Forex Knowledge hub PART-3
conditions in the market. The 2 lines are similar to the MACD lines in the sense that one line is faster than the other.
How to Apply Stochastics Like I said earlier, stochastics tells us when the market is overbought or oversold.
Stochastics are scaled from 0 to 100. When the stochastic lines are above 70 (the red dotted line in the chart above), then it means the market is overbought. When the stochastic lines are below 30 (the blue dotted line), then it means that the market is oversold. As a rule of thumb, we buy when the market is oversold, and we sell when the
market is overbought.
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Looking at the chart above, you can see that the stochastics has been showing overbought
conditions for quite some time. Based upon this information, can you guess where the price might go?
If you said the price would drop, then you are absolutely correct! Because the market was overbought for such a long period of time, a reversal was bound to happen.
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That is the basics of stochastics. Many traders use stochastics in different ways, but the
main purpose of the indicator is to show us where the market is overbought and
oversold. Over time, you will learn to use stochastics to fit your own personal trading
style. Okay, let's move on to RSI.
Relative Strength Index
Relative Strength Index, or RSI, is similar to stochastics in that it identifies overbought and oversold conditions in the market. It is also scaled from 0 to 100. Typically, readings
below 20 indicate oversold, while readings over 80 indicate overbought.
Using RSI
RSI can be used just like stochastics. From the chart above you can see that when RSI
dropped below 20, it correctly identified an oversold market. After the drop, the price quickly shot back up.
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RSI is a very popular tool because it can also be used to confirm trend formations. If you
think a trend is forming, take a quick look at the RSI and look at whether it is above or
below 50. If you are looking at a possible uptrend, then make sure the RSI is above 50. If you are looking at a possible downtrend, then make sure the RSI is below 50.
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In the beginning of the chart above, we can see that a possible uptrend was forming. To avoid fakeouts, we can wait for RSI to cross above 50 to confirm our trend. Sure enough,
as RSI passes above 50, it is a good confirmation that an uptrend has actually formed. Okey dokey, we've covered a smorgasbord of indicators, let's see how we can put all of what you just learned together...
Putting It All Together
In a perfect world, we could take just one of these indicators and trade strictly by what that indicator told us. The problem is that we DON’T live in a perfect world, and each of
these indicators has imperfections. That is why many traders combine different indicators
together so that they can “screen” each other. They might have 3 different indicators and
they won’t trade unless all 3 indicators give them the same answer.
As you continue your journey as a trader, you will discover what indicators work best for you. We can tell you that we like using MACD, Stochastics, and RSI, but you might have a
different preference. Every trader out there has tried to find the “magic combination” of indicators that will always give them the right signals, but the truth is that there is no such
thing. We urge you to study each indicator on its own until you know EXACTLY how it reacts to
price movement, and then come up with your own combination that fits your trading
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style. Later on in the course, we will show you a system that combines different indicators
to give you an idea of how they can compliment each other.
Summary
Everything you learn about trading is like a tool that is being added to your trader’s
toolbox. Your tools will make it easier for you to “build” your trading account.
Bollinger Bands
• Used to measure the market’s volatility
• They act like mini support and resistance levels
• Bollinger Bounce
o A strategy that relies on the notion that price tends to always return to the middle
of the Bollinger Bands
o You buy when the price hits the lower Bollinger band
o You sell when the price hits the upper Bollinger band
o Best used in ranging markets
• Bollinger Squeeze
o A strategy that is used to catch breakouts early
o When the Bollinger bands “squeeze” the price, it means that the market is very
quiet, and a breakout is eminent. Once a breakout occurs, we enter a trade on
whatever side the price made its breakout.
MACD
• Used to catch trends early and can also help us spot trend reversals
• It consists of 2 moving averages (1 fast, 1 slow) and vertical lines called a histogram, which
measures the distance between the 2 moving averages.
• Contrary to what many people think, the moving average lines are NOT moving averages
of the price. They are moving averages of other moving averages.
• MACD’s downfall is its lag because it uses so many moving averages.
• One way to use MACD is to wait for the fast line to “cross over” or “cross under” the slow
line and enter the trade accordingly because it signals a new trend.
Parabolic SAR
• This indicator is made to spot trend reversals; hence the name Parabolic Stop And
Reversal (SAR)
• This is the easiest indicator to interpret because it only gives bullish and bearish signals.
• When the dots are above the candles, it is a sell signal.
• When the dots are below the candles, it is a buy signal.
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• These are best used in trending markets that consist of long rallies and downturns.
Stochastics
• Used to indicate overbought and oversold conditions
• When the moving average lines are above 70, it means that the market is overbought and
we should look to sell.
• When the moving average lines are below 30, it means that the market is oversold and we
should look to buy.
Relative Strength Index (RSI)
• Similar to stochastics in that it indicates overbought and oversold conditions.
• When RSI is above 80, it means that the market is overbought and we should look to sell.
• When RSI is below 20, it means that the market is oversold and we should look to buy.
• RSI can also be used to confirm trend formations. If you think a trend is forming, wait for
RSI to go above or below 50 (depending on if you’re looking at an uptrend or downtrend)
before you enter a trade.
Each indicator has its imperfections. This is why traders combine many different indicators to “screen” each other. As you progress through your trading career, you will
learn which indicators you like the best and can combine them in a way that fits your trading style.
We know this has been a very loooooooooooonnnnng lesson, and we do encourage you to go back and read over anything you haven’t fully understood yet. Sometimes it just takes a couple times of reading before you truly grasp something. Once you understand the concepts of these indicators, go to a chart and start playing with
them. Really study how each indicator reacts to the price movement.
When you fully understand an indicator, then it will become another tool for your trader’s toolbox. For now you should just take a break. Grab some coffee or get something to eat. We know your eyes are hurting! Let this lesson soak in, and then come back when
you’re refreshed!
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Leading vs. Lagging Indicators
We’ve covered a lot of tools that can help you analyze charts and identify trends. In fact,
you may now have too much information to use effectively.
In this lesson, we’re going to look at streamlining your use of these chart indicators. We
want you to fully understand the strengths and weaknesses of each tool, so you’ll be able
to determine which ones work for you and your trading plan…and which ones don’t.
Leading versus Lagging Indicators
Let’s discuss some concepts first. There are two types of indicators: leading and lagging. A leading indicator gives a buy signal before the new trend or reversal occurs. A lagging indicator gives a signal after the trend has started and basically informs you “hey
buddy, pay attention, the trend has started, you’re missing the boat.”
You’re probably thinking, “Ooooh, I’m going to get rich with leading indicators!” since you
would be able to profit from a new trend right at the start. You’re right – you would “catch” the entire trend every single time, IF the leading indicator was correct every single
time. But it’s not. When you use leading indicators, you will experience a lot of fake-outs. Leading indicators
are notorious for giving bogus signals which will “mislead” you. Get it? Leading indicators
that "mislead" you? Ha-ha. Man we're so funny we even crack ourselves up.
The other option is to use lagging indicators, which aren’t as prone to bogus signals. Lagging indicators only give signals after the price change is clearly forming a trend. The
downside is that you’d be a little late in entering a position. Often the biggest gains of a trend occur in the first few bars, so by using a lagging indicator you could potentially miss out on much of the profit. Which sucks.
Oscillators and Trend Following Indicators
For the purpose of this lesson, let’s broadly categorize all of our technical indicators into one of two categories:
1. Oscillators
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1. Trend following or momentum indicators
Oscillators are leading indicators.
Momentum indicators are lagging indicators.
While the two can be supportive of each other, they're more likely to conflict with each
other. We’re not saying that one or the other should be used exclusively, but you must
understand the potential pitfalls of each
Oscillators / Leading Indicators
An oscillator is any object or data that moves back and forth between two points. In other
words, it’s an item that is going to always fall somewhere between point A and point B. Think of when you hit the oscillating switch on your electric fan.
Think of our technical indicators as either being “on” or “off”. More specifically, an oscillator will usually signal “buy” or “sell”, with the only exception being instances when the oscillator is not clearly at either end of the buy/sell range.
Does this sound familiar? It should! Stochastics, Parabolic SAR, and the Relative Strength
Index (RSI) are all oscillators. Each of these indicators is designed to signal a possible reversal, where the previous trend has run its course and the price is ready to change direction. Let’s take a look at a few examples.
On the 1-hour chart of USD/EUR below, we have added a Parabolic SAR indicator, as well as an RSI and Stochastic oscillator. As you have already learned, when the Stochastic and
RSI begin to leave their “oversold” region that is a buy signal.
Here we get buy signals between the hours 3:00 am EST and 7:00 am EST on 08/24/05. All
three of these buy signals occurred within one or two hours of each other, and this would
have been a good trade.
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We also got a sell signal from all three indicators between the hours of 2:00 am EST and
5:00 am EST on 08/25/05. As you can see, the Stochastic indicator remained in the
overbought for a pretty long time - about 20 hours. Usually when an oscillator remains in the overbought or oversold levels for a long period of time, that means there is a strong
trend occurring. In this example, since Stochastic stayed overbought, you see there was a strong uptrend present.
Now let’s take a look at the same leading oscillators messing up, just so you know these signals aren’t perfect. Looking at the chart below, you can quickly see that there were a lot
of false buy signals popping up. You’ll see how one indicator says to buy, while the other one is still saying sell.
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Around 1 am EST on 08/16/05, both RSI and Stochastic gave buy signals, while Parabolic SAR still showed a sell signal. Yes, Parabolic SAR gave a buy signal 3 hours later at 4 am
EST, but then Parabolic SAR turned into a sell signal one bar later. If you actually look at
the bar with the Parabolic SAR below it, notice how it’s a strong looking red bar with very
short shadows. Also, notice how the next bar closed below it. This would not have been a
good long trade.
On the last two oversold (buy) signals given by Stochastic, notice how there is no indicator
at all for RSI, but Parabolic SAR is giving sell signals. What’s going on here? They are each
giving you different signals!
What happened to such a good set of indicators?
The answer lies in the method of calculation for each one. Stochastic is based on the highto- low range of the time period (in this case, it’s hourly), yet doesn’t account for changes
from one hour to the next. The Relative Strength Index (RSI) uses change from one closing price to the next. And Parabolic SAR has its own unique calculations that can further cause
conflict. That’s the nature of oscillators – they assume that a particular chart pattern always results in the same reversal. Of course, that’s hogwash.
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While being aware of why a leading indicator may be in error, there’s no way to avoid
them. If you’re getting mixed signals, you’re better off doing nothing than taking a ‘best
guess’. If a chart doesn’t meet all your criteria, don’t force the trade! Move on to the next
one that does meet your criteria.
Momentum / Lagging Indicators
So how do we spot a trend? The indicators that can do so have already been identified as
MACD and moving averages. These indicators will spot trends once they have been
established, at the expense of delayed entry. The bright side is that there’s less chance of
being wrong.
On this 1-hour chart of EUR/USD, there was a bullish crossover for MACD at 3:00 am EST on 08/03/05 and the 10 period EMA crossed over the 20 period EMA at 5:00 am. These
two signals were all accurate, but if you waited for both indicators to give you a bull signal, you would have missed out on the big move. If you calculate from the start of the uptrend
at 10:00 pm EST on 08/02/05 to the close of the candle at 5:00 am EST on 08/03/05, you
would have watched a gain of 159 pips while sitting on the sidelines.
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Let’s take a look at the same chart so you can see how these crossover signals can
sometimes give false signals. We like to call them “fake-outs”. Look at how there was a
bearish MACD crossover after the uptrend we just discussed.
Ten hours later, the 20 EMA crossed below the 10 EMA giving a “sell” signal. As you can
see, the price didn’t drop but stayed pretty much sideways, then continued its uptrend. By the time both indicators were in agreement, you would’ve entered a short trade at the
bottom and set yourself up for a loss. Bummer, dude!
Summary
The Million Dollar Question
How do you figure out whether to freakin’ use oscillators, or trend following indicators, or
both? After all, we know they don’t always work in tandem.
This is probably the most challenging part about technical analysis. And why I call it the million dollar question.
We will provide the million dollar answer in a future lesson.
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For now, just know that once you're able to identify the type of market you are trading in,
you will then know which indicators will give accurate signals, and which ones are worthless at that time.
This is no piece of cake. But it's a skill you will slowly improve upon as your experience grows.
Summary
• There are two types of indicators: leading and lagging.
• A leading indicator gives a buy signal before the new trend or reversal occurs.
• A lagging indicator gives a signal after the trend has started
• Technical indicators into one of two categories: Oscillators and trend following or
momentum indicators.
• Oscillators are leading indicators.
• Momentum indicators are lagging indicators.
• If you're able to identify the type of market you are trading in, you will then know which
indicators will give accurate signals, and which ones are worthless at that time.
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Pattern Schmatterns
By now you have an arsenal of weapons to use when you battle the market. In this lesson
you will add yet another weapon: CHART PATTERNS!
Think of chart patterns as a land mine detector, because once you learn this, you will be
able to spot “explosions” on the charts before they even happen, making you a lot of money in the process.
In this lesson, we will teach you basic chart patterns and formations. When correctly identified, it usually leads to a huge breakout or “explosion” in this case. Remember, our whole goal is to spot big movements before they happen so that we can ride them out and rake in the cash! Chart formations will greatly help us spot conditions
where the market is ready to break out.
Here's the list of patterns that we're going to cover:
• Symmetrical Triangles
• Ascending Triangles
• Descending Triangles
• Double Top
• Double Bottom
• Head and Shoulders
• Reverse Head and Shoulders
Symmetrical Triangles
Symmetrical triangles are chart formations where the slope of the price’s highs and the
slope of the price’s lows converge together to a point where it looks like a triangle. What
is happening during this formation is that the market is making lower highs and higher lows. This means that neither the buyers nor the sellers are pushing the price far enough to make a clear trend. If this was a battle between the buyers and sellers, then this would be a draw.
This type of activity is called consolidation.
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In the chart above, we can see that neither the buyers nor the sellers could push the price
in their direction. When this happens we get lower highs and higher lows. As these two slopes get closer to each other, it means that a breakout is getting near. We don’t know
what direction the breakout will be, but we do know that the market will break out. Eventually, one side of the market will give in.
So how can we take advantage of this? Simple. We can place entry orders above the slope of the lower highs and below the slope of the higher lows. Since we already know that the
price is going to break out, we can just hitch a ride in whatever direction the market moves.
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In this example, if we placed an entry order above the slope of the lower highs, we
would’ve been taken along for a nice ride up. If you had placed another entry order below
the slope of the higher lows, then you would cancel it as soon as the first order was hit. Ascending Triangles
This type of formation occurs when there is a resistance level and a slope of higher lows. What happens during this time is that there is a certain level that the buyers cannot seem
to exceed. However, they are gradually starting to push the price up as evident by the higher lows.
In the chart above, you can see that the buyers are starting to gain strength because they are making higher lows. They keep putting pressure on that resistance level and as a result, a breakout is bound to happen. Now the question is, “Which direction will it go? -
Will the buyers be able to break that level or will the resistance be too strong?”
Many charting books will tell you that in most cases, the buyers will win this battle and the
price will break out past the resistance. However, it has been my experience that this is
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not always the case. Sometimes the resistance level is too strong, and there is simply not enough buying power to push it through.
Most of the time the price will in fact go up. The point we are trying to make is that we do not care which direction the price goes, but we want to be ready for a movement in EITHER direction. In this case, we would set an entry order above the resistance line and
below the slope of the higher lows.
In this scenario, the buyers won the battle and the price proceeded to skyrocket! Descending Triangles
As you probably guessed, descending triangles are the exact opposite of ascending triangles (we knew you were smart!). In descending triangles, there is a string of lower
highs which forms the upper line. The lower line is a support level in which the price cannot seem to break.
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In the chart above, you can see that the price is gradually making lower highs which tell us that the sellers are starting to gain some ground against the buyers. Now most of the
time, and we did say MOST - the price will eventually break the support line and continue to fall.
However, in some cases the support line is too strong, and the price will bounce off of it
and make a strong move up.
The good news is that we don’t care where the price goes. We just know that it’s about to
go somewhere. In this case we would place entry orders above the upper line (the lower
highs) and below the support line.
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In this case, the price did end up breaking the support line and proceeded to drop rather
quickly. (*note- The market tends to fall faster than it rises which means you usually make money faster when you are short).
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Double Top
A double top is a reversal pattern that is formed after there is an extended move up. The
“tops” are peaks which are formed when the price hits a certain level that can’t be broken. After hitting this level, the price will bounce off it slightly, but then return back to
test the level again. If the price bounces off of that level again, then you have a DOUBLE top!
In the chart above you can see that two peaks or “tops” were formed after a strong move up. Notice how the 2nd top was not able to break the high of the 1st top. This is a strong
sign that a reversal is going to occur because it is telling us that the buying pressure is just about finished.
With double tops, we would place our entry order below the neckline because we are anticipating a reversal of the uptrend.
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Wow! We must be psychic or something because we always seem to be right! Looking at
the chart you can see that the price breaks the neckline and makes a nice move down.
Remember, double tops are a trend reversal formation. You’ll want to look for these after there is a strong uptrend.
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Double Bottom
Double bottoms are also trend reversal formations, but this time we are looking to go long
instead of short. These formations occur after extended downtrends when two valleys or “bottoms” have been formed.
You can see from the chart above that after the previous
downtrend, the price formed two valleys because it wasn’t
able to go below a certain level. Notice how the 2nd
bottom wasn’t able to significantly break the 1st bottom.
This is a sign that the selling pressure is about finished, and
that a reversal is about to occur. In this situation, we would
place an entry order above the neckline.
Would you look at that!
The price breaks the neckline and makes a nice
move up. Remember, just like double tops,
double bottoms are also trend reversal
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formations. You’ll want to look for these after a strong downtrend.
Head and Shoulders
A head and shoulders pattern is also a trend reversal formation. It is formed by a peak
(shoulder), followed by a higher peak (head), and then another lower peak (shoulder). A
“neckline” is drawn by connecting the lowest points of the two troughs. The slope of this
line can either be up or down. In my experience, when the slope is down, it produces a
more reliable signal.
In this example, we can visibly see the head and shoulders pattern. The head is the 2nd
peak and is the highest point in the pattern. The two shoulders also form peaks but do not
exceed the height of the head.
With this formation, we look to make an entry order below the neckline. We can also calculate a target by measuring the high point of the head to the neckline. This distance is approximately how far the price will move after it breaks the neckline.
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You can see that once the price goes below the neckline it makes a move that is about the
size of the distance between the head and the neckline.
Reverse Head and Shoulders
The name speaks for itself. It is basically a head and shoulders formation, except this time it’s in reverse. A valley is formed (shoulder), followed by an even lower valley (head), and
then another higher valley (shoulder). These formations occur after extended downward
movements.
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Here you can see that this is just like a head and shoulders pattern, but it’s flipped upside
down. With this formation, we would place a long entry order above the neckline. Our
target is calculated just like the head and shoulders pattern. Measure the distance
between the head and the neckline, and that is approximately the distance that the price
will move after it breaks the neckline.
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You can see that the price moved up nicely after it broke the neckline. WE know you’re
thinking to yourself, “the price kept moving even after it reached the target.”
And our response is, “DON”T BE GREEDY!”
If your target is hit, then be happy with your profits. However, there are strategies where
you can lock in some of your profits and still keep your trade open in case the price continues to move your way. You will learn about those later on in the course.
Summary
Chart formations are like bazookas because they often create huge explosions on the chart.
Triangles
Symmetrical triangles
• Consist of lower highs and higher lows
• Place entry orders above the lower highs and below the higher lows
Ascending triangles
• Consist of higher lows and a resistance line
• It usually means that the price will break the resistance line and go higher but you should
place entry orders on both sides just in case the resistance line is too strong.
• Place your entry orders above the resistance line and below the higher lows.
Descending triangles
• Consist of lower highs and a support line
• Usually mean that the price will break the support line and go lower but you should place
entry orders on both sides just in case the support line is too strong.
• Place your entry orders above the lower highs and below the support line.
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Trend Reversal formations
Double Top
• Happens after an extended uptrend.
• Formed by 2 peaks that can’t break a certain level. This level becomes a resistance line.
• Place our short entry order below the low point of the valley in between the 2 peaks.
Double Bottom
• Happens after an extended downtrend.
• Formed by 2 valleys that can’t break a certain level. This level becomes a support line.
• Place our long entry order above the high point of the peak in between the 2 valleys.
Head and Shoulders
• Happens after an extended uptrend.
• Formed by a peak, followed by a higher peak, and then another lower peak. A neckline is
formed by connecting the low points of the two troughs or “valleys”.
• Place your short entry order below the neckline.
• We calculate our target by measuring the distance between the high point of the head and
the neckline. This is the approximate distance that the price will move after it breaks the
neckline.
Reverse Head and Shoulders
• Happens after an extended downtrend.
• Formed by a valley, followed by a lower valley, and then another higher valley. A neckline
is formed by connecting the high points of the 2 peaks.
• Place your long entry order above the neckline.
• We calculate our target by measuring the distance between the low point of the head and
the neckline. This is the approximate distance that the price will move after it breaks the
neckline.
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Pivot Points
Professional traders and market makers use pivot points to identify important support and
resistance levels. Simply put, a pivot point and its support/resistance levels are areas at
which the direction of price movement can possibly change.
Pivot points are especially useful to short-term traders who are looking to take advantage
of small price movements.
Pivot points can be used by both range-bound traders and breakout traders. Range-bound
traders use pivot points to identify reversal points. Breakout traders use pivot points to
recognize key levels that need to be broken for a move to be classified as a real deal
breakout.
Here is an example of pivot points plotted on a 1-hour EUR/USD chart:
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How to Calculate Pivot Points
The pivot point and associated support and resistance levels are calculated by using the
last trading session’s open, high, low, and close. Since Forex is a 24-hour market, most
traders use the New York closing time of 4:00pm EST as the previous day’s close. The calculation for a pivot point is shown below:
Pivot point (PP) = (High + Low + Close) / 3
Support and resistance levels are then calculated off the pivot point like so:
First level support and resistance:
First support (S1) = (2*PP) – High
First resistance (R1) = (2*PP) – Low
Second level of support and resistance:
Second support (S2) = PP – (High – Low)
Second resistance (R2) = PP + (High - Low)
Don’t worry you don’t have to perform these calculations yourself. Your charting software
will automatically do it for you and plot it on the chart.
Also keep in mind that some charting software also provides additional pivot point
features such as a third support and resistance level and intermediate levels or mid-point
levels (levels in between the main pivot point and support and resistance level).
These “extra levels” aren’t as significant as the main five but it doesn’t hurt to pay
attention to them. Here’s an example:
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How to Trade with Pivot Points
Breakout Trades
The pivot point should be the first place you look at to enter a trade, since it is the primary
support/resistance level. The biggest price movements usually occur at the price of the
pivot point.
Only when price reaches the pivot point will you be able to determine whether to go long
or short, and set your profit targets and stops. Generally, if prices are above the pivot it’s
considered bullish, and if they are below it’s considered bearish.
Let’s say the price is hovering around the pivot point and closes below it so you decide to
go short. Your stop loss would be above PP and your initial profit target would be at S1.
However, if you see prices continue to fall below S1, instead of cashing out at S1, you can
move your existing stop-loss order just above S1 and watch carefully. Typically, S2 will be
the expected lowest point of the trading day and should be your ultimate profit objective.
The converse applies during an uptrend. If price closed above PP, you would enter a long
position, set a stop loss below PP and use the R1 and R2 levels as your profit objectives.
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Range-bound Trades
The strength of support and resistance at the different pivot levels is determined by the
number of times the price bounces off the pivot level.
The more times a currency pair touches a pivot level then reverses, the stronger the level
is. Pivoting simply means reaching a support or resistance level and then reversing. Hence,
the word “pivot”.
If the pair is nearing an upper resistance level, you could sell the pair and place a tight
protective stop just above the resistance level.
If the pair keeps moving higher and breaks out above the resistance level, this would be
considered an upside “breakout”. You would also get stopped out of your short order but
if you believe that the breakout has good follow-through buying strength, you can reenter
with a long position. You would then place your protective stop just below the former
resistance level that was just penetrated and is now acting as support.
If the pair is nearing a lower support level, you could buy the pair and place a stop below
the support level.
Theoretically Perfect?
In theory, it sounds pretty simple huh? Dream on, pal!
In the real world, pivot points don’t work all the time. Price tends to hesitate around pivot
lines and at times it’s just ridiculously hard to tell what it will do next.
Sometimes the price will stop just before reaching a pivot line and then reverse meaning
your profit target doesn’t get reached. Other times, it looks like a pivot line is a strong
support level so you go long only to see the price fall, stop you out, then reverse back into
your direction.
You must be very selective and create a pivot point trading strategy that you intend to
strictly follow.
Let’s go look at a chart to see just how difficult and easy pivot points might be.
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Ooooh pretty colors! We like...
Look at the orange oval. Notice how the PP was a strong support but if you went long on
PP, it never was able to rise up to R1.
Look at the first purple circle. The pair broke down through PP but failed to reach S1
before reversing back to PP. On the second break down though (second purple circle), the
pair did manage to reach S1 before once again reversing back to PP.
Look at the pink oval. Again, PP acted as strong support but never was able to rise up to
R1.
On the yellow circle, the pair broke out to the downside again, sliced right through S1, and
managed to fall all the way down to S2.
If you ever attempted to go long on this chart, you would have been stopped out every
single time.
Personally, we would have not even thought about buying this pair - Why not? Well we
have a little secret. What we didn’t show you regarding this chart was that this pair was
trending down for quite some time now.
Remember the trend is your friend. We don’t like to backstab our friends, so we try our
best to never trade against the trend.
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In the next lesson, you will learn how to use multiple timeframes to trade with the correct
trend direction so you’re able to minimize possible mistakes such as the one above.
Forex Pivot Point Trading Tips
Here are some easy to memorize tips that will help you to make smart pivot point trading
decisions.
• If price at PP, watch for a move back to R1 or S1.
• If price is at R1, expect a move to R2 or back towards PP.
• If price is at S1, expect a move to S2 or back towards PP.
• If price is at R2, expect a move to R3 or back towards R1.
• If price is at S2, expect a move to S3 or back towards S1.
• If there is no significant news to influence the market, price will usually move from P to S1
or R1.
• If there is significant news to influence the market price may go straight through R1 or S1
and reach R2 or S2 and even R3 or S3.
• R3 and S3 are a good indication for the maximum range for extremely volatile days but can
be exceeded occasionally.
• Pivot lines work well in sideways markets as prices will most likely range between the R1
and S1 lines.
• In a strong trend, price will blow through a pivot line and keep going.
Summary
• Pivot points are a technique used by professional traders and market makers to
determine entry and exit points for the trading day based on the previous day’s
trading activity. It’s best to use this technique after determining the direction of
the trend.
• As the charts above show, pivots can be extremely useful in Forex since many
currency pairs usually fluctuate between these levels.
• Range-bound traders will enter a buy order near identified levels of support and a
sell order when the pair nears resistance.
• Pivot points also allow breakout traders to identify key levels that need to be
broken for a move to qualify as a bona fide breakout.
• The simplicity of pivot points definitely makes them a useful tool to add to your
trading toolbox. It allows you to see possible areas that are likely to cause price
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movement. You’ll become more in sync to market movements and make better
trading decisions.
• Learn to use pivot points along with other technical analysis tools such candlestick
patterns, MACD crossover, moving average crossovers, Stochastics
overbought/oversold levels. The greater the confirmation, the greater your
probability of success!
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Which Timeframe Should I Trade?
Welcome back to school freshman! As part of your initiation to high school you must pay
BabyPips.com $1 million dollars so that we can sit in a mansion in St. Thomas and sip Mai
Tais all day, MWUHAHAHA! (There’s that evil laugh again).
But seriously, you can send it to our Paypal account. We ’ll be waiting for it. Seriously. No
joke. We're not kidding. What? You thought this stuff was free? Wait a minute..this stuff is
free…. Sigh, nevermind. Okay back to work...
Which Timeframe Should You Trade?
One of the main reasons traders don’t do well as they should is because they’re usually
trading the wrong timeframe for their personality. New traders will want to learn how to get rich quick so they’ll start trading small timeframes like the 1-minute or 5-minute
charts. Then they end up getting frustrated when they trade because it’s the wrong timeframe for their personality.
Finally after a long period of timeframe unfaithfulness, we felt we were most comfortable trading the 1-hour charts. This timeframe is longer, but not too long, and trade signals
were fewer, but not too few. We now have more time to analyze the market and didn’t feel rushed anymore.
On the other hand, we have a friend who could never, ever, trade in a 1-hour timeframe. It would be way too slow for him and he’d probably think he was going to rot and die
before he could get in a trade. He prefers trading a 10-minute chart. It still gives him
enough time (but not too much) to make decisions based on his trading plan.
Another buddy of ours can’t figure out how we can trade a 1-hour chart because he thinks
it’s too fast! He trades only daily, weekly, and monthly charts. His name is Warren Buffet.
You might know him.
Okay, so you’re probably asking what the right timeframe is for you. Well, buddy, if you
had been paying attention, it depends on your personality. You have to feel comfortable with the timeframe you’re trading in.
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You’ll always feel some kind of pressure or sense of frustration when you’re in a trade
because real money is involved. But you shouldn’t feel that the reason for the pressure is
because things are happening so fast that you find it difficult to make decisions or so
slowly that you get frustrated.
When we first started trading, we couldn’t stick to a timeframe. We started with the 15-
minute chart. Then the 5-minute chart. Then we tried the 1-hour chart, the daily chart,
and 4-hour chart.
Trading timeframes are usually categorized into three types:
1. Long-term
2. Short-term or swing
3. Intraday or day-trading
Which one is better? It depends on....
Timeframe Breakdowns
Which one is better?
It depends on your personality!
Let me give you a breakdown of the three to help you choose:
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Timeframe Description Advantages Disadvantages
Long-term
Long-term traders will usually refer to daily and weekly charts. The weekly
charts will establishthe longer term perspective and assist in placing
entries in the shorter term daily.
Trades usually from a few weeks to many months, sometimes years.
Don’t have to watch markets intraday Fewer transactions
means less paying of spreads Large swings which require large stops
Usually 1 or 2 good trades a year so patience is required Bigger account
needed to ride longer term swings Frequent losing months Short-term
Short-term traders use hourly time frames and hold trades for several
hours to a week. More opportunities for trades Less chance of losing
months Less reliance on one or two trades a year to make money
Transaction costs will be higher (more spreads to pay) Overnight risk
becomes a factor Intraday Intraday traders use minute charts such
as 1-minute or 5- minute. Trades are held intraday and exited by market close. Lots of trading opportunities Less chance of losing months
No overnight risk Transaction costs will be much higher
(more spreads to pay)
Mentally more difficult due to frequency of trading Profits are limited by
needing to exit at he end of the day.
You have to decide what the correct timeframe is for YOU.
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You also have to consider the amount of capital you have to trade. Shorter timeframes
allows you to make better use of margin and have tighter stop losses. Larger timeframes
require a bigger account so you can handle the market swings without facing a margin call.
When you finally decide on your preferred timeframe is when the fun begins. This is when
you start looking at multiple timeframes to help you analyze the market.
’Long or Short?’
If you ever look at a currecny pair on different timeframes, you probably noticed that
markets can move in different directions at the same time. A moving average may rise on
a weekly chart, giving a buy signal, but fall on a daily chart, giving a sell signal. It may rally
on an hourly chart, telling us to go long, but sink on a 10 minute chart, telling us to short.
What the hell is going on?
Let’s play a quick game called “Long or Short”. The rules of the game are easy. You look at
a chart and you decide whether to go long or short. Easy. Okay ready?
5 Minute Chart
Let’s a take a look at a EUR/USD 5-minute chart on 11/03/05 around 4 am EST. Oooh it’s
so nice. It’s trading above its 100 simple moving average which is bullish and look! It just
broke out and closed above it’s previous resistance! Perfect time to go long right? I’ll take
that as a yes.
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Oh! You are WRONG! Look what happens next! It’s goes up a little bit but then drops like
rock. Oh too bad.
60 Minute Chart
Let’s look at the same exact chart on a higher timeframe. It’s the same date, 11/03/05 and
the same time, around 4 am EST.
Holy cow! The pair broke out of its down channel which is bullish. It’s trading above its
100 simple moving average which is bullish. The last candle broke and closed above its
previous resistance which is bullish. Looks like a bull, smells like a bull. Nothing but up
from here right? You say long.
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OOOHHHHH! Zero for two! How do you like your steak cooked? Because from the looks of
this chart…the bull got slaughtered. The pair even dropped back into its old down channel.
Look at that last candle, it was dropping so much, it couldn’t even stay inside my chart!
Amazing!
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4 Hour Chart
Okay, we’ve now moved up to an even higher timeframe chart. A 4-hour chart. It’s still the
same date and time, just a higher timeframe. If you had looked at this chart first, would
you still have been quick to go long on either the 5-minute or 1-hour chart?
It’s currently trading in a down channel which is bearish. The pair is hitting the upper
trend line of the down channel which is extremely bearish. Yes, it’s still trading above the
100 simple moving average which would count as bullish, but that channel would still
make me cautious. Especially since it’s trading around the upper trend line.
Look what happens! Droppin’ like its hot! The pair stayed true to its channel. It hit the
upper trend line and traveled down.
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Daily Chart
For fun’s sake, let’s go up one more timeframe to the daily chart.
Wow, will you look at that? The pair is trading in an obvious down trend. It’s below its 100
simple moving average and its in a down channel. On this chart, the trend direction is so
obvious! Do you also notice the last candle? It tested the upper trend line and reversed.
Not a very good bullish sign. Let’s look at what happens next.
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Hallelujah! The downtrend continues!
So what's the point?
All of the charts were showing the same date and time. They were just different
timeframes. Do you see now the importance of looking at multiple timeframes?
We used to just trade off 15-minute charts and that was it. We could never understand
why when everything looked good the market would suddenly stall or reverse. It never
crossed our minds to take a look at a larger time frame to see what was happening. When
the market did stall or reverse on my 15-minute chart, it was often because it had hit
support or resistance on a larger time frame.
It took me a couple of hundred bucks to learn that the larger the timeframe, the more
important support and resistance levels were. Trading using multiple time frames has
probably made us more money than any other one thing alone. It will allow you to stay in
a trade longer because you’re able to identify where you are relative to the big picture.
Most beginners look at only one timeframe. They grab a single timeframe, apply their
indicators and ignore other timeframes. The problem is that a new trend, coming from
another timeframe, often hurts traders who don’t look at the big picture.
Take a broad look at what’s happening. Don’t try to get your face closer to the market, but
push yourself further away.
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Select your preferred timeframe and then go up to the next higher timeframe. There you
make a strategic decision to go long or short based on the direction of the trend. You
would then return to your preferred timeframe to make tactical decisions about where to
enter and exit (place stop and profit target). Adding the dimension of time to your analysis
gives you an edge over the other tunnel vision traders who trade off on only one
timeframe.
There is obviously a limit to how many timeframes you can study. You don’t want a screen
full of charts telling you different things. Use at least two, but not more than three
timeframes because adding more will just confuse the geewillikers out of you and you’ll
suffer from paralysis analysis and go crazy.
We like to use three time frames. The largest time frame we consider our main trend, the
next time frame down as my medium trend and the smallest time frame as the short-term
trend.
You can use any time frame you like as long as there is enough time difference between
them to see a difference in their movement. You might use:
• 1 minute, 5 minute, and 30 minute
• 5 minute, 30 minute, and 4 hour
• 15 minute, 1 hour, and 4 hour
• 1 hour, 4 hour, and daily
• 4 hour, daily, and weekly and so on.
When you’re trying to decide how much time in between charts, just make sure there is
enough difference for the smaller time frame to move back and forth without every move
reflecting in the larger time frame. If the timeframes are too close, you won’t be able to
tell the difference which would be pretty useless.
Summary
• You have to decide what the correct timeframe is for YOU.
• Once you've found your preferred timeframe, go up to the next higher timeframe. There
you make a strategic decision to go long or short based on the direction of the trend. You
would then return to your preferred timeframe to make tactical decisions about where to
enter and exit (place stop and profit target).
• Adding the dimension of time to your analysis gives you an edge over the other tunnel
vision traders who only trade off on only one timeframe.
• Make it a habit to look at multiple timeframes when trading.
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• Choose a set of time frames that you are going to watch, and only concentrate on those
time frames. Pick three time frames: 1hr, 4hr, daily; 5 min, 15min, 1hr, and so on. And only
use those time frames. Learn all you can about how the market works during those time
frames.
• Don't look at too many time frames, you’ll be overloaded with too much information and
your brain will explode.
• Stick to two or three timeframes, any more than that is overkill.
• We can't repeat this enough: Get a bird's eye view. Using multiple timeframes resolves
contradictions between indicators and timeframes. Always begin your market analysis by
stepping back from the markets and looking at the big picture.
• Use a long-term chart to find the trend, and then return closer to the market to make
decisions about entries and exits.
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Elliott Wave Theory
Back in the old school days during the 1920-30s, there was this mad genius named Ralph
Nelson Elliott. Elliott discovered that stock markets, thought to behave in a somewhat
chaotic manner, actually, did not.
They traded in repetitive cycles, which he pointed out were the emotions of investors and
traders caused by outside influences (ahem, CNBC) or the predominant psychology of the
masses at the time.
Elliott explained that the upward and downward swings of the mass psychology always
showed up in the same repetitive patterns, which were then divided into patterns he
called "waves". He needed to claim this observation and so he came up with a super
original name: The Elliott Wave Theory.
The 5 – 3 Wave Patterns
Mr. Elliott showed that a trending market moves in what he calls a 5-3 wave pattern. The
first 5-wave pattern is called impulse waves and the last 3-wave pattern is called
corrective waves.
Let’s first take a look at the 5-wave impulse pattern. It’s easier if you see it as a picture:
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That still looks kind of confusing. Let’s splash some color on this bad boy.
Ah magnefico! Me likes colors. It’s so pretty! I’ve color-coded each wave along with its
wave count.
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Here is a short description of what happens during each wave. I am going to use stocks for
my example since stocks is what Mr. Elliott used but it really doesn’t matter what it is. It
can easily be currencies, bonds, gold, oil, or Tickle Me Elmo dolls. The important thing is
the Elliott Wave Theory can also be applied to the foreign exchange market.
Wave 1
The stock makes its initial move upwards. This is usually caused by a relatively small
number of people that all of the sudden (for a variety of reasons real or imagined) feel
that the price of the stock is cheap so it’s a perfect time to buy. This causes the price to
rise.
Wave 2
At this point enough people who were in the original wave consider the stock overvalued
and take profits. This causes the stock to go down. However, the stock will not make it to
its previous lows before the stock is considered a bargain again.
Wave 3
This is usually the longest and strongest wave. The stock has caught the attention of the
mass public. More people find out about the stock and want to buy it. This causes the
stock’s price to go higher and higher. This wave usually exceeds the high created at the
end of wave 1.
Wave 4
People take profits because the stock is considered expensive again. This wave tends to be
weak because there are usually more people that are still bullish on the stock and are
waiting to “buy on the dips”.
Wave 5
This is the point that most people get on the stock, and is most driven by hysteria. You
usually start seeing the CEO of the company on the front page of major magazines as the
Person of the Year. People start coming up with ridiculous reasons to buy the stock and
try to choke you when you disagree with them. This is when the stock becomes the most
overpriced. Contrarians start shorting the stock which starts the ABC pattern.
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ABC Correction
The 5-wave trends are then corrected and reversed by 3-wave countertrends. Letters are
used instead of numbers to track the correction. Check out this example of smokin’ hot 3-
wave corrective wave pattern!
Just because I’ve been using a bull market as my primary example doesn’t mean the Elliott
Wave theory doesn’t work on bear markets. The same 5 – 3 wave pattern can look like
this:
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Waves within a Wave
The other important thing you have to know about the Elliot Wave Theory is that a wave is
made of sub-waves? Huh? Let me show you another picture. Pictures are great aren't
they? Yee-haw!
Do you see how Wave 1 is made up of a smaller 5-wave impulse pattern and Wave 2 is
made up of smaller 3-wave corrective pattern? Each wave is always comprised of smaller
wave patterns.
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Okay, let’s look at a real example.
As you can, waves aren’t shaped perfectly in real life. You’ll also learn its sometimes
difficult to label waves. But the more you stare at charts the better you’ll get.
Okay, that’s all you need to know about the Elliott Wave Theory. Remember the market
moves in waves. Now when you hear somebody say “Wave 2 is complete.” You’ll know
what the heck he is talking about.
If you wish to become an Elliott Wave Theory guru, you can learn more about it at
www.elliottwave.com.
Summary
• According to the Elliott Wave Theory, the market moves in repetitive patterns called
waves.
• A trending market moves in a 5-3 wave pattern. The first 5-wave pattern are called
impulse waves. The second 3-wave pattern are called corrective waves.
• If you look hard enough at a chart, you'll see that the market really does move in waves.
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Can You Handle the Truth?
Let’s get into our favorite part of trading…creating your own trading system!
If you do a simple search in Google for “Forex trading systems” you'll find many many
many people out there who claim to have the “Holy Grail” system that you can purchase
for “only” a few thousand dollars.
These systems supposedly make thousands of pips a week and never lose. They will show
you supposed “results” of their perfect system and it will make your eyeballs turn into
dollar signs as you sit there and say to yourself, “Wow I can make all this money if I just
give this guy $3,000. Besides, if his system making thousands of pips a week, I’ll be able to
make my money back in no time.”
Slowww down cowboy. There are some things you should know before you give them
your credit card number and make that impulse buy.
The truth is that many of these systems DO in fact work. The problem is that traders lack
the discipline to follow the rules that go along with the system.
The second truth (there's such thing as a second truth?) is that instead of paying
thousands of dollars to buy a system, you can spend your time developing your own
system for free, and use that money you were going to spend as capital for your trading
account.
The third truth is that creating systems is not even that difficult. What is difficult is
following the rules that you set when you do develop your system.
There are many articles that sell systems, but we haven’t seen any that teach you how to
create your own system. This lesson will guide you through the steps you need to take to
develop a system that is right for you. At the end of the lesson, we will give you an
example of a system that we trade just so we can show you how awesome we are! (Insert
evil laugh here.)
Goals of your trading system
I know you’re saying, “DUH, my goal of my trading system is to make a billion dollars!”
While that is a wonderful goal, it’s not exactly the kind of goal that will make you a
successful trader.
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When developing your system, you want to achieve 2 very important goals:
1. Your system should be able to identify trends as early as possible.
2. Your system should be able to avoid you from whipsaws.
If you can accomplish those two things with your trading system, we GUARANTEE you will
be successful. The hard part about those goals is that they contradict each other. If you
have a system in which its sole purpose is to catch trends early, then you will probably get
faked out many times.
On the other hand, if you have a system in which its sole purpose is to avoid whipsaws,
then you will be late on many trades and will also probably miss out on a lot of trades.
Your task, when developing your system, is to find a compromise between the two goals.
Find a way to identify trends early, but also find ways that will help you distinguish the
fake signals from the real ones.
Always remember these two goals when you create your system. They will make you a lot
of money!
Six Steps to Setting Up Your System
The main focus of this article is to guide you through the process of developing your
system. While it doesn’t take long to come up with a system, it does take some time to
extensively test it. So be patient; in the long run, a good system can potentially make you
a lot of money.
Step 1: Time Frame
The first thing you need to decide when creating your system is what kind of trader you
are. Are you a day trader or a swing trader? Do you like looking at charts every day, every
week, every month, or even every year? How long do you want to hold on to your
positions?
This will help determine which time frame you will use to trade. Even though you will still
look at multiple time frames (go back to 7th grade if you forgot), this will be the main time
frame you will use when looking for a trade signal.
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Step 2: Find indicators that help identify a new trend.
Since one of our goals is to identify trends as early as possible, we should use indicators
that can accomplish this. Moving averages are one of the most popular indicators that
traders use to help them identify a trend. Specifically, they will use 2 moving averages
(one slow and one fast) and wait until the fast one crosses over or under the slow one.
This is the basis for what’s known as a “moving average crossover” system.
In its simplest form, moving average crossovers are the fastest ways to identify new
trends. It is also the easiest way to spot a new trend.
Of course there are many other ways traders’ spot trends, but moving averages are one of
the easiest to use.
Step 3: Find indicators that help CONFIRM the trend.
Our second goal for our system is to have the ability to avoid whipsaws, meaning that we
don’t want to be caught in a “false” trend. The way we do this is by making sure that
when we see a signal for a new trend, we can confirm it by using other indicators.
There are many good indicators for confirming trends, but I really like MACD, Stochastics,
and RSI. As you become more familiar with various indicators, you will find ones that you
prefer over others, and can incorporate those into your system.
Step 4: Define Your Risk
When developing your system, it is very important that you define how much you are
willing to lose on each trade. Not many people like to talk about losing, but in actuality, a
good trader thinks about what they could potentially lose BEFORE thinking about how
much they can win.
The amount you are willing to lose will be different than everyone else. You have to
decide how much room is enough to give your trade some breathing space, but at the
same time, not risk too much on one trade. You’ll learn more about money management
in a later lesson. Money management plays a big role in how much you should risk in a
single trade.
Step 5: Define Entries & Exits
Once you define how much you are willing to lose on a trade, your next step is to find out
where you will enter and exit a trade in order to get the most profit.
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Some people like to enter as soon as all of their indicators match up and give a good
signal, even if the candle hasn’t closed. Others like to wait until the close of the candle.
In my experience, I have found that it is best to wait until a candle closes before entering.
I have been in many situations where I will be in the middle of a candle and all my
indicators match up, only to find that by the close of the candle, the trade has totally
reversed on me!
It’s all really just a matter of trading style. Some people are more aggressive than others
and you will eventually find out what kind of trader you are.
For exits, you have a few different options. One way is to trail your stop, meaning that if
the price moves in your favor by ‘X’ amount, you move your stop by ‘X’ amount.
Another way to exit is to have a set target, and exit when the price hits that target. How
you calculate your target is up to you. Some people choose support and resistance levels
as their targets. Others just choose to go for the same amount of pips on every trade.
However you decide to calculate your target, just make sure you stick with it. Never exit
early no matter what happens. Stick to your system! After all, YOU developed it!
One more way you can exit is to have a set of criteria that, when met, would signal you to
exit. For example, you could make it a rule that if your indicators happen to reverse to a
certain level, you would then exit out of the trade.
Step 6: Write down your system rules and FOLLOW IT!
This is the most important step of creating your trading system. You MUST write your
trading system rules down and ALWAYS follow it. Discipline is one of the most important
characteristics a trader must have, so you must always remember to stick to your system!
No system will ever work for you if you don’t stick to the rules, so remember to be
disciplined. Oh yea, did I mention you should ALWAYS stick to your rules?
How to Test Your System
The fastest way to test your system is to find a charting software package where you can
go back in time and move the chart forward one candle at a time. When you move your
chart forward one candle at a time, you can follow your trading system rules and take
your trades accordingly. Record your trading record, and BE HONEST with yourself!
Record your wins, losses, average win, and average loss. If you are happy with your
results then you can go on to the next stage of testing: trading live on a demo account.
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Trade your new system live on a demo account for at least two months. This will give you
a feel for how you can trade your system when the market is moving. Trust me, it is a lot
different trading live than when you’re backtesting.
After two months of trading live on a demo account, you will see if your system can truly
stand its ground in the market. If you are still getting good results, then you can choose to
trade your system live on a REAL account. At this point, you should feel very confident
with your system and feel comfortable taking trades with no hesitation. At this point,
YOU’VE MADE IT!
Setup Your System in Six Steps
My “So Easy It’s Ridiculous” System
In this section I will give you an idea of what a trading system should look like. This should
give you an idea of what you should be looking for when you develop your system.
Trading Setup
• Trade on daily chart (swing trading)
• 5 EMA applied to the close
• 10 EMA applied to the close
• Stochastic (10,3,3)
• RSI (14)
Trading Rules
? Stop Loss = 30 pips
? Entry Rules
1. Enter long if:
o The 5 EMA crosses above the 10 EMA and both stochastic lines are heading up (do
not enter if the stochastic lines are already in the overbought territory)
o RSI is greater than 50
2. Enter short if:
o The 5 EMA crosses below the 10 EMA and both stochastic lines are heading down
AND (do not enter if the stochastic lines are already in oversold territory)
o RSI is less than 50
? Exit Rules
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• Exit when the 5 EMA crosses the 10 EMA in the opposite direction of your trade OR if RSI
crosses back to 50
Okay, let's take a look at some charts and see this baby in action...
My ’So Easy It’s Ridiculous’ System
As you can see, we have all the components of a good trading system. First, we’ve decided
that this is a swing trading system, and that we will trade on a daily chart. Next, we use
moving averages to help us identify a new trend as early as possible.
The Stochastics help us determine if it’s still ok for us to enter a trade after a moving
average crossover, and it also helps us avoid oversold and overbought areas. The RSI is an
extra confirmation tool that helps us determine the strength of our trend.
After figuring out our trade setup, we then determined our risk for each trade. For this
system, we are willing to risk 30 pips on each trade. Usually, the higher the timeframe, the
more pips you should be willing to risk because your gains will typically be larger than if
you were to trade on a smaller timeframe.
Next, we clearly defined our entry and exit rules. At this point, we would begin the testing
phase by starting with manual back tests.
Here are a couple of examples:
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If we went back in time and looked at this chart, we would see that according to our
system rules, this would be a good time to go long. To backtest, you would write down at
what price you would’ve entered, your stop loss, and your exit strategy. Then you would
move the chart one candle at a time to see how the trade unfolds.
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conditions in the market. The 2 lines are similar to the MACD lines in the sense that one line is faster than the other.
How to Apply Stochastics Like I said earlier, stochastics tells us when the market is overbought or oversold.
Stochastics are scaled from 0 to 100. When the stochastic lines are above 70 (the red dotted line in the chart above), then it means the market is overbought. When the stochastic lines are below 30 (the blue dotted line), then it means that the market is oversold. As a rule of thumb, we buy when the market is oversold, and we sell when the
market is overbought.
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Looking at the chart above, you can see that the stochastics has been showing overbought
conditions for quite some time. Based upon this information, can you guess where the price might go?
If you said the price would drop, then you are absolutely correct! Because the market was overbought for such a long period of time, a reversal was bound to happen.
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That is the basics of stochastics. Many traders use stochastics in different ways, but the
main purpose of the indicator is to show us where the market is overbought and
oversold. Over time, you will learn to use stochastics to fit your own personal trading
style. Okay, let's move on to RSI.
Relative Strength Index
Relative Strength Index, or RSI, is similar to stochastics in that it identifies overbought and oversold conditions in the market. It is also scaled from 0 to 100. Typically, readings
below 20 indicate oversold, while readings over 80 indicate overbought.
Using RSI
RSI can be used just like stochastics. From the chart above you can see that when RSI
dropped below 20, it correctly identified an oversold market. After the drop, the price quickly shot back up.
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RSI is a very popular tool because it can also be used to confirm trend formations. If you
think a trend is forming, take a quick look at the RSI and look at whether it is above or
below 50. If you are looking at a possible uptrend, then make sure the RSI is above 50. If you are looking at a possible downtrend, then make sure the RSI is below 50.
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In the beginning of the chart above, we can see that a possible uptrend was forming. To avoid fakeouts, we can wait for RSI to cross above 50 to confirm our trend. Sure enough,
as RSI passes above 50, it is a good confirmation that an uptrend has actually formed. Okey dokey, we've covered a smorgasbord of indicators, let's see how we can put all of what you just learned together...
Putting It All Together
In a perfect world, we could take just one of these indicators and trade strictly by what that indicator told us. The problem is that we DON’T live in a perfect world, and each of
these indicators has imperfections. That is why many traders combine different indicators
together so that they can “screen” each other. They might have 3 different indicators and
they won’t trade unless all 3 indicators give them the same answer.
As you continue your journey as a trader, you will discover what indicators work best for you. We can tell you that we like using MACD, Stochastics, and RSI, but you might have a
different preference. Every trader out there has tried to find the “magic combination” of indicators that will always give them the right signals, but the truth is that there is no such
thing. We urge you to study each indicator on its own until you know EXACTLY how it reacts to
price movement, and then come up with your own combination that fits your trading
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style. Later on in the course, we will show you a system that combines different indicators
to give you an idea of how they can compliment each other.
Summary
Everything you learn about trading is like a tool that is being added to your trader’s
toolbox. Your tools will make it easier for you to “build” your trading account.
Bollinger Bands
• Used to measure the market’s volatility
• They act like mini support and resistance levels
• Bollinger Bounce
o A strategy that relies on the notion that price tends to always return to the middle
of the Bollinger Bands
o You buy when the price hits the lower Bollinger band
o You sell when the price hits the upper Bollinger band
o Best used in ranging markets
• Bollinger Squeeze
o A strategy that is used to catch breakouts early
o When the Bollinger bands “squeeze” the price, it means that the market is very
quiet, and a breakout is eminent. Once a breakout occurs, we enter a trade on
whatever side the price made its breakout.
MACD
• Used to catch trends early and can also help us spot trend reversals
• It consists of 2 moving averages (1 fast, 1 slow) and vertical lines called a histogram, which
measures the distance between the 2 moving averages.
• Contrary to what many people think, the moving average lines are NOT moving averages
of the price. They are moving averages of other moving averages.
• MACD’s downfall is its lag because it uses so many moving averages.
• One way to use MACD is to wait for the fast line to “cross over” or “cross under” the slow
line and enter the trade accordingly because it signals a new trend.
Parabolic SAR
• This indicator is made to spot trend reversals; hence the name Parabolic Stop And
Reversal (SAR)
• This is the easiest indicator to interpret because it only gives bullish and bearish signals.
• When the dots are above the candles, it is a sell signal.
• When the dots are below the candles, it is a buy signal.
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• These are best used in trending markets that consist of long rallies and downturns.
Stochastics
• Used to indicate overbought and oversold conditions
• When the moving average lines are above 70, it means that the market is overbought and
we should look to sell.
• When the moving average lines are below 30, it means that the market is oversold and we
should look to buy.
Relative Strength Index (RSI)
• Similar to stochastics in that it indicates overbought and oversold conditions.
• When RSI is above 80, it means that the market is overbought and we should look to sell.
• When RSI is below 20, it means that the market is oversold and we should look to buy.
• RSI can also be used to confirm trend formations. If you think a trend is forming, wait for
RSI to go above or below 50 (depending on if you’re looking at an uptrend or downtrend)
before you enter a trade.
Each indicator has its imperfections. This is why traders combine many different indicators to “screen” each other. As you progress through your trading career, you will
learn which indicators you like the best and can combine them in a way that fits your trading style.
We know this has been a very loooooooooooonnnnng lesson, and we do encourage you to go back and read over anything you haven’t fully understood yet. Sometimes it just takes a couple times of reading before you truly grasp something. Once you understand the concepts of these indicators, go to a chart and start playing with
them. Really study how each indicator reacts to the price movement.
When you fully understand an indicator, then it will become another tool for your trader’s toolbox. For now you should just take a break. Grab some coffee or get something to eat. We know your eyes are hurting! Let this lesson soak in, and then come back when
you’re refreshed!
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Leading vs. Lagging Indicators
We’ve covered a lot of tools that can help you analyze charts and identify trends. In fact,
you may now have too much information to use effectively.
In this lesson, we’re going to look at streamlining your use of these chart indicators. We
want you to fully understand the strengths and weaknesses of each tool, so you’ll be able
to determine which ones work for you and your trading plan…and which ones don’t.
Leading versus Lagging Indicators
Let’s discuss some concepts first. There are two types of indicators: leading and lagging. A leading indicator gives a buy signal before the new trend or reversal occurs. A lagging indicator gives a signal after the trend has started and basically informs you “hey
buddy, pay attention, the trend has started, you’re missing the boat.”
You’re probably thinking, “Ooooh, I’m going to get rich with leading indicators!” since you
would be able to profit from a new trend right at the start. You’re right – you would “catch” the entire trend every single time, IF the leading indicator was correct every single
time. But it’s not. When you use leading indicators, you will experience a lot of fake-outs. Leading indicators
are notorious for giving bogus signals which will “mislead” you. Get it? Leading indicators
that "mislead" you? Ha-ha. Man we're so funny we even crack ourselves up.
The other option is to use lagging indicators, which aren’t as prone to bogus signals. Lagging indicators only give signals after the price change is clearly forming a trend. The
downside is that you’d be a little late in entering a position. Often the biggest gains of a trend occur in the first few bars, so by using a lagging indicator you could potentially miss out on much of the profit. Which sucks.
Oscillators and Trend Following Indicators
For the purpose of this lesson, let’s broadly categorize all of our technical indicators into one of two categories:
1. Oscillators
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1. Trend following or momentum indicators
Oscillators are leading indicators.
Momentum indicators are lagging indicators.
While the two can be supportive of each other, they're more likely to conflict with each
other. We’re not saying that one or the other should be used exclusively, but you must
understand the potential pitfalls of each
Oscillators / Leading Indicators
An oscillator is any object or data that moves back and forth between two points. In other
words, it’s an item that is going to always fall somewhere between point A and point B. Think of when you hit the oscillating switch on your electric fan.
Think of our technical indicators as either being “on” or “off”. More specifically, an oscillator will usually signal “buy” or “sell”, with the only exception being instances when the oscillator is not clearly at either end of the buy/sell range.
Does this sound familiar? It should! Stochastics, Parabolic SAR, and the Relative Strength
Index (RSI) are all oscillators. Each of these indicators is designed to signal a possible reversal, where the previous trend has run its course and the price is ready to change direction. Let’s take a look at a few examples.
On the 1-hour chart of USD/EUR below, we have added a Parabolic SAR indicator, as well as an RSI and Stochastic oscillator. As you have already learned, when the Stochastic and
RSI begin to leave their “oversold” region that is a buy signal.
Here we get buy signals between the hours 3:00 am EST and 7:00 am EST on 08/24/05. All
three of these buy signals occurred within one or two hours of each other, and this would
have been a good trade.
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We also got a sell signal from all three indicators between the hours of 2:00 am EST and
5:00 am EST on 08/25/05. As you can see, the Stochastic indicator remained in the
overbought for a pretty long time - about 20 hours. Usually when an oscillator remains in the overbought or oversold levels for a long period of time, that means there is a strong
trend occurring. In this example, since Stochastic stayed overbought, you see there was a strong uptrend present.
Now let’s take a look at the same leading oscillators messing up, just so you know these signals aren’t perfect. Looking at the chart below, you can quickly see that there were a lot
of false buy signals popping up. You’ll see how one indicator says to buy, while the other one is still saying sell.
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Around 1 am EST on 08/16/05, both RSI and Stochastic gave buy signals, while Parabolic SAR still showed a sell signal. Yes, Parabolic SAR gave a buy signal 3 hours later at 4 am
EST, but then Parabolic SAR turned into a sell signal one bar later. If you actually look at
the bar with the Parabolic SAR below it, notice how it’s a strong looking red bar with very
short shadows. Also, notice how the next bar closed below it. This would not have been a
good long trade.
On the last two oversold (buy) signals given by Stochastic, notice how there is no indicator
at all for RSI, but Parabolic SAR is giving sell signals. What’s going on here? They are each
giving you different signals!
What happened to such a good set of indicators?
The answer lies in the method of calculation for each one. Stochastic is based on the highto- low range of the time period (in this case, it’s hourly), yet doesn’t account for changes
from one hour to the next. The Relative Strength Index (RSI) uses change from one closing price to the next. And Parabolic SAR has its own unique calculations that can further cause
conflict. That’s the nature of oscillators – they assume that a particular chart pattern always results in the same reversal. Of course, that’s hogwash.
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While being aware of why a leading indicator may be in error, there’s no way to avoid
them. If you’re getting mixed signals, you’re better off doing nothing than taking a ‘best
guess’. If a chart doesn’t meet all your criteria, don’t force the trade! Move on to the next
one that does meet your criteria.
Momentum / Lagging Indicators
So how do we spot a trend? The indicators that can do so have already been identified as
MACD and moving averages. These indicators will spot trends once they have been
established, at the expense of delayed entry. The bright side is that there’s less chance of
being wrong.
On this 1-hour chart of EUR/USD, there was a bullish crossover for MACD at 3:00 am EST on 08/03/05 and the 10 period EMA crossed over the 20 period EMA at 5:00 am. These
two signals were all accurate, but if you waited for both indicators to give you a bull signal, you would have missed out on the big move. If you calculate from the start of the uptrend
at 10:00 pm EST on 08/02/05 to the close of the candle at 5:00 am EST on 08/03/05, you
would have watched a gain of 159 pips while sitting on the sidelines.
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Let’s take a look at the same chart so you can see how these crossover signals can
sometimes give false signals. We like to call them “fake-outs”. Look at how there was a
bearish MACD crossover after the uptrend we just discussed.
Ten hours later, the 20 EMA crossed below the 10 EMA giving a “sell” signal. As you can
see, the price didn’t drop but stayed pretty much sideways, then continued its uptrend. By the time both indicators were in agreement, you would’ve entered a short trade at the
bottom and set yourself up for a loss. Bummer, dude!
Summary
The Million Dollar Question
How do you figure out whether to freakin’ use oscillators, or trend following indicators, or
both? After all, we know they don’t always work in tandem.
This is probably the most challenging part about technical analysis. And why I call it the million dollar question.
We will provide the million dollar answer in a future lesson.
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For now, just know that once you're able to identify the type of market you are trading in,
you will then know which indicators will give accurate signals, and which ones are worthless at that time.
This is no piece of cake. But it's a skill you will slowly improve upon as your experience grows.
Summary
• There are two types of indicators: leading and lagging.
• A leading indicator gives a buy signal before the new trend or reversal occurs.
• A lagging indicator gives a signal after the trend has started
• Technical indicators into one of two categories: Oscillators and trend following or
momentum indicators.
• Oscillators are leading indicators.
• Momentum indicators are lagging indicators.
• If you're able to identify the type of market you are trading in, you will then know which
indicators will give accurate signals, and which ones are worthless at that time.
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Pattern Schmatterns
By now you have an arsenal of weapons to use when you battle the market. In this lesson
you will add yet another weapon: CHART PATTERNS!
Think of chart patterns as a land mine detector, because once you learn this, you will be
able to spot “explosions” on the charts before they even happen, making you a lot of money in the process.
In this lesson, we will teach you basic chart patterns and formations. When correctly identified, it usually leads to a huge breakout or “explosion” in this case. Remember, our whole goal is to spot big movements before they happen so that we can ride them out and rake in the cash! Chart formations will greatly help us spot conditions
where the market is ready to break out.
Here's the list of patterns that we're going to cover:
• Symmetrical Triangles
• Ascending Triangles
• Descending Triangles
• Double Top
• Double Bottom
• Head and Shoulders
• Reverse Head and Shoulders
Symmetrical Triangles
Symmetrical triangles are chart formations where the slope of the price’s highs and the
slope of the price’s lows converge together to a point where it looks like a triangle. What
is happening during this formation is that the market is making lower highs and higher lows. This means that neither the buyers nor the sellers are pushing the price far enough to make a clear trend. If this was a battle between the buyers and sellers, then this would be a draw.
This type of activity is called consolidation.
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In the chart above, we can see that neither the buyers nor the sellers could push the price
in their direction. When this happens we get lower highs and higher lows. As these two slopes get closer to each other, it means that a breakout is getting near. We don’t know
what direction the breakout will be, but we do know that the market will break out. Eventually, one side of the market will give in.
So how can we take advantage of this? Simple. We can place entry orders above the slope of the lower highs and below the slope of the higher lows. Since we already know that the
price is going to break out, we can just hitch a ride in whatever direction the market moves.
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In this example, if we placed an entry order above the slope of the lower highs, we
would’ve been taken along for a nice ride up. If you had placed another entry order below
the slope of the higher lows, then you would cancel it as soon as the first order was hit. Ascending Triangles
This type of formation occurs when there is a resistance level and a slope of higher lows. What happens during this time is that there is a certain level that the buyers cannot seem
to exceed. However, they are gradually starting to push the price up as evident by the higher lows.
In the chart above, you can see that the buyers are starting to gain strength because they are making higher lows. They keep putting pressure on that resistance level and as a result, a breakout is bound to happen. Now the question is, “Which direction will it go? -
Will the buyers be able to break that level or will the resistance be too strong?”
Many charting books will tell you that in most cases, the buyers will win this battle and the
price will break out past the resistance. However, it has been my experience that this is
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not always the case. Sometimes the resistance level is too strong, and there is simply not enough buying power to push it through.
Most of the time the price will in fact go up. The point we are trying to make is that we do not care which direction the price goes, but we want to be ready for a movement in EITHER direction. In this case, we would set an entry order above the resistance line and
below the slope of the higher lows.
In this scenario, the buyers won the battle and the price proceeded to skyrocket! Descending Triangles
As you probably guessed, descending triangles are the exact opposite of ascending triangles (we knew you were smart!). In descending triangles, there is a string of lower
highs which forms the upper line. The lower line is a support level in which the price cannot seem to break.
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In the chart above, you can see that the price is gradually making lower highs which tell us that the sellers are starting to gain some ground against the buyers. Now most of the
time, and we did say MOST - the price will eventually break the support line and continue to fall.
However, in some cases the support line is too strong, and the price will bounce off of it
and make a strong move up.
The good news is that we don’t care where the price goes. We just know that it’s about to
go somewhere. In this case we would place entry orders above the upper line (the lower
highs) and below the support line.
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In this case, the price did end up breaking the support line and proceeded to drop rather
quickly. (*note- The market tends to fall faster than it rises which means you usually make money faster when you are short).
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Double Top
A double top is a reversal pattern that is formed after there is an extended move up. The
“tops” are peaks which are formed when the price hits a certain level that can’t be broken. After hitting this level, the price will bounce off it slightly, but then return back to
test the level again. If the price bounces off of that level again, then you have a DOUBLE top!
In the chart above you can see that two peaks or “tops” were formed after a strong move up. Notice how the 2nd top was not able to break the high of the 1st top. This is a strong
sign that a reversal is going to occur because it is telling us that the buying pressure is just about finished.
With double tops, we would place our entry order below the neckline because we are anticipating a reversal of the uptrend.
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Wow! We must be psychic or something because we always seem to be right! Looking at
the chart you can see that the price breaks the neckline and makes a nice move down.
Remember, double tops are a trend reversal formation. You’ll want to look for these after there is a strong uptrend.
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Double Bottom
Double bottoms are also trend reversal formations, but this time we are looking to go long
instead of short. These formations occur after extended downtrends when two valleys or “bottoms” have been formed.
You can see from the chart above that after the previous
downtrend, the price formed two valleys because it wasn’t
able to go below a certain level. Notice how the 2nd
bottom wasn’t able to significantly break the 1st bottom.
This is a sign that the selling pressure is about finished, and
that a reversal is about to occur. In this situation, we would
place an entry order above the neckline.
Would you look at that!
The price breaks the neckline and makes a nice
move up. Remember, just like double tops,
double bottoms are also trend reversal
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formations. You’ll want to look for these after a strong downtrend.
Head and Shoulders
A head and shoulders pattern is also a trend reversal formation. It is formed by a peak
(shoulder), followed by a higher peak (head), and then another lower peak (shoulder). A
“neckline” is drawn by connecting the lowest points of the two troughs. The slope of this
line can either be up or down. In my experience, when the slope is down, it produces a
more reliable signal.
In this example, we can visibly see the head and shoulders pattern. The head is the 2nd
peak and is the highest point in the pattern. The two shoulders also form peaks but do not
exceed the height of the head.
With this formation, we look to make an entry order below the neckline. We can also calculate a target by measuring the high point of the head to the neckline. This distance is approximately how far the price will move after it breaks the neckline.
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You can see that once the price goes below the neckline it makes a move that is about the
size of the distance between the head and the neckline.
Reverse Head and Shoulders
The name speaks for itself. It is basically a head and shoulders formation, except this time it’s in reverse. A valley is formed (shoulder), followed by an even lower valley (head), and
then another higher valley (shoulder). These formations occur after extended downward
movements.
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Here you can see that this is just like a head and shoulders pattern, but it’s flipped upside
down. With this formation, we would place a long entry order above the neckline. Our
target is calculated just like the head and shoulders pattern. Measure the distance
between the head and the neckline, and that is approximately the distance that the price
will move after it breaks the neckline.
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You can see that the price moved up nicely after it broke the neckline. WE know you’re
thinking to yourself, “the price kept moving even after it reached the target.”
And our response is, “DON”T BE GREEDY!”
If your target is hit, then be happy with your profits. However, there are strategies where
you can lock in some of your profits and still keep your trade open in case the price continues to move your way. You will learn about those later on in the course.
Summary
Chart formations are like bazookas because they often create huge explosions on the chart.
Triangles
Symmetrical triangles
• Consist of lower highs and higher lows
• Place entry orders above the lower highs and below the higher lows
Ascending triangles
• Consist of higher lows and a resistance line
• It usually means that the price will break the resistance line and go higher but you should
place entry orders on both sides just in case the resistance line is too strong.
• Place your entry orders above the resistance line and below the higher lows.
Descending triangles
• Consist of lower highs and a support line
• Usually mean that the price will break the support line and go lower but you should place
entry orders on both sides just in case the support line is too strong.
• Place your entry orders above the lower highs and below the support line.
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Trend Reversal formations
Double Top
• Happens after an extended uptrend.
• Formed by 2 peaks that can’t break a certain level. This level becomes a resistance line.
• Place our short entry order below the low point of the valley in between the 2 peaks.
Double Bottom
• Happens after an extended downtrend.
• Formed by 2 valleys that can’t break a certain level. This level becomes a support line.
• Place our long entry order above the high point of the peak in between the 2 valleys.
Head and Shoulders
• Happens after an extended uptrend.
• Formed by a peak, followed by a higher peak, and then another lower peak. A neckline is
formed by connecting the low points of the two troughs or “valleys”.
• Place your short entry order below the neckline.
• We calculate our target by measuring the distance between the high point of the head and
the neckline. This is the approximate distance that the price will move after it breaks the
neckline.
Reverse Head and Shoulders
• Happens after an extended downtrend.
• Formed by a valley, followed by a lower valley, and then another higher valley. A neckline
is formed by connecting the high points of the 2 peaks.
• Place your long entry order above the neckline.
• We calculate our target by measuring the distance between the low point of the head and
the neckline. This is the approximate distance that the price will move after it breaks the
neckline.
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Pivot Points
Professional traders and market makers use pivot points to identify important support and
resistance levels. Simply put, a pivot point and its support/resistance levels are areas at
which the direction of price movement can possibly change.
Pivot points are especially useful to short-term traders who are looking to take advantage
of small price movements.
Pivot points can be used by both range-bound traders and breakout traders. Range-bound
traders use pivot points to identify reversal points. Breakout traders use pivot points to
recognize key levels that need to be broken for a move to be classified as a real deal
breakout.
Here is an example of pivot points plotted on a 1-hour EUR/USD chart:
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How to Calculate Pivot Points
The pivot point and associated support and resistance levels are calculated by using the
last trading session’s open, high, low, and close. Since Forex is a 24-hour market, most
traders use the New York closing time of 4:00pm EST as the previous day’s close. The calculation for a pivot point is shown below:
Pivot point (PP) = (High + Low + Close) / 3
Support and resistance levels are then calculated off the pivot point like so:
First level support and resistance:
First support (S1) = (2*PP) – High
First resistance (R1) = (2*PP) – Low
Second level of support and resistance:
Second support (S2) = PP – (High – Low)
Second resistance (R2) = PP + (High - Low)
Don’t worry you don’t have to perform these calculations yourself. Your charting software
will automatically do it for you and plot it on the chart.
Also keep in mind that some charting software also provides additional pivot point
features such as a third support and resistance level and intermediate levels or mid-point
levels (levels in between the main pivot point and support and resistance level).
These “extra levels” aren’t as significant as the main five but it doesn’t hurt to pay
attention to them. Here’s an example:
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How to Trade with Pivot Points
Breakout Trades
The pivot point should be the first place you look at to enter a trade, since it is the primary
support/resistance level. The biggest price movements usually occur at the price of the
pivot point.
Only when price reaches the pivot point will you be able to determine whether to go long
or short, and set your profit targets and stops. Generally, if prices are above the pivot it’s
considered bullish, and if they are below it’s considered bearish.
Let’s say the price is hovering around the pivot point and closes below it so you decide to
go short. Your stop loss would be above PP and your initial profit target would be at S1.
However, if you see prices continue to fall below S1, instead of cashing out at S1, you can
move your existing stop-loss order just above S1 and watch carefully. Typically, S2 will be
the expected lowest point of the trading day and should be your ultimate profit objective.
The converse applies during an uptrend. If price closed above PP, you would enter a long
position, set a stop loss below PP and use the R1 and R2 levels as your profit objectives.
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Range-bound Trades
The strength of support and resistance at the different pivot levels is determined by the
number of times the price bounces off the pivot level.
The more times a currency pair touches a pivot level then reverses, the stronger the level
is. Pivoting simply means reaching a support or resistance level and then reversing. Hence,
the word “pivot”.
If the pair is nearing an upper resistance level, you could sell the pair and place a tight
protective stop just above the resistance level.
If the pair keeps moving higher and breaks out above the resistance level, this would be
considered an upside “breakout”. You would also get stopped out of your short order but
if you believe that the breakout has good follow-through buying strength, you can reenter
with a long position. You would then place your protective stop just below the former
resistance level that was just penetrated and is now acting as support.
If the pair is nearing a lower support level, you could buy the pair and place a stop below
the support level.
Theoretically Perfect?
In theory, it sounds pretty simple huh? Dream on, pal!
In the real world, pivot points don’t work all the time. Price tends to hesitate around pivot
lines and at times it’s just ridiculously hard to tell what it will do next.
Sometimes the price will stop just before reaching a pivot line and then reverse meaning
your profit target doesn’t get reached. Other times, it looks like a pivot line is a strong
support level so you go long only to see the price fall, stop you out, then reverse back into
your direction.
You must be very selective and create a pivot point trading strategy that you intend to
strictly follow.
Let’s go look at a chart to see just how difficult and easy pivot points might be.
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Ooooh pretty colors! We like...
Look at the orange oval. Notice how the PP was a strong support but if you went long on
PP, it never was able to rise up to R1.
Look at the first purple circle. The pair broke down through PP but failed to reach S1
before reversing back to PP. On the second break down though (second purple circle), the
pair did manage to reach S1 before once again reversing back to PP.
Look at the pink oval. Again, PP acted as strong support but never was able to rise up to
R1.
On the yellow circle, the pair broke out to the downside again, sliced right through S1, and
managed to fall all the way down to S2.
If you ever attempted to go long on this chart, you would have been stopped out every
single time.
Personally, we would have not even thought about buying this pair - Why not? Well we
have a little secret. What we didn’t show you regarding this chart was that this pair was
trending down for quite some time now.
Remember the trend is your friend. We don’t like to backstab our friends, so we try our
best to never trade against the trend.
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In the next lesson, you will learn how to use multiple timeframes to trade with the correct
trend direction so you’re able to minimize possible mistakes such as the one above.
Forex Pivot Point Trading Tips
Here are some easy to memorize tips that will help you to make smart pivot point trading
decisions.
• If price at PP, watch for a move back to R1 or S1.
• If price is at R1, expect a move to R2 or back towards PP.
• If price is at S1, expect a move to S2 or back towards PP.
• If price is at R2, expect a move to R3 or back towards R1.
• If price is at S2, expect a move to S3 or back towards S1.
• If there is no significant news to influence the market, price will usually move from P to S1
or R1.
• If there is significant news to influence the market price may go straight through R1 or S1
and reach R2 or S2 and even R3 or S3.
• R3 and S3 are a good indication for the maximum range for extremely volatile days but can
be exceeded occasionally.
• Pivot lines work well in sideways markets as prices will most likely range between the R1
and S1 lines.
• In a strong trend, price will blow through a pivot line and keep going.
Summary
• Pivot points are a technique used by professional traders and market makers to
determine entry and exit points for the trading day based on the previous day’s
trading activity. It’s best to use this technique after determining the direction of
the trend.
• As the charts above show, pivots can be extremely useful in Forex since many
currency pairs usually fluctuate between these levels.
• Range-bound traders will enter a buy order near identified levels of support and a
sell order when the pair nears resistance.
• Pivot points also allow breakout traders to identify key levels that need to be
broken for a move to qualify as a bona fide breakout.
• The simplicity of pivot points definitely makes them a useful tool to add to your
trading toolbox. It allows you to see possible areas that are likely to cause price
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movement. You’ll become more in sync to market movements and make better
trading decisions.
• Learn to use pivot points along with other technical analysis tools such candlestick
patterns, MACD crossover, moving average crossovers, Stochastics
overbought/oversold levels. The greater the confirmation, the greater your
probability of success!
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Which Timeframe Should I Trade?
Welcome back to school freshman! As part of your initiation to high school you must pay
BabyPips.com $1 million dollars so that we can sit in a mansion in St. Thomas and sip Mai
Tais all day, MWUHAHAHA! (There’s that evil laugh again).
But seriously, you can send it to our Paypal account. We ’ll be waiting for it. Seriously. No
joke. We're not kidding. What? You thought this stuff was free? Wait a minute..this stuff is
free…. Sigh, nevermind. Okay back to work...
Which Timeframe Should You Trade?
One of the main reasons traders don’t do well as they should is because they’re usually
trading the wrong timeframe for their personality. New traders will want to learn how to get rich quick so they’ll start trading small timeframes like the 1-minute or 5-minute
charts. Then they end up getting frustrated when they trade because it’s the wrong timeframe for their personality.
Finally after a long period of timeframe unfaithfulness, we felt we were most comfortable trading the 1-hour charts. This timeframe is longer, but not too long, and trade signals
were fewer, but not too few. We now have more time to analyze the market and didn’t feel rushed anymore.
On the other hand, we have a friend who could never, ever, trade in a 1-hour timeframe. It would be way too slow for him and he’d probably think he was going to rot and die
before he could get in a trade. He prefers trading a 10-minute chart. It still gives him
enough time (but not too much) to make decisions based on his trading plan.
Another buddy of ours can’t figure out how we can trade a 1-hour chart because he thinks
it’s too fast! He trades only daily, weekly, and monthly charts. His name is Warren Buffet.
You might know him.
Okay, so you’re probably asking what the right timeframe is for you. Well, buddy, if you
had been paying attention, it depends on your personality. You have to feel comfortable with the timeframe you’re trading in.
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You’ll always feel some kind of pressure or sense of frustration when you’re in a trade
because real money is involved. But you shouldn’t feel that the reason for the pressure is
because things are happening so fast that you find it difficult to make decisions or so
slowly that you get frustrated.
When we first started trading, we couldn’t stick to a timeframe. We started with the 15-
minute chart. Then the 5-minute chart. Then we tried the 1-hour chart, the daily chart,
and 4-hour chart.
Trading timeframes are usually categorized into three types:
1. Long-term
2. Short-term or swing
3. Intraday or day-trading
Which one is better? It depends on....
Timeframe Breakdowns
Which one is better?
It depends on your personality!
Let me give you a breakdown of the three to help you choose:
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Timeframe Description Advantages Disadvantages
Long-term
Long-term traders will usually refer to daily and weekly charts. The weekly
charts will establishthe longer term perspective and assist in placing
entries in the shorter term daily.
Trades usually from a few weeks to many months, sometimes years.
Don’t have to watch markets intraday Fewer transactions
means less paying of spreads Large swings which require large stops
Usually 1 or 2 good trades a year so patience is required Bigger account
needed to ride longer term swings Frequent losing months Short-term
Short-term traders use hourly time frames and hold trades for several
hours to a week. More opportunities for trades Less chance of losing
months Less reliance on one or two trades a year to make money
Transaction costs will be higher (more spreads to pay) Overnight risk
becomes a factor Intraday Intraday traders use minute charts such
as 1-minute or 5- minute. Trades are held intraday and exited by market close. Lots of trading opportunities Less chance of losing months
No overnight risk Transaction costs will be much higher
(more spreads to pay)
Mentally more difficult due to frequency of trading Profits are limited by
needing to exit at he end of the day.
You have to decide what the correct timeframe is for YOU.
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You also have to consider the amount of capital you have to trade. Shorter timeframes
allows you to make better use of margin and have tighter stop losses. Larger timeframes
require a bigger account so you can handle the market swings without facing a margin call.
When you finally decide on your preferred timeframe is when the fun begins. This is when
you start looking at multiple timeframes to help you analyze the market.
’Long or Short?’
If you ever look at a currecny pair on different timeframes, you probably noticed that
markets can move in different directions at the same time. A moving average may rise on
a weekly chart, giving a buy signal, but fall on a daily chart, giving a sell signal. It may rally
on an hourly chart, telling us to go long, but sink on a 10 minute chart, telling us to short.
What the hell is going on?
Let’s play a quick game called “Long or Short”. The rules of the game are easy. You look at
a chart and you decide whether to go long or short. Easy. Okay ready?
5 Minute Chart
Let’s a take a look at a EUR/USD 5-minute chart on 11/03/05 around 4 am EST. Oooh it’s
so nice. It’s trading above its 100 simple moving average which is bullish and look! It just
broke out and closed above it’s previous resistance! Perfect time to go long right? I’ll take
that as a yes.
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Oh! You are WRONG! Look what happens next! It’s goes up a little bit but then drops like
rock. Oh too bad.
60 Minute Chart
Let’s look at the same exact chart on a higher timeframe. It’s the same date, 11/03/05 and
the same time, around 4 am EST.
Holy cow! The pair broke out of its down channel which is bullish. It’s trading above its
100 simple moving average which is bullish. The last candle broke and closed above its
previous resistance which is bullish. Looks like a bull, smells like a bull. Nothing but up
from here right? You say long.
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OOOHHHHH! Zero for two! How do you like your steak cooked? Because from the looks of
this chart…the bull got slaughtered. The pair even dropped back into its old down channel.
Look at that last candle, it was dropping so much, it couldn’t even stay inside my chart!
Amazing!
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4 Hour Chart
Okay, we’ve now moved up to an even higher timeframe chart. A 4-hour chart. It’s still the
same date and time, just a higher timeframe. If you had looked at this chart first, would
you still have been quick to go long on either the 5-minute or 1-hour chart?
It’s currently trading in a down channel which is bearish. The pair is hitting the upper
trend line of the down channel which is extremely bearish. Yes, it’s still trading above the
100 simple moving average which would count as bullish, but that channel would still
make me cautious. Especially since it’s trading around the upper trend line.
Look what happens! Droppin’ like its hot! The pair stayed true to its channel. It hit the
upper trend line and traveled down.
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Daily Chart
For fun’s sake, let’s go up one more timeframe to the daily chart.
Wow, will you look at that? The pair is trading in an obvious down trend. It’s below its 100
simple moving average and its in a down channel. On this chart, the trend direction is so
obvious! Do you also notice the last candle? It tested the upper trend line and reversed.
Not a very good bullish sign. Let’s look at what happens next.
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Hallelujah! The downtrend continues!
So what's the point?
All of the charts were showing the same date and time. They were just different
timeframes. Do you see now the importance of looking at multiple timeframes?
We used to just trade off 15-minute charts and that was it. We could never understand
why when everything looked good the market would suddenly stall or reverse. It never
crossed our minds to take a look at a larger time frame to see what was happening. When
the market did stall or reverse on my 15-minute chart, it was often because it had hit
support or resistance on a larger time frame.
It took me a couple of hundred bucks to learn that the larger the timeframe, the more
important support and resistance levels were. Trading using multiple time frames has
probably made us more money than any other one thing alone. It will allow you to stay in
a trade longer because you’re able to identify where you are relative to the big picture.
Most beginners look at only one timeframe. They grab a single timeframe, apply their
indicators and ignore other timeframes. The problem is that a new trend, coming from
another timeframe, often hurts traders who don’t look at the big picture.
Take a broad look at what’s happening. Don’t try to get your face closer to the market, but
push yourself further away.
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Select your preferred timeframe and then go up to the next higher timeframe. There you
make a strategic decision to go long or short based on the direction of the trend. You
would then return to your preferred timeframe to make tactical decisions about where to
enter and exit (place stop and profit target). Adding the dimension of time to your analysis
gives you an edge over the other tunnel vision traders who trade off on only one
timeframe.
There is obviously a limit to how many timeframes you can study. You don’t want a screen
full of charts telling you different things. Use at least two, but not more than three
timeframes because adding more will just confuse the geewillikers out of you and you’ll
suffer from paralysis analysis and go crazy.
We like to use three time frames. The largest time frame we consider our main trend, the
next time frame down as my medium trend and the smallest time frame as the short-term
trend.
You can use any time frame you like as long as there is enough time difference between
them to see a difference in their movement. You might use:
• 1 minute, 5 minute, and 30 minute
• 5 minute, 30 minute, and 4 hour
• 15 minute, 1 hour, and 4 hour
• 1 hour, 4 hour, and daily
• 4 hour, daily, and weekly and so on.
When you’re trying to decide how much time in between charts, just make sure there is
enough difference for the smaller time frame to move back and forth without every move
reflecting in the larger time frame. If the timeframes are too close, you won’t be able to
tell the difference which would be pretty useless.
Summary
• You have to decide what the correct timeframe is for YOU.
• Once you've found your preferred timeframe, go up to the next higher timeframe. There
you make a strategic decision to go long or short based on the direction of the trend. You
would then return to your preferred timeframe to make tactical decisions about where to
enter and exit (place stop and profit target).
• Adding the dimension of time to your analysis gives you an edge over the other tunnel
vision traders who only trade off on only one timeframe.
• Make it a habit to look at multiple timeframes when trading.
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• Choose a set of time frames that you are going to watch, and only concentrate on those
time frames. Pick three time frames: 1hr, 4hr, daily; 5 min, 15min, 1hr, and so on. And only
use those time frames. Learn all you can about how the market works during those time
frames.
• Don't look at too many time frames, you’ll be overloaded with too much information and
your brain will explode.
• Stick to two or three timeframes, any more than that is overkill.
• We can't repeat this enough: Get a bird's eye view. Using multiple timeframes resolves
contradictions between indicators and timeframes. Always begin your market analysis by
stepping back from the markets and looking at the big picture.
• Use a long-term chart to find the trend, and then return closer to the market to make
decisions about entries and exits.
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Elliott Wave Theory
Back in the old school days during the 1920-30s, there was this mad genius named Ralph
Nelson Elliott. Elliott discovered that stock markets, thought to behave in a somewhat
chaotic manner, actually, did not.
They traded in repetitive cycles, which he pointed out were the emotions of investors and
traders caused by outside influences (ahem, CNBC) or the predominant psychology of the
masses at the time.
Elliott explained that the upward and downward swings of the mass psychology always
showed up in the same repetitive patterns, which were then divided into patterns he
called "waves". He needed to claim this observation and so he came up with a super
original name: The Elliott Wave Theory.
The 5 – 3 Wave Patterns
Mr. Elliott showed that a trending market moves in what he calls a 5-3 wave pattern. The
first 5-wave pattern is called impulse waves and the last 3-wave pattern is called
corrective waves.
Let’s first take a look at the 5-wave impulse pattern. It’s easier if you see it as a picture:
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That still looks kind of confusing. Let’s splash some color on this bad boy.
Ah magnefico! Me likes colors. It’s so pretty! I’ve color-coded each wave along with its
wave count.
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Here is a short description of what happens during each wave. I am going to use stocks for
my example since stocks is what Mr. Elliott used but it really doesn’t matter what it is. It
can easily be currencies, bonds, gold, oil, or Tickle Me Elmo dolls. The important thing is
the Elliott Wave Theory can also be applied to the foreign exchange market.
Wave 1
The stock makes its initial move upwards. This is usually caused by a relatively small
number of people that all of the sudden (for a variety of reasons real or imagined) feel
that the price of the stock is cheap so it’s a perfect time to buy. This causes the price to
rise.
Wave 2
At this point enough people who were in the original wave consider the stock overvalued
and take profits. This causes the stock to go down. However, the stock will not make it to
its previous lows before the stock is considered a bargain again.
Wave 3
This is usually the longest and strongest wave. The stock has caught the attention of the
mass public. More people find out about the stock and want to buy it. This causes the
stock’s price to go higher and higher. This wave usually exceeds the high created at the
end of wave 1.
Wave 4
People take profits because the stock is considered expensive again. This wave tends to be
weak because there are usually more people that are still bullish on the stock and are
waiting to “buy on the dips”.
Wave 5
This is the point that most people get on the stock, and is most driven by hysteria. You
usually start seeing the CEO of the company on the front page of major magazines as the
Person of the Year. People start coming up with ridiculous reasons to buy the stock and
try to choke you when you disagree with them. This is when the stock becomes the most
overpriced. Contrarians start shorting the stock which starts the ABC pattern.
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ABC Correction
The 5-wave trends are then corrected and reversed by 3-wave countertrends. Letters are
used instead of numbers to track the correction. Check out this example of smokin’ hot 3-
wave corrective wave pattern!
Just because I’ve been using a bull market as my primary example doesn’t mean the Elliott
Wave theory doesn’t work on bear markets. The same 5 – 3 wave pattern can look like
this:
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Waves within a Wave
The other important thing you have to know about the Elliot Wave Theory is that a wave is
made of sub-waves? Huh? Let me show you another picture. Pictures are great aren't
they? Yee-haw!
Do you see how Wave 1 is made up of a smaller 5-wave impulse pattern and Wave 2 is
made up of smaller 3-wave corrective pattern? Each wave is always comprised of smaller
wave patterns.
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Okay, let’s look at a real example.
As you can, waves aren’t shaped perfectly in real life. You’ll also learn its sometimes
difficult to label waves. But the more you stare at charts the better you’ll get.
Okay, that’s all you need to know about the Elliott Wave Theory. Remember the market
moves in waves. Now when you hear somebody say “Wave 2 is complete.” You’ll know
what the heck he is talking about.
If you wish to become an Elliott Wave Theory guru, you can learn more about it at
www.elliottwave.com.
Summary
• According to the Elliott Wave Theory, the market moves in repetitive patterns called
waves.
• A trending market moves in a 5-3 wave pattern. The first 5-wave pattern are called
impulse waves. The second 3-wave pattern are called corrective waves.
• If you look hard enough at a chart, you'll see that the market really does move in waves.
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Can You Handle the Truth?
Let’s get into our favorite part of trading…creating your own trading system!
If you do a simple search in Google for “Forex trading systems” you'll find many many
many people out there who claim to have the “Holy Grail” system that you can purchase
for “only” a few thousand dollars.
These systems supposedly make thousands of pips a week and never lose. They will show
you supposed “results” of their perfect system and it will make your eyeballs turn into
dollar signs as you sit there and say to yourself, “Wow I can make all this money if I just
give this guy $3,000. Besides, if his system making thousands of pips a week, I’ll be able to
make my money back in no time.”
Slowww down cowboy. There are some things you should know before you give them
your credit card number and make that impulse buy.
The truth is that many of these systems DO in fact work. The problem is that traders lack
the discipline to follow the rules that go along with the system.
The second truth (there's such thing as a second truth?) is that instead of paying
thousands of dollars to buy a system, you can spend your time developing your own
system for free, and use that money you were going to spend as capital for your trading
account.
The third truth is that creating systems is not even that difficult. What is difficult is
following the rules that you set when you do develop your system.
There are many articles that sell systems, but we haven’t seen any that teach you how to
create your own system. This lesson will guide you through the steps you need to take to
develop a system that is right for you. At the end of the lesson, we will give you an
example of a system that we trade just so we can show you how awesome we are! (Insert
evil laugh here.)
Goals of your trading system
I know you’re saying, “DUH, my goal of my trading system is to make a billion dollars!”
While that is a wonderful goal, it’s not exactly the kind of goal that will make you a
successful trader.
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When developing your system, you want to achieve 2 very important goals:
1. Your system should be able to identify trends as early as possible.
2. Your system should be able to avoid you from whipsaws.
If you can accomplish those two things with your trading system, we GUARANTEE you will
be successful. The hard part about those goals is that they contradict each other. If you
have a system in which its sole purpose is to catch trends early, then you will probably get
faked out many times.
On the other hand, if you have a system in which its sole purpose is to avoid whipsaws,
then you will be late on many trades and will also probably miss out on a lot of trades.
Your task, when developing your system, is to find a compromise between the two goals.
Find a way to identify trends early, but also find ways that will help you distinguish the
fake signals from the real ones.
Always remember these two goals when you create your system. They will make you a lot
of money!
Six Steps to Setting Up Your System
The main focus of this article is to guide you through the process of developing your
system. While it doesn’t take long to come up with a system, it does take some time to
extensively test it. So be patient; in the long run, a good system can potentially make you
a lot of money.
Step 1: Time Frame
The first thing you need to decide when creating your system is what kind of trader you
are. Are you a day trader or a swing trader? Do you like looking at charts every day, every
week, every month, or even every year? How long do you want to hold on to your
positions?
This will help determine which time frame you will use to trade. Even though you will still
look at multiple time frames (go back to 7th grade if you forgot), this will be the main time
frame you will use when looking for a trade signal.
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Step 2: Find indicators that help identify a new trend.
Since one of our goals is to identify trends as early as possible, we should use indicators
that can accomplish this. Moving averages are one of the most popular indicators that
traders use to help them identify a trend. Specifically, they will use 2 moving averages
(one slow and one fast) and wait until the fast one crosses over or under the slow one.
This is the basis for what’s known as a “moving average crossover” system.
In its simplest form, moving average crossovers are the fastest ways to identify new
trends. It is also the easiest way to spot a new trend.
Of course there are many other ways traders’ spot trends, but moving averages are one of
the easiest to use.
Step 3: Find indicators that help CONFIRM the trend.
Our second goal for our system is to have the ability to avoid whipsaws, meaning that we
don’t want to be caught in a “false” trend. The way we do this is by making sure that
when we see a signal for a new trend, we can confirm it by using other indicators.
There are many good indicators for confirming trends, but I really like MACD, Stochastics,
and RSI. As you become more familiar with various indicators, you will find ones that you
prefer over others, and can incorporate those into your system.
Step 4: Define Your Risk
When developing your system, it is very important that you define how much you are
willing to lose on each trade. Not many people like to talk about losing, but in actuality, a
good trader thinks about what they could potentially lose BEFORE thinking about how
much they can win.
The amount you are willing to lose will be different than everyone else. You have to
decide how much room is enough to give your trade some breathing space, but at the
same time, not risk too much on one trade. You’ll learn more about money management
in a later lesson. Money management plays a big role in how much you should risk in a
single trade.
Step 5: Define Entries & Exits
Once you define how much you are willing to lose on a trade, your next step is to find out
where you will enter and exit a trade in order to get the most profit.
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Some people like to enter as soon as all of their indicators match up and give a good
signal, even if the candle hasn’t closed. Others like to wait until the close of the candle.
In my experience, I have found that it is best to wait until a candle closes before entering.
I have been in many situations where I will be in the middle of a candle and all my
indicators match up, only to find that by the close of the candle, the trade has totally
reversed on me!
It’s all really just a matter of trading style. Some people are more aggressive than others
and you will eventually find out what kind of trader you are.
For exits, you have a few different options. One way is to trail your stop, meaning that if
the price moves in your favor by ‘X’ amount, you move your stop by ‘X’ amount.
Another way to exit is to have a set target, and exit when the price hits that target. How
you calculate your target is up to you. Some people choose support and resistance levels
as their targets. Others just choose to go for the same amount of pips on every trade.
However you decide to calculate your target, just make sure you stick with it. Never exit
early no matter what happens. Stick to your system! After all, YOU developed it!
One more way you can exit is to have a set of criteria that, when met, would signal you to
exit. For example, you could make it a rule that if your indicators happen to reverse to a
certain level, you would then exit out of the trade.
Step 6: Write down your system rules and FOLLOW IT!
This is the most important step of creating your trading system. You MUST write your
trading system rules down and ALWAYS follow it. Discipline is one of the most important
characteristics a trader must have, so you must always remember to stick to your system!
No system will ever work for you if you don’t stick to the rules, so remember to be
disciplined. Oh yea, did I mention you should ALWAYS stick to your rules?
How to Test Your System
The fastest way to test your system is to find a charting software package where you can
go back in time and move the chart forward one candle at a time. When you move your
chart forward one candle at a time, you can follow your trading system rules and take
your trades accordingly. Record your trading record, and BE HONEST with yourself!
Record your wins, losses, average win, and average loss. If you are happy with your
results then you can go on to the next stage of testing: trading live on a demo account.
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Trade your new system live on a demo account for at least two months. This will give you
a feel for how you can trade your system when the market is moving. Trust me, it is a lot
different trading live than when you’re backtesting.
After two months of trading live on a demo account, you will see if your system can truly
stand its ground in the market. If you are still getting good results, then you can choose to
trade your system live on a REAL account. At this point, you should feel very confident
with your system and feel comfortable taking trades with no hesitation. At this point,
YOU’VE MADE IT!
Setup Your System in Six Steps
My “So Easy It’s Ridiculous” System
In this section I will give you an idea of what a trading system should look like. This should
give you an idea of what you should be looking for when you develop your system.
Trading Setup
• Trade on daily chart (swing trading)
• 5 EMA applied to the close
• 10 EMA applied to the close
• Stochastic (10,3,3)
• RSI (14)
Trading Rules
? Stop Loss = 30 pips
? Entry Rules
1. Enter long if:
o The 5 EMA crosses above the 10 EMA and both stochastic lines are heading up (do
not enter if the stochastic lines are already in the overbought territory)
o RSI is greater than 50
2. Enter short if:
o The 5 EMA crosses below the 10 EMA and both stochastic lines are heading down
AND (do not enter if the stochastic lines are already in oversold territory)
o RSI is less than 50
? Exit Rules
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• Exit when the 5 EMA crosses the 10 EMA in the opposite direction of your trade OR if RSI
crosses back to 50
Okay, let's take a look at some charts and see this baby in action...
My ’So Easy It’s Ridiculous’ System
As you can see, we have all the components of a good trading system. First, we’ve decided
that this is a swing trading system, and that we will trade on a daily chart. Next, we use
moving averages to help us identify a new trend as early as possible.
The Stochastics help us determine if it’s still ok for us to enter a trade after a moving
average crossover, and it also helps us avoid oversold and overbought areas. The RSI is an
extra confirmation tool that helps us determine the strength of our trend.
After figuring out our trade setup, we then determined our risk for each trade. For this
system, we are willing to risk 30 pips on each trade. Usually, the higher the timeframe, the
more pips you should be willing to risk because your gains will typically be larger than if
you were to trade on a smaller timeframe.
Next, we clearly defined our entry and exit rules. At this point, we would begin the testing
phase by starting with manual back tests.
Here are a couple of examples:
School of Pipsology - 159
If we went back in time and looked at this chart, we would see that according to our
system rules, this would be a good time to go long. To backtest, you would write down at
what price you would’ve entered, your stop loss, and your exit strategy. Then you would
move the chart one candle at a time to see how the trade unfolds.
School of Pipsology - 160
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