Beginner's Guide to TA

10 - Tips on Using Indicators

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It's time to get serious! From here on out we're going to be concocting consistent trades, using the instruments seen in the past lessons.

Before we start our adventure, however, allow me to share some suggestions and ideas that have matured through years of experience.

  • The 80-20 rule applies more to trading than other aspects of life. 80% of your results will be determined by 20% of your effort. So whatever approach you decide to use, make sure you eliminate all unnecessary clutter from charts. Similarly, don't waste time trying to orchestrate complex theories connecting fundamentals and market movement. Be efficient above all else!
  • The KISS rule also applies to trading in a big way. In order for the 80-20 rule to "work" for you, you need to have a simple & subtle approach. You want to combine simple technical prompts with an equally simple yet logical way of absorbing & digesting emerging fundamentals. If you can't explain what you do to a 5-year old, then it's too complicated. Simplify!
  • Know precisely what you're waiting for. Don't go "looking" for trades. Our brain is trained to "find" what we are searching for. If you are actively "looking" for trades, your brain will find them for you. However, they will most likely be losing trades - the reason being that you were not "letting the market come to you". You were "forcing your view" upon the market. This is easier said than done…but if you catch yourself "searching" for a trade, it's probably best to stop immediately and do something else. Chances are, there really was no good trade to get stuck into, and you were looking for action where there was none. A bored trader looking for action is seldom more than a gambler.

How to set up your charts

With that said, it is time to take action. And that does not mean opening up a chart, overlaying all the indicators we have seen in the past lessons, and then clicking "Buy". A chart can say more than 1000 words...but that's only useful if you can understand them.

1. The first thing to do is remember what exactly we are seeing, when we look at charts. Nowadays the most common chart is a Candlestick chart. But what exactly are we watching? As we noted in the previous lesson, price (as highlighted by candles or bars or even a line chart) is a reflection of current market psychology.

It's too easy to think of "price action" as an independent or impersonal concept. In reality, at any given time, the price of a financial asset is determined by the forces of supply and demand. Edwards & Magee, in 1948, had already defined price action appropriately:

"The market price reflects not only the differing value opinions of many orthodox security appraisers, but also the hopes and fears and guesses and moods, rational and irrational, of […] buyers and sellers, as well as their needs and the resources…"

Edwards & Magee gave a very precise definition that included the psychological aspect of human decision making. Price movement is determined by investors' decisions in response to a complex mix of psychological, sociological, political, economic and monetary factors.

So when you watch a price chart, the right questions to ask are:

"what is the market thinking?"
"is the market showing signs of strength, weakness or consolidation?"
"how (and why) is the market reacting to this level/piece of news/situation?"

For Example, in December 2015 the market was surprised by the ECB. The EUR/USD burst upwards and many traders were wondering at what point it might stop. Using the logic described above, we shall attempt to make an educated guess.

The first thing to do is observe where, in the past, the market has "made a decision". Where are the most recent points from which the market has moved aggressively in one direction or the other?

After finding our "reaction zone", we need to have patience and wait until the market reaches the zone again. Only then does it make sense to observe price action, and "ask the market what it thinks" this time round. This is the "strategic" plan, which tends to be more robust on the higher time frames (4H/Daily/Weekly). Instead, from a tactical point of view, it is entirely possible to use various time frames and in the chart below, we have "magnified" the reaction zone using a 4H chart.

Hence, the important thing isn't the candle in itself; it's WHEN & WHERE you see certain candle formations that make them "important".

NZDUSD 1H Chart - the best places to proceed with "candle watching" are at prior levels/zones of importance. That is where it makes sense to ask the market "what are you thinking?" Conversely, the beautiful long Doji in the middle of nowhere has much less significance.

2. The second thing to do is "zoom out". By learning to "zoom out" you can automatically avoid "confusing the trees for the forest". Observe the chart below. By just taking into account recent developments, you might be thinking that we're headed for a massive break to the downside.

However, if you just broaden your view a little, you can see how flawed that hypothesis was. We were in fact just popping below an ugly range, and had yet to challenge the origin of the recent upwards momentum.

3. We have seen the importance of watching market reactions at previously important junctures. You can think of them as "conflict zones" where the bulls & bears, for whatever reason, fought it out and one side dominated the other, causing some sort of evident order flow imbalance.

These evident levels that have turned the tide in the past, are likely to react in the same way in the future, if the fundamental background remains the same. Otherwise, what was a prior level of support might flip to resistance as reverse orders hit the market, caused by a shift in market sentiment.

NZD/USD 4H - Examples of levels that have shifted from support to resistance and vice-versa.

So the key is to have a firm grasp on market direction at all times:

if the market is trending upwards, ask yourself where likely support will be;
if the market is trending downwards, ask yourself where likely resistance will be.

4. This brings us to the next topic: indicators. Too often, aspiring traders start to overlay indicators on their charts without the slightest idea of what the indicators actually indicate. Here is the key: anything you overlay on top of a pure price chart should be thoroughly understood. You must know why you're using something, rather than just doing it because it should give you some magical power of intuition.

Generally speaking, markets can be in "trend mode" or "range mode". Some indicators can assist with making decisions during trending modes, while some indicators are useless and will lead to steep losses in this same phase. Vice versa, some indicators are useful tools during range-bound markets, but will lead to steep losses during trending phases.

Observe the following charts.

NZDUSD Daily Chart - The entire group of "trend indicators", which is made of many permutations of Moving Averages, TrendLines, SuperTrend, Ichimoku, etc. all "indicate" the same thing: a tendency in prices. When prices are trending, these indicators can be useful tools.

NZDUSD Daily Chart - the entire group of "Oscillators" (Stochastics, Momentum, MACD, CCI, etc) "indicates" the same thing: price is currently "high" or "low" compared to the range in the lookback period, which is usually 14 Candles. When prices are in a range, these tools can be useful.

As a rule of thumb:

  • Trend Indicators are useful in evidently trending markets, because they keep you on the right side of the move and are "automatic trend lines" from which price may find support or resistance. Common moving averages are the 10, 20, 50, 55, 100, and 200. In range-bound markets, trend indicators will lead to "whipsaws" where price continues to flip from above to below the averages in a non-directional fashion.
  • Oscillators are useful in range-bound markets, because they will suggest shorting at tops and buying bottoms. Of course, this works great in range-bound situations but is suicide in a strong trending market. Just like the Oscillator chart above, strong trends can maintain oscillators in "oversold" or "overbought" territory for long periods of time, generating many false signals.

That is why you really need to understand the nature of the indicators you overlay on your price chart. For example, what is an RSI? Many traders use RSI without knowing what it actually means. A logical approach would be to study the formula: it is showing you whether the bullish bars or bearish bars are bigger. That's it!

Below is a basic calculation of the RSI:

Source: Proprietary Calculation

And what does it look like on a Price chart?

This is the ONLY way to utilize indicators: know what they are. Know what they can and can't do for you. Do not overlay indicators thinking they can solve your problems for you, or give you some kind of edge. They can't. Indicators are mostly "eye candy" that can facilitate your job, but they cannot do your job for you.

We know that identifying market direction is of fundamental importance. You need to know whether to be looking North or South, so you can know whether to be Long, Short or Flat on any given day. No confusion is tolerable on this matter.

One indicator that can be of use in this case is a simple moving average. But which SMA to choose? There are many common permutations, but essentially you need to decide what your objectives are. Are you going to trade shorter term cycles? Maybe a 20-period SMA might suit you well. If you're looking for longer term cycles, maybe a 50 or 55-period SMA would suit you better. In any case, the moving average is not magical. It will only tell you the strength of the trend you are watching, at any given time.

Observe the following example: the USD vs. all major trading partners.

USD Screen: which is the best looking currency pair to bet your hard earned capital on?

Which are the strongest, most evident trends to trade? Confused? Use these two measures:

  • inclination of the moving average. The more inclined the average, the stronger the trend.
  • distance between price and the moving average. The further away price is, the stronger the trend.

You can immediately see that the bottom three - USD/CAD, NZD/USD and GBP/USD - are the winners!

4.1 Overbought and Oversold. Many indicators are "normalized" and oscillate between 0 and 100. Traditional technical analysis would hold that "above 80" or "below 20" are "overbought" and "oversold" areas respectively, where the market has run enough and is due for a correction.

Unfortunately, by following this kind of mantra, you will end up catching falling knives and fading into strong rallies.

The market does not know "overbought" or "oversold". The market will continue to trot along relentlessly, snatching the stops of anyone who gets in its way.

GBP/USD 1H - whenever price pushes beyond the lookback period of your indicator, you will have an "extreme reading". However, the market does not always care, and will often push right through it after a brief pause.

So what is a more savvy way to use the "overbought/oversold" concept, in a useful way? Simply go with the flow! Instead of using the indicators to trade against the trend, look for the indicator to help you leg into the trend!

If the market is trending down so strongly that it pulls back when overbought but largely ignores oversold, you could look to short the next overbought period to get maximum value:

GBP/USD 1H - Using an oscillator like the stochastic, to help you leg into an existing trend at potential turning points, is an effective and simple way of including the instrument into your plan.

4.2 Divergences. One useful aspect of indicators, that is more difficult to see with the naked eye, is the divergence trade. A divergence happens when price and indicator go their separate ways:

  • price makes a higher high while the indicator does not;
  • price makes a lower low while the indicator does not.

But once again, we first need to understand what exactly a divergence is. Observing the chart above, it becomes evident. A momentum divergence occurs when you get the range over X bars (the lookback period in the indicator - 14 is usually the default) being less than the range over X bars to the previous high or low (essentially price did not push as hard this time, to get there).

Of course, triggering trades by using divergences works best when prices are vibrating clear previous supply or demand zones.

5. We are almost finished setting our stall. However, we still need to make the acquaintance of the only chart pattern that matters: peak & trough action. Natural peaks (swing highs) and troughs (swing lows) reveal the "pulse" of the market on any given time frame.

GBP/USD 4H chart highlighting the peak-trough sequence.

By observing the sequence of peaks and troughs, it becomes quite easy to spot the first signs of strength (a higher low in a downtrend) or weakness (a lower high in an uptrend). Traders will be on guard if this happens, since it's a warning sign that momentum is fading and a reversal might be in store.

Putting it all together

Now let us observe how we can combine all elements, both technical and fundamental, to create effective trade opportunities. Here is a recent example on USD/CAD:

As of January 19th 2016, the Loonie had been the worst performing currency over the past quarter. This weakness was due to Crude Oil having fallen continuously over the course of 2015, which caused job losses in the Canadian energy sector and took its toll on manufacturing activity as well.

USD/CAD Daily Chart

On January 20th the market was on the lookout for the Bank of Canada policy decision, and the accompanying statement by Governor Poloz. CPI, Employment, Ivey PMI, Housing were all trending lower heading into the Bank of Canada's decision. Regarding rates, consensus was for no change, but there was a small chance of a 0.25% cut given the general situation. Governor Poloz had said back in December 2015: "The bank is now confident that Canadian financial markets could also function in a negative interest rate environment."

USD/CAD had been a' buy-on-dips' for the longest time, due to fundamental factors and externalities.

What happened next?

USD/CAD - Source

If we're only observing a chart, then we can notice how the orders around the day's low at 4550 were taken, and the orders around 4500 (Big Round Number) were also probed but resisted and pushed USD/CAD back up. Technically speaking, we've had a large reversal intraday and the drop was bought - all in the context of a clear uptrend on the Daily charts. So looking long would be the right course of action for a pure chart reader.

But what about the chart reader who also pays attention to the day's fundamental flavour? The message from Governor Poloz, who declined to forecast the Loonie's fate, focused on the currency's "shock absorber" role in protecting the Canadian economy from the impact of falling Oil prices. Hence, he downplayed domestic economic developments (which helped form the market's dovish expectations) by saying that CAD has been a hostage to Commodities. This implied that the Bank of Canada could tolerate even more weakness in its currency.

On balance, the message was: rates on hold but less dovish/slightly encouraging talk. The fundamental backdrop has changed and it would seem logical to sell USD/CAD, at least in the near term.

The market started to invert the peak/trough cycle, and made a couple of clear breakouts to the downside in the following 2 days.

USD/CAD in the following 2 days.

And as the trend progressed, it was quite simple to use the technical indicators we have explored, in order to leg back into the new trend. For example, after a few days, the market started pulling back to a prior resistance zone and printed an evident divergence, which allowed for a solid opportunity to get short again.

USD/CAD 1H divergence

And as the days progressed, there were other opportunities as well. For example, a clear doji rejection of a prior support level, alongside an extreme stochastic reading; and then another divergence trade.

Yet another example is NZD/USD, from the beginning of February 2016.
During the Asian session on February 3rd, 3 events brought the Kiwi under the spotlight:

  1. Despite a poor GDT dairy auction, Kiwi was not affected. This was a sign of strength, since the prior GDT auctions had a negative impact on the "bird".
  2. Employment surprised to the upside - and we know that employment is one of the more important fundamental drivers in FX.
  3. Last but not least, RBNZ Governor Wheeler downplayed the importance of low inflation. The market was expecting dovish remarks, and instead got a confident stand from Wheeler.

These were, without a doubt, positive surprises. Here is what the chart looked like, as the London session got under way on February 3rd.

NZD/USD: fundamental shift - enough to flip the technicals?

And in fact, it was quite easy to spot potential "pullbacks" using the extreme stochastic reading, in line with the moving average directional cue and the recent fundamental improvement, to leg into NZD/USD longs multiple times during the same day.

Key Points:

  • Technical indicators can be useful if (and only if) you understand what they can do for you.
  • Do not, however, hang your hat on any particular indicator. They only indicate; they don't guarantee success.
  • Price action is the reflection of the market's current psychology, and it is most important near key zones such as prior swing points or support/resistance levels.
  • The market's natural rhythm, as evidenced by the peak/trough sequence, is all a trader really needs in order to know what the dominant side of the market is.
  • Fundamental influences (as noted in the previous article) are the cornerstone of successful speculation. The market's expectations are built on emerging fundamentals, so it is key to match the technicals with a clear fundamental picture, in order to stack the odds firmly in your corner.
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