This article is written with the intent to explain basic supply and demand economics and how retail forex traders could benefit from this knowledge. Most retail forex traders are not finance geek and have limited knowledge about market dynamics and how forex market operates.
Early Trading Years
I entered the world of forex trading about four years ago and I came from a Management
background. When I started trading, I did not have any clue whatsoever about forex market. I used to visit different trading forums and financial news websites in search of a profitable system, where I saw different explanation of price movements. Some financial news website would say that the reason US Dollar fell against Euro because it reached a 50% fibonacci retracement, whereas another forum would state that the price fell because it hit 100 day moving average, other financial experts would argue that prices fell cause it touched a descending trend line and a bunch of experts would say that price fell cause it reached a resistance level.
As a novice trader, I used to scratch my head because all these different explanations were too much for me to grasp and it was hard to keep up with it. As a result, I used to fill my charts with tons of indicators, where it was sometimes hard to even see price candles. I knew that there has to be some logical explanation for all these price movements. So I decided to dig deep and do some research and find the one idea that above all is what drives the market and is displayed on our charts. It did not took me long to realize that all these price movements, I see on currency charts are result of supply and demand imbalance. If price is moving up it means there are more willing buyers for that currency at that point in time and if it is moving down it means there are more willing sellers for that particular currency. Price is simply moving from one zone to another zone to fill these orders. The information I am presenting in this article about Supply & Demand is learned and attained from numerous sources and I will try my level best to explain it in the simplest of form. Some folks might disagree with my point of view, but I always believe that two people might see similar thing and have completely different point of view. So let's get started:
Definition
Q. What is the definition of Supply ?
A. Supply is the quantity of an item available for buyers at a certain price. Q. What is the definition of demand ?
A. Demand is the quantity of an item which is wanted by buyers at a certain price. Q. What is imbalance of Supply & Demand?
A. (I) If the available Supply of an item exceeds the demand for it then prices tend to fall. (II) If demand for a certain item exceeds the available supply then prices tend to rise. Q. What is Price equilibrium ?
A. The market price at which the supply of an item equals the quantity demanded.
From above definitions, we now understand what is supply, demand, imbalance of supply &
From above definitions, we now understand what
is supply, demand, imbalance of supply &
demand and price equilibrium. Now let's
go into further details with some examples.
Example - Supply Exceeds Demand
From the above explanation, we now know that
supply and demand are fundamental driver of
price. Now lets look it into simple context to
better understand how supply exceeds demand. Let's assume its winter season and a customer goes to an electronics retail store to buy something. As he enters a store he sees a sign board offering 50% discount on air conditioners, but he hardly see anybody interested in buying it, despite the low price. What could be the reason for it. The simple and logical reason is since its winter, and the weather is cold, this item is not wanted by buyers cause it's of no use to them right now, however since the store is aware that there is lack of demand for this item, they are offering discounted price to entice buyers. This is classic example of supply exceeding demand viz. there is less demand for air conditioner in winter season, but more supply available, as such item was offered at a discounted price.
Example - Demand Exceeds Supply
Now lets look at similar scenario to understand how demand exceeds supply. It's winter season and a customer goes to an electronic retail store to buy a Heater, but it was out of stock, so he goes to another store hoping he would get it there, but unfortunately they are also out of stock. Thereafter, he goes to third store and finally he sees heaters available, at that store, but the problem is there are lot of customers already standing in line to buy it. Moreover, there is no discount offered on heater, in fact the price is much higher than normal, but lot of customers are still buying it. This is classic example of demand exceeding supply viz. there is more demand for heater being a winter season, but available supply is limited. Since many stores are out of stock, this particular store which have heaters raised the price due to excessive demand.
Now here is another scenario to understand Price equilibrium. It's winter season and a customer went to an electronic retail store to buy a Heater, there he sees enough heaters available at the store and some people are buying it. The store is not offering any discount nor the price is higher than normal. Since there was enough quantity available for this item and limited number of customers are buying it, the customer decides to check another store to see, if he can get a better price. He knows that this item will not be out of stock for the time being, so he visits another store and notice the same scenario as store one. This is classic example of price equilibrium viz. a supply of heater by retail store & demand by customers are equal, as such price is not at discount nor it is higher than normal.
How to identify Supply & Demand Levels on Forex Chart
Now that we have better understanding of price equilibrium and imbalance of Supply & Demand. We will go a step further and see how we can benefit from this knowledge in forex market. As in any market the purpose of trader / speculator / investor is to buy an item or instrument at discount (wholesale price) and sell at retail price, the forex market is no different. We as retail traders are unable to see actual buy/sell orders in forex market, but we can apply our knowledge of supply & demand to identify our next level of interest, where we believe smart money (large players / institutional traders, real market movers) are most likely to place their orders. Our main area of interest would be, where price made a substantial move from a particular zone and where actual imbalance of supply and demand between buyers and sellers occurred. It could be a series of candles or one candle, but it should clearly show a decision point where either buyers or sellers took charge. Once a zone is identified, our job is to wait until price approaches that zone again. We could either place a limit order or watch price action to enter trade at that zone.
As with any system or strategy we cannot be 100% sure that price will again respect that zone, but there is a higher probability than not that price would react at that zone, considering the way price left that level the first time, suggest that buyers/sellers consider it as an important zone. Let's look at attached chart example, which is self explanatory:
Price Structure
There are four common structures that are used to identify supply & demand levels on forex charts: 1) Drop- Base- Rally
2) Rally-Base-Drop 3) Rally-Base-Rally 4) Drop-Base-Drop
_____________________________________________________________________________ I firmly believe that once a trader understands supply & demand dynamics and trade with patience, discipline and proper risk management, he/she could achieve success in trading.
Here are some of my favorite Quotes from successful traders:
• Don't think about what the market's going to do, you have absolutely no control over that. Think about what you're going to do if it gets there.
• All we can do at best is look for historical reasons and apply this to a level or price area for possible future moves. Trading is neither science or art, it is a reflection of what value humans place on a particular financial instrument at a given point in time.
• If you must play, decide upon three things at the start: the rules of the game, the stakes, and quitting time
The Holy Grail of Trading [2/2]
Risk Management / Part 2 - by Ken
Part 1 of this article can be found here - >
In the following practical demonstration of Risk Management, I have scrolled EUR/USD chart back to Oct 2010 as the starting point of this exercise. Chart contains only Chaos Semafor indicator for showing 3 levels highs and lows. Purely for information not for our entry and exit decisions. Time to get on with our 10 exercise trades.
Trade 1:
We have one fresh supply zone and one demand zone. The fresh word here refers to zones are not been visited by price yet. Then we have some mid supply zones which we will ignore unless we see some decent opportunity. Now we wait and see what price does.
NB. I use an alert indicator which plays a sound when price is approaching wherever I place the
alerter's horizontal line. I don't have to sit and watch the price on any particular chart. Please see end of this article for the indicators mentioned/used in this exercise.
See how price sliced through the first mid-weak zone. We cannot see any decent PA here to prompt us to sell, especially considering demand at bottom was established with an engulfing candle. So we ignore it. If upper supply works and price turns down towards demand then so be it. We'll wait for the next opportunity. Do not worry about missed opportunities. Markets present no ends of entry opportunities on a daily basis.
As expected all weak zones are taken out. After price touched the main supply zone we have been watching, it produced a juicy bear engulfing candle. Now we are looking for an entry opportunity that fits in with our Risk Profile. It comes first and second candle after the engulfing one. Since we are all excited and cannot wait we enter as soon as price hits our stop range. Now we have to wait and see without doing anything stupid in the meantime.
Please note that this entry doesn't fit conventional supply and demand trading. Textbook entry would have been when price traveled further up within supply zone so that we can have our 40 pips stop just outside [above the upper border] the supply zone. However, after price hitting supply zone then seeing such a nice engulfing bear bar we decided it's worth taking the risk and entered at first possible opportunity.
The price hit our first target. Decision time. Do we close or let it run? Obviously, we don't take a long time here to think about closing or not. We should already have a pretty good idea by now what we'd be doing when price hit the TG1.
We already know that best possible signal we hope to see on charts is a nice engulfing candle on right place. Meaning in and around strong zones. We have a nice engulfing and a decent PA. In this occasion we decide to move our stop break-even +, define TG2 and let it run.
Since price sliced through our TG2, we decide to move our stop to TG2 and let it run. Looking for the price to hit the bottom demand or at least come bit more close to it.
We were proven to be right on this occasion. With patience and without unreasonable fear we have managed to maximize our gain by sensible trailing. We put our third and final target just off the demand zone to ensure quick exit. Often price can mess around before hitting the actual zone. Some may ask why that bull engulfing candle pattern on the way down didn't work. Look at where it formed? Do you see any decent zone around there? Besides, we put off from our entry radar levels between the supply and demand zones we decided to trade.
Please note that not all price movement as straightforward as the above one. That's why it's very important that when we catch a nice opportunity we don't waste it with premature exits.
Trade 2:
In accordance to our Risk Profile and dirt simple trading plan we take the buy in the demand zone. Our stop works out to be just outside of the demand zone which is ideal.
Now, there are various approaches on entries in and around supply and demand zones. Some enter when price hits the zone, some wait and see if the the candle makes it into zone, closes inside the zone, or goes through therefore invalidate the zone. There are others who wait to see if price is going to be contained in the zone by watching PA to give them some clues.
Each approach has it's own advantages and disadvantages. Waiting for PA confirmation may take some time and it'll most likely will happen outside the zone thus increasing stop pips count. Of course it's still not guaranteed it'll work. On the other hand taking the trade when price hits the zone will reduce our stop pips count but we do not have any indication or clue if it'll be contained within the zone or not.
In my case I do not subscribe to any particular one. I use all of them depending on the zone and how price travels, the speed price hits the zone. The above is a good example of for the first approach.
We have a fresh fairly strong looking zone which is established with an engulfing bull candle and hitting the zone with fairly big H1 candle.
As you can see price hit our TG1 nicely. Instead of closing we expanded our TG to about from 80 pips to 120 pips and moved our stop to break-even + 19 pips. Our TG2 is almost hit but not quite. Since we moved BE to plus 19 pips we can afford to wait and see.
All looking good so far. We locked our trade. We are fairly safe. We won't be taking any loss on this trade unless something unexpected happens or we leave this trade like this over the weekend and market gaps down to well below our entry price.
TG2 also hit with a nice big bull candle. Instead of closing we decided to trail. Moved TG further up and moved our stop to break-even + 122 pips.
We could have moved our TG further up but notice the left boxed dirty price action zone. We don't want to get involved in any dirty price action. It's best to take what we have [once hit the dirty zone] and run. If TG3 hit we'd be achieving over 4:1 reward ratio. No point getting greedy. If it slices through the dirty zone so be it. We'll wait for the next opportunity.
As this trade is fairly secured, we may go ahead and look for another trading opportunity on another instrument.
TG3 is hit comfortably and Trade 2 closed with 170 pips gain.
There is a nice bear engulfing candle in dirty zone which established a new supply zone. Why didn't we take a sell order around there. Well we already decided we'll only trade clean and strong zones. What about that current bull engulfing candle then. Are we not going to trade it? Yes we would consider this buy after a good engulfing bull bar around previous spike. Additionally, price has been bounced from fresh demand and not reached any serious supply yet. However, we cannot take this buy trade as stop would be bigger than our Risk Profile allows us. We need to wait for the next candle and see if it's going to come to within our 40 pips range.
Unfortunately, price didn't come down enough to allow us enter with a maximum 40 pips stop as defined in our Risk profile in fresh demand zone. However, we took a sell order in fresh supply zone without waiting candle finish or PA config. All was good other than amount of time price took to reach supply zone.
As you can see it hit our stop and this Trade 3 closed with 40 pips loss.
A new zone established at new high with an bear engulfing candle. If the risk is small, newly established zone looks attractive, looks a worth try. We will have to wait and see what kind of risk level it'll offer on the next candle.
Instead of closing we decided to trail as the candle following the one hit the target worked out nicely. So, we moved the stop to TG1. Locked our 80 pips gain and moved the TG further down.
Again instead of closing we decided to trail. Selling pressure looks quite promising. Already sliced through a minor ranging zone and gunned into bigger one. Decided to go for the full monty by moving target all the way down. However, this doesn't mean we will not keep trailing at reasonable distance.
Target hit on weaker demand zone. Trade 4 closed with 405 pips gain.
Are we going to buy here? Not as yet. It's a weak demand zone and we don't see any convincing PA as yet. So, we wait and see.
Now we have our bull engulfing candle. Only downside is it's on a weak zone. We can not take the entry as yet. Price is well out of our stop range.
Even though PA and levels have some warning signs for buyers we went ahead and bought it. Managed to reduce stop size to 27 pips.
Stop is hit. Trade 5 is closed with 27 pips loss.
Lower main zone hit. We have to remember it's no longer fresh zone. This is the second visit. We cannot enter a buy. It's outside of or stop range.
Since the lower demand was not fresh we decided to wait and see the finish of the big bear candle. Eventually, it took out lower demand. Established new supply zone and selling pressure is still on.
Even though it's a minor supply we take the sell trade almost within the zone. We could have sold bit higher and therefore reduce our stop amount but we wanted a bit of PA confirmation. A weak but some indication that sell is still on. We had better indication as to where price may be heading on the near left. Note those big engulfing bear candles within/around the supply zone.
Some call it previous demand zone turned into supply zone. That's a bit too techie for me. The fact is that sellers are in charge as we can see on the chart. All the remaining buyers from the origin of the demand zone already used their buying power and remaining ones are wasted at subsequent visit.
Additionally worth noting that we see on the charts new lower highs and two demand zones are taken out without much difficulty. Especially the lower main one taken out with such a zeal that we need to take notice of heavy selling pressure. What this means is that selling the peaks may be better option than buying in minor demand zones.
When TG1 is hit, we moved our stop BE+9 and TG2 to 118 pips. We let it run; trusting our analysis about heavy selling. We could have taken well over 120 pips with further trailing but let it run and it's almost hitting our stop.
On this occasion we got back previous low, but sometimes price takes the stop by a couple of pips or so. For those who cannot handle frustration when such thing happens best to trail more closely or close the position when TG1 is reached.
Trade 6 closed with 209 pips gain
Why we took this long entry when we were convinced there are heavy sellers and were saying best to sell peaks. Price created a form of gap and hit the rejection point. This knowledge may be out of the beginner's domain. So, lets just say we see heavy selling up to a certain point then rejection. Since it fits to our stop range we want to try this newly established zone.
Just short of our TG1. It looks turning against us. We don't want the winning trade to turn into a looser so we moved stop to BE+10
Since we have a nice bull candle it would be shame to close here rather than trailing. So we move the stop to TG1 and TG expanded to TG2 for 160 pips.
TG2 is hit and decided to close due to price structure on the left. Trade 7 closed with 160 pips gain.
Since we already have a supply zone just above, we have decided to go with the newly established supply zone just below the existing one.
Note: Conventional supply and demand trading method advises us to wait for the price to visit the
established zone before entering the trade. The reason for this is that establishing zone usually takes more than a couple of candle. However, in this exercise we have been taking trades just after a zone created. We go in early if we see attractive PA when establishing a zone. And of course we always keep left of the chart under constant observation. We look at left and trade the right.
Trade is developing nicely. TG1 is hit. Instead of close we have moved stop to BE+29 pips and expanded the target all the way down to near demand. Now we are targeting just over 250 pips. It would be real nice if we get it. That would be over 1:6 reward ratio.
What the heck.. Since price moving nicely in our direction we have the opportunity to move stop to our TG2 and let it run. Heavy selling pressure. We know overall market direction is south [down]. The downside is if it turns from here we'd be loosing a buy entry in demand zone.
Demand is taken out with ease. We have locked 1:7 reward ratio by moving our stop bit further down. Now we can sit and relax. Let the price do it's thing. See what else it may offer. At this point it doesn't matter a bit if it turns and hit our stop. If it doesn't then we may be onto something bigger here. However, we will still trail it at a reasonable distance.
Run is still on. We have no rush to exit. We just have to keep our greed in check here and let the price do it's thing. After all we don't catch such moves every day.
Traders with enough screen time will know that once price hits an important psychological level it's bound to react. We are trading EUR/USD and it hit sub 1.30. Lets assume we are new and not familiar with such stuff. So we leave our trailing as it's at 652 pips.
As expected bounced from new territories of 1.29. Our stop is hit. Trade 8 is closed with 652 pips gain.
We have missed the lower demand while waiting for our previous trade. Decided to enter a long on upper demand. Couldn't take previous hits as it was not in range of our stop. As you can see our initial TG is already hit. Not closing it. Moving stop to BE+ and expanding the TG.
Since it took out previous highs we keep trailing it. Already secured about 282 pips. Let see if market is willing to give us more.
Closed here manually after seeing rejection and especially engulfing bear candle. Trade 9 closed with 307 pips gain.
We couldn't take the sell order as it was just outside our stop range by 1 or 2 pips. We just cannot say what's 1 or 2 pips. We could take that sell. Look how it worked fine. Yes, but we cannot compromise on our Risk profile. Once it's defined we must keep it's rules to the pips, until we decide to work out a new one. We just cannot work out a new Risk Profile to fit in our current trade. So best is too keep it if it's working until it doesn't over a period of time. Discipline must be there at all times.
Initial TG is hit. Again instead of close we started to trail by moving stop BE+35 and expanding the TG.
Unfortunately, on this occasion price didn't go in our direction. It hit our stop. Trade 10 is closed with 35 pips gain.
MACD
Introduction
So, we've looked at what the MACD is, where all it's components are derived from and what trading signals it produces. Now we're looking at how to trade with the MACD. Traders use the MACD indicator in a number of ways to realise a trading opening.
• The MACD Divergence
• The MACD Histogram Crossover and Divergence • The Signal/Trigger Line Crossover
• The MACD zero line crossover
In our last section on The MACD, the indicator is best used in trending markets and shouldn’t really be used in range bound markets – not even to predict a new trend. The MACD
indicator allows us to determine how strong a trend really is (or if we’re in a range). If the MACD is hovering and flat around the zero line then this identifies a range bound market and if the MACD is trending strongly through or from zero (up or down) then there will be a strong trend trend. We can see this in the below McDonalds Chart.
Using MACD to Identify Trends
So the MACD and it's histogram should be used for trading in trending markets. Once we have established a primary trend (Dow Theory Tenet 1) there are a number of ways we can trade with the MACD on the continuation or this trend from it's retracement (Secondary Trend).
Trading the MACD Divergence
The MACD Divergence is either loved or hated by traders and often gives us false signals. The Divergence between the market price and the MACD is signalling weakness in trend. When the MACD is moving in the opposite direction to the market price this is a signal that the markets momentum MAY reverse at some point. Be aware though, that there are plenty of situations where trend hasn't reversed on MACD divergences.
In the below chart we have examples of positive and negative divergence. Positive divergence is seen when the MACD is increasing (making higher peaks and higher troughs), while less than zero, against a downtrend in price (lower peaks and lower troughs) – This is a Bullish Divergence
(although the market is still in a bearish primary trend, we anticipate a bullish retracement or reversal). A negative divergence occurs when The MACD trends down, while above zero, against an up trend in price – A Bearish Divergence.
These Divergences occurs because the current price momentum still outpace it’s, growing opposite momentum. This opposite momentum may take some time to be strong enough to win the day. You can see in this case the Momentum did change while the MACD was in positive and negative divergence, indicated by the yellow line.
MACD Divergence
The MACD divergence is an indicator which really needs to be used in conjunction with other indicators. The MACD divergence tells us trend may reverse at some point due to a shift in momentum. Other indicators needed will include volume. Volume is important here because as momentum wanes volume should decrease, indicating a lack of conviction in the current trend. This divergence (along with histogram resistance) is particularly useful if the divergence shows a secondary trend (retracement) possible reversal. This may indicate the primary trend is about to begin again, which is a signal for trend traders to enter the market.
Instead of an indicator that is going to trigger trading signals, MACD Divergence is really an early warning system. Many traders will wait for the trend to confirm its reversal before entering the market - using the MACD divergence as a filter, only entering MACD/signal line crossover signals after a divergence. As we can see in the above chart the green circles represent possible entry points where the MACD crosses the signal line. Trend traders may give the 1st circled entry point a miss, as it's against the primary trend and hopefully just a retracement to the downward trend resistance line. The 2nd entry point would interest a trend trader though, as it's signalling a trend and momentum continuation. Many divergences will last for a long time, so patience is needed.
Trading the MACD Histogram
As well as setting up trading strategies around the MACD divergence and its signal, traders may also set up trading strategies around the MACD Histogram. Remember, the MACD histogram is a derivative of the MACD and it's 9 day MA signal - measuring the distance between the two, therefore changes in momentum. There are two ways of using MACD histogram to trade - The zero crossover and the divergence. The crossover will produce actual trading signals, where momentum and trend has changed, while the divergence is more subtle. The histogram divergence is almost a filter, or early warning system. It allows traders to see slight changes in momentum (even though price trend looks the same to the naked eye), which may lead to a full blown trend reversal in the future. Traders may filter out all MACD/signal line triggers that aren't associated with a
Trading the MACD Histogram Zero Crossover
The Histogram zero line crossover occurs when the MACD equals the MACD 9-day moving average (it's signal). It's exactly the same as trading the MACD/signal line crossover as discussed later in this section, just graphically different. So, we won't spend much time on it here.
Trading signals are triggered when the the histogram crosses it's zero line. When the histogram crosses above the zero line buy signals are triggered and when the histogram crosses below the zero line, sells signals are generated. I've shown this in the chart below. As shown these signals occur when the MACD and it's signal cross. Once again, the MACD histogram should only be used in a trend following strategy.
Trading The MACD Histogram Crossover Trading The Histogram Divergence
The histogram divergence is used to anticipate a MACD-Signal crossover - an early warning system if you like, when trading with the trend. It can be used effectively as a filter to all those
MACD/signal line crossovers, filtering out crossovers that don’t have a divergence associated with it. There are 2 types of histogram divergence - The Peak-Trough and Slant divergences. In both cases a full-bodied divergence generating over a few weeks is a better indicator than a shallow divergence developing over a few days – so go long and large, not short and shallow.
We have two examples of the Peak-Trough Histogram Divergence – one Positive and one negative. A negative (or bearish) divergence forms when the histogram makes consecutive lower peaks and the MACD and price form consecutive higher peaks – price momentum is weakening in a similar way to the MACD divergence above. This can be seen in "The MACD Histogram Peak-Trough Negative Divergence" Chart .
We have a histogram negative divergence indicating a possible price reversal to the bearish side. This price reversal is confirmed when the MACD crosses below the signal, which could be a trade entry point to short the USD against Japanese Yen (green circle). As with the MACD divergence the Histogram divergence indicates many false trade signals; so it’s used as part of an overall trading strategy where other trading tools are also utilised.
The MACD Histogram Peak-Trough Negative Divergence
A Positive histogram Divergence forms when the MACD and price form lower troughs and the histogram forms higher troughs – price momentum is turning away from the downside, to a bullish trend. This can be seen on the above chart “MACD Histogram Positive Divergence” where the lower well-defined troughs on the MACD are highlighted in Red and the Higher well-defined troughs in the histogram are highlighted in green. Notice MACD moved to a lower low in late May, but the histogram formed a higher low. It follows, if traders are using this divergence as an early warning signal before committing, a good entry level maybe Jun 6th or Jun 13th when the MACD crosses above the signal/trigger. Remember, this is a trend following indicator.
The MACD Peak-Trough Positive Divergence
The Slant divergence acts the same way as the peak-trough histogram divergence, but is minus the peaks and troughs. The Histogram in both the positive (bullish) and negative (bearish) divergences will slope towards the zero line indicating that price momentum is weakening and the price of the security is maybe about to turn. (Remember the histogram measures the distance between MACD and it’s 9-day moving average signal line. Momentum weakens as these lines converge).
In the below chart we've zoomed into a section of an IBM weekly chart following a primary up trend. Within this primary up trend we can see two retracements. Two positive histogram slant divergences have been highlighted, where the histogram diverges with the price and the MACD itself, indicating a momentum change. If traders are using the histogram divergence as an early warning to possible momentum change then they will act on the buy signals where the MACD crosses the signal line (or where the histogram crosses zero). These buy triggers are highlighted with green circles. These two bullish divergences bring IBM out of retracement back on to the primary trend.
You can also see two negative divergences, one a peak-trough divergence (May-Jul 99) and one a possible slant divergence (Dec 98). Trend traders will use these negative divergences to highlight where the primary trend maybe about to retrace and sell on the MACD-signal crossover.
Remember, other indicators should be used as part of your trading strategy. The MACD Signal/Trigger Crossover
We touched upon the trading possibilities of the MACD price crossover in the section – “The Moving Average Convergence Divergence – MACD”. The signal crossover is the most common MACD signal - when the MACD crosses above the 9-day EMA (Exponential Moving Average) trigger line a buy (or exit the short) signal is created and when the MACD crosses below the signal line a sell/short signal is created. This is a great signal confirmation in itself, or just after a divergence and is generally traded with other indicators to get a clearer picture of where momentum is going. Again, this is better used in trending markets.
Below, we have an S&P 500 hourly chart in a primary up trend. We can see how traders utilise this indicator in a trading environment. On the 22nd the MACD (Blue line) crosses below the 9-day EMA trigger line. This indicates that traders should sell a long position. Indeed, momentum shifted to the downside until the MACD crossed above our trigger (white line) on the 27th. This crossover on the 27th is a buy signal where momentum reversed again to continue the primary trend. In effect the area between this sell signal and buy signal is a primary trend retracement.
The signal to exit this long position comes on the 5th when the blue MACD crosses under the white signal. Trend traders may sell here and await the retracement to follow it's course. On the 7th we can see a criss-cross buy/sell signal. Anyone entering a buy here would have been burned, as price continued to fall and a quick strong sell signal developed. In fact we can see a negative divergence here, indicating a turn in momentum to the downside. This turn to the down side may have been a retracement or full blown trend reversal. Other indicators need to be utilised to indicate whether the
retracement is to continue,or not... Use volume, Fibonacci retracements and see where support and resistance are before trading.
MACD Signal Line Crossover
In the above example I've indicated that traders will sell on the retracements and buy on the continuation of the primary trend. This may not be the case for all traders. As part of a trading strategy, a long-term trader may be happy to keep his long position going into a retracement.
He/she may have a long position that only gets sold when long term trend lines are broken, or when previous support areas are lost. By the end of this course, hopefully you'll be aware of many
trading strategies and pick the one best for your needs.
If you find yourself in a situation where you see a buy signal crossover (MACD crosses above 9-day signal) above the zero line. or a sell signal crossover below the zero line, this indicates
momentum is continuing and these signals are still valid. Just be aware of any divergence that you see, indicating the possible change in momentum in the future.
The MACD Zero Line Crossover
As the name suggests the MACD zero line crossover highlights buy/short positions that may be profitable to a trader. When the MACD crosses the zero line it indicates that momentum has already reversed. Traders will employ other indicators into their trading strategy to try to determine whether it’s still a good trade to enter into. To determine a strong trading signal The MACD will pass the zero line in a strong manner at a decent angle. This will also coincide with a strong histogram indicating good price momentum continuation. If the MACD crosses zero flatly or just above the zero line this indicates a range, which isn’t good to trade with The MACD.
In the Chart Below This strong signal is highlighted on the left where the MACD is also moving away from the 9-day trigger line. This strong MACD and rising histogram (the difference between MACD and trigger) shows good rising price momentum – a good buy signal. In this situation the trade sell signal occurs when the MACD crosses under the signal. As the MACD heads towards zero a “MACD zero line crossover” trade should be anticipated, but only if it crosses in a strong manner. We can see that when the MACD crosses back across zero and the histogram is strong – a good short signal. We can exit the trade at the next MACD/signal crossover.
In the below example out trading profits are indicated by the green and red trend lines. If we had traded the MACD signal/trigger crossover our profits would have been greater between the two trades (indicated by the grey trend lines). However, using the MACD zero line crossover is an extra confirmation that momentum has turned and strong, as well as triggering less false signals. In effect the zero line crossover is another way of looking at the double moving average crossover, as when the MACD crosses zero, the 2 moving averages cross each other.
MACD zero line crossover Changing The MACD Parameters
The standard setting for MACD is the difference between the 12 and 26-period EMAs. Chartists looking for more sensitivity may try a shorter short-term moving average and a longer long-term moving average. MACD(5,35,5) is more sensitive than MACD(12,26,9) and might be better suited for weekly charts. Chartists looking for less sensitivity may consider lengthening the moving averages. A less sensitive MACD will still oscillate above/below zero, but the centerline crossovers and signal line crossovers will be less frequent.
To Sum Up
The MACD and MACD Histogram are great for spotting trend, identifying changes in trend & price momentum and establishing trading trigger entry & exit points. Many trend following trading strategies will have MACD at their heart. The MACD can't tell us if prices are overbought or oversold though and as the MACD is a derivative of price it's difficult to compare Momentum against different stocks, or against historical prices of the same market. But it's unique in bringing together trend and momentum. To compare other markets and historical prices we can use the
We can set the indicators price action sensitivity. The sensitivity of the indicator to price action determines how quickly the trader enters the move and how accurate these trading signals are. If the indicator is set to low sensitivity then you generate less false signals, but you may see the move too late, or not see it at all. With high sensitivity you are more likely to catch the move into the trade, but you may generate false trading signals. For instance a swing trader (trading with a horizon of 4 to 5 days) may set the MACD to 3, 10, 16 once they've drill down to an hourly chart from a daily chart. Reducing the parameters of the moving averages will increase the sensitivity and highlight more signals - good and bad. Good charting software will allow the parameters to be changed. Technical analysis is not an exact science and although these indicators can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.
Introduction
Fibonacci (Full name: Leonardo Pisano) was a 13th Century Italian mathematician who developed a sequence of mathematical numbers, which described how life is bound by the same mathematical principles. We can use his findings to interpret (in mathematical and charting terms) how the individual ceases to act alone, but acts as a collective, making group decisions. We'll find out how Fibonacci's (shortened to Fib's) mathematical relationship between his sequences of numbers and crowd mentality plays a critically important role in charting, as well as in nature itself. A more in depth look at Fibonacci numbers can be found on Wikipedia etc… but for now, we as traders only need to know the basics.
Fibonacci’s numbers are:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc.
Each number is simply the sum of the 2 proceeding numbers. It’s remarkable characteristic is the ratio between the numbers - Each number is approximately 1.618 times greater than the proceeding number. This ratio strengthens as we climb higher in numbers. In mathematical learning this is sometimes called retracement studies.
The key Fib ratios are:
• 61.8% (the golden Rule) - Divide 1 number by it’s following number. I.e. 13/21 = 0.619 • 38.2% - divide 1 number by the number 2 places up. I.e. 55/144 = 0.3819
• 23.6% - divide 1 number by the number 3 places up. I.e. 21/89 = 0.23596
The ratio of 61.8 is known as the “Golden Ratio”. It’s found in all walks of life and forms the building blocks in the laws of nature. The golden ratio can be seen throughout the mathematical construction of nature – From architecture, sunflowers, snail’s shells & spiral galaxies. For example the ratio of female bees to male bees in a hive is 1.618 and the difference between the distance from your fingertips to your shoulder and your fingertips to your elbow has the Golden Ratio. This Golden Ratio is also found in finance.
Fibonacci in Technical Analysis
The 1st thing to note is, when using "The Fibonacci Retracement" we are working on the basis that a trend will continue and the reversals are corrective in nature. In other words the retracement's are
temporary pull-backs and up-turns within a larger trend. The section on "retracement or reversal – a checklist" will help to identify whether the trend is correcting or reversing.
Most Charting Software will have the Fibonacci Tool that can be utilised by chartists. The Fib retracement is created by taking 2 extreme points (usually a peak and trough) on a chart. The extreme points of the Fib are divided vertically by Fib’s ratios – 23.6%, 38.2% and 61.8%. A 50% retracement is also added, because it is an important psychological number. This 50% level was derived from Dow theory and the assertion that a 50% retracement is psychologically on the mind of the collective. These ratios between peak and trough are then drawn horizontally on the chart and are used as stated in the above paragraph to highlight potential trend retracement support and
resistance areas. These areas are useful for trade entry and exit.
WFM - Fibonacci Retracement
The above Whole Foods chart shows how Fib is drawn and used. The Fib is drawn between the trough of a trend (price $34) and it's peak at $66.56. The charting software automatically draws on the ratios at 23.6, 38.2, 50, 61.8 and 100 (Sometimes a 78.1 will also be drawn). See how, as we’ve circled, these ratios offer reversal, support and resistance opportunities. You’ll see that 100 on our Fib scale (right hand side on the chart) signals the start of the drawn line, this is because it will take a 100% price reversal to get back to this price level of $34.
Fibonacci Assumptions and Rules
These ratios don’t always hold, but do offer good technical indication for the trader especially when used with other indicators and price action. Since ALL traders are aware of Fibs and use them WIDELY the ratio levels tend to become self-prophesising, especially is you draw the Fib between obvious peaks and troughs. Fib lines can be drawn from candle body to candle body, or from shadow (or wick) highs and shadow lows, but it’s best not to mix bodies and shadows. They can also be drawn from any peak, trough in any timeframe and be perfectly valid in tech analysis. However, Fibs work better over the longer term. The shorter the timeframe then the less reliable the data can be as volatility skews support and resistance levels. It’s like any survey – the more data the better the result. Fibs can be used in any chart time-frame, but just bear in mind that it’s better to use multi-time frame analysis focusing on a daily chart over a longer period prior to focusing down.
Always use other tech analysis in conjunction with Fibs. Candlesticks, Price action, volume, chart patterns & indicators are always worth confirming 1st.
Trading Fibonacci - A Leading Indicator for Entry
Fibonacci is sometimes thought of as leading indicator particularly if used in a trend. As we have discussed price doesn’t always go up in a trend, as a trend has periods of consolidation. Traders will use Fibonacci Retracement to predict the price downturn/up turn in a period of trend consolidation and then look for entry points if the trend is to continue. The Fib levels of 23.6, 38.2, 50, 61.8 are Alert Zones that traders can anticipate trades from – hence a leading indicator. Keep in mind that these fib levels are not hard reversal, support and resistance levels; but are zones for potential tech analysis.
In our example of EUR/USD below in mid April a strong up trend reached a long consolidation point until late August where the trend continued with higher lows and higher highs. This
bottoming of the consolidation occurred on the 50% Fib retracement line where the currency pairing bottomed a couple of times before taking off. I’ve circled the 50% Fibs that traders Many looking to enter at. You’ll also see a 38.2% retracement where bull traders entered, but this rally was very short lived. As a leading indicator The Fib is allowing traders to forecast where a reversal MAY take place and MAY indicate trading opportunities when used with price action and
technical analysis. A trend is deemed stronger if the consolidation hits the 38.2% retracement then rebounds to continue the trend.
EUR/USD - Fibonacci as a Leading Indicator Fibonacci Trading Confirmation
Combining Fib retracement with other tech analysis is a must. In our EUR/USD chart above we have a stochastic oscillator. Notice how an oversold 20 crossover line, a stochastic / 5 period MA cross over and 50% retracement align on the 24th/25th Aug. There’s also a spinning top indicating a possible reversal (See Price action Module 5). Before trading, traders like to get confirmation. Confirmation in the way of:
• A double confirmation of Fib support levels • Candlestick patterns (see price action module 5)
• Increased volume on trend continuation
• Moving averagessupport & resistance levels met • Trend Lines Met
• Previous Resistance becomes support and vice-versa (below chart)
Looking back at previous support and resistance levels is a good idea to get confirmation that the Fib retracement is holding. These historical levels can be previous Fib extension levels, or other levels set by moving averages, significant round numbers, etc... In the chart below, look how a previous resistance level now become support and this coincides with a 50% retracement. This level is highlighted with a blue line. This 50% Fib Retrace, is not only support from a previous resistance level, it also holds 3 times. This is good trading confirmation.
USD/CHF - Fibonacci Extension now becomes Support Trading Fibonacci - Setting Profit Targets with the Extension
Fibonacci can be used to calculate profit-taking levels. We’ll use the same Fibonacci set-up as above on the EUR/USD and highlight the whole profit set-up in a new chart of EUR/USD below. The Fib is kept in the same place, so we have an up trend between June and Aug with a retracement to the end of Aug. To calculate profit targets we can use Fibonacci Extensions. The most common of which are 0.382 and 0.618.
We use The ABCD Fibonacci pattern to establish our trading strategy. The start point of our Fib is labelled A, while the end of the Fib is labelled B – That’s the easy bit. Now it gets a wee bit harder as we need to establish our trade entry point. If we have established we’re in a trend and we’ve recognized the down turn is a consolidation period prior to the trend continuing then we need to find our entry point (The section Retracement or Reversal – a Checklist, in this module should help here).
In or example, using Fib retracement, the EUR/USD retraces back to 50% on 24th Aug with a stochastic oversold signal. We could have entered here, or we could have entered on the 31st Aug or 10th Sep. At both these later dates the 50% retracement has been confirmed, indicating support. In our example entry was 31st of Aug as a double bounce on support is good
confirmation that support will hold (volumes can help here where buying pressure will increase on support – not shown. SMA will also help confirmation). This Long (BUY) entry point is our C
point. Be aware of support and resistance levels and trading channels, as your profit targets could be affected be these.
EUR/USD - Fibonacci Extension to Set Profit Targets
Our profit target needs to be set now. This is where Fib Extensions come into play. Some software applies these automatically, but others you will need to edit yourself. Usually you can edit the properties of Fibonacci to achieve this. You’ll see on our example I’ve had to edit the Fib with a -38.2, -50 and –61.8 to get the extensions – these are our 0.382, 0.50 and 0.618 extensions. You can calculate the Fib extension yourself by the following formula where A = the 100% retracement and B is the 0% retracement.
Up tend: D = B + {(B-A) x Fib Extension} Downtrend: D = B – {(A-B) x Fib Extension} Important: Some traders will calculate from A meaning our 0.618 extension becomes 1.618 – just be aware of this when looking at other resources.
In our EUR/USD example our profit target at D occur on 14th Oct. If our entry point is 50% retracement, our target should be 50% extension (or 1.5 in some software). The same applies for 38.2% and 61.8% etc… We could have reduced our expectations here and taken profit at the 38.2 extension, which would have also been profitable. It’s almost like a self-fulfilling event, as most technical traders will be looking at the same stand out Fibonacci to profit. The 50% extension was hit on the button, prior to profit taking. Notice how the FX pairing hits the 61.8% extension exactly prior to a reverse - This has now become an important resistance level as can be seen to the far right of our chart.
Example Fibonacci Trade
Fibonacci Simple Trend Trade (Using above EUR/USD chart) • Draw Fib and get Fib retracement confirmation (see above) • Confirmation set at point (C)
• Stop/Loss placed either at next Fib level below entry point (in this case 61.8%). This allows the trade to breathe, but may be a little to much for some. It all depends on your risk
threshold. A longer term trader may place the stop way back at the 100% retracement, while a day trader may place the stop under the last candle bottom
• Risk/Reward. If target is D (1.41), entry (C) is 1.26 and you lace a stop at 1.245 (under 61.8%) your risk reward is profit (D)-(C) = 0.15 / potential loss (C)-Stop = 0.015 = 10:1. • Set trailing stop under trend line, moving averages of below the last candle low.
Fibonacci Extensions - Future Support and Resistance
As indicated in the above paragraph, Fibonacci extensions can form important support and
resistance levels for future price action. As seen in the above EUR/USD currency pairing chart the November high at extension level 61.8% now becomes resistance for future price moves in January 2011. Support and resistance levels can be seen along the length of the extension as we go ever higher. For instance the 1.382% (or 2.138%), 161.8% (or 261.8%), etc.. may also become an important support/resistance level in the future too.
To Sum Up
The value of Fibonacci's numbers is clear to see in nature as well as in finance and should be an important part of your trading strategy. As we've seen Fibonacci is a trading tool used by many Chartists to anticipate trade entry points as well as setting profit targets and stop/loss positions. However, it's not an all-in-one trading solution and should always be utilised with other technical analysis.
There's a strong relationship between Fibonacci, human nature and crowd mentality. One theory that we'll go on to talk about is The Elliot Wave, which used Fibonacci as it's basis. This theory and the psychology of trading need to be looked at at this point.
Some points to note are:
o Fibonacci ratio retracements don’t always happen, but play around with Fibs to
satisfy yourself of it’s worth to your own trading strategy.
o Be aware of support and resistance levels and trading channels, as your profit targets will be affected be these too.
o It’s best to trade in the direction of the trend.
o Use Multi-timeframe analysis, other chart patterns, price action and other tech
analysis for confirmation of trend, entry and exit.
Peak and Trough Analysis
Peak and Trough Analysis is a useful tool to identify when a security is trending or is in a period of consolidation. Spotting trend is important for trend traders as many trend traders will only trade when there's a definite trend to be seen. Trading in a trend tends to let your profits run and is usually more predictable than range trading. However many traders do trade in ranges and we'll study this and other types of trading in future sections. Peak and trough analysis is also useful to gain points of entry to the trade, especially if combined with other technical indicators. Again, we'll delve deeper into technical indicators in future sections.
As we've seen in our section on Dow Theory price action never goes up or down in a uniform manner, it zigzag's. This zigzag motions forms the peaks and troughs in charts. In an up trend each new peak is higher than the previously observed peak and each new trough is higher than the last observed trough. In a down trend each new peak is lower than the previously observed peak and
each new trough is also lower than the last observed trough. This is what defines a trend - higher highs (peaks) and higher lows (troughs) for the up trend and lower highs and lower lows for the down trend.
Some charting software will highlights peaks and troughs for traders (%-zigzag indicator), but spotting them yourself is possible. To do so, one must bring up your chart focusing on primary trend and simply highlight all the significant highs and lows. After a while you'll get used to
spotting them... This should indicate whether you're in a long term trend, or not. Your primary trend
is determined by your trading horizon, i.e. if you are a day trend trader (in and out of a trade within a day or thereabouts) you may want to focus on a primary trend of a few months. A trend traders will then usually only trade in the direction of the long term trend.
In our Forex example of the USD/JPY cross-pairing, a down trend looked like it had started in May 2010 and finished in Nov 2010, but by highlighting the main peaks and troughs with arrows we can see the circled red arrows indicated there weren't lower lows until June 2010. The down trend actually started in June 2010 with consecutive lower highs and lower lows. Trend trading would have been difficult prior to June 2010, as technically the price may still have been in a range.
Peak and Trough Analysis
Combining Peak and Trough Analysis with other trend spotting technical indicators like moving averages is ALWAYS wise in forming trading strategies. It's also wise to make sure the timeframe isn't too short, so remember to use Multi-Timeframe Analysis to figure out the markets general direction.
Be aware that if the trend journeys into a consolidation range, it can do so for quite some time. In general a range can last between 33% and 66% of the length of the trend, but not in all cases. Don't be fooled thinking that the trend will reverse after this consolidation period either. The trend can continue on it's merry way after this consolidation. We'll go on to talk about consolidation chart patterns in later sections.
Other Methods of Spotting Trend
occurs when prices are contained by an upward or downward sloping 20-period Moving Average. Others will utilise The Average Directional Index (ADX) to identify trend. All of these indicators can be found under Module 3 in our course.
Trend Traders
Regardless of how one defines trend, the goal of trend trading is the same - join the move early and hold the position until the trend reverses. The basic mindset of trend trader is "I am right or I am out?" The implied bet all trend traders make is that price will continue in its present direction. If it doesn't there is little reason to hold onto the trade. Therefore, trend traders typically trade with tight stops and often make many probative forays into the market in order to make the right entry. By nature, trend trading generates far more losing trades than winning trades and requires rigorous
risk control. The usual rule of thumb is that trend traders should never risk more than 2% of their capital on any given trade. Module 7 has more on Managing Money
Introduction
Many of the most successful traders will only trade when there's a trend present and some like to catch the new trend early on the reversal. Whatever the trading style, all traders need to know the difference between a trend retracement and a full-blown trend reversal.
We've gone through some of the indicators, chart patterns and talked support and resistance already, but knowing retracement versus reversal is a must. Whether you're looking to use Fibonacci, Moving Averages or Trend Lines as part of a trend following strategy, or looking for the reversal, then it’s worthwhile identifying whether the change in a trend is a correction or a complete turn-around.
Traders thus face the following dilemma:
• If they're in a position relying on the trend continuing, do they hold onto their position? This
could lead to losses if the retracement turns out to be a longer term reversal.
• They could close their position and re-enter if the price starts moving with the overall trend again. Of course there could be a missed trade opportunity if price sharply moves on.
Money is also wasted on spreads if you decide to re-enter.
• They could close the position permanently. This could result in a loss (if price went against
you) or a huge profit (if you closed at a top or bottom) depending on the structure of your trade and what happens after.
Because reversals can happen at any time, choosing the best option isn't always easy. This is why using trailing stops can be a great risk management technique when trading with the trend (See the Module on Risk Management) . You can employ it to protect your profits and make sure that you will always walk away with some pips in the event that a long-term reversal happens. In our
Moving Averages and Parabolic SAR section (amongst others) we've explained some trading examples utilising the trailing stop.
Retracement or Reversal - The Difference
In a retracement or correction the long-term trend is still intact, so if you gambled on a full-blown reversal it could have been a costly trade. It’s important to know the difference between the two, as this will influence our decisions to hold, sell or buy the security with a view to picking it up later on.
A retracement is defined as a temporary price movement against the established trend. Another way to look at it is an area of price movement that moves against the trend but returns to continue the trend.
Reversals are defined as a change in the overall trend of price. When an uptrend switches to a downtrend, a reversal occurs. When a downtrend switches to an uptrend, a reversal also occurs. Retracement or Reversal - A Check list
There are key differences between the reversal and retracement as highlighted in the following check list.
Retracement or Reversal Check list
Retracement / Correction Reversal
Volume Small Selling Volume Large Selling Volume
Money Flow Buying Interest during decline is still present and selling interest in a up trend is still present
Buying interest is small in a down trend and selling interest is small in up trend. Both force price to reverse
Chart Patterns Continuation Patterns (Wedges, Triangles, Flag & Pennant)
Reversal Patterns (Head & Shoulders, Double Top) Time Frame They are short lived These are Longer Term
movements
Fundamentals No Change Change or Speculation of change Candlesticks Lots of Indecision Candles with
long shadows and small bodies
Reversal Candles lick engulfing, soldiers etc…
This list is by no means fool proof, but give a trader a base for understanding the corrective nature of a market. Just remember to be aware of the time frame you're dealing in. A weekly chart looking out 5 years may see a retracement, but that very same retracement may be a reversal on a daily chart - Remember time-frame analysis.
Identifying Retracement
There are a few ways to identify retracements other than the checklist above. These are: 1. Fibonacci Retracements
2. Pivot Points 3. Trend Lines
4. Candlestick Patterns 1.Fibonacci Retracement
A popular way to identify retracements is to use Fibs. For the most part, price retracements hang around the 38.2%, 50.0% and 61.8% Fib level before continuing the overall trend. If price goes
beyond these levels, it May signal that a reversal is happening. As you may have figured out by now, technical analysis isn't an exact science, which means nothing certain...
For an in depth look at Fibonacci Retracement see our section earlier in the Module. 2.Pivot Points
Another way to see if price is staging a reversal is to use pivot points (intra-day only). In an
uptrend, traders will look at the pivot or lower support points (S1, S2, S3) and wait for them to hold or break. If broken, a reversal could be in the making! In a downtrend, traders will look at the pivot & higher resistance points (R1, R2, R3) and wait for it to hold or break.
Pivot Points - Reversal or Retracement 3.Trend Lines
The last method is to use trend lines. When a major trend line is broken, a reversal may be in effect. We've already looked at how to draw trend lines, how support and resistance can affect trend and how moving averages can act as trend lines, so if you're unsure then please revisit the relevant section.
4. Candlestick Patterns
By using trend lines in conjunction with candlestick chart patterns discussed in Module 5, a trader may be able to get a high probability of a reversal.
To Sum Up
You now have the tools to try to differentiate between a retracement and a reversal. Using the "Check List" and the "Identifying Retracement" section will give you a fighting chance. While these methods can identify the difference between retracements and reversals, they aren't the only way. At the end of the day, nothing can substitute for practice and experience. With enough trading time, you can find a method that suits your trading personality in identifying retracements and reversals.
Reversals can happen at any time. Retracements can turn into reversals without warning. This makes using trailing stops very important. With trailing stops, you can effectively prevent yourself from exiting a position too early during a retracement and exit a reversal in a pinch.
The Bullish Engulfing Pattern
Trading with Engulfing Patterns - by Richard Krivo
What qualifies as an engulfing candle is fairly simple: as long as the body of a candle engulfs the previous candle in terms of the body and wicks, it would be considered an engulfing candle
(Sometimes you may find trader's don't count the wicks). As such, it can indicate that a move in the opposite direction of the candle that was “engulfed”may take place.
In other words, if a bullish candle is engulfed by bearish candle, the higher probability direction to trade the pair will be to short it. If a bearish candle is engulfed by a bullish candle, the higher probability direction to trade the pair will be to buy it.
Remember, just because a trader sees an engulfing candle does not mean that a move in the
opposite direction is assured. As far as being certain goes, a trader can be certain that a candle is an engulfing candle, but we can never be certain of what may transpire on the chart going forward. Keep in mind, as is the case when interpreting candlesticks, a trader cannot make a decision regarding what a candle might turn out to be until that candle is closed. So, always wait for a candle to close before making a trading decision based on whether it's engulfing or not.
A simple trading strategy is to take a trade when the engulfing candlestick is in the direction of the main trend. In other words, in a correctional take profits retracement we would look for bullish engulfing candles and in a short bullish correction we would look for bearish engulfing candles. Should the trade be taken, the stop can be placed below the bullish engulfing candle in an uptrend and above the bearish engulfing candle in a down trend. See more on stop/losses in our Module 7 Lastly, as usual, nothing in trading is a certainty and not all engulfing candlestick patterns will lead to a reversal. Testing a system with proper risk management is essential prior to trading
Really only useful if found in a downtrend. We can see the pattern on the left above where the hollow candle body completely engulfs the filled candle body. This pattern doesn’t indicate
indecision, but that buyers are back in the market - The short bear candle is running out of steam and being engulfed by a strong long bull candle. The longer the white (hollow) candle against the black (filled) candle the greater the chance of reversal and if there is increased volume we’ll also increase our chances of a reversal. The black candle shouldn’t really be a doji as it’s fairly easy to engulf. If the shadow is engulfed, then this is better, but not necessary and finally the shadows on both candles should be small or non-existent. Again, further confirmation is needed for reversal. This pattern can also confirm a continuation of trend and continued buying pressure. If seen passing through a resistance level then this may confirm a break of resistance. This pattern is valid as long as the body is engulfed.
The Bearish Engulfing Pattern
Only useful in an up trend and is the exact opposite to the bullish engulfing pattern – it is the 2nd diagram on the left above. The same rules apply here as they did above and we should always look
for other confirmation in the form of further price action to the downside (like the three black crows, below) and increased downside volume.
The Piercing and Dark Cloud Cover Patterns
These two blends work in the same ways as the previous two. The Piercing pattern is a bullish pattern where the hollow 2nd candle drives up from below the previous filled candle to above half way of the previous filled candle. Both candles should be fairly large bodied with small shadows. If the white candle doesn’t finish above the black candles middle then this isn’t considered bullish. This is the third diagram above. Again, confirmation is required for reversal. Dark Cloud Cover is the mirror image of The Piercing Pattern.
Three White Soldiers and Three Black Crows Reversal
Solid Confirmation is found if reversed momentum is followed up with strong corroboration – the most famous of these are the three white soldiers and the three black crows. The 3 white soldiers equal 1 long white (hollow) candle and the 3 black crows equal a long black/red (filled) candle. Both these blends can be seen in reversal patterns and are used to confirm that the reversal has taken place.
These two formations will be more prevalent after a long trend that is going through a reversal. Ideally the 3 candles should start within the last candle and close near the high (in the case of the 3 white soldiers) or the low (in the case of the three black crows). In the 3 white soldiers chart below the soldiers are the reversal and in the 3 black crows chart the black crows confirm a spinning top candlestick showing indecision.
Three White Soldiers & three Black Crows Reversal The Use of Other Technical Analysis is Beneficial
Candlesticks provide an excellent means to identify short-term reversals, but should not be used alone. Other aspects of technical analysis can and should be incorporated to increase reversal robustness. For instance support and resistance, Fibonacci retracement and overbought and oversold oscillators can play an important part in any price action trading strategy. Look how support coincides with a bullish engulfing candlestick pattern and how The Stochastic crosses the bullish 50 line below helping to confirm the reversal.
