Yesterday your editor sent assistant publisher Joanne Ha, and Swarm Trading technical analyst Gabriel Andre out to the local coffee shop.
We armed them with a pencil, paper, a tape-recorder and the task of coming back with some of the basics of foreign exchange trading.
They came back almost an hour later with much more material than we expected. Therefore today’s Money Morning will be completely handed over to them.
For the record, Gabriel enjoyed a skinny milk hot chocolate (sans marshmallow), and Jo’s poison was a skinny latte with one sugar.
But before I hand over the reins, I did promise a visit to the Money Morning Mailbag. But there isn’t enough room today. So we’ll print a selection of them tomorrow. Also, we’ll go through the NAB and ANZ half-year results.
Until then…
Three Technical Indicators Used by the Pros
by Gabriel Andre & Joanne Ha
Joanne Ha (JH): Gabriel, Money Morning readers have asked for more information on foreign exchange markets. They want to know how to trade them and what you should look out for. What information can you give to readers?
Gabriel Andre (GA): OK. If you are new to the FX markets (also called Forex), then you need to know the basics. The fact is that you cannot succeed in the FX market without understanding a few key things.
JH: That’s good. Many of our readers would probably know as much as me about how to trade the FX market – virtually nothing. The one thing I do know – because you’ve told me this before – is that technical analysis is very important when trying to figure out what moves a currency.
GA: Yes, that is right. Actually, nearly all FX systems and discretionary traders rely heavily on this analysis to forecast trends and therefore to make trades.
JH: So, do you think you could explain to readers, say, the best two or three indicators that you use when watching the FX market?
GA: Of course. There are several popular methods of analysing FX movements. Because of the huge amounts of macro capital flows that create the liquidity, the FX markets have the following characteristics that fit well with chartist analysis:
- FX markets have trends and are cyclical
- Global traders and investors do not act independently of each other
- Large FX moves are episodic and are typically followed by range trading
JH: Whoa! I think we’ve hit a speed bump there. I’m pretty quick with hand-to-hand combat, but you’d better take one step back and explain exactly why people trade FX to begin with.
GA: OK. Let me give you a quick summary of the FX market…
Different countries have different currencies. Companies and people export their goods and import other company’s and peoples goods. To do this they need to pay for it in a currency. If, as an Australian you buy something from the United States then you have to convert your money from Australian dollars into US dollars to pay for it – because that is the currency the seller will accept.
To do this it means you have to SELL the Australian dollar – AUD, and BUY the US dollar – USD. With any FX trade you are actually always trading one currency against another. Therefore, someone in the US buying Australian goods would need to SELL the US dollar and BUY the Australian dollar.
Does that help?
JH: Yep, I’ve got that. So, in theory the more people SELL a currency the lower it should go in comparison to the currency you BUY. One falls, the other rises?
GA: That’s right. It is this buying and selling of one currency against another that causes the price to move. Traders will look at the indicators and then analyse whether that makes one currency cheap or expensive compared to the current price.
JH: I’m getting it now. I don’t think I’m ready to become an FX trader just yet but I get what you’re saying. So, before I rudely interrupted you before you were about to explain the indicators you and many other traders use for the FX market.
GA: I’ll go through three of the most popular technical indicators that FX traders use to determine entry and exit points, to identify supports and resistances and to detect trends and reversals. Here’s an overview of the most famous ones. And I even have some charts so you can see how they work.
First, Fibonacci Ratios. It is based on the numerical series or sequences established by the mathematician Leonardo Fibonacci. It measures the difference between two extreme points. They are horizontal lines that correspond to intermediary Fibonacci ratios. This is called the Fibonacci retracement.
This is where the market often assumes that after a significant rise or fall, prices return to their previous levels. Therefore it retraces a large portion of the original move before it continues in the original direction. Prices will then find support and resistance levels on those key Fibonacci ratios which are 23.6%, 38.2%, 50%, 61.8% and 100%.
Fibonacci retracements often apply when a straight move has been posted, whether on the downside (sharp decline) or on the upside (sharp rise). The more identifiable a trend the better. Take a look at this chart…
Here you can see the AUD/USD price action retraced a large decline between September 22 and October 27 last year (points A and B on the chart). The Fibonacci ratios have been acting here as resistance levels to the rebound generated at the end of the decline. That’s why the price action posted a first high price on the 38.2% ratio level (point C). Then several weeks later it posted a peak on the 50% ratio level (point D).
JH: OK. And that’s an indicator anyone can use?
GA: Yes, it is available on almost every charting package, and even on many trading platforms as well. The same goes for the next indicator…
The Stochastic Oscillator. This compares where a currency pair rate (or price) closed relative to its price range over a given number of days. The Stochastic Oscillator has two lines. The main line is called %K. The second line, called %D, is a moving average of %K.
The interpretation of this indicator is almost the same as other oscillators (Relative Strength Index and Commodity Channel Index). A “SELL” signal is triggered when either one of the two lines moves above 80% and then falls back below that level. A “BUY” signal is triggered when either one of the two lines moves below 20% and then rises back above this level.
There is also another interpretation, which is to buy when the %K line rises above the %D line, and to sell when the %K line falls below the %D line.
The chart above is an example of Stochastic applied to the AUD/NZD currency pair. The red line is the %K, calculated over a period of 5 days, and the dash line represents the %D calculated with a period of 3 days. Due to those parameters, this tool is useful for short-term countertrends and quick reversal moves. It is therefore very complementary with longer-term indicators like Fibonacci and the other indicator I’ll explain shortly.
JH: That one seems a little more complicated, but I’m getting the hang of it. So what’s the last indicator you’ve got for me?
GA: Yes, the final one is the Tom DeMark Sequential Indicator (TDSI). There is only one problem with this indicator. You won’t find it on any charting package apart from the Bloomberg Professional service. That’s a top of the line system used by professional traders and fund managers.
But it’s important to know what some of the pros use that all other traders can’t. Whereas conventional indicators are typically trend followers, the TDSI is designed specifically to anticipate trend reversals. There are several DeMark indicators but the TDSI is the most commonly used and is strongly reliable when it comes to identify and anticipate turning points on currency pairs’ rates.
The TDSI identifies when a trend is completing and has exhausted. It consists of two patterns, a TD Setup and a TD Countdown. Here we just consider the TD Setups, which are the shortest in duration. They last for exactly nine price bars (it can be daily, weekly, monthly, or even intraday) when completed. Indeed, when there have been nine consecutive price bars in which each bar’s close is higher than the close four price bars earlier, a “SELL” setup appears. If before price bar 9 is reached a price bar fails to close higher than that of four bars previously then the Setup is abandoned and the sequence is not valid anymore.
On the other side, a “BUY” setup appears when there are nine consecutive price bars where each bar’s close is lower than the close four bars before.
The example here is a daily chart of the EUR/USD from February to May 2004. At mid-March, there is a sequence of 9 consecutive bars that create a “BUY” signal. A “SELL” signal is triggered after another completed bullish sequence in early April.
JH: I like that one. Now can you give Money Morning readers a quick rundown on the best currencies to actually trade?
GA: Yes, but when we talk about which is the best currency to trade we refer to it as a currency ‘pair.’ Remember that when you trade FX you are always trading one currency against another. You are always trading on how one currency is valued against another. Typically, the “best pairs” are the most liquid and volatile currency pairs. They are the ones where making money is possible in a short period of time.
The EUR/USD (Euro v. US Dollar) is the most traded pair in the world, therefore it’s the most liquid and the less costly.
JH: What do you mean by ‘less costly’?
GA: I mean that the spread between the “bid” price and the “ask” price is very small whatever the time zone you are trading in. For instance, today the price for EURUSD is 1.3173/1.3176. In other words, if you want to buy one Euro you have to pay USD$1.3176 and if you want to sell one Euro you will only receive USD$1.3173. The spread is only 3 ‘pips.’ In this example a ‘pip’ is 1/100th of a cent.
JH: Got it.
GA: The USD/JPY (US Dollar v. Yen) is also popular and traded a lot during Asian working hours. In case you didn’t know, the FX market is a market that is open 24 hours a day, 5 days a week from early Monday morning when Asian markets open through until early Saturday morning – our time – when US markets close.
But for Australian investors and traders, the best pairs to trade are the AUD/USD (Australian Dollar v. US Dollar), AUD/NZD (against New Zealand Dollar), AUD/JPY and EUR/AUD.
JH: Thanks Gabriel, you’ve helped me understand it more. And hopefully it’s helped Money Morning readers too.
Other Stuff on the Markets
A strong 2% rally on Wall Street overnight. And another strong rally for the Aussie dollar.
That has followed a number of weak falls in the US and Australian markets. This could be a positive sign for the market if sellers are becoming less active.