Secrets of Winning Forex Strategies

Chart 1.17B: The triple top - EUR/JPY

The Downtrend 1) RIDE THE TREND WITH PULLBACKS AND PAUSE A downtrend can be identified by a series of lower lows and lower highs. Similar to an uptrend, the price does not move in a straight line when it trends down. There will be periods of pausing and rebound or pullbacks, which present trading opportunities. By trading on the pullbacks you can ride on the trend and profit from the action, and then wait for reversal patterns to trade again. Chart 1.18: The downtrend - USD/CHF (28 Dec 07)

Chart 1.19A: The pullback Chart 1.19B: After the pullback

Bearish Flag Not all downtrends are alike. Sometimes, the price will fall gradually to form a smooth downtrend that can last five to six hours before it reverses, as seen in the chart 1.18. Some downtrends are shorter, lasting one to two hours before reversing. For shorter term downtrends, they generally have more steep vertical declines in price, forming more than one flag. The pauses and consolidations form the rectangle. Trading the Bearish Flag Once the price breaks the lower trend line, you will sell and ride the downtrend. Chart 1.20A: Bearish flag

Chart 1.20B: Bearish flag of EUR/CHF

Bearish Pennant As you know, when price falls, it does not fall in a straight line, just as in an uptrend. During a downtrend, the price may move sideways and take a longer pause. This will lead to the formation of a bearish pennant pattern. The pennant generally appears as a triangle shape. Trading the Bearish Pennant You will enter to sell when the price breaks below the lower trend line of the pennant. Chart 1.21A: Bearish pennant

Chart 1.21B: Bearish Pennant - EUR/USD

End of Downtrend There are a few patterns to mark the end of a downtrend. Some may end swiftly with the appearance of one or more candlestick reversal patterns and then move up. But sometimes, there is more resistance for the price to reverse, and a struggle between the bear and the bull takes place over a time period. When this happens, it will lead to formation of a series of highs and lows to form three common reversal chart patterns – the inverse head and shoulder, double bottom, and triple bottom forma- tions before the downtrend is finally reversed for the price to move up. The first sign of the reversal is generally the appearance of certain candlestick reversal patterns. The other sign will be an upside penetration of the trend line and the formation of a higher low (see chart 1.22A and 1.22B). First, we look at five common candlesticks, which are useful to indicate that the downtrend will soon reverse. Chart 1.22A: A break above the trend line

Chart 1.22B: A trend line break after a downtrend CANDLESTICKS REVERSAL PATTERNS 1) Bullish Engulfing Pattern 2) Hammer 3) Bullish Harami Cross 4) Morning Star and Morning Doji Star 5) Spinning Tops

BULLISH ENGULFING PATTERN This is a pattern formed by two candlesticks. The first is a black candle and the second is a white candle that is longer than the previous candle engulfing it. The presence of shadows is not important in this case. HAMMER The shape is exactly like the hanging man pattern but it appears at the end of a downtrend. It has a small body and long lower shadow (with no upper shadow). The smaller the body and the longer the long lower shadow, the better the actual signal. It does not matter if the body is black or white.

Chart 1.23: Bullish engulfing Chart 1.24: Hammer

BULLISH HARAMI CROSS The bullish Harami cross consists of a big black candle followed by a doji that forms within the length of the black candle. MORNING STAR AND MORNING DOJI STAR This is a bullish reversal pattern that consists of three candlesticks. The first candle is a long black candle followed by a smaller body candle which can be black or white and the third candle is a white candle that closes more than 50% of the first black candle. If the middle candle is replaced by a Doji, then it is called a Morning Doji Star and it is an even more reliable reversal signal

Chart 1.25: Morning star Chart 1.26: Morning doji star

SPINNING TOPS The appearance of one or more spinning tops after a downtrend indicates weakness in selling pressure and that a potential reversal may take place. Chart 1.27: Spinning top

TWEEZER BOTTOM The tweezer bottom is formed by two candlesticks with bottoms of equal length. The bottom can be composed of real bodies, wick and/ or dojis. A tweezer bottom appearing in a downtrend is a reversal signal telling you that selling pressure has eased and the trend is set to go up. In real market conditions, you may see a few variations of the pattern whereby the two candles may not always appear to be side by side but separated by two or more candles (see below). TWEEZER BOTTOM VARIATIONS

Chart 1.28: Tweezer bottom

Inverse Head and Shoulders Pattern This pattern is identical to the head and shoulders pattern discussed earlier except that it is now inversed. It happens at the end of the downtrend and signals a reversal. The left shoulder is formed when the price dips down and then rebounds before it falls again to a lower low to form the head. The right shoulder is formed when the price dips again to try to form a lower price than the head but fails and then creates a higher low. By connecting the highs of the pattern, the neckline is formed. Chart 1.29A: Inverse head and shoulders pattern

HOW TO TRADE THE PATTERN Buy when the price rises above the neckline on the right shoulder. DOUBLE BOTTOM PATTERN Double bottoms are identical to double tops except they work in the opposite way and thus create a buy signal. Double bottoms basically tell us that the market has tested a price level on two occasions, and on both times refused to go lower. Chart 1.29B: Inverse head and shoulders formation

Chart 1.30A: Double bottom They can also come in the form of triple and quadruple bottoms. Chart 1.30B: Triple bottom

Chart 1.30C: Double bottom - USD/JPY (03 Jan 08)



The Sideways Movement Sideways movements are common in the forex market. They can occur for a few reasons, such as when the market is taking a rest and consolidating after a considerable uptrend or downtrend. They can also occur pending the release of news and economic data that will determine the market’s next move while many traders are sitting by the side line. While there is no way to predict how long the market will be in the consolidation phase, it can last as short as two hours or as long as up to six hours. There are two types of sideways movements. The consolidation phase can take place within a very narrow price range and looks like a flat line as seen in Chart 1.31C, or it can move in a broader price range of 20 to 30 pips, making it choppy to trade, as seen in Chart 1.31E. TRADING SIDEWAYS MOVEMENTS Draw the support and resistance lines and wait for a breakout above the resistance line or a breakout below the support line. In general, after a breakout, there is a tendency to trend in one single direction, as shown in Chart 1.31C, 1.31D and 1.31E which makes it a very rewarding trade. Just ride on the trend and count your profit along the way.

Chart 1.31A: Sideways breakout leading to an uptrend Chart 1.31B: Sideways breakout leading to an downtrend

Chart 1.31C: Sideway - USD/CHF (28 Dec 2007) Chart 1.31D: Sideway - GBP/USD (07 Jan 08)

Chart 1.31E: Range trading EUR/JPY before a breakout

Training the Eye Now that you have learnt how the patterns and trends look, you will be able to spot these trends and patterns in real time the next time you see them. Once spotted, you should visualise what will happen next in your mind and see for yourself if the trade turns out the way you have planned. Of course, there will be times when it does not play out the way you want it to. However, as you watch it happen a few times, you will become a more confident trader. Practice makes perfect. HOW TO PRACTISE 1) Practise on your demo account. Spot these patterns in real time and apply your trading strategy. 2) Find these patterns on historical charts and see these patterns repeating themselves. Practise on a daily basis. The more you practice, the more profitable you will become.

Principles for Trading A systematic approach to trading is essential to increaing your success in trading. Here are six simple steps that will guide you in your trading. 1) Determine what kind of trend it is 2) Determine if it is at the beginning, middle, or end of a trend 3) Think what is likely to happen next 4) Decide on the trading strategy 5) Prepare your set-up by identifying your entry and exit levels 6) Be patient and wait for the trigger before you enter In Part II of the book, you will learn the tools that you can use to trade with the trends and patterns discussed in Part 1 of the book.



PART II Forex Trends and Patterns in Action

PART 2.0 Determining the Type of Trend THE IMPORTANCE OF KNOWING THE TREND IN TRADING In Part I of the book we showed you the different types of trends. There is uptrend and downtrend, as well as no trend. No trend is also referred to as a sideways market. Each trend will require a different strategy to trade. A strategy that works for an uptrend may not work in a sideways, no-trend market. This is why it is very important to know which trend you are trading. Knowing the trend will determine the right strategy to use for trading that particular trend. The appropriate strategy will call for the use of the appropriate setup, chart patterns, as well as choosing the appropriate indicator to use for trading that particular trend. More importantly, you want to trade with the trend. You may have heard the phrase, “the trend is your friend”. Indeed, you should make the trend your friend. When it is an uptrend, you want to trade with the uptrend and go long, but not go against it by shorting the market, as you will be wrong. Learn to trade with the trend. In Part II of the book, we will introduce to you the technical tools that you can use to confirm the trends and to plan your trading setup.

HOW TO DETERMINE A TREND Sometimes it is easy to know there is a trend. One look at the chart and you can see prices going higher and higher. It is an uptrend. Sometimes, it is not so clear cut. While prices are going higher, it seems to be coming down just as fast as it is going up. So how do we determine the trend? What can we use to help us determine the trend? Trend Lines One of the tools involves the use of trend lines. In an uptrend, you will notice the trend will hug the trend line. When it is time for the trend to end, the price will cut through the trend line, and this is a signal that the direction of the trend has changed. Chart 20.1 shows an example of a simple trend line. In the chart, an uptrend line is drawn on the chart. The uptrend line is drawn by trying to connect two price lows to form an upward sloping line. With the trend line, we can see clearly that price is moving higher. We can say that the price is in an uptrend. As long as the price stays above the uptrend line, it is in an uptrend. When the price moves below the uptrend line, it means a break from this uptrend, and it is a sign of an end to the uptrend.

Chart 20.1: Connecting two low points to form an uptrend line From the uptrend line, another line parallel to it is added to the chart and placed at the highs of the uptrend. Together, the uptrend line and its parallel line form an up- trend price channel. The price should stay within the uptrend channel as it progresses higher, and once it breaks the uptrend line on the downside, we can say that the uptrend is over.

Chart 20.2: Trend lines on uptrend movement Trend lines can be drawn for downtrends as well. Below (Chart 20.3) is an example of trend lines drawn on the downtrend. We can draw a downtrend line by connecting two important lower highs to get the downward sloping downtrend line. In the example, the downward sloping trend line is constructed by joining three lower highs to form the downtrend line. With more points used to form the trend line, the trend line is usually stronger and it will take a strong move to reverse out of the trend line.

Chart 20.3: Drawing a downtrend line with three lower highs We will draw the downtrend line and follow that up by drawing a parallel line to the downtrend line. With these two lines, we’ll have a downtrend price channel. As long as the price stays within the downtrend channel, the downtrend is intact. Once the price moves out of the downtrend channel, we can say that the down- trend is over. There is an end to the downtrend.

Chart 20.4: Trend lines on downtrend movement Sometimes, the price may not be in an uptrend or downtrend. It can be in a sideways movement. In a sideways movement, the trend lines will be horizontal. It will not be upward sloping or downward sloping. We can draw this horizontal line by using similar highs to form the upper horizontal line. We can do likewise for the lower horizontal line. With these two horizontal lines, we can have a sideway prices channel. An example is shown below in Chart 20.5

Chart 20.5: A sideways price channel With trend lines drawn across the chart, the trend looks so much more obvious. You can draw multiple trend lines on the chart as well. There can be a trend within a bigger trend in itself too. In the example below (Chart 20.6), we have a major uptrend. Within the major uptrend, there were two minor uptrend, a sideways movement, as well a short downtrend.

Chart 20.6: Trend within a trend, using trend lines One indicator we can use to confirm the direction of the trend, be it an uptrend, downtrend, or no-trend sideways market is by using a moving average indicator.

WHAT IS A MOVING AVERAGE? A moving average is a series of data added together and divided by the parameter to determine the average of the data series. The advantage of using a moving aver- age is that it helps to smooth the series of data points and reduce random move- ment. In this way, the moving average gives us a more meaningful result by taking out random data points. There are three basic types of moving averages. They are: 1. Simple moving average (SMA) 2. Exponential moving average (EMA) 3. Weighted moving average (WMA) The difference between the three types of moving averages lies in their calculation. Simple moving average (SMA) All the data is added up and divided by the number of data to get the average. All data is treated the same regardless of being earlier or later in the sequence. Exponential moving average (EMA) A greater importance is placed on the latest data, with the latest data given greater weightage in the calculation. Weighted moving average (WMA) The weighted moving average theory is similar to the exponential moving average theory. The latest data is given greater weight compared to earlier data. The differ- ence between the weighted moving average and the exponential moving average lies in the weighting used in the moving average calculation.

While both the exponential and weighted moving averages will be faster and more sensitive to price movement than the simple moving average, their speed and sensitivity are not so great as to produce a significantly different result. There is only a subtle difference between the three moving averages. The result would be better if one were to choose a faster parameter than to choose a weighted moving average over a simple moving average of the same parameter. All three types of moving averages work well in a trend. When the price is rising, all three moving averages will track the price well and give the trader an idea of the trend in the market. The greater the slope of the moving average, the stronger is the trend. However, in a sideways market, all three types of moving averages will not work well. They will give signals that will turn out to be false and wrong. How is the Moving Average Used? There are three ways to use a moving average. 1. Price and Moving Average Crossover Whenever the price and moving average meet each other, it is a signal to enter into a position. If the price crosses the moving average and falls lower, it repre- sents a sell signal. When the price crosses the moving average and moves higher, it is a buy signal. 2. Dual Moving Average Crossover In this case, two moving averages are used. When the two moving averages intersect, a signal is given. When the faster moving average cuts the slower moving average and moves higher, it is a buy signal. For the sell signal, the faster moving average would have cut the slower moving average and started to move lower.

Chart 20.7: Signals from a price and moving average crossover 3. Moving Average as a Support/Resistance The moving average acts as a moving support if it is below the price. When the price drops to the moving average, it is time to buy. The price may cut the moving average or move slightly below the moving average. Only if the price moves by more than a certain amount, e.g. 20 pips, would the support be invalidated.

Chart 20.8 and 20.9 show the moving average acting either as a support or as a resistance. In the first chart (20.8), the moving average is acting as a support, while in the second chart (20.9), the moving average is acting as a resistance. In later chapters, we will show you how you can use the moving average as a support or resistance to trade with the trend. Chart 20.8: Moving average as a support

Chart 20.9: Moving average as a resistance Choosing the Parameter of the Moving Average When choosing a parameter for your moving average, you may want to take this into consideration. 1. Fast Parameter Any number less than 20 can be considered a fast parameter. A fast parameter will track prices very closely and be very sensitive to price changes. When using a fast parameter, there will be more signals given. These signals will be early as well when there is a change in trend from an uptrend to a downtrend. However, when you have early signals, you tend to have more false signals as well. You will get signals that are premature too. There are always two sides to a coin. As the fast parameter tracks

price more closely, a fast parameter is good when one is using the moving average to enter into trend changes. 2. Medium Parameter A parameter from 20 to 50 can be considered a medium parameter. This medium parameter will be further away from the price and give the trader a good feel of the trend. Fewer signals will be given by this parameter, but the signals given will be more accurate. As a medium parameter is less sensitive to price movement, the signals given will be slower and further away from the turning point compared to a faster moving average. A good way to use this medium parameter would be as a support level for a trader to enter into a trend after a pullback. 3. Slow Parameter 100 or 200-period parameters are considered to be slow. The signals generated will be few and far in-between. However, the signals that do get generated will be very reliable. This type of moving average is usually used in association with price. Price crossover of a 200-period moving average is usually a trend change and necessitates an entry position or a reversal of position. Using the Moving Average to Determine the Trend in the Market In using the moving average to determine the trend, we will need to use a fast parameter. Why do we need a fast parameter? We want the moving average to be sensitive to price changes. In this example, we will use a parameter of 10 periods. Below is a chart of the EUR/CHF.

Chart 20.10: Example of an uptrend - EUR/CHF By adding a moving average to the chart, and with the help of the trend line, which you learned about earlier in this book, you can get a better picture of the trend. Below is an example with trend lines and a moving average.

Chart 20.11: Trend determined by trend lines and the moving average When the moving average is flat, it tells us there is no trend in the market. This is the period from 0800 to 1400. From 1400 to 1700 hours, the price was in an up- trend, which ended at 1700. There was a small downtrend, which lasted an hour till 1800 hours. By using a moving average and looking at the direction in which the moving average is heading towards, we have an idea of the trend. The slope of the moving average can tell us the strength of the trend.

When the angle or gradient of the slope is higher, it shows that the trend is stronger. When the angle is 180 degrees or the gradient is flat or close to zero, it is a flat or sideways market. When the gradient of the slope is negative, it is a downtrend in progress.



PART 2.1 Stage of the Trend Once you’ve spotted a trend, whether an uptrend or a downtrend, the next thing is to ask: “Is it at the beginning, middle , or end of a trend?” Even if you know how the market is trending, it does not mean you can go right into it. For a better decision, you’ll need to know at what stage the trend is in at the moment. You don’t want to jump into an uptrend and go long only to find that it ends after you have entered a trade. For that we need to learn how to determine the stages of a trend. Three Stages of a Trend There are three stages of a trend. Beginning Stage This is the earliest part of the trend. It could be an uptrend or a downtrend. The trend has just started and is in its infant stage. If you manage to get into the trend at this stage, you have a lot of profit potential. You can keep your position for a longer period of time, as at its infant stage, the trend is not going to reverse that soon. Mid-Trend Stage The trend is at its mid-life. There is still another part to it. At this stage, there is still some profit to be generated if you can get into the trend. Another good point from this knowledge is that you can estimate where the trend will likely terminate.

Ending Stage This is the part where if you were to get in, it is going to cost you money. The trend, be it an uptrend or downtrend, is in its last stage nearing the finishing line. The trend is likely to reverse any time soon. The profit potential is low while the risk of a reversal is very high. It is best not to get into a trend at this stage. Rather, you should be looking to go in the opposite direction of the current trend. You should be looking for signs and signals to go against the current trend. Now that we know the various stages of the trend, how do we determine which stage of its life cycle the trend is in? We can use a Relative Strength Indicator (RSI) to guide us in determining the stages of a trend. This is one of the two technical indicators we will introduce to help determine the stages of a trend. WHAT IS THE RALATIVE STRENGTH INDICATOR? This indicator was introduced to the world by Welles Wilders in 1978. RSI, as it is commonly referred to, measures the internal strength of the currency pair’s market condition by comparing its average gain against its average loss over a period of time. The formula is listed below: where RS = Average Gain/Average Loss Welles Wilders recommended five uses for the RSI. For Forex trading purposes in this book, we will look into how to use three of these five uses to aid in determining the stages of a trend.

The three uses are: 1. Extreme Value A value in RSI above 70 is considered overbought and near a top, while a value below 30 is considered oversold and near a bottom. 2. Value of 50 as a Centerline As the RSI line crosses above this line, we will consider the currency pair to be bullish while a crossing below 50 would be considered bearish. 3. Divergence Warning When the RSI does not follow the price in making a new high or low, we have a divergence warning about a top or bottom in the process of forming. Example of divergence: In the chart 21.1, we show two examples of a divergence. Points 1 and 2 illustrate a bullish divergence while points 3 and 4 show a bearish divergence. At point 2, while the price falls lower than at point 1, the RSI did not fall lower than point 1. The RSI did not follow the price but instead diverged from the price. This is a divergence. It is a warning that the price is near a low and an impending reversal to the upside is on the horizon. We call this a bullish divergence. At point 4, while the price is higher than at point 3, the RSI is not higher than at point 3. This is a divergence. As this divergence warns of a high and an impending reversal to the downside, we call this a bearish divergence.