Stocks & Commodities V.

24:9 (19-24): Trading The Forex Wave by Raghee Horner CHART PATTERNS

This Tool Travels The Charts

Trading The Forex Wave

Chart patterns are powerful tools and it is important to identify them by finding their building blocks. Heres how. of congestion or consolidation. Congestion is typically a wider-ranging sideways market with higher volatility and a little more erratic support and resistance levels as compared to consolidation. Consolidation is a narrower sideways market with firm support and resistance levels, in that the levels have little variance between the highs that make up resistance and the lows that make up support. It is during these sideways markets that two of my favorite patterns for momentum trading develop: triangles and rectangles. Both patterns were born of the fact that they were initially referring to the stock market, where there is a buyside bias. So consolidation is that low-volume, quiet channel where a stock is typically bought with little notice. Congestion typically follows an uptrend and is an interesting mix of selling muddled with latecomers to the uptrend who are buying. Since there is not enough interest and money chasing the market higher, however, the market levels off into a wider range, compared to the accumulation cycle. When talking about markets such as commodity futures and foreign exchange, this is not as apparent, especially in the forex market, where the buyside bias is not as prevalent. PATTERN POWER As the visual embodiment of price action, chart patterns are powerful tools. Early on, I memorized the criteria as well as nuances of chart patterns like triangles, rectangles, wedges, flags, head & shoulders, and rounded tops/bottoms. I scanned charts for hours looking for these gems. Back then, that meant flipping through large, printed, daily charts that were mailed to my home once a week. With pen and ruler in hand, I would draw the lines of the patterns I was familiar with. Those were great daysand long days. Starting something new is always exciting, and discovering charting patterns only to see that my analysis was (mostly) right was a thrill. But I still

nly after I embraced market cycles did I truly begin to understand what to do with all the lines and levels I had learned to draw on my charts. Early on, as I began teaching myself to trade in the late 1980s to early 1990s, there were few books available about technical analysis. I found myself gravitating toward price (instead of news) because my mother was a bit of a market timer (although not trained nor aware that she was indeed using market timing). CHARTS, CHARTS, CHARTS Price and price action made sense to me, and so I ventured into charting armed with my fathers old engineering graph paper, drawing my own charts based on the closing price I would get from my commodity futures broker. It was also during this time I went to college and discovered the books that ended up shaping my view of the markets. Books by chartists Richard Schabacker and Richard Wyckoff were like the light I was searching for in my quest to become a trader. What is interesting about those books was that they were written in the early 1900s but are still as true and applicable today as anything current on my bookshelf. The other pivotal moment in my trading was the introduction of market cycles to my chart analysis. My bread and butter trades are momentum trades. My definition of this is an entry style based on entering a market as it breaks out or breaks down from a sideways market. Sideways markets are cycles

by Raghee Horner

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Stocks & Commodities V. 24:9 (19-24): Trading The Forex Wave by Raghee Horner

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KEN SMITH

Stocks & Commodities V. 24:9 (19-24): Trading The Forex Wave by Raghee Horner

wanted to know what went wrong on those patterns that whipsawed me. Before entering any market, it is vital that a trader (or investor) know the market cycle that a chart is in. Markets travel in one of four market cycles at any time: Accumulation (consolidation) Distribution (congestion) Mark up (uptrend), or Mark down (downtrend). The next challenge that every chartist faces is how to determine the market cycle that a chart is in.

(GBP AO-FX British Pound Sterling Composite, 60) Dynamic 0.00-24.00 EZ2-Wave 1.8850 1.8800 1.8750 1.87358635 1.87185096 1.8702297 1.8650 0 0.0003
eSIGNAL

MACD (12,26,9,C)

05/24 05/25 05/26 When we look back at price, its FIGURE 1: FLAT, SIDEWAYS WAVE. When such a situation arises, its best to look for patterns that work well during easy to see whats sideways markets. happened. The key to charting analysis is being able to EXPONENTIAL MOVING AVERAGES determine when a market is trending or Defining exponentially smoothed moving averageswhich, heading sideways. I do this quickly and for most traders, would be a series of closing pricesis easily with a tool I refer to as the Wave, simply another form of a moving average. An exponentially which is made up of three individual 34smoothed moving average utilizes a smoothing constant period exponential moving averages () that approximates the number of days for a simple (EMAs)one on the high, one on the moving average. This constant is multiplied times the difference between todays closing price and yesterdays close, and one on the low. These three EMAs create a wave that moving average value. This new value is then added to travels across the chart, and by looking in the direction in which yesterdays moving average value: the lines are traveling, I can determine if there is a trend and how strong it is. More important, the Wave tells me when there is no EMAtoday = EMAyesterday + (Ptoday - EMAyesterday) trend at all, which is when I set up a momentum trade. The 60-minute chart of the British pound in Figure 1 has a The actual formula that is mathematically reduced for a flat, sideways Wave. This gets my attention because now I will geometrically (exponentially) weighted moving average is: look to draw trendlines and support & resistance levels, and determine if there is a chart pattern. I will only use congestion Exponential Moving AverageThe EMA for day D is calculated as: EMAD = PRD + (1-)EMAD -1 and consolidation patterns like triangles (symmetrical and asymmetrical) and rectangles in the sideways market cycles where PR is the price on day D and (alpha) is a smoothing that I have identified using the sideways Wave. This is a key constant (0-1). Alpha may be estimated as 2/(n+1), where component to using chart patterns. Congestion and consolidan is the simple moving average length. tion patterns should only be used in sideways markets. The constant approximates for a simple moving averIt is important to identify chart patterns by finding the age. Its value is determined by the formula 2/(n + 1) where building blocks of the pattern, but I realized I dont want to n is the number of days for a simple moving average. An enter trades by searching for specific patterns like triangles or approximation for a 10-day moving average would use an head & shoulders. After all, what is a symmetrical triangle but = 2/(10+1) = 0.18. Thom Hartle the convergence of an uptrend and downtrend? No matter the head & shoulders location, inverse or otherwise, what is a REFERENCES neckline but support or resistance? Once all the trendlines and Granger, C.W.J., and Paul Newbold [1986]. Forecasting support & resistance levels are drawn, only then can I look for Economic Time Series, 2d ed., Academic Press. patterns whose lines and levels may have formed. Hutson, Jack K. [1984]. Filter Price Data: Moving AverThis is a very different approach compared to looking for a ages Vs. Exponential Moving Averages, Technical specific pattern. Look hard enough at the clouds and youll see Analysis of STOCKS & COMMODITIES, Volume 2: a bunny; look hard enough at the charts with a specific pattern May/June. in mind and the pattern will appear.
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THE WAVE

Stocks & Commodities V. 24:9 (19-24): Trading The Forex Wave by Raghee Horner

lows me to confirm a move after the price breaks through either the support or resistance level. So when prices finally broke through the support of multiple uptrend lines as well as support levels (Figure 3), all I had to do was acknowledge the price trigger of the short and glance at the MACD histogram reading. I use the MACD histogram in an on/off fashion so in this scenario, the MACD histogram simply has to be negative or below the zero line. While the MACD histogram is not much below the zero line, in the on/off way I use it the histogram is negative so the trade is confirmed. As prices break through the bottom of the triangle chart pattern, support is giving way. In this case, support is an uptrend line, and that line is half of what makes up this triangle pattern. One of the challenges of trading support & resistance levels and chart patterns (GBP AO-FX British Pound Sterling Composite, 60) Dynamic 0.00-24.00 is how to confirm that the pattern has indicated an entry. It is not the patterns EZ2-Wave 1.8850 Only after drawing the lines and levels on the chart can I see that a triangle pattern (Figure 2) has formed, and the triangle is the kind of pattern I like to see when setting up momentum trades. Without this pattern, there would be no way to mark and measure the potential breakout or breakdown. This pattern along with the sideways Waveoffers me a momentum setup on this 60-minute chart of the pound. In a momentum setup, I dont carry a bias as to which side prices may break. There is no trend, and as a momentum trader, I am waiting for the momentum to reveal itself. I do, however, use a confirmation indicator, the moving average convergence/divergence (MACD) histogram. This al1.8800 1.8750 1.87358635 1.87185096 1.8702297 ? 2 MACD (12,26,9,C) 1.8650 0 0.0009 05/24 05/25 05/26

TRIANGLES

The triangle is the kind of pattern I like to see when setting up momentum trades.
job to confirm, only to trigger. Because I use the MACD histogram to confirm that the pattern has been pierced, I do not have to wait for the candle to close, thus optimizing the chart patternbased momentum entry.

FIGURE 2: TRIANGLE PATTERNS. After drawing trendlines and support and resistance levels, a triangle pattern emerged. This is an ideal pattern on which to base a momentum trade.

TRADING THE WAVE

The follow-through from a triangle pattern with a sideways Wave is usually swift (Figure 4), as momentum trading is like getting on the base of a trend. As a market cycles from trending to sideway to trending again, a sideways market typically precedes a trend, and thus, if the momentum persists in an organized way, the Wave will also shift from the sideways direction and angle upward or downward, signaling a shift away from the balance of an accumulation or distribution cycle to a trend. Momentum trades can be effectively traded by: 1 Identifying a chart with a flat Wave. 2 Drawing all the uptrends, downtrends, support, and resistance lines that are on the chart and see if a congestion or consolidation pattern has formed. (The only time you really need to spend time. draw-

(GBP AO-FX British Pound Sterling Composite, 60) Dynamic 0.00-24.00 EZ2-Wave 1.8850 1.8800 1.8750 1.87344999 1.87167662 1.86088508 1.8688 2 MACD (12,26,9,C) 1.8650 0 0.0009 05/24 05/25 05/26

FIGURE 3: A CONFIRMATION INDICATOR. Here, the MACD is used as a confirmation indicator. When prices pierced through the support level, the MACD slid into negative territory, enough of a sign to enter a short position.

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Stocks & Commodities V. 24:9 (19-24): Trading The Forex Wave by Raghee Horner

ing the lines and levels on a chart is when you see a sideways Wave.) 3 Waiting for the price trigger. This means that you will wait for prices to pierce the support or resistance levels of the chart pattern, and only then go to step 4. 4 Checking the MACD histogram for confirmation of the price break direction. The positions will be exited based on significant support or resistance levels. The method is similar to setting up a trade in which you determine when a trade is no longer valid and then identify the support or resistance levels from which to place stop-losses.

(GBP AO-FX British Pound Sterling Composite, 60) Dynamic 0.00-24.00

1.8800 EZ2-Wave 1.87321284 1.8750 1.8708551 1.86909736 ? MACD (12, 26, 9, C) 0 -0.001 05/24 05/25 05/26 1.8600 1.8573

Raghee Horner is a trader, teacher, and author, with more than 15 years experience in the markets. She produces daily commentary for TradeDirectFX.com, offers analysis about the forex market for eSignal, and is a frequent speaker at the Forex Trader Expo.

FIGURE 4: THE FOLLOW-THROUGH. You can see that the follow-through was quick. Thus, its important to enter the trade as soon as the indication is given to do so.

Wyckoff, Richard D. [1997]. How I Trade And Invest In Stocks And Bonds, reprint, Fraser Publishing Co.
See Traders Glossary for definition

SUGGESTED READING
Gopalakrishnan, Jayanthi [2006]. How Does The Forex Market Work? Raghee Horner, interview, Technical Analysis of STOCKS & COMMODITIES, Volume 24: April. Schabaker, Richard W., and Donald R. Mack [1997]. Technical Analysis And Stock Market Profits: A Course In Forecasting, Financial Times Prentice Hall, reprint.

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