Common Chart Indicators
Bollinger Bands
Bollinger bands are used to measure a market’s volatility. Basically, this little tool tells us
whether the market is quiet or whether the market is LOUD! When the market is quiet, the
bands contract; and when the market is LOUD, the bands expand. Notice on the chart below that
when the price was quiet, the bands were close together, but when the price moved up, the bands
spread apart.
That’s all there is to it. Yes, we could go on and bore you by going into the history of the
Bollinger band, how it is calculated, the mathematical formulas behind it, and so on and so forth,
but we really didn’t feel like typing it all out.
The Bollinger Bounce
One thing you should know about Bollinger Bands is that price tends to return to the middle of
the bands. That is the whole idea behind the Bollinger bounce (smart, huh?). If this is the case,
then by looking at the chart below, can you tell us where the price might go next?
If you said down, then you are correct! As
you can see, the price settled back down
towards the middle area of the bands.
That’s all there is to it. What you just saw
was a classic Bollinger bounce. The reason
these bounces occur is because Bollinger
Bands act like mini support and resistance
levels. The longer the time frame you are in,
the stronger these bands are. Many traders
have developed systems that thrive on these
bounces, and this strategy is best used when
the market is ranging and there is no clear
trend.
MACD
MACD is an acronym for Moving Average Convergence Divergence. This tool is used to
identify moving averages that are indicating a new trend, whether it’s bullish or bearish. After
all, our #1 priority in trading is being able to find a trend, because that is where the most money
is made.
With an MACD chart, you will usually see three numbers that are used for its settings.
The first is the number of periods that is used to calculate the faster moving average.
The second is the number of periods that are used in the slower moving average.
And the third is the number of bars that is used to calculate the moving average of the
difference between the faster and slower moving averages.
For example, if you were to see “12,26,9” as the MACD parameters (which is usually the default
setting for most charting packages), this is how you would interpret it:
The 12 represents the previous 12 bars of the faster moving average.
The 26 represents the previous 26 bars of the slower moving average.
The 9 represents the previous 9 bars of the difference between the two moving averages. This
is plotted by vertical lines called a histogram (The blue lines in the chart above).
There is a common misconception when it comes to the lines of the MACD. The two lines that
are drawn are NOT moving averages of the price. Instead, they are the moving averages of the
DIFFERENCE between two moving averages.
In our example above, the faster moving average is the moving average of the difference
between the 12 and 26 period moving averages. The slower moving average plots the average of
the previous MACD line. Once again, from our example above, this would be a 9 period moving
average.
This means that we are taking the average of the last 9 periods of the faster MACD line, and
plotting it as our “slower” moving average. What this does is it smoothes out the original line
even more, which gives us a more accurate line.
The histogram simply plots the difference between the fast and slow moving average. If you
look at our original chart, you can see that as the two moving averages separate, the histogram
gets bigger. This is called divergence, because the faster moving average is “diverging” or
moving away from the slower moving average.
As the moving averages get closer to each other, the histogram gets smaller. This is called
convergence because the faster moving average is “converging” or getting closer to the slower
moving average. And that, my friend, is how you get the name, Moving Average Convergence
Divergence! Whew, we need to crack our knuckles after that one!
MACD Crossover
Because there are two moving averages with different
“speeds”, the faster one will obviously be quicker to react to
price movement than the slower one. When a new trend
occurs, the fast line will react first and eventually cross the
slower line. When this “crossover” occurs, and the fast line
starts to “diverge” or move away from the slower line, it
often indicates that a new trend has formed.
From the chart above, you can see that the fast line crossed
under the slow line and correctly identified a new
downtrend. Notice that when the lines crossed, the
histogram temporarily disappears. This is because the
difference between the lines at the time of the cross is 0. As
the downtrend begins and the fast line diverges away from
the slow line, the histogram gets bigger, which is good
indication of a strong trend.
There is one drawback to MACD. Naturally, moving
averages tend to lag behind price. After all, it's just an
average of historical prices. Since the MACD represents moving averages of other moving
averages and is smoothed out by another moving average, you can imagine that there is quite a
bit of lag. However, it is still one of the most favored tools by many traders.
Common Patterns
Head and Shoulders Pattern
A head and shoulders pattern is also a trend reversal formation. It is formed by a peak (shoulder),
followed by a higher peak (head), and then another lower peak (shoulder). A “neckline” is drawn by
connecting the lowest points of the two troughs. The slope of this line can either be up or down. In my
experience, when the slope is down, it produces a more reliable signal.
In this example, we can visibly see the head and shoulders pattern. The head is the 2nd peak and is the
highest point in the pattern. The two shoulders also form peaks but do not exceed the height of the head.
With this formation, we look to make an entry order below the neckline. We can also calculate a target by
measuring the high point of the head to the neckline. This distance is approximately how far the price will
move after it breaks the neckline.
You can see that once the price goes below the neckline it makes a move that is about the size of the
distance between the head and the neckline.
Ascending Triangles
This type of formation occurs when there is a resistance level and a slope of higher lows. What
happens during this time is that there is a certain level that the buyers cannot seem to exceed.
However, they are gradually starting to push the price up as evident by the higher lows.
In the chart above, you can see that the buyers are starting to gain strength because they are
making higher lows. They keep putting pressure on that resistance level and as a result, a
breakout is bound to happen. Now the question is, “Which direction will it go? - Will the buyers
be able to break that level or will the resistance be too strong?”
Many charting books will tell you that in most cases, the buyers will win this battle and the price
will break out past the resistance. However, it has been my experience that this is not always the
case. Sometimes the resistance level is too strong, and there is simply not enough buying power
to push it through.
Most of the time the price will in fact go up. The point we are trying to make is that we do not
care which direction the price goes, but we want to be ready for a movement in EITHER
direction. In this case, we would set an entry order above the resistance line and below the slope
of the higher lows.
In this scenario, the buyers won the battle and the price proceeded to skyrocket!
Elliott Wave Theory
Back in the old school days during the 1920-30s, there was this mad genius named Ralph Nelson
Elliott. Elliott discovered that stock markets, thought to behave in a somewhat chaotic manner,
actually, did not.
They traded in repetitive cycles, which he pointed out were the emotions of investors and traders
caused by outside influences (ahem, CNBC) or the predominant psychology of the masses at the
time.
Elliott explained that the upward and downward swings of the mass psychology always showed
up in the same repetitive patterns, which were then divided into patterns he called "waves". He
needed to claim this observation and so he came up with a super
original name: The Elliott Wave Theory.
The 5 – 3 Wave Patterns
Mr. Elliott showed that a trending market moves in what he calls
a 5-3 wave pattern. The first 5-wave pattern is called impulse
waves and the last 3-wave pattern is called corrective waves.
Let’s first take a look at the 5-wave impulse pattern. It’s easier if
you see it as a picture:
That still looks kind of confusing. Let’s splash some
color on this bad boy.
Here is a short description of what happens during each
wave. I am going to use stocks for my example since
stocks is what Mr. Elliott used but it really doesn’t
matter what it is. It can easily be currencies, bonds,
gold, oil, or Tickle Me Elmo dolls. The important thing
is the Elliott Wave Theory can also be applied to the
foreign exchange market.
Wave 1
The stock makes its initial move upwards. This is
usually caused by a relatively small number of people that all of the sudden (for a variety of
reasons real or imagined) feel that the price of the stock is cheap so it’s a perfect time to buy.
This causes the price to rise.
Wave 2
At this point enough people who were in the original wave consider the stock overvalued and
take profits. This causes the stock to go down. However, the stock will not make it to its previous
lows before the stock is considered a bargain again.
Wave 3
This is usually the longest and strongest wave. The stock has caught the attention of the mass
public. More people find out about the stock and want to buy it. This causes the stock’s price to
go higher and higher. This wave usually exceeds the high created at the end of wave 1.
Wave 4
People take profits because the stock is considered expensive again. This wave tends to be weak
because there are usually more people that are still bullish on the stock and are waiting to “buy
on the dips”.
Wave 5
This is the point that most people get on the stock, and is most driven by hysteria. You usually
start seeing the CEO of the company on the front page of major magazines as the Person of the
Year. People start coming up with ridiculous reasons to buy the stock and try to choke you when
you disagree with them. This is when the stock becomes the most overpriced. Contrarians start
shorting the stock which starts the ABC pattern.
Source: http://www.babypips.com/school/
Bollinger Bands
Bollinger bands are used to measure a market’s volatility. Basically, this little tool tells us
whether the market is quiet or whether the market is LOUD! When the market is quiet, the
bands contract; and when the market is LOUD, the bands expand. Notice on the chart below that
when the price was quiet, the bands were close together, but when the price moved up, the bands
spread apart.
That’s all there is to it. Yes, we could go on and bore you by going into the history of the
Bollinger band, how it is calculated, the mathematical formulas behind it, and so on and so forth,
but we really didn’t feel like typing it all out.
The Bollinger Bounce
One thing you should know about Bollinger Bands is that price tends to return to the middle of
the bands. That is the whole idea behind the Bollinger bounce (smart, huh?). If this is the case,
then by looking at the chart below, can you tell us where the price might go next?
If you said down, then you are correct! As
you can see, the price settled back down
towards the middle area of the bands.
That’s all there is to it. What you just saw
was a classic Bollinger bounce. The reason
these bounces occur is because Bollinger
Bands act like mini support and resistance
levels. The longer the time frame you are in,
the stronger these bands are. Many traders
have developed systems that thrive on these
bounces, and this strategy is best used when
the market is ranging and there is no clear
trend.
MACD
MACD is an acronym for Moving Average Convergence Divergence. This tool is used to
identify moving averages that are indicating a new trend, whether it’s bullish or bearish. After
all, our #1 priority in trading is being able to find a trend, because that is where the most money
is made.
With an MACD chart, you will usually see three numbers that are used for its settings.
The first is the number of periods that is used to calculate the faster moving average.
The second is the number of periods that are used in the slower moving average.
And the third is the number of bars that is used to calculate the moving average of the
difference between the faster and slower moving averages.
For example, if you were to see “12,26,9” as the MACD parameters (which is usually the default
setting for most charting packages), this is how you would interpret it:
The 12 represents the previous 12 bars of the faster moving average.
The 26 represents the previous 26 bars of the slower moving average.
The 9 represents the previous 9 bars of the difference between the two moving averages. This
is plotted by vertical lines called a histogram (The blue lines in the chart above).
There is a common misconception when it comes to the lines of the MACD. The two lines that
are drawn are NOT moving averages of the price. Instead, they are the moving averages of the
DIFFERENCE between two moving averages.
In our example above, the faster moving average is the moving average of the difference
between the 12 and 26 period moving averages. The slower moving average plots the average of
the previous MACD line. Once again, from our example above, this would be a 9 period moving
average.
This means that we are taking the average of the last 9 periods of the faster MACD line, and
plotting it as our “slower” moving average. What this does is it smoothes out the original line
even more, which gives us a more accurate line.
The histogram simply plots the difference between the fast and slow moving average. If you
look at our original chart, you can see that as the two moving averages separate, the histogram
gets bigger. This is called divergence, because the faster moving average is “diverging” or
moving away from the slower moving average.
As the moving averages get closer to each other, the histogram gets smaller. This is called
convergence because the faster moving average is “converging” or getting closer to the slower
moving average. And that, my friend, is how you get the name, Moving Average Convergence
Divergence! Whew, we need to crack our knuckles after that one!
MACD Crossover
Because there are two moving averages with different
“speeds”, the faster one will obviously be quicker to react to
price movement than the slower one. When a new trend
occurs, the fast line will react first and eventually cross the
slower line. When this “crossover” occurs, and the fast line
starts to “diverge” or move away from the slower line, it
often indicates that a new trend has formed.
From the chart above, you can see that the fast line crossed
under the slow line and correctly identified a new
downtrend. Notice that when the lines crossed, the
histogram temporarily disappears. This is because the
difference between the lines at the time of the cross is 0. As
the downtrend begins and the fast line diverges away from
the slow line, the histogram gets bigger, which is good
indication of a strong trend.
There is one drawback to MACD. Naturally, moving
averages tend to lag behind price. After all, it's just an
average of historical prices. Since the MACD represents moving averages of other moving
averages and is smoothed out by another moving average, you can imagine that there is quite a
bit of lag. However, it is still one of the most favored tools by many traders.
Common Patterns
Head and Shoulders Pattern
A head and shoulders pattern is also a trend reversal formation. It is formed by a peak (shoulder),
followed by a higher peak (head), and then another lower peak (shoulder). A “neckline” is drawn by
connecting the lowest points of the two troughs. The slope of this line can either be up or down. In my
experience, when the slope is down, it produces a more reliable signal.
In this example, we can visibly see the head and shoulders pattern. The head is the 2nd peak and is the
highest point in the pattern. The two shoulders also form peaks but do not exceed the height of the head.
With this formation, we look to make an entry order below the neckline. We can also calculate a target by
measuring the high point of the head to the neckline. This distance is approximately how far the price will
move after it breaks the neckline.
You can see that once the price goes below the neckline it makes a move that is about the size of the
distance between the head and the neckline.
Ascending Triangles
This type of formation occurs when there is a resistance level and a slope of higher lows. What
happens during this time is that there is a certain level that the buyers cannot seem to exceed.
However, they are gradually starting to push the price up as evident by the higher lows.
In the chart above, you can see that the buyers are starting to gain strength because they are
making higher lows. They keep putting pressure on that resistance level and as a result, a
breakout is bound to happen. Now the question is, “Which direction will it go? - Will the buyers
be able to break that level or will the resistance be too strong?”
Many charting books will tell you that in most cases, the buyers will win this battle and the price
will break out past the resistance. However, it has been my experience that this is not always the
case. Sometimes the resistance level is too strong, and there is simply not enough buying power
to push it through.
Most of the time the price will in fact go up. The point we are trying to make is that we do not
care which direction the price goes, but we want to be ready for a movement in EITHER
direction. In this case, we would set an entry order above the resistance line and below the slope
of the higher lows.
In this scenario, the buyers won the battle and the price proceeded to skyrocket!
Elliott Wave Theory
Back in the old school days during the 1920-30s, there was this mad genius named Ralph Nelson
Elliott. Elliott discovered that stock markets, thought to behave in a somewhat chaotic manner,
actually, did not.
They traded in repetitive cycles, which he pointed out were the emotions of investors and traders
caused by outside influences (ahem, CNBC) or the predominant psychology of the masses at the
time.
Elliott explained that the upward and downward swings of the mass psychology always showed
up in the same repetitive patterns, which were then divided into patterns he called "waves". He
needed to claim this observation and so he came up with a super
original name: The Elliott Wave Theory.
The 5 – 3 Wave Patterns
Mr. Elliott showed that a trending market moves in what he calls
a 5-3 wave pattern. The first 5-wave pattern is called impulse
waves and the last 3-wave pattern is called corrective waves.
Let’s first take a look at the 5-wave impulse pattern. It’s easier if
you see it as a picture:
That still looks kind of confusing. Let’s splash some
color on this bad boy.
Here is a short description of what happens during each
wave. I am going to use stocks for my example since
stocks is what Mr. Elliott used but it really doesn’t
matter what it is. It can easily be currencies, bonds,
gold, oil, or Tickle Me Elmo dolls. The important thing
is the Elliott Wave Theory can also be applied to the
foreign exchange market.
Wave 1
The stock makes its initial move upwards. This is
usually caused by a relatively small number of people that all of the sudden (for a variety of
reasons real or imagined) feel that the price of the stock is cheap so it’s a perfect time to buy.
This causes the price to rise.
Wave 2
At this point enough people who were in the original wave consider the stock overvalued and
take profits. This causes the stock to go down. However, the stock will not make it to its previous
lows before the stock is considered a bargain again.
Wave 3
This is usually the longest and strongest wave. The stock has caught the attention of the mass
public. More people find out about the stock and want to buy it. This causes the stock’s price to
go higher and higher. This wave usually exceeds the high created at the end of wave 1.
Wave 4
People take profits because the stock is considered expensive again. This wave tends to be weak
because there are usually more people that are still bullish on the stock and are waiting to “buy
on the dips”.
Wave 5
This is the point that most people get on the stock, and is most driven by hysteria. You usually
start seeing the CEO of the company on the front page of major magazines as the Person of the
Year. People start coming up with ridiculous reasons to buy the stock and try to choke you when
you disagree with them. This is when the stock becomes the most overpriced. Contrarians start
shorting the stock which starts the ABC pattern.
Source: http://www.babypips.com/school/
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