Nice Chart to Wake Up To

If you were short the EUR/USD today, that is - which as luck would have it I was.


I haven't seen volatility like this in quite a while...over 200 pips of movement. Hope you're all short the Euro today as well!

Crazy Candlestick Pattern

I just thought I'd point out this rather rare candlestick pattern from last week's EUR/USD daily charts. This unusual creature emerged on May 29, undoubtedly in response to some piece of news I wasn't paying attention to at the time:


What you're seeing here is a 100 pip range, and a closing price just 1 pip above the open. In candlestick parlance it looks like a Doji Star to me, or possibly a very narrow Spinning Top. This is just about the clearest illustration of market ambivalence and uncertainty you'll ever see: the price aggressively testing both short and long directions and then settling back within 1 pip of where it all started. The upper shadow is also substantially longer than the lower one, and you can see how the next day the price headed lower in response to such a dramatic failure to make any progress upwards.

This is also the perfect illustration of an intraday whipsaw or range-based trading opportunity. If you had your stop-loss set at a safe distance and your limit order at a modest, realistic exit point, you could've made money on either a short or long trade. But I wouldn't plan on one of these showing up on a regular basis.

Charts vs. No Charts: A Thought Experiment

This is a topic I revisit periodically because I think the ways that traders interact with their charts raise all kinds of important issues in trading discipline and execution. First off, I should state my own bias: I look at charts every day, primarily a candlestick / moving average / Bollinger Band combination, but I don't make trading decisions based on them. They're fun to look at, always fascinating, but for me, also dangerous. My worst trading decisions were all made based on charts because, as I've written before, they can be very deceptive. On the other hand, some of my best trading ideas came from looking at charts; however, their development and execution all took place on spreadsheets. In fact, all my current trades are identified by equations run through an Excel spreadsheet, and I could spend my entire day without looking at a chart once and it wouldn't affect my trading activity. I'd probably just get a little bored without any pretty candlesticks to look at.

So that's the background for the thought experiment I came up with. (In case you're wondering what I mean by "thought experiment," here's an excerpt from the Wikipedia definition: "A thought experiment in the broadest sense is the use of an imagined scenario to help us understand the way things really are. The understanding comes through reflection on the situation...Thought experiments are well-structured hypothetical questions that employ 'What if?' reasoning.")

Now here's my "What if" question: What if two traders of similar experience and temperament traded the same currency pair using exactly the same trading indicators for exactly the same period. However, one trader makes all his trading decisions based on the indicators depicted on a chart. The other trader doesn't look at a chart once, but responds to the same signals identified by equations in an Excel sheet or comparable software. After an initial trial period, the traders would then switch places and trade using the other system for the same period of time. This way both traders would have used both systems, providing a more balanced set of data to draw conclusions from.

At the end of these test periods, what would the trading results look like? Would the charts have enabled the traders to make decisions with better market context and understanding of the larger trends at work...or would they have led to confusion, indecision, and losses as the traders got caught by deceptive patterns, jumped to conclusions about where an indicator was heading, or delayed their trades because of contradictory visual cues?

And over at the chart-free trading desk, would the traders have benefited from the strict Yes/No answers this more mechanical system would generate? Would they place their trades more precisely and exit them with more discipline and less second-guessing? Or would they have gotten bored by the relative lack of discretion allowed them, along with the absence of interesting visuals, and gotten sloppier in their trading as a result? Or maybe during the stress of a losing streak, they'd have begun doubting the integrity of the system without a chart to reassure them that their indicators were valid.

Of course, the ultimate deciding factor would be the total profits (or losses) resulting from each system. So which would win? You can probably figure out my answer - feel free to leave yours in the comments below!

Related topics:
Don't let your charts deceive you
The perils of chart burnout
Know your candlestick patterns

Know Your Candlestick Patterns

One of my goals in continuing to improve my trading system is to test out every type of bullish and bearish candlestick pattern to see if it's worth adding to the mix. In researching the different types of candlesticks, I came across this great free resource that illustrates dozens of patterns associated with uptrends and downtrends in a market. Check it out: Hotcandlestick.com

Note that those with green borders are classified as continuation signals, and those with red borders as reversal signals - an important distinction. Depending on what currency you're trading and the timeframe of chart you're looking at, you may not see some of them that often, if ever. For instance, I don't know if I've ever seen a "Tweezer Top" or "Tweezer Bottom" on the daily EUR/USD chart. But they're still good to know about.

Hope this helps you make the most of your candlestick charts!

Related topic:
Candlestick Chart Tutorial

Don't let your charts deceive you. Remember, scale is everything

One risk of chart-based trading strategies is misinterpreting, or overinterpreting, the visual data presented by a chart and concluding that a new trend is emerging when nothing could be further from the truth. We humans are visually-oriented creatures, and are inclined to see patterns even when they aren't there. The risk of jumping to false conclusions based on a chart increases when you're looking at a time scale much shorter than you're used to, displaying pip ranges much smaller than you're accustomed to.

For example, I recently switched from an hour chart to a five minute candlestick chart and was amazed at the exciting trends that were suddenly jumping out at me from the screen. I quickly realized that what looked like major movements were in fact just upticks of a few pips, and that the shorter time scale gave the illusion of faster, more dramatic market activity. When I switched back to my hour chart, it became clear that all the movement was actually happening within a very narrow range.

When I first got started trading, I would often be staring at a 5 minute CCI (Commodity Channel Index) chart for hours, even during the low-volume doldrums of the afternoon, since I didn't know any better. One of the problems I had with the CCI as a newbie trader was that what often looked like an important trend on the chart, as the CCI shot upward or plunged downward, was often just a movement of 7 or 8 pips. The CCI is like that: it can swing widely up and down regardless of whether the price is moving 10 pips or 100 pips. If you don't keep a careful eye on the price and just watch the CCI, you might end up making a trade that looks big on the chart and ends up so small it's hardly worth your while. I found this was especially true during those afternoons, when the CCI would continue to spike up and down based on the smallest price movements. I eventually found it helpful to have a candlestick chart running alongside my CCI chart to give me some more perspective on what the price was actually doing.

Remember, a chart signal or indicator will work with whatever prices are fed into it, keeping up a constant visual chatter even when there's not much to talk about. Many charts and signals will also shift their scale to fit whatever the current range is, which can create an illusion of market activity even when volumes are low. A CCI or Bollinger Band or ADX or MACD won't just turn itself off and say, Hey, charting these prices isn't worth my while, and it's likely it lose you money as well. They'll just chart what's there, and it's up to you to decide whether they're saying anything meaningful. Often they aren't, and there are many times when the best strategy is to just leave your charts for a while, go get lunch, watch the Simpsons, have a beer, go swimming, walk the dog, and come back to them when the market's really moving.

Related topics:
The Perils of Chart Burnout
Common Errors When Designing a Trading Strategy

Candlestick Chart Tutorial

If you've spent any time playing around with charting software, you're probably familiar with the candlestick chart, one of the most popular ways to visually depict the movement of a market within and between specified time periods. In fact, candlestick charts are just about the fastest, user-friendliest, and most colorful way to get a clear picture of market behavior.

When I was just learning about this type of chart, one of my favorite resources was this tutorial provided by TradingDay.com. Here I learned the fascinating origins of candlestick charting in the Japanese rice markets of the 17th Century, when Homma, a trader in rice futures, invented these charts to help in his analysis of rice prices. The tutorial also teaches you how to spot bullish and bearish candlestick signals, such as the Harami, the Three Black Crows, the Three White Soldiers, and other indicators that date back centuries (no, the markets don't really change that much, just the traders.) It includes diagrams of each chart formation with pointers on when to enter short and long trades, as well as this helpful comparison of candlestick charting with the Western bar and line chart formats.

Looking to combine a candlestick chart with other indicators? I'd recommend 5 and 20-period moving averages and Bollinger Bands, as well as Stark Bands and Parabolic SAR if your charting software provides them. But don't let your charts get too cluttered -- you may find yourself getting burnt out on all the data. No matter how great your charts are, one of the most valuable skills you can develop is knowing when to take a break.

Related topic:
Know Your Candlestick Patterns

The Perils of Chart Burnout

One thing I discovered after hours of staring at candle charts, CCI graphs, stochastics, Bollinger Bands, Stark bands, moving averages, Parabolic SARs, and a variety of other more exotic charts and signals was that, no matter how much visual information I had in front of me, I still wasn't able to predict the future with much accuracy. In fact, I noticed my predictions got progressively worse the longer I watched the markets on a minute by minute basis, and the more charts and signals I looked at.

When you're just getting started as a forex trader (and I still consider myself a newbie) it's easy to confuse a lot of information with a lot of certainty, and a lot of cool charts and nifty signals with high trading odds. In some cases this may be the case, but all too often, especially for beginners, it's easy to get swamped with data and begin thinking that you're seeing patterns and trends that aren't there. The fact is, most of the 50 different signals you're looking at are really just variations on the same theme -- a change of price direction, a breakout, an emerging trend, a statistical anomaly, an oversold or overbought condition, and so on. For example, when I realized that the CCI graph was describing the same price behaviour as one moving average crossing over another and then approaching and rebounding off the Bollinger Bands, I felt more confident in being able to look at fewer charts and still receive the same information.

In addition to getting burnt out looking at too many different charts, you can burnt out looking at them too long. There are long periods when there's just not much going on in the markets, and you'll only drive yourself loopy staring at a chart at those times waiting for something to happen. If you can identify the really important periods and confine your attention to those, you'll avoid hours of frustration when the charts aren't describing much of anything. You'll also avoid the risk of jumping on a false signal that looks like the real thing but leads nowhere, which are common during periods of low market activity.

Another problem with charts, which I alluded to earlier, is that they can give you the illusion of certainty. Here's one example I was often guilty of -- for a while, I was absolutely sure I knew what would happen when the price crossed above or below a Bollinger Band. After trending up or downward for a while, it would obviously have to bounce back above or below the band and head in the opposite direction. Right? Well, yes, eventually that's usually what happens. But when you're constantly looking for that "Bollinger bounce," it's very easy to start filtering all the incoming information to point exclusively toward that bounce. And if you're like me, you may then overinterpret one of these signals, make an impulsive prediction, and trade on it. You may then discover, as I did on numerous occasions, that what looked exactly like the beginning of a rebound up or down may in fact be part of a minor holding pattern until the price continues its original trend, leaving you sputtering as your stop-loss gets vaporized.

The lesson that you'll eventually learn, if you're paying attention to all the money you're losing, is that it's impossible to know for sure, and very often you'll get it wrong. That's the key fact here: very often you'll get it wrong. If you can't accept that you'll get it wrong, or that you'll have to wait longer than you expected to be proved correct, then charts aren't going to help you. What will help you is adjusting your expectations, and realizing that staring at a chart 12 hours a day may in fact be as harmful as it is helpful. The more data you have to interpret, reinterpret, second-guess at, third-guess at, and lose sleep over, the more likely you are to resort to wishful thinking, trade out of boredom or desperation, hang on to bad trades too long, and end up blowing your whole account at 2:00 in the morning. In short, the more likely you are to get burnt out or burnt up.

These days I look at charts for maybe 15 minutes a day. I spend far more time working with Excel sheets of price data, testing potential signals, looking at long-term trade statistics, and developing simple yes/no, short/long indicators and entry points that allow me to place trades and then leave them alone for hours or days. Oh, and I still spend quite a bit of time playing with FX Engines, which allows me to do all of the above on a highly automated basis.

Perhaps most importantly, I get far more sleep and feel much less anxious about my trades than I did when I was staring at charts all day (and much of the night).

Related topic:
Limiting your emotional exposure to the markets

Free Online Forex Charts - Well Worth a Bookmark!

I thought I'd pass on this handy charting tool for your forex bookmarks. It's provided by Forex Capital Markets (FXCM) and allows you to generate detailed web-based charts for all the major currency pairs. It runs off a Javascript applet, so you'll need the necessary plugins installed, but those aren't hard to get. I've found it useful in situations where I'm away from my home computer and hence don't have access to the charting software on my desktop (DealBook FX, for example). With the DailyFX charts it's easy to check out currency action from any computer with a standard web browser like Internet Explorer.

You can specify timeframes from ticks up to months and switch between line charts, dot charts, forest and candlestick charts, and several other formats. There's also a great selection of studies, including MACD, Stochastics, Parabolic SAR, ADX, exponential moving averages, Bollinger Bands, RSI, CCI, and a variety of oscillators. Not to mention Fibonacci fans and retracements.

Another nifty thing about the applet is you can actually draw in the chart window, adding your own trend lines, highs and lows, and other visual markers of your own choosing. Zoom in and out for a closer look or to make a more detailed notation on the chart, or overlay the chart of another currency pair on top for quick comparison.

I've found this a fun charting tool to play around with, and I think you will too. Who knows, you may even stumble on some indicators you weren't aware of before!

Creating "Flash Cards" to Improve Your Trading Skills

One strategy I've pursued in the never-ending quest to improve my trading skills is creating flash cards from screenshots of forex charts. These cards can help remind you of the key factors in winning (and losing) trades, so you get better at recognizing these patterns the next time they show up. Many successful forex traders reap their profits using finely-honed pattern recognition skills; in fact, this may be the most "intuitive" way to trade forex, and the more practice you get recognizing the right patterns, the better your odds are likely to be. Over time, your collection of forex flash cards will become an in-depth visual record of your trading history that you can for valuable insights.

Below are some examples of screenshots I took following winning and losing trades. This one shows the 5-minute CCI (Commodity Channel Index) and candlestick chart with 5 and 20 unit moving averages that I had open when I made a successful 8 pip short trade of the EUR/USD in August 2005:



And below we see an unsuccessful attempt to trade the EUR/USD short, using only the 5-minute CCI chart (I was using Woodie's CCI system at the time):



In this case, the clear lesson is that what seems like a valid signal -- that little downward spike the lower arrow is pointing to -- can often turn around in an instant and become a false one that loses you 11 pips and leaves you shaking your head in exasperation. In fact, this is a perfect example of the type of losing trade that eventually made me swear off the 5-minute chart entirely. Ah, memories.

All of these screenshots were taken on a rather geriatric Dell PC from the charts on Global Forex Trading's DealBook software. First, I'd hit the "Print Screen" key to capture the screen image I wanted, then I'd paste it into my Microsoft Paint program and crop it down until it just displayed the chart images I wanted. After that, I'd save the images into either my "Good Trades" or "Bad Trades" folder, and voila, my digital flash cards were complete. I could easily review them on screen, or print them out if I wanted a hard copy as well. On some of the cards, I'd also type in a few comments about the circumstances surrounding the trade -- whether I'd waited too long to enter or exit, whether I'd been indulging in an excess of wishful thinking (I usually had), and anything else relevant to that particular gain or loss.

If you're a chart-based trader, you may find these types of flash cards a valuable addition to your arsenal. They're a convenient record of what worked for you and what didn't, and by looking at them on a regular basis you can begin to intuitively recognize the patterns that will make or lose you money.