Forex Technical Indicators – Part 2

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Forex Technical Indicators

On Balance Volume

Overview
On Balance Volume (“OBV”) is a momentum indicator that relates volume to price change.
On Balance Volume was developed by Joe Granville and originally presented in his book New Strategy of Daily Stock Market Timing for Maximum Profits.

On Balance Volume is a running total of volume.  It shows if volume is flowing into or out of a security.  When the security closes higher than the previous close, all of the day’s volume is considered up-volume.  When the security closes lower than the previous close, all of the day’s volume is considered down-volume.

Interpretation
The basic assumption, regarding OBV analysis, is that OBV changes precede price changes.  The theory is that smart money can be seen flowing into the security by a rising OBV.  When the public then moves into the security, both the security and the OBV will surge ahead.

If the security’s price movement precedes OBV movement, a “non-confirmation” has occurred.  Non-confirmations can occur at bull market tops (when the security rises without, or before, the OBV) or at bear market bottoms (when the security falls without, or before, the OBV).

The OBV is in a rising trend when each new peak is higher than the previous peak and each new trough is higher than the previous trough.  Likewise, the OBV is in a falling trend when each successive peak is lower than the previous peak and each successive trough is lower than the previous trough.  When the OBV is moving sideways and is not making successive highs and lows, it is in a doubtful trend.

Once a trend is established, it remains in force until it is broken.  There are two ways in which the OBV trend can be broken.  The first occurs when the trend changes from a rising trend to a falling trend, or from a falling trend to a rising trend.

The second way the OBV trend can be broken is if the trend changes to a doubtful trend and remains doubtful for more than three days.  Thus, if the security changes from a rising trend to a doubtful trend and remains doubtful for only two days before changing back to a rising trend, the OBV is considered to have always been in a rising trend.

Price Patterns

Overview
A basic principle of technical analysis is that security prices move in trends.  We also know that trends do not last forever.  They eventually change direction and when they do, they rarely do so on a dime.  Instead, prices typically decelerate, pause, and then reverse.  These phases occur as investors form new expectations and by doing so, shift the security’s supply/demand lines.

The changing of expectations often causes price patterns to emerge.  Although no two markets are identical, their price patterns are often very similar.  Predictable price behavior often follows these price patterns.

Chart patterns can last from a few days to many months or even years.  Generally speaking, the longer a pattern takes to form, the more dramatic the ensuing price move.

Interpretation
The following sections explain several of the more common price patterns.  For more information on chart patterns, we suggest the book, Technical Analysis of Stock Trends by Robert Edwards and John Magee.

Head and Shoulders
Rounding Tops and Bottoms
Triangles
Double Tops and Bottoms

Price Patterns

Head-and-Shoulders

The Head-and-Shoulders price pattern is the most reliable and well-known chart pattern.  It gets its name from the resemblance of a head with two shoulders on either side.  The reason this reversal pattern is so common is due to the manner in which trends typically reverse.

A up-trend is formed as prices make higher-highs and higher-lows in a stair-step fashion.  The trend is broken when this upward climb ends.  As you can see in the illustration (Intel, INTC), the “left shoulder” and the “head” are the last two higher-highs.  The right shoulder is created as the bulls try to push prices higher, but are unable to do so.  This signifies the end of the up-trend.  Confirmation of a new down-trend occurs when the “neckline” is penetrated.

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During a healthy up-trend, volume should increase during each rally.  A sign that the trend is weakening occurs when the volume accompanying rallies is less than the volume accompanying the preceding rally.  In a typical Head-and-Shoulders pattern, volume decreases on the head and is especially light on the right shoulder.

Following the penetration of the neckline, it is very common for prices to return to the neckline in a last effort to continue the up-trend.  If prices are then unable to rise above the neckline, they usually decline rapidly on increased volume.

An inverse (or upside-down) Head-and-Shoulders pattern often coincides with market bottoms.  As with a normal Head-and-Shoulders pattern, volume usually decreases as the pattern is formed and then increases as prices rise above the neckline.

Price Patterns

Rounding Tops and Bottoms

Rounding tops occur as expectations gradually shift from bullish to bearish.  The gradual, yet steady shift forms a rounded top.  Rounding bottoms occur as expectations gradually shift from bearish to bullish.

Volume during both rounding tops and rounding bottoms often mirrors the bowl-like shape of prices during a rounding bottom.  Volume, which was high during the previous trend, decreases as expectations shift and traders become indecisive.  Volume then increases as the new trend is established.

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Price Patterns


Triangles

A triangle occurs as the range between peaks and troughs narrows.  Triangles typically occur as prices encounter a support or resistance level which constricts the prices.

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A “symmetrical triangle” occurs when prices are making both lower-highs and higher-lows.

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An “ascending triangle” occurs when there are higher-lows (as with a symmetrical triangle), but the highs are occurring at the same price level due to resistance. The odds favor an upside breakout from an ascending triangle.

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A “descending triangle” occurs when there are lower-highs (as with a symmetrical triangle), but the lows are occurring at the same price level due to support.  The odds favor a downside breakout from a descending triangle.

Just as pressure increases when water is forced through a narrow opening, the “pressure” of prices increases as the triangle pattern forms.  Prices will usually breakout rapidly from a triangle.  Breakouts are confirmed when they are accompanied by an increase in volume.

The most reliable breakouts occur somewhere between half and three-quarters of the distance between the beginning and end (apex) of the triangle.  There are seldom many clues as to the direction prices will break out of a symmetrical triangle.  If prices move all the way through the triangle to the apex, a breakout is unlikely.

Price Patterns

Double Tops and Bottoms

A double top occurs when prices rise to a resistance level on significant volume, retreat, and subsequently return to the resistance level on decreased volume.  Prices then decline marking the beginning of a new down-trend.

A double bottom has the same characteristics as a double top except it is upside-down.

Price Oscillator

Overview
The Price Oscillator displays the difference between two moving averages of a security’s price.  The difference between the moving averages can be expressed in either points or percentages.

The Price Oscillator is almost identical to the MACD, except that the Price Oscillator can use any two user-specified moving averages.  (The MACD always uses 12 and 26-day moving averages, and always expresses the difference in points.)

Interpretation
Moving average analysis typically generates buy signals when a short-term moving average (or the security’s price) rises above a longer-term moving average.  Conversely, sell signals are generated when a shorter-term moving average (or the security’s price) falls below a longer-term moving average.  The Price Oscillator illustrates the cyclical and often profitable signals generated by these one or two moving average systems.

Price Rate-Of-Change

Overview
The Price Rate-of-Change (“ROC”) indicator displays the difference between the current price and the price x-time periods ago.  The difference can be displayed in either points or as a percentage.  The Momentum indicator displays the same information, but expresses it as a ratio.

Interpretation
It is a well recognized phenomenon that security prices surge ahead and retract in a cyclical wave-like motion.  This cyclical action is the result of the changing expectations as bulls and bears struggle to control prices.

The ROC displays the wave-like motion in an oscillator format by measuring the amount that prices have changed over a given time period.  As prices increase, the ROC rises; as prices fall, the ROC falls.  The greater the change in prices, the greater the change in the ROC.

The time period used to calculate the ROC may range from 1-day (which results in a volatile chart showing the daily price change) to 200-days (or longer).  The most popular time periods are the 12- and 25-day ROC for short to intermediate-term trading.  These time periods were popularized by Gerald Appel and Fred Hitschler in their book, Stock Market Trading Systems.

The 12-day ROC is an excellent short- to intermediate-term overbought/oversold indicator.  The higher the ROC, the more overbought the security; the lower the ROC, the more likely a rally.  However, as with all overbought/oversold indicators, it is prudent to wait for the market to begin to correct (i.e., turn up or down) before placing your trade.  A market that appears overbought may remain overbought for some time.  In fact, extremely overbought/oversold readings usually imply a continuation of the current trend.

The 12-day ROC tends to be very cyclical, oscillating back and forth in a fairly regular cycle.  Often, price changes can be anticipated by studying the previous cycles of the ROC and relating the previous cycles to the current market.

Relative Strength Index (RSI)

Overview
The Relative Strength Index (“RSI”) is a popular oscillator.  It was first introduced by Welles Wilder in an article in Commodities (now known as Futures) Magazine in June, 1978.

The name “Relative Strength Index” is slightly misleading as the Relative Strength Index does not compare the relative strength of two securities, but rather the internal strength of a single security.  A more appropriate name might be “Internal Strength Index.”

Interpretation
When Wilder introduced the Relative Strength Index, he recommended using a 14-day Relative Strength Index.  Since then, the 9-day and 25-day Relative Strength Indexs have also gained popularity.  The fewer days used to calculate the Relative Strength Index, the more volatile the indicator.

The Relative Strength Index is a price-following oscillator that ranges between 0 and 100.  A popular method of analyzing the Relative Strength Index is to look for a divergence  in which the security is making a new high, but the Relative Strength Index is failing to surpass its previous high.  This divergence is an indication of an impending reversal.  When the Relative Strength Index then turns down and falls below its most recent trough, it is said to have completed a “failure swing.”  The failure swing is considered a confirmation of the impending reversal.

In Mr. Wilder’s book, he discusses five uses of the Relative Strength Index:

Tops and Bottoms.  The Relative Strength Index usually tops above 70 and bottoms below 30.  It usually forms these tops and bottoms before the underlying price chart.
Chart Formations.  The Relative Strength Index often forms chart patterns such as head and shoulders or triangles  that may or may not be visible on the price chart.
Failure Swings (also known as support or resistance penetrations or breakouts).  This is where the Relative Strength Index surpasses a previous high (peak) or falls below a recent low (trough).
Support and Resistance.  The Relative Strength Index shows, sometimes more clearly than price themselves, levels of support and resistance.
Divergences.  As discussed above, divergences occur when the price makes a new high (or low) that is not confirmed by a new high (or low) in the Relative Strength Index.  Prices usually correct and move in the direction of the Relative Strength Index.

Stochastic Oscillator

Overview
The Stochastic Oscillator compares where a security’s price closed relative to its price range over a given time period.

Interpretation
The Stochastic Oscillator is displayed as two lines.  The main line is called “%K.”  The second line, called “%D,” is a moving average of %K.  The %K line is usually displayed as a solid line and the %D line is usually displayed as a dotted line.

There are several ways to interpret a Stochastic Oscillator.  Three popular methods include:

  • Buy when the Oscillator (either %K or %D) falls below a specific level (e.g., 20) and then rises above that level. Sell when the Oscillator rises above a specific level (e.g., 80) and then falls below that level.
  • Buy when the %K line rises above the %D line and sell when the %K line falls below the %D line.

Look for divergences.  For example, where prices are making a series of new highs and the Stochastic Oscillator is failing to surpass its previous highs.

Support and Resistance

The foundation of most technical analysis tools is rooted in the concept of supply and demand.  There is nothing mysterious about support and resistance–it is classic supply and demand.  Remembering “Econ 101” class, supply/demand lines show what the supply and demand will be at a given price.

Resistance is equivalent to a “supply” line.  When prices increase, the quantity of sellers also increases as more investors are willing to sell at these higher prices.  When too much selling occurs, however, prices retreat.  When this happens repeatedly near a specific price level,  resistance forms at that price level.

Support is equivalent to a “demand” line.  When prices decrease, the quantity of buyers increases as more investors are willing to buy at lower prices.  When too much buying occurs, however, prices rise.  When this happens repeatedly near a specific price level, support forms at that price level.

Following the penetration of a support/resistance level, it is common for traders to question the new price levels.  For example, after a breakout above a resistance level, buyers and sellers may both question the validity of the new price and may decide to sell.  This creates a phenomena referred to as “traders’ remorse” where prices return to a support/resistance level following a price breakout.

The price action following this remorseful period is crucial.  One of two things can happen.  Either the consensus of expectations will be that the new price is not warranted and  prices will move back to their previous level; or investors will accept the new price and prices will continue to move in the direction of the penetration.

When a resistance level is successfully penetrated, that level becomes a support level.  Similarly, when a support level is successfully penetrated, that level becomes a resistance level.
Use the Trendline tool to draw support and resistance lines on you MetaStock for Java charts.

Trendlines

In the preceding section, we saw how support and resistance levels can be penetrated by a change in investor expectations (which results in shifts of the supply/demand lines).  This type of a change is often abrupt and “news based.”

In this section, we’ll review “trends.”  A trend represents a consistent change in prices (i.e., a change in investor expectations).  Trends differ from support/resistance levels in that trends represent change, whereas support/resistance levels represent barriers to change.

As shown in the following chart, a rising trend is defined by successively higher low-prices.  A rising trend can be thought of as a rising support level–the bulls are in control and are pushing prices higher.

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As shown in the next chart, a falling trend is defined by successively lower high-prices.  A falling trend can be thought of as a falling resistance level–the bears are in control and are pushing prices lower.

 

Volume

Overview
Volume is simply the number of shares (or contracts) traded during a specified time frame (e.g., hour, day, week, month, etc).  If volume is reported for the security, MetaStock for Java automatically plots it along the bottom of the chart as a histogram. The analysis of volume is a basic yet very important element of technical analysis.  Volume provides clues as to the intensity of a given price move.

Interpretation
Low volume levels are characteristic of the indecisive expectations that typically occur during consolidation periods (i.e., periods where prices move sideways in a trading range). Low volume also often occurs during the indecisive period during market bottoms.

High volume levels are characteristic of market tops when there is a strong consensus that prices will move higher.  High volume levels are also very common at the beginning of new trends (i.e., when prices break out of a trading range).  Just before market bottoms, volume will often increase due to panic-driven selling.

Volume can help determine the health of an existing trend.  A healthy up-trend should have higher volume on the upward legs of the trend, and lower volume on the downward (corrective) legs. A healthy downtrend usually has higher volume on the downward legs of the trend and lower volume on the upward (corrective) legs.

Volume Oscillator

Overview
The Volume Oscillator displays the difference between two moving averages of a security’s volume.  The difference between the moving averages can be expressed in either points or percentages.

Interpretation
You can use the difference between two moving averages of volume to determine if the overall volume trend is increasing or decreasing.  When the Volume Oscillator rises above zero, it signifies that the shorter-term volume moving average has risen above the longer-term volume moving average, and thus, that the short-term volume trend is higher (i.e., more volume) than the longer-term volume trend.

There are many ways to interpret changes in volume trends.  One common belief is that rising prices coupled with increased volume, and falling prices coupled with decreased volume, is bullish.  Conversely, if volume increases when prices fall, and volume decreases when prices rise, the market is showing signs of underlying weakness.

The theory behind this is straight forward.  Rising prices coupled with increased volume signifies increased upside participation (more buyers) that should lead to a continued move.  Conversely, falling prices coupled with increased volume (more sellers) signifies decreased upside participation.

 

Forex Technical Indicators – Part 1

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