This key chapter provides a precise set of questions you need to answer as you get
started to trade.
Now that the big picture has been reviewed, it’s time to prepare to trade.
When you fi rst look at a currency chart, one of the fi rst questions that comes to mind is: what is the predominant direction of the currency? You arrive at the answer to this question by looking at the charts. This process is also called technical analysis and is a major skill that takes years to acquire. This book provides a framework for you to start building your knowledge and skills in analyzing forex charts. A great deal of technical analysis uses mathematics to evaluate patterns of price movements. Some analysts have tried to apply advanced concepts such as chaos theory, fractal mathematics; and
even quantum physics to gain an edge in trading. Promising new work is also being done to model fi nancial behavior that is similar to a chemical reaction with the ingredients being emotions. As new algorithms are created they will extend technical analysis to new levels. The main point is that if you are new to forex trading, you should not fear that you don’t know enough to get started.
The fi rst step for the new trader is to become skilled in understanding what the currency pair is doing, rather than trying to predict what it will do. This distinction is profoundly important because prediction is extremely diffi cult. Instead, you should try to obtain a fi rm understanding of where prices are and assess where trading opportunities will be. This is quite different from prediction, which has as a goal a specific time and price in the future. Projecting currency prices is really constructing a map of possible routes the currency can take. The effective trader will develop strategies for each possible outcome.
What Direction is the Currency Pair Trading?
If forex prices were random, the charts would look like the one below. In this chart there is no apparent pattern or direction. The theory of a random walk, even if applicable to the equity markets, has not been claimed to work in forex. Forex prices reflect global forces and maybe chaotic, which is often confused with being random. Forex markets are not random.
In contrast, forex prices move in patterns, and patterns tend to persist. It is similar to Newton’s 3rd law of motion. Restated here for forex: A currency pair will stay in a pattern until news moves it out.
The geometry of the price action reveals what kind of patterns the market is establishing. Understanding patterns leads to an understanding of what the market is doing. Understanding what the market is doing leads to formulating trading strategies.
Let’s explore some important patterns that a trader needs to find.
The Importance of Trend Direction Price Trends and Direction
Prices move in three basic ways: up, down, and sideways. When they move consistently in a direction, it is called a trend. Whether you are viewing a monthly chart or a 5-minute chart, observing which of these three patterns is in place is very important to find out.
The Trend is Your Friend.
We all have heard the phrase “the trend is your friend.” What is a trend? How do you spot it? How do you know when it’s over? Over any period of time a trend is best understood as representing a pattern where prices sustain a sequence of higher highs and higher
lows. For example, if you are looking at a daily chart, whether it is a bar chart or candlestick chart, an uptrend can be spotted and drawn. To draw a trend, connect either the lows or the highs and extend the line across the chart. A downtrend connects the highest high to the next lower high and is extended. An uptrend connects the lows of the
chart, starting with the lowest low and going to the next higher low. By drawing a trend line, you’re asking yourself not only what the pattern is but also can project where the pattern will be broken.
When a trend pattern is noticed it’s a serious development. Consider the following: Each day more than 1.5 trillion dollars is traded in the forex market. If a day trend emerges, the market has decided that the particular currency pair has a range of action. An uptrend means that the global sentiment is such that that there is a dominance of buyers over sellers for a period of time. A downtrend means that the sellers are more powerful and have forced the price highs each day to get lower and lower. This makes the day pattern very important because it refl ects the accumulated decisions around the world on the
value of that currency. Once a day trend is in effect, the market will continue the trend until some new information on global economic or geopolitical conditions change the trend. Trend direction usually goes from a downtrend to a sideways action to resumption of a downtrend or a reversal of the trend. Following the trends through this neverending
cycle is one of the most fascinating aspects of trading forex.
Note: Please see Abe’s book “Understanding Forex: Trading to Win” for the remainder of the chapter. Copies can be obtained from the Freebie section of forexhound.com