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The Currency
Combo
Integrating strategies can increase
forex trade confidence.
Before entering a trade, traders must do whatever
they can to put the odds in their favor. Candlesticks have been
helping traders in this for hundreds of years. From analyzing an
individual candlestick right up to complex patterns involving a
group of them, traders may gain a substantial advantage by learning
to use them. Because they do an excellent job in giving visual cues
to what is happening in the market, a candlestick chart can quickly
show whether there is a trade coming, one setting up, or if nothing
much happening. Since there are excellent books already written on
the topic, this article will instead focus on how to combine
candlesticks with a crossover strategy on the US Dollar Index to
provide more reliable buy and sell signals.
No matter what timeframe you are using – from one
minute to monthly – there are advantages to performing a
candle-by-candle analysis. Why? The shape of the candle – where it
opens or closes, its relation to the previous candle or candles, its
position in the overall trend, and if it's at or near levels of
support or resistance – can provide insight about where price is
going. By knowing what the highest probability outcome is for the
next candle, a trader can make a more rapid decision as to whether
he or she should stay in, stay out, take a profit, or take a loss.
Figure 1: DAILY
CHART SHOWING THE COMBINATION CANDLESTICK, AND MOVING AVERAGE
CROSSOVER SIGNAL STARTEGIES. Point 1 shows the five-day
predictive moving average (PMA) crossing above the five-day simple
moving average (SMA) together with a bullish harami candlestick
pattern. The trader is warned that the move may be coming to an end
by an engulfing bear candlestick pattern (point 2). This is followed
by a bearish harami, and then the five-day PMA again crosses below
the five-day MA, generating a signal (S1). The bearish engulfing
pattern at point 4 is immediately followed by a bullish engulfing
candlestick pattern, after which the PMA upward crossover confirms a
buy signal (B1). At point 6, a bearish engulfing (as well as a
tweezer top) warns that the move may be nearing an end, and this is
confirmed the next day by the PMA crossover generating a sell signal
(S2). Point 7 shows a bullish harami followed by another potential
crossover buy signal.
A Case Study in
Candle Psychology
Being able to identify patterns is as important as knowing what an
individual candlestick may be trying to tell us. When we look at
the final couple of weeks of October 2005 in the US Dollar Index on
the left-hand side of Figure 1, we see three separate attempts in
five days to break above resistance at 90.20, only to have the
sellers knock prices back down. On the 20th and 21st of the month,
two more attempts were made and both were failures (point 3).
This tells the trader that the short-term buying
pressure has diminished and to expect selling pressure in two forms.
First, the bears now have the upper hand and will start pushing the
price lower. Second, the bulls who bought anticipating a
breakthrough will now sell based on the failure. On October 21, the
bulls could not even push it high enough to challenge the resistance
level before the sellers drove the index lower (S1). The following
day there was more buying interest, but the entire action took place
in the bottom half of the prior day’s candle.
Day 3 of the pattern opened and moved downward as
expected. The interesting part is that instead of closing at or
near its low, the candle retraced back to vicinity of prior support,
which is far more bullish than we would have expected (point 4).
The next day failed to produce a new low, and engulfed the bearish
body of the previous day (a bullish engulfing pattern) before it
bounced off near term resistance and closed just below it as the
bulls began to move in.
October 31 then opened with the sellers trying one
more time to drive the index to a new short-term low, producing the
third-higher low in three days before the bulls take over and broke
it up through short-term resistance. All the traders who recognized
the resistance and were waiting for it to break now jump in, adding
fuel to the move.
Traders poised at the 90.20 resistance level put
sell-stops below that level to take some profit, and- combined with
the bears who shorted, thinking the level would hold yet again-
created the seventh failure at 90.20 in three weeks.
Combined with the bearish doji candlestick pattern that appeared on
November 1, 2005, the failure indicated that a move could be nearing
completion, telling traders to prepare for a change in direction.
This occurred the next day but the downside move on November 2 was
just enough to get the bears to go short.
As any experienced trader knows, once it is broken,
prior resistance becomes support, and on November 3, that was what
happened to the 90.20 level; much to the bears’dismay, the bulls
take over. This is important, since those who went short below the
resistance level seriously considering buying to cover their
positions.
November 4, 2005, saw sellers breathe a sigh of
relief as the index dipped back under the resistance level.
Unfortunately for the shorts, that relief was short-lived as the
bulls pushed it back up and through resistance. No one should have
been surprised by the size of the day’s move, as not only did the
bulls join the party, the disciplined bears were forced to cover,
thereby adding more buying pressure.
By using a profit-taking strategy of exiting if the
next day violates the prior day’s low and combining that with three
consecutive candles where the sellers have won the daily battle, the
trade could have been exited on November 10 for a very nice gain.
However, no other signal confirmed this exit. That exit turned out
to be a shakeout as the bulls resumed their push, and over the next
five days they pushed the index to a prior resistance level from May
2004 (to point 6).
A One-Two
Trading Punch
In Figure 1, the daily chart shows the combination candlestick and
moving average crossover signal strategies. Point 1 shows the
three-day moving average crossing over the five-day moving average
after the occurrence of a bullish harami candlestick pattern. On
examination, the trader is warned that the move may be coming to an
end by engulfing bear candlestick pattern (point 2). This is
followed by a bearish harami at point 3. The three-day moving
average crosses below the five-day moving average, capturing a
profit for the trader and exiting before the drop on October 24,
2005 (S1).
This move was relatively short-lived. The two lines
crossed back over, capturing a profit for the trader and exiting
prior to the big drop on October 24, further confirmed by another
harami, but this time bearish, at point 3.
Two days later, a new near-term low was created in
the index. The three-day MA (blue) crossed above the five-day
(black) MA again for the open on October 31, confirmed by the
engulfing bull candlestick pattern the day before at point 4. Note
the buy signal (B1) captured a 14-day uptrend and the MA lines did
not cross again until November 18.
The combination of signals not only allowed the
trader to capture greater profits compared to a candle exit but also
kept the trader in the trade early on; many traders would have
covered at the resistance level of 90.20, and not have reentered
until that level was broken to the upside.
Finally, an exit signal was generated at S2 after an
engulfing bear pattern, followed by a tweezer top pattern the next
day. There was, in addition, the blue three-day moving average
crossing below the five-day moving average. As the moving averages
got set to cross one another again in early December 2005, a bullish
harami candlestick pattern occurred at point 7 (immediately
following the bearish engulfing pattern that negated it) confirming
another buy signal. However, as we will see, the buy would have been
into historic resistance, making it a lower- probability trade.
Simon Says Take
a Giant Step Back
Traders are often guilty of not seeing the forest for the trees.
They are so intent on the time frame in which they trade that they
fail to consider the bigger picture. Longer-term charts, such as
weekly and monthly periods, tend to filter out shorter-term noise
and paint a better overall picture about what is really going on.
Figure 2: SEEING THE FOREST FOR THE TREES.
On this weekly chart of the
US Dollar Index, you can identify areas of support and resistance
level. These can be applied to your –shorter-term trades.
On a weekly chart of the US Dollar Index in Figure 2,
the blue channel top line between April 2004 and November 2005 high
provides a high-water mark that should have kept the trader out of a
long trade in late November. In periods of consolidation, which are
generally more visible on longer-term charts, it is safer to stay
out until historical resistance is broken. Unconfirmed candlestick
reversal patterns also have a habit of being less reliable in
channels or strong trends and can generate false signals.
Supporting Cast
= More Successful Trades
In any market, it is of utmost importance to get as many confirming
indicators as possible in your favor before you enter the trade.
There is also an optimum number of indicators for each trader:
Relying on a single indicator produces too many false signals and
leads to whipsaws, while too many indicators ultimately leads to
analysis paralysis.
Marrying candlestick patterns with a moving average
crossover is one example of an effective way of accomplishing this.
Combine this with looking at a minimum of two or more time frames to
better see the big picture and you will find that your confidence
for entering and exiting trades as well as your trading account will
take a dramatic turn for the better.
Some Powerful
Patterns Worth Knowing
Matt Blackman,
market analyst for
www.TradingEducation.com, is a technical trader, author,
reviewer and keynote speaker. He is a Market Technicians
Association (MTA) affiliate, a Canadian Society of Technical
Analysts member, and is enrolled in the Chartered Market Technicians
(CMT) program. |
