Combination of Trading Indicators

The combined trading methods provide an objective view of price activity. It helps you to build up a view on price direction and timing, reduce fear and avoid over trading. Furthermore, these methods tend to provide signals of price movements prior to their occurring in the market.

The tools used methods are moving averages and oscillators. (Oscillators are trading tools that offer indications of when a currency is overbought or oversold). Though there are countless mathematical indicators, here we will cover only the most important ones.

1. Simple and Exponential Moving Average (SMA - EMA)
2. Moving Average Convergence-Divergence (MACD)
3. Bollinger Bands
4. The Parabolic System, Stop-and-Reverse (SAR)
5. RSI (Relative Strength Index)

1. Moving Average

A moving average is an average of a shifting body of prices calculated over a given number of days. A moving average makes it easier to visualize market trends as it removes – or at least minimizes - daily statistical noise. It is a common tool in technical analysis and is used either by itself or as an oscillator.

There are several types of moving averages, but we will deal with only two of them: the simple moving average (SMA) and the exponential moving average (EMA).

A. Simple moving average (SMA)

• Definition The simple moving average is an arithmetic mean of price data. It is calculated by summing up each interval's price and dividing the sum by the number of intervals covered by the moving average. For instance, adding the closing prices of an instrument for the most recent 25 days and then dividing it by 25 will get you the 25 day moving average.
  Though the daily closing price is the most common price used to calculate simple moving averages, the average may also be based on the midrange level or on a daily average of the high, low, and closing prices.
• Advantages Moving average is a smoothing tool that shows the basic trend of the market.
  It is one of the best ways to gauge the strength a long-term trend and the likelihood that it will reverse. When a moving average is heading upward and the price is above it, the security is in an uptrend. Conversely, a downward sloping moving average with the price below can be used to signal a downtrend.
• Drawbacks It is a follower rather than a leader. Its signals occur after the new movement, event, or trend has started, not before. Therefore it could lead you to enter trade some late.
  It is criticized for giving equal weight to each interval. Some analysts believe that a heavier weight should be given to the more recent price action.
• Example You can see from the chart below examples of two simple moving averages - 5 days (Red), 20 days (blue).

B. Exponential Moving Average (EMA) The exponential moving average (EMA) is a weighted average of a price data which put a higher weight on recent data point.

• Characteristics The weighting applied to the most recent price depends on the specified period of the moving average. The shorter the EMA period, the more weight will be applied to the most recent price.
  An EMA can be specified in two ways: as a percentage-based EMA, where the analyst determines the percentage weight of the latest period's price, or a period-based EMA, where the analyst specifies the duration of the EMA, and the weight of each period is calculated by formula. The latter is the more commonly used.
• Main Advantages compared to SMA Because it gives the most weight to the most recent observations, EMA enables technical traders to react faster to recent price change.
  As opposed to Simple Moving Average, every previous price in the data set is used in the calculation of EMA. While the impact of older data points diminishes over time, it never fully disappears. This is true regardless of the EMA's specified period. The effects of older data diminish rapidly for shorter EMAs than for longer ones but, again, they never completely disappear.
• Example You can see from the chart below the difference between SMA (in blue) and EMA (in green) calculated over a 20-day period.

2. MACD (Moving Average Convergence-Divergence)

The moving average convergence-divergence indicator (MACD) is used to determine trends in momentum.

• Calculation It is calculated by subtracting a longer exponential moving average (EMA) from a shorter exponential moving average. The most common values used to calculate MACD are 12-day and 26-day exponential moving average.
  Based on this differential, a moving average of 9 periods is calculated, which is named the "signal line".
  MACD = [12-day moving average – 26-day moving average] > Exponential Weighted Indicator
  Signal Line = Moving Average (MACD) > Average Weighted Indicator
• Interpretation Due to exponential smoothing, the MACD Indicator will be quicker to track recent price changes than the signal line. Therefore,
  When the MACD crossed the SIGNAL LINE: the faster moving average (12-day) is higher than the rate of change for the slower moving average (26-day). It is typically a bullish signal, suggesting the price is likely to experience upward momentum.
  Conversely, when the MACD is below the SIGNAL LINE: it is a bearish signal, possibly forecasting a pending reversal.
• Example of a MACD You can see from the chart below example of a MACD. The MACD Indicator is represented in green and the Signal Line in Blue.

3. Bollinger Bands

Bollinger Bands were developed by John Bollinger in the early 1980s. They are used to identify extreme highs or lows in price. Bollinger recognized a need for dynamic adaptive trading bands, whose spacing varies based on the volatility of the prices. During period of high volatility, Bollinger bands widen to become more forgiving. During periods of low volatility, they narrow to contain prices.

• Calculation Bollinger Bands consist of a set of three curves drawn in relation to prices:
  The middle band reflects an intermediate-term trend. The 20 day - simple moving average (SMA) usually serves this purpose.
  The upper band is the same as the middle band, but it is shifted up by two standard deviations, a formula that measures volatility, showing how the price can vary from its true value
  The lower band is the same as the middle band, but it is shifted down by two standard deviations to adjust for market volatility.
  Bollinger Bands establish a Bandwidth, a relative measure of the width of the bands, and a measure of where the last price is in relation to the bands.
  
  Lower Bollinger Band = SMA - 2 standard deviationsUpper Bollinger Band = SMA + 2 standard deviations.
  Middle Bollinger Band = 20 day - simple moving average (SMA).
• Interpretation The probability of a sharp breakout in prices increases when the bandwidth narrows.
  When prices continually touch the upper Bollinger band, the prices are thought to be overbought; triggering a sell signal.
  Conversely, when they continually touch the lower band, prices are thought to be oversold, triggering a buy signal.
• Example of Bollinger Bands You can see from the chart below the Bollinger Bands of the S&P 500 Index, represented in green.

4. The Parabolic System, Stop-and-Reverse (SAR)

The parabolic SAR system is an effective investor's tool that was originally devised by J. Welles Wilder to compensate for the failings of other trend-following systems.

• Description The Parabolic SAR is a trading system that calculates trailing "stop-losses" in a trending market. The chart of these points follows the price movements in the form of a dotted line, which tends to follow a parabolic path.
• Interpretation When the parabola follows along below the price, it is providing buy signals.
  When the parabola appears above the price, it suggests selling or going short.
  The “stop-losses” dots are setting the levels for the trailing stop-loss that is recommended for the position. In a bullish trend, a long position should be established with a trailing stop that will move up every day until activated by the price falling to the stop level. In a bearish trend, a short position can be established with a trailing stop that will move down every day until activated by the price rising to the stop level.
  The parabolic system is considered to work best during trending periods. It helps traders catch new trends relatively early. If the new trend fails, the parabola quickly switches from one side of the price to the other, thus generating the stop and reverse signal, indicating when the trader should close his position or open an opposing position when this switch occurs.
• Example of an SAR parabolic study You can see from the chart below in green the Parabolic System applied to the USDJPY pair.

5. Relative Strength Index (RSI)

The RSI was developed by J. Welles Wilder as a system for giving actual buy and sell signals in a changing market.

• Definition RSI is based on the difference between the average of the closing price on up days vs. the average closing price on the down days, observed over a 14-day period. That information is then converted into a value ranging from 0 to 100.
  When the average gain is greater than the average loss, the RSI rises, and when the average loss is greater than the average gain, the RSI declines.
• Interpretation The RSI is usually used to confirm an existing trend. An uptrend is confirmed when RSI is above 50 and a downtrend when it's below 50.
  It also indicates situations where the market is overbought or oversold by monitoring the specific levels (usually “30” and “70”) that warn of coming reversals.
  An overbought condition (RSI above 70) means that there are almost no buyers left in the market, and therefore prices are more likely to decline as those who previously bought will now take their profit by selling.
  An oversold condition (RSI below 30) is the exact opposite.
• Example of RSI You can see in red from the chart below the Relative Strength Index of the GBPUSD pair.

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SAR with other indicators Combinations

Combining the SAR with other indicators

The Parabolic SAR (i.e. stop and reverse) indicator is a trend seeking indicator which is used to detect when a trend stops and reverses. Therefore, it detects the stopping of an uptrend and a reversal of the price to a downtrend, and vice versa. On a chart, the Parabolic SAR is marked by dots which appear under the candlesticks when the downtrend stops and reverses to an uptrend, and appear under the candles when the uptrend stops and reverses to a downtrend.

If you look closely at the workings of the Parabolic SAR, it will be very obvious that this indicator has a lot of lag. Usually, the price would have been on its way by the time the signal appears, so a trader who relies only on the Parabolic SAR for trade signals will only be able to enter trades very late indeed, and will only pick a few pips, if any at all. Therefore, the trader must combine the Parabolic SAR with other indicators or trade signals to be able to catch the reversal moves early. In this article, we will show you two cracking ways that the Parabolic SAR can be used to pick out profitable trading signals.

Strategy 1: Using the Parabolic SAR with the MACD and the 200 SMA
This strategy which is used on the 4 hour chart, uses the following indicators:
a) 200 Simple Moving Average, which helps the trader to detect the ongoing trend. If the price action is below the 200 SMA, then this is a sign that the currency pair is in a long term downtrend. If the price action is above the 200 SMA, then the currency pair is in a long term uptrend. It is important to know this as this will eventually help you determine which Parabolic SAR is valid and which should be ignored.

b) The 13 Simple Moving Average, which is the short term moving average that will serve as a support (for a long trade setup) or resistance (for a short trade setup). A bounce of retreat of the price on this moving average is significant for trade entry as we will demonstrate shortly.

c) Forexoma-MACD Histogram, which is a custom forex indicator that was developed by Forexoma Corporation. Unlike the traditional MACD, the Forexoma-MACD is colour-coded and once the trend of an asset changes, the colour of the bars of the MACD changes as well, enabling traders to detect trend changes earlier instead of waiting for the traditional cross above or below the zero line.

d) Parabolic SAR, applied to the chart with its default settings.

Short Trade Setup
For a short trade, we will be looking for the following setup:

a) Price located below the 200 SMA. This is the first parameter. Therefore the bias for the trade should be to go short. If the 200 SMA is below the price but the 13SMA described below is above the price, then the 200 SMA can be used as a support line for trade exit. The 200 SMA can indeed act as a support or resistance if the price action is close enough. For the short trade, we are looking for the price of the currency pair to be below the 200 SMA, or for any upside correction to hit and retreat from the 200 SMA.

b) Any upside move that butts off the 13 Simple Moving Average, and this occurs at almost the same time as:

c) Parabolic SAR indicator appearing above the price action AND

d) Forexoma-MACD changes from blue to red, or has already changed to red colour.

Once these signals all align, then enter short at the open of the candle following the signal. We see a perfect example below:

In this example, we see the grey vertical grid line which we have drawn in order to show that the signals occurred at about the same time. So we see the Forexoma-MACD colour indicator change colour from blue to red, and the price action bouncer off in a downward motion from the 200 SMA and the 13 SMA, which both act as very strong resistance factors. This downward move was good for a massive 350 pips, which serves to show why the 4hour chart is such a brilliant chart for this trade setup.

Stop Loss: This should be set at a 5 pips below the first dot of the Parabolic SAR.

Profit Target: Use the change in the signal of the Parabolic SAR (i.e. appearing BELOW the price action) as the trade exit signal.

Long Trade Setup
We move ahead to just 4 days after the short trade setup above, to see how a long trade setup plays out. Remember, this is a stop and reverse strategy, so the end of the short trade above could signal the long trade setup if the parameters are correctly aligned.

We will be looking out for the following:
a) Price located below the 200 SMA. If the 200 SMA is located above the price action, then it should be used as a resistance level, suitable for trade exit. This condition only holds if the 13 SMA is located below the price action.
b) Candlesticks that bounce upward off the 13 Simple Moving Average, and this occurs at almost the same time as:
c) Parabolic SAR indicator appearing below the price action AND
d) Forexoma-MACD changes from red to blue, or has already changed to blue colour.
Look at the chart below:

Once more, we have our grey vertical grid line for referencing where the parameters line up. We can see that the MACD histogram has already changed colour to blue, so we look for where the candlesticks bounce up from the 13 SMA at the same time that the Parabolic SAR is below the price action. This is shown at the area circled with green ink. The long trade should then be opened at the open of the next candle. The trade shown above was good for at least 300 pips.

Stop Loss: This should be set at a 5 pips below the first dot of the Parabolic SAR.

Profit Target: You can use the 200 SMA as the exit point. Otherwise, the change in signal of the Parabolic SAR (i.e. appearing above the price action) can be used as the trade exit signal.

This is one of the two ways that the Parabolic SAR can be used with good results, securing many profitable trades in the process.

Strategy 2: Using the Parabolic SAR with the ATR, Simple Moving Averages and Multiple Time Frames

How interesting does this get? Now we want to show how to use the Parabolic SAR with multiple time frames so that you avoid the trap of getting signals when indeed the market is going to end up being flat for quite some time.

When the market is trending, then you can really make some good money with the Parabolic SAR. You simply trade with the corresponding stop and reverse signals. But when you run into a consolidating market, then things can get very ugly. You do not want to get a Parabolic SAR trade signal when the market is flat. Not only will you make no money, but indeed the risk of losing money can be very real. This strategy helps you avoid that by using the Average True Range (ATR) indicator which we discussed last week, and multiple time frames (15 minutes, one hour and 4 hour charts).

The strategy starts with attaching the simple moving averages to the chart. The simple moving averages are your key tools that tell you if the market is trending or flat. The moving averages to use are:
a) 8 Simple Moving Average
b) 21 Simple Moving Average

Ideally, the shorter term moving average (i.e. the 8 SMA) must have crossed the 21 SMA, and both must have been pointing to a particular direction. These are what will point to the trend of the asset. So they should be pointing upwards or downwards. If they are pointing sideways, then the market is going to be flat and you should stay away from the market.

Next, the Parabolic SAR indicator is added to the charts and left in its default settings (though you can change the color if you wish).

The ATR indicator is also added to the mix in its default settings. All these indicators are available on Forex4you’s MT4 trading platform and can be added using the Indicator tab or the Insert button at the top of the page.

Long Entry Rules
Ensure that the candlesticks (representing the price action) are above the 8 SMA and that the 8 SMA is above the 21 SMA. Both simple moving averages must be heading upwards, indicating an uptrend, and we want to trade with the trend because it is our friend. These scenarios must occur on the 15 minute, one hour and 4 hour charts simultaneously.

At the same time, the values of the Average True Range must be close to the upper limit of the range, signifying that the market will have enough volatility to perform according to the trade’s expectation. If the ATR were to be at the baseline, or at the lower end of the spectrum, this would negate the trade signal.

The entry should be made on the 15 minute chart, at the candle where the Parabolic SAR has appeared below the candlesticks, signifying a bullish signal. For better entry, you can wait to see if the price action will try to move down below the 8 SMA. Usually, it will be resisted at that level and start to move up. So you get the opportunity to take the trade from the true starting point, garner more pips and make money.

Stop Loss: This is set at the price level that corresponds to the first dot of the Parabolic SAR as the starting point. As a new dot of the Parabolic SAR appears below the candles but at a higher level, the stop loss is manually adjusted to the new levels. You continue to adjust the stop loss upwards (effectively locking in the profits as you move along) until the trade reaches its logical conclusion.

Profit Target: Profits are taken either by closing the trade manually when the Parabolic SAR appears above the price action, or when the moving averages start to turn sideways. This means that the trader has to watch the trade from start to finish; it is not a “set and forget” trade strategy.

Short Entry Rules
Simply reverse what is done for the long trade. Make sure that the price action is below the 8 SMA and that the 8 SMA is also below the 21 SMA. Both the 8 SMA and 21 SMA must be pointing downwards, signifying a downtrending price action, and this situation must be found on the 15 minute, one hour and 4 hour charts simultaneously.

At the same time, the values of the Average True Range must be close to the lower limit of the range.

The entry should be made on the 15 minute chart, at the candle where the Parabolic SAR has appeared below the candlesticks, signifying a bullish signal. For better entry, you can wait to see if the price action will try to move down below the 8 SMA. Usually, it will be resisted at that level and start to move up. So you get the opportunity to take the trade from the true starting point, garner more pips and make money.

Stop Loss: Set the stop loss at the price level that corresponds to the first dot of the Parabolic SAR, and keep adjusting it as the new dots of the Parabolic SAR appear above the candles but at a lower level, effectively locking in your profits as the trade progresses to its logical end.

Profit Target: Closing the trade manually when the Parabolic SAR appears below the candlesticks, or when the moving averages start to turn sideways are the two ways to take profits from a short trade entry.

See a typical BULLISH setup below:

Notice how the signals all tally with each other, allowing the opportunity to take the trade on the 15 minute chart. Practice how to detect a short trade setup as your assignment following this article.

Strategy 1 is a long term trading strategy while Strategy 2 is a short term trading strategy. If you have been mystified by the Parabolic SAR, this article should clear up the cobwebs.

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Trading with Moving Averages Explained

Understanding Moving Averages plus Trading with Moving Averages 

Moving averages, also called MAs in short, are the most widely used and oldest technical indicator used by traders because of its simplicity in both construction and uses. It is among the “Lagging indicators” as it provides signals or direction of price after a significant change in that direction.

Moving averages are very effective in case of trend analysis as this indicator dampen short term fluctuations and smoothen out the price so that a trader or analyst can focus on major or long term price movement, due to this laggard. It is also a very popular indicator as its signals are simple, clear and easy to understand.

Moving averages calculated by taking the close price of the currency pair, or you can choose open, high or low price instead of close price. Moving averages are simply average price of the currency pair for last ‘X’ number of periods. It includes the new price data as it develops hence called moving averages.

Types of Moving Average

There are different types of moving averages, among them 2 types of moving averages are highly popular and widely use. They are,

1. Simple Moving Averages (SMA)
2. Exponential Moving Averages (EMA)

Simple Moving Averages (SMA) :

This is the based on the basic calculation of the moving average as mentioned above; by dividing the sum of the values of ‘X’ number of periods by the number of periods ‘X’. Because of its calculation method it is simple and smoother than other type of moving averages. You can choose any number as periods of any moving average, such as 10, 13, 15, 20, 25, 28, 30 etc. There are some numbers recommended in case of moving averages. Such as 10, 25, 30, 50, 100, 150 and 200; most of the traders use these periods of moving averages.

Calculation of SMA:

SMA of n periods = n period sum/n

n = the period or number of day’s you choose to plot moving averages. Such as 10,20 or 30.

There is an example of simple moving average given in the chart above. We can see SMA25 or 25 day’s simple moving average (blue colored line) in the daily chart of EUR/USD.

Exponential Moving Averages (EMA):

Exponential Moving Averages also known as EMAs. This type of moving averages designed and developed to reduce the lag or delaying nature of SMA by applying more weight on most recent price or data.

Calculation of EMA:

You have to go three steps to calculate exponential moving average. First, you have to calculate simple moving average of your chosen period. Then you have to calculate the weighting multiplier to put more weight in recent price data. Then you can calculate exponential moving average using simple moving average and weighting multiplier which you have calculated before. All three steps of calculation would be like this,

SMA = n period sum/n where, n = number of periods chosen to calculate EMA

Multiplier = (2/ (n+1))

EMA = {Close – EMA (previous day)} x multiplier + EMA (previous day)

Here is an example of EMA in the chart given below,

In the chart above, blue colored line is 30 day’s exponential moving average (EMA30) in the daily chart of EUR/USD.

Simple Moving Averages (SMA) Vs Exponential Moving Averages (EMA) :

Calculation of SMA and EMA is different. Thus, there are some differences in their characteristics. The key difference is the lag factor. If same periods of moving average plotted, then we will be able to see the significant difference. Let’s check out the significant difference between SMA and EMA.

In the daily chart of EUR/USD, we have plotted SMA30 and EMA30. Red colored line is SMA30, and blue colored line is EMA30. These two moving averages have a difference in appearance though they are of same periods. If you look at the chart carefully you will find that, EMA reacts faster with the price than SMA reacts with the price. This means, EMA is faster and choppier than SMA. Thus, SMA is lazier but smoother than EMA. Both SMA and EMA are an effective tool. It depends on trader who has to choose the type and period of moving average he/she will use depending on his/her trading style.

Trading with Moving Averages :

Moving averages can be used for various reasons. Such as,

1. Trend Identification
2. Trend Reversals
3. Dynamic Support and Resistance

Trend Identification :

Moving averages are very useful to identify trend and the direction of the trend. The trend is in an uptrend as price or candle is above the moving average. Inversely, if price/candle is below the moving average and the moving average is heading downward then the trend is downtrend. There is no valid trend (flat trend) if price or candle is in a range with moving average, and the moving average is flat. All these situations have shown in the chart of daily EUR/USD given below.

Trend Reversal:

Trend reversals identified by the crossover between two or more moving averages of different periods. Let’s take two moving averages in consideration, SMA10 and SMA30. SMA10 is faster than SMA30 as its period is smaller than SMA30. When SMA10 crosses above SMA30 then it is a sign that trend has reversed to uptrend from downtrend. We should keep in mind that if short term moving average is below the long term moving average then the trend is down. And if short term moving average is above the long term moving average then the trend is uptrend and if both moving averages stay in the same point then there is no or flat trend. Now, when SMA10 crosses SMA30 from above then it is a confirmation that the trend has reversed to downtrend from uptrend. Both uptrend and downtrend reversals have shown in the example in the daily chart of EUR/USD given below.

Dynamic Support and Resistance:

In an uptrend price tends to get support whenever its price or candle comes near moving average. Thus, most of the times price bounces back to its previous trend from the moving average. This scenario is bullish pullback. Inversely, when a currency pair is in downtrend then it tends to get resistance when price or candle comes near moving average. Thus, price tends to bounce back to downward from this moving average. This is a bearish pullback. Both bullish and bearish pullback has shown in the example chart of daily EUR/USD given below.

In this way, moving averages can be used as dynamic support and resistances.

Conclusion:

All the methods of using moving average are very useful for trend identification. Moving average crossover signals should be used only for trend identification. Trading crossover signals might make you depressed as these are late signals and can provide many whipsaws. Trading the pullbacks near the moving averages is a very effective strategy. However, other momentum indicators or oscillators should be use with moving averages to make a better combination to provide entry signals.

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More About Volatility Indicators – Bollinger Bands Explained

Volatility Indicators – Bollinger Bands Explained

Introduction:

Bollinger band is a volatility indicator developed by John Bollinger. This indicator measures volatility based on standard deviation. Bollinger band is most used volatility indicator and one of the widely used indicators in technical analysis.

Calculation:

Calculation of Bollinger band is based on a simple moving average. The default period of Bollinger band and moving average is 20. However, many traders use Bollinger bands of 15 or 25 periods. The calculation of Bollinger band is as follows,

Middle Band = 20 day SMA or Simple Moving Average

Upper Band = 20 day SMA + (20 day Standard Deviation)

Lower Band = 20 day SMA – (20 day Standard Deviation)

Bollinger band appears as a band consists of 3 moving averages like lines. Here is an example chart containing Bollinger bands.

Interpretation:

Bollinger band can be used in many ways. Different traders use this indicator in different ways. Such as,

1. Bollinger Band Bounce
2. Bollinger Band Squeeze
3. Bollinger Band Breakout

Bollinger Band Bounce:

This is very simple and effective trading method for short term trading. Traders usually use this for short term trading or scalping in forex market. This strategy involves buying when candlestick hit the lower Bollinger band and selling when candlestick hit upper Bollinger band. It is better if you follow the trend while trading Bollinger band bounces.

4 hour chart of USD/CAD is showing several entry signals for both long and short positions.

Bollinger Band Squeeze:

When a currency pair becomes less volatile, Bollinger band becomes squeezed. In squeezed condition, distance between upper, lower and middle bands becomes narrow. This scenario occurs when the price of the pair is ranging in a narrow range. This indicates low volatility and a sign of a breakout or breakdown. Squeezed Bollinger band after a prolonged downtrend indicates accumulation period. Inversely squeezed Bollinger band after a prolonged uptrend indicates distribution period. But it is extremely difficult to identify accumulation and distribution phase properly. This is why traders usually add other indicators to understand the possible price direction after the squeezed state.

On the 4 hour chart of AUD/USD, we can see entry signals for long positions as Bollinger band was squeezed and MACD moved above the zero line.

4 hour chart of AUD/USD (given above) is showing sell signal or entry signal for long position when the Bollinger band was squeezed and MACD crosses below the zero line/centerline.

Bollinger Band Breakout:

A breakout occurs when candlesticks hit upper or lower Bollinger band. Breakouts and breakdowns mostly occur after a squeezed state of the Bollinger band. A squeezed condition of Bollinger band indicates the possibility of a breakout or breakdown. Thus, traders generally trade breakouts or breakdowns after Bollinger band squeeze.

 4 hour chart of USD/CAD is showing breakout and breakdown after a squeezed state of the Bollinger band.

Summary:

Volatility plays a vital role in Bollinger band trading strategies. Such as, Bollinger band bounce strategy works well when there is a confirmed trend and volatility is high. Breakouts and breakdowns carry more success if found after a prolonged squeeze state of the Bollinger band. Traders should consider these factors while trading with Bollinger bands.

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All About MACD from a deferent angle

 

Talking Points:

• While no indicator is perfect, they can help traders address probabilities in a market
• Moving Averages can be helpful, but often lack an active signaling mechanism
• MACD takes trading with moving averages one step further

The journey for most traders starts in a similar way…

Traders are drawn to markets because of the potential. And like anything else in life, most people understand that training and education are vitally necessary parts of success. Most will then act on this understanding, and will begin learning the ‘tools of the trade.’

And that is where the quest will begin…

In the FX markets, Technical Analysis often receives a heavier portion of this focus and there are a couple of different reasons for that. This journey of learning technical analysis can be a short couple of days or might take years or even decades. Regardless of how the trader approaches learning Technical Analysis, one thing that is fairly uniform is that the ‘common’ indicators are learned first before more advanced studies like price action or Elliot Wave.

These are the indicators like RSI, or Stochastics, or Pivot Points. And what will often happen is that after a trader learns how to use the indicator, they also learn that the indicator isn’t a panacea, and is from time-to-time, incorrect.

Does this mean that the indicator is worthless and can’t be used?

Absolutely not! It merely reiterates what all of us should know about markets going in… which is that markets are unpredictable no matter how you approach them.

Rather, trading is but a series of probabilities; and indicators can be helpful tools to look to trade with those probabilities.

In this article, we’re going to examine one of the more versatile indicators that is also one of the first discarded by new traders in their initial trading education: MACD.

The MACD Line

MACD is an acronym that is short for Moving Average Convergence Divergence, which is really just a long and drawn out way of saying it measures the relationship of moving averages.

The moving average is, in-and-of-itself, a very formidable indicator. It’s easy and simple and it just averages the last X periods worth of closing prices. The moving average is often the very first indicator learned because of how simple it is to teach and understand. And the benefits of trading with a moving average can be very clear and apparent, especially if the indicator is being used for trend analysis.

But, trading with a moving average doesn’t always work; and so traders will then learn the benefit of the moving average crossover. By adding a second moving average, we stand the chance to be able to ‘slow down’ the indicator signals. Whereas trading with one moving average entailed buying or selling when price crossed over, the crossover waits for one moving average to cross another before triggering a signal.

But, once again – this doesn’t always work. And this is where MACD comes into play. Traders wanted a way to try to enter the position at the early stage of a move… far before a moving average crossover might take place.

So, rather than watching moving averages, these traders plotted the difference between the averages as an oscillator (shown below).

MACD measures the spatial relationship of exponential moving averages

Created with Marketscope/Trading Station II

In this example, a 13 (in green) and 34 period (in blue) EMA is shown on the price chart. Notice when the two moving averages cross (highlighted with the red circle), MACD correspondingly crosses the ‘0’ line.

As the distance between the moving averages grows larger (or diverges), MACD moves lower to illustrate the growing difference that’s being seen in the EMAs.

On the flip side, when prices move higher, MACD will begin moving higher to reflect the convergence of the Exponential Moving Averages. If price moves high enough, MACD will eventually go up and over the ‘0’ line, and if prices can continue moving higher, the distance between the 13 and 34 period EMAs will also grow, and MACD will again show that divergence (this time to the up-side with an increasingly large MACD value).

This is the MACD line, and it’s the heart-and-soul of the indicator. But, at this point, there is no difference between the MACD line and a simple moving average crossover.

The Signal Line

The MACD line can bring a lot of value, in-and-of-itself, but it’s far from a panacea. After all, MACD is just the spatial relationship between those two EMAs, and if that’s what one wants to trade for, why not just follow a couple of moving averages?

The next part of the indicator is a key element to trading with MACD, and this is called ‘the signal line.’ The signal line is a moving average applied to MACD. By default, the signal line is usually a 9 period EMA; but this is really up to each individual trader. So, the signal line is a moving average based on the difference between two other moving averages. While this may sound confusing, do not worry – most charting packages can do this for you fairly easily and you don’t have to perform the mathematical computations for each.

By applying the signal line, the trader opens up the possibility of entering the trend far before a crossover of the 13 and 34 period moving averages would usually allow.

As an example, take a look at the previous setup we had investigated when MACD crossed down and under the ‘0’ line (and when the 13 and 34 period EMAs had crossed); but this time we’re going to apply the signal line to MACD.

MACD crossover with signal line will takes place far sooner than the crossover of Moving Averages

Created with Marketscope/Trading Station II

This is the benefit of MACD: The fact that it may allow for an earlier entry into a trend is what makes this such a phenomenal indicator. Sure, it won’t work all-of-the-time, but this is trading and there is nothing that works all-of-the-time.

MACD can make for a fantastic indicator in strategies because of just this feature; and if often functions best as a ‘trigger’ into positions in trend-based strategies.

The Histogram

The last part of the indicator is a further extension of the mathematical relationship between all of these moving averages.

The histogram measures the difference between the MACD line, and the signal line. When MACD crosses the signal line, the histogram goes to a value of ‘0.’

The Histogram measures the difference between MACD and Signal lines

Created with Marketscope/Trading Station II

As you can see in the above image, as the MACD and the signal lines converge or diverge; the histogram will reflect this properly. As MACD falls further underneath the signal line, the histogram will print lower to reflect this growing difference.

As MACD crosses over the signal line, the histogram will crossover ‘0’ and will continue to move higher as long as MACD continues moving higher above the signal line.

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Moving Averages

 Moving Average Indicator

Moving averages provide an objective measure of trend direction by smoothing price data. Normally calculated using closing prices, the moving average can also be used with median, typical , weighted closing, and high, low or open prices as well as other indicators.

Moving Average Types

There are several different types of moving averages, each with their own peculiarities.

    Simple moving averages are the easiest to construct, but also the most prone to distortion.
    Weighted moving averages are difficult to construct, but reliable.
    Exponential moving averages achieve the benefits of weighting combined with ease of construction.
    Wilder moving averages are used mainly in indicators developed by J. Welles Wilder. Essentially the same formula as exponential moving averages, they use different weightings — for which users need to make allowance.

 Moving Average Time Frames

Shorter length moving averages are more sensitive and identify new trends earlier, but also give more false alarms. Longer moving averages are more reliable but less responsive, only picking up the big trends.

Use a moving average that is half the length of the cycle that you are tracking. If the peak-to-peak cycle length is roughly 30 days, then a 15 day moving average is appropriate. If 20 days, then a 10 day moving average is appropriate. Some traders, however, will use 14 and 9 day moving averages for the above cycles in the hope of generating signals slightly ahead of the market. Others favor the Fibonacci numbers of 5, 8, 13 and 21.

    100 to 200 Day (20 to 40 Week) moving averages are popular for longer cycles;
    20 to 65 Day ( 4 to 13 Week) moving averages are useful for intermediate cycles; and
    5 to 20 Days for short cycles.


 Trading Signals

The simplest moving average system generates signals when price crosses the moving average:

    Go long when price crosses to above the moving average from below.
    Go short when price crosses to below the moving average from above.

The system is prone to whipsaws in ranging markets, with price crossing back and forth across the moving average, generating a large number of false signals. For that reason, moving average systems normally employ filters to reduce whipsaws.

More sophisticated systems use more than one moving average.

    Two Moving Averages uses a faster moving average as a substitute for closing price.
    Three Moving Averages employs a the third moving average to identify when price is ranging.
    Multiple Moving Averages use a series of six fast moving averages and six slow moving averages to confirm each other.
    Keltner Channels use bands plotted at a multiple of average true range to filter moving average crossovers.
    The popular MACD ("Moving Average Convergence Divergence") indicator is a variation of the two moving average system, plotted as an oscillator which subtracts the slow moving average from the fast moving average.

1. Simple Moving Average

The Simple Moving Average is arguably the most popular technical analysis tool used by traders. The Simple Moving Average (SMA) is used mainly to identify trend direction, but is commonly used to generate buy and sell signals. The SMA is an average, or in statistical speak - the mean. An example of a Simple Moving Average is presented below:

• The prices for the last 5 days were 25, 28, 26, 24, 25. The average would be (25+28+26+26+27)/5 = 26.4. Therefore, the SMA line below the last days price of 27 would be 26.4. In this case, since prices are generally moving higher, the SMA line of 26.4 would be acting as support (see: Support & Resistance).

The chart below shows a 20-day Simple Moving Average acting as support for prices.

Moving Average Acting as Support - Buy Signal

When price is in an uptrend and subsequently, the moving average is in an uptrend, and the moving average has been tested by price and price has bounced off the moving average a few times (i.e. the moving average is serving as a support line), then buy on the next pullbacks back to the Simple Moving Average.

A Simple Moving Average can serve as a line of resistance as the chart shows:

Moving Average Acting as Resistance Sell Signal

At times when price is in a downtrend and the moving average is in a downtrend as well, and price tests the SMA above and is rejected a few consecutive times (i.e. the moving average is serving as a resistance line), then buy on the next rally up to the Simple Moving Average.

The examples above have been only using one Simple Moving Average; however, traders often use two or even three Simple Moving Averages. The advantages to using more than one Simple Moving Average is discussed on the next page.

2. Moving Average Crossovers

Moving average crossovers are a common way traders use Moving Averages. A crossover occurs when a faster Moving Average (i.e. a shorter period Moving Average) crosses either above a slower Moving Average (i.e. a longer period Moving Average) which is considered a bullish crossover or below which is considered a bearish crossover.

The chart below shows the 50-day Simple Moving Average and the 200-day Simple Moving Average; this Moving Average pair is often looked at by big financial institutions as a long range indicator of market direction:

Note how the long-term 200-day Simple Moving Average is in an uptrend; this is a signal that the market is quite strong. Generally, a buy signal is established when the shorter-term 50-day SMA crosses above the 200-day SMA and contrastly, a sell signal is indicated when the 50-day SMA crosses below the 200-day SMA.

In the chart above of the S&P 500, both buy signals would have been extremely profitable, but the one sell signal would have caused a small loss. Keep in mind, that the 50-day, 200-day Simple Moving Average crossover is a very long-term strategy.

For those traders that want more confirmation when they use Moving Average crossovers, the 3 Simple Moving Average crossover technique could be used. An example of this is shown in the chart below.

 The 3 Simple Moving Average method is usually interpreted as follows:

1. The first crossover of the quickest SMA (in the example above, the 10-day SMA) across the next quickest SMA (20-day SMA) acts as a warning that prices are reversing trend; however, usually a buy or sell order is not placed yet.
2. The second crossover of the quickest SMA (10-day) and the slowest SMA (50-day) finally triggers the buy or sell signal.

There are numerous variants and methodologies for using the 3 Simple Moving Average crossover method, some are provided below:

• A more conservative approach is to wait until the middle SMA (20-day) crosses over the slower SMA (50-day); but this is basically a two SMA crossover technique, not a three SMA technique.
• A money management technique of buying a half size when the quick SMA crosses over the next quickest SMA and then the other half when the quick SMA crosses over the slower SMA.
• Instead of halves, buy or sell one-third of a position when the quick SMA crosses over the next quickest SMA, another third when the quick SMA crosses over the slow SMA, and the last third when the second quickest SMA crosses over the slow SMA.

Moving Average crossovers are important tools in a traders toolbox. In fact crossovers are included in the most popular technical indicators including the Moving Average Convergence Divergence (MACD) indicator (see: MACD). Other moving averages deserve careful consideration in a trading plan.

3. Exponential Moving Average (EMA)

The Exponential Moving Average (EMA) weighs current prices more heavily than past prices. This gives the Exponential Moving Average the advantage of being quicker to respond to price fluctuations than a Simple Moving Average; however, that can also be viewed as a disadvantage because the EMA is more prone to whipsaws (i.e. false signals).
The chart below of eBay (EBAY) stock shows the difference between a 10-day Exponential Moving Average (EMA) and the 10-day regular Simple Moving Average (SMA):

The main thing to notice is how much quicker the EMA responds to price reversals; whereas the SMA lags during periods of reversal.
The chart below shows the difference between moving average crossovers (see: Moving Average Crossovers) buy and sell signals with a EMA and a SMA.

As the chart above illustrates, even though EMA's are quicker to respond to price movement, EMA's are not necessarily faster to give buy and sell signals when using moving average crossovers.
Also note that the concept illustrated in the chart above with Exponential Moving Average crossovers is the concept behind the wildly popular Moving Average Convergence Divergence (MACD) indicator; (see: MACD).
Since Exponential Moving Averages weigh current prices more heavily than past prices, the EMA is viewed by many traders as quite superior to the Simple Moving Average; however, every trader should weigh the pros and the cons of the EMA and decide in which manner they will be using moving averages.
Nevertheless, Moving Averages remain the most popular and arguably the most effective technical analysis indicator out on the market today.

4. Weighted Moving Average

The Weighted Moving Average places more importance on recent price moves; therefore, the Weighted Moving Average reacts more quickly to price changes than the regular Simple Moving Average (see: Simple Moving Average). A basic example (3-period) of how the Weighted Moving Average is calculated is presented below:

• Prices for the past 3 days have been $5, $4, and $8.
• Since there are 3 periods, the most recent day ($8) gets a weight of 3, the second recent day ($4) receives a weight of 2, and the last day of the 3-periods ($5) receives a weight of just one.
• The calculation is as follows: [(3 x $8) + (2 x $4) + (1 x $5)] / 6 = $6.17

The Weighted Moving Average value of 6.17 compares to the Simple Moving Average calculation of 5.67. Note how the large price increase of 8 that occured on the most recent day was better reflected in the Weighted Moving Average calculation.
The chart below of  stock illustrates the visual difference between a 10-day Weighted Moving Average and a 10-day Simple Moving Average:

Buy and sell signals for the Weighted Moving Average indicator are discussed in depth with the Simple Moving Average indicator (see: Simple Moving Average).

5. Adaptive Moving Average

Adaptive Moving Averages changes its sensitivity to price fluctuations. The Adaptive Moving Average becomes more sensitive during periods when price is moving in a certain direction and becomes less sensitive to price movement when price is volatile.
The chart below contract shows the difference between an Exponential Moving Average (see: Exponential Moving Average) which weights current prices more heavily than past prices and the Adaptive Moving Average which changes sensitivity based on price volatility:

The advantage of the Adaptive Moving Average is show above in the e-mini chart in the center where price became directionless and choppy. During that period the Adaptive Moving Average maintained a straight line appearance; whereas, the Exponential Moving Average moved with the choppiness of prices. However, when price trended, like on the far right of the e-mini chart above, the Adaptive Moving Average kept up with the Exponential Moving Average.
The Adaptive Moving Average is definitely an unique technical indicator that is worth further investigation.

6. Typical Price Moving Average

The Typical Price Moving Average combines the Pivot Point concept and the Simple Moving Average. The Pivot Point (see: Pivot Points) calculation is shown below:

• Pivot Point = (High + Low + Close) / 3

The calculated Pivot Point number is then inputted into the regular Simple Moving Average (see: Simple Moving Average) equation; rather than the input of the closing price, the Pivot Point calculation is used.
The chart below shows the slight difference between a 10-day Simple Moving Average and a 10-day Typical Price Moving Average:

The Typical Price attempts to give a more real representation of where price has been by incorporating the high and low price into the most often used closing price. The Typical Price is consequently seen as a more pure Simple Moving Average; nevertheless, as can be referenced by the chart above, there is not much difference between either Moving Average. Buy and sell signals for the Typical Price Moving Average indicator are discussed in depth on the Simple Moving Average indicator pages (see: Simple Moving Average).

7. Triangular Moving Average

The Triangular Moving Average is a Simple Moving Average that has been averaged again (i.e. averaging the average); this creates an extra smooth Moving Average line.
The chart below contract shows the relation between a 10-day Simple Moving Average and a 10-day Triangular Moving Average:

Generally, simple moving averages are smooth, but the re-averaging makes the Triangular Moving Average even smoother and more wavelike.
Buy and sell signals for the Triangular Moving Average indicator are discussed in depth on the Simple Moving Average indicator pages (see: Simple Moving Average).

Summary: Moving Averages

• There are many types of moving averages. The two most common types are a simple moving average and an exponential moving average.
• Simple moving averages are the simplest form of moving averages, but they are susceptible to spikes.
• Exponential moving averages put more weight to recent price, which means they place more emphasis on what traders are doing now.
• It is much more important to know what traders are doing now than to see what they did last week or last month.
• Simple moving averages are smoother than exponential moving averages.
• Longer period moving averages are smoother than shorter period moving averages.
• Using the exponential moving average can help you spot a trend faster, but is prone to many fake outs.
• Smooth moving averages are slower to respond to price action but will save you from spikes and fake outs. However, because of their slow reaction, they can delay you from taking a trade and may cause you to miss some good opportunities.
• You can use moving averages to help you define the trend, when to enter, and when the trend is coming to an end.
• Moving averages can be used as dynamic support and resistance levels.
• One of the best ways to use moving averages is to plot different types so that you can see both long term movement and short term movement.

You got all of that? Why don't you open up your charting software and try popping up some moving averages. Remember, using moving averages is easy. The hard part is determining which one to use! That's why you should try them out and figure out which best fits your style of trading. Maybe you prefer a trend-following system. Or maybe you want use them as dynamic support and resistance. Whatever you choose to do, make sure you read up and do some testing to see how it fits into your overall trading plan. 

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