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 Stochastics
Stochastic studies, or oscillators, are another useful
tool for monitoring the expected sustainability of a trend.
They provide a trader with information about the closing
price in the current trading period relative to the prior
performance of the instrument being analyzed.
Stochastics are measured and represented by two different
lines, %K and %D and are plotted on a scale ranging from
0 to 100. Indications above 80 represent strong upward
movement while level indications below 20 represent strong
downward movements. The mathematics behind the studies
are not as important as knowing what the stochastics are
telling you. The %K line is the faster, more sensitive
indicator while the %D line takes more time to turn. When
the %K line crosses over the %D line, this could be an
indication that a market is about to reverse course. Stochastic
studies are not useful in choppy, sideways markets. At
times when prices are fluctuating in a narrow range, the
%K and %D lines might be crossing many different times
and will be telling you nothing more than the market is
moving sideways.
Stochastics are most useful in measuring the strength
of a trend and as augurs of a coming reversal in prices.
When prices are making new highs or lows and your stochastics
are doing the same, you can be reasonably certain that
the trend will continue. On the other hand, many traders
finds that the best trading opportunity comes when their
stochastic indicator is flattening out or moving in the
opposite direction of prices. When these divergences occur,
it's time to book profits and/or to establish a position
in the opposite direction of the prior trend.
As should always be the case when using any technical
tool, do not act on the first signal you see. Wait at
least one or two trading sessions for confirmation of
what the study is indicating before you commit to a position.
Relative Strength Index (RSI)
RSI measures the momentum of price movements. It is also
plotted on a scale ranging from 0 to 100. Traders will
tend to look at RSI readings over 80 as an indicator of
a market that is overbought or susceptible to a downturn,
and readings under 20 as a market that is oversold or
ready to turn higher.
This logic therefore implies that prices cannot rise or
fall forever and that by using an RSI study, one can determine
with a reasonable degree of certainty when a reversal
will come about. However, be very wary of trading on RSI
studies alone. In many instances, an RSI can remain at
very lofty or sunken levels for quite a while without
prices reversing course. At these times, the RSI is simply
telling you that a market is quite strong or quite weak
and shows no signs of changing course.
RSI studies can be adjusted to whatever time sensitivity
a trader feels necessary for his or her particular style.
For instance, a 5-day RSI will be very sensitive and will
tend to give many more signals, not all of them sustainable,
than say a 21-day RSI, which will tend to be less choppy.
As with other studies, try a variety of time periods for
the currency that you are trading based on your trading
style. Longer term, position type traders, will tend to
find that shorter time frames used for an RSI (or any
other study for that matter) will give too many signals
and will result in over-trading. On the other hand, shorter
time frames will probably be ideal for day-traders trying
to capture many shorter-term price fluctuations.
As with stochastics, look for divergences between prices
and the RSI. If your RSI turns up in a slumping market
or turns down during a bull run, this could be a good
indication that a reversal is just around the corner.
Wait for confirmation before you act on divergent indications
from your RSI studies.
Bollinger Bands
Bollinger Bands are volatility curves used to identify
extreme highs or lows in relation to price. Bollinger
Bands establish trading parameters, or bands, based on
the moving average of a particular instrument and a set
number of standard deviations around this moving average.
For example, a trader might decide to use a 10-day moving
average and 2 standard deviations to establish Bollinger
Bands for a given currency. After doing so, a chart will
appear with price bars capped by an upper boundary line
based on price levels 2 standard deviations higher than
the 10-day moving average and supported by a lower boundary
line based on 2 standard deviations lower than the 10-day
moving average. In the middle of these two boundary lines
will be another line running somewhat close to the middle
area depicting in this case, the 10-day moving average.
Both the moving average and the number of standard deviations
can be altered to best suit a particular currency.
Jon Bollinger, creator of Bollinger Bands recommends using
a simple 20-day moving average and 2 standard deviations.
Because standard deviation is a measure of volatility,
Bollinger Bands are dynamic indicators that adjust themselves
(widen and contract) based on the current levels of volatility
in the market being studied. When prices hit the upper
or lower boundaries of a given set of Bollinger Bands,
this is not necessarily an indication of an imminent reversal
in a trend. It simply means that prices have moved to
the upper limits of the established parameters. Therefore,
traders should use another study in conjunction with Bollinger
Bands to help them determine the strength of a trend.
MACD - Moving Average Convergence Divergence
MACD is a more detailed method of using moving averages
to find trading signals from price charts. Developed by
Gerald Appel, the MACD plots the difference between a
26-day exponential moving average and a 12-day exponential
moving average. A 9-day moving average is generally used
as a trigger line, meaning when the MACD crosses below
this trigger it is a bearish signal and when it crosses
above it, it's a bullish signal.
As with other studies, traders will look to MACD studies
to provide early signals or divergences between market
prices and a technical indicator. If the MACD turns positive
and makes higher lows while prices are still tanking,
this could be a strong buy signal. Conversely, if the
MACD makes lower highs while prices are making new highs,
this could be a strong bearish divergence and a sell signal.
Fibonacci Retracements
Fibonacci retracement levels are a sequence of numbers
discovered by the noted mathematician Leonardo da Pisa
during the twelfth century. These numbers describe cycles
found throughout nature and when applied to technical
analysis can be used to find pullbacks in the currency
market.
Fibonacci retracement involves anticipating changes in
trends as prices near the lines created by the Fibonacci
studies. After a significant price move (either up or
down), prices will often retrace a significant portion
(if not all) of the original move. As prices retrace,
support and resistance levels often occur at or near the
Fibonacci Retracement levels.
In the currency markets, the commonly used sequence of
ratios is 23.6 %, 38.2%, 50% and 61.8%. Fibonacci retracement
levels can easily be displayed by connecting a trend line
from a perceived high point to a perceived low point.
By taking the difference between the high and low, the
user can apply the % ratios to achieve the desired pullbacks.
One final word of advice: Don't get too caught up in the
mathematics involved in putting together each study. It
is much more important to understand how and why studies
can and should be manipulated based on the time periods
and sensitivities that you determine are ideal for the
currency you are trading. These ideal levels can only
be determined after applying several different parameters
to each study until the charts and studies begin to reveal
the "details behind the details."
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