In
the article I wrote about technical analysis, I explained that everything
you see on the price charts, including trendlines, triangles, pennants, flags
and … are all created by support and resistance levels which are in fact selling
and buying limit levels. In this article I want to talk about these formations
in more details and show you some strategies that you can use to take proper
positions. You can use the techniques you learn here both in forex and stock
market.
A
trendline is the direction of the price movement which is formed by different
peaks and valleys (highs and lows).
Some
traders use only trendline to trade. It means when they see a trend, they just
take the proper position and follow the trend. When there is an uptrend, they
take a long position and when there is a downtrend, they take a short position.
A
trend is called uptrend we have higher lows and downtrend when we have lower
highs.
Some
other traders don’t trust the trendlines. They think that it is always possible
that a reversing happens. So they don’t take any position when there is a trend.
They wait for a reversal. Both strategies have some advantages and disadvantages.
Here
below, you see a big uptrend in the EUR-USD daily chart. It is a big uptrend
but as you see there are a lot of smaller trendlines too.
Swing
traders use big moving average lines to find the trends and then take their
positions. A simple moving average which is set to 40 (40 SMA) is a very common
tool among the swing traders. Let’s see how the above chart will look like if
we add a 40 simple moving average to it. I set the moving average in the way
that if it goes up, its color will be changed to green and when it goes down,
its color will be changes to red.
In
this strategy, it is time to buy when the price breaks up the moving average
and then goes down to retest it as a support and fails to break down the moving
average and goes up while the moving average color is green. All these three
events should happen. Otherwise you have to wait.
As
you see in the below chart, there is only 5 trading opportunity in two years
(this is the real meaning of swing trading) but for swing traders it is really
good because they trade big amounts and some of these 5 trading opportunities
are really good and profitable. Another thing is that we only go long in an
uptrend because going short is trading against the market. Professional trader
always avoid trading against the market.
The stop
loss should be placed few pips under the support line. This is the position
of the stop loss in the trade # 3:
Using
this strategy, you could make 2876 pips in two years:
trade
#1: 187 pips
trade #2: 762 pips
trade #3: 500 pips
trade #4: 456 pips
trade #5: 971 pips
As
swing traders trade huge amounts, it could be a lot of money. For example if
a bank trader, traded 1 Billion Euro, he would made about $287,600,000 for the
bank. This is a huge profit but this trading system looks so boring for many
traders because they like to make more trades. If you are among those traders,
you can use a smaller moving average like 20 but you have to keep in your mind
that you will have more false signals and your stop loss will be triggered more.
There
is another option too: You can use the same moving average in the smaller time
frames like one hour chart. Lets try it and see how it works:
As
you see it also works on the smaller time frames. You have to be careful not
to enter to any trade as soon as the moving average changes its color. You are
trading the trends and so the trend should change its direction completely before
you enter. You have to plot the trendlines and know the supports and resistance
levels and take the proper position only when both the trend direction and the
moving average color are changed. If you like to be more conservative, you have
to wait for the price to retest the moving average and if it failed, take your
position.
So
add a 40SMA to your favorite currency pair and time frame and check the back
data and see how would you trade using this system.
This
strategy can be used only when we have a good trendline. It can not be used
when the we have a range or channel. For example at this time that I am writing
this article, (Feb 17, 2008), this strategy can not be used for the EUR-USD
daily chart because the market is ranging and the price is breaking up and down
the 40 moving average continuously.
Another
way for following the trendlines is using a combination of moving averages and
an indicator which is called Moving Average Convergence Divergence or MACD.
This indicator is a highly lagging indicator. Its delay is a problem but it
is necessary for making sure that a trend is finished and another one is started.
You
can easily setup a system with two exponential moving averages (EMA) which are
set to 12 and 26 and also a MACD indicator with the traditional default setting
which is 12, 26, 9. Try to use different colors for each of the moving averages.
You should buy when MACD two lines have already crossed and diverged and they
are moving toward the overbought area and at the same time, the 12 and 26 EMAs
are crossed:
And
you should sell when the MACD is moving toward the oversold area while its two
lines have already crossed and diverged and at the same time the 12 and 26 EMAs
are crossed:
This
system with the same settings can be used for all different time frames even
the daily.
What
is my favorite system regarding the trendlines?
I
don’t use any of the moving averages and indicators. I only use candlesticks, 20
Bollinger Bands, technical analysis and Fibonacci levels to find the beginning
and the end of the trends. I find patterns like head and shoulders, triangles,
wedges, pennants and flags and wait for their breakout and enough confirmation
and then will take the proper position.
What
are the advantages and disadvantages of my technique?
The
most important advantage of my technique is that it is fast. It is not delayed.
It shows you the top and the bottom of the trends. If you learn it properly
and if you learn to use it on time, it will not have any disadvantages and it
will not hit your stop loss even once. You can learn this system through my
reports.
Head
and Shoulders, Double tops and bottoms and sometimes triple tops and bottoms
are the most important patterns. You have to learn to find and see these patterns
on the charts. This is one of the most important part of my strategy.
Head
and Shoulders:
Head
and Shoulders form at the top of uptrends or bottom of downtrends. They are
the most common patterns. They are strong reversal signals but you have to wait
for them to be formed completely and show their reversal power.
In
an uptrend, a Head and Shoulders will act as a reversal only when the price
succeeds to break down the Head and Shoulders neckline. Otherwise the price
will go up and may retest the neckline once again in future but nobody knows
when.
Here
is a typical Head and Shoulders that succeeded to work as a reversal:
Please
note that in Head and Shoulders, shoulders have to form lower than the head.
Sometimes one of the shoulders is higher than the other one. When the shoulders
and the head peaks are at the same level, they are called triple tops. I will
explain about it later.
At
the above chart, the Head and Shoulders is formed at the top of an uptrend and
when the Head and Shoulders succeeded to work as a reversal, the price went
down and the uptrend became finished.
How
do you trade using the Head and Shoulders Pattern?
If
a Head and Shoulders come when you already have a long position, you have to
close your position and fix your profit. But if you don’t have any position,
you have to wait for the Head and Shoulders breakdown. Then you can take a short
position and put your stop loss few pips above the neckline plus the spread:
Here
is some other examples of Head and Shoulders:
A
defective Head and Shoulders that failed to work as a reversal (as you see its
neckline couldn’t be broken down and so the price kept on going up) :
Another
Head and Shoulders that failed:
Another
Head and Shoulders that failed:
Double
and Triple Tops and Bottoms:
These
patterns act like Head and Shoulders. They are reversal signals but you have
to wait for their neckline to be broken down in case they are at the end of
an uptrend. In fact, Double and Triple Tops and Bottoms are different versions
and forms of Head and Shoulders. Sometimes they look so similar to Head and
Shoulders.
A
Double Top that almost worked as a reversal:
A
small Triple Top:
A
Double Bottom that worked as a strong reversal signal:
Triangles:
There
are three kinds of triangles: Ascending, Descending and Symmetrical.
There
are some rules about the triangles but I recommend you not to take any position
according to these rules because they don’t work sometimes. For example they
say in an uptrend, an Ascending Triangle will break up and will work as a continuation
pattern. I suggest you to wait for the break out and then take the proper position.
Here
is a Descending Triangle in an downtrend that worked as a continuation pattern.
As you see there is a double top inside the triangle. It means all of these
patterns are related to each other and there is almost the same psychology behind
their formation:
Here
is a Descending Triangle at the beginning of an uptrend that worked as a continuation
signal. As you see there is a Head and Shoulders pattern inside the triangle
that failed. So the price kept on going up:
A
Symmetrical Triangle that worked as a continuation pattern:
You
just need to wait for the breakout and then you can take the proper position.
This will be much safer than taking a position according to some rules that
sometimes don’t work. So you don’t have to memorize the rules and the name of
the triangles. You just need to find them and wait for their breakout.
A
good example of a descending triangle that worked as a reversal signal:
As
you see, there is a triple top inside the triangle. The first one has made a
“High”; the second one has made another high which is lower than the first one
high (so it has made a lower high); also the last one has made a high which
is lower than the second one high (another lower high).
What
does that mean? It
means the price failed to break the high of the previous top each time and so
the Bears are taking the control and it is highly possible the price goes down.
Then you could go short when the price succeeded to break down the triangle
support. To have a more secure trade, you could wait for the price to break
even the low price of the candlestick that broke down the support. Your stop
loss had to be placed above the high price of the candlestick that broke down
the support plus the spread:
Now
a question:
What
pattern would it form if the high of the first and last top were both lower
than the high of the second top? Yes; Head and Shoulders.
A
good example of an Ascending Triangle that worked as a reversal signal:
As
you see, you could go short when the price broke down the low price of the candlestick
that broke down the triangle. And your stop loss had to be the high price of
the same candlestick plus the spread.
As
you see the rules are not reliable. Descending or ascending triangles in an
uptrend or downtrend can work both reversal or continuation patterns. So you
have to wait for the market to show you the direction.
Wedges,
Pennants and Flags:
These
patterns are so similar to each other and can be considered the same. In most
cases they work as the continuation patterns but they can also work as reversal
patterns. So you have to wait for a clear breakout and then take your position.
Here
below you see a Descending Wedge that worked as a continuation pattern. This
Wedge can be known or called a Pennant or Flag too.
You
could take a long position when the price broke the high price of the candlestick
that broke the wedge resistance. Your stop loss had to be placed a few pips
under the low price of the same candlestick:
A
flag that worked as a continuation pattern:
A
big flag that worked as a continuation:
How
would you trade using the above flag?
Another
Pennant that worked as a continuation pattern. As you see in the last two examples,
I have placed the stop loss above the last high inside the pennant because the
pennants in these two examples are a little narrow and so I wanted to have a
bigger stop loss. So the stop loss will not be triggered because of the small
fluctuations.
A
pennant that worked as a reversal:
Let
me show the above pennant with a higher magnification because there are some false
breakouts that I want you to see and know how you can distinguish them.
1,
2 and 3 are showing false breakouts. As you see in all the three cases just
the lower shadow of the candlesticks could break down the support line but their
close price are all above the support. It means the supports couldn’t be broken
and you still had to wait.
Another
important thing in this example is that the price has tried to break down the
support line for about 7 times whereas it tried to break up the resistance only
for three times. What does that mean? Experience shows that when the market
insists very hard to break down a support or up a resistance, it will succeed
finally. So when you see a support or resistance has been retested for more
than 4 times, you have to be ready for a breakout.
Ok!
Lets keep on talking about the false breakouts. Case number 3 is also a false
break down at the beginning. Let me show it with a bigger magnification:
As
you see only the lower shadows could break down the support line and so it had
to be considered as a false break down but then the candlestick which is surrounded
by the blue ellipse in the above image tells you that the support is almost
broken. The safest way is to go short when the low price of this candlestick
becomes broken by the next candlestick or candlesticks.
It
is easy, isn’t it? You just need to keep your eyes open and see the signals
and understand what the candlesticks tell you. There is no indicator that can
show you the optimum time to enter to any trade in all the above examples. You
only need to determine the optimum time through technical analysis and reading
the candlesticks signals.
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