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.

Bollinger Band Tutorial and Rules

For those who, like me, are fans of John Bollinger's famous bands, I just made an interesting discovery while poking around on Mr. Bollinger's official site. He offers this in-depth tutorial on the history of trading bands, of which Bollinger Bands are one type, and discusses the development of a predecessor of his bands, called Bomar Bands, by Marc Chaikin of Bomar Securities in the 1970s. The tutorial then goes on to explain how he developed his own bands based on the statistical measure of standard deviation, which makes them highly sensitive to extreme deviations in price.

There is also an excellent discussion of multiple counting of different indicators based on the same information, an analytical error many traders are probably familiar with. Multiple counting can lead you to assume that all your indicators are reinforcing each other with additional information, when they're really just reflecting the same, single piece of data.

The tutorial concludes with these 15 rules for setting up and interpreting Bollinger Bands in your charts. They're a must-read for anyone who uses this indicator regularly, especially if you're prone to overinterpreting them - a risk with any indicator, no matter how nifty-looking and well-designed it is.

Overall, the tutorial's a great free resource and well worth adding to your technical analysis bookmarks.

Speaking of Bollinger Bands, the EUR/USD just completed this classic "tag" of the upper band on my 4-hour charts. But as Bollinger himself cautions in his rules, this is not necessarily a sell signal (if only trading were that easy!)

Related links:
BollingerBands.com
Bollinger Band Tutorial

Bollinger Band Trade Filtering

In the spirit of my New Year's resolution to put my trading system on a diet, I've been exploring ways to more aggressively filter out unnecessary trades, boost my trading odds, lower spread costs, and generally fine-tune my system to optimize its performance.

One filtering method I've found that shows a lot of promise involves Bollinger Bands, but not in the way they're usually used. Until now I used Bollingers to identify points where the price was likely to begin a reversal from a (relatively) overbought or oversold position (in forex, all things are relative). But for my current trade filtering project, I'm using them to identify periods of low volatility, when the EUR/USD pair is trading within a narrower range.

The measurement I'm using to determine these periods is the distance between the upper and lower Bollinger Band. When the bands are further apart, the market tends to be in a more volatile, wider-ranging phase. My forex strategy works best in these types of periods (as do most trading systems, I suspect). When the bands are close together, volatility is lower and my system tends to accumulate losses and trading costs.

So what I've done is have my trades switched off when the Bollinger Bands are too close together; the optimal distance between them is something I've determined through a lot of backtesting. What I've found is that my trading odds and performance improve significantly, with fewer big drawdowns and pointless trades when the markets are in the doldrums. Of course, because Bollingers are a lagging indicator, I also miss some big breakouts when the market shifts back from low to high volatility. But I'm willing to live with that - consistent trading performance is far preferable in the long run, and there's nothing that can kills your morale more quickly than waiting out a series of bad trades when the market's drifting in no particular direction. The more of those ugly periods I can avoid, the better!

Related topics:
A Nice Bollinger Band Trade
Put Your Trading System on a Diet
The Quest for a "Kill Switch" Signal

The Economist Weighs in on Technical Analysis (A Must-Read for Fibonacci Fans)

This week's Economist has a provocative article on the use of Fibonacci numbers and other technical indicators by traders and market analysts. Its starting point is a recent study by professors at Cass Business School in the UK. Entitled "Magic numbers in the Dow", it reports the results of a giant backtest on Dow Jones market data using Fibonacci percentages in an attempt to predict market reversals. Turns out they weren't much help at all.

The Economist article then goes on to assert that the whole field of technical analysis is on shaky scientific ground, with very little evidence to support its claims that certain indicators can consistently predict certain trends. Overall, it's a well-written and rightfully skeptical look at some of the underlying assumptions of technical analysis and the "chartists" who use it. Here are some particularly memorable excerpts:

• "The academics looked at the Dow Jones Industrial Average over the period 1914-2002 and found no idication that trends reverse at the 61.8% [Fibonacci] level, or indeed at any predictable milestone."
  
  
• "The recommendations of technical analysis can be so hedged about with qualifications that they can validate almost any market outcome."
  
  
• "Too often, rules are so vague and complex as to make replication impossible"
  
  
• "Some technical predictions may be self-fulfilling; if everyone believes the dollar will rebound at 100 Yen, they will buy as it approaches that level."
  
  
• "Chartists fall prey to their own behavioral flaw, finding 'confirmation' of patterns everywhere, as if they were reading clouds in their coffee futures."
  

I am in complete agreement that those using technical analysis can skew their judgement through selection bias and wishful thinking - in fact I wrote a whole post about it. I also agree that before using any technical indicator, you should be able to formulate its predictions as a testable hypothesis, and should then rigorously backtest those predictions with as much historical data as you can get your hands on.
However, based on my own trading experiences, I question the rather unkind generalization the writer then goes on to make that the entire field of technical analysis is largely bunk. My personal rebuttal to this assertion is that (a) I've created a trading system based entirely on multiple technical indicators (b) I've backtested it thoroughly (c) the results don't look too random to me. The day this system starts making completely useless predictions is the day I'll give some credence to sweeping claims made by skeptics of technical analysis.

I also question the assumption made in both the university study and the article that traders are using the same rigidly-defined technical indicators all the time in all market conditions. While all of my indicators were created using certain basic concepts of support, resistance, continuation, and reversal, I then tweaked and optimized each of them extensively based on actual market data. And I continue to tweak and optimize them all the time, because the market's behavior changes, and therefore the signals need to change too. I think most experienced traders would look at their signals as dynamic, flexible entities that must frequently be retested and recalibrated lest they get rusty and break down - or even discarded, if they've stopped working altogether.

As for the specific conclusions reached about Fibonacci numbers and their predictive abilities (or lack of them), it could very well be that they're of no use in predicting the Dow, at least in certain timeframes. However, they may be of use in predicting activity in other markets. I've found there's a great deal of variability in how effective signals are based on (a) what timeframe they're being applied to and (b) what market they're being used in. I don't personally use Fibonacci numbers because I find them too rigid a signal - instead, I've identified other ratios that seem to be particularly relevant to the EUR/USD market, and I'll continue to adapt these ratios in response to changing market conditions. Again, flexibility and adaptability are the keys here.

If reading these kinds of studies shakes your confidence, the best way to regain it is to go back to the data and see what it tells you. If you find a signal performs consistently and accurately over time, then congratulations, you've found a type of technical analysis that works. If your signal fails miserably, then toss it out and look for another one. Repeat as needed. And whatever you do, don't take an isolated study on Fibonacci numbers and the Dow as the last word on technical analysis!

Further reading:
The Economist: Technical Failure
Magic numbers in the Dow

Related topics:
Designing a Trading System, Tip #1: The Data is Your Friend
Beware of selection bias when designing your forex trading strategy. (Or, how wishful is your thinking?)

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

A Nice Bollinger Band Trade

Since I'm in the midst of a short EUR/USD trade triggered by the upper Bollinger Band, I thought I'd post a snapshot to illustrate the strategy behind this trade. Here's the daily EUR/USD chart from my Metatrader platform. As you can see, a couple days ago, on Sunday, August 6, the price left the upper Bollinger and traded entirely within the band. This pattern, which is very similar to the Doji Star candlestick formation, suggested an imminent reversal downwards. Sure enough, on Monday (below the yellow arrow), the EUR/USD dropped over 60 pips.

Today the downtrend seems to be continuing, after some extreme volatility prompted by the Federal Reserve's rate announcement - that's the huge upward spike you see that nearly hit 1.2900 today. Having weathered that short-lived storm, my trade's showing a profit of 67 pips, plus a few additional pips in interest. Yet another reason Bollinger Bands are one of my favorite chart indicators

Related topics:
Exhaustion signals: Profiting when the market is overbought or oversold
Candlestick Chart Tutorial

Action and Reaction

After the long downtrend in the EUR/USD over the past week my trading signals are telling me it's time for a reversal upwards, so for July 19 I'm placing a long trade for this pair. Hopefully it'll pan out - initial signs are good, as it's already up several pips over my entry price. But it's really too soon to tell, and if I followed my own advice I wouldn't be checking on the price at all. Oh well, too late.

Anyway, this long trade after a very steep, dramatic downtrend is a good illustration of the importance of signals that can capture both action and reaction in your trading system. Because the market is constantly bouncing back and forth in reaction to itself, as well as to outside events, and if you're only looking for the action without anticipating the reaction, you're missing out on a lot of trades. Now I'm going to try to get some sleep and hopefully this bearish EUR/USD market will decide to turn bullish for me. Just for a day, that's all I'm asking!

Post-mortem:
The trade worked - check out that reversal! My EUR/USD long position is currently up over 70 pips from my entry price last night.

Related topic:
Exhaustion signals - profiting when the market is overbought or oversold

Exhaustion Signals - Profiting when the market is overbought or oversold

Some of the most effective signals I've integrated into my trading system are those based on the principle that the market will become exhausted and the price will begin rising or falling back towards its moving average after a strong upward or downward run. These signals go by various names - I prefer "exhaustion," because it's most vivid and immediately familiar, but terms like "overbought" and "oversold" are equally if not more commonly used. "Contrarian" or "correction" also apply, when used in this particular context.

Recent EUR/USD activity offers an excellent case study in a profitable trading opportunity in overbought conditions - as of this writing, I'm up over 100 pips on a short trade that caught the downtrend pictured in the daily chart to the left. After a major uptrend in the EUR/USD last week, the market is now correcting downwards, presenting a great chance to gather pips by going short.

There are a number of advantages I've found with these types of signals:

• They can be focused on a very specific moment during an uptrend or downtrend, and carefully tuned until they trigger trades at the optimal point in the trend. As a result they are more selective and precise than many other types of signals.

• They can be built around readily available chart indicators such as Bollinger Bands, moving averages, CCI signals, candlestick patterns, and highs and lows.

• When properly designed, they perform with a high degree of consistency. They never score 100%, of course, but then I've never come across a signal that does.

Drawbacks of exhaustion signals are that, well, sometimes the market doesn't get exhausted, and continues on its original course upward or downward. This is something you can expect to happen periodically, and it shouldn't be a surprise that it does - every signal has a failing, and this is the big one for exhaustion triggers. The key when designing these signals, as it is for any signal, is backtesting them extensively with historical data to determine their overall effectiveness and profitability over years of market activity. Only then will you have the confidence in them to execute trades consistently over a long enough period to see positive results.

Here are a few examples of exhaustion signals I use to trigger EUR/USD trades:

• If the market has seen a run-up of X pips over the past Y trading days, I sell the EUR/USD short (don't really feel like giving away my X and Y values today).

• If the previous day's closing price was below the upper Bollinger Band calculated over Z periods, and the high price from two days previous was above the upper Bollinger Band, I sell short. (I use a customized Bollinger equation to calculate my bands, and I'll just say it differs significantly from the standard default Bollingers you'll find in most charting software.)

• If the previous trading day's closing price was above the lower Bollinger Band calculated over Z periods, and the closing prices of the two days before that were below the lower Bollinger Band, I go long (buy) the EUR/USD.

Hopefully these will give you some ideas for designing your own signals for profiting from overbought and oversold conditions. If you have any exhaustion trading strategies you'd like to share, please feel free to post them in the comments.

Related topic:
A Nice Bollinger Band Trade

Signals Using Maximum / Minimum Prices

One type of signal you may find profitable to study is the behavior of maximum and minimum prices during a particular period of trading. I've found that some pretty reliable signals can be discovered by comparing maximums and minimums over time. What you'll need is an extensive set of historical price data and a willingness to test out various min/max iterations.

Just about the simplest signal to try is comparing the previous trading day's maximum or minimum price against the maximum or minimum for a selected preceding time period. What happens if the previous day's maximum exceeds the previous week's maximum? Or if the previous day's minimum drops lower than the previous week's minimum? How about the two preceding weeks, or the preceding month?

You can treat a given week's maximum or minimum the same way, for instance by comparing last week's max or min against the previous month's. Or try reducing the time scale and see what happens when the previous 15 minute period's max price crosses above the previous 4 hour maximum.

You get the idea - it really couldn't be more straightforward. Give it a try and I have a feeling you'll start discovering some profitable signals. Once you have, your next challenge is to trade them consistently - even after they've been wrong, which they inevitably will be every so often. Maximum luck to you!

Related topics:
An Easy Signal Using Minimum Prices
An Easy Signal Using Maximum Prices

Signals aren't set in stone - so don't be afraid to fine-tune them

The first forex signal I was ever introduced to was the Commodity Channel Index, or CCI. The CCI is the heart of Woodie's CCI system (yes, that's Woodie himself there with Barbara Bush), and my first forex broker recommended I try this straightforward trading method. So I did, just taking my account rep's word for it that it would work. He told me to set up the CCI with 5-minute periods and a range of 14 periods. So I did, again taking his word for it. At this point I really had no idea why 14 periods would be better than 10 or 20 periods, and I didn't know enough to ask, or to test out the theory that 14 was the magic number with historical data. And with that, I started trading Woodie's system, blindly accepting that this off-the-shelf strategy would work for me. Well, it didn't - or rather, I didn't know how to make it work.

At various other times, I've used similar standard set-ups of other signals. For instance, 5 and 20 period MAs, or 20 period Bollinger Bands. If asked why I was using these particular set-ups, the most honest answer I could've given was that "I read about them somewhere" or "Someone told me to do it this way." I had no personal experience or evidence to base my signal choices on, so I simply had to take other peoples' word that they would work. I don't think it was a coincidence that my trading results were poor. Very poor.

It was only later, when I'd begun using extensive historical data to guide my trading, that I really started fine-tuning and customizing my signals. For example, after trying to design a signal around 20 period Bollinger Bands with daily (24-hour) periods , I began testing out various other ranges of periods: 15 period bands, 12 period bands, 10 period bands, and so on. To my surprise, the most powerful signals were derived from 10-period daily Bollinger Bands - far more powerful than bands based on 20 periods, which I'd always understood to be the standard. Lesson learned! Likewise with moving averages - after extensive testing of many different periods, I found that a combination of 5 and 10 period MAs yielded the most significant results. Perhaps just as importantly, I also discovered that moving medians generated some very interesting signals as well. Now I've never seen a moving median mentioned anywhere outside my own spreadsheets, and had it not been for my new-found willingness to test, tweak, recalibrate and recalculate every potential signal, I don't think I would've ever stumbled on them.

Fine-tuning my signals in this manner also taught me that certain isolated events frequently emphasized in trading tutorials and chart-based trading systems were often less important that I'd originally assumed. For instance, a moving average cross, which certainly worth noticing, predicted a lot fewer trades than the ongoing relationship between two moving averages: how far one was from the other, whether the distance was increasing or decreasing, whether their more recent movements were in conflict or agreement with their longer term movements. I think focusing exclusively on chart-based trading led me to overemphasize single events at the expense of the total set of interactions between signals.

The lesson I hope I'm conveying amid all this rambling is that you shouldn't take anyone's word for it that a given signal will work at all, or will work better than other signals. All signals are just equations that someone else invented, and they can all be recalculated, tested, and retested with new parameters and different values. Think of signals as your employees. You wouldn't just take a new hire and put them straight to work - you'd spend some time getting to know them, training them for the tasks you expect them to carry out, and seeing how they perform in different situations. Signals work for you, and it's up to you to make the best use of their abilities.

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