Do not rely on chart “patterns” such as trendlines, head and shoulder formations, pennants, etc. These are an attempt by experts to give meaning to a chart where none is justified, especially in terms of prediction. It is easy enough to look at past charts and say that is a head and shoulders pattern or another chart is a pennant formation. But where is the predictive power in that. None at all. As a trader you want to be able to look at a chart before trendlines have been formed and say this trendline will occur. But this is impossible. The best you can do is to make a prediction on a percentage amount that this trendline may occur and a head and shoulders will occur with a certain other percentage.
These patterns are very subjective. How a trendline is drawn can be affected by whether a trader is in a buy mood or a sell mood. The trader will draw a trendline more positively if the trader is bullish.
Other chart patterns do have significance. Support and resistance levels are real and do provide some predictive ability, at least on a percentage basis. This is because traders have memories so that when a chart price approaches or reaches a previous price there is a psychological factor at play which the traders themselves give to the price. Some traders will have bought at a certain price while others will have shorted at that price, and so will have placed stop losses and buy orders in relation to those prices.
Other factors that affect chart prices are the trading by amateurs will affect opening prices more while prices towards the end of the day will reflect the buying/selling by the professionals.
Another thing that affects a chart price is when there is a bull market prices will be lower at the start of the week and prices will be higher towards the end of the week.
These are charts that prices using vertical bars that look like candles but with a wick at both ends. The body of the candlestick represents the opening and closing prices while the wicks represent the highest/lowest price during the day. The top wick represents the highest price while the bottom wick represents the lowest day price. When the closing price is lower than the opening price then the candle is drawn in a different colour to show that the price has fallen. The only shortcoming to candlestick chart analysis is that they ignore by/selling volume and also ignore technical indicators.
The theory that the market is always fairly priced according to all the available information at any given time is false. The price is nearly always overpriced or underpriced. The efficient market theory does not explain support and resistance levels and deviations from fundamental evaluations that may take years to correct themselves. Another pet theory is that the markets are random. Prices do have a random element but it only partly explains price and movements.
Support and Resistance levels
A support price is a lower price level that when the price reaches it, it triggers buying to pushing back up the price from that level.
A resistance price is where a price level that gets reached causes people to sell and so pushes back down the price from that level.
However, support and resistance levels can be said to be firmer when there is heavy volume or trading when a support or resistance level is reached. Support/resistance levels are less confirmed when the trading volume is low.
Usually high volume of trading near support/resistance levels cause the price to reverse while low volume usually causes the price to stabilise around the support/resistance level or even continue past the support/resistance level.
The longer a support or resistance level has been in force, the stronger it becomes with buyers and sellers mentally creating a level. Many traders will place automatic trades at those levels, further entrenching the support/resistance level.
Trading rules to experiment with:
1. If you have bought into a trend tighten your stop less.
2. Support and resistance levels are more meaningful on longer term charts rather than short term charts.
3. Good traders trade with several time framed (often 3) charts of the same currency pair for confirmation of market direction.
4. Real support/resistance levels should be taken from weekly charts.
5.Support/resistance levels give buying opportunities such as false breakouts. When a price breaks through a support/resistance level on low volume, expect it to reverse again. And if it breaks on high volume, expect it to continue.
Currency pairs usually spend most of their time trading sideways moving between a range determined by the support and resistance levels in force. Only occasionally does the chart develop a trend with higher highs or lower lows. And once the trend has finished it will develop a new range.
Professional traders are more patient than amateurs, they wait watching for when a breakout stops reaching new highs then they short the currency pair, expecting the price to fall. Likewise with a downside breakout stops developing lower lows, then they execute a buy trade. Also, they place tight, trailing stop losses on these type of trades, just in case the trend restarts.
Breakouts on thin volume tend to be false breakouts while a breakout on heavy volume is more likely to be a true price breakout.
Trends and Trading Ranges
Trends are when prices on a chart keep rising or falling over an extended period of time. There will be deviations up and down from the trend but each high will be higher than the previos high(or lower for downtrends). When you have bought into such a trend then you should have a wider stop loss compared to a trade within a range. This will allow you to keep gaining while the trend is in force without being stopped out due to a small set back.
Trading ranges on the other hand has prices that rise and fall but usually never rise above the resistance level or below the support level. When you trade a currency pair within a range then you need to have tighter stop losses just in case the price decides to breakout out of the range and become a trend. In a trading range, you need to buy when the price hits the support and you need to sell when the price hits the resistance level.
The real skill of an expert trader is looking at a chart and being able to predict the start of a trading range or a trend a reasonable percentage of the time. Then they place their trades early on. And when the prediction goes in their favour they reap the reward but when the prediction is wrong then the pull the trade. The expert will cininually work at increasing the number of winning to losing predictions. An amateur will need more assurance of the trend or trading range and usually trade late when most of the movement has passed or when the trend or trading range is near its end and will incur losses. Trading late leaves the amateur with less gains when he is right and greater losses when he is wrong. On the other hand when an amateur tries to trade early, he will not be as good as the expert in predicting the trend or range and be wrong more often, again incurring losses.
Sometimes if you have traded a price range at the support level , the price might continue to rise until it passes the resistance level and has turned into a trend. The expert on seeing this will have the flexibility to recognise the need to widen his stop loss and ride the trend higher.
One way you could identify a trend is by looking at the 22 day exponential moving average (22EMA). If it is continually rising or falling, then you are in a trend. Potential buying opportunities occur when the spot price falls/rises back to the moving average line. The expectation is that the price will continue to rise/fall.
To Trade or not To Trade – that is the question
Once you have found an uptrend or downtrend, then comes the decision to trade immediately or wait for a pull back or better price. But if you wait for a pull back, so will many other cautious investers. Other traders may have bought immediately and want to add more on a pull back. Other traders may have shorted the currency pair and on realising the trend were looking for the pull back as a way to get out. Other traders may have mistakenly gotten out of the trade and want back in. On the other hand deep pull backs may not be buying opportunities at all but rather the end or the reversal of a trend.
Another way to trade a trend, used by some cautious investors, is to buy in stages of say 3 lots. One third may be purchased when a trend has been identified. A middle third when a dip occurs and the final third when the trend is confirmed, such as a higher high or higher low.
But for each trade remember the 2% rule. Never trade more than 2% of your capital on any individual trade. Expert traders will put on smaller trades with wider stop losses in a trend, and when they trade a range they trade larger amounts but use tighter stop losses.
Mixed messages from different chart time frames
When looking at the price chart of your currency pair, the hourly chart may show a rising trend, the daily chart may show a falling trend, while the monthly chart may show that you are in a trading range. It is your job as a trader to make sense of these mixed signals.
When trading a particular timed frame such as the hourly chart then you will make better decisions if you you refer to another chart with a longer time frame for confirmation. Some experts will trade with charts in three different time frames simultaneously.