Trading the forex market involves great discipline and dedication to analyzing the market. To make a sound and reliable decision to sell or buy a currency, traders need to perform several types of analysis and strictly follow the rules of their trading strategy. Whatever your strategy is based on, it probably involves one of the following types of analysis, or a combination of them.
The Three Types of Forex Analysis.
The most important types of analysis in the forex market are:
- Technical analysis
- Fundamental analysis
- Sentiment analysis
Technical analysis is a relatively young type of analysis, but it has already gathered a significant number of followers – especially in the forex market. The basic premise of technical analysis is that historical price action may predict the price action in the future. That means, all you need to make a trading decision is to just looking at the chart!
The forex market, being open 24 hours a day, creates a lot of data that can be analyzed with technical analysis, making it such a popular type of analysis in this market. Technical analysis involves studying of price trends, charts, indicators, support and resistance etc. and will be covered in detail in the next lessons.
The other major type of analysis is fundamental analysis, which tries to measure a currency’s real value based on various news and economic indicators of a country. Similar to a stock trader who analyses the stock with news about the company, forex fundamental traders analyze the currency with news from a particular country. To do so, traders follow news, economic data reports like GDP growth and inflation rates, political and social events of a country to arrive at the true value of a country’s currency.
The third type of analysis, called sentiment analysis, tries to give an insight into how market participants are feeling about a currency – are they bearish, bullish or neutral. Psychologically, people tend to follow crowds and unconsciously act in similar ways. That’s where sentiment analysis comes into play, which is especially useful when combining with technical and fundamental analysis. It’s always good to know how market participants feel about a currency, are they optimistic or pessimistic. In the end, it’s supply and demand that drive the value of a currency.
Which Type of Analysis for Forex Trading is Best?
This is a million-dollar question and any trader you ask will probably have a different answer. The truth is, no type of analysis is better than the other per se. For some traders, they might feel the most comfortable using technical analysis because they don’t want to follow all the news required for fundamental analysis. For others who enjoy short-term big wins, fundamental analysis is what determines the true value of a currency in their eyes. At the end of the day, you should choose whatever analysis you feel comfortable (and profitable) with, but keep in mind that using all types of analysis in combination – although it might seem overwhelming in the beginning – could really be worth the effort.
Types of Forex Charts
Charts are an essential tool in forex trading. As you will spend a lot of time in front of charts, choosing the right chart type is crucial for success. There are three main types of charts when trading forex: the line chart, the bar chart and the candlestick chart.
The Line Chart
A line chart is made of a line which connects all previous closing prices. It’s a simple chart which only shows information about closing prices, and is usually only used to present the general movement of a currency pair. The chart above shows a line chart on the EUR/USD currency pair.
A bar chart shows more information about the price than a line chart. It shows the closing price just like the line chart, but gives additional information on the opening price, highs and lows for a time period. The chart above shows a bar chart on EUR/USD.
The height of a bar shows the trading range for the used time frame, the bottom indicates the lowest trading price, and the top indicates the highest trading price for that time frame.
Additionally, there are little left-side and right-side hashes on each bar. They represent the opening price (left hash) and the closing price (right hash) of the time period. As you can see, each previous closing price is the next bar’s opening price, unless in situations where gaps in price form due to extraordinary market events (a price gap is shown inside the red circle on the chart above). Bar charts are also called OHLC charts, because they show the Open, High, Low and Close of the price. The following picture shows how a bar chart is formed:
A candlestick chart is very similar to a bar chart; only it presents the price information in a graphically more appealing way. Just like the bar chart, the candlestick chart is also an OHLC chart – it shows the Open, High, Low and Close of the price in the time period.
The highest and lowest prices are presented by vertical lines on both sides of a candlestick, while the opening and closing prices are connected in such a way that they form the “body” of the candlestick. In the traditional way of candlestick charting, the body is filled or colored if the closing price is below the opening price (that is, the price went down). The following picture explains how a candlestick is formed:
The main advantage of using candlestick charts over bar charts is that they are very easy to understand and analyze. They are also easy to use for beginners, as you can immediately spot the price movement and what happened in the market. Candlesticks also form the very popular candlestick patterns, which can be used to determine entry and exit points in the market. You will learn more on candlestick patterns later, let’s introduce first the concepts of support and resistance in the forex market in the following article.
Forex Support and Resistance
Support and resistance are the most crucial concepts in technical analysis. Simply said, a support price is a price where the market should have difficulty to fall below (i.e. it will find “support” on that price level), while a resistance price is a price where the market will have difficulty to break above (i.e. the market will find “resistance” on that price level).
The market will usually test the support and resistance lines a few times before breaking them. The more the market tests and bounces off the lines, the more important the support and resistance lines become. A break of either the support or resistance line is then followed by an extensive down or up move, as the stop orders become filled and the market gets saturated with buy and sell orders.
It’s also important to note that when a support breaks, it becomes a resistance in the future. Similarly, a break of the resistance will act as a support afterwards. Although support and resistance lines can be used on any currency pair and time frame, they become more important with longer time frames.
As pictures oftentimes best describe new concept, here is an example of support and resistance in the forex market.
On the chart above, point (1) shows a price level where the price made a swing low, and didn’t manage to extend its move downwards. Now, we can draw a horizontal support line which will give us clues in the future where the market might have difficulties to move lower. And that’s exactly what happened at point (2). The market respected the previous low, the support price, and bounced off from the support line. Point (3) shows a break of the support line – a break of the support is usually followed by an extensive down-move. The magic happens at point (3), where the previous support line now acts as a resistance line and rejects the price which tries to break above.
Trend lines are another basic tool in a trader’s technical toolbox. A trendline connects multiple lows or highs, and the line itself is then projected into the future. Traders use trendlines much like they do support and resistance lines, only the trendlines need not to be horizontal lines. It is expected that the price will bounce of the trendline, and the trendline becomes more important with each price-bounce off the trendline. A downward trendline is shown on the following chart.
As can be seen from the chart, the downward trendline on USD/CHF connects lower highs, from point (1) which is the beginning of the trendline, to point (4) where the trendline is broken. To draw a trendline like this, you need at least two lower highs (points (1) and (2)). The price bounces off the trendline at points (2) and (3), before it’s ultimately broken at point (4). As with support and resistance lines, the broken trendline which acted as resistance at points (2) and (3), will after the break act as a support line.
If we extend what we’ve said about trendlines by drawing a parallel line with the same angle as the initial trendline, we will have created a channel. Channels are another popular tool when it comes to a forex trader’s technical analysis, just like support and resistance or trendlines. Let’s see what a channel looks like.
By connecting the higher highs (points 1, 3, 5, 6 and 7) and higher lows (points 2 and 4) with two parallel trendlines, we’ve created a channel on EUR/USD. The price bounces off the upper and lower trendline of the channel until it finally breaks the lower trendline at point (8).
How to Trade Support and Resistance
Trading support and resistance lines, trendlines and channels are a popular trading strategy. However, this strategy is usually used in combination with other types of analysis, like fundamental to reveal ideal entry and exit points.
However, some traders do rely solely on support and resistance trading. The basic idea behind this is to trade the bounces off support and resistance lines, trendlines and channels. Let’s see how to enter trades based on support and resistance, trendlines and channels.
Japanese Forex Candlesticks
Candlesticks are the most popular way to display the price of a financial instrument. Invented by Japanese rice traders in the 17th century, their popularity rose in the West in recent decades. Whereas the “western” bar and line charts focus primarily on the open and close price, candlestick charts truly represent the psychology and supply/demand of the markets. Their biggest advantage is in their excellent way to graphically display price-action in relation to prior candlestick bars. With their bodies, which represent opening and closing price, the experienced trader (and beginners alike) immediately “feel” the market in a way best to see trading opportunities.
Knowing candlestick patterns is a rewarding tool for all traders. In the following lines we will show you the most common candlestick patterns and their meaning, so you can use them in your daily trading.
Japanese Candlestick Anatomy
As you already know from the previous article where we introduced the major types of forex charts, candlesticks are based on OHLC (Open-High-Low-Close) of the price. The opening and closing prices are displayed as the body of the candlestick, whereas the lowest and highest prices of the entire trading day are displayed as the “wicks” on the upper and lower side. If the price closes above the opening price, the body of the candlestick will be light. If it closes below the opening price, the body will be dark, or filled in.
Single Candlestick Patterns
Single candlestick patterns are formed with just one candlestick. Two of the major single candlestick patterns are the “Hanging Man” and the “Hammer” pattern. A “Hanging Man” pattern forms at the top of an uptrend, while a “Hammer” pattern forms at the bottom of a downtrend (i.e. “the price is hammering out”). As these are reversal candlestick patterns (just like the majority of them), a “hanging man” formation signals that we might be at the top of an uptrend, while a “hammer” pattern tells us the price reached the bottom of a downtrend and might reverse soon.
These candlestick patterns have a small body and long lower shadows, and it’s not important if they are bullish or bearish. The following picture shows the “Hanging Man” and “Hammer” patterns.
A formation of these single candlestick patterns shows that after the price opened, the sellers had enough power to outperform the buyers, thus moving the price downward. During the session, buyers regained their buying power and the price moved upward again, closing near the opening price (therefore the small body.)
It sends the message that an upward or downward trend lost steam and a reversal is likely to happen. I would like to ask you to open your trading platform and spot some Hanging Man and Hammer patterns to get a feeling of how they behave. You will probably be surprised after you see how often they form after an uptrend or downtrend finishes!
Dual Japanese Candlesticks
Now that you know the major single candlestick patterns, let’s expand our knowledge with dual and triple candlestick patterns.
Dual Candlestick Patterns
Inverted Hammer Pattern
The inverted hammer pattern forms at the bottom of a downtrend, and is a reversal pattern consisting of two candlesticks. It looks just like a hammer pattern, but inverted. It has a small real body and a long upper shadow, and forms after a long black candlestick. Buyers were dominant at the beginning, but sellers prevailed in the end and closed the session near its opening price, creating a long upper shadow. The following chart shows what an inverted hammer looks like.
The inverted hammer pattern.
The engulfing pattern is a major candlestick pattern, which signals a possible reversal of the trend. It can be both bearish and bullish, depending on where the pattern forms and the combination of candlesticks involved. A bullish engulfing pattern forms at the bottom of a downtrend, with the second white candlestick totally engulfing the first black candlestick. It’s mandatory that the white candlestick’s body totally wraps around the first black candlestick’s body. A bearish engulfing pattern forms at the top of an uptrend, with the black candlestick’s body totally engulfing the previous white candlestick’s body. Examples of both the bullish and bearish engulfing patterns are shown on the following picture.
A bearish engulfing pattern (1), and bullish engulfing pattern (2)
The Dark Cloud Cover
The Dark Cloud Cover is a top reversal, multiple candlesticks pattern. It is formed by two candlesticks of opposite colors. The second black candlestick opens above the prior white candlestick’s high, and then closes within the first candlestick’s white body. The more it penetrates into the white candlestick, the greater is the importance of the reversal formation. Some argue that the black candlestick needs to penetrate at least 50% into the prior white candlestick. An example of the dark cloud cover pattern is shown on figure 1.3.
Dark Cloud Cover Pattern
This formation reflects that after a session where buyers dominated (the white candlestick of the formation), in the second session the price opened even higher, after which sellers regained their power and outperformed the buyers. In this situation, the buyers are not as much convinced in their long position as they were before. This is a signal that the uptrend could end and reverse. But bear in mind that the engulfing patters are more dominant than the dark cloud cover patterns. If the second session’s black body of the dark cloud cover pattern would totally cover (engulf) the prior white body, a bearish engulfing pattern would form.
Triple Candlestick Patterns
The Morning Star
The morning star consists of three candlesticks, and is a bullish reversal pattern. The morning star appears after a downtrend, with a small candlestick forming with a gap away from the previous session’s close. The small real body of the candlestick represents an equilibrium between supply and demand, and a downtrend will likely reverse under such conditions. The third white candlestick of this pattern closes deep inside the first black candlestick’s real body. The following picture shows the morning star pattern.
The morning star pattern. The color of the star’s body is not important
The Evening Star
The evening star is the opposite formation of a morning star. It is a bearish reversal pattern, consisting of three candlesticks. The first of them is a white candlestick, which forms after an uptrend. This is the first candlestick of this pattern. Then, a small real body candlestick forms with a gap away from the first session’s close price. This is the evening star of our pattern. It signals that the uptrend might be over, and that a reversal is probably ahead. The third candlestick has a black body and closes deep inside the first session’s body. The next picture shows an evening star pattern.
The evening star pattern.
Japanese Candlestick Cheat Sheet
There are a lot of Japanese candlestick patterns, and it might be hard for you to remember all of them. That’s why we will give you an overview of all the major and minor candlestick patterns, so you can easily identify them on the chart. The following cheat sheet will help you with this.
Understanding and trading the Japanese candlestick patterns is a rewarding tool for every trader, and should be learned in the early stages of your trading career as these patterns truly represent the fight between bulls and bears in the market. Knowing candlestick patterns gives you an excellent overview of the supply and demand of a currency pair. These patterns are also followed by big players in the forex market, which give additional importance to these patterns and make them a valuable tool to predict future price-action.
Although some of the major patterns can be traded independently without confirmation signals, you will see the best results if you combine candlestick patterns with other types of analysis, and wait for confirmation signals before entering a trade based on this technique.
Different Types of Currency Brokers
When choosing a forex broker, it’s very important to understand which types of brokers exist and what their main characteristics are. This will be covered in this article.
You’ve probably heard about the definitions “dealing desk,” “no dealing desk,” “market makers,” “straight through processing,” etc., but do you know what all this means? Let’s explain it now. There are two primary types of forex brokers:
1) Dealing Desk brokers (DD)
2) No Dealing Desk brokers (NDD)
No Dealing Desk brokers are further divided into:
a) Straight Through Processing (STP) brokers
b) Electronic Communication Network + Straight Through Processing (ECN + STP)
Let’s explain each of the listed types of brokers.
Dealing Desk Brokers (DD)
Dealing Desk brokers are also called “market makers,” as they are the entity that provides liquidity to their traders. They create a market for their client, which means they take the other side of a client’s position.
Just like other brokers, dealing desk brokers make money through the difference in bid and ask price, called the spread. Since they set both the bid and ask price, dealing desk brokers offer fixed spreads for their clients. This means that traders don’t see real interbank rates, but with the advance of technology and the huge competition between brokers, the offered rates are literally the same as interbank rates.
If you place a trade with your dealing desk broker, they will first try to find a matching opposite order from their existing clients to minimize their risk. If there is no matching order, dealing desk brokers will need to take the opposite side of your trade. If a trader performs well and is profitable, a dealing desk broker will usually pass his trades to the market and liquidity providers so they don’t have any risk while holding his profitable position.
The next chart shows the main difference between dealing desk and no dealing desk brokers.
No Dealing Desk Brokers
NDD brokers do not match their clients’ positions through a dealing desk, but send them automatically to the interbank market. They simply link their clients with the liquidity providers, and charge either a small commission for doing so, or have slightly higher spreads than dealing desk brokers.
NDD brokers can be straight through processing (STP), or straight through processing + electronic communication network (STP+ECN) brokers.
STP and ECN Brokers
STP brokers pass your order to their liquidity providers which have access to the interbank market. STP brokers have many liquidity providers, which offer different bid and ask prices for a currency pair. They sort their quotes by the highest bid prices, and lowest ask prices, add a small markup to the price and quote the price to their clients.
That’s why STP brokers usually charge slightly higher spreads than dealing desk brokers, and can also have a variable spread to compensate if their liquidity providers widen their spreads.
ECN brokers on the other hand, create a platform for market participants where they can directly trade against each other. They are doing so by offering their best bid and ask prices, and orders are then matched based on the best possible prices. ECN brokers can connect many different types of market participants like traders, hedge funds, banks, and even other brokers. The nature of their business makes it difficult to charge spreads, and that’s why they will charge a small connection for connecting the various market participants together. ECN broker usually have higher deposit requirements than other types of brokers.
The following table shows the difference between the different types of forex brokers.
What to Consider Before Choosing a Broker
With so many different forex brokers out there, it can be a difficult task for traders to go through all the offers and select the best forex broker for their needs. Let’s discuss some major points that traders should pay attention to when picking a broker.
The main point when choosing a forex broker is security. You want to deposit your money only with a secure broker, and avoid bucket shops and scams which we will discuss in the next article.
To check the security of a forex broker, you need first to find out how the broker is regulated. They will usually list the regulatory body on their website.
There are many regulatory bodies out there, and below is a list of the main regulators in the forex industry.
- Cyprus: Cyprus Securities and Exchange Commission (CySEC)
- United States: National Futures Association (NFA) and Commodity Futures Trading Commission (CFTC)
- United Kingdom: Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA)
- Australia: Australian Securities and Investment Commission (ASIC)
- Switzerland: Swiss Federal Banking Commission (SFBC)
- Germany: Bundesanstalt für Finanzdienstleistungsaufsicht (BaFIN)
- France: Autorité des Marchés Financiers (AMF)
- Canada: Autorité des Marchés Financiers (AMF)
You need to make sure that your broker of choice is regulated by one of the bodies above.
When opening a position, you will always have to pay for the transaction cost. Naturally, that’s why you want to find a broker with the lowest spread and commission.
But, be aware that the cheapest broker is not always the best. As said above, the foremost characteristic of a broker is security, and non-regulated brokers will usually try to attract customers by offering lower spreads than the competition.
That’s why you need to find a balance between low transaction costs, and broker reliability.
Deposit and Withdrawal
Before opening an account with a broker, find some reviews on the internet to make sure that the process of deposit and withdrawal is fast and without problems.
Brokers only hold your funds to facilitate trading, and that’s why there is no reason for them to make it difficult to withdraw your profits.
This is the place where you will spend the majority of your time while trading. Brokers offer various trading platforms, from in-house solutions to popular trading platforms like the MetaTrader.
Whichever you choose, make sure that it’s reliable, fast and user-friendly. Also, look for the additional functionality like news feeds, charting tools and other. Trading platforms should suit your needs to make trading easier.
Fast trade execution is very important in forex trading, especially if you are a scalper (a trader who prefers to make many short-term daily trades.) If the market conditions and liquidity are normal, your broker should fill your order at the price you see when you click the buy or sell button. It’s also very important that you have a stable and fast internet connection to communicate with the broker’s trading platform.
Opening a Forex Trading Account
Now that you’ve learned how to choose a reliable broker, it’s time to open your first trading account! Brokers usually try to make this as easy as possible, so opening a trading account can be made in three easy steps:
- Choosing an account type
- Activating your account
Choosing the Account Type
The first step in opening your trading account is to select the account type you want. There will usually be two options: opening a personal account and opening a corporate account.
Brokers have also offered “standard,” “mini” and “micro” accounts in the past, with the difference in the minimal lot size that you can open with the account. Nowadays, many brokers allow you to open custom lot sizes so this isn’t a big deal anymore.
Trading with custom lot sizes is very popular as you can easily manage your risk per trade, especially if you are new to the market or an inexperienced trader.
The account registration involves submitting some documents to confirm your identity. This will usually vary from to broker, but with stricter regulations of retail forex trading there is no way around this. Sending a document that confirms your identity and address (like an electricity bill for example) will usually be enough.
After you have completed the steps above, it’s time to wait for the broker to do his part of work. In a few days, you should receive an email that confirms your account is activated, your username and password to log on to the broker’s system, and several ways to fund your account.
After you fund your account, you’re ready for your first live trade!
But, before opening a live trade, you should make sure that you’ve traded on demo account for at least a few months to get a feel for how the market is moving. Being profitable on a demo account doesn’t mean you will be profitable on a live account! Trading on a live account with real money involves different emotions that you need to control to become successful in the long run.
Even when you open a live account, always have proper risk management and never deposit more than you’re ready to lose!
Using the Fibonacci Sequence in Forex Trading
The Fibonacci Sequence is a popular concept in technical analysis. Traders around the world use Fibonaccis in their daily trading, making it a tool based on self-fulfilling expectations, and that’s why the price will often bounce of the Fibonacci levels.
Let’s start with introducing Leonardo Fibonacci, the famous Italian mathematician. He discovered a simple series of numbers that describes the proportions of things in nature and the universe.
The Fibonacci series looks like this: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89…
If you look closer at the numbers above, you can conclude that each number is the sum of the previous two numbers in the series. For example, 2+3 is 5, 3+5 is 8, 8+5 is 13 and so on. This indefinite series hides something very interesting – the “golden mean”.
If you divide each number with its succeeding number, you will get 0.618. For example, 5/8 is equal to 0.618, just like 55/89 is equal to 0.618. This ratio is called the “golden mean” and can be found in many places in the nature. The ratio between alternate numbers, like 34/89, will always return 0.382 as the result.
Let’s stop here with the math and go back to using the Fibonacci ratios in trading. There are two Fibonacci concepts in technical analysis which we will cover in this article, and they are:
- Fibonacci retracements
- Fibonacci extensions
Fibonacci retracements and extensions use similar ratios for drawing the Fibonacci tool on the chart. You don’t have to know how to calculate these ratios; your charting platform will do it for you. The ratios are also derived from the Fibonacci number series, and are as follows:
- Fibonacci retracement levels: 0.236, 0.382, 0.500, 0.618, 0.764
- Fibonacci Extension Levels: 0, 0.382, 0.618, 1.000, 1.382, 1.618
How to Use Fibonacci Retracement to Enter a Forex Trade
Fibonacci retracements levels are essentially used as support and resistance lines. The following chart shows the price bouncing off the 0.618 Fibonacci level after a correction move, and continues its prior uptrend.
To draw the Fibonacci retracement on the chart, you need to determine the previous swing lows and swing highs. Then select the Fibonacci tool in your charting platform, and connect these two swings. The tool will automatically draw the retracement level on the chart.
The right time to enter a trade based on Fibonacci retracements, is to wait for the price to bounce off the retracement level (usually the 0.618 or 0.382), and making sure that the next candlestick confirms the bounce. A stop-loss order should be place just below the retracement line.
Fibonacci Retracement is NOT Foolproof!
You should also be aware that Fibonacci retracements are NOT foolproof. They can fail just like any other support and resistance line. Let’s take a look at the following chart:
At point (1), it seems like the price will bounce of the 0.500 Fibonacci retracement level. Even the following candlestick closes well above the retracement level. But, just a few bars later, the price plunges and breaks every retracement level on the chart. This shows that a trader should never rely solely on Fibonacci retracements, because if underlying fundamentals are strong enough, even the most important support and resistance lines will eventually fail.
How to Use Fibonacci Retracement with Support and Resistance
Fibonacci retracements are especially important when they form a confluence zone with a previous support or resistance level. This situation is shown on the next chart.
During its correction phase, the price finds support at the 0.382 retracement level. But, it just happened that this same level matches a previous support zone, marked with the red rectangle. This is called a confluence zone and adds substantially to the importance of the Fibonacci level. The price touched the 0.382 level a few times and skyrocketed afterwards.
How to Use Fibonacci Retracement with Trend Lines
Similar to support and resistance lines, Fibonacci retracements can also form confluence zones with trendlines. The following chart shows such a situation.
The price touched the 0.500 level at point (1), which happened to be at the same level as a previous trendline. This made a strong support at this level and the price continued to trade higher. Just like with support and resistance lines, this situation made a good trade opportunity.
How to Use Fibonacci Retracement with Japanese Candlesticks
Another popular way to use Fibonacci retracements is with candlesticks. In this case, candlesticks are used as a confirmation signal that the price will respect the retracement level and continue its previous trend after the correction phase. The following chart shows the price touching the 0.786 retracement level, and a small red candlestick at point (1), called a spinning top. This candlestick signals a top and that the price might reverse soon. That’s our confirmation for opening a short position.
How to Use Fibonacci Extensions to Know When to Take Profit
Now that we know that Fibonacci retracement levels are used similar to support and resistance lines, it’s time to introduce Fibonacci extension levels.
Fibonacci extensions are used to determine when to exit a trend. They show possible targets that the price can reach after bouncing off a Fibonacci retracement. The following chart shows a Fibonacci extension used to take profits.
To draw a Fibonacci extension on the chart, you need select three points with your mouse. The swing high, swing low, and the lower high of the correction. The tool will then automatically draw each extension level on the chart.
On the chart below, the price touched the 61.8% Fibonacci extension level where many traders have put their take profit order.
How to Use Fibonacci to Place Your Stop so You Lose Less Money
Fibonacci levels are not only used to determine possible price reversals and take profit levels, but also for stop-loss levels to minimize possible losses. Stop-loss orders are usually put just above (in a downtrend) or below (in an uptrend) of the Fibonacci retracement levels. Let’s take a look at the following chart.
After the spinning top candlestick confirmed our short position, we’ve put a stop-loss order just above the 0.786 retracement level. If the price breaks above the 0.786 level, the stop-loss order will prevent further losses.
Summary: Fibonacci Trading
The Fibonacci tools are widely used in the trading community. We’ve covered the Fibonacci retracements and extensions, but there are many more Fibonacci tools like the Fibonacci arcs, Fibonacci time-zones, Fibonacci fans etc. These are less used tools but they are also based on Fibonacci ratios to determine possible levels for price reversals and targets.
Fibonacci retracements are used to determine levels where the price may end its correction phase and reverse, while Fibonacci extensions show possible levels for closing the position and taking profits.
As we said earlier, Fibonacci tools are not foolproof and should ideally be confirmed with candlestick patterns, prior support and resistance levels or trendlines. These confluence zones give a high probability of an upcoming price reversal.
Moving averages are probably the most popular technical tool in forex trading. They are used to identify trends in currency pairs, and also as dynamic support and resistance levels. The most commonly used moving average settings in the forex market are the 50-day, 100-day and 200-day MA, which are followed by many market participants and thus represent significant support and resistance levels. Shorter periods can also be used, but they can create an MA indicator which is more volatile and reacts more quickly to price changes.
The most common types of moving averages used in the forex market are the simple moving average (SMA), and the exponential moving average (EMA).
Simple Moving Average (SMA) Explained
A simple moving average (SMA) represents the average price for a given periods of time. For example, a 20-day SMA will plot the average price for the 20 previous closing prices. When the most recent candlestick closes, the 20-day SMA will exclude the last candlestick from its calculation and include the new candlestick’s closing price. All periods have an equal weight in the calculation of the simple moving average. A chart with an SMA plotted on it is presented in the following graphic:
Simple moving averages give the same weight to older price actions as they do to more recent price actions. To solve this problem, traders use the second type of moving averages – the exponential moving average (EMA).
Exponential Moving Average (EMA)
An exponential moving average (EMA) is very similar to an SMA, except that EMAs give more weight to recent prices. This means that EMAs react faster to price changes than SMAs. Here is the same chart as above, except that the 20-day SMA is replaced with a 20-day EMA.
As you can notice on the chart above, an exponential moving average changes its direction faster than a simple moving average in times when the price makes new highs and lows. This is an important characteristic as recent price action is more significant to a trader than past price actions.
Simple vs. Exponential Moving Average – Which is Better to Use?
It’s important to note that moving averages are lagging indicators in their nature. This means, by the time a moving average changes its direction the price has already made its move, and more often than not the perfect entry point has already passed. Unlike SMAs, EMAs reduce this lagging effect to some extent as they give more importance to recent price changes. Like other lagging indicators, moving averages are best used to confirm an up- or downtrend and to indicate the strength of the move in price. In this regard, exponential moving averages will give a more accurate result than simple moving averages.
Forex Technical Indicators
Let’s take a look at the most popular technical indicators in the forex market. We will explain what each indicator measures, how it can be applied in trading a provide examples of trades based on the indicators.
How to Use Bollinger Bands
Bollinger Bands are used to measure the price volatility of a currency pair. This indicator plots two bands, an upper and a lower band, which are two standard deviations away from a simple moving average. Simply said, in a volatile market the bands widen, and when market conditions are calm the bands will come close to each other. Traders usually look for two conditions when using Bollinger Bands, the “squeeze” and the “breakout”.
A Bollinger Band breakout, which can be seen at point (1), is simply a candlestick closing outside the upper or lower band. This situation is very rare, as 90-95% of all price action takes place inside the bands. A breakout implies that recent price action is heavily dominated by either buyers or sellers, and that the price may proceed in the direction of the breakout. Indeed, that’s what we see on the chart. Another breakout can be seen at point (2).
How to Use the MACD Indicator
The Moving Average Convergence-Divergence, or MACD, is another popular indicator in the forex market. It’s primarily used to identify trends in their early stages of development. The MACD consists of three moving averages, with the third being a moving average of the difference between the first two moving averages. Although this may seem complicated, it actually isn’t. Let’s see how the MACD indicator looks like on a chart.
The usual settings for the MACD are 13 periods and 26 periods for the faster and slower moving averages, and a 9-period MA of the difference between the first two MAs which acts as a signal line. The histogram (green) simply represents the distance between the signal line (red) and the line which represents the difference between the faster and slower moving averages (grey).
Let’s stop with the theory for a second, and explain how the MACD is used. A simple crossover of the two plotted lines signals that the previous trend may end, and that a new trend is on its way. The signal line (red) crossing from below indicates a potential uptrend, while the signal line crossing the second line from above indicates a potential downtrend.
How to Use Parabolic SAR
Beside identifying trends in their early stage and entering trades, it’s equally important to know when a trend might end. A perfect entry without a perfect exit has little value to the trader. That’s where Parabolic SAR (Stop And Reversal) comes into play. This is a very simple indicator, which plots lines (or dots) above or below the price on the chart. An example is given in the next chart.
This indicator creates trading signals that are simple to use. If the PSAR line is below the price, it’s a signal to BUY. And if the PSAR line is above the price, it’s a signal to SELL. The green arrows show how GBP/USD reacted with the PSAR above and below the price.
How to Use Stochastic
Another popular technical indicator in forex is the Stochastic indicator. This indicator is popularly used to identify oversold and overbought market conditions. The Stochastic is presented in a range between 0 and 100. Generally, if the Stochastic lines break above 80, it represents an overbought market condition with the possibility that the price will drop. Similarly, a break below 20 indicates an oversold market condition, and traders should be aware that the price may rise very soon. This means, a Stochastic over 80 gives a SELL signal, while a Stochastic below 20 gives a BUY signal.
The chart above shows two trade entries based on the Stochastics. At point (1), the Stochastic breaks below 20 and gives a buy signal, while at point (2) the Stochastic breaks above 80 and gives a sell signal.
How to Use RSI
The Relative Strength Index, or RSI, is an indicator very similar to the Stochastic. Beside its use to identify overbought and oversold conditions, the RSI is also used to confirm up- and downtrends. The RSI is presented on a scale between 0 and 100, where a reading above 70 indicates overbought conditions, while a reading below 30 indicates oversold conditions.
The chart above shows trade signals based on the RSI indicator. Points (1) and (2) indicate overbought market conditions and a potential to open a short position, while point (3) indicates an oversold area and gives a signal for a long position. Beside overbought and oversold areas, a reading of the RSI above 50 confirms a forming uptrend, while a reading below 50 confirms a downtrend in it’s early stage.
How to Use ADX
The Average Directional Index, or ADX, is an indicator primarily used to gauge the strength of the current trend. Unlike Stochastics, it doesn’t return information on whether the trend is bullish or bearish. The ADX can receive a value between 0 and 100, with readings above 50 indicating a strong trend, and reading below 20 indicating a weak trend. Because of that, the ADX is widely used to determine whether the market is trading sideways or about to start a new trend.
The chart above shows both market conditions and their respective ADX readings. The ranging market shows an ADX reading below 20, while the trending market shows a reading above 50.
Ichimoku Kinko Hyo
Ichimoku Kinko Hyo is an effective indicator used primarily on JPY pairs. It translates from Japanese as “a glance at a chart in equilibrium”, and indicates future support and resistance areas as well as future price movement. Let’s take a look at how Ichimoku Kinko Hyo looks like on a chart.
Well, this looks a little bit more complicated than the previous indicators. Let’s explain first what all these lines mean.
Kijun Sen (blue line): This is also called the standard or base line, and it averages the highest high and the lowest low for the past 26 periods.
Tenkan Sen (red line): Or turning line. This line averages the highest high and lowest low for the past 9 periods, and is essentially a faster version of the blue line.
Chikou Span (green line): This is also called the lagging line, because it plots today’s closing price 26 periods behind.
Senkou Span (orange lines): The first Senkou line averages the standard line and turning line and plots 26 periods ahead.
The second Senkou line averages the highest high and the lowest low for the past 52 periods and, just like the first Senkou line, plots 26 period ahead.
Now, let’s explain the signals that these lines create:
- The Senkou lines act as support lines if the price is above the lines (like in our example), or as resistance lines if the price is below the Senkou lines.
- The standard line is an indicator of future price movement. If the price remains above the standard line it gives a bullish signal, while a price below the standard line gives a bearish signal.
- A cross of the Chikou line below the price creates a sell signal, while a cross above the price creates a buy signal.
Trading with Multiple Chart Indicators
As traders, we can’t rely on a single indicator to give perfect trade signals. No mentioned indicator is able to do that. Rather, traders combine more indicators and wait for their signals to line up to enter trades with a higher success rate.
One of the indicators commonly used together are the Bollinger Bands and the Stochastic.
The chart above shows how a combination of signals from both the Bollinger Bands and Stochastic can create nice trade setups. At point (1), a Bollinger Bands breakout signals a BUY, but when looking closer at the Stochastics that is in the overbought area, entering a long position doesn’t look like a smart move anymore. Indeed, the price fell inside the bands again.
Point (2) shows a bearish Bollinger Band breakout accompanied with an overbought Stochastics. Opening a short position at this place will be turn into a profitable trade.
What is the Best Technical Indicator in Forex
Although there are dozens of technical indicators available to the trader, it’s difficult to pick the best. Technical indicators in their very nature rely on past price action and lag the current market situation more or less. Traders who wish to use technical indicators in their trading strategy should therefore test which particular indicator works best for them. For some it might be MACD, while others may swear on the Bollinger Bands. However, technical indicators should never be used on their own, but in combination with other means of analysis or just as a confirmation to enter a trade. For example, Stochastics can nicely be used to prevent entering short positions when the market is oversold, or long positions when the market is overbought.
Popular Chart Indicators
In this article we gave a brief overview of the most popular chart indicators available in forex trading. Keep in mind there many more indicators, but we picked the one we consider the most useful in the forex market.
Here is a quick overview of the indicators we covered:
· Bollinger Bands are used to measure price volatility, and their most popular strategies include the “squeeze” and the “breakout”
· The MACD indicator is used to identify trends in their early stages
· Parabolic SAR is used to identify possible trend reversals (Stop And Reversal – SAR), and for spotting profitable exit points.
· Stochastic indicator measures overbought and oversold market conditions. A reading above 80 gives a SELL signal, and a reading below 20 a BUY signal.
· The Relative Strenght Index or RSI, is also used to identify overbought and oversold market conditions. A reading above 70 gives a SELL signal, and a reading below 30 a BUY signal. A reading above or below 50 can also be used to confirm an early up- or downtrend, respectively.
· The ADX indicator gauges the strength of the current trend. It’s primarily used to identify sideways markets (reading below 20), and trending markets (reading above 50).
· Ichimoku Kinko Hyo gives information about possible future price movements. The Senkou lines act as support and resistance lines, and the Kijun Sen and Chikou lines give signals for long and short positions. This indicator returns best result on JPY pairs.
As technical indicators are lagging, I encourage traders to also apply other types of analysis and combine them with technical indicators. That’s when the best trading results are achieved.
Leading vs. Lagging Indicators
Now that we have covered some popular technical indicators in the forex markets, let’s explain the concept of indicators a little bit closer. Generally, there are two main types of indicators: leading indicators, and lagging indicators.
As their names might suggest, leading indicators (or oscillators) give signals before a change in price happens. They are leading the price. On the other hand, lagging indicators (or momentum indicators) “lag” behind the price, and are used to confirm that a change in trend has already happened.
Now you may think that leading indicators are the only tool you need to make a lot of money in the forex market – just follow their signals and get rich. Unfortunately, it’s not that easy. Leading indicators are notorious for their fake signals. There will give false signals from time to time, which could bring you a huge loss if you follow them blindly.
Lagging indicators also have their downsides, as these indicators will give signals only when the trend already starts. That’s why relying solely on leading indicators will lead to a lot of missed opportunities over time.
Using Oscillators to Look Out for the End of a Trend
We’ve already introduced some oscillators in the previous article, like the Stochastic, Parabolic SAR and Relative Strength Index (RSI). If you’re still not sure what they represent and how to trade them, we encourage you to read through the previous articles again.
To summarize again, these indicators are used to identify a possible trend reversal. They are leading indicators as they signal a reversal before it actually happens.
The following chart shows all three indicators plotted on the EUR/USD chart. All indicators occasionally lined up and gave buy and sell signals. As you can see, trading on these signals would be very profitable.
Now, let’s see a chart with the same indicators but with opposite signals.
As you can see, in August and September all three indicators gave totally different signals, with the RSI giving no signal at all. Later in October, the Parabolic SAR gave a sell signal, while both the Stochastic and RSI were well below the 30 and 20 levels and thus giving a buy signal.
Using Momentum Indicators to Confirm a Trend
Lagging or momentum indicators are primarily used to confirm a trend. Among the indicators discussed in earlier articles, the MACD and moving averages are examples of momentum indicators.
The downside of relying on these indicators for opening a position is that you’ll probably miss the huge move that appears at the beginning of a trend. These indicators are lagging, and give signals with a delay. The positive side is that they are less likely to give false signals compared to oscillating indicators.
The chart above shows the MACD indicator combined with two moving averages – a 10-period EMA and a 50-period EMA. Both indicators gave buy signals in August and sell signals in October, confirming trends in their early phase of development.
The two main groups of indicators are lagging indicators (or momentum indicators), and leading indicators (or oscillators). Momentum indicators lag behind the price, and are generally used to confirm a trend which has already begun. This means that relying on momentum indicators to enter a trade will lead to a lot of missed pips in your daily trading.
On the other hand, oscillator are leading indicators and have the ability to predict future price movement, but are famous for their false signals which, if followed blindly, can lead to huge losses in your trading account. The best way of using any type of technical indicators is to combine them with other types of indicators and wait for the signals to overlap, or to include other types of analysis like candlestick and chart patterns.
Why Chart Patterns are so Important
Chart patterns are a very effective tool for a trader. They are used to for signaling reversal or continuation of the current trend, and to identify entry and exit points of a position.
Chart patterns are formed over time and consist of multiple candlesticks. They have the ability to predict future price-action with a high probability, making them very popular among traders in the forex market.
Chart patterns can be grouped into three main groups:
- Reversal chart patterns
- Continuation chart patterns
- Bilateral chart patterns
Reversal chart patterns signal that the underlying trend is about to reverse. During an uptrend, reversal chart patterns hint that a fall in price might be ahead. And during a downtrend, these chart patterns signal that a rise in price could come soon.
Double Tops and Double Bottoms
Double tops are formed on a top an uptrend, making two swing highs at around the same price level. In the following chart a Double Top formation is shown, with points (1) and (2) showing two highs at the same price level. This is an indication that buyers have no power to push the price up, and that a change in trend could come soon. The red line below the formation is called the “neckline”. A break of the neckline signals the potential for opening a short position, with the target being the same distance as the height of the formation from the neckline (marked with the red arrow).
Double bottoms are similar to double tops, only that they form during a downtrend. The following chart shows a double bottom formation. Points (1) and (2) are the swing lows of the double bottom formation, with both lows around the same price level. Point (3) is the neckline of the formation. Just like a double top, the take profit level is set at the height of the double bottom formation from the neckline to the low (red dotted arrows).
What is a Head and Shoulders Pattern and How to Trade It
A head and shoulders pattern is a chart formation that predicts a bullish-to-bearish reversal, and is considered one of the most reliable chart formations in technical analysis. This pattern occurs at the top of an uptrend, signaling that bulls have lost steam and a reversal might be ahead. Let’s take a look at a head and shoulders pattern in a chart.
The chart above shows a head and shoulders formation on the 4-hour USD/CHF pair. Points (1) and (3) are the shoulders of the formation, while point (2) is the head. That’s why this formation is called “head and shoulders”. Line (4) is the neckline of the formation, the break of which signals the opportunity to enter a short position. The exit point is the height of the formation from the neckline to the top of the head, marked with the red arrows.
What is a Wedge Chart Pattern and How to Use It
A wedge pattern is another popular reversal chart pattern. Wedge patterns can be divided into rising wedges, and falling wedges.
A rising wedge is a bearish formation that forms at the top of an uptrend, and signals that a change in trend is ahead. Conversely, a falling wedge is a bullish formation that forms at the bottom of a downtrend, just before a start of a new uptrend.
A rising wedge is shown at the chart above. As you can see, this formation begins wide at the beginning, and narrows by the end of the pattern while making higher highs and higher lows. In contrast to a falling wedge, a rising wedge slopes up. The break of the lower trendline signals an opportunity to enter a short position, with the exit point being the height of the formation in its early beginning (red arrows).
Similarly, a falling wedge makes lower highs and lower lows, and slopes down. A break of the upper trendline signals the opportunity to enter a long position, with the exit target being the height of the wedge in its beginning.
What is a Rectangle Chart Pattern and How it’s Used to Trade Breakouts
A rectangle pattern forms when the price fluctuates between parallel support and resistance lines. This pattern is a continuation pattern, which means that it signals that the previous trend is about to continue. Rectangle patterns can be bullish and bearish, depending where they form.
A bullish rectangle forms during an uptrend, and suggests that the price will continue to trade higher. Conversely, a bearish rectangle forms during a downtrend a hints that the downtrend is about to continue.
The following chart shows a bullish rectangle pattern.
The break above the upper resistance line is the point where you should open a long position. Just like the other mentioned patterns, the exit point is the height of the formation, i.e. the height of the rectangle in this case.
What are Bullish and Bearish Pennants and How to Trade them
Pennants are chart formations very similar to triangles. They are continuation patterns which form after strong up or down moves. In the forex market, strong moves in price are usually followed by signs of exhaustion, and this is where correction moves and pennants often form, before the trend continues its direction. Depending on the trend, pennants are classified into bullish and bearish pennants. The following chart shows a bullish pennant on the USD/CHF chart.
The red lines on the chart show the formation of a pennant after a strong upmove. As you can see, the form of the pennant is very similar to a rectangle. A buy order is places after the break of the upper trendline, and a stop loss order just below the pennant. Unlike other chart formations, pennants signal a much stronger move and the exit target is the height of the earlier move (red dotted line). Bearish pennants are similar to bullish pennants, only that they form during a strong downtrend. This can be seen on the next chart.
You will enter a short position after the lower trendline breaks, with the exit target equal the height of the previous move. In this case, stop loss orders are placed just above the pennant formation.
What are Triangle Chart Patterns and How to Trade them
Triangle chart patterns are so-called bilateral chart patterns, because they can signal that the price can move either up or down.
Triangle chart patterns can be grouped into three groups:
- Ascending triangles, with the upper trendline being horizontal and the lower having an up-slope
- Descending triangles, with the lower trendline being horizontal and the upper having a down-slope
- And Symmetrical triangles, where both trendlines slope in different directions and narrow by the end of the triangle.
Let’s give an example for all three of them.
The following chart shows an ascending triangle, with a horizontal upper trendline and up-sloping lower trendline. A break above the upper trendline signals a buy opportunity, while a break below the lower trendline signals a sell opportunity, like in our example. The target price is the height of the triangle (red dotted arrows), while a stop-loss can be placed just above the upper trendline.
A descending triangle has a horizontal lower trendline, and a down-sloping upper trendline. A break above the upper trendline is a buy signal, and a break below the lower trendline is a sell signal, like in our example. The price target is the height of the triangle, and a stop-loss should be placed just above the upper trendline.
A symmetrical triangle, just as its name suggests, has symmetrical upper and lower trendlines which narrow by the end of the formation. Again, a break of the upper trendline signals that the price may trade higher, while a break of the lower trendline signals that the price may trade lower. In our example, you would enter a long position with the break of the upper trendline, with the target being the height of the triangle, and a stop-loss order placed just below the lower trendline.
What are Pivot Points?
Pivot points are significant price levels used by traders to determine potential support and resistance levels. As pivot points use the previous period’s high, low and close price to predict future price movement, they are considered as leading indicators. They are especially popular in the forex market, as pivot points require a very liquid market to provide reliable signals. There are many different methods of calculating pivot points, but we will stick to the most popular method – the five-point system.
How are Pivot Points Calculated?
The five-point system of calculating pivot points consists of five significant price levels which act as support or resistance levels. These are the pivot point, the support 1, the support 2, the resistance 1 and the resistance 2. As the names suggest, the pivot point is the most significant price level which acts both as support and resistance depending on the current price-level, while the support 1 and resistance 1 have higher importance as potential support and resistance levels and support 2 and resistance 2.
The following table summarizes how these points are calculated. Keep in mind that all price levels in the formulas are related to the previous period’s data.
Pivot Point (P) = (High + Low + Close)/3
Support 1 (S1) = (P x 2) – High
Support 2 (S2) = P – (High – Low)
Resistance 1 (R1) = (P x 2) – Low
Resistance 2 (R2) = P + (High – Low)
The pivot point is simply the arithmetic average of the sum of previous high, low and close price. The S1 line is the pivot point level multiplied by 2, minus the previous period’s high. The S2 line is the pivot point minus the previous high and previous low, etc.
It’s important to note that different time frames use different data to calculate the pivot point levels.
Pivot Points for 1-, 5-, 10- and 15-minute charts use the prior day’s high, low and close, the 30- 60- and 4-hour charts use the prior week’s high, low and close. Pivot Points for daily charts use the prior month’s data, and finally weekly and monthly time frames use the prior year’s data to calculate the pivot points. The following chart shows how pivot points look on the EUR/USD 4-hour chart, based on the previous week’s high, low and close prices. Keep in mind that once a week starts and pivot points are plotted on the chart, they remain the same for the entire week at the 30-, 60-, and 4-hour charts.
Using Pivot Points for Range Trading
Using pivot points for range trading is very straight-forward, as you can use all the pivot levels as regular support and resistance levels. If, for example, the price tests the S1 level and reverts back, it’s a good opportunity to open a long position just above S1, and to place stop loss just below the S1 level. On the other hand, if the price reaches the R1 level, you could trade the bounce off the level with a stop loss order just above the R1 level. The following chart shows the use of pivot points during a ranging market.
At point (1), the price tried to break the S1 level but failed, with the following candlestick closing above the support level. This gives an opportunity to go long, with a stop loss just below the S1 level. At point (2), the price tested the R1 level but reverted, signaling an opportunity for going short.
Using Pivot Points to Trade Breakouts
Trading Pivot Point breakouts is similar to trading regular support and resistance breakouts. Pivot levels won’t hold forever, and when they break they provide trading opportunities. The following chart shows how to trade pivot breakouts, combined with trading price reversals from the pivot lines. Trading pivot breakouts can be done in two ways: the aggressive way, where you enter a trade as soon as the pivot line breaks, and the safe way, where you wait for the price to test the broken pivot line again.
At point (1), the price breaks above the pivot point on the EUR/USD pair. Using the aggressive approach, you could open a long position right away at this point. At point (2), the price breaks the R1 level, but tests the same level again. This would give a good opportunity to enter the market the safe way. Point (3) shows the price testing the R1 level the next day, but failing to break it – this is where you would enter a short position. Point (4) shows a breakout of the pivot point, which would make a good trade based on the aggressive approach. And finally, the price tests the S1 level at point (5) signaling the opportunity for going long. Stop loss levels are always placed just above or below the previous pivot levels, depending on if they act as support or as resistance levels.
Using Pivot Points to Measure Market Sentiment
Pivot points can also be used to measure the current market sentiment. To do this, you simply need to determine if the price trades above or below the main pivot point (P). If the price trades or breaks above the pivot point, this signals that buyers are in charge and that the overall market sentiment is bullish. On the other hand, a break below the pivot point means that seller are starting to dominate, and the market sentiment shifts to bearish. The following chart shows an example of trading the break below the pivot point (P), with a stop loss places just above the pivot point.
Pivot points are a great addition to regular support and resistance lines, as they work great in the liquid forex market. We introduced the five-point method of calculating standard pivot points: the main pivot point (P), support 1 and resistance 1, and support 2 and resistance 2. Pivot points can be used both in ranging markets, where traders place trades when the price tests a pivot level and reverses, as well as trending markets, where breakouts above or below the pivot points give solid trading opportunities. Keep in mind that different timeframes are based on different pivot points calculations, and that all pivot points are calculated using the previous period’s data.
What is the Elliott Wave Theory?
The Elliott Wave Theory, named after Ralph Nelson Elliott, is a theory which suggests that financial markets (including the forex market) trade in repetitive cycles which are influenced by the overall psychology of the market participants in the market. According to Elliott, the upward and downward swings in the markets are caused by the expectations of the masses, forming an identifiable pattern of price movement which Mr.Elliott named the 5-3 wave pattern. This means that by correctly identifying the repetitive cycles, traders can predict where the price will move next.
These repetitive cycles are called “waves”, which can be further divided into impulse waves and corrective waves.
Impulse and Corrective Waves
The first 5 waves in the “5-3 wave pattern” are called impulse waves, while the last 3 waves are called corrective waves.
Among the first 5 waves, waves 1, 3 and 5 are motive, which means the follow the direction of the trend, while waves 2 and 4 are corrective.
Let’s take a look at the 5-3 wave pattern in the following graphic.
Wave 1 is the first wave of the pattern, which forms when a small number of people feel that the price is low and start to buy the financial instrument, causing the price to rise. At wave 2, some of the investors from the initial wave feel that the security became overvalued, and start taking profits, causing the price to fall. Wave 3, which is usually the longest wave, signals that the security caught the attention of the mass public, who enter the market and cause to price to rise again. At wave 4, some of the market participants take profits again, forming a new corrective wave. And finally, wave 5 is mostly driven by hysteria, where the mass public start buying again on various beliefs that the stock is still a bargain.
This is where traders whose trading decisions are based on analysis and not on following the crowd start to sell the security, forming the first correction move (a). The security makes a new high at point (b) again, before it continues its correction wave (c), with the price further falling down.
There are some important rules which you should pay attention to:
- Wave 3 can never be the shortest impulse wave
- Wave 2 can never break below the start of Wave 1
- Wave 4 can never enter into the same price area as Wave 1.
This was the brief explanation of the Elliott wave theory and its impulse (1,2,3,4,5) and corrective waves (a,b,c).
It’s important to note that Elliott waves are made of smaller waves, which in turn are made of even smaller waves and so on. These smaller waves are called fractals. They look the same as the longer waves, which means they are also made of impulse and corrective waves. The following picture shows the concept of fractals inside Elliott waves.
While looking at a chart, you will probably not see perfect waves right away. Instead, as each wave consists of smaller waves, which also consist of smaller waves etc., you need to look for the 5-3 wave pattern. Knowing how the whole cycle of Elliott waves looks like, it will be much easier for you to spot and trade this rewarding technical concept.
How to Trade with Elliott Waves
Let’s say you open up your trading platform and see something like this.
You can immediately identify that after an up-move (wave 1), the pair makes a correction move (wave 2). As you already know how Elliott waves form, you predict that the strong third wave is about to start and look for a level to enter. This is where you use the Fibonacci retracement levels, which we’ve covered in the previous articles. Elliott waves tend to respect Fibonacci levels for their correction moves. Let’s draw the Fibonacci levels on our chart.
As you can see, the correction move touched the 50% Fibonacci level before it continued to trade upwards. This is where you would enter your long position (red area), and catch the third wave! A stop loss order could be placed just below the 50% Fibonacci retracement level.
Elliott waves are among the hardest technical tools to master. You need to look for the impulse and corrective waves, as well as for fractals inside the waves to correctly identify all the Elliott waves. According to the 5-3 wave pattern, a complete Elliott wave cycle consists of 5 impulse waves making higher highs and higher lows, and three corrective waves making lower highs and lower lows. The first 5 impulse waves can be divided into motive waves which go in the direction of the trend (waves 1,3 and 5), and corrective waves which go against the trend (waves 2 and 4). Each of the waves consist of smaller and smaller waves, called fractals, which look the same as the bigger waves. Elliott waves often respect Fibonacci retracements, which can used to identify price levels for entering the waves at their beginning stage of development.
What are Harmonic Price Patterns?
Harmonic price patterns are a group of chart formations which are used to identify price retracements of trends. The price levels of these potential retracements are based on the Fibonacci retracements and extensions, which you’ve already learned from our previous articles.
Remember, it’s important to wait for the entire pattern for form, before we can make any trading decisions based on them.
Let’s now explain the most common harmonic price patterns, which are
· The ABCD Pattern
· The Three Drive Pattern, and
· The Gartley Pattern
The ABCD Pattern
The ABCD pattern is the simplest harmonic price pattern, which consists of the AB and CD lines (also known as “legs”), and the BC line which is called the correction or retracement.
Key rules for the formation of the ABCD pattern are:
- The BC line is the 0.618 Fibonacci retracement level of the initial AB line
- The CD line is the 1.272 Fibonacci extension level of the BC line
- The length of the AB line is equal to the length of the CD line
- The period it takes to form the AB line is roughly the same as for the CD line
If this looks complicated to you, just look at the following graphic and everything will become clear. It’s much easier to grasp difficult technical concepts when looking at a picture. The following graphic shows a bearish and bullish ABCD pattern, depending on if the form during an uptrend or downtrend.
The Three-Drive Pattern
The three-drive pattern is very similar to the ABCD pattern, except that it has one more leg (here called “drives”) and one more correction or retracement (3 drives and 2 corrections or retracements compared to the ABCD pattern).
All retracement and extension levels are the same as with the ABCD pattern.
- Point A is the 0.618 Fibonacci retracement level of the initial drive 1, while point B is the 0.618 Fib-level of the drive 2
- Drive 2 is the 1.272 Fibonacci extension level of the correction A, while drive 3 is the 1.272 extension level of the correction B
- The period it takes to form the corrections A and B, and the period it takes to form drives 2 and 3 should roughly be equal
The Gartley Pattern
The Gartley pattern is another harmonic price pattern, that is based on the basic ABCD patter. The only difference is that this pattern is preceded by a significant up- or down-move, and that the correction and retracement levels are slightly different.
As you already know how the ABCD pattern is formed, let’s jump over to look at a Gartley pattern on the following graphic.
As you can see from the chart above, all conditions for a bullish Gartley pattern have been met, and the price made a huge up-move after the complete pattern has formed! The stop-loss level can be placed just below the recent swing low (below the 1.272 extension level).
Summary Harmonic Price Patterns
Harmonic price patterns are based on Fibonacci retracements and extensions, and you need to wait for the complete pattern for form before entering buy or sell positions.
We have covered the three most common harmonic price patterns – the ABCD pattern, the Three-Drive pattern and the Gartley pattern. The three-drive pattern is basically an extended ABCD pattern, with an additional leg (“drive”) and extension. The Gartley pattern is also very similar to an ABCD pattern, only preceded with a significant up- or down-move. Harmonic price patterns might be difficult to spot in the beginning, but with a little practice you will be rewarded with an extremely powerful tool.
You already know what major currency pairs are. For reminder, major pairs are all pair that include the US dollar as either the base, or the counter currency, such as EUR/USD and USD/JPY.
Cross pairs don’t include the US dollar. When the forex market gained momentum after WW2, in order to exchange Swiss francs for Japanese yen for example, investors had to exchange the Swiss francs first for US dollars, and then the US dollars for Japanese yens. Fortunately, with the invention of cross pairs this is no longer the case. One can immediately exchange their national currency for the desired currency. Examples of cross pairs are: EUR/JPY, EUR/CHF, GBP/JPY, AUD/CAD and others.
Currency Cross Pairs give Additional Trading Opportunities
While the major pairs are all linked to the US dollar and its performance, currency crosses can give a variety of trading opportunities regardless on how the US dollar is performing. Traders around the world track the US dollar because it has the largest impact on the forex market. In fact, more than 80% of transactions include the US dollar! If the dollar performs well, this will usually universally reflect across all major pairs that involve the US dollar. Take a look at the following chart and notice how the performance of the dollar affected other pairs.
On the contrary, trading currency crosses opens a variety of trading opportunities with a limited impact of the dollar performance.
Currency Crosses are Less Stressful than Majors
As the largest economy in the world, the United States regularly report a lot of economic data which have a significant impact on the forex market, especially the major pairs. Those reports often cause huge spikes in pairs that include the US dollar, which can make it more difficult to spot beginnings of trends or reversals. On the other hand, cross pairs often have a smoother price action making them less stressful to trade than the major pairs. Take a look at the following chart with the EUR/USD on the left, and GBP/JPY on the right. The cross pair made a much smoother ride to the bottom, with less spikes, than the EUR/USD pair.
Profiting from Interest Rate Differentials
Trading the differentials in interest rates, also called a “carry trade”, is a very popular forex trading strategy. As the name suggests, it’s based on interest rate differentials between two currencies. Traders buy the currency with the larger interest rate, and sell the currency with the lower interest rate.
A popular example of carry trades is the AUD/JPY trade. The Reserve Bank of Australia had raised its interest rates to 6.25% from 2002 to 2007, while the Bank of Japan kept their rates at record low 0%. As a result, the Australian dollar skyrocketed in value against the Japanese yen. Not only did traders profit on the AUD appreciation, but also on overnight interest rollovers on both currencies as they were long on AUD and short on JPY.
Obscure Currency Crosses
Any cross pairs that don’t include the euro or yen can be very difficult to trade. Those include pairs such as AUD/CHF, CAD/CHF, AUD/NZD and others. Since very few traders trade these crosses, their liquidity is usually low which results in huge price fluctuations. In addition, these pairs tend to have very wide spreads, so you would better avoid them all together unless you have a secret trading strategy for obscure currency crosses! The following chart shows how hard it can be to trade these crosses, like NZD/CHF for example.
What is a Time-Frame in Forex?
A time-frame in forex refers to the period in which a candlestick forms on the chart. There are many time-frames available in forex trading, from the 1-minute TF to the monthly TF, and anything in between such as 30-minutes, 1-hour, 4-hours, daily and weekly time-frames. A smaller time-frame is essentially a zoomed-in larger time-frame, as the following charts show. A candlestick on the left (daily) chart represents one day of trading, while a candlestick on the right (4-Hour) chart represents 4 hours of trading. Six of the 4-Hour sticks form a daily candlestick.
What Time-Frame is Best for You?
The best time-frame to trade depends pretty much on the trader’s personality. Some traders that like excitement and fast-paced trading would choose the 5-minute, 15-minute or 30-minute charts, while others prefer the daily and weekly charts. However, keep in mind that the market can act very unpredictable on shorter time-frames, and create a lot of false signals.
New traders to forex usually rush to make profits and choose very short time-frames, which leads to overtrading and accumulation of losses. You should always practice first on a demo account and choose which time-frame suits you best before moving to a real account.
Breakdown of Time-Frames
Which time-frame to choose depends again on you. Long-term and fundamental traders tend to stick to longer time-frames, such as the daily or weekly. This gives them enough room to analyze the market from a fundamental aspect, but the larger price swings on those charts also require a larger trading account and wider stop-losses.
Swing traders usually use anything between a 30-minutes to a 4-hour time-frame. They hold trades for several hours to a few days, and have more trading opportunities compared to long-term traders. As a drawback, the transaction cost also raises with more positions.
Intraday traders use short time-frames, such as the 1-minute, 5-minute or 15-minute time-frame. Trades are held during the day and exited by market close. This gives a lot of trading opportunities, but also increases the transaction costs that need to be paid. The unpredictable market behavior on short TFs makes intraday trading also more difficult and risky than swing and longer-term trading.
The following table presents the major advantages and drawbacks of the mentioned trading styles.
Using Multiple Time-Frames in Trading
Using multiple time-frames when analyzing the market is a powerful technique in forex. Price tends to act different on shorter and longer time-frames, and trends that are established on longer time-frames may not be recognized on shorter ones. Furthermore, support and resistance levels are stronger on longer TFs, but you can get better entry and exit points on shorter TFs. This is why you want to have the bigger picture of the market by analyzing multiple time-frames simultaneously.
When you open your preferred time-frame, let’s say the 4-hour time-frame, jump to the daily to see how the price is acting and if a trend is established, and then switch to the hourly TF to get better entry and exit points. This way, you get more information from the market than just looking at the 4-hour chart.
Guide to Market Sentiment
The forex market is made up of many traders, investors and companies that sell their goods and services overseas in different currencies. It’s said that the price contains all available information, which means that with a disciplined trading approach and fundamental and technical analysis all traders can be consistently profitable.
However, obviously this is not the case. Two different traders can have very opposite views on where the market is heading – one might be bearish and the other bullish. Now imagine that all market participants have an impact on the market, just with their different views on the market. As with any other financial market, this is also the case with forex, and at this point market sentiment analysis comes into play.
Market sentiment is simply a measure of the overall emotional and psychological state of forex market participants. It gives us clues about what percentage of market participants are currently bullish or bearish on the markets. A number of reports and indicators provide us with valuable information about the current market sentiment, the most famous of which is the Commitment of Traders report.
What is the Commitment of Traders Report?
The Commitment of Traders report (COT) is published every Friday at around 2:30 pm EST by the Commodity Futures Trading Commission (CFTC). The report measures the net long and short positions taken by traders, and in this way, provides important information on whether the market sentiment is leaning more to the bullish or bearish side.
You can find the COT report on CFTC’s website here:
Scroll down to the “Current Legacy Reports” and find “Chicago Mercantile Exchange” on the list. After that, click on the “Futures Only” short format in the same row on the right.
You might ask yourself why do we use reports from the futures market. As forex is traded OTC (over the counter), there is no way to get the current open positions on the spot FX market, and the futures market is therefore our best shot to try to measure the market sentiment.
How to Read the COT Report?
After you open the short format of the report, you will get a table of future contracts that are published in the report. Just scroll down to find the instrument you’re interested in (currencies), which will look something like this for the euro:
The report shows the total non-commercial (i.e. speculators and traders), commercial (i.e. big companies that try to hedge their currency risk) and nonreportable (i.e. positions that do not meet the CFTC’s reporting requirement) positions on the market.
Traders focus on long and short positions of non-commercial traders, and try to spot extreme levels on long and short positions. For example, the report above shows that almost twice as much non-commercial traders are currently long on euro futures (187,053 contracts), compared to traders who are short (96,220 contracts). This signals that the majority of traders reported by the COT report are bullish on the euro.
How to Interpret and find Tops and Bottoms with the COT Report?
Simply said, hedgers (commercial traders) buy when the market is at its bottom, while speculators (non-commercial traders), sell as the price falls. This means, positions of commercial traders can be used to determine possible market tops and bottoms (reversals), while positions of non-commercial traders can be used for trend following. Of course, it might be hard to determine when a sentiment extreme will occur, that’s why the best way to trade COT reports is to combine them with fundamental and technical analysis.
Another way to determine the current market sentiment is to calculate the percentage of long and short positions. A simple way to do this is using the following two formulas:
% long = number of long positions / (long + short positions)
% short = number of short positions / (long + short positions)
From our example above, we can calculate that around 66% of non-commercial traders are net long (187,053 / (187,053 + 96,220)). The higher the percentage, the higher the chance that the market will move in that direction. Generally, a percentage of 80% or above is a strong signal that the market will be bearish or bullish.
Trading the News
Just like with stock markets, the news is ultimately what makes currencies move. Traders around the world closely watch forex news and announcements, which can change their perception of the market and a particular currency in a matter of seconds. This is what makes support and resistance lines break, and how trends reverse and establish. Knowing the fundamentals and market perception by following the news is just as important as knowing the main technical levels of a currency pair.
Trading the news can be very profitable if you correctly predict how the market is going to move. However, news trading has also its drawbacks. Spreads can widen significantly during major news releases as traders bet heavily on one side of the market. This will also increase your transaction costs, as spreads can widen as much as 50 pips in some cases! In addition, slippage can occur when you try to open your position, which means that your order might not be triggered at the price at which you placed your order, but at a far different price.
When trading the news, you should stick to the majors as they are the most liquid pairs and can help to lower your transaction costs (spread) and slippage during important news releases. The most liquid currency pairs include EUR/USD, GBP/USD and USD/JPY, and these three pairs are also the most traded pairs worldwide.
The price volatility just before the news release can also be hectic and without a clear bias, as market participants open their speculative orders and try to guess how the release will affect the market. The following table shows the times at which various countries release their important news.
Which News Releases Should I Trade?
There are many news releases in the forex market on a daily basis, but the most market-moving releases tend to be those related to the US dollar. The dollar is the world’s most traded currency, as well the main reserve currency of central banks worldwide, which makes the dollar-related news the most important in the market.
The following table shows which releases move the market the most:
Table Goes Here
Out of these news, the labor data (unemployment and NFP) tends to have the largest impact on the market, with an average pip movement of more than 140 pips on the EUR/USD pair during the release.
Several days before the actual news release, economists and analysts will publish a forecast (market expectation) of the actual release. This number is called the market consensus. Once the news is released, that released number is called the actual number.
For example, if the United States are expected to release the US unemployment rate, and the market consensus is 5.5%, if the actual number is above the consensus this will have a negative effect on the US dollar, and if the actual number is below the consensus this will have a positive impact on the currency.
Buy the rumors, sell on the news.
You will often hear this phrase not only in the forex market, but in other financial markets as well. This phrase refers to the fact that most traders trade based on their own market expectations for a given news report (the rumor). Once the report shows that their market expectations were incorrect, they will close their positions and the market will move in the opposite direction. Rumors will have one effect on the currencies, and news (actual numbers) can have an opposite effect.
How to Trade the News with a Directional Bias?
News can be traded in two ways:
· With a directional bias
· With a non-directional bias
Trading with a directional bias means that you already have a guess on what numbers will be released in the report and where the market will move. Let’s go back to our example with the US unemployment rate. You could research what the consensus and actual number were in the past, and try to guess what the actual number will be now. Remember, we said that the consensus number is 5.5%.
Let’s say the US unemployment rate was steadily increasing in the past months, which brings you to the conclusion that the actual number could be worse than the consensus number. This would lead to a fall in value of the US dollar, and you have a directional bias about that.
Trading with a non-directional bias means that traders don’t have a guess on where the markets will be going, but they do know that news releases will create sufficient price volatility to profit from wherever the price decides to go! Essentially, you are prepared to trade the market in either direction, and don’t worry much about the actual numbers that are released.
Trading with a non-directional bias can be done with the straddle strategy. In general, you would place two limit orders before the news release: one above the previous swing high, and one below the previous swing low. When the numbers are released and the market starts to move, one of your limit orders will be triggered and you will have an open trade just by trading the market volatility of the news release! The following chart shows how the trade with the straddle strategy.
On September 1, the US reported the non-farm payrolls which missed expectations (156K actual vs. 180K consensus). However, by placing two limit orders just like on the chart above, you could catch the huge 50-pips movement just after the NFP release. With a trailing stop of around 10 pips, you could still make a nice profit of 40 pips in 5 minutes. However, as mentioned earlier, due to increased spread and possible slippage, the straddle strategy might be relatively less profitable than taking a directional bias and opening a position before the numbers are actually released.
Trading the news can be profitable if you know how to handle the risk associated with it. There are many news that are released daily and which have a large impact on the forex market, but the most market-moving releases tend to come from the United States.
There are two main ways to trade the news: with a directional bias, and with a non-directional bias. While trading with a non-directional bias might look easier at first, as you don’t have to guess where the market will go, it’s also riskier as it can involve higher spreads and a potential slippage. It’s also a good idea to stick to the major pairs when trading the news, as due to their liquidity they will usually have lower spreads.
What is a Carry Trade?
In forex, you can make money even if the price of the currencies doesn’t move. In fact, many large investors with a large amount capital do this, and it’s called “carry trade”.
A carry trade involves buying a currency which pays a larger interest rate, and simultaneously selling or borrowing a currency with a lower interest rate. In this trade, you are collecting the higher interest rate on the currency you bought, while paying a lower interest rate on the currency you sold or borrowed. You make a profit only from the interest rate differential of the currencies involved.
It’s a simple yet very profitable strategy, considering the daily interest payments in the forex market and the availability of leverage. If you hold a position overnight, your broker will automatically credit/debit your account with the overnight interest rate difference. This is also called “rollover cost” in the FX jargon.
The following table shows the current interest rates on major currencies in October 2017.
In the past, a popular carry trade was buying AUD and selling JPY, but most central banks slashed their interest rates to spur economic growth and inflation after the 2008 economic crisis. The NZD/CHF pair offers the largest interest rate differential as of October 2017. A simple long position on NZD/CHF would collect a 2.50% yearly interest rate, but with the help of leverage, the possible profit can be much larger (as well the loss if the position goes against you.)
When do Carry Trades Work?
Carry trades work best when risk-aversion among investors is low. This means, they are optimistic and want to buy higher-yielding currencies and sell lower-yielding ones. When risk-aversion is high (i.e. a risk-off market environment), investor will put their money into safe-haven, low-yielding currencies such as the US dollar, Swiss franc and Japanese yen, which will make them appreciate in value. The capital loss on selling/borrowing these low-yielding currencies in carry trades will then offset any interest gain.
Market expectations of future interest rate hikes are also important, as countries that perform well might have to hike their interest rates in order to control inflation. This in turn will have a direct impact on a carry trade position.
On the other hand, when a country is not performing that well, chances are it will have to lower interest rates to spur economic activity.
Criteria and Risk of Carry Trades
As mentioned above, finding a possible carry trade is pretty simple. All you have to do is to watch for (1) the interest rate differential, and (2) for an uptrend of the higher-yielding currency.
As you can see, the AUD/CHF pair fulfills both criteria. The pair has a 2.25% interest rate differential, and the following chart shows that the Australian dollar is trending up since late 2015.
However, just like any trade, carry trade involves the risk that the position goes against you (i.e. AUD falls in value), offsetting any interest gain. To prevent this, you should put an appropriate stop-loss that will protect you against heavy losses, but that still gives enough room for the pair to fluctuate as carry trade is longer term strategy.
Summary Carry Trades
Carry trades can be very profitable if the interest rate differential is high and if the high-yielding pair is trending up, especially with the use of leverage. A carry trade involves buying a higher-yielding currency and selling or borrowing a lower-yielding one. The interest rate differential represents the potential profit if the price of the pair remains flat, and the interest rates don’t change. Your broker will automatically add the interest gain to your account if you hold the position overnight, called rollover. However, today’s interest rates are relatively low compared to past numbers, and you should always use a stop-loss to limit your risk if the trade goes against you.
Contract for Difference (CFD) Trading
The foreign exchange (also called forex or fx) market is more than buying and selling currencies to make a profit. There is no such thing as typical fx trading. Different methods are used to create a profit, depending on personal preference of the trader. One method is Contract for Difference (CFD) trading. CFD is a method of trading the forex that allows the trader to not just profit from the end price of a given currency, but from the changes in the price of a currency.
How CFD Trading Works
Typical online CFD trading might go something like this: A trader enters into a contract to purchase euros in a standard lot of 10,000 at a value of $1.50 (USD) each. The trading period ends with the price at $1.55. The profit is $0.05 each, which totals $500 for the lot, minus the pip spread that the broker charges.
Although a trader may enter into a CFD intentionally, he or she doesn’t need to consciously trade CFDs. Technically, all forex transactions are CFD trades. The goal for all traders in all transactions is to buy low and sell high. A trader entering the market with a buy or sell order at the time of purchase is known as the price entry. The profit or loss happens when the trader exits the trade and pays the pip spread. Knowing what the market is going to do next depends on the skill, knowledge and experience of the trader, as well as how the trader uses the information at his or her disposal.
Generally, CFDs are entered when there is a trend noted in the forex market. The forex trend is an extended view of the direction of the market. Instead of drastic highs and lows, there appears to be a slower, consistent movement in a particular direction. The forex rate can trend in one of three ways: It can go up (bullish), down (bearish), or sideways (consolidation). A bullish (or long) market is a trend upwards (higher highs and higher lows). A bearish (or short) market is a trend downwards (lower highs and even lower lows).
This information may seem overwhelming to the beginner forex trader, but by taking small steps, the new forex trader will begin to understand that each piece of information fits into the puzzle of what makes a trader successful.
How to Day Trade the Forex Market
Learning to trade currencies is a process that takes time. Successful traders will generally choose a strategy that suits a particular goal or lifestyle. One such approach gaining in popularity is Forex day trading. A trader using this particular tactic typically holds a position for no more than 24 hours.
On the other hand, an intraday trader holds a position for more than 24 hours, but generally not long-term. Positions held in intraday Forex trading might be for just a couple of days or weeks, but can sometimes be longer. When considering Forex trading strategies, the successful trader will not choose just day or intraday trading, but may see fit to combine both methods, depending on the circumstances.
Automating Short Term Trades
There are different types of day trading and intraday trading systems, which will perform trades automatically, based on pre-set parameters. The use of one or more automated trading systems, combined with a thorough Forex education is the mark of the knowledgeable trader. However, using too many systems or indicators (or using the wrong one) can create confusion and lead to losses.
Choose a day trading system that aligns with your individual trading personality. Each trader is different; trading systems should be unique and flexible to fit the needs of the individual. Some day trading systems offer buy and sell signals for a trending market, while some offer signals for a sideways market. Using a trading system is not the only avenue of finding success, but for many traders, it’s an easy way to stay on top of the market.
It’s not difficult for the average person to learn day trading. However, it takes a certain degree of dedication and study to fully understand the benefits and drawbacks. Everyone learns at his or her own pace, and a number of Forex learning systems cater to self-paced learning. Understanding the natural up and down wave movement that is a daily part of the Forex market is the first step toward a successful trading career; knowing yourself and your goals is equally important. Taking the time to identify your goals will help to uncover your particular trading style. Whatever style or strategy you choose, there is information and education available to sharpen your skills and broaden your knowledge to help you gain the advantage.
Trading Forex Futures
Forex futures is a derivative of the Forex market. However, the volume of Forex futures trading is about 1% of the total Forex market. This market operates in much the same way as traditional futures, such as for commodities: The futures are purchased on a contract, which specifies the currency pair(s), the amount, the date of purchase, and the price of the purchase on that date.
How Forex Futures Work
Although the Forex market is not centralized and is operated from various countries around the world, the majority of Forex options, including futures, are traded through the Chicago Mercantile Exchange (CME) and its partners, including brokerages.
Currency futures trading was introduced in 1972 by the CME. Due to the lack of access to the interbank exchange markets that some commodity traders suffered, the International Monetary Market (IMM) was created in the same year. The IMM is now a division of the CME, which averaged 754,000 futures contracts per day, according to 2009 reports.
Technically, when trading Forex futures, the trader is no longer trading over-the-counter (OTC). Futures are offered only in whole numbers, unlike the spot market. It’s also important to note that all futures quotes on the Forex calendar are made against the U.S. dollar (USD).
Once you decide to trade Forex futures, your broker will give you the specifics on the transaction: contract size, time line, pip spread, pricing limits, etc. The option to hedge or speculate on the trade should be detailed in the contract as well. Signals also come into play here. The best Forex signals may or may not include futures signals, so examine the signal software you choose, carefully.
Hedging vs Speculating Forex Futures
Hedging and speculating are quite common on the Forex futures market. Hedging is used to neutralize or mitigate the effect that fluctuations in the currency market have on international revenue. On the other side of the coin, speculating is a way for traders to maximize profit potential by incurring more risk.
The Forex market alone is not without risk; the Forex futures market can involve even more risk. Although not recommended for beginner Forex traders, it pays to understand all derivatives of the Forex to get a better grasp on the market as a whole, and to be able to anticipate trends.
How to Use Forex Market Indicators
Foreign Exchange indicators and charting software can be a great deal of help for savvy traders who know how to use them when trading the Forex. When making this important decision, consider these key points:
- What can one Forex charting software or indicator offer that others cannot provide?
- What is the percentage of winning trades that actually come from using this indicator or software?
- Can a particular Forex system be paired to work with another system?
These questions are important when considering committing to one or more systems. Since one system is usually not sufficient for all market conditions, working with a variety of Forex indicators or charting software may make the critical difference when trading based on the commonalities found on each system. Utilizing multiple systems could put the best winning percentage on your side.
Why Traders Need to Use Indicators
Why use indicators and software while trading? The short answer is timing and precision. In trading the Forex, everything comes down to percentages. For example, a given trade has a certain percentage of winning; it also has a certain percentage of losing. Using the Forex indicators and software tools at your disposal, can enable you to trade quickly in response to the actions of the market. You can also start building and charting your percentage of winning and losing trades, which will enable you to get a feel of the market, building your confidence as a trader.
After you find FX charts and indicators that you like to work with, try combining two or more of them to build a system that will help you to locate and execute high percentage winning trades automatically. This will enable you to monitor the different Forex charts and wait until the Forex trade signals on each one agree on a promising trade.
Trading the forex market can be great deal of fun, but it has risks. Using indicators and charts to build trading systems are vital for traders who wish to take full advantage of available tools to find the highest percentage winning trades.
How to Trade Currency Crosses with Fundamental Announcements
Currency crosses are a popular choice among traders who trade the news. Simply said, you want to match a good performing currency with a currency that performs not that well. If, for example, the Bank of England decides to raise interest rates, your first thought might be to buy GBP/USD. However, what if the US economy also performs well and the US dollar appreciates? The price action on GBP/USD could be flat.
With currency crosses, you could match GBP with a currency that doesn’t perform that well. Let’s say Japan reports economic data that missed market expectations. Buying the GBP/JPY could be a much better choice than buying GBP/USD in this case.
Synthetic Currency Pairs – And Why You Shouldn’t Trade them
Synthetic currency pairs are usually created by big institutional traders, who want to place large orders on the forex market but can’t due to the lack of liquidity in some currency pairs.
Let’s say a big trader wants to place a large long order on GBP/CHF. As the pair isn’t as liquid as the majors, the big trader creates a synthetic pair by buying both GBP/USD (buy GBP, sell USD), and USD/CHF (buy USD, sell CHF), which both are highly liquid pairs. The sell and buy USD positions cancel each other out, and the institutional trader is left with a long GBP/CHF position.
However, retail traders shouldn’t try to replicate those large traders. First, many brokers often a variety of cross pairs so that you can immediately place an order on any cross pair you like, paying relatively tight spreads compared to synthetic pairs. And second, as a synthetic pair involves the opening of two separate positions, you would have to lock up unnecessary capital of your trading account which increases the chances of a margin call.
Unless you have millions available to trade on forex, it’s better not to mess around with synthetic currency pairs.
The Characteristics of Major Currency Crosses
As noted earlier, the euro and yen are the most traded currencies after the US dollar. And as many countries also hold a significant amount of euro and yen as their reserve currencies, they’re also among the most liquid currencies.
Euro crosses: Euro crosses include all pairs that include the euro as the base or counter currency, but exclude the US dollar. Examples of euro crosses are EUR/JPY, EUR/CHF and EUR/GBP. Any news from these countries tend to have a much larger impact on these pairs then US news tend to have. Switzerland and Great Britain, for example, trade the most with the Eurozone, and traders watch for economic releases from these countries to determine whether their currencies will raise of fall against the euro. The Brexit vote in 2016, for example, had a big impact on the EUR/GBP pair, as the following chart shows.
Yen crosses: Beside the euro, the Japanese yen is also a popular currency in cross pairs. They include EUR/JPY, GBP/JPY, AUD/JPY and NZD/JPY. Nevertheless, traders should also follow the USD/JPY pair, as a break of major support and resistance levels on this pair tends to spill over to yes crosses as well. This means, if the yen is appreciating in USD/JPY, it might also appreciate across yen crosses, and vice versa. The yen crosses are also often used for carry trades, as interest rates on the yen have long been among the smallest in the world. The AUD/JPY pair, which we already mentioned, was a popular carry trade choice. The next chart shows the AUD/JPY carry trade until 2007.
How to Use Crosses to Trade the Majors?
Currency crosses can provide valuable clues about the relative strength of major currency pairs. For example, if you see potential trade setups to go long on GBP/USD or short on USD/JPY, how would you decide which trade to take? An answer to this might be hidden in currency crosses, specifically the GBP/JPY cross. If the pound is relatively stronger than the yen, i.e. the cross pair is trending upwards, this might be a signal to go long on GBP/USD.