TECHNICAL ANALYSIS

The main strengths of technical analysis are flexibility. There is flexibility with regard to the principal instrument. A trader may easily apply his technical expertise to trade another currency when trading activity in the currency that he trade slows down.

There is also flexibility regarding markets. Trader can apply the same technical principles in every market, either spot or future markets. Finally, there is time frame flexibility. Again the same technical principles can apply to different trading styles and time frames.

However, technical analysis is not perfect. Technical analysis is done based on previous and current information. So, technical analysis has its disadvantages. The Forex market has a degree of randomness and prediction done by technical analysis will not completely accurate. It is impossible to forecast everything correctly just based on previous and current information.

Moreover, technical analysis more often gain less profit because it need time to identify the trends in chart. Thus, trader will late for a trading opportunity and takes less profit. Finally, technical analysis focuses only on charts and do not take other precise factors into consideration. Somehow, a good trading system must make use of both technical and fundamental analysis.

After introduction to the chart types and major chart information, the subject now is moved from chart interpretation to the quantitative trading methods which provide more objective view of price activity. The tools of the quantitative trading methods are the moving averages (discussed in this subchapter) and the technical indicator is a result of mathematical calculations based on indications of price and/or volume. The values obtained are used to forecast possible price changes. Technical indicators can be categorized into three groups; line studies, volume indicators, and oscillators.

Moving averages

Moving averages are one of the oldest and most popular technical analysis tools. The moving average is an average price of a financial instrument over a given time period. As shown in figure 8, the line is smoother if longer time period is used. There are three types of moving averages:

1. Simple moving average (SMA).
2. Linearly weighted moving average (LWMA)
3. Exponential moving average (EMA)

The simple moving average is calculated by summing up the prices of instrument closure over a certain number of single periods:

Where N = the number of calculation periods.

Whereas the different with linearly weighted moving average is this type of moving average assigns more weight to the more recent closing prices while SMA use equal weight to each closing prices. For EMA, it also takes account of the previous price information in addition of assigning different weights to them. Traders can use different time period of moving average such as short-term, medium-term, and long-term periods.

Trading signals

Buying signal on a two moving average combination occurs when the shorter term of moving average intersects the longer term upwards. While selling signal occurs when the longer term of moving average intersects the shorter term downwards. The same concept applies to three or more combinations of moving averages.

This type of signal is known as cross. There are two kinds of crosses. When two consecutive moving averages intersect each other while they move in opposite direction, this is called dead cross and this signal is would be fake. On the other hand, two consecutive moving averages intersect while move in the same direction, this is called golden cross and the signal most probably show a new price trend that the currency market will move.

On Balance Volume (OBV)

Volume indicators are used to determine the investor's interest in the market. When volume increases, it shows a rising interest in market and vice versa. Sudden increase of volume may signal a trend reversal. One of the volume based indicators is the On Balance Volume (OBV) as shown in figure 3.9.

OBV is a momentum indicator that relates volume to price change. When the security closes higher than the previous close, all of the day's volume is considered up-volume. All of the day's volume is considered down-volume if reverse situation. The basic concept is the OBV changes will precede price changes. Once a trend is formed, it remains in force until it is broken.

The calculation equation for OBV indicator is:

If today's close is greater than yesterday's close then use + sign, else if today's close is less than yesterday's close then use – sign. OBV (i) is the indicator value of the current period, OBV (i-1) is the indicator value of the previous period, and VOLUME (i) is the volume of the current bar.

Bollinger Bands

The Bollinger Bands indicator as shown in figure 10 is a widely used technical indicator and has similarity with another indicator named Envelopes. As the name given, this indicator consists of a pair of upper and lower bands generated from a certain standard deviations away from a moving average middle line. Therefore, Bollinger Bands is price chart plotted indicator. Since standard deviations is a measure of volatility, the bands size of the indicator will be widen when volatile while it will be contracted when less volatile period. As a result, the prices are likely to remain between the top and bottom line of the bands.

Overbought condition is likely to be identified when the price reaches the upper bands and a reverse of trend may occur. This condition indicates a chance for selling signal. For the inverse, a buying signal arise when the price reaches the lower bands as oversold condition and trend reversal may occur. However, a continuation of a strong current trend is expected if the prices break through the bands. In addition, Bollinger Bands can clearly recognize the price movement pattern. The small bands width reflects a range-bounce price pattern whereas large bands width shows a trending price pattern. Bollinger Bands is calculated by equation:

Equation 3: Middle Line = SUM CLOSE, NN

Equation 4: Top Line = Middle Line + D × StdDev

Equation 5: Bottom Line = Middle Line – D × StdDev

Where:

Equation 6: StdDev = i=0NCLOSE –SMA (CLOSE, N) 2N ;

D is the number of deviations parameter to add or subtract for the simple moving average (integers or fractions). N is the number of periods.

Moving Average Convergence/Divergence (MACD)

The MACD indicator as shown in figure 11 is the difference between a 12-period and 26-period EMA. Besides, a signal line of 9-period moving average is plotted on MACD chart for the purpose of showing trade opportunities. The buying signal is generated when the intersection is upwards while selling signal is generated when the intersection is downwards. In addition, MACD can be used to detect the overbought and oversold conditions.

An indication that an end to the current trend may be occurs when the MACD diverges from the exchange rate. A bullish divergence occurs when the MACD indicator is making new highs while the exchange rate fails to reach new highs. A bearish divergence occurs when the MACD is making new lows while the exchange rate fails to reach new lows. Both of these divergences are most significant when they occur at overbought or oversold levels.

The moving average of oscillator (OsMA) is just the difference between the oscillator and oscillator smoothing. In this case, MACD is the oscillator and the MACD signal line is the oscillator smoothing. The MACD is calculated by equation:

Equation 7: MACD = EMA(CLOSE, 12) – EMA(CLOSE, 26)

Relative Strength Index (RSI)

The RSI is a popular oscillator that measures the relative strength between upward and downward movement in a specified timeframe. RSI is a price following oscillator and ranges between 0 to 100. As shown in figure 12, the 30 and 70 levels are used as warning signals. Values that above 80 indicate an overbought condition and below 20 indicate an oversold condition. If the market has equal strength of upward and downward movement, then the RSI will be at level 50. Upward strength is stronger when RSI > 50 and downward strength is stronger when RSI < 50.

Another popular method of analyzing the RSI is to look for a divergence, in which the exchange rate is making a new high, but the RSI is failing to surpass its previous high. This divergence is an indication of an impending reversal. Therefore, RSI is a favorite indicator that used to determine overbought and oversold condition as well as a nice trend confirmation tool. The calculation equation for RSI is:

Where RS is the average of inclining prices for N days divided by the average of declining prices for N days.

Acceleration/Deceleration — AC

Accumulation/Distribution (A/D)

Alligator

In principle, Alligator Technical Indicator is a combination of Balance Lines (Moving Averages) that use fractal geometry and nonlinear dynamics.

Average Directional Movement Index

Awesome Oscillator

Bears Power

Every day trading represents a battle of buyers ("Bulls") is pushing prices up and sellers ("Bears") are pushing prices down. Depending on what party scores off, the day will end with a price that is higher or lower than that of the previous day. Intermediate results, first of the entire highest and lowest price, allow to judge about how the battle was developing during the day.

It is very important to be able to estimate the Bears Power balance since changes in this balance initially signalize about possible trend reversal. This task can be solved using the Bears Power oscillator developed by Alexander Elder and described in his book titled Trading for a Living. Elder based on the following premises when deducing this oscillator:

- moving average is a price agreement between sellers and buyers for a certain period of time,

- The lowest price displays the maximum sellers' power within the day.

On these premises, Elder developed Bears Power as the difference between the lowest price and 13-period exponential moving average (LOW - EMA).

This indicator is better to use together with a trend indicator (most frequently Moving Average):
if trend indicator is up-directed and the Bears Power index is below zero, but growing, it is a signal to buy;
It is desirable that, in this case, the divergence of bases were being formed in the indicator chart.

The first stage of this indicator calculation is calculation of the exponential moving average (as a rule, it is recommended to use the 13-period EMA).

Equation 14: BEARS = LOW - EMA

Where:

BEARS — Bears Power;
LOW — the lowest price of the current bar;
EMA — exponential moving average.
In the down-trend, LOW is lower than EMA, so the Bears Power is below zero and histogram is located below zero line. If LOW rises above EMA when prices grow, the Bears Power becomes above zero and its histogram rises above zero line.

Bulls Power

Every day trading represents a battle of buyers ("Bulls") pushes prices up and sellers ("Bears") pushes prices down. Depending on what party scores off, the day will end with a price that is higher or lower than that of the previous day. Intermediate results, first of the entire highest and lowest price, allow to judge about how the battle was developing during the day.

It is very important to be able to estimate the Bulls Power balance since changes in this balance initially signalize about possible trend reversal. This task can be solved using the Bulls Power oscillator developed by Alexander Elder and described in his book titled Trading for a Living. Elder based on the following premises when deducing this oscillator:

- moving average is a price agreement between sellers and buyers for a certain period of time,
- The highest price displays the maximum buyers' power within the day.
On these premises, Elder developed Bulls Power as the difference between the highest price and 13-period exponential moving average (HIGH - EMA).
This indicator is better to use together with a trend indicator (most frequently Moving Average):
- if trend indicator is down-directed and the Bulls Power index is above zero, but falling, it is a signal to sell;
- It is desirable that, in this case, the divergence of peaks were being formed in the indicator chart.

The first stage of this indicator calculation is calculation of the exponential moving average (as a rule, it is recommended to use the 13-period EMA).
Equation 15: BULLS = HIGH - EMA
Where:
BULLS — Bulls Power;
HIGH — the highest price of the current bar;
EMA — exponential moving average.
In the up-trend, HIGH is higher than EMA, so the Bulls Power is above zero and histogram is located above zero line. If HIGH falls under EMA when prices fall, the Bulls Power becomes below zero and its histogram falls under zero line.

Commodity Channel Index

Commodity Channel Index Technical Indicator (CCI) measures the deviation of the commodity price from its average statistical price. High values of the index point out that the price is unusually high being compared with the average one, and low values show that the price is too low. In spite of its name, the Commodity Channel Index can be applied for any financial instrument, and not only for the wares.

There are two basic techniques of using Commodity Channel Index:

1. Finding the divergences
the divergence appears when the price reaches a new maximum, and Commodity Channel Index cannot grow above the previous maximums. This classical divergence is normally followed by the price correction.

2. As an indicator of overbuying/overselling
Commodity Channel Index usually varies in the range of ±100. Values above +100 inform about overbuying state (and about a probability of correcting decay), and the values below 100 inform about the overselling state (and about a probability of correcting increase).

Equation:

1. To find a Typical Price. You need to add the HIGH, the LOW, and the CLOSE prices of each bar and then divide the result by 3.
TP = (HIGH + LOW +CLOSE)/3

2. To calculate the n-period Simple Moving Average of typical prices.
SMA(TP, N) = SUM[TP, N]/N

3. To subtract the received SMA(TP, N) from Typical Prices.
D = TP — SMA(TP, N)

4. To calculate the n-period Simple Moving Average of absolute D values.
SMA(D, N) = SUM[D, N]/N

5. To multiply the received SMA(D, N) by 0,015.
M = SMA(D, N) * 0,015

6. To divide M by D
CCI = M/D

DeMarker

Demarker Technical Indicator is based on the comparison of the period maximum with the previous period maximum. If the current period (bar) maximum is higher, the respective difference between the two will be registered. If the current maximum is lower or equaling the maximum of the previous period, the naught value will be registered. The differences received for N periods are then summarized. The received value is used as the numerator of the DeMarker and will be divided by the same value plus the sum of differences between the price minima of the previous and the current periods (bars). If the current price minimum is greater than that of the previous bar, the naught value will be registered.

When the indicator falls below 30, the bullish price reversal should be expected. When the indicator rises above 70, the bearish price reversal should be expected.

If you use periods of longer duration, when calculating the indicator, you'll be able to catch the long term market tendency. Indicators based on short periods let you enter the market at the point of the least risk and plan the time of transaction so that it falls in with the major trend.

The value of the DeMarker for the "i" interval is calculated as follows:

The DeMax(i) is calculated:
If high(i) > high(i-1) , then DeMax(i) = high(i)-high(i-1), otherwise DeMax(i) = 0

The DeMin(i) is calculated:
If low(i) < low(i-1), then DeMin(i) = low(i-1)-low(i), otherwise DeMin(i) = 0

The value of the DeMarker is calculated as:
DMark(i) = SMA(DeMax, N)/(SMA(DeMax, N)+SMA(DeMin, N))

Envelopes

Envelopes Technical Indicator is formed with two Moving Averages one of which is shifted upward and another one is shifted downward. The selection of optimum relative number of band margins shifting is determined with the market volatility: the higher the latter is, the stronger the shift is.

Envelopes define the upper and the lower margins of the price range. Signal to sell appears when the price reaches the upper margin of the band; signal to buy appears when the price reaches the lower margin.

The logic behind envelopes is that overzealous buyers and sellers push the price to the extremes (i.e., the upper and lower bands), at which point the prices often stabilize by moving to more realistic levels. This is similar to the interpretation of Bollinger Bands.

Where:
SMA — Simple Moving Average;
N — averaging period;
K/1000 — the value of shifting from the average (measured in basis points).

Force Index

Force Index Technical Indicator was developed by Alexander Elder. This index measures the Bulls Power at each increase, and the Bulls Power at each decrease. It connects the basic elements of market information: price trend, its drops, and volumes of transactions. This index can be used as it is, but it is better to approximate it with the help of Moving Average. Approximation with the help a short moving average (the author proposes to use 2 intervals) contributes to finding the best opportunity to open and close positions. If the approximations is made with long moving average (period 13), the index shows the trends and their changes.

- It is better to buy when the forces become minus (fall below zero) in the period of indicator increasing tendency;
- The force index signalizes the continuation of the increasing tendency when it increases to the new peak;
- The signal to sell comes when the index becomes positive during the decreasing tendency;
- The force index signalizes the Bears Power and continuation of the decreasing tendency when the index falls to the new trough;
- If price changes do not correlate to the corresponding changes in volume, the force indicator stays on one level, which tells you the trend is going to change soon.

The force of every market movement is characterized by its direction, scale and volume. If the closing price of the current bar is higher than the preceding bar, the force is positive. If the current closing price if lower than the preceding one, the force is negative. The greater the difference in prices is, the greater the force is. The greater the transaction volume is, the greater the force is.

Market Facilitation Index

Market Facilitation Index Technical Indicator (BW MFI) is the indicator which shows the change of price for one tick. Absolute values of the indicator do not mean anything as they are, only indicator changes have sense. Bill Williams emphasizes the interchanging of MFI and volume:

- Market Facilitation Index increases and volume increases — this points out that: a) the number of players coming into the market increases (volume increases) b) the new coming players open positions in the direction of bar development, i.e., the movement has begun and picks up speed;

- Market Facilitation Index falls and volume falls. It means the market participants are not interested anymore;

- Market Facilitation Index increases, but the volume falls. It is most likely, that the market is not supported with the volume from clients, and the price is changing due to traders' (brokers and dealers) "on the floor" speculations;

- Market Facilitation Index falls, but the volume increases. There is a battle between bulls and bears, characterized by a large sell and buy volume, but the price is not changing significantly since the forces are equal. One of the contending parties (buyers vs. sellers) will eventually win the battle. Usually, the break of such a bar lets you know if this bar determines the continuation of the trend or annuls the trend. Bill Williams calls such bar "curtsying".

To calculate Market Facilitation Index you need to subtract the lowest bar price from the highest bar price and divide it by the volume.

Momentum

The Momentum Technical Indicator measures the amount that a security's price has changed over a given time span.

There are basically two ways to use the Momentum indicator:

- You can use the Momentum indicator as a trend-following oscillator similar to the Moving Average Convergence/Divergence (MACD). Buy when the indicator bottoms and turns up and sell when the indicator peaks and turns down. You may want to plot a short-term moving average of the indicator to determine when it is bottoming or peaking.

If the Momentum indicator reaches extremely high or low values (relative to its historical values), you should assume a continuation of the current trend. For example, if the Momentum indicator reaches extremely high values and then turns down, you should assume prices will probably go still higher. In either case, only trade after prices confirm the signal generated by the indicator (for example, if prices peak and turn down, wait for prices to begin to fall before selling).

- You can also use the Momentum indicator as a leading indicator. This method assumes that market tops are typically identified by a rapid price increase (when everyone expects prices to go higher) and that market bottoms typically end with rapid price declines (when everyone wants to get out). This is often the case, but it is also a broad generalization.

As a market peaks, the Momentum indicator will climb sharply and then fall off — diverging from the continued upward or sideways movement of the price. Similarly, at a market bottom, Momentum will drop sharply and then begin to climb well ahead of prices. Both of these situations result in divergences between the indicator and prices.

Momentum is calculated as a ratio of today's price to the price several (N) periods ago.

Where:
CLOSE(i) — is the closing price of the current bar;
CLOSE(i-N) — is the closing bar price N periods ago.

Money Flow Index

Money Flow Index (MFI) is the technical indicator, which indicates the rate at which money is invested into a security and then withdrawn from it. Construction and interpretation of the indicator is similar to Relative Strength Index with the only difference that volume is important to MFI.

When analyzing the money flow index one needs to take into consideration the following points:

- Divergences between the indicator and price movement. If prices grow while MFI falls (or vice versa), there is a great probability of a price turn;

- Money Flow Index value, which is over 80 or under 20, signals correspondingly of a potential peak or bottom of the market.

The calculation of Money Flow Index includes several stages. At first one defines the typical price (TP) of the period in question.

Then one calculates the amount of the Money Flow (MF):

If today's typical price is larger than yesterday's TP, then the money flow is considered positive. If today's typical price is lower than that of yesterday, the money flow is considered negative.

A positive money flow is a sum of positive money flows for a selected period of time. A negative money flow is the sum of negative money flows for a selected period of time.

Then one calculates the money ratio (MR) by dividing the positive money flow by the negative money flow:

And finally, one calculates the money flow index using the money ratio:

Parabolic SAR

Parabolic SAR Technical Indicator was developed for analyzing the trending markets. The indicator is constructed on the price chart. This indicator is similar to the Moving Average Technical Indicator with the only difference that Parabolic SAR moves with higher acceleration and may change its position in terms of the price. The indicator is below the prices on the bull market (Up Trend), when it's bearish (Down Trend), it is above the prices.

If the price crosses Parabolic SAR lines, the indicator turns, and its further values are situated on the other side of the price. When such an indicator turn does take place, the maximum or the minimum price for the previous period would serve as the starting point. When the indicator makes a turn, it gives a signal of the trend end (correction stage or flat), or of its turn.

The Parabolic SAR is an outstanding indicator for providing exit points. Long positions should be closed when the price sinks below the SAR line, short positions should be closed when the price rises above the SAR line. It is often the case that the indicator serves as a trailing stop line.

If the long position is open (i.e., the price is above the SAR line), the Parabolic SAR line will go up, regardless of what direction the prices take. The length of the SAR line movement depends on the scale of the price movement.

Where:
SAR(i-1) — is the value of the indicator on the previous bar;
ACCELERATION — is the acceleration factor;
EPRICE(i-1) — is the highest (lowest) price for the previous period (EPRICE=HIGH for long positions and EPRICE=LOW for short positions).

The indicator value increases if the price of the current bar is higher than previous bullish and vice versa. The acceleration factor (ACCELERATION) will double at the same time, which would cause Parabolic SAR and the price to come together. In other words, the faster the price grows or sinks, the faster the indicator approaches the price.

Standard Deviation

Standard Deviation — value of the market volatility measurement. This indicator describes the range of price fluctuations relative to simple moving average. So, if the value of this indicator is high, the market is volatile, and prices of bars are rather spread relative to the moving average. If the indicator value is low, the market can described as having a low volatility, and prices of bars are rather close to the moving average. Normally, this indicator is used as a constituent of other indicators. Thus, when calculating Bollinger Bands, one has to add the symbol standard deviation value to its moving average.

Where:
SQRT — square root;
SUM (..., N) — sum within N periods;
SMA (..., N) — simple moving average having the period of N;
N — calculation period.

Stochastic Oscillator

The Stochastic Oscillator Technical Indicator compares where a security's price closed relative to its price range over a given time period. The Stochastic Oscillator is displayed as two lines. The main line is called %K. The second line, called %D, is a Moving Average of %K. The %K line is usually displayed as a solid line and the %D line is usually displayed as a dotted line.

There are several ways to interpret a Stochastic Oscillator. Three popular methods include:

- Buy when the Oscillator (either %K or %D) falls below a specific level (for example, 20) and then rises above that level. Sell when the Oscillator rises above a specific level (for example, 80) and then falls below that level;

- Buy when the %K line rises above the %D line and sell when the %K line falls below the %D line;

- Look for divergences. For instance: where prices are making a series of new highs and the Stochastic Oscillator is failing to surpass its previous highs.

The Stochastic Oscillator has four variables:

%K periods. This is the number of time periods used in the stochastic calculation;

%K Slowing Periods. This value controls the internal smoothing of %K. A value of 1 is considered a fast stochastic; a value of 3 is considered a slow stochastic;

%D periods. his is the number of time periods used when calculating a moving average of %K;

%D method. The method (i.e., Exponential, Simple, Smoothed, or Weighted) that is used to calculate %D.

The formula for %K is:

Where:
CLOSE — is today's closing price;
LOW(%K) — is the lowest low in %K periods;
HIGH(%K) — is the highest high in %K periods.

The %D moving average is calculated according to the formula: %D = SMA(%K, N) Where:
N — is the smoothing period;
SMA — is the Simple Moving Average.