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Using
Technical Indicators
A good understanding of the basic tenets of technical
analysis can vastly improve one's trading skills.
When using technical analysis, price is the primary tool.
Simply put, "everything is already in the rate."
However, technical analysis involves a bit more than simply
staring at price charts hoping to find a "yellow
brick road" to a bonanza payday. Along with various
methods of plotting price action on charts by using bars,
candlesticks, and Xs and Os on point and figure charts,
market technicians also employ many technical studies
that help them to delve deeper into the data. By using
these studies in conjunction with their price charts,
traders are able to build much stronger cases to buy,
sell or remain on the sidelines than they could by simply
looking at price charts alone.
Here are descriptions of some of the more widely used
and time-tested studies that technicians keep in their
toolboxes:
Moving Averages
Stochastics
RSI
Bollinger Bands
MACD
 Moving
Averages
One of the most basic and widely used indicators in a
technical analyst's tool box, moving averages help traders
verify existing trends, identify emerging trends, and
view overextended trends about to reverse. Moving averages
are lines overlaid on a chart indicating long term price
trends with short term fluctuations smoothed out.
There are three basic types of moving averages:
•
Simple
• Weighted
• Exponential
A simple moving average gives equal weight to each price
point over the specified period. The user defines whether
the high, low, or close is used and these price points
are added together and averaged. This average price point
is then added to the existing string and a line is formed.
With the addition of each new price point the sample set
drops off the oldest point. The simple moving average
is probably the most widely used moving average.
A weighted moving average gives more emphasis to the latest
data. A weighted moving average multiplies each data point
by a weighting factor which differs from day to day. These
figures are added and divided by the sum of the weighting
factors. A weighted moving average allows the user to
successfully smooth out a curve while having the average
more responsive to current price changes.
An exponential moving average is another way of "weighting"
the more recent data. An exponential moving average multiplies
a percentage of the most recent price by the previous
period's average price. Defining the optimum moving average
for a particular currency pair involves "curve fitting".
Curve fitting is the process of selecting the right number
of periods with the correct type of moving average to
produce the results the user is trying to achieve. By
trial and error, technicians work with the time periods
to fit the price data.
Because the moving average is constantly changing based
on the latest market data, many traders will use different
"specified" time frames before they come up
with a series of moving averages that are optimal for
a particular currency.
For example, a trader might create a 5-day, a 15-day and
a 30-day moving average for a currency and then plot them
on his or her price chart. He might start out using simple
moving averages and end up using weighted moving averages.
In creating these moving averages, traders need to decide
on the exact price data that will be used in this study;
meaning closing prices vs. opening prices vs. high/low/close
etc. After doing so, a series of lines are created that
reflect the 5-day, 15-day and 30-day moving average of
a currency.
Once the data is layered over a price chart, traders can
determine how well these chosen periods keep track of
the trend being followed. If, for example, a market is
trending higher, you'd expect the 30-day moving average
to be a very accurate trend line, providing a line of
support for prices on their way higher. If prices seem
too close under this 30-day moving average on several
occasions without resulting in a halt in the up trend,
a trader will simply adjust the time period to say a 45-day
or 60-day moving average in order to optimize the average.
In this way, the moving average will act as a trend line.
After determining the optimum moving average for a currency,
this average price line can be used as a line of support
in maintaining a long position or resistance in maintaining
a short position. Breaches of this line can also be used
as a signal that a currency is in the process of reversing
course, in which case a trader will want to pare back
an existing position or come up with entry levels for
a new position. For example, if you determine that a 30-day
moving average has shown itself to be a good support line
for USD-JPY in an upward trending market, then market
closes under this 30-day moving average line could be
a signal that this trend could be running out of steam.
However, it is important to wait for confirmation of these
signals. One way to do this is to wait for another close
below the level. On the second close under the average,
you should begin to pare down your position. Another confirmation
involves using other, shorter term moving averages.
While a longer term moving average can help to define
and support a particular trend, shorter term moving averages
can provide lead signals that a trend is ending before
prices dip below your longer term moving average line.
For this reason, most traders will plot several moving
averages on the same chart. In a market that is trending
higher, a shorter term moving average might signal a market
reversal by turning down and crossing over the longer
term moving average. For example, if you are using a 15-day
and a 45-day moving average in a market that is in an
up trend, and the 15-day moving average turns down and
crosses over the 45-day moving average, this could be
an early signal that the up trend is ending and it is
probably time to begin to pare down your position.
Continued |
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