INDICATORS

Technical indicators compose a separate class of mathematical transformations, that allow to show those or these results. As a rule such primary indicators (from the point of view of technical analysis) is the price and the volume. However they are not the only "original sources". It also should be listed volatility, for example, or correlation with other financial instruments. We will talk about the price firstly to make the description more clear for the beginning traders.

There are some hundreds of more or less well-known indicators and thousands of different variations and authors' developments of different traders, that are less wide-spread, but are used in trading in some cases. We have no such a possibility to list all of them, that is why we will note two major classes of indicators: trend indicators (or trend-followers) and advanced (oscillators). Now we will review two examples for each indicator class.

TREND CLASS (TRENDS-FOLLOWERS) INDICATORS

In general it must be noted that these indicators show very clearly the prevailing trend. The weak side of these indicators is the fact that they delay a little, and work bad during flats. In the framework of this class we will review "Moving average" (MA) indicator and "Moving average convergence/divergence (MACD).

"Moving average" - is one of the simplest indicators. From the mathematic point of view it is average price of analyzed financial instrument for the last n-time intervals. The difference of "Moving average" from the simple average resides in the fact that while forming a new price bar, the first bar is taken into account unlike the last one. Thus the average "moves" to the right with the formation of new prices. Let us see the illustration. 

Picture 13. MA construction

The last (current) MA value in x-point, denoted by red sphere is a simple arithmetical average (sum of the value divided into its quantity) of n of last prices of the given financial instrument. B-area, noted by yellow colour - is a period of averaging, i.e. that bars quantity that takes for the MA value calculation. The larger averaging period the less "flexible" will MA be, and later it will react on the new trend. However it will filter better small and insignificant changes in price. The smaller MA period, the more sensible it will be, but it will lead to the situation when it will react on the price changes that do not compose a trend.

The arrow on the illustration shows the direction of the movement of this period (i.e. with the appearance of a new price the interval will move one bar right). On the illustration we can see, that in the beginning of the given period there is area that is equal to n (denoted as A), for which the value of moving average with n averaging period is impossible to define, because of lack of information.

As we can see on the illustration MA shows very good the general direction of the development of the trend, well smoothing small price fluctuations, which are not significant for the trading. We must note that MA indicator itself might be considered as the simplest numerical filter (NF). The delay is connected with the nature of MA. The size of delay is the half of averaging period.

In the conclusion of description of this indicator, it is noted, that there are lots of variants of calculation of moving averages. Firstly, not only n closing prices (close) may be the original source of data for MA calculation. Instead of it "Typical price" (Typical price = (High + Low + Close) or " Median price" (Median price = (High + Low) or other price features might be used. Also in the role of enter (enter features) another MA indicator may be used (in general, it may be any other indicator). In this case the phrase "double price smoothing" is used. On the analogy the price might be smoothen three, four and etc times, it has to be remembered that the smoothing like this increases the delay.

Secondly, there are different types of MA (simple, exponential, measured, smoothen etc). Apart from this there is the whole underclass of dynamic moving averaging that aims to adjust to the market. If the flat formation happens (where classic MA works badly), the averaging period of dynamic MA increases to decrease the quantity of false signals. As soon as the indicator fixes the beginning of the movement, MA period decreases sharply to reflect more flexibly a new trend.

Moving average convergence/divergence. This indicator is based on two exponential moving average convergence and is calculated as the difference between them. One of them is called "fast" and the other - "slow" (respectively to their periods). It is clear, that "fast" moving average convergence may be both higher and lower than "slow" one. And this leads to the situation when the size of difference between them can appear both in the area of positive numbers and negative ones. In the chart this data is denoted (as a rule) in the form of histogram, but they also may be depicted with a simple curve. Also the indicator has "signal" line that looks like simple Moving average convergence of histogram value.

Picture 14. MACD construction

MACD has a number of features.

Firstly, crossing:

• to buy in time of crossing of histogram signal line bottom-up;
• to sell in time of crossing of histogram signal line top-down.

Secondly, it is overbought/oversold, that may be judged by the analytics depending on the distance of histogram from zero value.

Thirdly, it is divergence. Bullish divergence appears when histogram MACD forms new maximums and the price cannot form them. Bearish divergence is the situation when histogram form new minimums, and the price cannot do the same. Divergences overbought and oversold areas are considered to be the strongest and the most significant signals.

Picture 15. MACD bullish divergence

As we can see on the illustration, at a-point the price has formed a local maximum that is correspond to MACD maximum at a-point. MACD indicator at b-point has formed a new maximum, that is larger than previous one. At the same time, at b-point the price cannot reach a-level.

It has to be noted that MACD is plotted in separate area of a chart (in contrast to MA that is depicted directly at the price chart).

OSCILLATOR CLASS

In this class we will review such indicators as StochasticOscillator and DeMarker.

StochasticOscillator is regarded to be one of the most wide-spread indicators and gives way only to MA. This indicator takes into consideration (when calculating) not only closing prices in that or this time interval, but also both maximums and minimums of the prices, that were reached during the same interval. It reflects closing price of the last time interval in relationship to price interval (from maximum to minimum) for n-intervals in the past. StochasticOscillator values are calculated in percents that is why it, as a rule, is built in separate frame with 0 to 100 interval, however, some variations of this indicator permit to build StochasticOscillator directly on the price chart.

According to the idea of creator of this indicator, J. Lane (the president of InvestmentEducatorsInc. corp.) in process of descendant trend formation the closing prices of bars are situated near the lower ground of the diapason (channel). In the contrary, during ascendant trend formation the closing prices stand near the maximum of the diapason (channel). These claims are quiet logical, because in case of descendant tendency the price constantly forms new minimum, and thus the last prices are situated near this minimum. In case of ascendant trend new maximums are formed constantly, and the closing prices respectively are situated near those maximums.

In the illustration you can see that while forming ascendant trend, the last closing prices "crowd" new upper ground of price diapason (channel).

Let us see the formula of formation of this indicator in details. It consists of two lines %K and %D. These names are the result of long research work, when a group of traders tried to find more convenient variant, giving names to new indicators like %A, %B, %c etc. %D (slow stochastics ) and %K (fast stochastics ) came out to be functional. Let us take into consideration n-periods. At this time interval we have a local maximum (it will be denoted as Maxn) and minimum (Minn )  Closing price will be C. 

Then 

%D - it is MA of %K for which, as a rule, very small averaging period is chosen. Moreover method of calculation of this moving average may be different (depending on trader), for example, simple MA, exponential MA etc.

There are following trading signals of this indicator:

• To buy subject to the line of indicator (%K and %D) will first lower in the oversold area (on default, it is 20%) and then leave it, starting to lift. To sell when the line of indicator (%K and %D) will first lift from the overbought area (on default it is 80%) and then leave it, going down.
• To buy when crossing %D line with %K bottom-up. To sell crossing %K line with %D line top-down.

Besides, the fact of reaching by the indicator (%K and %D) the overbought area itself can be regarded as a prove of the delaying of price rising tendency in near future, and the reaching the oversold area can be regarded as a signal of delay of price decrease. 

Analytics also track the divergences between maximum and minimum of the price, and corresponding extremums of the indicator (the same way as MACD divergences).

The following illustration show abstract (typical) picture of the readings of StochasticOscillator. 

Picture 16 Construction of StochasticOscillator indicator at an abstract chart

DeMarker. It is the second indicator of this type, that will be reviewed as an example for our course - the indicator of Thomas R. DeMark (the author of the book "New Science of Technical Analysis"). It works to define if the current maximum of the bar could overcome previous maximum. According to the author, he tried to create an indicator without any typical disadvantages of oscillator indicators and that could identify potential extremums (maximums and minimums).

"Inside" of the indicator following happens. In case when current bar maximum is higher than previous one, their difference (delta) is registered. We will denote it as ∆max. If the current maximum did not become higher than previous one, then ∆max. is equal to zero. And vice versa, if the current bar minimum is lower than previous one, then the difference - delta of minimums is calculated (let it be ∆min)

Then the current indicator value is calculated using the formula:

Where SMA_n – is a simple MA in n-period.

Picture 17 Construction of DeMarker indicator at an abstract chart

Thus the indicator can take values within 0 and 1. The author singles out 0.3 and 0.7 levels. The overbought of the market takes place when the indicator reaches the area higher than 0.7-point. the oversold zone is lower than 0.3-point. In case of finding the indicator in these areas the delay or change in tendency might be expected. The basic signals of this indicators are: 

• The selling signal at the moment of quitting the overbought area (i.e. the line crosses the indicator of 0.7 level top-down).
• The buying signal at the moment of quitting the oversold area (i.e. the line crosses the indicator of 0.3 level bottom-up).

The indicator is built in a separate frame, where you can see trends and patterns of graphic analysis like at the price graph (for example, "head & shoulders", "double top" etc.). The trying of a tendency may also be a separate signal of the indicator. As well as for the other indicators, the divergence with the price may also be tracked by DeMerker.

FLAT & THE CONTINUATION PATTERNS

FLAT

Flat is a specific type of tendency: "flat" or "side" trend ("stub"). When the price fluctuates in more or less stable horizontal (or close to horizontal) channel, this situation is called flat.

"Narrow" and "expansible" flats deserve a particular attention. Progressive narrowing of price channel (consolidation) happens in the case, if price fluctuation decays slowly. As a rule in paradigm of the narrow flat a correction takes place subject to market participants have not agreed yet that general tendency exhausted (it means they do not ready for trend change), but has no strength for further development of prevailing tendency.

Picture 7. Narrowing and widening of flat channel

THE CONTINUATION PATTERNS

A. "Flag"

Flag as the model of continuation pattern is shown at the following illustration.

Flag is the movement of the price in certain range, that is shown by red dashed line on the illustration. The potential of the movement when the price leaves the channel has at least the same size as "flagpole".

Picture 11. "Flag" continuation pattern

B. "Pennon"

Picture 12. "Pennon" continuation pattern

"Pennon" pattern is one of the individual cases of the flag pattern. It is formed in those cases when the support gradually increases, and the resistance gradually lowers. From the point of view of price dynamics the consolidation takes place. The break in the level of resistance, as a rule, leads to the formation of new current trend and the potential of this movement is no smaller than the size of the "flagpole".

REVERSAL PATTERN

Following patterns are related to the reversal pattern:

A. "Hummer", or "Hanging Man"

Reversal candlestick:

• The body is situated in the upper (lower) part of the price range. The colour of the body does not matter.
• The lower shadow is twice longer than the body
• A reversal candlestick does not have upper shadow or this shadow is too short
• The longer the lower shadow the shorter the upper one, the bigger the body the more the potential.
• Although the body colour does not matter, but bullish colour of the hummer
• -big bullish potential, bearish colour of the Hanging Man
• -big bearish potential

Features:

• In the case if the Hanging Man the confirmation of the bearish signal is very important. The bigger the price gap down between the body of the Hanging Man and opening price for the next day (interval), the bigger the possibility that the Hanging Man will form the top.
• Previous price dynamics characterizes the hummer. If stands before the hummer a candlestick has clearly bearish features (for example, the long body without shadows) - it proves that the bearish market growths in its strength. Then it is necessary to wait for the confirmation that the bulls control the situation), for example, the next candlestick with higher closing price than closing of the hummer. It is important to watch if the hummer breaks the important level of support.

B. "Double top" or "Double bottom"

Reversal models of "Double top" (the change of bullish trend with bearish one) and "Double bottom" (the change of bearish trend with bullish one) forms if the price builds two local extremums, and then breaks the line in its foundation (the line of support in bullish trend or line of resistance in the bearish trend).

The illustration shows usual models of "Double top" and "Double bottom". "double bottom" chart is mirroring of "double top".

This graph lets analytics to expect that after breaking the level of support (in "Double top") or the level of resistance (in "Double bottom") the price may move in the same direction at the distance, that is at least larger than the graph itself (from the foundation to the maximum or to the minimum).

B. "Head & shoulders", or three-way graphs.

The graphs of this class reminds "Double top" or "double bottom". The general rules of its drawdown are the same of those described above with the exception of the fact that the model makes three tops instead of two. We will review only one variant - the change of ascendant trend with descendant, but it means that in "mirroring" everything will be the same in the change of descendent trend with ascendant one.

The model consists of three tops. In the case if two (side) tops are situated at the lower level, and the central top is on the higher one, than this model is called "Head & Shoulders". The same model but with condition that all three tops are at the near levels, then it will be called "Triple top". In case of breaking the foundation of the model the price will (supposedly) move in the direction of this break at the distance no larger than the size of the chart itself (from the foundation to the highest top).

TRENDS

Trend is your friend. This is one of general rules of the technical analysis. Usually the meaning of this phrase is interpreted this way: once began, trend is aimed to develop in given direction and develops until the opposite trend starts. We talked about price movement earlier. However not every price movement is a trend. Ascendant trend is that complex of price movement in which each next maximum is higher than previous one, or each next minimum is higher than previous too. Descendant trend is such a complex of movement in which each new minimum is lower than previous minimum, and each new maximum is lower than previous maximum.

From the notion we may come to the conclusion that to identify trend we will need no less than three points (for example, two minimums and one maximum). This identification in general case should be regarded as preliminary one: until the forth point (another minimum - for our example) will not prove or contradict forward assumption.

The opposite trend or flat (see below) starts, as a rule, when disruption of significant part of extremum takes place. For example, if at the moment ascendant trend takes place, the disruption of another significant minimum will lead to the beginning of descendant trend. On the contrary, at the moment of descendant trend the disruption of another maximum might mean the start for ascendant trend.

No matter what trend it is (ascendant or descendant or "side" trend (see below)), a line that crosses consecutive minimums is called the line of support, and a line that crosses consecutive maximums is called the line of resistance

VOLATILITY AND SEASONALITY

Volatility (mobility) is an ability of price to change its current value. Volatility takes place when there are high volumes of demand and supply. Another transaction at Forex changes the price that or this way (for example, if all the volume that sellers wanted to sell at the price of 1.37541 is bought it will lead to the increase of ask price and it will reach the 1.37542 level, where new selling are available). The change in price depends on the cooperative work of sellers and buyers.

Let us see on a simple example how and why market "waves" are formed (here it should be mentioned that in reality market waves are formed more difficult way and have more specific stages of development, but our task is to show a simple model, and for more detailed learning it has to be recommended a book about wave analysis and Elliott Wave Principle from the List of Recommended Literature). For example, in some time period there is a point of "balance" of demand and supply at the 1.37500. Suppose in addition to this that there are some new buyers in the market (see "Stage 1", pic. 4).

Picture 4. The development of market wave (simplified)

They set orders for purchase and increase demand. Each purchase leads to the price increase, and if there are many such transactions, then the price starts to grow gradually. At this moment other traders see the increase in price on their monitors and suppose that ascendant movement has began. As a result the simple "viewers" in the past become buyers (bulls). This increase of supply starts to move the price upwards. So-called "ascendant wave" is formed ("Stage 2", Pic. 4).

However, each demand has its limit, and sooner or later it is satisfied. The quantity of buyers that are ready to enter the marker decreases. Some of the traders that wanted to buy, but saw that the price became high enough and was too "high" from their point of view, - refuse to buy. The traders oriented on very short-term time horizon note that they have some profit from their purchase transaction, that was closed later. They start to fix it (it means to sell). All this leads to decrease in demand, and increase in supply. Price rising becomes slower ("Stage 3", Pic. 4).

Delay of price rising reflects at the traders' monitors, and they decide that the "correction" will be possible soon. Either with the aim of fixing or hedging, traders start to increase the volume of sells, and that leads to increase of supply over demand and this, in its turn, price decrease. ("Stage 4", pic. 4).

Such process take place constantly in the market. As the result of this, big and small market movements are formed (the size of the movement depends on the cooperative work of traders and on the quantity of bulls and bears). The result of market movement is the formation of trends (tendencies). We will discuss it later (see ch. 2.3. Trends).

It is clear from the above description that volatility depends directly on the players’ activity. Thus Forex market has certain seasonality. During the trade sessions in different regions the volatility changes. Trade sessions in regions are divided as follows (the time pointed in correspondence to time zone UTC/GMT 0):

• Pacific Region
  • Wellington - from 20:00 to 05:00
  • Sidney - from 22:00 to 07:00
• Asia
  • Tokio - from 23 to 08:00
  • Hong Kong, Singapore - from 00:00 to 09:00
• Europe
  • Frankfurt, Zurich, Paris - from 07:00 to 16:00
  • London - from 08:00 to 17:00
• America
  • New-York - from 13:00 to 22:00
  • Chicago - from 14:00 to 23:00

As you can see from this graphic, there are periods when trade sessions "overlay" each other. At this moment there are the highest quantity of players on the market. This gives rise to the biggest volatility. Here we say "as a rule" because, of course, there are some exceptions. For example, if in the region or the government given the trading platforms are closed because of that or this national holiday, then the volatility at Forex at this time will be much lower, than usually. The same untypical volatility decrease may be overviewed when the market waits for some important macroeconomic news.

Apart from changes in the volatility within 24 hours, there are some other "types" of seasonality. For example, traditionally in the middle of the week (Wednesday, Thursday) the volatility on average is higher than in the beginning or the end. In the middle of the month (on the average) the volatility is higher than in the first or the last days. In summer the volatility is lower than in winter because of mass vacations (traders are people too, they take a rest sometimes). And so on. But we cannot speak about the strict rules here. For example, the first Friday of every month - is a day of issuing of important macroeconomic news like information about job market in the USA (so-called "payrolls"). This makes first Friday "untypical": the market is practically unmoved until the news are issued. As a rule it starts moving faster and stronger after issuing. That is why it is important to understand that it is impossible to make "general rules". The analysis of the context should be made and the corresponding changes should take place.

PRICE AND SPREAD

Price is the cornerstone of trading. No matter what goods we are talking about, every time the situation may be described like this: a seller considers the value of these goods to be lower than value of money he wants to get, and a buyer considers the value of goods higher than value of the money he is ready to pay for these goods. If the opinion of the value of goods and money is opposite, then transaction takes place only in case that a seller and a buyer agree on the price. At Forex the goods are money, but it does not change the sense of the trading. Here we take into consideration the value of one currency against the other.

The main question that a trader should decide on - is "how the price will change?" (in that or this financial instrument). On this basis he will build his opinions about the value of that or this currency. If he thinks that one currency will grow in its price against the other he will take decision to buy it. Otherwise - to sell it.

To make forecasts about the price changes more successful you must know how it is formed and what it depends on. One of the fundamental statements of Dow Jones' theory is that "the Price takes into account everything". It means that the level of current price reflects all the factors that can influence it (economic, technical, political, natural and others). Most traders have no doubt about verity of this phrase. However, it is impossible to take into consideration "everything" (it means endless quantity of factors), and this can be a reason for certain indefiniteness in the consciousness of a beginning trader.

We will take into consideration a simple model (from the point of view of technical analysis and regardless fundamental knowledge). In correspondence to this model, in conditions of absolutely free market the price depends on demand and supply. Demand is a total volume of the financial instrument that traders (bulls) in the market will want to obtain in near future. The demand is determined by claims for purchase set at the market ( it means that it is not enough to have only a desire: it is necessary to set an order to influence somehow the demand). Supply, on the contrary, is a total volume of this financial instrument that is set for selling by traders (bears).

The influence on demand and supply looks as follows:

• the increase in demand (new buyers come to the market (traders-bulls)) means increase of prices;
• the increase in supply (new sellers come to the market (traders-bears)) means decrease of prices.

We say "as a rule" because there are situations when increase in demand is followed by corresponding increase in supply. In this case trade volumes might become significantly bigger without any change of price. Likewise the supply increase might be "swallowed" by simultaneous increase of demand. That is why it is possible to discuss a foundation of more or less significant price movement if the changes bring to "deformation" of the level of demand and supply.

Spread is the difference between the lowest price of supply (bid) and the highest price of demand (ask). The size of this difference constantly changes as the market always forges ahead. Let us see it on the following example. In certain time period the rate of pair EURUSD is equal to 1.37513/1.37541. It means that in this time period it is possible to buy euro at the price of 1.37541 (it is the lowest price at which you can buy it) and it is possible to sell it at the price of 1.37513 (it is the highest price at which you can sell it). In this case spread is equal to 28 points (2.8 of standard point).

Each trader wants to buy at the lowest prices and to sell at the highest ones (this is one of "golden rules" of trading). If, for example, you do not want to buy at the price of 1.37541, you can set an order for the purchase at the level of 1.37500 and wait until the price reaches this level. However, it will happen only if demand does not increase, and the supply exceeds the demand at least a bit. In this case the sellers have nothing else to do than to lower price until it reaches the level of 1.37500 - then it will be sold to you at the desirable price (and so you can buy it at the price of 1.37500). And in opposite case: you are not ready to sell at the price of 1.37513. You set the order, for example, at 1.37550 level and wait until the price reaches it. It can happen in case if supply does not increase, and demand exceeds supply, at least, a bit. Then the buyers will have nothing to do than to buy at higher price. Sooner or later one will buy from you at the price of 1.37550.

As a matter of fact it has to be noted that spread (that is also known as "rate differences") takes place not only at Forex. The difference between price of purchase and selling is a part of every exchange office or bank. However, in Forex this difference is the lowest possible.