Types of Indicators: Lesson 5A

Oscillators and Momentum Indicators

We’ve covered a hell lot of tools that can help you analyze charts and identify trends. In fact, you may now have too much information to use effectively.

In this lesson, we’re going to look at streamlining your use of these chart indicators. We want you to fully understand the strengths and weaknesses of each tool, so you’ll be able to determine which ones work for you and your trading plan…and which ones don’t.

Leading versus Lagging Indicators

Let’s discuss some concepts first. There are two types of indicators: leading and lagging.

A leading indicator gives a buy signal before the new trend or reversal occurs.

A lagging indicator gives a signal after the trend has started and basically informs you “hey buddy, pay attention, the trend has started, you’re missing the boat.”

You’re probably thinking, “Boohoo, I’m going to get rich with leading indicators!” since you would be able to profit from a new trend right at the start. You’re right – you would “catch” all of the trend every single time IF the leading indicator was correct every single time. But it’s not. When you use leading indicators, you will experience a lot of fake outs. Leading indicators are notorious for giving bogus signals which will “mis-lead” you.

Get it? Leading indicators that "mis-lead" you? Ha-ha. Man I'm so funny I even crack myself up.

The other option is to use lagging indicators, which aren’t as prone to bogus signals. Lagging indicators only give signals after the price change is clearly forming a trend. The downside is that you’d be a little late in entering a position. Often the biggest gains of a trend occur in the first few bars so by using a lagging indicator you could potentially miss out on much of the profit. This sucks.

Oscillators and Trend Following Indicators

For the purpose of this lesson, let’s broadly categorize all of our technical indicators into one of two categories:

1. Oscillators

2. Trend following or momentum indicators

Oscillators are leading indicators.

Momentum indicators are lagging indicators.

While the two can be supportive of each other, they're more likely to conflict with each other. I’m not saying that one or the other should be used exclusively, but you must understand the potential pitfalls of each.

Oscillators/Leading Indicators

An oscillator is any object or data that moves back and forth between two points. In other words, it’s an item that is going to always fall somewhere between point A and point B. Think of when you hit the oscillating switch on your electric fan.

Think of our technical indicators as either being “on” or “off”. More specifically, an oscillator will usually signal “buy” or “sell”, with the only exception being instances when the oscillator is not clearly at either end of the buy/sell range.

Does this sound familiar? It should! Stochastics, Parabolic SAR, and the Relative Strength Index (RSI) are all oscillators. Each of these indicators is designed to signal a possible reversal, where the previous trend has run its course and the price is ready to change direction.

Let’s take a look at a few examples.

On this 1-hour chart of USD/EUR below, we have added a Parabolic SAR indicator, as well as an RSI and Stochastic oscillator. As you have already learned, when the Stochastic and RSI begin to leave their “oversold” region. That is a buy signal. Here we get sell signals between the hours 3:00 am EST and 7:00 am EST on 08/24/05. All three of these buy signals occurred within one or two hours of each other, and this would have been a good trade.

We also got a sell signal from all three indicators between the hours of

2:00 am EST and 5:00 am EST on 08/25/05. As you can see, Stochastic indicator remained in the overbought for a pretty long time. About 20 hours. Usually when an oscillator remains in the overbought or oversold levels for a long period of time, that means there is a strong trend occurring. In this example, since Stochastic stayed overbought, you see there was a strong uptrend present. 

Now let’s take a look at the same leading oscillators messing up, just so you know these signals aren’t perfect. Looking at the chart below, you can quickly see that there were a lot of false buy signals popping up. You’ll see how one indicator says to buy, while the other one is still saying sell.

Around 1 am EST on 08/16/05, both RSI and Stochastic gave buy signals, while Parabolic SAR still showed a sell signal. Yes, Parabolic SAR gave a buy signal 3 hours later at 4 am EST, but then Parabolic SAR turned into a sell signal one bar later. If you actually look at the bar with the Parabolic SAR below it, notice how it’s a strong looking red bar with very short shadows. Also, notice how the next bar closed below it. This would not have been a good long trade.

On the last two oversold (buy) signals given by Stochastic, notice how there is no indicator at all for RSI, but Parabolic SAR is giving sell signals. What’s going on here? They are each giving you different signals!

What happened to such a good set of indicators?

The answer lies in the method of calculation for each one. Stochastic is based on the high-to-low range of the time period (in this case, it’s hourly), yet doesn’t account for changes from one hour to the next. The Relative Strength Index (RSI) uses change from one closing price to the next. And Parabolic SAR has its own unique calculations that can further cause conflict.

That’s the nature of oscillators – they assume that a particular chart pattern always results in the same reversal. Of course, that’s hogwash.

While being aware of why a leading indicator may be in error, there’s no way to avoid them. If you’re getting mixed signals, you’re better off doing nothing than taking a ‘best guess’. If a chart doesn’t meet all your criteria, don’t force the trade! Move on to the next one that does meet your criteria.

Momentum/Lagging Indicators

So how do we spot a trend? The indicators that can do so have already been identified as MACD and moving averages. These indicators will spot trends once they have been established at the expense of delayed entry. The bright side is that there’s less chance of being wrong.

On this 1-hour chart of EUR/USD, there was a bullish crossover for MACD at 3:00 am EST on 08/03/05 and the 10 period EMA crossed over the 20 period EMA at 5:00 am. These two signals were all accurate, but if you waited for both indicators to give you a bull signal, you would have missed out of the big move. If you calculate from the start of the uptrend at 10:00 pm EST on 08/02/05 to the close of the candle at 5:00 am EST on 08/03/05, you would’ve watched a gain of 159 pips while sitting on the sidelines.

Let’s take a look at the same chart so you can see how these crossover signals can sometimes give false signals. I like to call them “fakeouts”. Look at how there was a bearish MACD crossover after the uptrend we just discussed. Ten hours later, the 20 EMA crossed below the 10 EMA giving a “sell” signal. As you can see, the price didn’t drop but stayed pretty much sideways, then continued its uptrend. By the time both indicators were in agreement, you would’ve entered a short trade at the bottom and set yourself up for a loss. Bummer dude.

The Million Dollar Question

How do you figure out whether to freaking’ use oscillators, or trend following indicators, or both? After all, we know they don’t always work in tandem.

This is probably the most challenging part about technical analysis. And why I call it the million dollar question.

We will provide the million dollar answer in a future lesson.

For now, just know that once you're able to identify the type of market you are trading in, you will then know which indicators will give accurate signals, and which ones are worthless at that time.

This is no piece of cake. But it's a skill you will slowly improve upon as your experience grows.

Summary:

• There are two types of indicators: leading and lagging.
• A leading indicator gives a buy signal before the new trend or reversal occurs.
• A lagging indicator gives a signal after the trend has started
• Technical indicators into one of two categories: Oscillators and trend following or momentum indicators.  
• Oscillators are leading indicators.
• Momentum indicators are lagging indicators.
• If you're able to identify the type of market you are trading in, you will then know which indicators will give accurate signals, and which ones are worthless at that time.

The only place success comes before work is in the dictionary.

By now you have an arsenal of weapons to use when you battle the market.  In this lesson you will add yet another weapon: CHART PATTERNS!

Think of it as a land mine detector because once you learn it, you will be able to spot “explosions” on the charts before they even happen, and potentially make you a lot of money in the process.

In this lesson, I will teach you basic chart patterns and formations.  When correctly identified, it usually leads to a huge breakout or “explosion” in this case.  Remember, our whole goal is to spot big movements before they happen so that we can ride them out and rake in the cash!  Chart formations will greatly help us spot conditions where the market is ready to break out.

Here's the list of patterns that we're going to cover:

• Symmetrical Triangles
• Ascending Triangles
• Descending Triangles
• Double Top
• Double Bottom
• Head and Shoulders
• Reverse Head and Shoulders

Symmetrical Triangles

Symmetrical triangles are chart formations where the slope of the price’s highs and the slope of the price’s lows converge together to a point where it looks like a triangle.  What is happening during this formation is that the market is making lower highs and higher lows.  This means that neither the buyers nor the sellers are pushing the price far enough to make a clear trend.  If this was a battle between the buyers and sellers, then this would be a draw. This type of activity is called consolidation. 

In the chart above, we can see that neither the buyers nor the sellers could push the price in their direction.  When this happens we get lower highs and higher lows.  As these two slopes get closer to each other, it means that a breakout is getting near.  We don’t know what direction the breakout will be, but we do know that the market will break out.  Eventually, one side of the market will give in.  So how can we take advantage of this?  Simple.  We can place entry orders above the slope of the lower highs and below the slope of the higher lows.  Since we already know that the price is going to break out, we can just hitch a ride in whatever direction the market moves.

In this example, if we placed an entry order above the slope of the lower highs, we would’ve been taken along for a nice ride up.  If you had placed another entry order below the slope of the higher lows, then you would cancel it as soon as the first order was hit. 

Ascending Triangles

This type of formation occurs when there is a resistance level and a slope of higher lows.  What happens during this time is that there is a certain level that the buyers cannot seem to exceed.  However, they are gradually starting to push the price up as evident by the higher lows. 

In the chart above, you can see that the buyers are starting to gain strength because they are making higher lows.  They keep putting pressure on that resistance level and as a result, a breakout is bound to happen.  Now the question is, “Which direction will it go?”  “Will the buyers be able to break that level or will the resistance be too strong?” 

Many charting books will tell you that in most cases, the buyers will win this battle and the price will break out past the resistance.  However, it has been my experience that this is not always the case.  Sometimes the resistance level is too strong and there is simply not enough buying power to push it through. 

Most of the time the price will in fact go up.  The point I am trying to make is that we do not care which direction the price goes, but we want to be ready for a movement in EITHER direction.  In this case, we would set an entry order above the resistance line and below the slope of the higher lows.

In this scenario, the buyers won the battle and the price proceeded to skyrocket! 

Descending Triangle

As you probably guessed, descending triangles are the exact opposite of ascending triangles (I knew you were smart!).  In descending triangles, there is a string of lower highs which forms the upper line.  The lower line is a support level in which the price cannot seem to break.

In the chart above, you can see that the price is gradually making lower highs which tell us that the sellers are starting to gain some ground against the buyers.  Now most of the time, and I did say MOST; the price will eventually break the support line and continue to fall.  However, in some cases, the support line is too strong, and the price will bounce off of it and make a strong move up. 

The good news is that we don’t care where the price goes.  We just know that it’s about to go somewhere.  In this case we would place entry orders above the upper line (the lower highs) and below the support line. 

In this case, the price did end up breaking the support line and proceeded to drop rather quickly.  (*note- The market tends to fall faster than it rises which means you usually make money faster when you are short).

Double Top

A double top is a reversal pattern that is formed after there is an extended move up.  The “tops” are peaks which are formed when the price hits a certain level that can’t be broken.  After hitting this level, the price will bounce off of it slightly, but then return back to test the level again.  If the price bounces off of that level again, then you have a DOUBLE top! 

In the chart above you can see that two peaks or “tops” were formed after a strong move up.  Notice how the 2nd top was not able to break the high of the 1st top.  This is a strong sign that a reversal is going to occur because it is telling us that the buying pressure is just about finished.

With double tops, we would place our entry order below the neckline because we are anticipating a reversal of the uptrend. 

Wow!  I must be a psychic or something because I always seem to be right!  Looking at the chart you can see that the price breaks the neckline and makes a nice move down.   Remember, double tops are a trend reversal formation.  You’ll want to look for these after there is a strong uptrend. 

Double Bottom

Double bottoms are also trend reversal formations, but this time we are looking to go long instead of short.  These formations occur after extended downtrends when two valleys or “bottoms” have been formed. 

You can see from the chart above that after the previous downtrend, the price formed two valleys because it wasn’t able to go below a certain level.  Notice how the 2nd bottom wasn’t able to significantly break the 1st bottom.  This is a sign that the selling pressure is about finished, and that a reversal is about to occur.  In this situation, we would place an entry order above the neckline. 

Would you look at that!  The price breaks the neckline and makes a nice move up.  Remember, just like double tops, double bottoms are also trend reversal formations.  You’ll want to look for these after a strong downtrend.

Head and Shoulders

A head and shoulders pattern is also a trend reversal formation.  It is formed by a peak (shoulder), followed by a higher peak (head), and then another lower peak (shoulder).  A “neckline” is drawn by connecting the lowest points of the two troughs.  The slope of this line can either be up or down.  In my experience, when the slope is down, it produces a more reliable signal.

In this example, we can visibly see the head and shoulders pattern.  The head is the 2nd peak and is the highest point in the pattern.  The two shoulders also form peaks but do not exceed the high of the head. 

With this formation, we look to make an entry order below the neckline.  We can also calculate a target by measuring the high point of the head to the neckline.  This distance is approximately how far the price will move after it breaks the neckline.

You can see that once the price goes below the neckline it makes a move that is about the size of the distance between the head and the neckline.

Reverse Head and Shoulders

The name speaks for itself.  It is basically a head and shoulders formation, except this time it’s in reverse.  A valley is formed (shoulder), followed by an even lower valley (head), and then another higher valley (shoulder).  These formations occur after extended downward movements. 

Here you can see that this is just like a head and shoulders pattern, but it’s flipped upside down.  With this formation, we would place an long entry order above the neckline.  Our target is calculated just like the head and shoulders pattern.  Measure the distance between the head and the neckline and that is approximately the distance that the price will move after it breaks the neckline.

You can see that the price moved up nicely after it broke the neckline.  I know you’re thinking to yourself, “the price kept moving even after it reached the target.”  And my response is, “DON”T BE GREEDY!”  If your target is hit, then be happy with your profits.  However, there are strategies where you can lock in some of your profits and still keep your trade open in case the price continues to move your way.  You will learn about those later on in the course. 

Summary:

Chart formations are like bazookas because they often create huge explosions on the chart.

Symmetrical triangles

• Consists of lower highs and higher lows
• Place entry orders above the lower highs and below the higher lows

Ascending triangles   

• Consists of higher lows and a resistance line 
• It usually means that the price will break the resistance line and go higher but you should place entry orders on both sides just in case the resistance line is too strong.
• Place your entry orders above the resistance line and below the higher lows.

Descending triangles  

• Consists of lower highs and a support line    
• I usually means that the price will break the support line and go lower but you should place entry orders on both sides just in case the support line is too strong.
• Place your entry orders above the lower highs and below the support line.

Trend Reversal formations

Double Top

• Happens after an extended uptrend.
• Formed by 2 peaks that can’t break a certain level. This level becomes a resistance line.
• Place our short entry order below the low point of the valley in between the 2 peaks.

Double Bottom

• Happens after an extended downtrend.
• Formed by 2 valleys that can’t break a certain level. This level becomes a support line.
• Place our long entry order above the high point of the peak in between the 2 valleys.

Head and Shoulders

• Happens after an extended uptrend.
• Formed by a peak, followed by a higher peak, and then another lower peak. A neckline is formed by connecting the low points of the two troughs or “valleys”.
• Place your short entry order below the neckline.
• We calculate our target by measuring the distance between the high point of the head and the neckline. This is the approximate distance that the price will move after it breaks the neckline.  

Reverse Head and Shoulders

• Happens after an extended downtrend.
• Formed by a valley, followed by a lower valley, and then another higher valley. A neckline is formed by connecting the high points of the 2 peaks.
• Place your long entry order above the neckline.
• We calculate our target by measuring the distance between the low point of the head and the neckline. This is the approximate distance that the price will move after it breaks the neckline.

We are what we repeatedly do. Excellence, then, is not an act, but a habit.

- Aristotle

Technical Indicators- An introduction (Lesson 4A)

MACD

MACD is an acronym for Moving Average Convergence Divergence.  This tool is used to identify moving averages that are indicating a new trend, whether it’s bullish or bearish.  After all, our #1 priority in trading is being able to find a trend, because that is where the most money is made. 

With MACD charts, you will usually see three numbers that are used for its settings. The first is the number of periods that is used to calculate the faster moving average, the second is the number of periods that is used in the slower moving average, and the third is the number of bars that is used to calculate the moving average of the difference between the faster and slower moving averages.

For example, if you were to see “12,26,9” as the MACD parameters (which is usually the default setting for most charting packages), this is how you would interpret it:

1. The 12 represents the previous 12 bars of the faster moving average.

2. The 26 represents the previous 26 bars of the slower moving average.

3. The 9 represents the previous 9 bars of the difference between the two moving averages.  This is plotted by vertical lines called a histogram (The blue lines in the chart above). 

There is a common misconception when it comes to the lines of the MACD.  The two lines that are drawn are NOT moving averages of the price.  Instead, they are the moving averages of the DIFFERENCE between two moving averages. 

In our example above, the faster moving average is the moving average of the difference between the 12 and 26 period moving averages.  The slower moving average plots the average of the previous MACD line.  Once again, from our example above, this would be a 9 period moving average.  This means that we are taking the average of the last 9 periods of the faster MACD line and plotting it as our “slower” moving average.  What this does is it smoothes out the original line even more, which gives us a more accurate line. 

The histogram simply plots the difference between the fast and slow moving average.  If you look at our original chart, you can see that as the two moving averages separate, the histogram gets bigger.  This is called divergence because the faster moving average is “diverging” or moving away from the slower moving average.   As the moving averages get closer to each other the histogram gets smaller.  This is called convergence because the faster moving average is “converging” or getting closer to the slower moving average.  And that, my friend, is how you get the name, Moving Average Convergence Divergence!  Whew, I need to crack my knuckles after that one.
Ok, so now you know what MACD does.  Now I’ll show you what MACD can do for YOU.

MACD Crossover

Because there are two moving averages with different “speeds”, the faster one will obviously be quicker to react to price movement than the slower one.  When a new trend occurs, the fast line will react first and eventually cross the slower line.  When this “crossover” occurs, and the fast line starts to “diverge” or move away from the slower line, which often indicates that a new trend has formed.

From the chart above, you can see that the fast line crossed under the slow line and correctly identified a new downtrend.  Notice that when the lines crossed, the histogram temporarily disappears.  This is because the difference between the lines at the time of the cross is 0.  As the downtrend begins and the fast line diverges away from the slow line, the histogram gets bigger, which is good indication of a strong trend.

There is one drawback to MACD.  Naturally, moving averages tend to lag behind price.  After all, it's just an average of historical prices.  Since the MACD represents moving averages of other moving averages and is smoothed out by another moving average, you can imagine that there is quite a bit of lag.  However, it is still one of the most favoured tools by many traders. Let's now take a look at Parabolic SAR...

Parabolic SAR

Up until now, we’ve looked at indicators that mainly focus on catching the beginning of new trends.  And although it is important to be able to identify new trends, it is equally important to be able to identify where a trend ends.  After all, what good is a well-timed entry without a well-timed exit? 

One indicator that can help us determine where a trend might be ending is the Parabolic SAR (Stop and Reversal).  A Parabolic SAR places dots, or points, on a chart that indicate potential reversals in price movement.  From the chart above, you can see that the dots shift from being below the candles during the uptrend, to above the candles when the trend reverses into a downtrend. 

Using Parabolic SAR

The nice thing about the Parabolic SAR is that it is really simple to use.  Basically, when the dots are below the candles, it is a buy signal; and when the dots are above the candles, it is a sell signal.  This is probably the easiest indicator to interpret because it assumes that the price is either going up or down.  With that said, this tool is best used in markets that are trending, and that have long rallies and downturns.  You DON’T want to use this tool in a choppy market where the price movement is sideways.

Stochastic

Stochastic is another indicator that helps us determine where a trend might be ending.  By definition, stochastic is an oscillator that measures overbought and oversold conditions in the market.  The 2 lines are similar to the MACD lines in the sense that one line is faster than the other.

How to Apply Stochastics

Like I said earlier, stochastics tells us when the market is overbought or oversold.  Stochastics are scaled from 0 to 100.  When the stochastic lines are above 70 (the red dotted line in the chart above), then it means the market is overbought.  When the stochastic lines are below 30 (the blue dotted line), then it means that the market is oversold.  As a rule of thumb, we buy when the market is oversold, and we sell when the market is overbought.

Looking at the chart above, you can see that the stochastics has been showing overbought conditions for quite some time.  Based upon this information, can you guess where the price might go?

If you said the price would drop, then you are absolutely correct!  Because the market was overbought for such a long period of time, a reversal was bound to happen. 

That is the basics of stochastic.  Many traders use stochastic in different ways, but the main purpose of the indicator is to show us where the market is overbought and oversold.  Over time, you will learn to use stochastic to fit your own personal trading style. Okay, let's move on to RSI.

Relative Strength Index (RSI)

Relative Strength Index, or RSI, is similar to stochastic in that it identifies overbought and oversold conditions in the market.  It is also scaled from 0 to 100. Typically, readings below 20 indicate oversold, while readings over 80 indicate overbought. 

Using RSI

RSI can be used just like stochastic.  From the chart above you can see that when RSI dropped below 20, it correctly identified an oversold market.  After the drop, the price quickly shot back up. 

RSI is a very popular tool because it can also be used to confirm trend formations.  If you think a trend is forming, take a quick look at the RSI and look at whether it is above or below 50.  If you are looking at a possible uptrend, then make sure the RSI is above 50.  If you are looking at a possible downtrend, then make sure the RSI is below 50

In the beginning of the chart above, we can see that a possible uptrend was forming.  To avoid fake outs , we can wait for RSI to cross above 50 to confirm our trend.  Sure enough, as RSI passes above 50, it is a good confirmation that an uptrend has actually formed. Okay, we've covered a smorgasbord of indicators, let's see how we can put all of what you just learned together (its combination).

Putting It All Together

In a perfect world, we could take just one of these indicators and trade strictly by what that indicator told us.  The problem is that we DON’T live in a perfect world, and each of these indicators has imperfections.  That is why many traders combine different indicators together so that they can “screen” each other.  They might have 3 different indicators and they won’t trade unless all 3 indicators give them the same answer. 

As you continue you journey as a trader, you will discover what indicators work best for you.  I can tell you that I like using MACD, Stochastics, and RSI, but you might have a different preference.  Every trader out there has tried to find the “magic combination” of indicators that will always give them the right signals, but the truth is that there is no such thing. 

I urge you to study each indicator on it’s own until you know EXACTLY how it reacts to price movement, and then come up with your own combination that fits your trading style.  Later on in the course, I will show you a system that combines different indicators to give you an idea of how they can compliment each other.

Summary:

• Everything you learn about trading is like a tool that is being added to your trader’s toolbox.  Your tools will make it easier for you to “build” your trading account. 
• Bollinger Bands
  • Used to measure the market’s volatility
  • They act like mini support and resistance levels
  • Bollinger Bounce
    • A strategy that relies on the notion that price tends to always return to the middle of the Bollinger Bands
    • You buy when the price hits the lower Bollinger band
    • You sell when the price hits the upper Bollinger band
    • Best used in ranging markets
  • Bollinger Squeeze
    • A strategy that is used to catch breakouts early
    • When the Bollinger bands “squeeze” the price, it means that the market is very quiet, and a breakout is eminent.  Once a breakout occurs, we enter a trade on whatever side the price made its breakout. 
• MACD
  • Used to catch trends early and can also help us spot trend reversals
  • It consists of 2 moving averages (1 fast, 1 slow) and vertical lines called a histogram, which measures the distance between the 2 moving averages.
  • Contrary to what many people think, the moving average lines are NOT moving averages of the price.  They are moving averages of other moving averages.
  • MACD’s downfall is its lag because it uses so many moving averages. 
  • One way to use MACD is to wait for the fast line to “cross over” or “cross under” the slow line and enter the trade accordingly because it signals a new trend.
• Parabolic SAR
  • This indicator is made to spot trend reversals; hence the name Parabolic Stop And Reversal (SAR)
  • This is the easiest indicator to interpret because it only gives bullish and bearish signals. 
  • When the dots are above the candles, it is a sell signal.
  • When the dots are below the candles, it is a buy signal.
  • These are best used in trending markets that consist of long rallies and downturns.
• Stochastics
  • Used to indicate overbought and oversold conditions
  • When the moving average lines are above 70, it means that the market is overbought and we should look to sell.
  • When the moving average lines are below 30, it means that the market is oversold and we should look to buy.
• Relative Strength Index (RSI)
  • Similar to stochastics in that it indicates overbought and oversold conditions.
  • When RSI is above 80, it means that the market is overbought and we should look to sell.
  • When RSI is below 20, it means that the market is oversold and we should look to buy.
  • RSI can also be used to confirm trend formations.  If you think a trend is forming, wait for RSI to go above or below 50 (depending on if you’re looking at an uptrend or downtrend) before you enter a trade.
• Each indicator has its imperfections.  This is why traders combine many different indicators to “screen” each other.  As you progress through your trading career, you will learn which indicators you like the best and can combine them in a way that fits your trading style.

I know this has been a very loooooooooooonnnnng lesson, and I encourage you to go back and read over anything you haven’t fully understood yet.  Sometimes it just takes a couple times of reading before you truly grasp something.  Once you understand the concepts of these indicators, go to a chart and start playing with them.  Really study how each indicator reacts to the price movement. 

When you fully understand an indicator, then it will become another tool for your trader’s toolbox.  For now you should just take a break.  Grab some coffee or get something to eat.  I know your eyes are hurting!  Let this lesson soak in, and then come back when you’re refreshed!

The price of success is hard work, dedication to the job at hand, and the determination that whether we win or lose, we have applied the best of ourselves to the task at hand.

- Vince Lombardi

Orders, Market Instrument & Indicators (The real combination)- Lesson Four

Orders and Positions

When you want to open a position you need to place an "entry" order. If and when the entry order executes, the position becomes "open" and starts its life on the market. At one point in time, you will place an "exit" order to "close" the position. A position can be "long" (entry order is to buy and exit order is to sell an instrument) or "short" (entry order is to sell and exit order is to buy an instrument).

At the point when you place your entry order, you need to define price level at which you want to buy or sell certain instrument. You also need to specify type of the order and quantity of the instrument you want to trade. There are 3 order types:

Market Order

Placing a market order means that you will buy at your broker's current "ask" (or "offer") price, or sell at your broker's current "bid" price, what ever that price currently is. For example, suppose you are buying EUR/USD. The current market, as quoted by your broker is 1.2934 / 1.2938. This means that your broker is willing to buy EUR/USD from you at 1.2934, and sell it to you at 1.2938.

Stop Order

Initiating a trade with a stop order means that you will only open a position if the market moves in the direction you are anticipating. For example, if USD/JPY is currently 108.72 and you believe it will move higher, you could place a stop order to buy at 108.82. This means that the order will only be executed if the market moves up to 108.82. The advantage is that if you are wrong and the market moves straight down, you will not have bought (because 108.82 will never have been reached). The disadvantage is that 108.82 is clearly a less attractive rate at which to buy than 108.72. Opening a position with a stop order is usually appropriate if you wish to trade only with strong market momentum in a particular direction.

Limit Order

A limit order is an order to buy below the current price, or sell above the current price. For example, if EUR/USD is trading at 1.2952 / 56 and you believe the market will rise, you could place a limit order to buy at 1.2945. If executed, this will give you a long position in EUR/USD at 1.2945, which is 11 pips better than if you had just bought EUR/USD with a market order. The disadvantage of the limit order is that if EUR/USD moves straight up from 1.2952 / 56, your limit at 1.2945 will never be filled and you will miss out on the profit opportunity even though your view on the direction of EUR/USD was correct. Opening a position with a limit order is usually appropriate if you believe that the market will remain in a range before moving in your anticipated direction, allowing the order to be filled first.

For both entry and exits orders you can specify price levels at which you want them to be executed. You have to specify entry levels when you place you entry order, while most brokers would allow you to specify exit levels at any time.

Calculating Profit

The objective of forex currency trading is to exchange one currency for another in the expectation that the market rate or price will change so that the currency you bought has increased its value relative to the one you sold. If you have bought a currency and the price appreciates in value, then you must sell the currency back in order to lock in the profit.

Let us assume that you open a long position by buying USD/JPY for 107.58 (quantity of 100000) and few hours after that, you close the position by selling USD/JPY for 107.74 (quantity of 100000). These two trades would bring you profit of (107.74 - 107.58) * 100000 = JPY 16000 (JPY is the counter or quote currency in the USD/JPY pair). You can than convert the profit to a currency you like, for example JPY 16000 = 16000 / 107.74 = USD 148.51.

We can also say that these two trades would bring you 16 "pips" profit. A "pip" is the smallest increment in any instrument. For asset types other than forex, the smallest increment is often called "tick". In EUR/USD one pip is 0.0001, in USD/JPY one pip is 0.01. Expressing position profits in pips is often very useful for quick calculations and estimates.

One pip, from the example above, would bring you 0.01 * 100000 = JPY 1000 profit, or JPY 1000 = 1000 / 107.74 = USD 9.28

Common Guidelines

Plan your trade and trade your plan: You must have a trading plan to succeed. A trading plan should consist of a position, why you enter, stop loss point, profit taking level, plus a sound money management strategy. A good plan will remove all the emotions from your trades.

The trend is your friend: Do not buck the trend. When the market is bullish, go long. On the reverse, if the market is bearish, you short. Never go against the trend.

Focus on capital preservation: This is the most important step that you must take when you deal with your trading capital. You main goal is to preserve the capital. Do not trade more than 10% of your deposit in a single trade. For example, if your total deposit is $10,000, every trade should limit to $1000. If you don't do this, you'll be out of the market very soon.

Know when to cut loss: If a trade goes against you, sell it and let go. Do not hold on to a bad trade hoping that the price will go up. Most likely, you end up losing more money. Before you enter a trade, decide your stop loss price, a price where you must sell when the trade turns sour. It depends on your risk profile as of how much you should set for the stop loss.

Take profit when the trade is good: Before entering a trade, decide how much profit you are willing to take. When a trade turns out to be good, take the profit. You can take profit all at one go, or take profit in stages. When you've recovered your trading cost, you have nothing to lose. Sit tight and watch the profit run.

Be emotionless: Two biggest emotions in trading: greed and fear. Do not let greed and fear influence your trade. Trading is a mechanical process and it's not for the emotional ones. As Dr. Alexander Elder said in his book "Trading for a Living", if you sit in front of a successful trader and observe how he trades, you might not be able to tell whether he is making or losing money. That's how emotionally stable a successful trader is.

Do not trade based on a tip from a friend or broker: Trade only when you have done your own research and analysis. Be an informed trader.

Keep a trading journal: When you buy a currency or stock, write down the reasons why you buy, and your feelings at that time. You do the same when you sell. Analyze and write down the mistakes you've made, as well as things that you've done right. By referring to your trading journal, you learn from your past mistakes. Improve on your mistakes, keep learning and keep improving.

When in doubt, stay out: When you have doubt and not sure where the market or stock is going, stay on the sideline. Sometimes, doing nothing is the best thing to do.

Do not overtrade: Ideally you should have 3-5 positions at a time. No more than that. If you have too many positions, you tend to be out of control and make emotional decisions when there is a change in market. Do not trade for the sake of trading.

As a general rule, a position is kept open until one of the following occurs:

1) Realization of sufficient profits from a position; When one opens a trade via any of the order types, the life of that trade in the market is open until when the trader feel otherwise, but base on this the trader will go on to close the position if and only if sufficient profit is made. Say a 200 pip profit could trigger any trader to stop a trade; hence this is achieved via the realization of sufficient profit from the position.

2) Specified stop-loss is triggered; usually in opening an order, stop loss points are normally specified in the entry form. The Stop Loss points in any trade are market price points that are targeted to minimize losses. They are given to ensure that, should a currency weaken by a certain percentage, a short position/Long Position will be covered even though this involves taking a loss.

3) Another position that has a better potential appears and you need these funds. I term this “greedy stops”, because when a better position is noticed and one needs fund from a present position that is not doing too well. It will be better then to stop that lingering position and use funds to enter a better order position.

“Knowing is not enough; we must apply, willing is not enough; we must do”

- Johann Wolfgang Von Goethe

2.16 Market Instruments, Chart Indicators & The Results of Its

Combinations

Common Chart Indicators

Congratulations on making it to this point. Each time you make it to the next level you continue to add more and more tools to your trader’s toolbox.  “What’s a trader’s toolbox?” you say simple!  Your trader’s toolbox is what you will use to “build” your trading account.  The more tools (education) you have in your trader’s toolbox (YOUR BRAIN), the easier it will be for you to build. 

So for this lesson, as you learn each of these indicators, think of them as a new tool that you can add to that toolbox of yours.  You might not necessarily use all of these tools, but it’s always nice to have the option, right?  Now, enough about tools already!  Let’s get started!

Bollinger Bands

Bollinger Bands are a technical trading tool created by John Bollinger in the early 1980s. They arose from the need for adaptive trading bands and the observation that volatility was dynamic, not static as was widely believed at the time.
The purpose of Bollinger Bands is to provide a relative definition of high and low. By definition prices are high at the upper band and low at the lower band. This definition can aid in rigorous pattern recognition and is useful in comparing price action to the action of indicators to arrive at systematic trading decisions.
Bollinger Bands consist of a set of three curves drawn in relation to securities prices. The middle band is a measure of the intermediate-term trend, usually a simple moving average, which serves as the base for the upper and lower bands. The interval between the upper and lower bands and the middle band is determined by volatility, typically the standard deviation of the same data that were used for the average. The default parameters, 20 periods and two standard deviations, may be adjusted to suit your purposes:
Middle Bollinger Band = 20-period simple moving average
Upper Bollinger Band = Middle Bollinger Band + 2 * 20-period standard deviation
Lower Bollinger Band = Middle Bollinger Band - 2 * 20-period standard deviation
Two important tools are derived from the Bollinger Bands: Bandwidth, a relative measure of the width of the bands, and %b, a measure of where the last price is in relation to the bands.
Bandwidth = (Upper Bollinger Band - Lower Bollinger Band) / Middle Bollinger Band
%b = (Last - Lower Bollinger Band) / (Upper Bollinger Band - Lower Bollinger Band)
Bandwidth is most often used to quantify The Squeeze, a volatility-based trading opportunity. %b is used to clarify trading patterns and as an input for trading systems.

Bollinger bands are used to measure a market’s volatility.  Basically, this little tool tells us whether the market is quiet or whether the market is LOUD!  When the market is quiet, the bands contract; and when the market is LOUD, the bands expand.  Notice on the chart below that when the price was quiet, the bands were close together, but when the price moved up, the bands spread apart.

That’s all there is to it.  Yes, I could go on and bore you by going into the history of the Bollinger band, how it is calculated, the mathematical formulas behind it, and so on and so forth, but I really don’t feel like typing it all out.  My fingers are cramping. 

In all honesty, you don’t need to know any of that junk.  I think it’s more important that I show you some ways you can apply the Bollinger bands to your trading.

Note: If you really want to learn about the calculations of a Bollinger band, then you can go to www.bollingerbands.com

The Bollinger Bounce

The first thing you should know about Bollinger Bands is that price tends to return to the middle of the bands.  That is the whole idea behind the Bollinger bounce (smart, huh?).  If this is the case, then by looking at the chart above, can you tell me where the price might go next?

If you said down, then you are correct!  As you can see, the price settled back down towards the middle area of the bands.

That’s all there is to it.  What you just saw was a classic Bollinger bounce.  The reason these bounces occur is because Bollinger Bands act like mini support and resistance levels. The longer the time frame you are in, the stronger these bands are.  Many traders have developed systems that thrive on these bounces. This strategy is best used when the market is ranging and there is no clear trend. 

Now let’s look at a way to use Bollinger Bands when the market does trend.

Bollinger Squeeze

The Bollinger squeeze is pretty self explanatory.  When the bands “squeeze” together, it usually means that a breakout is going to occur.  If the candles start to break out above the top band, then the move will usually continue to go up.  If the candles start to break out below the lower band, then the move will usually continue to go down.  Looking at the chart above, you can see the bands squeezing together.  The price has just started to break out of the top band.  Based on this information, where do you think the price will go?

If you said up, you are correct!  This is how a typical Bollinger Squeeze works.  This strategy is designed for you to catch a move as early as possible.  Setups like these do not come by everyday, but you can probably spot them a few times a week if you are looking at a 15 minute chart. 

So now you know what Bollinger Bands are, and you know how to use them.  There are many other things you can do with Bollinger Bands, but these are the 2 most common strategies associated with them.  So now you can put this in your trader’s toolbox, and we can move on to the next indicator, MACD.