from the last Swing Low as we did in the examples; another is
from the lowest Swing Low of the past 30 bars. Again, the point is that there is no one
right way to do it, and consequently it becomes a guessing game.
Alright, let’s see how Fibonacci extension levels can be used during a downtrend. In a
downtrend, the general idea is to take profits on a short trade at a Fibonacci price
extension level since the market often finds at least temporary support at these levels.
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On this 1-hour EUR/USD chart, we plotted the Fibonacci extension levels by clicking on the
Swing High at 1.21377 on 07/15/05 and dragged the cursor to the Swing Low at 1.2021 on
08/15/15 and then down to the retracement High of 1.2085. The following Fibonacci
extension levels created are 1.2041 (0.382), 1.2027 (0.500), 1.2013 (0.618), 1.1969
(1.000), 1.1925 (1.382), 1.1911 (1.500), and 1.1897 (1.618).
Now let’s look at what actually happened after the retracement Swing Low occurred.
• The market fell down almost to the 0.382 level which for right now is acting as a support
level
• The market then traded sideways between the retracement Swing High level and 0.382
level
• Finally, the market broke through the 0.382 and rested on the 0.500 level
• Then it broke the 0.500 level and fell all the way down to the 1.000 level
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Alone, Fibonacci levels will not make you rich. However, Fibonacci levels are definitely
useful as part of an effective trading method that includes other analysis and techniques.
You see, the key to an effective trading system is to integrate a few indicators (not too
many) that are applied in a way that is not obvious to most observers.
All successful traders know it’s how you use and integrate the indicators (including
Fibonacci) that makes the difference. The lesson learned here is that Fibonacci Levels can
be a useful tool, but never enter or exit a trade based on Fibonacci Levels alone.
Summary
Fibonacci retracement levels are 0.236, 0.382, 0.500, 0.618, 0.764
Traders use the Fibonacci retracement levels as support and resistance levels. Since so
many traders watch these same levels and place buy and sell orders on them to enter
trades or place stops, the support and resistance levels become a self-fulfilling
expectation.
Fibonacci extension levels are 0, 0.382, 0.618, 1.000, 1.382, 1.618
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Traders use the Fibonacci extension levels as profit taking levels. Again, since so many
traders are watching these levels and placing buy and sell orders to take profits, this tool
usually works due self-fulfilling expectations.
In order to apply Fibonacci levels to your charts, you’ll need to identify Swing High and
Swing Low points.
A Swing High is a candlestick with at least two lower highs on both the left and right of
itself.
A Swing Low is a candlestick with at least two higher lows on both the left and right of
itself.
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Price Smoothies
A moving average is simply a way to smooth out price action over time. By “moving
average”, we mean that you are taking the average closing price of a currency for the last
‘X’ number of periods.
Like every indicator, a moving average indicator is used to help us forecast future prices.
By looking at the slope of the moving average, you can make general predictions as to
where the price will go.
As we said, moving averages smooth out price action. There are different types of moving
averages, and each of them has their own level of “smoothness”. Generally, the smoother
the moving average, the slower it is to react to the price movement. The choppier the
moving average, the quicker it is to react to the price movement.
We’ll explain the pros and cons of each type a little later, but for now let’s look at the
different types of moving averages and how they are calculated.
Simple Moving Average
Simple Moving Average (SMA)
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A simple moving average is the simplest type of moving average (DUH!). Basically, a
simple moving average is calculated by adding up the last “X” period’s closing prices and
then dividing that number by X. Confused??? Allow me to clarify.
If you plotted a 5 period simple moving average on a 1 hour chart, you would add up the
closing prices for the last 5 hours, and then divide that number by 5. Voila! You have your
simple moving average.
If you were to plot a 5 period simple moving average on a 10 minute chart, you would add
up the closing prices of the last 50 minutes and then divide that number by 5.
If you were to plot a 5 period simple moving average on a 30 minute chart, you would add
up the closing prices of the last 150 minutes and then divide that number by 5.
If you were to plot the 5 period simple moving average on the a 4 hr. chart………………..OK
OK, I think you get the picture! Let’s move on.
Most charting packages will do all the calculations for you. The reason we just bored you
(yawn!) with how to calculate a simple moving average is because it is important that you
understand how the moving averages are calculated. If you understand how each moving
average is calculated, you can make your own decision as to which type is better for you.
Just like any indicator out there, moving averages operate with a delay. Because you are
taking the averages of the price, you are really only seeing a “forecast” of the future price
and not a concrete view of the future. Disclaimer: Moving averages will not turn you into
Ms. Cleo the psychic!
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Here is an example of how moving averages smooth out the price action.
On the previous chart, you can see 3 different SMAs. As you can see, the longer the SMA
period is, the more it lags behind the price. Notice how the 62 SMA is farther away from
the current price than the 30 and 5 SMA. This is because with the 62 SMA, you are adding
up the closing prices of the last 62 periods and dividing it by 62. The higher the number
period you use, the slower it is to react to the price movement.
The SMA’s in this chart show you the overall sentiment of the market at this point in time.
Instead of just looking at the current price of the market, the moving averages give us a
broader view, and we can now make a general
Exponential Moving Average
Exponential Moving Average (EMA)
Although the simple moving average is a great tool, there is one major flaw associated
with it. Simple moving averages are very susceptible to spikes. Let me show you an
example of what I mean:
Let’s say we plot a 5 period SMA on the daily chart of the EUR/USD and the closing prices
for the last 5 days are as follows:
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Day 1: 1.2345
Day 2: 1.2350
Day 3: 1.2360
Day 4: 1.2365
Day 5: 1.2370
The simple moving average would be calculated as
(1.2345+1.2350+1.2360+1.2365+1.2370)/5= 1.2358
Simple enough right?
Well what if Day 2’s price was 1.2300? The result of the simple moving average would be
a lot lower and it would give you the notion that the price was actually going down, when
in reality, Day 2 could have just been a one time event (maybe interest rates decreasing).
The point I’m trying to make is that sometimes the simple moving average might be too
simple. If only there was a way that you could filter out these spikes so that you wouldn’t
get the wrong idea. Hmmmm…I wonder….Wait a minute……Yep, there is a way!
It’s called the Exponential Moving Average!
Exponential moving averages (EMA) give more weight to the most recent periods. In our
example above, the EMA would put more weight on Days 3-5, which means that the spike
on Day 2 would be of lesser value and wouldn’t affect the moving average as much. What
this does is it puts more emphasis on what traders are doing NOW.
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When trading, it is far more important to see what traders are doing now rather than
what they did last week or last month.
SMA vs. EMA
Which is better: Simple or Exponential?
First, let’s start with an exponential moving average. When you want a moving average
that will respond to the price action rather quickly, then a short period EMA is the best
way to go. These can help you catch trends very early, which will result in higher profit. In
fact, the earlier you catch a trend, the longer you can ride it and rake in those profits!
The downside to the choppy moving average is that you might get faked out. Because the
moving average responds so quickly to the price, you might think a trend is forming when
in actuality; it could just be a price spike.
With a simple moving average, the opposite is true. When you want a moving average
that is smoother and slower to respond to price action, then a longer period SMA is the
best way to go.
Although it is slow to respond to the price action, it will save you from many fake outs.
The downside is that it might delay you too long, and you might miss out on a good trade.
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SMA EMA
Pros:
Displays a smooth chart, which eliminates
most fakeouts.
Quick moving, and is good at showing recent
price swings.
Cons:
Slow moving, which may cause a lag in buying
and selling signals.
More prone to cause fakeouts and give errant
signals.
So which one is better? It’s really up to you to decide. Many traders plot several different
moving averages to give them both sides of the story. They might use a longer period
simple moving average to find out what the overall trend is, and then use a shorter period
exponential moving average to find a good time to enter a trade.
In fact, many trading systems are built around what is called “Moving Average
Crossovers”. Later in this course, we will give you an example of how you can use moving
averages as part of your trading system.
Time for recess! Go find a chart and start playing with some moving averages. Try out
different types and look at different periods. In time, you will find out which moving
averages work best for you. Class dismissed!
Summary
• A moving average is a way to smooth out price action.
• There are many types of moving averages. The 2 most common types are: Simple Moving
Average and Exponential Moving Average.
• Simple moving averages are the simplest form of moving averages, but they are susceptible to spikes.
• Exponential moving averages put more weight to recent prices and therefore show us
what traders are doing now.
• It is much more important to know what traders are doing now than to see what they did
last week or last month.
• Simple moving averages are smoother than Exponential moving averages.
• Longer period moving averages are smoother than shorter period moving averages.
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• Choppy moving averages are quicker to respond to price action and can catch trends
early. However, because of their quick reaction, they are susceptible to spikes and can
fake you out.
• Smooth moving averages are slower to respond to price action but will save you from spikes and fake outs. However, because of their slow reaction, they can delay you from
taking a trade and may cause you to miss some good opportunities.
• The best way to use moving averages is to plot different types on a chart so that you can
see both long term movement and short term movement.
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Bollinger Bands
Congratulations on making it to the 5th grade! Each time you make it to the next grade
you continue to add more and more tools to your trader’s toolbox. “What’s a trader’s toolbox?” you say… Simple! Your trader’s toolbox is what you will use to “build” your
trading account. The more tools (education) you have in your trader’s toolbox (YOUR
BRAIN), the easier it will be for you to build.
So for this lesson, as you learn each of these indicators, think of them as a new tool that
you can add to that toolbox of yours. You might not necessarily use all of these tools, but
it’s always nice to have the option, right? Now, enough about tools already! Let’s get
started!
Bollinger Bands
Bollinger bands are used to measure a market’s volatility. Basically, this little tool tells us
whether the market is quiet or whether the market is LOUD! When the market is quiet,
the bands contract; and when the market is LOUD, the bands expand. Notice on the chart
below that when the price was quiet, the bands were close together, but when the price moved up, the bands spread apart.
That’s all there is to it. Yes, we could go on and bore you by going into the history of the
Bollinger band, how it is calculated, the mathematical formulas behind it, and so on and so
forth, but we really didn’t feel like typing it all out.
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In all honesty, you don’t need to know any of that junk. We think it’s more important that
we show you some ways you can apply the Bollinger bands to your trading.
Note: If you really want to learn about the calculations of a Bollinger band, then you can
go to www.bollingerbands.com
The Bollinger Bounce
One thing you should know about Bollinger Bands is that price tends to return to the
middle of the bands. That is the whole idea behind the Bollinger bounce (smart, huh?). If
this is the case, then by looking at the chart below, can you tell us where the price might
go next? If you said down, then you are
correct! As you can see, the price
settled back down towards the middle
area of the bands.
That’s all there is to it. What you just saw was a classic Bollinger bounce. The reason these
bounces occur is because Bollinger Bands act like mini support and resistance levels. The longer the time frame you are in, the stronger
these bands are. Many traders have developed
systems that thrive on these bounces, and this
strategy is best used when the market is ranging
and there is no clear trend.
Now let’s look at a way to use Bollinger Bands
when the market does trend.
Bollinger Squeeze
The Bollinger squeeze is pretty self explanatory. When the bands “squeeze” together, it
usually means that a breakout is going to occur. If the candles start to break out above the top band, then the move will usually continue to go up. If the candles start to break
out below the lower band, then the move will usually continue to go down.
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Looking at the chart above, you can see the bands squeezing together. The price has just
started to break out of the top band. Based on this information, where do you think the
price will go?
If you said up, you are correct! This is how a typical Bollinger Squeeze works. This strategy
is designed for you to catch a move as early as possible. Setups like these don’t occur
everyday, but you can probably spot them a few times a week if you are looking at a 15 minute chart.
So now you know what Bollinger Bands are, and you know how to use them. There are many other things you can do with Bollinger Bands, but these are the 2 most common
strategies associated with them. So now you can put this in your trader’s toolbox, and we can move on to the next indicator.
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MACD
MACD is an acronym for Moving Average Convergence Divergence. This tool is used to
identify moving averages that are indicating a new trend, whether it’s bullish or bearish.
After all, our #1 priority in trading is being able to find a trend, because that is where the
most money is made.
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 are 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 packages), 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.
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• 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 blue lines in the chart above).
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. What this does is it smoothes out the
original line even more, which gives us a more accurate line.
The histogram simply plots the difference between the fast and slow moving average. If
you look at our original chart, 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! Whew, we need to crack our knuckles after that one!
Ok, so now you know what MACD does. Now I’ll show you what MACD can do for YOU.
MACD Crossover
Because there are two moving averages with different “speeds”, the faster one will
obviously be quicker to react to price movement than the slower one. When a new trend
occurs, the fast line will react first and eventually cross the slower line. When this
“crossover” occurs, and the fast line starts to “diverge” or move away from the slower line, it often indicates that a new trend has formed.
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From the chart above, you can see that the fast line crossed under the slow line and correctly identified a new downtrend. Notice that when the lines crossed, the histogram
temporarily disappears. This is because the difference between the lines at the time of the cross is 0. As the downtrend begins and the fast line diverges away from the slow line, the
histogram gets bigger, which is good indication of a strong trend.
There is one drawback to MACD. Naturally, moving averages tend to lag behind price.
After all, it's just an average of historical prices. Since the MACD represents moving averages of other moving averages and is smoothed out by another moving average, you
can imagine that there is quite a bit of lag. However, it is still one of the most favored tools by many traders.
Parabolic SAR
Up until now, we’ve looked at indicators that mainly focus on catching the beginning of new trends. And although it is important to be able to identify new trends, it is equally
important to be able to identify where a trend ends. After all, what good is a well-timed entry without a well-timed exit?
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One indicator that can help us determine where a trend might be ending is the Parabolic
SAR (Stop And Reversal). A Parabolic SAR places dots, or points, on a chart that indicate
potential reversals in price movement. From the chart above, you can see that the dots
shift from being below the candles during the uptrend, to above the candles when the
trend reverses into a downtrend.
Using Parabolic SAR
The nice thing about the Parabolic SAR is that it is really simple to use. Basically, when the
dots are below the candles, it is a buy signal; and when the dots are above the candles, it is a sell signal. This is probably the easiest indicator to interpret because it assumes that
the price is either going up or down. With that said, this tool is best used in markets that are trending, and that have long rallies and downturns. You DON’T want to use this tool in
a choppy market where the price movement is sideways.
Stochastics
Stochastics are another indicator that helps us determine where a trend might be ending.
By definition, a stochastic is an oscillator that measures overbought and oversold
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Commission Free Trading
You know what’s great about trading currencies? You pay NO commissions! Because you deal directly with the market maker via a purely electronic online exchange, you eliminate both ticket costs and middleman brokerage fees. There is still a cost to initiating any trade,
but that cost is reflected in the bid/ask spread that is also present in futures or equities trading. Brokers are compensated for their services through the bid-ask spread instead of via commissions.
Price Certainty When trading Forex, you get rapid execution and price certainty under normal market
conditions. In contrast, the futures and equities markets do not offer price certainty or instant trade execution. Even with the advent of electronic trading and limited guarantees
of execution speed, the prices for fills for futures and equities on market orders are far from certain. The prices quoted by brokers often represent the LAST trade, not necessarily the price for which the contract will be filled.
Guaranteed Limited Risk
Traders must have position limits for the purpose of risk management. This number is set relative to the money in a trader’s account. Risk is minimized in the spot FX market because the online capabilities of the trading platform will automatically generate a
margin call if the required margin amount exceeds the available trading capital in your account. All open positions will be closed immediately, regardless of the size or the nature of positions held within the account. In the futures market, your position may be liquidated at a loss, and you will be liable for any resulting deficit in the account. That sucks.
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Impress Your Date with Your Forex Lingo
As in any new skill that you learn, you need to learn the lingo...especially if you wish to woo your love's heart. You, the newbie, must know certain terms like the back of your
hand before making your first trade. Some of these terms you've already learned, but it never hurts to have a little review.
Major and Minor Currencies
The eight most frequently traded currencies (USD, EUR, JPY, GBP, CHF, CAD, NZD and AUD) are called the major currencies. All other currencies are referred to as minor
currencies. Do not worry about the minor currencies, they are for professionals only. Actually, on this site we'll mostly cover what we call the Fab Five (USD, EUR, JPY, GBP, and
CHF). These pairs are the most liquid and the most sexy.
Base Currency
The base currency is the first currency in any currency pair. It shows how much the base currency is worth as measured against the second currency. For example, if the USD/CHF
rate equals 1.6350, then one USD is worth CHF 1.6350. In the Forex markets, the U.S. dollar is normally considered the “base” currency for quotes, meaning that quotes are expressed as a unit of $1 USD per the other currency quoted in the pair. The primary exceptions to this rule are the British pound, the Euro, and the Australian and New
Zealand dollar.
Quote Currency
The quote currency is the second currency in any currency pair. This is frequently called
the pip currency and any unrealized profit or loss is expressed in this currency.
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Pip
A pip is the smallest unit of price for any currency. Nearly all currency pairs consist of five
significant digits and most pairs have the decimal point immediately after the first digit,
that is, EUR/USD equals 1.2538. In this instance, a single pip equals the smallest change in
the fourth decimal place - that is, 0.0001. Therefore, if the quote currency in any pair is
USD, then one pip always equal 1/100 of a cent.
One notable exception is the USD/JPY pair where a pip equals $0.01.
Bid Price
The bid is the price at which the market is prepared to buy a specific currency pair in the
Forex market. At this price, the trader can sell the base currency. It is shown on the left side of the quotation.
For example, in the quote GBP/USD 1.8812/15, the bid price is 1.8812. This means you sell
one British pound for 1.8812 U.S. dollars.
Ask Price
The ask is the price at which the market is prepared to sell a specific currency pair in the
Forex market. At this price, you can buy the base currency. It is shown on the right side of
the quotation.
For example, in the quote EUR/USD 1.2812/15, the ask price is 1.2815. This means you
can buy one Euro for 1.2815 U.S. dollars. The ask price is also called the offer price.
Bid/Ask Spread
The spread is the difference between the bid and ask price. The “big figure quote” is the
dealer expression referring to the first few digits of an exchange rate. These digits are often omitted in dealer quotes. For example, the USD/JPY rate might be 118.30/118.34,
but would be quoted verbally without the first three digits as “30/34”.
Quote Convention
Exchange rates in the Forex market are expressed using the following format:
Base currency / Quote currency Bid / Ask
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Transaction Cost
The critical characteristic of the bid/ask spread is that it is also the transaction cost for a
round-turn trade. Round-turn means both a buy (or sell) trade and an offsetting sell (or
buy) trade of the same size in the same currency pair. For example, in the case of the
EUR/USD rate of 1.2812/15, the transaction cost is three pips.
The formula for calculating the transaction cost is:
Transaction cost = Ask Price – Bid Price
Cross Currency
A cross currency is any pair in which neither currency is the U.S. dollar. These pairs exhibit
erratic price behavior since the trader has, in effect, initiated two USD trades. For
example, initiating a long (buy) EUR/GBP is equivalent to buying a EUR/USD currency pair and selling a GBP/USD. Cross currency pairs frequently carry a higher transaction cost. Margin
When you open a new margin account with a Forex broker, you must deposit a minimum
amount with that broker. This minimum varies from broker to broker and can be as low as
$100 to as high as $100,000.
Each time you execute a new trade, a certain percentage of the account balance in the
margin account will be set aside as the initial margin requirement for the new trade
based upon the underlying currency pair, its current price, and the number of units (or
lots) traded. The lot size always refers to the base currency.
For example, let's say you open a mini account which provides a 200:1 leverage or .5%
margin. Mini accounts trade mini lots. Let's say one mini lot equals $10,000. If you were to open one mini-lot, instead of having to provide the full $10,000, you would only need $50
($10,000 x .5 = $50).
Leverage
Leverage is the ratio of the amount capital used in a transaction to the required security
deposit (margin). It is the ability to control large dollar amounts of a security with a
relatively small amount of capital. Leveraging varies dramatically with different brokers,
ranging from 2:1 to 400:1.
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Margin + Leverage = Possible Deadly Combination
Trading currencies on margin lets you increase your buying power. Meaning that if you
have $5,000 cash in a margin account that allows 100:1 leverage, you could purchase up
to $500,000 worth of currency because you only have to post one percent of the purchase price as collateral. Another way of saying this is that you have $500,000 in buying power. With more buying power, you can increase your total return on investment with less cash
outlay. But be careful, trading on margin magnifies your profits AND losses.
Margin Call
All traders fear the dreaded margin call. This occurs when your broker notifies you that
your margin deposits have fallen below the required minimum level because an open
position has moved against you.
While trading on margin can be a profitable investment strategy, it is important that you
take the time to understand the risks. Make sure you fully understand how your margin
account works, and be sure to read the margin agreement between you and your broker. Always ask any questions if there is anything unclear to you in the agreement. Your positions could be partially or totally liquidated should the available margin in your
account fall below a predetermined threshold. You may not receive a margin call before your positions are liquidated (the ultimate unexpected birthday gift). Margin calls can be effectively avoided by monitoring your account balance on a very regular basis and by utilizing stop-loss orders (discussed later) on every open position to
limit risk. Protect Yo Self Before You Wreck Yo Self
Before we go any further we are going to be 100% honest with you and tell you the following before you consider trading currencies:
1. All forex traders, and we mean all traders LOSE money on trades.
Ninety percent of traders lose money, largely due to lack of planning and training
and having poor money management rules. Also, if you hate to lose or are a super
perfectionist, you'll probably have a hard time adjusting to trading.
2. Trading forex is not for the unemployed, those on low incomes, or who can't
afford to pay their electricity bill or afford to eat.
You should have at least $10,000 of trading capital (in a mini account) that you can
School of Pipsology - 45
afford to lose. Don’t expect to start an account with a few hundred dollars and
expect to become a kazillionaire.
The Forex market is one of the most popular markets for speculation, due to its enormous
size, liquidity and tendency for currencies to move in strong trends. You would think
traders all over the world would make a killing, but success has been limited to very small
percentage of traders.
Many traders come with the misguided hope of making a gazillion bucks, but in reality, lack the discipline required for trading. Most people usually lack the discipline to stick to a
diet or to go to the gym three times a week. If you can't even do that, how do you think you're going to succeed trading?
Short term trading IS NOT for amateurs, and it is rarely the path to “get rich quick”. You can't make gigantic profits without taking gigantic risks. A trading strategy that involves
taking a massive degree of risk means suffering inconsistent trading performance and often suffering large loss. A trader who does this probably doesn’t even have a trading
strategy - unless you call gambling a trading strategy!
Forex Trading is not a Get-Rich-Quick Scheme!
Forex trading is a SKILL that takes TIME to learn.
Skilled traders can and do make money in this field. However, like any other occupation or career, success doesn’t just happen overnight.
Forex trading isn’t a piece of cake (as some people would like you to believe). Think about it, if it was, everyone trading would already be millionaires. The truth is that even expert
traders with years of experience still encounter periodic losses.
Drill this in your head: there are NO shortcuts to Forex trading. It takes lots and lots of TIME to master.
There is no substitute for hard work and diligence. Practice trading on a DEMO ACCOUNT and pretend the virtual money is your own real money.
Do NOT open a live trading account until you are trading PROFITABLY on a demo account.
If you can't wait until you're profitable on a demo account, at least demo trade for 2 months. Hey, at least you were able to hold off losing all your money for two months
right? If you can't hold out for 2 months, cut your hands off.
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Concentrate on ONE major currency pair.
It gets far too complicated to keep tabs on more than one currency pair when you first
start trading. Stick with one of the majors because they are the most liquid which makes
their spreads cheap.
You can be a winner at currency trading, but as in all other aspects of life, it will take hard work, dedication, a little luck, a lot of common sense, and a whole lot of good judgment.
School of Pipsology - 47
Types of Trading
Congratulations! You’ve gotten through the Pre-School and are ready to begin your first day of class. You did go through the Pre-School right? By now you’ve learned some history
about the Forex, how it works, what affects the prices, blah blah blah.
We know what you’re thinking…BORING! SHOW ME HOW TO MAKE MONEY ALREADY! Well, say no more my friend; because here is where your journey as a Forex trader begins…
This is your last chance to turn back… Take the red pill, and we take you back to where you were and you will forget all about this. You can go back to living your average life in
your 9-5 job and work for someone else for the rest of your life.
OR
You can take the green pill (green for money! Yeah!) And learn how you can make money
for yourself in the most active market in the world, simply by using a little brain power. Just remember, your education will never stop. Even after you you must constantly pursue as much knowledge as you can, so that you can become a true FOREX MASTER! Now pop that green pill in, wash it down with some chocolate milk, and grab your lunchbox…School of Pipsology is now in session! Note: the green pill was made with a brainwashing serum. You will now obey everything
that we tell you to do! Mwuahahaha! <--evil laugh
Two Types of Trading
There are 2 basic types of analysis you can take when approaching the forex:
1. Fundamental analysis
2. Technical analysis.
There has always been a constant debate as to which analysis is better, but to tell you the
truth, you need to know a little bit of both. So let’s break each one down and then come
back and put them together.
Fundamental Analysis
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Fundamental analysis is a way of looking at the market through economic, social and
political forces that affect supply and demand. (Yada yada yada.) In other words, you look
at whose economy is doing well, and whose economy sucks. The idea behind this type of
analysis is that if a country’s economy is doing well, their currency will also be doing well.
This is because the better a country’s economy, the more trust other countries have in that currency.For example, the U.S. dollar has been gaining strength because the U.S. economy is gaining strength. As the economy gets better, interest rates get higher to control inflation
and as a result, the value of the dollar continues to increase. In a nutshell, that is basically what fundamental analysis is.
Later on in the course you will learn which specific news events drive currency prices the most. For now, just know that the fundamental analysis of the Forex is a way of analyzing
a currency through the strength of that country’s economy.
Technical Analysis
Technical analysis is the study of price movement. In one word, technical analysis =
charts. The idea is that a person can look at historical price movements, and, based on
the price action, can determine at some level where the price will go. By looking at charts,
you can identify trends and patterns which can help you find good trading opportunities.
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The most IMPORTANT thing you will ever learn in technical analysis is the trend! Many, many, many, many, many, many people have a saying that goes, “The trend is your
friend”. The reason for this is that you are much more likely to make money when you can find a trend and trade in the same direction. Technical analysis can help you identify
these trends in its earliest stages and therefore provide you with very profitable trading
opportunities.
Now I know you’re thinking to yourself, “Geez, these guys are smart. They use crazy
words like "technical" and "fundamental" analysis. I can never learn this stuff!” Don't
worry yourself too much. After you're done with the School of Pipsology, you too will be
just as....uhmmm..."smart?" as us.
By the way, do you feel that green pill kicking in yet? Bark like a dog!
So which type of analysis is better?
Ahh, the million dollar question. Throughout your journey as an aspiring Forex trader you will find strong advocates for both fundamental and technical trading. You will have those
who argue that it is the fundamentals alone that drive the market and that any patterns found on a chart are simply coincidence. On the other hand, there will be those who argue
that it is the technicals that traders pay attention to and because traders pay attention to it, common market patterns can be found to help predict future price movements.
Do not be fooled by these one sided extremists! One is not better than the other...
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In order to become a true Forex master you will need to know how to effectively use both
types of analysis. Don't believe me? Let me give you an example of how focusing on only
one type of analysis can turn into a disaster.
• Let’s say that you’re looking at your charts and you find a good trading opportunity. You
get all excited thinking about the money that’s going to be raining down from the sky. You
say to yourself, “Man, I’ve never seen a more perfect trading opportunity. I love my
charts.”
• You then proceed to enter your trade with a big fat smile on your face (the kind where all
your teeth are showing).
• But wait! All of a sudden the trade makes a 30 pip move in the OTHER DIRECTION! Little
did you know that there was an interest rate decrease for your currency and now
everyone is trading in the opposite direction.
• Your big fat smile turns into mush and you start getting angry at your charts. You throw
your computer on the ground and begin to pulverize it. You just lost a bunch of money,
and now your computer is broken. And it’s all because you completely ignored
fundamental analysis.
(Note: This was not based on a real story. This did not happen to me. I was never this
naive. I was always a smart trader.... From the overused sarcasm, I think you get the
picture)
Ok, ok, so the story was a little over-dramatized, but you get the point.
The Forex is like a big flowing ball of energy, and within that ball is a balance between
fundamental and technical factors that play a part in determining where the market will
go.
Remember how your mother or father used to
tell you as a kid that too much of anything is
never good? Well you might've thought that
was just hogwash back then but in the Forex,
the same applies when deciding which type of
analysis to use. Don't rely on just one. Instead,
you must learn to balance the use of both of
them, because it is only then that you can
really get the most out of your trading.
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Types of Charts
Let’s take a look at the three most popular types of charts:
1. Line chart
2. Bar chart
3. Candlestick chart
Line Charts
A simple line chart draws a line from one closing price to the next closing price. When
strung together with a line, we can see the general price movement of a currency pair
over a period of time.
Here is an example of a line chart for EUR/USD:
Bar Charts
A bar chart also shows closing prices, while simultaneously showing opening prices, as
well as the highs and lows. The bottom of the vertical bar indicates the lowest traded price
for that time period, while the top of the bar indicates the highest price paid. So, the
vertical bar indicates the currency pair’s trading range as a whole. The horizontal hash on
the left side of the bar is the opening price, and the right-side horizontal hash is the
closing price.
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Here is an example of a bar chart for EUR/USD:
NOTE: Throughout our lessons, you will see the word “bar” in reference to a single piece
of data on a chart. A bar is simply one segment of time, whether it is one day, one week,
or one hour. When you see the word ‘bar’ going forward, be sure to understand what
time frame it is referencing.
Bar charts are also called “OHLC” charts, because they indicate the Open, the High, the
Low, and the Close for that particular currency. Here’s an example of a price bar:
Open: The little horizontal line on the left is the
opening price
High: The top of the vertical line defines the highest
price of the time period
Low: The bottom of the vertical line defines the
lowest price of the time period
Close: The little horizontal line on the right is the
closing price
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Candlestick Charts
Candlestick charts show the same information as a bar chart, but in a prettier, graphic
format.
Candlestick bars still indicate the high-to-low range with a vertical line. However, in
candlestick charting, the larger block in the middle indicates the range between the
opening and closing prices. Traditionally, if the block in the middle is filled or colored in,
then the currency closed lower than it opened.
In the following example, the ‘filled color’ is black. For our ‘filled’ blocks, the top of the
block is the opening price, and the bottom of the block is the closing price. If the closing
price is higher than the opening price, then the block in the middle will be “white” or
hollow or unfilled.
We don’t like to use the traditional black and white candlesticks. We feel it’s easier to look
at a chart that’s colored. A color television is much better than a black and white television, so why not in candlestick charts?
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We simply substituted green instead of white, and red instead of black. This means that if
the price closed higher than it opened, the candlestick would be green. If the price closed
lower than it opened, the candlestick would be red. In our later lessons, you will see how
using green and red candles will allow you to “see” things on the charts much faster, such
as uptrend/downtrends and possible reversal points.
For now, just remember that we use red and green candlesticks instead of black and white
and we will be using these colors from now on.
Check out these candlesticks…BabyPips.com style! Awww yeeaaah! You know you like that!
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Here is an example of a candlestick chart for EUR/USD. Isn’t it pretty?
The purpose of candlestick charting is strictly to serve as a visual aid, since the exact same
information appears on an OHLC bar chart. The advantages of candlestick charting are:
• Candlesticks are easy to interpret, and are a good place for a beginner to start figuring out
chart analysis.
• Candlesticks are easy to use. Your eyes adapt almost immediately to the information in
the bar notation.
• Candlesticks and candlestick patterns have cool names such as the shooting star, which
helps you to remember what the pattern means.
• Candlesticks are good at identifying marketing turning points – reversals from an uptrend
to a downtrend or a downtrend to an uptrend. You will learn more about this later.
Now that you know why candlesticks are so cool, it’s time to let you know that we will be
using candlestick charts for most, if not all of chart examples on this site.
Summary
Types of Trading:
• There are 2 types of analysis: Fundamental and Technical
• Fundamental analysis is the analysis of a market through the strength of its
economy. (i.e. the dollar gets stronger because the US economy is getting
stronger)
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• Technical analysis is the analysis of price movements. Technical analysis = charts.
• Technical analysis also helps us identify trends which can help us find profitable
trading opportunities.
• To become a successful trader, you must always incorporate both types of analysis.
Types of Charts:
• There are three types of charts:
1. Line charts
2. Bar charts
3. Candlestick charts
• We will be using candlesticks from now on
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What is a Candlestick?
While we briefly covered candlestick charts in the previous lesson, we’ll now dig in a little
and discuss them more in detail. First let’s do a quick review.
What is a Candlestick?
Back in the day when Godzilla was still a cute little lizard, the Japanese created their own
old school version of technical analysis to trade rice. A westerner by the name of Steve
Nison “discovered” this secret technique on how to read charts from a fellow Japanese
broker and Japanese candlesticks lived happily ever after. Steve researched, studied, lived,
breathed, ate candlesticks, began writing about it and slowly grew in popularity in 90s. To
make a long story short, without Steve Nison, candle charts might have remained a buried
secret. Steve Nison is Mr. Candlestick.
Okay so what the heck are candlesticks?
The best way to explain is by using a picture:
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Candlesticks are formed using the open, high, low and close.
• If the close is above the open, then a hollow candlestick (usually displayed as white) is
drawn.
• If the close is below the open, then a filled candlestick (usually displayed as black) is
drawn.
• The hollow or filled section of the candlestick is called the “real body” or body.
• The thin lines poking above and below the body display the high/low range and are called
shadows.
• The top of the upper shadow is the “high”.
• The bottom of the lower shadow is the “low”.
Sexy Bodies and Strange Shadows
Sexy Bodies
Just like humans, candlesticks have different body sizes. And when it comes to forex
trading, there’s nothing naughtier than checking out the bodies of candlesticks!
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Long bodies indicate strong buying or selling. The longer the body is, the more intense the
buying or selling pressure.
Short bodies imply very little buying or selling activity. In street forex lingo, bulls mean
buyers and bears mean sellers.
Long white candlesticks show strong
buying pressure. The longer the white
candlestick, the further the close is above
the open. This indicates that prices
increased considerably from open to close
and buyers were aggressive. In other
words, the bulls are kicking the bears’
butts big time!
Long black (filled) candlesticks show strong
selling pressure. The longer the black
candlestick, the further the close is below
the open. This indicates that prices fell a great deal from the open and sellers were
aggressive. In other words, the bears were grabbing the bulls by their horns and body
slamming them.
Mysterious Shadows
The upper and lower shadows on candlesticks provide important clues about the trading session.
Upper shadows signify the session high. Lower shadows signify the session low.
Candlesticks with long shadows show that trading action occurred well past the open and close.
Candlesticks with short shadows indicate that most of the trading action was confined near the open and close.
If a candlestick has a long upper shadow
and short lower shadow, this means that
buyers flexed their muscles and bided
prices higher, but for one reason or
another, sellers came in and drove prices
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back down to end the session back near its open price.
If a candlestick has a long lower shadow and short upper shadow, this means that sellers
flashed their washboard abs and forced price lower, but for one reason or another, buyers
came in and drove prices back up to end the session back near its open price.
Basic Candlestick Patterns
Spinning Tops Candlesticks with a long upper shadow, long lower shadow and small real bodies are
called spinning tops. The color of the real body is not very important.
The pattern indicates the indecision between the buyers and sellers
The small real body (whether hollow or
filled) shows little movement from open to
close, and the shadows indicate that both
buyers and sellers were fighting but
nobody could gain the upper hand.
Even though the session opened and
closed with little change, prices moved
significantly higher and lower in the
meantime. Neither buyers nor sellers
could gain the upper hand, and the result
was a standoff. If a spinning top forms during an uptrend, this usually means there aren’t many buyers left
and a possible reversal in direction could occur.
If a spinning top forms during a downtrend, this usually means there aren’t many sellers left and a possible reversal in direction could occur.
Marubozu
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Sounds like some kind of voodoo magic huh? "I will cast the evil spell of the Marubozu on
you!" Fortunately, that's not what it means. Marubozu means there are no shadows from
the bodies. Depending on whether the candlestick’s body is filled or hollow, the high and
low are the same as it’s open or close. If you look at the picture below, there are two
types of Marubozus.
A White Marubozu contains a long white
body with no shadows. The open price
equals the low price and the close price
equals the high price. This is a very bullish
candle as it shows that buyers were in
control the whole entire session. It usually
becomes the first part of a bullish
continuation or a bullish reversal pattern.
A Black Marubozu contains a long black
body with no shadows. The open equals
the high and the close equals the low. This
is a very bearish candle as it shows that
sellers controlled the price action the
whole entire session. It usually implies bearish continuation or bearish reversal. Doji
Doji candlesticks have the same open and close price or at least their bodies are extremely
short. The doji should have a very small body that appears as a thin line.
Doji suggest indecision or a struggle for turf positioning between buyers and sellers. Prices move above and below the open price during the session, but close at or very near the open price.
Neither buyers nor sellers were able to gain control and the result was essentially a draw.
There are four special types of Doji lines. The length of the upper and lower shadows can vary and the resulting candlestick looks like a cross, inverted cross or plus sign. The word
"Doji" refers to both the singular and plural form.
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When a doji forms on your chart, pay special attention to the preceding candlesticks.
If a doji forms after a series of candlesticks with long filled bodies (like white marubozus),
the doji signals that the buyers are becoming exhausted and weakening. In order for price
to continue rising, more buyers are needed but there aren’t anymore! Sellers are licking their chops and are looking to come in and drive the price back down. Keep in mind that even after a doji forms,
this doesn’t mean to automatically short.
Confirmation is still needed. Wait for a
bearish candlestick to close below the long
white candlestick’s open.
If a doji forms after a series of candlesticks
with long hollow bodies (like black
marubozus), the doji signals that sellers
are becoming exhausted and weakening.
In order for price to continue falling, more
sellers are needed but sellers are all
tapped out! Buyers are foaming in the
mouth for a chance to get in cheap.
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While the decline is sputtering due to lack
of new sellers, further buying strength is
required to confirm any reversal. Look for
a white candlestick to close above the long
black candlestick’s open.
Reversal Patterns
Prior Trend
For a pattern to qualify as a reversal pattern, there should be a prior trend to reverse.
Bullish reversals require a preceding downtrend and bearish reversals require a prior
uptrend. The direction of the trend can be determined using trendlines, moving averages,
or other aspects of technical analysis.
Hammer and Hanging Man
The hammer and hanging man look exactly alike but have totally different meaning
depending on past price action. Both have cute little bodies (black or white), long lower
shadows and short or absent upper shadows.
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The hammer is a bullish reversal pattern that forms during a downtrend. It is named
because the market is hammering out a bottom.
When price is falling, hammers signal that the bottom is near and price will start rising
again. The long lower shadow indicates that sellers pushed prices lower, but buyers were
able to overcome this selling pressure and closed near the open.
Word to the wise… just because you see a hammer form in a downtrend doesn’t mean
you automatically place a buy order! More bullish confirmation is needed before it’s safe
to pull the trigger. A good confirmation example would be to wait for a white candlestick
to close above the open of the candlestick on the left side of the hammer.
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Recognition Criteria:
• The long shadow is about two or three times of the real body.
• Little or no upper shadow.
• The real body is at the upper end of the trading range.
• The color of the real body is not important.
The hanging man is a bearish reversal pattern that can also mark a top or strong
resistance level. When price is rising, the formation of a hanging man indicates that sellers
are beginning to outnumber buyers. The long lower shadow shows that sellers pushed
prices lower during the session. Buyers were able to push the price back up some but only
near the open. This should set off alarms since this tells us that there are no buyers left to
provide the necessary momentum to keep raising the price. .
Recognition Criteria:
• A long lower shadow which is about two or three times of the real body.
• Little or no upper shadow.
• The real body is at the upper end of the trading range.
• The color of the body is not important, though a black body is more bearish than a white
body.
Inverted Hammer and Shooting Star
The inverted hammer and shooting star also look identical. The only difference between
them is whether you’re in a downtrend or uptrend. Both candlesticks have petite little
bodies (filled or hollow), long upper shadows and small or absent lower shadows.
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The inverted hammer occurs when price has been falling suggests the possibility of a reversal. Its long upper shadow shows that buyers tried to bid the price higher. However,
sellers saw what the buyers were doing, said “oh hell no” and attempted to push the price back down. Fortunately, the buyers had eaten enough of their Wheaties for breakfast and
still managed to close the session near the open. Since the sellers weren’t able to close the price any lower, this is a good indication that everybody who wants to sell has already sold. And if there’s no more sellers, who is left? Buyers. The shooting star is a bearish reversal pattern that looks identical to the inverted hammer
but occurs when price has been rising. Its shape indicates that the price opened at its low, rallied, but pulled back to the bottom. This means that buyers attempted to push the price
up, but sellers came in and overpowered them. A definite bearish sign since there are no
more buyers left because they’ve all been murdered.
Summary
Candlesticks are formed using the open, high, low and close.
• If the close is above the open, then a hollow candlestick (usually displayed as white) is drawn.
• If the close is below the open, then a filled candlestick (usually displayed as black) is drawn.
• The hollow or filled section of the candlestick is called the “real body” or body.
• The thin lines poking above and below the body display the high/low range and are called shadows.
• The top of the upper shadow is the “high”.
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• The bottom of the lower shadow is the “low”.
Long bodies indicate strong buying or selling. The longer the body is, the more intense the buying or selling pressure.
Short bodies imply very little buying or selling activity. In street forex lingo, bulls mean buyers and bears mean sellers.
Upper shadows signify the session high.
Lower shadows signify the session low.
Candlesticks with a long upper shadow, long lower shadow and small real bodies are
called spinning tops. The pattern indicates the indecision between the buyers and sellers
Marubozu means there are no shadows from the bodies. Depending on whether the
candlestick’s body is filled or hollow, the high and low are the same as it’s open or close.
Doji candlesticks have the same open and close price or at least their bodies are extremely short.
The hammer is a bullish reversal pattern that forms during a downtrend. It is named because the market is hammering out a bottom.
The hanging man is a bearish reversal pattern that can also mark a top or strong resistance level.
The inverted hammer occurs when price has been falling suggests the possibility of a reversal.
The shooting star is a bearish reversal pattern that looks identical to the inverted hammer
but occurs when price has been rising.
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Support and Resistance
Support and resistance is one of the most widely used concepts in trading. Strangely
enough, everyone seems to have their own idea on how you should measure support and resistance.
Let’s just take a look at the basics first.
Look at the diagram above. As you can see, this zigzag pattern is making its way up (bull market). When the market moves up and then pulls back, the highest point reached
before it pulled back is now resistance.
As the market continues up again, the lowest point reached before it started back is now
support. In this way resistance and support are continually formed as the market oscillates
over time. The reverse of course is true of the downtrend.
Plotting Support and Resistance
One thing to remember is that support and resistance levels are not exact numbers. Often times you will see a support or resistance level that appears broken, but soon after find
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out that the market was just testing it. With candlestick charts, these "tests" of support
and resistance are usually represented by the candlestick shadows.
Notice how the shadows of the candles tested the 2500 resistance level. At those times it
seemed like the market was "breaking" resistance. However, in hindsight we can see that
the market was merely testing that level.
So how do we truly know if support or resistance is broken?
There is no definite answer to this question. Some argue that a support or resistance level is broken if the market can actually close past that level. However, you will find that this is
not always the case. Let's take our same example from above and see what happened
when the price actually closed past the 2500 resistance level.
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In this case, the price had closed twice above the 2500 resistance level but both times ended up falling back down below it. If you had believed that these were real breakouts
and bought this pair, you would've been seriously hurtin! Looking at the chart now, you can visually see and come to the conclusion that the resistance was not actually broken;
and that it is still very much in tact and now even stronger.
So to help you filter out these false breakouts, you should think of support and resistance
more of as "zones" rather than concrete numbers. One way to help you find these zones is
to plot support and resistance on a line chart rather than a candlestick chart. The reason is
that line charts only show you the closing price while candlesticks add the extreme highs
and lows to the picture. These highs and lows can be misleading because often times they
are just the "knee-jerk" reactions of the market. It's like when someone is doing something really strange, but when asked about it, they simply reply, "Sorry, it's just a reflex."
When plotting support and resistance, you don't want the reflexes of the market. You only
want to plot its intentional movements.
Looking at the line chart, you want to plot your support and resistance lines around areas
where you can see the price forming several peaks or valleys.
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Other interesting tidbits about support and resistance:
1. When the market passes through resistance, that resistance now becomes support.
2. The more often price tests a level of resistance or support without breaking it the stronger
the area of resistance or support is.
Trend Lines
Trend lines are probably the most common form of technical analysis used today. They
are probably one of the most underutilized as well.
If drawn correctly, they can be as accurate as any other method. Unfortunately, most
traders don’t draw them correctly or they try to make the line fit the market instead of the
other way around.
In their most basic form, an uptrend line is drawn along the bottom of easily identifiable support areas (valleys). In a downtrend, the trend line is drawn along the top of easily
identifiable resistance areas (peaks).
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Channels
If we take this trend line theory one step further and draw a parallel line at the same angle
of the uptrend or downtrend, we will have created a channel.
To create an up (ascending) channel, simply draw a parallel line at the same angle as an
uptrend line and then move that line to position where it touches the most recent peak.
This should be done at the same time you create the trend line.
To create a down (descending) channel, simple draw a parallel line at the same angle as
the downtrend line and then move that line to a position where it touches the most recent valley. This should be done at the same time you created the trend line. When prices hit the bottom trend line this may be used as a buying area. When prices hit
the upper trend line this may be used as a selling area.
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Summary
When the market moves up and then pulls back, the highest point reached before it
pulled back is now resistance.
As the market continues up again, the lowest point reached before it started back is now
support.
In their most basic form, an uptrend line is drawn along the bottom of easily identifiable
support areas (valleys). In a downtrend, the trend line is drawn along the top of easily
identifiable resistance areas (peaks).
To create an up (ascending) channel, simply draw a parallel line at the same angle as an
uptrend line and then move that line to position where it touches the most recent peak.
To create a down (descending) channel, simple draw a parallel line at the same angle as
the downtrend line and then move that line to a position where it touches the most
recent valley.
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Fibonacci Who?
We will be using Fibonacci ratios a lot in our trading so you better learn it and love it like your mother. Fibonacci is a huge subject and there are many different studies of Fibonacci
with weird names but we’re going to stick to two: retracement and extension.
Let me first start by introducing you to the Fib man himself…Leonard Fibonacci.
Leonard Fibonacci was a famous Italian mathematician, also called a super duper uber geek, who had an “aha!” moment and discovered a simple series of numbers that created
ratios describing the natural proportions of things in the universe
The ratios arise from the following number series: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144
……
This series of numbers is derived by starting with 1 followed by 2 and then adding 1 + 2 to
get 3, the third number. Then, adding 2 + 3 to get 5, the fourth number, and so on.
After the first few numbers in the sequence, if you measure the ratio of any number to
that of the next higher number you get .618. For example, 34 divided by 55 equals 0.618.
If you measure the ratio between alternate numbers you get .382. For example, 34
divided by 89 = 0.382 and that’s as far as into the explanation as we’ll go.
These ratios are called the “golden mean.” Okay that’s enough mumbo jumbo. Even I’m
about to fall asleep with all these numbers. I'll just cut to the chase; these are the ratios
you have to know:
Fibonacci Retracement Levels
0.236, 0.382, 0.500, 0.618, 0.764
Fibonacci Extension Levels
0, 0.382, 0.618, 1.000, 1.382, 1.618
You won’t really need to know how to calculate all of this. Your charting software will do all the work for you. But it’s always good to be familiar with the basic theory behind the indicator so you’ll have knowledge to impress your date. Traders use the Fibonacci retracement levels as support and resistance levels. Since so many traders watch these same levels and place buy and sell orders on them to enter
trades or place stops, the support and resistance levels become a self-fulfilling
expectation.
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Traders use the Fibonacci extension levels as profit taking levels. Again, since so many traders are watching these levels and placing buy and sell orders to take profits, this tool
usually works due self-fulfilling expectations.
Most charting software includes both Fibonacci retracement levels and extension level
tools. In order to apply Fibonacci levels to your charts, you’ll need to identify Swing High
and Swing Low points.
A Swing High is a candlestick with at least two lower highs on both the left and right of itself.
A Swing Low is a candlestick with at least two higher lows on both the left and right of itself.
Let's take a closer look at Fibonacci retracement levels...
Fibonacci Retracement
In an uptrend, the general idea is to go long the market on a retracement to a Fibonacci
support level. In order to find the retracement levels, you would click on a significant
Swing Low and drag the cursor to the most recent Swing High. This will display each of the
Retracement Levels showing both the ratio and corresponding price level. Let’s take a look
at some examples of markets in an uptrend.
Watch how to draw Fibonacci retracement levels on a chart
This is an hourly chart of USD/JPY. Here we plotted the Fibonacci Retracement Levels by
clicking on the Swing Low at 110.78 on 07/12/05 and dragging the cursor to the Swing
High at 112.27 on 07/13/05. You can see the levels plotted by the software. The
Retracement Levels were 111.92 (0.236), 111.70 (0.382), 111.52 (0.500), and 111.35
(0.618). Now the expectation is that if USD/JPY retraces from this high, it will find support
at one of the Fibonacci Levels because traders will be placing buy orders at these levels as
the market pulls back.
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Now let’s look at what actually happened after the Swing High occurred. The market
pulled back right through the 0.236 level and continued the next day piercing the 0.382
level but never actually closing below it. Later on that day, the market resumed its
upward move. Clearly buying at the 0.382 level would have been a good short term trade.
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Now let’s see how we would use Fibonacci Retracement Levels during a downtrend. This is
an hourly chart for EUR/USD. As you can see, we found our Swing High at 1.3278 on
02/28/05 and our Swing Low at 1.3169 a couple hours later. The Retracement Levels were
1.3236 (0.618), 1.3224 (0.500), 1.3211 (0.382), and 1.3195 (.236). The expectation for a
downtrend is if it retraces from this high, it will encounter resistance at one of the
Fibonacci Levels because traders will be placing sell orders at these levels as the market
attempts to rally.
Let’s check out what happened next. Now isn’t that a thing of beauty! The market did try
to rally but it barely past the 0.500 level spiking to a high 1.3227 and it actually closed
below it. After that bar, you can see that the rally reversed and the downward move
continued. You would have made some nice dough selling at the 0.382 level.
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Here’s another example. This is an hourly chart for GBP/USD. We had a Swing High of
1.7438 on 07/26/05 and a Swing Low of 1.7336 the next day. So our Retracement Levels
are: 1.7399 (0.618), 1.7387 (0.500), 1.7375 (0.382), and 1.7360 (0.236). Looking at the
chart, the market looks like it tried to break the 0.500 level on several occasions, but try as
it may, it failed. So would putting a sell order at the 0.500 level be a good trade?
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If you did, you would have lost some serious cheddar! Take a look at what happened. The
Swing Low looked to be the bottom for this downtrend as the market rallied above the
Swing High point.
You can see from these examples the market usually finds at least temporary support
(during an uptrend) or resistance (during a downtrend) at the Fibonacci Retracements
Levels. It’s apparent that there a few problems to deal with here. There’s no way of
knowing which level will provide support. The 0.236 seems to provide the weakest
support/resistance, while the other levels provide support/resistance at about the same
frequency. Even though the charts above show the market usually only retracing to the
0.382 level, it doesn’t mean the price will hit that level every time and reverse. Sometimes
it’ll hit the 0.500 and reverse, other times it’ll hit the 0.618 and reverse, and other times
the price will totally ignore Mr. Fibonacci and blow past all the levels like similar to the
way Allen Iverson blows past his defenders with his nasty first step. Remember, the
market will not always resume its uptrend after finding temporary support, but instead
continue to decline below the last Swing Low. Same thing for a downtrend. The market
may instead decide to continue above the last Swing High.
The placement of stops is a challenge. It’s probably best to place stops below the last
Swing Low (on an uptrend) or above the Swing High (on a downtrend), but this requires
taking a high level of risk in proportion to the likely profit potential in the trade. This is
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called reward-to-risk ratio. In a later lesson, you will learn more money management and
risk control and how you would only take trades with certain reward-to-risk ratios.
Another problem is determining which Swing Low and Swing High points to start from to
create the Fibonacci Retracement Levels. People look at charts differently and so will have
their own version of where the Swing High and Swing Low points should be. The point is,
there is no one right away to do it, but the bad thing is sometimes it becomes a guessing
game.
Fibonacci Extension
The next use of Fibonacci you will be applying is that of targets. Let’s start with an
example in an uptrend.
In an uptrend, the general idea is to take profits on a long trade at a Fibonacci Price
Extension Level. You determine the Fibonacci extension levels by using three mouse clicks.
First, click on a significant Swing Low, then drag your cursor and click on the most recent
Swing High. Finally, drag your cursor back down and click on the retracement Swing Low.
This will display each of the Price Extension Levels showing both the ratio and
corresponding price levels.
Watch how to draw Fibonacci extension levels on a chart
On this 1-hour USD/CHF chart, we plotted the Fibonacci extension levels by clicking on the
Swing Low at 1.2447 on 08/14/05 and dragged the cursor to the Swing High at 1.2593 on
08/15/15 and then down to the retracement Swing Low of 1.2541 on 08/15/05. The
following Fibonacci extension levels created are 1.2597 (0.382), 1.2631 (0.618), 1.2687
(1.000), 1.2743 (1.382), 1.2760 (1.500), and 1.2777 (1.618).
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Now let’s look at what actually happened after the retracement Swing Low occurred.
• The market rallied to the 0.500 level
• fell back to the retracement Swing Low
• then rallied back up to the 0.500 level
• fell back slightly
• rallied to the 0.618 level
• fell back to the 0.382 level which acted as support
• then rallied all the way to the 1.382 level
• consolidated a bit
• then rallied to the 1.500 level
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You can see from these examples that the market often finds at least temporary
resistance at the Fibonacci extension levels - not always, but often. As in the examples of
the retracement levels, it should be apparent that there are a few problems to deal with
here as well. First, there is no way of knowing which level will provide resistance. The
0.500 level was a good level to cover any long trades in the above example since the
market retraced back to its original level, but if you didn’t get back in the trade, you would
have left a lot of profits on the table.
Another problem is determining which Swing Low to start from in creating the Fibonacci
Extension Levels. One way is from the last Swing Low as we did in the examples; another is
from the lowest Swing Low of the past 30 bars. Again, the point is that there is no one
right way to do it, and consequently it becomes a guessing game.
Alright, let’s see how Fibonacci extension levels can be used during a downtrend. In a
downtrend, the general idea is to take profits on a short trade at a Fibonacci price
extension level since the market often finds at least temporary support at these levels.
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On this 1-hour EUR/USD chart, we plotted the Fibonacci extension levels by clicking on the
Swing High at 1.21377 on 07/15/05 and dragged the cursor to the Swing Low at 1.2021 on
08/15/15 and then down to the retracement High of 1.2085. The following Fibonacci
extension levels created are 1.2041 (0.382), 1.2027 (0.500), 1.2013 (0.618), 1.1969
(1.000), 1.1925 (1.382), 1.1911 (1.500), and 1.1897 (1.618).
Now let’s look at what actually happened after the retracement Swing Low occurred.
• The market fell down almost to the 0.382 level which for right now is acting as a support
level
• The market then traded sideways between the retracement Swing High level and 0.382
level
• Finally, the market broke through the 0.382 and rested on the 0.500 level
• Then it broke the 0.500 level and fell all the way down to the 1.000 level
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Alone, Fibonacci levels will not make you rich. However, Fibonacci levels are definitely
useful as part of an effective trading method that includes other analysis and techniques.
You see, the key to an effective trading system is to integrate a few indicators (not too
many) that are applied in a way that is not obvious to most observers.
All successful traders know it’s how you use and integrate the indicators (including
Fibonacci) that makes the difference. The lesson learned here is that Fibonacci Levels can
be a useful tool, but never enter or exit a trade based on Fibonacci Levels alone.
Summary
Fibonacci retracement levels are 0.236, 0.382, 0.500, 0.618, 0.764
Traders use the Fibonacci retracement levels as support and resistance levels. Since so
many traders watch these same levels and place buy and sell orders on them to enter
trades or place stops, the support and resistance levels become a self-fulfilling
expectation.
Fibonacci extension levels are 0, 0.382, 0.618, 1.000, 1.382, 1.618
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Traders use the Fibonacci extension levels as profit taking levels. Again, since so many
traders are watching these levels and placing buy and sell orders to take profits, this tool
usually works due self-fulfilling expectations.
In order to apply Fibonacci levels to your charts, you’ll need to identify Swing High and
Swing Low points.
A Swing High is a candlestick with at least two lower highs on both the left and right of
itself.
A Swing Low is a candlestick with at least two higher lows on both the left and right of
itself.
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Price Smoothies
A moving average is simply a way to smooth out price action over time. By “moving
average”, we mean that you are taking the average closing price of a currency for the last
‘X’ number of periods.
Like every indicator, a moving average indicator is used to help us forecast future prices.
By looking at the slope of the moving average, you can make general predictions as to
where the price will go.
As we said, moving averages smooth out price action. There are different types of moving
averages, and each of them has their own level of “smoothness”. Generally, the smoother
the moving average, the slower it is to react to the price movement. The choppier the
moving average, the quicker it is to react to the price movement.
We’ll explain the pros and cons of each type a little later, but for now let’s look at the
different types of moving averages and how they are calculated.
Simple Moving Average
Simple Moving Average (SMA)
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A simple moving average is the simplest type of moving average (DUH!). Basically, a
simple moving average is calculated by adding up the last “X” period’s closing prices and
then dividing that number by X. Confused??? Allow me to clarify.
If you plotted a 5 period simple moving average on a 1 hour chart, you would add up the
closing prices for the last 5 hours, and then divide that number by 5. Voila! You have your
simple moving average.
If you were to plot a 5 period simple moving average on a 10 minute chart, you would add
up the closing prices of the last 50 minutes and then divide that number by 5.
If you were to plot a 5 period simple moving average on a 30 minute chart, you would add
up the closing prices of the last 150 minutes and then divide that number by 5.
If you were to plot the 5 period simple moving average on the a 4 hr. chart………………..OK
OK, I think you get the picture! Let’s move on.
Most charting packages will do all the calculations for you. The reason we just bored you
(yawn!) with how to calculate a simple moving average is because it is important that you
understand how the moving averages are calculated. If you understand how each moving
average is calculated, you can make your own decision as to which type is better for you.
Just like any indicator out there, moving averages operate with a delay. Because you are
taking the averages of the price, you are really only seeing a “forecast” of the future price
and not a concrete view of the future. Disclaimer: Moving averages will not turn you into
Ms. Cleo the psychic!
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Here is an example of how moving averages smooth out the price action.
On the previous chart, you can see 3 different SMAs. As you can see, the longer the SMA
period is, the more it lags behind the price. Notice how the 62 SMA is farther away from
the current price than the 30 and 5 SMA. This is because with the 62 SMA, you are adding
up the closing prices of the last 62 periods and dividing it by 62. The higher the number
period you use, the slower it is to react to the price movement.
The SMA’s in this chart show you the overall sentiment of the market at this point in time.
Instead of just looking at the current price of the market, the moving averages give us a
broader view, and we can now make a general
Exponential Moving Average
Exponential Moving Average (EMA)
Although the simple moving average is a great tool, there is one major flaw associated
with it. Simple moving averages are very susceptible to spikes. Let me show you an
example of what I mean:
Let’s say we plot a 5 period SMA on the daily chart of the EUR/USD and the closing prices
for the last 5 days are as follows:
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Day 1: 1.2345
Day 2: 1.2350
Day 3: 1.2360
Day 4: 1.2365
Day 5: 1.2370
The simple moving average would be calculated as
(1.2345+1.2350+1.2360+1.2365+1.2370)/5= 1.2358
Simple enough right?
Well what if Day 2’s price was 1.2300? The result of the simple moving average would be
a lot lower and it would give you the notion that the price was actually going down, when
in reality, Day 2 could have just been a one time event (maybe interest rates decreasing).
The point I’m trying to make is that sometimes the simple moving average might be too
simple. If only there was a way that you could filter out these spikes so that you wouldn’t
get the wrong idea. Hmmmm…I wonder….Wait a minute……Yep, there is a way!
It’s called the Exponential Moving Average!
Exponential moving averages (EMA) give more weight to the most recent periods. In our
example above, the EMA would put more weight on Days 3-5, which means that the spike
on Day 2 would be of lesser value and wouldn’t affect the moving average as much. What
this does is it puts more emphasis on what traders are doing NOW.
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When trading, it is far more important to see what traders are doing now rather than
what they did last week or last month.
SMA vs. EMA
Which is better: Simple or Exponential?
First, let’s start with an exponential moving average. When you want a moving average
that will respond to the price action rather quickly, then a short period EMA is the best
way to go. These can help you catch trends very early, which will result in higher profit. In
fact, the earlier you catch a trend, the longer you can ride it and rake in those profits!
The downside to the choppy moving average is that you might get faked out. Because the
moving average responds so quickly to the price, you might think a trend is forming when
in actuality; it could just be a price spike.
With a simple moving average, the opposite is true. When you want a moving average
that is smoother and slower to respond to price action, then a longer period SMA is the
best way to go.
Although it is slow to respond to the price action, it will save you from many fake outs.
The downside is that it might delay you too long, and you might miss out on a good trade.
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SMA EMA
Pros:
Displays a smooth chart, which eliminates
most fakeouts.
Quick moving, and is good at showing recent
price swings.
Cons:
Slow moving, which may cause a lag in buying
and selling signals.
More prone to cause fakeouts and give errant
signals.
So which one is better? It’s really up to you to decide. Many traders plot several different
moving averages to give them both sides of the story. They might use a longer period
simple moving average to find out what the overall trend is, and then use a shorter period
exponential moving average to find a good time to enter a trade.
In fact, many trading systems are built around what is called “Moving Average
Crossovers”. Later in this course, we will give you an example of how you can use moving
averages as part of your trading system.
Time for recess! Go find a chart and start playing with some moving averages. Try out
different types and look at different periods. In time, you will find out which moving
averages work best for you. Class dismissed!
Summary
• A moving average is a way to smooth out price action.
• There are many types of moving averages. The 2 most common types are: Simple Moving
Average and Exponential Moving Average.
• Simple moving averages are the simplest form of moving averages, but they are susceptible to spikes.
• Exponential moving averages put more weight to recent prices and therefore show us
what traders are doing now.
• It is much more important to know what traders are doing now than to see what they did
last week or last month.
• Simple moving averages are smoother than Exponential moving averages.
• Longer period moving averages are smoother than shorter period moving averages.
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• Choppy moving averages are quicker to respond to price action and can catch trends
early. However, because of their quick reaction, they are susceptible to spikes and can
fake you out.
• Smooth moving averages are slower to respond to price action but will save you from spikes and fake outs. However, because of their slow reaction, they can delay you from
taking a trade and may cause you to miss some good opportunities.
• The best way to use moving averages is to plot different types on a chart so that you can
see both long term movement and short term movement.
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Bollinger Bands
Congratulations on making it to the 5th grade! Each time you make it to the next grade
you continue to add more and more tools to your trader’s toolbox. “What’s a trader’s toolbox?” you say… Simple! Your trader’s toolbox is what you will use to “build” your
trading account. The more tools (education) you have in your trader’s toolbox (YOUR
BRAIN), the easier it will be for you to build.
So for this lesson, as you learn each of these indicators, think of them as a new tool that
you can add to that toolbox of yours. You might not necessarily use all of these tools, but
it’s always nice to have the option, right? Now, enough about tools already! Let’s get
started!
Bollinger Bands
Bollinger bands are used to measure a market’s volatility. Basically, this little tool tells us
whether the market is quiet or whether the market is LOUD! When the market is quiet,
the bands contract; and when the market is LOUD, the bands expand. Notice on the chart
below that when the price was quiet, the bands were close together, but when the price moved up, the bands spread apart.
That’s all there is to it. Yes, we could go on and bore you by going into the history of the
Bollinger band, how it is calculated, the mathematical formulas behind it, and so on and so
forth, but we really didn’t feel like typing it all out.
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In all honesty, you don’t need to know any of that junk. We think it’s more important that
we show you some ways you can apply the Bollinger bands to your trading.
Note: If you really want to learn about the calculations of a Bollinger band, then you can
go to www.bollingerbands.com
The Bollinger Bounce
One thing you should know about Bollinger Bands is that price tends to return to the
middle of the bands. That is the whole idea behind the Bollinger bounce (smart, huh?). If
this is the case, then by looking at the chart below, can you tell us where the price might
go next? If you said down, then you are
correct! As you can see, the price
settled back down towards the middle
area of the bands.
That’s all there is to it. What you just saw was a classic Bollinger bounce. The reason these
bounces occur is because Bollinger Bands act like mini support and resistance levels. The longer the time frame you are in, the stronger
these bands are. Many traders have developed
systems that thrive on these bounces, and this
strategy is best used when the market is ranging
and there is no clear trend.
Now let’s look at a way to use Bollinger Bands
when the market does trend.
Bollinger Squeeze
The Bollinger squeeze is pretty self explanatory. When the bands “squeeze” together, it
usually means that a breakout is going to occur. If the candles start to break out above the top band, then the move will usually continue to go up. If the candles start to break
out below the lower band, then the move will usually continue to go down.
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Looking at the chart above, you can see the bands squeezing together. The price has just
started to break out of the top band. Based on this information, where do you think the
price will go?
If you said up, you are correct! This is how a typical Bollinger Squeeze works. This strategy
is designed for you to catch a move as early as possible. Setups like these don’t occur
everyday, but you can probably spot them a few times a week if you are looking at a 15 minute chart.
So now you know what Bollinger Bands are, and you know how to use them. There are many other things you can do with Bollinger Bands, but these are the 2 most common
strategies associated with them. So now you can put this in your trader’s toolbox, and we can move on to the next indicator.
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MACD
MACD is an acronym for Moving Average Convergence Divergence. This tool is used to
identify moving averages that are indicating a new trend, whether it’s bullish or bearish.
After all, our #1 priority in trading is being able to find a trend, because that is where the
most money is made.
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 are 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 packages), 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.
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• 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 blue lines in the chart above).
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. What this does is it smoothes out the
original line even more, which gives us a more accurate line.
The histogram simply plots the difference between the fast and slow moving average. If
you look at our original chart, 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! Whew, we need to crack our knuckles after that one!
Ok, so now you know what MACD does. Now I’ll show you what MACD can do for YOU.
MACD Crossover
Because there are two moving averages with different “speeds”, the faster one will
obviously be quicker to react to price movement than the slower one. When a new trend
occurs, the fast line will react first and eventually cross the slower line. When this
“crossover” occurs, and the fast line starts to “diverge” or move away from the slower line, it often indicates that a new trend has formed.
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From the chart above, you can see that the fast line crossed under the slow line and correctly identified a new downtrend. Notice that when the lines crossed, the histogram
temporarily disappears. This is because the difference between the lines at the time of the cross is 0. As the downtrend begins and the fast line diverges away from the slow line, the
histogram gets bigger, which is good indication of a strong trend.
There is one drawback to MACD. Naturally, moving averages tend to lag behind price.
After all, it's just an average of historical prices. Since the MACD represents moving averages of other moving averages and is smoothed out by another moving average, you
can imagine that there is quite a bit of lag. However, it is still one of the most favored tools by many traders.
Parabolic SAR
Up until now, we’ve looked at indicators that mainly focus on catching the beginning of new trends. And although it is important to be able to identify new trends, it is equally
important to be able to identify where a trend ends. After all, what good is a well-timed entry without a well-timed exit?
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One indicator that can help us determine where a trend might be ending is the Parabolic
SAR (Stop And Reversal). A Parabolic SAR places dots, or points, on a chart that indicate
potential reversals in price movement. From the chart above, you can see that the dots
shift from being below the candles during the uptrend, to above the candles when the
trend reverses into a downtrend.
Using Parabolic SAR
The nice thing about the Parabolic SAR is that it is really simple to use. Basically, when the
dots are below the candles, it is a buy signal; and when the dots are above the candles, it is a sell signal. This is probably the easiest indicator to interpret because it assumes that
the price is either going up or down. With that said, this tool is best used in markets that are trending, and that have long rallies and downturns. You DON’T want to use this tool in
a choppy market where the price movement is sideways.
Stochastics
Stochastics are another indicator that helps us determine where a trend might be ending.
By definition, a stochastic is an oscillator that measures overbought and oversold
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