The Fundamentals Of Technical Analysis

Technical analysis is appointed to analyze market movement (the movement of prices, volumes and open interests) using the information obtained for a past time. Mainly, it is the chart study of past behavior of currencies prices in order to forecast their future performance. It is one of the most significant tools available for the forecasting of financial markets. Such analysis has been an increasingly utilized forecasting tool over the last two centuries.

The main strength of technical analysis is the flexibility with regard to the underlying instrument, regarding the markets and regarding the time frame. A trader who deals several currencies but specializes in one may easily apply the same technical expertise to trading another currency. A trader who specializes in spot trading can make a smooth transition to dealing currency futures by using chart studies, because the same technical principles apply over and over again, regardless of the market. Finally, different players have different trading styles, objectives, and time frames.

Technical analysis is easy to compute what is important while the technical services are becoming increasingly sophisticated and reasonably priced.

Prior to this historic open market intervention, technical analysis provided ample selling signals.

Price
The Fundamental Principles of Technical Analysis are based on the Dow Theory with the following main thesis:
1. The price is a comprehensive reflection of all the market forces. At any given time, all market information and forces are reflected in the currency prices.
2. Price movements are historically repetitive.
3. Price movements are trend followers.
4. The market has three trends: primary, secondary, and minor. The primary trend has three phases: accumulation, run-up/run-down, and distribution. In the accumulation phase the shrewdest traders enter new positions. In the run-up/run-down phase, the majority of the market finally "sees" the move and jumps on the bandwagon. Finally, in the distribution phase, the keenest traders take their profits and close their positions while the general trading interest slows down in an overshooting market. The secondary trend is a correction to the primary trend and may retrace onethird, one-half or two-thirds from the primary trend.
5. Volume must confirm the trend.
6. Trends exist until their reversals are confirmed. Figure F.1. shows example of reversals in a bearish currency market. The buying signals occur at points A and B when the currency exceeds the previous highs.

Figure F.1. A reversal of bearish currency

Cycles of currency price change are the propensity for events to repeat themselves at roughly the same time and are an important ground to justify the Dow Theory.

Cycle identification is a powerful tool that can be used in both the long and the short term. The longer the term, the more significance a cycle has. Figure F.2. shows a series of three cycles. The top of the cycle (C) is called the crest and the bottom (T) is known as trough. Analysts measure cycles from trough to trough.

Cycles are gauged in terms of amplitude, period, and phase. The amplitude shows the height of the cycle, the period shows the length of the cycle, the phase shows the location of a wave trough.

Figure F.2. The structure of cycles

Figure F.3. The two gauging measures of a cycle: period and phase.

Volume and Open Interest
Volume consists of the total amount of currency traded within a period of time, usually one day. For example, by year 2000, the total foreign currency daily trading volume was $1.4 trillion. But traders are naturally more interested in the volume of specific instruments for specific trading periods, because large trading volume suggests that there is interest and liquidity in a certain market, and low volume warns the trader to veer away from that market.

The risks of a low-volume market are usually very difficult to quantify or hedge. In addition, certain chart formations require heavy trading volume for successful development. An example is the head-and-shoulder formation. Therefore, despite its obvious importance, volume is not easy to quantify in all foreign exchange markets.

One method to estimate volume is to extrapolate the figures from the futures market. Another is "feeling" the size of volume based on the number of calls on the dealing systems or phones, and the "noise" from the brokers' market.

Open interest is the total exposure, or outstanding position, in a certain instrument. The same problems that affect volume are also present here. As it was already mentioned, figures for volume and open interest are available for currency futures. If you have access to printed or electronic charts on futures, you will be able to see these numbers plotted at the bottom of the futures charts.

Volume and open interest figures are available from different sources, although one day late such as the newswires (Bridge Information Systems, Reuters, Bloomberg), newspapers (the Wall Street Journal, the Journal of Commerce), Weekly printed charts (Commodity Perspective, Commodity Trend Service).

The Elliott Waves

Basics of Wave Analysis

The Elliott waves principle is a system of empirically derived rules for interpreting action in the markets. Elliott pointed out that the market unfolds according to a basic rhythm or pattern of five waves in the direction of the trend at one larger scale and three waves against that trend. In a rising market, this five wave/three-wave pattern forms one complete bull market/bear market cycle of eight waves. The five-wave upward movement as a whole is referred to as an impulse wave, and the three-wave countertrend movement is described as a corrective wave (See Figure EW1). Within the five-wave bull move, waves 1, 3 and 5 are themselves impulse waves, subdividing into five waves of smaller scale; while waves 2 and 4 are corrective waves, subdividing into three smaller waves each. As shown in Figure 6.1, subwaves of impulse sequences are labeled with numbers, while subwaves of corrections are labeled with letters.

Figure EW1. The basic Elliott Wave pattern

Following the cycle shown in the illustration, a second five-wave upside movement begins, followed by another three-wave correction, followed by one more five-wave up move. This sequence of movements constitutes a fivewave impulse pattern at one larger degree of trend, and a three-wave corrective movement at the same scale must follow. Figure EW2 shows this larger-scale pattern in detail.
As the illustration shows, waves of any degree in any series can be subdivided and resubdivided into waves of smaller degree or expanded into waves of larger degree.

Figure EW2. The larger pattern in detail

Fibonacci Analysis

The Fibonacci analysis gives ratios which play important role in the forecasting of market movements. This theory is named after Leonardo Fibonacci of Pisa, an Italian mathematician of the late twelfth and early thirteenth centuries He introduced an additive numerical series - Fibonacci sequence.
The Fibonacci sequence consists of the following series of numbers: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987, 1597, 2584, 4181, (etc.), which exhibit several remarkable relationships, in particular the ratio of any term in the series to the next higher term. This ratio tends asymptotically to 0.618 (the Fibonacci ratio). In addition, the ratio of any term to the next lower term in the sequence tends asymptotically to 1.618, which is the inverse of 0.618. Similarly constant ratios exist between numbers two terms Golden spirals appear in a variety of natural objects, from seashells to hurricanes to galaxies.
The financial markets exhibit Fibonacci proportions in a number of ways, particularly it constitute a tool for calculating price targets and placing stops. For example, if a correction is expected to retrace 61.8 percent of the preceding impulse wave, an investor might place a stop slightly below that level. This will ensure that if the correction is of a larger degree of trend than
expected, the investor will not be exposed to excessive losses. On the other hand, if the correction ends near the target level, this outcome will increase the probability that the investor's preferred price move interpretation is accurate.

The Directional Movement Index (DMI)

The directional movement index provides a signal of trend presence in the market. The line simply rates the price directional movement on a scale of0 to 100. The higher the number, the better the trend potential of a movement, and vice versa. (See Figure DMI1.) This system can be used by itself or as a filter to the SAR system.

Figure DMI1. Example of the directional movement index (DMI)

The Parabolic System (SAR)

The parabolic system is a stop-loss system based on price and time. The system was devised to supplement the inadvertent gaps of the other trend-following systems. The name of the system is derived from its parabolic shape, which follows the price gyrations. It is represented by a dotted line.

When the parabola is placed under the price, it suggests a long position. Conversely, when placed above the price, the parabola indicates a short position. (See Figure SAR1.) The parabolic system can be used with oscillators. SAR stands for stop and reverse. The stop moves daily in the direction of the new trend. The built-in acceleration factor pushes the SAR to catch up with the currency price. If the new trend fails, the SAR signal will be generated.

Figure SAR1. An example of the SAR parabolic study

Bollinger Bands

The Bollinger bands combine a moving average with the instrument's volatility. The bands were designed to gauge whether prices are high or low on a relative basis via volatility. The two are plotted two standard deviations above and below a 20-day simple moving average.

The bands look a lot like an expanding and contracting envelope model. When the band contracts drastically, the signal is that volatility is low and thus likely to expand in the near future. An additional signal is a succession of two top formations, one outside the band followed by one inside. If it occurs above the band, it is a selling signal. When it occurs below the band, it is a buying signal. (See Figure BB1.)

Figure BB1. A market example of Bollinger bands

Commodity Channel Index (CCI)

The commodity channel index was developed by Donald Lambert. It consists of the difference between the mean price of the currency and the average of the mean price over a predetermined period of time (See Figure CCI1.).

A buying signal is generated when the price exceeds the upper (+100) line, and a selling signal occurs when the price dips under the lower (-100) line. (See Figure CCI1.)

Figure CCI1. An example of the commodity channel index

The Larry Williams %R

The Larry Williams %R is a version of the stochastics oscillator. It consists of the difference between the high price of a predetermined number of days and the current closing price, which difference in turn is divided by the total range. This oscillator is plotted on a reversed 0 to 100 scale. Therefore, the bullish reversal signals occur at under 80 percent, and the bearish signals appear at above 20 percent. The interpretations are similar to those discussed under stochastics. (See Figure LR1.)

Figure LR1. An example of the Larry Williams %R oscillator

Rate of Change (ROC)

The rate of change is another version of the momentum oscillator. The difference consists in the fact that, while the momentum's formula is based on subtracting the oldest closing price from the most recent, the ROC's formula is based on dividing the oldest closing price into the most recent one. (See Figure ROC1)

Figure ROC1. An example of the rate of change (ROC) oscillator

ROC = (CCP/OCP) * 100, where
CCP - current closing price;
OCP = old closing price for the predetermined period Larry Williams %R.

The Relative Strength Index (RSI)

The relative strength index is a popular oscillator devised by Welles Wilder. The RSI measures the relative changes between the higher and lower closing prices. (See Figure 5.43.)

Figure RSI1. An example of the RSI oscillator

The formula for calculating the RSI is:
Л5/=100-[100/(1+RS)], where
RS - (average of X days up closes/average of X days down closes);
X - predetermined number of days The original number of days, as used by its author, was 14 days. Currently, a 9-day period is more popular.

The RSI is plotted on a 0 to 100 scale. The 70 and 30 values are used as warning signals, whereas values above 85 indicate an overbought condition (selling signal) and values under 15 indicate an oversold condition (buying signal.) Wilder identified the RSI's forte as its divergence versus the underlying price.