Wednesday, 15 March 2017

Lesson 4 – Introduction to Forex Trading - Understanding the basics - Part 3

Intro to Channels

Traders often talk about following the trend- and for good reason. Trading in the same direction as the trend is far more forgiving in terms of entry price, since there is already a bias towards price moving in the trade direction.

Less commonly talked about though, are methods for defining the range of acceptable movement, both with the trend and against, for the trend to still be considered valid.

One of the most effective ways of doing this is to draw trend channels onto the chart using parallel trend lines. This is, however, a skill that is very much open to interpretation, making it seem more of an art than a black and white set of rules.

channel 1

Fig 1. EURAUD H4 chart with trend channels drawn

Correct application of trend channels allows the user to not only define the strength of the trend via its angle, but also the volatility within the trend via the width between the channel extremes. This in turn gives the trader a useful set of tools for finding potential support and resistance, as well as the ability to clearly determine when a trend has ended and reversal signals should be taken.

With the benefit of hindsight, this is a fairly simple task to neatly define trends in this way (see Fig.1 as an example). However, this is with the ability to see how the trend ended up developing, which obviously you do not have when trading live.
Therefore, a step-by-step method is required for drawing a channel as early as possible within a new trend.
When there is a mature trend, as shown in Fig 2, the bearish trend has been clearly defined. Parallel lines have been placed on the chart to touch the highest number of turning points possible without any significant overshoot. This allows traders to see when the trend has broken to the upside.

channel fig 2

Fig 2. Price breaks through the upper bounds of the bearish channel

For the next stage, reference points are required. Turning points can be used for these. In the example above, price rallied higher after the breakout and retraced to form a new higher low for the trend. It is therefore possible to draw trend lines between these points, and observe that a straight line can clearly define all of the turning points at this early stage.

Fig 2 shows the master trend line drawn onto the chart. This could have also been found by drawing a line from the bottom to the low of the first retracement, which gives a good idea where the second high may run out of steam.

However, this is only useful at this stage for placing a counter trend short at the second high. This is not a good idea early on in a bullish trend, so it is better to wait for confirmation from the second high.

channels fif 3

Fig 3. Trend Angle has been defined

The low of the channel can be defined by copying the master trend line to the low of the chart, so that there is no price within this new trend that overshoots the trend line.

channel fig 4

Fig 4. Defining the low of the trend

channel fig 5


Fig 5. Low of the channel shows support

Now that the channel has been defined, the chart shows that when price reaches the low of the bullish channel, there is a reasonable chance of an accurate long trade entry.

channel fig 6

Fig 6. Rally from long entry

The rally shown in Fig 6 has gone so well that price, after testing the highs of the channel several times, finally gathers momentum and breaks through to the upside. This means that the channel needs to be re-evaluated by copying the master trend line to the next significant turning point, which will give a reasonable idea of where the next resistance should be. Remember, you’re not really using these as entry points for trades, since the trend is bullish, so you want to be buying, not selling. As such, these offer good suggestions for where to take profit if desired.

channel fig 7

Fig. 7. Repeat the expansion of the channel until the entire trend is defined with a maximum and minimum.

As shown, the trend has now been defined, and the new upper limit of the channel is correctly predicting where the tops of rallies have begun to sell off. Also notice that the previous tops of the channels, now shown as dashed lines, will act as support rather than resistance when price retraces to them from above, and return to resistance when price is below them.

Fig 8 shows examples of further long entry possibilities from these broken resistance lines turned support.

channel fig 8


Fig 8. Fully defined trend channel

With the low of the channel defined, once price sharply moves towards it, a decision has to be made. It is necessary to check to see if there are other angles that may better define the trend, now that you have lots of turning points to reference against. These other angles may allow a push below the current low of the channel without breaking the bullish trend.

channel fig 9

Fig 9. Break of trend

If this is the case, you can simply redraw the channel, as long as you are sure that the new trend angle and associated channel is a better definition of this trend. Alternatively, as shown in this example, the channel may be correctly drawn, so a break below the low of the channel will signal a trend change and the need for short entries.


Trend & Momentum

When trading in the financial markets, it is essential to understand the properties of the security in question, and the factors that affect it. The analysis of these factors is referred to as fundamental analysis. This is because you are evaluating the fundamental properties of the security and trying to place a price on it based on your analysis.

An example of fundamental analysis would be to look at a company’s financial statements, calculate a number of ratios, and then proceed to compare them to similar companies or its respective industry.
The number that you end up with will sometimes differ from the actual price, and this can happen for a number of reasons. Large price differences can occur as a result of market participants’ belief that the security should be valued at its current price because this price may incorporate new information that is not reflected in the company’s financial statements.

In order to become better at valuing securities or predicting future prices, you need to look more closely at what is happening in the market through technical analysis, which mainly deals with price action and trading volume. The concepts of trend and momentum play key roles in technical analysis, as financial statement ratios do for fundamental analysis.

Trend

When someone asks “What’s the latest trend?” this can refer to many different things. They might be asking about the latest fashionable outfits or the latest home decor styles, among many other things.
The essence of the question, however, is identical for each subject. That is, the purpose of this question is to find out about the most recent news regarding the subject, whatever that may be. With this in mind, when considering trends in financial markets, traders are generally thinking about the most recent price action of a security or index, and hoping to use this information to make an educated guess about where the price is heading.

The easiest way to determine the trend of a security is by looking at its price chart. This can be shown through many different types of charts, but usually a candlestick chart is used. There are also many indicators that come in handy. The most popular are moving averages, which are lagging indicators that confirm the price trend. A lot of traders like to draw their own lines on their chart, which helps them better visualize current and possible future trends.

trend line


The chart above is a good example that demonstrates a number of tools that can be used to examine the trend of a security. In the chart you can see the 200-day moving average highlighted in yellow. This is a simple moving average that can be used to determine the long-term trend. There is also a 10-day exponential moving average in blue; this moving average shows the short-term trends. Finally, there is a trend line placed by the trader themselves. As mentioned earlier, this line is used to show the general trend, with a hypothesis as to where price will be in the future.


Momentum

Another focal concept in technical analysis is momentum. Momentum here refers to the speed at which the price changes. When looking at a candlestick chart, there are candles that are very long and others that are not so much.

A candle shows the price increase/decrease during a chosen time frame, therefore it can be said that there was more momentum (in one direction than the other) during the time of a long candle than that of a short, where both candles have the same duration.

Similar to trends, there are numerous indicators that help illustrate momentum; these types of indicators are called oscillators and are widely used. There are many different types of oscillators which will be covered in depth in later lessons.

The main function of an oscillator is to try to determine where a price trend will reverse, and therefore they are used to find points to enter a trade that will make traders the most money.
As you can imagine, these types of indicators are most accurate when the price action is moving in easily visible trends with little disturbance; the greater the standard deviation within a trend, the less accurate the oscillator.

Using both trend and momentum together will make it much easier to theorize future prices. Using these in conjunction with fundamental analysis will provide you with a good idea of the direction of the price of a security.

< Lesson 4 Part 2

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