Uncommon Theory-Mathod

Chaos Theory'

A mathematical concept that explains that it is possible to get random results from normal equations. The main precept behind this theory is the underlying notion of small occurrences significantly affecting the outcomes of seemingly unrelated events. Chaos theory has been applied to many different things, from predicting weather patterns to the stock market. Simply put, chaos theory is an attempt to see and understand the underlying order of complex systems that may appear to be without order at first glance. 

Related to financial markets, proponents of chaos theory believe that price is the very last thing to change for a stock, bond, or some other security. Price changes can be determined through stringent mathematical equations predicting the following factors:
1) A trader's own personal motives, needs, desires, hopes, fears and beliefs are complex and nonlinear.
2) Volume changes
3) Acceleration of the changes
4) Momentum behind the changes
Chaos theory is highly controversial and extremely complicated.

 The science of chaos has given us a couple of principles that are applicable in the financial markets:

• You, your nails, your market orders follow the path of least of resistance

• The path of least resistance is determined by the always underlying (and typically unseen) structure

Let us say you have a river running down the mountain. The behavioural decisions that the river makes does not depend on the mind of the river but the riverbed itself. So if you have a riverbed that is shallow and narrow that river is going to go down in rapids. If you have a riverbed that is wide and deep you are going to have a calm pond. So if you want to change the flow of that river you can get buckets and start a bucket brigade or go up to the start of the river where the force of the water is still so slow that it only takes replacing a few rocks to change the direction and it will change everything.

Then there is this thing called the butterfly effect.

That theory simply says that somewhere in South America there is this little Monarch butterfly that flaps its wings as it is flying around looking for some pollen and it sees a flower over here and as he is going there he sees a better flower somewhere else and decides to change its path. As he changes his mind, that is a fractal. The change in his path sets up a little air current and that air current sets up another air current that sets up another air current that keeps the high level winds off of the Antarctica which causes a hurricane like the El Niño, which causes a drought next year in the bean belt and we are going to have beans in the teens because of this little Monarch butterfly that changed his mind.

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So how do we trade fractals and what do they look like on a chart? 

• A fractal is a trend change
• A swing top or a swing bottom is a fractal
• The end of every Elliot wave is a fractal
• A fractal requires a minimum of five bars
• Fractals show the path of least resistance
• A fractal trading system works in all time frames

In the example below you have the market going up as evident by the highs. All we care about here is the highs and not the open, high, low and close. Any time you have a sequence of five bars where you have one bar that has two preceding lower highs followed by two preceding lower highs you have a fractal.

If you have a fractal whose middle finger is parallel to the top, the second one does not count. They both count as one (as in the case below where you have two candles whose highs are identical). In the chart below you see how the market started trading up, changed its mind and now it is going down. Coming up, the left leg must be longer than the right leg for a buy fractal to be valid.

 

After the buy fractal triggers a long position, the sell fractal is negated. For a new sell fractal to set up you will need to see a high, followed by three lower lows and two higher lows, none of which can trade through the high of the first bar. When you have a fractal in one direction which is followed by a fractal in the other direction you have an Elliot wave of one degree or another.

 

So this market started trading up the page, changed its mind (like the Monarch butterfly) and traded down the page. It then changed its mind again and traded through the previous high, just following the path of least resistance. By religiously taking trades only when fractals break, we effectively rule out fighting the market. The challenge, of course, is to avoid double tops/bottoms and not get caught long on up thrusts and short on springs.

 You always hear that what goes up must come down but one of the things that chaos teaches us is that Newton's laws of motions do not apply universally. They apply to man-made things. Market fundamentalists have a fundamentally flawed conception of how financial markets operate. They believe that financial markets tend toward equilibrium.

Equilibrium theory in economics is based on a false analogy with physics. Physical objects move the way they move irrespective of what anybody thinks but financial markets attempt to predict a future that is contingent on the decisions people make in the present. Instead of just passively reflecting reality, financial markets are actively creating the reality that they, in turn, reflect. There is a two-way connection between present decisions and future events, which George Soros calls reflexivity.

So having said all that; when do I want to be in a trade?

• when I can make the most amount of money in the least amount of time
• when volatility explodes and ranges expand
• when odds increase of a directional move
• when risk:reward is favourable

You do not want to put your hard earned cash at risk in a market that just moves about randomly but get onboard a market that has clearly signalled that it is done consolidating and now ready to move.

Look for inside candles (range contraction) and then a break uptown or downtown (range expansion). As a rule of thumb, the longer the timeframe the rarer the trade but the more powerful the signal will be.

Also the more inside candles within inside candles the more powerful the signal will be. The reason is that the more time traders have to build positions the bigger the effect as these positions are unwound.

Below is a great example of how just by looking at candles you can pinpoint the most opportune time to get in.

Only imagine how many traders looking at overbought indicators either sold out too early or faded the move.

 

Fractals 

 Many people believe that the markets are random. In fact, one of the most prominent investing books out there is "A Random Walk Down Wall Street" (1973) by Burton G. Malkiel, who argues that throwing darts at a dartboard is likely to yield results similar to those achieved by a fund manager (and Malkiel does have many valid points). However, many others argue that although prices may appear to be random, they do in fact follow a pattern in the form of trends. One of the most basic ways in which traders can determine such trends is through the use of fractals. Fractals essentially break down larger trends into extremely simple and predictable reversal patterns. This article will explain what fractals are and how you might apply them to your trading to enhance your profits.

What Are Fractals? When many people think of fractals in the mathematical sense, they think of chaos theory and abstract mathematics. While these concepts do apply to the market (it being a nonlinear, dynamic system), most traders refer to fractals in a more literal sense. That is, as recurring patterns that can predict reversals among larger, more chaotic price movements. These basic fractals are composed of five or more bars. The rules for identifying fractals are as follows:

• A bearish turning point occurs when there is a pattern with the highest high in the middle and two lower highs on each side.
• A bullish turning point occurs when there is a pattern with the lowest low in the middle and two higher lows on each side.

The fractals shown in Figure 1 are two examples of perfect patterns. Note that many other less perfect patterns can occur, but the basic pattern should remain intact for the fractal to be valid.

Figure 1

The obvious drawback here is that fractals are lagging indicators - that is, a fractal can't be drawn until we are two days into the reversal. While this may be true, most significant reversals last many more bars, so most of the trend will remain intact (as we will see in the example below). Applying Fractals to Trading Like many trading indicators, fractals are best used in conjunction with other indicators or forms of analysis. Perhaps the most common confirmation indicator used with fractals is the "Alligator indicator", a tool that is created by using moving averages that factor in the use of fractal geometry. The standard rule states that all buy rules are only valid if below the "alligator's teeth" (the center average), and all sell rules are only valid if above the alligator's teeth.

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Figure 2 is an example of such a setup:

Figure 2

The obvious drawback here is that fractals are lagging indicators - that is, a fractal can't be drawn until we are two days into the reversal. While this may be true, most significant reversals last many more bars, so most of the trend will remain intact (as we will see in the example below). Applying Fractals to Trading Like many trading indicators, fractals are best used in conjunction with other indicators or forms of analysis. Perhaps the most common confirmation indicator used with fractals is the "Alligator indicator", a tool that is created by using moving averages that factor in the use of fractal geometry. The standard rule states that all buy rules are only valid if below the "alligator's teeth" (the center average), and all sell rules are only valid if above the alligator's teeth.

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Figure 2 is an example of such a setup: 

Figure 3

Here is a basic rule setup that is used when using a chart with a four-hour time frame:

• Initiate a position when the price has hit the farthest Fibonacci band, but only after a daily (D1) fractal takes place.
• Exit a position after a daily (D1) fractal reversal takes place.

Notice how the fractals pinpoint meaningful tops and bottoms? This helps to take the guesswork out of deciding at which Fibonacci level to trade - all we have to do is check to see if the daily fractal occurred. We should also note that the trend strength began increasing at the sell fractal, and topped at the buy fractal. Although we lose some pips with the confirmation, it saves us from losing out on mere market noise - 139 pips certainly isn't bad for three days!

Things to Consider Here are a few things to remember when using fractals:

• They are lagging indicators. They are best used as confirmation indicators to help confirm that a reversal did take place. Real-time tops and bottoms can be surmised with other techniques.
• The longer the time period (i.e. the number of bars required for a fractal), the more reliable the reversal. However, you should also remember that the longer the time period, the lower the number of signals generated.
• It is best to plot fractals in multiple time frames and use them in conjunction with one another. For example, only trade short-term fractals in the direction of the long-term ones. Along these same lines, long-term fractals are more reliable than short-term fractals.
• Always use fractals in conjunction with other indicators or systems. They work best as decision support tools, not as indicators on their own.

Conclusion As you can see, fractals can be extremely powerful tools when used in conjunction with other indicators and techniques, especially when used to confirm reversals. The most common usage is with the "Alligator indicator"; however, there are other uses too, as we've seen here. Overall, fractals make excellent decision support tools for any trading method. Resources These are the two main charting packages that contain fractals:

• MetaTrader 
• TradeStation for equities (via plug-in)

If you want to know more about chaos theory and its applications in the marketplace, an excellent book on the topic is "Profiting From Chaos" (1994) by Tonis Vaga.

Chaos Theory Market Fractals - By-Nadeem Walayat's.

Are Elliott Wave's Chaos Theory?

Whilst there are many elements to chaos theory, my focus that grew out of studying the Julia and Mandelbrot sets was fractals. In that clearly the stock and other market price action resembles fractal structures as the same structure appears to repeat on ALL time frames. At the time it seemed that Elliott Wave and Chaos theory were very similar of not the same thing, in that Elliott Waves are the fractals for market price action that appear to on ALL time frames as discovered in the 1930's by RN Elliott which was decades before Mandelbrot appeared on the scene.
However on spending many, many years going down this path I concluded that Elliott Waves and Chaos Theory are NOT the same. Elliott Wave theory is something ELSE, yes, it resembles Chaos Theory i.e. Fractals, but it is not Chaos theory Fractals.
Again they look very similar but in a way Chaos Theory is Elliott Waves without having to know the WAVES! That may sound confusing but that is actually how it is. In Chaos Theory all one would know is What is Impulse and What is Corrective, and that is it! None of the 5th of the 5th of the 5th or ABC or the rest matter, just Impulse or Corrective. Which is probably what many experienced elliotticians eventually conclude without ever having ventured into chaos theory that at the end of the day the only thing that matters is Impulse or Corrective and not What Elliott Wave implies i.e. that Stocks 1987 peak was the final 5th of the 5th of the 5th and then so were each of the subsequent bull market peaks right into the present days bull market.

Fractal Theory

In a way Chaos Theory should really have been called Fractal Theory, because rather than chaos i.e. randomness it actually implies order and structure, and that structure is found in fractals.
The point about Fractals is that they give you a window into probabilities for price action on ALL market levels, i.e. hourly, daily, weekly, monthly, even yearly. I.e. fractals are akin to flexible pattern recognition, simple patterns that repeat and result in high probabilities given certain conditions which in themselves are flexible, so it unlike traditional chart patterns such as Head and Shoulders, the interpretation of market fractals is dependant upon changing conditions, such as trend, cycles, and volume.

What are Market Fractals ?

Simply put Market fractals are trend changes. A trend change is either a reversal of the Impulse trend or an end of the Corrective trend on ANY time frame.

Fractal Patterns

Fractal patterns are not complicated, you already know the more common ones, such as spike, double and triple tops and bottoms that occur on ALL time frames, what you don't know or have not studied are the conditions that increase their probabilities for particular markets at particular points in time, such as volume, preceding trend, and momentum oscillators (I use the MACD) once you factor these into the equation amongst your TRIGGER (Fractal) increases in probability exponentially, as it reduces the instances of its occurrence. Still it does requires HARD WORK for the market one trades to identify the current TRIGGERS (Fractals), especially when one starts going down the path of fractals of fractals i.e. in this example, a double top plus double top fractal. 

Trading Fractals

It all boils down to practice, knowing current fractal patterns and having them engrained in your mind, and then you WAIT for the FRACTAL TRIGGERS, and REACT in real time, just as as you trade traditional price patterns such as double and triple tops as identified in real time. Fractal triggers are not limited to Bar charts, as you can use other types of charts, my preference is for swing charts as illustrated in "How to Trade Commodities" by WD Gann (not to confuse with the rest of his work which in my opinion is a red herring).
Once you understand that Chaos Theory comprises fractals that give a high probability of an outcome given x, y,z condition then one starts to see fractals EVERYWHERE, for fractals ARE Nature. It is how our universe is constructed on every level, we are living in an unfolding fractal universe, nothing is fixed, everything is in motion, if you understand this then you will now know more truth than anything you will find in any ancient superstition.
The bottom line is this, that there is no black or white, no holy grail, everything has its basis in how we interpret the world around us is be it markets or the wider environment, fractals appear to offer the best window into a better interpretation of the world in our time, until the next innovation comes along.

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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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More About Trendline from a different Look -

More About Trend-line from a different Look -

What is A Trend-line ?

Trendlines are drawn with a diagonal line between two or more price pivot points. Look at the Daily chart below of the EUR/USD currency pair.

The pair made a significant swing high on February 1^st of this year, followed by another significant swing high on the 13^th of February. We can now draw a trendline by connecting the highs of these 2 price pivot points. You need a minimum of two price points to draw a trendline, although more is better of course.

How do you trade trend line?

There are two ways to profit from trendlines.
Method number 1 – Look for a continuation of the trend
The first and most obvious one is to look for price to turn once it hits the trendline. The chart below shows areas where price hit the trendline only to turn back down.

Where do you enter and place your stops?
The Entry is when price hits the trendline. These areas are marked with arrows on the chart below. The initial stop loss is placed above the trendline giving us a low risk entry. A trailing stop is also usually employed when trading trendlines. As the trendline moves lower you move the stop loss just above the line, thus lowering your risk further.
Trendlines are dynamic support and resistance levels
Trendlines are support and resistance levels but unlike horizontal lines which are static in nature, trendlines are dynamic. Notice how on the charts above we only connected the first 2 swing points. If we extend the trendline further down we get the chart below.

As price moves lower your trendlines may need to be adjusted somewhat to reflect the new price action. Don’t be afraid to make these changes as adjusting the line can lead to more accurate entries.
Method Number 2 – Look for the trend to reverse
The second way to trade trendlines is to look for areas of possible trend reversal. This happens when the trendline no longer can contain the price. The price makes a brakeout and reverses the previous trend. We have identified one such instance on the chart below.

The big 2 month downtrend in the EUR/USD during February and March is drawing to a close as the single currency starts to turn back up. The trendline is broken and soon after we get the first significant price close above the line. The stop loss is placed just below the price swing low.
An Example from the Long Side
Below is an example on the EUR/JPY 1 Hour chart. It shows the same concepts we talked about before just from the long side. The pair made a significant swing low on April 4^th, followed by another significant swing low the next day. We draw a trendline by connecting the lows of these 2 price pivot points.

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