Trading Indicators

In a recent post I discussed a new indicator that I have built to identify pullbacks. Recently I was asked if I was trading the indicator. Absolutely not!

I use indicators for two purposes - firstly to identify specific criteria that are part of my trading plan, or a trade setup that I am testing. For example, I have an indicator that identifies swing high and swing low fractal bars. Using the indicator allows me to adjust the detailed criteria that define these price patterns so that I can speed up back-testing.

Secondly I use indicators as a measure of momentum, or more correctly, changes in momentum. This is easiest to understand using an analogy with physics. If an object is moving it has 3 characteristics: position, velocity and acceleration. I use price charts to assess position, price charts plus moving averages to assess velocity, and indicators to assess acceleration.

Target Reached

The title says it all!



And just as a reminder, here is the chart from when the target was first identified:

EURJPY Gartley Outcome

Hot on the heals from the Gartley for GBPCHF, here is the outcome for the 2nd Gartley pattern that I identified, this time on EURJPY.



The pattern successfully identified the entry level (green line segment) and the target price (light blue line segment). Just to be very clear, this is not a retrospective analysis. The levels were identified on an earlier post whilst price was still moving upwards.

The final impulse move downwards is attributable to the Non Farm Payroll announcements at 13:30 (UK time) that delivered worse than expected results (although maybe not so surprising).

So now I'm getting quite excited by geometry!

More of a geometric challenge for me was the EURUSD posting from yesterday. The wedge geometry identifies a bullish move to a target price level. My entry price for a trade was below the level a the time, and it looked like I had missed the chance of an elegant entry. But a poor NFP result was expected to push USD higher, which could have created a move totally contrary to the geometric "prediction". So was looking like either the move wasn't going to happen, or I had missed it. I was curious to see how the geometry would deal with a significant news event. I thought it would just break the pattern, but actually the outcome was a bullish impulse move preceded by a spike downwards - giving me both my entry and a push towards my target. WOW!

GBPCHF Gartley Outcome

Yesterday I posted a setup based on a potential Gartley pattern. Here is the outcome.


How cool is that!

Gartley on EURJPY

Oh dear, I seem to be seeing patterns everywhere. Lets see how this one pans out. If it's a Gartley pattern I'd expect price to rise to the trade entry level marked by the green segment, with a target price marked in light blue and the stop in red.

EURUSD Wedge

In earlier posts I had been anticipating the breakout of EURUSD, then waiting for a subsequent pullback to make an entry; however, price didn't pullback to the levels that I was looking for. Recent commentaries that I have read for EURUSD are very bearish. Here is a contrarian view, based on the geometry of a bearish descending wedge formation.



Price has retraced to a confluence of 50.0% and 61.8% fibonacci levels. The last 2 lows appear just below a monthly pivot level, and are divergence against momentum indicators. Projections from the wedge formation anticipate that price could reach 1.4750 in Mid-October. I've indicated a potential entry level, based at the last low. However, its possible that this price won't be revisited and an alternative would be to scalp an entry on a smaller time frame somewhere close the the pivot level at 1.4545. Of course the NFP announcement tomorrow could cause a swing to the low side to trigger the entry. If the result of the NFP is further bearish movement, I still think there would be a possibility for entry at about 1.4450.

Gartley Pattern

Is this a Gartley Pattern? Hmmm, I'm not so good at detecting these! The ratios seem right, but it looks abit "squishy" to me. Anyhow, I've marked my trade setup (paper only!) to see how it performs.

Pullback Indicator

Following on from my previous posting, I have created a custom indicator to identify the pullback setup.

In the price chart below for EURJPY the fibonacci levels for a pullback have been marked, with levels for entry, stop and target prices marked with line segments (green, red and blue respectively).



Below the price chart is the custom indicator.

The black lines indicate price range, with the yellow line representing close price. When a pullback opportunity occurs, the yellow line splits into 3 lines - red representing the 100% pullback level for the stop, the green representing the 61.8% retracement level for the entry, and the blue line representing the target price with a 2.6:1 reward-to-risk ratio. During the period of the split lines, the yellow line represents a 1:1 reward-to-risk ratio that can be used to achieve break-even by scaling out 50% of the position of this price level.

A trade would be triggered if price crosses up through the green line.

My motivation for creating the indicator was to speed up manual testing of pullback strategies and to facilitate automated backtesting.

Keeping it Simple

Currently I'm in back-test mode to test overall performance of different strategies. One strategy is very simple, and just involves identifying pull-back opportunities (i.e. when price fails to make a new high or low) then setting an order at 61.8% retracement level with a stop at 100%, and setting a target with a 2.6 to 1 reward to risk ratio. The key aspect of this strategy is to draw the retracement to the nearest swing low or swing high, even if it appears insignificant, and even if there is ambiguity in the trend.

In the chart below, entry levels are in green with stop in red and targets in blue. Obviously the ordering of the levels indicates if the position is long or short. There are some other trade setups in the same time period, but they didn't trigger so are not shown.

Volatility Analysis

Here is an interesting posting that discusses the combined use of bollinger bands and average true range indicator to evaluate conditions of volatility and the impact that can have on formation of trends ... read it here

EURUSD Breakout

Finally the EURUSD breakout has occurred.



I'll be looking for a pullback to the resistance level, with buying opportunities in a zone between 14,360 and 14,460, subject to further analysis.

Here is the breakout in close-up - notice that price hit a price target level at 14,632 which is a monthly pivot level - even though I am a month behind on updating my pivot levels.

EURUSD

In my last post I showed EURUSD at a critical price level. Since then, price has made a couple of failed breakout attempts, and has been pushed backwards by the surprising announcement from the Bank of England to increase the levels of quantitative easing. However, positive economic reports keep being delivered to the market - there are no signs of momentum weakening, and a bullish breakout is still on the cards.

News Events for the Week

Well of course it's the 1st week of the month, so the biggie is the Non Farm Payroll announcement on Friday at 13:30 BST. No matter what instrument you follow (FTSE, DOW, EURUSD) prices are at a critical level and on the verge of a new trend. The consensus expectation is for the unemployment levels to increase by 345k. This would be the smallest increase for almost a year, and compares to 467k for last month. A figure lower than this may tilt the balance and cause the dollar to breakout lower, whereas a significantly higher figure may bring a return to dollar strength with more risk-averse trading.

Thursday brings interest rate decisions for the Bank of England at mid-day and from the European Central Bank at 12:45. The expectation is for the BOE rate to remain at 0.50% and the ECB rate to remain at 1.0%. These announcements should be non-events if the consensus prevails, though there may be reaction to the small print regarding BOE's bond purchasing scheme (printing money, quantitative easing, whatever-you-want-to-call-it).

Tuesday brings the Reserve Bank of Australia interest rate decision at 5:30 BST. The AUD has been strong recently and is at historically significant levels. Current interest rates are at 3.0% and expected to remain unchanged. As with the BOE, the commentary is likely to be more significant, especially if there are clues to a potential increase in rates within a specified timeframe.

Trading Divergence Part 3

Step 2: Validation of the divergence setup
In the example I gave in Part 1, price is in a downward trend making a low D1 followed by a lower low D3, whereas a technical indicator fails to make a new low at the time of D3. These points are shown in the chart below. D2 marks the high point between the lows D1 and D3.



Validation looks at the price level D3 in relation to D1 and D2. If you draw a fibonacci expansion based on the length D2-D1 then D3 should lie on either the 123.6% or the 138.2% level. The platform I use doesn't provide a tool to do fibonacci expansions, so this is how I do it: draw a line segment from D2 to D1. Move the segment so that it starts at D1. In the chart above the segment is shown as D1-P21. Now draw the fibonacci retracement levels from P21 to D1; D3 should lie on the 23.6% level or 38.2% level. In the example above, D3 is precisely on the 23.6% level.

The next step is to determine a potential target level. This is based on fibonacci expansion levels from D3 to D2. I use the same trick as before and draw the line D2 to P32. The usual target level I take is the 61.8% expansion level. The minimum target I would use is the 23.6% level.

The next step will be to look at the entry criteria ...

Trading Divergence Part 2

Why Validate?
In yesterday's post I said I would next take a look at how to validate the pattern of divergence between price and a technical indicator. Before I do that, it's worth understanding the reason why that is necessary.

Like all patterns associated with technical indicators, they are easy to "trade" in hindsights. Yesterdays post included a chart that demonstrated divergence - the pattern was in the centre of the chart and it was easy to see the price action that occurred as a result of the divergence. But trading occurs on the right hand edge, so here is an example of divergence from yesterday evening:



This divergence is an indication that the bearish run is losing momentum and that there is potential for an upturn on price. However, as you can see from the chart below, a long trade would have almost certainly have failed:



So validation of the divergence pattern is a process of applying a set of rules to assess whether or not the divergence is sufficiently compelling to place a trade. I'll discuss this in a subsequent post.

Trading Divergence Part 1

Wow, it's been a long time since I have posted anything here, so let's try and get back into a routine. I'll do this slowly, step by step. This post is about trading divergence.

Step 1: Defining Divergence
Most technical indicators are derived from price action over a defined period of time. When you look at the structure of the oscillator in terms of highs and lows, it generally follows the same pattern as price. In particular, if price is in an uptrend, making higher highs, then the oscillator will also make higher highs. Occasionally this pattern fails, and price makes a new high whilst the oscillator fails to make a new high, or makes a lower high (the reverse applies to downtrends). This disconnect between the price and the oscillator is divergence. More specifically, it is regular divergence. There is also a form of divergence known as hidden divergence, which I'll describe some other time.

Technical indicators are often criticized for lagging price action and therefore only delivering insights in retrospect. You can argue whether that is a reflection of the indicators themselves, or the authors of books that describe technical setups in the middle of the chart, as opposed to the right-hand edge - the place where traders have to operate. Divergence however, it very definitely a leading indicator i.e. it precedes price action. It can be used as a warning not to enter a trend following trade, or as a cue to enter a counter-trend trade.

The screenshot below shows divergence between price and both Stochastic and MACD indicators. The divergence is marked with solid blue line segments, and occurs between about 21:00 and midnight of the 16th.



Ignore the red line going across the chart, it's not relevant to this discussion. But notice how the divergence correctly anticipated an end to the immediate downtrend, with a significant upward adjustment following it.

One way to use divergence is just to be aware of it, and not get caught entering a trend following trade when this pattern occurs. But can it be traded directly? Yes it can, but you need to qualify the setup. Because it is a leading indicator, sometimes the adjustment to price does not follow immediately, but there are ways to validate the setup and set entry and exit levels that improve the odds of success.

Coming Soon ... Part 2: Validating the Divergence Pattern ...

Outcome for Breakout with Divergence

Last week I posted a setup for a breakout trade. However, I noted that there was divergence between the price action and momentum, which is a warning that the trade could fail. Did price hit the target? Yes, the choice for target price (solid green line)worked well, but price pulled back higher before making the move.



Below is a close-up of the breakout region. Notice that the breakout level (solid blue line) is penetrated, which would have triggered entry into the trade, followed by a exit at the stop loss level (solid red line). The challenge with trading is to perform flawless execution. It's not sufficient to enter place a trade in the right direction and anticipate the correct target price.

Head & Shoulders

Ok I know I said I would give the outcome of the yesterdays trade setups, but I think that will have to wait until tomorrow now. However, here is an interesting chart. It's the daily price of US dollar versus the Yen. A classic head and shoulders reversal pattern has formed. A break of the neckline would suggest that the medium term target will be down the the level marked on the chart.

Breakout Setup With Divergence

Here is a setup for a breakout short on GBPCHF. Price moving down through the blue line would trigger an entry short, with the stop-loss level marked in red, and the target price marked by the solid green horizontal line (at a level coincident with the 200-period moving average and just above the support level at 1.7100.



The setup was identified at about 10pm but as time went by, it became evident that the RSI was failing to converge with price. I look for a horizontal level on RSI as well as price, but it was creeping upwards. The lack of convergence is only slight, and doesn't show up on the 1 hour chart. The price break may be sufficient to correct the lack of convergence. It doesn't show up too well on the image above, but is clearer when the horizontal scale is squashed up abit more. In the chart below I've compressed the time range and you can clearly see that the RSI is rising even though price is on a flat level.



So based on this, I decided not to take the trade, but thought it would be interesting to document the outcome. I'll take a look at it in the morning and post the result.

Live Divergence Trade

Well, I haven't been writing much in this blog recently, so as penance I thought I would log a trade that is a live setup at the moment. EURUSD has formed a divergence pattern. Price has made new highs, but they are not matched by new highs on the RSI indicator.



As I am writing this my entry point (short) has just been triggered. The setup is based on fibonacci retracement levels. My entry was at the 23.6% level (1.3643) with a target exit price at the 123.6% extension level (1.3532).



Tomorrow I'll give an update on how this trade performed.

Must Be Non-Farm Payroll Day ... !

Trade of the Day

Below is a 4H chart for EURUSD.



Usually I wait for price to breakout of the ranges indicated by the green and red levels. In particular, for EURUSD I would wait for a break short through the red level. However, The innediate price action was bullish, and this was supported by divergence on the chart. So I decided to take the bounce from the support level and look for opportunities to go long. Short time frame tick charts gave me the chance for a pullback as shown below:



Entry worked perfectly at the 61.8% retracement level giving me an entry price of 1.3187 with a stop of 22 pips. I scaled-out at 1.3198 giving me a breakeven trade. However, price failed to make a new high. But what was forming was a breakout trade setup. Here it is on a 15 minute chart:



Since I was already at breakeven I was able to trade the breakout without increasing my overall risk exposure. The breakout was spectacular!

Sunil Is Coming To Town

Before trading I had been interested in technical analysis for many years. Sunil helped me make the transition from analyst to trader by showing me how to create specific trade setups based on technical analytics. In particular, he helped me trade negative divergence effectively, and introduced me to the camelback setup and harmonic patterns such as the gartley and butterfly. At the time, Sunil was working at fxinstructor.com.

Sunil is a regular contributor at fxstreet.com as well as running his own trading website: fibforex123.com.

Sunil is running a workshop in London on 26-27 April. Full details are here.

Currency Correlations

The table below shows the level of correlation between various currency pairs.



A correlation is similar to an average calculation, and is determined over a period of time. The table was calculated from daily data from year 2000 to 2008. It therefore only reflects the general average level of correlation. It's important to realise that correlations evolve over time, and in just the same way that an average price can be represented as a moving average, so too, a correlation can be represented as a moving correlation. The chart below illustrates 60-day moving correlations for 3 currency pairs, and shows how drammatic changes in correlation can quickly develop.

Recent Trades

Pivot Bar Trade

It's not often I trade pivot bars, but this trade worked well for me today. The pivot bar is indicated by the green arrow on the chart, with the blue line representing my exit point. Entry was one pip about the high of the pivot bar, with a stop one pip below.

Bullls-eye!

After yesterdays sloppy (lack of) target setting, today it was important for me to have clear target levels for all my trades. Here is a trade setup for a breakout short on USDCAD:



My entry was placed one pip below the solid blue line, and my stop one pip above the red line. The solid green line was my target price, placed 5 pips above the light green horizontal line. This last line represents an earlier level of resistance identified on the 4 hour range chart that I posted on my analysis section over the weekend. You can find it here.

Here is the outcome of the trade:



Price moved to exactly the area I had located, giving me a 103 pip profit from a 19 pip risk.

No Limits

A frustrating trading day today. I was using a slightly different exit strategy to lock in break-even earlier, and changed my daily routine to allow me to trade from the office between 7 to 8.30. The result was I took good entries short on EURJPY and AUDJPY, on top of open trades for GBDUSD and USDCHF. In an hour I had taken about 400 pips. But a combination of having a recent emphasis on swing trades, and concentrating on break-even exits resulted in my leaving the last portion of the trade open, even though my analysis on longer time frames had clear target levels that were being approached. End result, the pips slipped out of my fingers and it looks like I will finish break-even for the day.

Another Day Another Currency Pair

... but the same pattern that I discussed on Thursday:

Repeating and Overlapping Pullbacks

As I've mentioned many times now, my common trade setup is to enter a trend when price retraces to the 61.8% fibonacci level. My first exit is between the 23.6% and 38.2% level, to partially protect my position if the price fails to make a new low (assuming a short trade). My second exit is at the fibonacci extension 123.6%. This is the minimum price move I expect, if the pattern completes successfully. My third target is open, or at about 200% extension, to take advantage of a bigger move.

The chart below shows 3 consecutive completions of a pullback to 61.8% followed by a move to the target level at 123.6%.



It makes me wonder if, rather than using the open position to collect the big profits, it would be more efficient to target the 123.6% level more aggressively but also to stack multiple entries for each successive pullback.

Something for me to look out for and test!

Double Bluff

Here is a classic example of price setting up for a breakout:



A long position can be taken if price breaks just above the blue line, with a stop placed just below the red line.

In an earlier post I described a converging breakout. This looks for convergence with RSI and MACD indicators. So here is the same setup with the indicators added:



I've included the standard representation of the MACD, but I really only focus on the blue curve, and remove the histogram and red signal line to reduce clutter. To trade the breakout I want to see convergence of the indicators. In this instance the indicators are weakening (particularly the MACD), indicating that the breakout may fail, so I don't take this type of breakout.

Here is what happened:



Price moves high enough to trigger the trade and get you excited, then retraces downward taking out the stop loss position.

Then to rub salt into the injury, it moves off in the direction you anticipated and probably reaches your target!



This is a pattern of behaviour I see quite often. That green bar that spiked down to knock out the stop loss position - I think it's possible to trade it. So it's a project I'm working on to define the setup rules and then back-test.

Oh, finally, I did take the trade, using another setup that worked. I'll talk about it later in the week.

4 Hour Range Chart Explained

I've been adding a number of charts and analyses under the analysis of currency pair links on the right hand side of the page. For some currency pairs I have included only a 4 hour range chart, with no commentary; so here is an explanation of how to interprete them.

For illustration purposes here is the chart for EURGBP:



I use the chart to determine whether to trade, and in what direction. The green and red lines show the trading range for the currency pair. That is, a technical region where the price is failing to make new highs or lows. If price penetrates the green resistance level, I look for opportunities to go long. If price moves below the red line I look to go short. The blue horizontal line represents the target price, and is constructed by a simple projection of the height of the trading range (the blue diagonal lines where used to measure and project the heights).

Here is another example:



CHFJPY has broken above the green resistance line and I am looking for opportunities to go long: either a breakout or pullback on a 15M chart.

What Next For Cable?

Cable: Slang used among forex traders referring to the exchange rate between the U.S. dollar and the British pound sterling. The origins of this term are attributed to the fact that in the 1800s, the dollar/pound sterling exchange rate was transmitted via transatlantic cable. source

GBPUSD is attempting to breakout of a downward price channel:



I've posted a detailed top-down analysis of this currency pair that you can find here.

On the right hand side of this blog you will find links for easy access to these top-down analyses of currency pairs.

No Break for Kiwi

Yesterdays trade was left open as a swing trade, to take advantage of a potential breakout of NZDUSD through the 5600 level. If the breakout was successful, the target for the move would have been an additional 300 pips to 5900. However, it was a quiet day and the currency pair found resistance at 5625. I've closed the trade this evening at 5600, making the trade worth 165 pips, against an initial risk of 45 pips.

Review of Todays NZDUSD Trade

In my last post I showed the setup for an entry long on NZDUSD based on limit orders to be triggered at a pullback to the 61.8% fibonacci level (adjusted for spread, my entry price was 5435). Actually there were 2 potential swing lows that I could have used to for the identification of the pullback level, I marked them as A and B on the chart. I used level A, although usually I am more conservative and would use the more significant level B. But I did decide to place my stop below level B for added safety (it was still within my money management limit for the trade). One check I did was to overlay the fib retracements for both levels A and B:



Fib levels for A are in blue, those for B in red. the 61.8% level for A coincided with the 50% level for B which gave me more confidence in the selection. And as you can see the entry worked perfectly with a clean bounce beyond the recent swing high from where the pullback began.

As I mentioned in last post, I created 3 trades so that I could scale-out of the trade. I like my first exit to be close to the 23.6% fib level, and subsequent exits to be aligned to fibonacci extensions from the pullback. My trading platform takes stop and limit levels as a relative number of pips from my entry price, which is frustrating because I know the absolute price levels and so have to compute the relative size. So frustrating in fact (especially when I am trying to quickly set up 3 trades) that I use a rule to simplify the process; I use multiples of my stop to define my exit levels: 0.5, 2, 5. The last one is discretionary, I can also use 4 or keep it open. For this trade I used 0.5, 2, 4. However, this should be based on the stop being below A, whereas I used a stop at B and didn't compensate for this, subsequently my exit prices were higher than intended. The chart below shows my exit levels with horizontal lines in blue and green representing intended and actual levels respectively:



As you can see there is a big discrepancy between my actual exit levels (green) and my intended exit levels (blue). And the net result of this is that the trade is still active, whereas it could have been wrapped up by 1pm. This problem resulted because I use multipliers on my stop level based on the assumption that my stop is closely aligned to the 100% fib level, but in this instance I had used a much more conservative stop. However, this stop is below the low for the day and I have exceeded breakeven, so on this basis I've removed the limit exit on my last part of the trade and am allowing the trade to run on to tomorrow (lets swing!).

Another problem with using multipliers of the stop rather than calculating from absolute price levels is my final level was above an important round number (5600) which also corresponded to a historical level I had identified on longer term charts (I did say I was bleary eyed!).

So tomorrow, we'll see whether the price breaks the 5600 level.