Technical Analysis

The world of technical analysis offers a vast arsenal of indicators and tools. This section focuses on some of the most widely used ones to equip you for navigating the market.

While exploring a variety of indicators can be beneficial, it's crucial to choose a few that resonate with you and fit your trading style. Getting overwhelmed by too many signals can cloud judgment. Here, we'll delve into:

• Bollinger Bands: This popular technique uses bands to visualize price volatility.

• Parabolic SAR (Stop and Reverse): Designed to identify potential trend reversals, especially useful in trending markets.

• Average True Range (ATR): This volatility gauge helps you set appropriate stop-loss levels.

• Average Directional Index (ADX): This indicator sheds light on whether the market is trending or ranging.

By understanding these core indicators, you can build a solid foundation for your technical analysis toolkit.

Bollinger Bands

Developed by John Bollinger, Bollinger Bands are a popular technical indicator that gauges market volatility. They consist of three lines:

• A middle band: This is a simple moving average (SMA) of the price.

• An upper band: Plotted two standard deviations above the SMA, it reflects higher volatility periods.

• A lower band: Plotted two standard deviations below the SMA, it reflects lower volatility periods.

Bollinger Bands offer valuable insights for traders in two key ways:

• Identifying Squeeze Plays: When the upper and lower bands contract, signifying decreased volatility, a breakout (price moving above the upper band or below the lower band) might be imminent, potentially signaling a larger price move.

• Spotting Support and Resistance: The Bollinger Bands themselves can act as dynamic support and resistance zones. Price often finds temporary support at the lower band and resistance at the upper band, although breakouts can and do occur.

Trading the Squeeze

Bollinger Bands offer valuable clues about upcoming volatility changes. When the upper and lower bands narrow, signifying a squeeze, it suggests a potential breakout is brewing. This is because standard deviation, the measure of volatility used by the bands, shrinks as price movements become more compressed.

A breakout from a squeeze often marks the start of a new trend. However, the direction of the breakout remains uncertain until it occurs. The key takeaway is that a squeeze highlights the potential for a significant price move in either direction.

Here's how to interpret breakouts:

• Upward Breakout: If price candles surge above the upper Bollinger Band, the move often continues upwards, indicating a potential bullish trend.

• Downward Breakout: Conversely, if price candles plunge below the lower Bollinger Band, the price may continue downwards, suggesting a potential bearish trend.

Looking at the chart below, you can see that after the bands get narrower during the squeeze, prices break out with greater volume and rally lower. If price breaks out below the lower band, a new downtrend may be developing. This is a good opportunity to sell just below the breakout point.

If prices break out above the upper band, a new uptrend may be developing. Wait for a candlestick signal and buy just above the breakout. You can enter a buy position after the first candle closes above the upper band.

Bollinger Bands can also function as dynamic support and resistance levels. This means prices often find temporary support at the lower band and resistance at the upper band, creating bounce opportunities.

This strategy works best in ranging markets where price tends to fluctuate within a specific zone. Here's how to approach it:

• Buy signals: Look for buying opportunities when the price dips towards the lower Bollinger Band. The idea is to capitalize on a potential bounce back up towards the middle of the bands.

• Sell signals: Conversely, consider selling when the price climbs near the upper Bollinger Band, anticipating a potential reversal downwards.

Important Caveats:

• Breakouts can occur: While bounces are common, Bollinger Bands are not impenetrable barriers. Be prepared for potential breakouts where price decisively moves beyond the bands.

• False signals are possible: Not every touch of the bands results in a bounce. Other factors can influence price movements.

By incorporating Bollinger Bands as dynamic support and resistance, you can identify potential entry and exit points for ranging markets. Remember, this strategy should be used in conjunction with other technical indicators and risk management techniques for a more comprehensive trading approach.

Let us look at an example now.

The Bollinger Bounce strategy leverages the tendency of prices to reverse course near the Bollinger Bands. As you can see on the chart, prices often act like a ball bouncing between the upper and lower bands. Here's how to identify potential trading opportunities:

• Buy signals: Look for buying opportunities when the price dips towards the lower Bollinger Band and then starts to reverse upwards. This bounce suggests potential buying pressure and a possible return towards the middle of the bands.

• Sell signals: Conversely, consider selling when the price climbs near the upper Bollinger Band and then starts to reverse downwards. This bounce suggests potential selling pressure and a possible decline back towards the middle of the bands.

Remember: The Bollinger Bounce is a probabilistic strategy, not a guaranteed outcome. Prices can break through the bands (especially during strong trends), and not every touch of the bands results in a bounce.

Parabolic SAR (Stop and Reverse)

The Parabolic SAR (SAR) is a technical indicator that helps traders identify potential trend reversals. Unlike stop-loss orders, which are triggered by price reaching a certain level, the SAR indicator uses a series of dots to depict potential turning points.

Understanding the SAR Indicator:

• Appearance: The SAR appears as a series of dots plotted either above or below the price on a chart.

• Behavior: These dots tend to curve like a parabola (a U-shaped curve), hence the name.

• Trend Following: The SAR is a trend-following indicator. During an uptrend, the dots (SAR) are typically placed below the price bars. Conversely, during a downtrend, the dots appear above the price bars.

How the SAR Helps Identify Reversals:

• Early Trend Signs: At the start of a trend, the SAR dots move slowly. As the trend strengthens, the dots accelerate, getting closer to the price action.

• Potential Reversal: When the SAR dots move to the opposite side of the price bars (i.e., from below the price to above in an uptrend, or vice versa), it can signal a potential trend reversal.

  
  

Referring to the chart above, as the price moves higher, the dots are below the trend moving higher and are seen as bullish. This is a buy signal. The dots are deemed to be bearish once they move above the prices and the trend changes. This is a sell signal. If you are already in a position, the SAR can help you time when to exit – so if you are long and the trend reversed, shown by the SAR, then exit (close) your long position.

Average True Range (ATR) Indicator

The Average True Range (ATR) is a technical indicator that serves as a volatility gauge. It measures the average amount of price movement (usually in pips for forex trading) over a chosen period. Unlike some indicators, the ATR doesn't predict price direction – it simply reflects how much the price can potentially fluctuate. Here's a key takeaway:

• Higher ATR: Indicates a more volatile market where prices tend to move more significantly within a given timeframe.

• Lower ATR: Indicates a less volatile market where price movements tend to be more muted.

By understanding the ATR's reading, traders can:

• Set Stop-Loss Levels: The ATR can be a helpful tool for setting stop-loss orders, which are used to limit potential losses. In a volatile market (high ATR), a wider stop-loss may be needed compared to a less volatile market (low ATR).

• Adjust Trading Strategy: Volatility can impact trading strategies. The ATR can help traders adapt their approach based on the current market conditions.

For example, if you are trading the hourly chart, and you want the ATR for the last 20 hours, you set the ATR on your chart settings for that amount.

By knowing the average range of price movement in the past 20 hours, you can set a better stop loss level and limit the risk on your trade. This will give you enough breathing room so that you don’t get stopped out too soon.

For example, if you are trading NZDUSD and the ATR was 10 pips in the last 20 hours, you would know that you should set your stop loss for more than 10 pips. If you set it less than 10 pips you could get stopped out sooner.

Average Directional Index (ADX)

A common challenge for traders is gauging trend strength. This is where the Average Directional Index (ADX) comes in. Unlike some indicators, the ADX doesn't tell you the direction of the trend (up or down), but it sheds light on whether a trend exists at all and, if so, how powerful it is.

The Power of the ADX:

• Trend Strength Indicator: The ADX is an oscillator that fluctuates between 0 and 100. Generally:

  • Values below 20 suggest a weak or nonexistent trend.

  • Values between 20 and 50 suggest a trend of moderate strength.

  • Values above 50 suggest a strong trend.

• Focus on Strength, Not Direction: The ADX doesn't predict if the market is bullish (uptrend) or bearish (downtrend). It simply gauges the strength of the prevailing trend, regardless of direction.

By incorporating the ADX into your analysis, you can:

• Identify Trending Markets: The ADX can help you differentiate between trending and choppy range-bound markets.

• Time Entries and Exits: Stronger trends (higher ADX readings) can potentially offer better opportunities for trend-following entry and exit points.

  
  

Referring to the chart above, we can see prices are initially in an uptrend before fading into a range. Since ADX only measures the strength of the trend, we can see that as prices rose the ADX reading strengthened. Once prices traded sideways, and there was no longer a trend, the ADX fell and hovered at around 20.