Using Candlesticks to Identify Reversals

What are candlesticks?

Candlestick charts convey information pertaining to price action, or the movement of a currency pair’s price over the specified amount of time. Each candlestick contains four attributes:
· the opening price of the currency pair at the time the candle opened
· the closing price · the high of the time frame
· the low of the time frame
On a daily chart, each candle represents a 24 hour period; on an hourly chart each candle represents an hour, and so on. A visual analysis of a candlestick is as follows:

Price Channels

Support and Resistance do not have to be horizontal lines, and often in a market that is moving higher or lower, trend lines effectively connect the high points or the low points to create a price channel that acts similarly to a horizontal range. Support and resistance levels function in the same manner in a trending market as in a rangebound one. However the line that is following the trend--support in an uptrend or resistance in a downtrend) should be considered by far the stronger of the two. Only when there is a trade with minimal risk involved should you enter a position based only on the resistance line above the price in an uptrend.

The same trend lines can be drawn in a bear market where the price is continuously moving lower.


There is no exact formula for drawing such lines. Some traders prefer to connect only the bodies of the candles and to exclude the high and low points outside of the open and close, but that is not a requirement. If the line does not look valid to you, chances are it is not relevant, because other traders are using the same charts.

Risk-Reward Ratios

Is the estimated potential loss of a trade (risk) to the estimated potential gain (reward). Before entering into any trade, good traders first think about how much risk to take on any particular trade. We try to apply the 1:3 risk/ reward, for example if your average gain on winning trades is $1000 and you have consistently risked $300 per trade then your risk-reward ratio would be 3.3 to 1 (i.e. $1000 / $300). Since no one can win on every trade therefore your profits would cover your losses and at the end of the day you will be a winner.

Support and Resistance in Momentum Markets

Another way to use support and resistance is to trade outside of the range; in other words, to anticipate a breakout. This involves placing orders to buy above resistance and to sell below support. The rationale is that the market will gain momentum once it breaks out of the range, and thus by placing orders just below/above support/resistance, traders will be able to make big gains when the market moves out of the range. Momentum trading is a bit counter-intuitive, as it involves buying at a higher price and selling at a lower price.

Below is a chart that illustrates the concept of momentum trading. Note how the pair accelerates once it breaks out of a narrow range:

Support and Resistance Zones

Because technical analysis is not an exact science, it is sometimes useful to create support and resistance zones. Each pair has its own characteristics and the analysis should reflect the intricacies of the pair. Sometimes exact support and resistance levels are best and sometimes zones work better. Generally, the tighter the range, the more exact the level. If the trading range spans less than 2 months and the price range is relatively tight, then more exact support and resistance levels are probably best suited. If a trading range spans many months and the price range is relatively large, then it is probably best to use support and resistance zones. These are only meant as general guidelines and each trading range should be judged on its own merits.

Trading Range

Trading ranges can play an important role in determining support and resistance as turning points or as continuation patterns. A trading range is a period of time when prices move within a relatively tight range, between support and resistance. This signals that the forces of supply and demand are evenly balanced. When the price breaks out of the trading range, above or below, it signals that a winner has emerged. A break above is a victory for the bulls (demand or Buyers) and a break below is a victory for the bears (supply or sellers). The simplest way of using support and resistance in trading is to simply trade the range: in other words, traders can simply buy at support, and sell at resistance. A key advantage of this is that the market is range-bound approximately 80% of the time, making it a very viable strategy for most market conditions. The downside of range-bound trading, though, is twofold: · Range-bound trading generally does not yield substantial gains on a per-trade basis. · When the market breaks out of the range, it often will make big moves. As a result, traders using range-bound strategies can suffer overwhelmingly large losses when the market breaks out of the range. The chart below illustrates the concept of range-bound trading
Note how this pair repeatedly fails to cross beyond certain support and resistance levels, and simply fluctuates between an upper and lower band.

Resistance

Resistance is the price level at which selling is thought to be strong enough to prevent the price from rising further and the logic dictates that as the price advances towards resistance, sellers become more inclined to sell and buyers become less inclined to buy. By the time the price reaches the resistance level, it is believed that supply will overcome demand and prevent the price from rising above resistance.

The market has a memory. When price makes a new High and then retreats, sellers who missed the previous peak will be inclined to sell when price returns to that level. Afraid of missing out a second time, they may enter the market in numbers sufficient to overwhelm buyers. The resulting correction will reinforce market perceptions that price is unlikely to move higher and establish a resistance level. Resistance does not always hold and a break above resistance signals that the bulls have won out over the bears. A break above resistance shows a new willingness to buy and/or a lack of incentive to sell. Resistance breaks through and new highs are made that would indicate that buyers have increased their expectations and are willing to buy at even higher prices. In addition, sellers could not be tempted into selling until prices have rallied above resistance or above the previous high. Once resistance is broken, another resistance level will have to be established at a higher level. Another principle of technical analysis stipulates that support can turn into resistance and visa versa. Once the price breaks below a support level, the broken support level can turn into resistance. The break of support signals that the forces of supply have overcome the forces of demand. Therefore, if the price returns to this level, there is likely to be an increase in supply, and hence resistance. The other side is resistance turning into support. As the price advances above resistance, it signals changes in supply and demand. The breakout above resistance proves that the forces of demand have overwhelmed the forces of supply. If the price returns to this level, there is likely to be an increase in demand and support will be found. Therefore we first plot long-term charts and begin by analyzing the daily and weekly charts going back for a couple of years. This provides more visibility and a better long-term perspective on a market. Once the long-term has been has been established then review the daily and the intra-day charts. A short-term market view alone can often be deceptive. Even if you only trade the very short term, you will do better if you're trading in the same direction as the intermediate and longer-term trends. Take in the general view of the chart to determine the direction of the trend, and follow it. We need to try to identify support and resistance levels, the best place to buy a market is near support levels that support is usually a previous reaction low. The best place to sell a market is near resistance levels. Resistance is usually a previous peak. After a resistance peak has been broken, it will usually provide support on subsequent pullbacks. In other words, the old "high" becomes the new "low." In the same way, when a support level has been broken, it will usually produce selling on subsequent rallies -- the old "low" can become the new "high." It is very important to make sure that we trade in the direction of that trend. We “Buy dips if the trend is up” and “Sell rallies if the trend is down” But in each case, let the bigger time frame chart determine the trend, and then use the shorter-term chart for timing entry. Find support and resistance levels; the best place to buy a market is near a support level, and that support is usually a previous reaction low. The best place to sell a market is near resistance levels. Resistance is usually a previous peak. After a resistance peak has been broken, it will usually provide support on subsequent pullbacks. In other words, the old "high" becomes the new "low." In the same way, when a support level has been broken, it will usually produce selling on subsequent rallies -- the old "low" can become the new "high." Stops are best placed after we first identify support and resistance on the charts and you place yours stop beyond those levels and at that time you decide if the risk reward on the trade is acceptable to you When price makes a new High and then retreats, sellers who missed the previous peak will be inclined to sell when price returns to that level. Afraid of missing out a second time, they may enter the market in numbers sufficient to overwhelm buyers. The resulting correction will reinforce market perceptions that price is unlikely to move higher and establish a resistance level.

Support

Support and resistance represent key turning points where the forces of Sellers (supply) and buyers (Demand) meet. In the financial markets, prices are driven by excessive supply (down) and demand (up). Supply is synonymous with bearish, bears and selling. Demand is synonymous with bullish, bulls and buying. Support is the price level at which demand is thought to be strong enough to prevent the price from declining further. The logic dictates that as the price declines towards support and gets cheaper, buyers become more inclined to buy and sellers become less inclined to sell. By the time the price reaches the support level, it is believed that demand will overcome supply and prevent the price from falling below support. Support is the price level at which demand is thought to be strong enough to prevent the price from declining further and the logic dictates that as the price declines towards support and gets cheaper, buyers become more inclined to buy and sellers become less inclined to sell. By the time the price reaches the support level, it is believed that demand will overcome supply and prevent the price from falling below supportIn all markets the excessive supply will drive prices down, while demand will drive the markets up. As demand increases, prices advance and as supply increases, prices decline. When supply and demand are equal, prices move sideways as bulls and bears slug it out for control. The market has a memory. When price falls to a new low and then rallies, buyers who missed out on the first trough will be inclined to buy if price returns to that level. Afraid of missing out for a second time, they may enter the market in sufficient numbers to take away from sellers. The result will be a rally, reinforcing perceptions that price is unlikely to fall further and creating a support level. A decline below support indicates a new willingness to sell and/or a lack of incentive to buy. A break of support and making new lows signal that sellers have reduced their expectations and are willing sell at even lower prices. In addition, buyers could not be tempted into buying until prices declined below support or below the previous low. Once support is broken, another support level will have to be established at a lower level

Support and Resistance

Support and Resistance are the basis of most technical analysis chart patterns. Identification of key support and resistance levels is an essential ingredient to successful technical analysis. Even though it is sometimes difficult to establish exact support and resistance levels, being aware of their existence and location can greatly enhance analysis and forecasting abilities. If a pair is approaching an important support level, it can serve as an alert to be extra vigilant in looking for signs of increased buying pressure and a potential reversal. If a pair is approaching a resistance level, it can act as an alert to look for signs of increased selling pressure and a potential reversal. If a support or resistance level is broken, it signals that the relationship between supply and demand has changed. A resistance breakout signals that demand (bulls) has gained the upper hand and a support break signals that supply (bears) has won the battle.

Different Time Frames

Technical analysis tools will be valid on all time frames, but we strongly recommend using daily charts for most of your analysis. Medium term positions based on daily charts, using hourly charts for more precise entry points, have two advantages over short term positions based on 5 or 15 minute charts.
1) The spread is less significant for a longer term position. 5 pips out of a price target of 20 is a huge obstacle to overcome on trade after trade. 5 pips out of a 100 pip target is manageable.
2) Longer term charts are statistically much more reliable, since they are based on more data. Indicators have a higher degree of reliability on a daily chart than on an hourly chart or 15 minute chart. Trading on a weekly or monthly chart would likely be more accurate from a technical standpoint than a daily chart would be, but a slower time frame also means less precise entry points, and the wider stops necessary to trade a monthly chart are often beyond the capacity for many accounts. We recommend as a general rule risking no more than 2% of your account balance on a single trade, and this is sometimes difficult with a monthly or weekly chart.

Why Technical Analysis Works

· Extremely popular, and hence offers insight into what many traders are doing
· More clear-cut and less controversial than fundamental analysis
· A simple way of making trading decisions

Many traders believe that technical analysis is a self-fulfilling prophecy – in other words, it works solely because it is popular and is used by many traders. For example, many technical traders put a 20 day moving average line on charts not because the moving average itself is statistically important, but rather because it is an extremely common indicator used by active traders of all sizes. The rationale is simple: if so many traders are basing their decisions off moving averages and other indicators, then those indicators must be watched closely, for they offer insight into what a vast majority of traders in the market are doing. Because of this rationale, traders should focus on the most popular indicators in the trading community, and should use them in the most common way. This is the best way of tapping into the “psychology” of the market – in other words, it is a simple but highly effective way of understanding what other traders are up to, and how the market may move because of it. Contrary to popular belief, it is NOT a study that requires complex mathematics or computer algorithms. Rather, it is a study that requires looking at the same tools other traders use to understand what is happening in the market. Below is a list of the most common indicators, all of which will be covered in the lessons that follow:
• Key Candlestick Patterns
• Fibonacci Retracements
• Moving Averages
• RSI
• Stochastics
• MACD
• Bollinger Bands
While it may seem intimidating, technical analysis is actually fairly simple – often far simpler than fundamental analysis. It simply requires an abundance of the two traits that are most necessary to be a successful trader: discipline and patience.

What is Technical Analysis?

· Technical analysis involves the forecasting of exchange rate movement based solely upon statistics and price patterns
Simply put, technical analysis is the analysis of the market based on price action. While fundamental analysis looks at economic factors and geopolitical conditions (such as economic numbers, capital flows, and key political events) in an attempt to forecast exchange rates, technical analysis relies on the statistics and patterns in price movement for its forecast. Technical analysis has gained great popularity in recent history, especially as trends in computerized trading continue to develop and active traders continue to refine their strategies to best assess what is going on in the market at all times. In today’s marketplace, technical analysis has become an essential tool for any aspiring trader.

What is the Margin?

Margin
If you have a standard cash stock account, you know that money should be deposited for the full amount of the position you are trading, or if you have a margin account, for at least half of the position. This is in contrast to the FX market, where only a small percentage of the actual position value needs to be deposited prior to taking on the entering the trade. This small deposit, known as the margin, is not a down payment, but rather a performance bond or good faith desposit to ensure against trading losses. The margin requirement allows traders to hold positions much larger than their account value.
Margin requirements are as low as 1% (and as low as 0.5% on the mini account), meaning for every standard lot size of 100,000 units, you must commit $1,000. However, if you wanted to control a $100,000 in the stock market, you would have to deposit at the very least, $50,000. Even in the futures market you would have to deposit at least $5,000 to control a $100,000 position.
On your trading station, you can see that there are two types of margin: usable and used. Your used margin is the amount of funds you have committed to existing positions, and your usable margin is the amount of money you have available to commit to new positions. Account equity is your account balance plus or minus any floating profit or loss.
For example, say you open an account with $10,000. At this point your account balance and equity are both $10,000, your usable margin is $10,000 and your used margin is $0, as you have yet to place a trade. Next, you buy 7 lots of USD/JPY, which requires you to maintain $7,000 in equity. Now your used
margin is $7,000 and your usable margin is $3,000. Essentially, this means that you can sustain market losses totalling $3,000 before your account equity falls below the minimum margin requirement of $7,000, at which point the dealing desk will close all open positions. This automatic margin call feature prevents your account from ever reaching a negative account balance.

Selling a Currency Pair Short

Key Concepts
Traders have equal opportunities to profit regardless of whether the exchange rate is rising or falling.
The number of pips a currency pair moves determines how much a trader will earn or lose on the position.
One of the premier advantages of the foreign exchange market is that profit opportunities are equally present in all market conditions; it is just as easy to profit when the exchange rate is declining as it is when the rate is rising. If, for example, Trader A believes the pound will fall against the value of the US dollar – meaning 1 pound will buy fewer US dollars – then he can simply place an order to sell GBP/USD. This trade works in essentially the same manner as the trade to go long (buy) the pair, with the only
difference being which currency is being bought and sold. Let’s assume Trader A believes that the GBP will decline in value with respect to the USD -- in other words, that the exchange rate will fall from the 1.8455 level. Accordingly, he places an order to sell 1 lot of GBP/USD, thus borrowing 100,000 pounds and buying an equivalent amount of USD with the proceeds. Since 1 pound can purchase 1.8455 US dollars at the time Trader A places his trade, he can purchase 184,550 US dollars with the 100,000 pounds he borrowed. As in the previous example, the borrowed amount will be repaid when the transaction is closed. Let’s assume that Trader A is correct in his belief that the pound will fall in value against the USD, and that the GBP/USD reaches 1.8355 – a drop of 100 pips from Trader A’s entry point. Now, Trader A decides to take his profit and close out the trade. Accordingly, he must repay the 100,000 pounds that were borrowed. Since the cost of 1 pound has now dropped to 1.8355, this means that the cost of 100,000 pounds is 183,550 (100,000 * 1.8355). This amount is then subtracted from 184,550, which was the number of dollars that Trader A received when he initially placed the trade. The result is a profit of $1,000 (184,550 – 183,550).

A summary of the transaction is as follows:
Initial transaction: 100,000 pounds were borrowed and exchanged for US dollars at a rate of 1.8455 US dollars per pound, or a total of 184,550 USD Final transaction: The borrowed amount of 100,000 pounds was repaid at a cost of 1.8355 US dollars per pound, or a total of 183,550 USD Amount of pounds initially borrowed: 100,000 Amount of pounds repaid via close of trade: 100,000 Net number of pounds: 0
Amount of dollars initially purchased: 184,550
Amount of dollars used to pay off the 100,000 pounds that were borrowed: 183,550
Dollars remaining after borrowed pounds are paid off: 1,000
In the examples given above, Trader A had the potential to earn a profit of $1,000 when the exchange rate rose 100 pips and also when it fell 100 pips. For any currency pair in which the US dollar is the second in the pair – like the GBP/USD, EUR/USD, AUD/USD, and NZD/USD – the value of a pip is fixed at $10 per 100,000 unit lot. In the Mini account, where a mini lot is 1/10th the size of a 100k lot, the pip value is 1/10th that of the 100K account. Accordingly, the pip value for any pair in which the USD is the counter currency is fixed at $1.

How an FX Trade Works

Any foreign exchange transaction ultimately begins with two events:
· One currency is being borrowed.
· The proceeds from the borrowed currency are used to finance the currency that is being bought.
· Currency pairs are typically traded in increments of 100,000 units of the base currency. A 100,000 unit increment in a currency trade is referred to as a lot. (For example, a trader who is trading 5 lots is trading 500,000 units of currency).
After gaining an intuitive understanding of how exchange rates move, one can begin FX trading, thereby speculating on the exchange rate so as to potentially reap profits from the fluctuating value of currencies. Essentially, clients can borrow one currency and buy another, and profit from exchange rate movements. This concept is most easily explained and understood through an example of an actual trade:
Trader A wishes to speculate on GBP/USD. Believing that the GBP will rise against the USD, or that the exchange rate will move upwards, the trader places an order to buy GBP/USD at a market rate of 1.8455. In terms of volume, let’s assume that Trader A is speculating on 100,000 units of the base currency – which is the standard lot size, or trading increment, used in the foreign exchange market. Since the base currency is the first currency in the pair, we know that Trader A is speculating on the value of 100,000 British pounds with respect to the US dollar.
In this example, Trader A is buying British pounds, since he believes the pound will rise in value with respect to the US dollar. Accordingly, he finances the transaction of buying 100,000 pounds by borrowing an equivalent amount of US dollars.
For Trader A, the value of the amount borrowed is a function of the exchange rate. Since the exchange rate at the time of the transaction was 1.8455, we know that the market cost for 1 British pound was 1.8455 US dollars. Hence, 100,000 pounds cost $184,550 (1.8455 * 100,000). This borrowed amount of 184,550 USD must be paid back when the transaction is closed. Let’s assume that Trader A is correct in assuming that the British pound would rise in value with respect to the USD, and that the exchange rate moved to 1.8555 – 100 pips above the rate at which Trader A entered. If Trader A were to close his position now, the 100,000 pounds he purchased at the onset of the transaction would be sold, and his debt of 184,550 dollars would be paid off. At an exchange rate of 1.8555, Trader A’s 100,000 pounds are now worth 185,550 US dollars (100,000 * 1.8555). After repaying the borrowed amount of 184,550, this leaves him with a profit of $1,000. A summary of the transaction is as follows: Initial transaction: Purchase of 100,000 pounds at a cost of 1.8455 US dollars per pound, or a total of 184,550 USD
Final transaction: Sale of 100,000 pounds at a price of 1.8555 US dollars per pound, or 185,550
USD
Amount of pounds initially purchased: 100,000
Amount of pounds sold through the closing transaction: 100,000
Net number of pounds: 0
Amount of dollars initially borrowed: 184,550
Amount of dollars purchased upon close of trade: 185,550
Dollars remaining after borrowed dollars are paid off: 1,000

Measuring Exchange Rate Movement

Key Concepts
A pip is the unit of measurement for exchange rate movement.
The number of pips a currency pair moves determines how much a trader will earn or lose on the position.
A pip is the last significant digit in an exchange rate, and is the term used to define the unit of measurement for exchange rate movements. The number of pips that the exchange rate moves dictates how much a trader has gained or lost through an FX trade. In the example above, if the rate moves from 1.8455 to 1.8555, the pair has risen by a 100 points or pips.

How Speculators Can Profit from FX Trading

What the Exchange Rate Means Key Concepts
The base currency is the term for the first currency in the pair. The counter currency is the term for the second currency in the pair. The exchange rate represents the number of units of the counter currency that one unit of the base currency can purchase. In a foreign exchange trade, clients are speculating on the exchange rate between two currencies. The exchange rate measures the relative value of a currency -- meaning it measures how much one currency is worth in terms of another currency. For example, let’s suppose the exchange rate for the GBP/USD (Great British pound/United States dollar) is 1.8455. This means that 1 British pound (the first currency in the pair, also known as the base currency) is the equivalent of 1.8455 US dollars (the second member of the pair, known as the counter currency). This is the standard quoting convention for exchange rates; the exchange rate represents how much 1 unit of the base currency (first currency in the pair) can purchase of the counter currency (second currency in the pair). So, if the GBP/USD exchange rate were to rise from 1.8455 to 1.8555, that would mean that 1 GBP would have gone from being able to purchase 1.8455 US dollars to being able to purchase 1.8555 US dollars.