Theory: Divergence

If you have been around Forex chat rooms or forums for any amount of time, one term you would have heard of many times is Divergence. While by no means a fool proof indication,

it is a nice thing to store in the back of your already full brain to help you in confirming suspected trend changes.

Above is a snap shot of the hourly chart of AUD/USD in the week just gone (click on it to see it larger). Divergence is essentially when an indicator is trending in the opposite direction to the price. You can see in the above chart, a trend line clearly shows the price at this time is making a series of lower highs and lower lows, so it is in a clear downtrend.

Below that is an indicator called the Stochastics, with settings of 15, 5, 5. Here you can see that as the price is making lower lows, the indicator is making HIGHER lows, so the price is downtrending, the stochastic indicator is in an uptrend, this is Divergence.

When you see this occur, look out for a sign of a reversal of the current price trend, in this case, it happened when the price broke the trend line as indicated by the orange area. I don't trade this method currently of course, but it something good to know, and something to look out for if you are trying to figure out if the trend will continue.

Best of luck, hope it helps.

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Theory: Chart Correlation

I thought I would mention a very simple concept that I know a lot of traders know of, but there may be some who don't. The concept is of chart correlation, i.e. when one pair goes up, another pair goes down.

This concept is especially true for all the majors and there is a very simple reason why. All the majors have one thing in common, the USD, in general it is the USD that drives the pairs up and down, there are of course the odd exception with region specific data releases etc, but as a whole it is the USD that drives things. So if the USD gets stronger, then more than likely the USD/JPY will rise, while the EUR/USD will fall. Don't believe me? Let's look at some charts I have prepared earlier ;), I have overlayed and coloured them to make them easier to compare:

EUR/USD 1H over the USD/CHF 1H

You can see they are practically mirror images of each other. Now how about two pairs with USD as their base currency, lets look at the EUR/USD again but against the GBP/USD:

EUR/USD 1H over the GBP/USD 1H

You can see they play follow the leader for most of the time. You can see then that most of the time, it would be contradictory to have a swing trade short on the EUR/USD and a short on the USD/CHF at the same time, one is doomed for failure. You can compare all the majors and the action is essentially the same, here is the EUR/USD over the USD/JPY:

EUR/USD 1H over the USD/JPY 1H

I think I have made my point. There is however the odd exception, although not amongst the majors, currently that "black sheep" is the USD/CAD. You would expect, with the USD as it's base also it should follow the pattern of the USD/JPY and the USD/CHF, but, as it is a commodity and energy reliant pair, and considering the current energy crisis the world is under, the USD/CAD currently is leading it's own life. Here is the EUR/USD over the USD/CAD to show you what I mean:

EUR/USD over the USD/CAD

You can see, apart from the new year action that for quite some time the USD/CAD bucked the trend, and moved in the same direction as the EUR/USD as demand for oil prices rose, gold hit new 5 year highs and the canadian economy was going great guns. If you have a charting package that let's you overlay charts, then it is well worth doing every now and then to see how pairs are moving compared to others, it just may stop you trading against yourself.

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Theory: Candlesticks

Hi all, today I'll have a quick chat on the theory of Japanese Candlesticks. In case you did not realise, there are three main ways to view a trading chart, you can view it as a line chart, a bar chart, or a candlestick chart. Below are what each of these look like:



Candlestick's were first introduced in the 1600's, strangely enough to analyze the price of rice contracts. There is no special calculation, they are simply an alternative way of representing current prices. Below is the basic rundown of what a single candlestick looks like, and how it is interpreted.

This is a candlestick you would see most often in a downtrend, with the black body being a sign that the closing price finished lower than the opening price.

Here you can see labelled the opening, closing, high and low of the particular period that this candle is representing, which could be 5 minutes, 1 hour or 1 day depending on what chart you are looking at.

Some charts have candles that represent this scenario coloured in red, either way, the main thing is to remember that usually this type of candle will usually be filled.

So that is what a "down" candle looks like, a candle representing the opposite scenario, i.e. when the closing price finishes above the opening price usually is white, or uncoloured and looks like below:

You can see that the main difference between this candle and the above candle is that the closing price is above the opening price, indicating that during this period, the price went up during this period.

Some charting packages will show this candle as a green candle, some as white, or some with no colour at all, just an outline. If you set the colour scheme yourself, just recognise that you need to make this candle different to the above candle so you can distinguish the difference.

Now if I was to run through every type of candle that existed in the theory of candlestick charts, I would more than likely get cramp and brain freeze, and not finish this article. So instead, I will run through some basic deduction you can take from interpreting a few different types of candles.

Have a look at this candle (called an inverse hammer), you can see the main difference between this candle and the basic candle I showed you above is the lack of a thin line below body (the thicker white area) of the candle. So what does this mean? The thin lines are refered to as "wicks" or "shadows", and represent when prices move up or down, but are then dragged back.

How to read this candle? Well here the price closed well above it's opening price, there was a push for higher prices as represented by the upper wick, which was pulled back slightly. Depending on the market, you may read this as a sign that price will continue with the upward push, as the price didn't retract too far, and there was no real push for lower prices.

Ok here is another (called a hammer), the inverse of the previous candle, here you can see the closing price was lower than the opening price, hence the black body of the candle. It has a medium length wick also, which again is a sign that there was a move to push the prices lower. You make this candle to be a sign of strength in a down move, or a sign of a reversal, or pause in an uptrend.

To me the wicks are just as important as the bodies of candles, and should be taken into as much consideration as the colour and length of the body. Now there are a bucket load of different candle types as I mention earlier, but to give you an idea, here are a few that I find to be the most telling when reading candlestick charts.

This candle is referred to as a "doji", and you can see has very little, or in this case no body to it. This candle is a sign of indicision in the market, as the wicks above and below the non existant body reflect that there was a push up, and a push down, resulting in a stalemate with the opening price and the closing price being the same in the end.



This candle, a hammer, is a strong sign if seen at the bottom of a downtrend, when you suspect that a currency may be oversold. Here you can see a very long bottom wick in comparison to it's body, and tells the story that prices made a strong move down, but was dragged back above it's opening price, hence the white body. A candle with such a long wick as this, is usually a good sign that the momentum of a downward move is stalling or reversing.


Here you can see a variation on the inverse hammer candle I showed you previously, with the main difference being that this one having a much longer upper wick, and the closing price finished below the opening price. This candle can quite often be a sign of a change in momentum, as the strong push to higher prices, as shown by the long upper wick, was pulled back so far that the prices closed lower, a sign that future pushes to higher prices may be rejected. This candle is especially valid in an uptrend where you may suspect that a currency is overbought.

There are so many more, and I haven't even touched on combining these candles into different formations. I have however, provided a link to an e-book on this subject that covers all the basics in a text book fashion that can be a good reference for you all.

Please do not take this candles as given, like any other indicator, they are just guides that can help you, but it is always safe to look for confirmation either in the next candle or with other indicators. Oh and one last tip, never trade on an incomplete candle, always wait for that period to end before assuming the candle is a certain type. Quite often the biggest moves are at the end of the period you are looking at, and what you thought was one type of candle become something completely different in the matter of seconds.

Best of luck with them, I personally feel candles tell you much more than a line graph ever could, and while bar charts can tell you the same information, I find candlesticks much easier, and more importantly, much faster to read. Please leave a comment if there is something vital I have missed.

Happy trading!

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Theory: ADX

Hi all! Well I have mentioned previously that the only indicator I consistently keep on my charts is an indicator called the ADX, or Average Directional Index (why do they always like using "X" for index .. shouldn't it be "I" ... anyway).
I use it primarily to keep me in trades that are moving strongly, and to give me hints on how strong a move actually is.

So, considering I talk about it so often I thought it best to give a general rundown on what the indicator can be used for and how you might be able to use it in your trading system.

The ADX was developed by J. Welles Wilder, yep the same guy who developed the Parabolic and RSI indicators, clever chap that Wilder. Interestingly, Wilder considered the ADX to be his best achievement in terms of indicators, and considering the widespread use of RSI and Parabolics, makes you wonder why more aren't using the ADX (although I am sure plenty are, I have after all only surveyed my next door neighbour and my dog).

First of all let's have a look at what it looks like:

At first it looks all a little like last night's spaghetti, but really it is quite simple. There are three lines, a trend following line, a positive directional line (+DI) and a negative directional line (-DI). In laymans terms, the black line tracks trends, the red line is a signal line to go short, and the green line a signal line to go long.

First the theoretical way to use it. When the red (-DI) line crosses above the green (+DI) line, it is a signal to go short, and vise versa, green above red is a signal to go long (yep just like Moving Average crossovers). Like all indicators though, there is always lag, and as such I pay little attention to these lines and prefer to get my direction signals of the price action itself. The black line though is something different, it is a line that indicates if a trend is in place. If it rises from below 20 (I use 25) to above 20, it is a sign that a trend is developing and to stick with the trade. While the black line rises, I will always stay with a trade unless there is some news announcement coming up that I am worried about. Once the black line ticks down from above 25, it is a signal for you to assess your position as the run may have come to an end for now.

While such a simple technique (I am all about simplicity), you will be surprised how well it will keep you in those strong moves. So that is it, pretty easy huh ... any questions, just throw me an email or comment here.

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Theory: Fibonacci

My trading activity has been very low lately, but Ill be sure to post at least the results soon, but instead, I thought I would put together a new theory article for you all, this time about Fibonacci.

Fibonacci was named after a mathemetician and trained accountant by the name of Leonardo Pisano in the 1100's (ah yes I remember them well ... those were the days). He came up with, amongst other things, a series of numbers that is now referred to as the Fibonacci sequence, where each number is the sum of the two numbers preceding it. Here is the beginning of it, and of course it goes on to infinity:

1, 1 (1+0), 2 (1+1), 3 (2+1), 5 (3+2), 8 (5+3) etc.

Pretty simple huh! ... this guy is famous cause of that simplicity though, which gives us all hope ;). Anyhow from these numbers a whole bunch of ratios can be taken from them, now I'm not going to pretend to understand them, but the main ratios, that are reproduced through the world, in nature, buildings, cells, ice cream ... ok not ice cream ... are:

0.236, 0.50, 0.382, 0.618 ...

There are many more, but these are the main ones to concern us beginner traders, and here is why. Quite often in the liquid markets of Forex, prices respect these levels when they move, meaning, just like Pivot Lines, prices will quite often pause, and more often reverse at these levels. Most charting packages have the ability to add Fibonacci lines to your charts, for example in Metatrader 4 all you do is; if the price was moving down, drag a line from the recent peak, to the most recent bottom and the lines are added for you. Unfortunately Marketiva does not offer them as yet, however here is a chart with them drawn:

The blue dotted lines are the fibonacci lines that correspond to the ratio's I was talking about. You can see in the move up, that the 38.2 fibonacci line formed the point for the price to reverse its retracement and continue with the trend (support). Of course, any of these lines could have been the points of reversal, but a reversal at the 38.2 line is a good sign that the trend will continue as the retracement was shallow.

The other line that I find most commonly hit is the 61.8 line as shown here:


Be a little more wary when such a deep retracement occurs, as it is less likely (although not in the above case) that the previous support will be broken again.

So what do you do with this knowledge? Can you trade with fibonacci alone? In my opinion, no as you don't know which line will be the turning point without the aid of other indicators or reading the price action, but they can be an excellent addition to your trading system to confirm other signals. For example if you have a signal from another indicator telling you a reversal is about to happen, and price is hovering at a fibonacci line, this might give you added confidence to place the trade.

Happy trading!

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