- Overview
- Bullish and Bearish Flags
- Doji Candlestick Formation
- Fibonacci Theory
- Hammer Candlestick Formation
- Japanese Candlesticks
- Morning Star
- Support and Resistance
- Trend Lines

Next: Technical Analysis Part 2.

#### Overview: Understanding Technical Analysis

Technical analysis is the study of historical price action in order to identify patterns and determine probabilities of future movements in the market through the use of technical studies, indicators, and other analysis tools.

Technical analysis boils down to two things:

identifying trend

identifying support/resistance through the use of price charts and/or timeframes

Markets can only do three things: move up, down, or sideways.

Prices typically move in a zigzag fashion, and as a result, price action has only two states:

Range – when prices zigzag sideways

Trend – prices either zigzag higher (up trend, or bull trend), or prices zigzag lower (down trend, or bear trend)

#### Why is technical analysis important?

Technical analysis of a market can help you determine not only when and where to enter a market, but much more importantly, when and where to get out.

#### How can you use technical analysis?

Technical analysis is based on the theory that the markets are chaotic (no one knows for sure what will happen next), but at the same time, price action is not completely random. In other words, mathematical Chaos Theory proves that within a state of chaos there are identifiable patterns that tend to repeat.

This type of chaotic behavior is observed in nature in the form of weather forecasts. For example, most traders will admit that there are no certainties when it comes to predicting exact price movements. As a result, successful trading is not about being right or wrong: it’s all about determining probabilities and taking trades when the odds are in your favor. Part of determining probabilities involves forecasting market direction and when/where to enter into a position, but equally important is determining your risk-to-reward ratio.

Remember, there is no magical combination of technical indicators that will unlock some sort of secret trading strategy. The secret of successful trading is good risk management, discipline, and the ability to control your emotions. Anyone can guess right and win every once in a while, but without risk management it is virtually impossible to remain profitable over time.

#### Bullish and Bearish Flags

Bullish flags are formations occur when the slope of the channel connecting highs and lows of consolidating prices after a significant move up is parallel and declining. The trend before the flag must be up.

Bearish flags are formations occur when the slope of the channel connecting highs and lows of consolidating prices after a significant move down is parallel and rising. The trend before the flag must be down.

#### Why are Bullish and Bearish Flags important?

Flags imply that the market cannot decide whether to break up or down. Once the flag is broken by the price, there may be a substantial move in the direction of the break.

#### So how do I use them?

Flags can be used to interpret large breaks in price. If the price breaks through the flag to the downside, there may be a large move down. Similarly, if the price breaks through the flag to the upside, there may be a large move up. We may use these to help identify trend or to confirm a Gartley or butterfly pattern.

#### Doji Candlestick Formation

Doji form when the open and close of a candlestick are equal, or very close to equal.

Considered a neutral formation suggesting indecision between buyers and sellersâ€“bullish or bearish bias depends on previous price swing, or trend.

Length of upper and lower shadows (wicks and tails) may vary giving the appearance of a plus sign, cross, or inverted cross.

#### Why are Doji important?

Completed doji may help to either confirm, or negate, a potential significant high or low has occurred.

May act as a leading indicator suggesting a short-term price swing/trend reversal may be in progress.

Doji may also help confirm, or strengthen, other reversal indicators especially when found at support or resistance, after long trend or wide-ranging candlestick.

Long-legged doji represent a more significant amount of indecision as neither buyers nor sellers take control.

Gravestone doji indicate that buyers initially pushed prices higher, but by the end of the session sellers take control driving prices back down to the session low.

Dragonfly doji indicate that sellers initially drove prices higher, but by the end of the session buyers take control driving prices back up to the session high.

Failed doji suggest a continuation move may occur.

#### So how do I use doji to place trades?

Doji are neutral indicators that simply represent a tie in the never-ending battle between buyers (bulls) and sellers (bears). On their own, doji are not much help in making sound, high probability trading decisionsâ€” as is the case with any single indicator. This is mainly due to the fact that even if a doji does signal the beginning of a price swing reversal, it will not give any indication as to how far the reversal my go or how long it may last.

High probability trades are identified through a convergence of trading signals that help identify and confirm both entries and exits based on two key components: (1) trend (2) support & resistance. Without having identified those two components in advance a doji, as is the case with any other solo indicator, is nothing more than a coin-toss in terms of determining probabilities.

But when used in conjunction with other forms of analysis, doji can be helpful in confirming or negating significant high/lows, which in turn helps a trader determine whether a short-term trend is likely to reverse, or continue. In other words, a single doji is a just a small piece of the puzzle in helping a trader determine a higher probability point at which to either or enter, and/or exit a position.

Let us take a look at how doji can be used with other basic technical indicators to make a high probability trading decision. The first things we want to do is determine support & resistance, and trend. The idea is to sell near resistance, and buy near support. Trend helps tell a trader which direction to enter, and which to exit. (enter the market shot with a sell order, or enter the market long with a buy order), and which to exit.

The most basic ways to determine support & resistance is based off previously established highs and lows.

Another way to identify more significant levels of support and resistance in terms of trend reversals is based off previously established significant highs (peaks) and lows (valleys). These peaks and valleys help a trader identify the beginning and ending points of price swings, or trends.

Based off these significant highs and lows, a widely recognized form of technical analysis referred to as Fibonacci retracements may be used to identify support or resistance. These Fibonacci retracement levels represent percentage corrections of previously established price swings, or trends. The most common Fibonacci retracement levels are 38.2%, 50%, 61.8%, and 78.6% of the previous swing, or trend.

No one no matter how experienced a trader, no one knows with any degree of certainty what the market will do next or how far the market will go. This explains why some traders may choose to have multiple profit targets. One age old trading mantra says, (cut your losses quickly, and let your profits run.) Although this, for good reason, is an excellent piece of advice it is often misinterpreted by both new and veteran traders alike. A trader must (let profits run) only to logical profit objects, which generally reflect levels of support and resistance. This is where trend analysis, plays a significant role in helping to determine which profit targets, or how many, a specific trade calls for.

The mistake for most traders is not wanting to (get out too early) and as a consequence greed oftentimes takes over. This almost always leads to giving those profits back, and in many cases turning a winning trade into a losing trade. Multiple profit targets tend to lead to more complicated exit strategies in which stop management becomes essential. One key aspect of successful trading that will help to determine the quality and probability of a trade is the risk vs. reward ratio. In my opinion, this is without question the single most important factor of a high quality trade.

For now, let us just keep it simple and see what this trade setup looks like using the same USD/CHF example. We will assume the most conservative profit target (set just above the 38.2% Fibonacci retracement level adding 4 pips for the spread).

Now that we have determined out exits BEFORE entering into the market, we will be able to perform the 2 absolutely essential/crucial components of proper risk/money management, and trading in general. Depending on exactly where we enter the market we are able to determine 1) the risk vs. reward ratio, and 2) the amount of risk on the trade. The risk vs. reward ratio in many cases will be the determining factor based on a traders winning percentage. The risk itself will help determine the appropriate size trade to place. Let us assume we entered this short trade just after the doji completed, the sop-loss order was placed 1 pip above the high of the completed doji adding 4 pips for the spread, and the limit order was placed 5 pips above the first profit target, or T1 (just above 38.2% retracement of B-to-C, plus the 4 pip spread).

Assuming the risk vs. reward ratio is acceptable, you may then determine the appropriate size trade to place based on your percentage risk per trade. As a general rule of thumb most traders do not risk more than 1-3% of their total trading capital (1-3% account balance).

So all a trader can do is decide what is logical, understand why those levels are logical, and never look back. One of the worst and most destructive habits of nearly all traders is to look back after a trade has completed to (see what happened.)

On their own, doji are not much help in making sound, high probability trading decisionsâ€”as is the case with any single indicatorâ€“for two reasons:

Doji may help identify significant highs/lows and the potential for an ensuing market reversal (thus a higher probability market entry), but doji will not help identify exits based on that entry in advance. So the question, oftentimes, is not, (where do I get in?) but equally if not more important is, (where do I get out?) A high probability trade is defined by a combination of several important factors, but two separate, but essential components:

Risk vs. reward ratio

Winning percentage

Having a high winning percentage means nothing if you lose your shirt when you are wrong. A 80% win ratio combined with a 1:4 risk-to-reward ratio results in a trader being (break-even) over an extended period of time in terms of your overall account balance. Whereas a trader with only a 33% win ratio will have (break-even) results while maintaining a 2:1 risk-to-reward ratio. Placing high probability entries and exits in terms of technical analysis boils down to two things:

Identifying support & resistance levels

Identifying market trend.

There are hundreds, if not thousands, of ways to identify those two components, and the idea is to look for confirmation across indicators and/or timeframes to help determine the strength of your signal.

The risk vs. reward ratio in many cases will be the first determining factor based on a traders winning percentage. However, most traders do not know there true winning percentage for one of two reasons:

Not enough trades have been placed to accurately determine an average winning percentage

This is where the mathematical law of law large numbers comes into play. This law basically states that the more occurrences you have of a specific event, the closer you will come to the true probability of that event reoccurring. Trading is all about probabilities, not certainties. So and understanding and application of this law is essential. Think about flipping a coin 10 times, and getting 8 heads.

We all know that the odds of flipping a coin are 50/50. So no one in their right mind would assume there is an 80% chance of getting heads based off those 10 initial flips. So the law of large numbers when dealing with probabilities is essentially this: the more flips occur the closer you get to the 50/50 average we know to exist. Even after 100 flips you may still not see a true representation of those odds because somewhere along those 100 flips you may see 10 heads or ten tails in a row. This is where the law of averages comes into play. Since we know the odd are 50/50, that suggests that if we see 10 heads in a row, well somewhere down the line we will probably see 10 tails in a row to average our the 50/50 probability. Funny thing isâ€¦.let us say someone sees 20 heads flipped in a row. How many people do you think would be willing to bet money that the next flip is going to be tails. They are probably asking themselve (20 heads in a row, what are the odds! The next one HAS to be tails!)

Lack of consistency

Most traders do not follow the same rules, if any, each and every time they place a trade. Most place several trades, and then (try) something else. Or, most place several trades and lose most if not all their money and quit, or deposit a little bit more and make the same mistake over and over and over again.

#### Fibonacci Theory

Before we get in too much about what Fibonacci is, let’s first answer the question “who is Fibonacci?” Leonardo Pisano, or Leonardo Fibonacci as he is most widely known, was a European mathematician in the Middle Ages who wrote Liber Abaci (Book of Calculation) in 1202 AD. In this book he discussed a variety of topics including how to convert currencies and measurements for commerce, calculations of profit and interest, and a number of mathematical and geometric equations. However, there are two things that jump to the forefront of our discussion in today’s world. First, in the beginning portions of Liber Abaci he discussed the benefits of using the Arabic numeral system. At the time, the influence of the defunct Roman Empire was still strong, and the preference of most European citizens was to use Roman numerals. However, in Liber Abaci, Fibonacci provided a very powerful, influential, and easy-to-understand argument for using the Arabic numeral system. From that point on, the Arabic numeral system got a strong foothold in the European community and soon became the dominant method of mathematics in the region and eventually throughout the world. It was so strong that we still use the Arabic numeral system to this day.

The second important section of Liber Abaci that we use today is the Fibonacci sequence. The Fibonacci sequence is a series of numbers where each number in the series is the equivalent of the sum of the two numbers previous to it.

##### Fibonacci sequence:

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144â€¦and so on,

out to infinity

As you can see from this sequence, we need to start out with two “seed” numbers, which are 0 and 1. We then add 0 and 1 to get the next number in the sequence, which is 1. You then take that value and add it to the number previous to it to get the next number in the sequence. If we continue to follow that pattern we get this:

##### 1 + 1 = 2; 1 +2 = 3; 2 + 3 = 5; 3 + 5 = 8; 5 + 8 = 13;

8 + 13 = 21; 13 + 21 = 34; 21 + 34 = 55; etc.

The Fibonacci sequence is so important to this discussion because we need those numbers to get our Fibonacci ratios. Without the Fibonacci sequence, the Fibonacci ratios wouldn’t exist.

#### What Makes a Fibonacci Ratio?

With the advent of the internet, there has been a lot of misinformation on which values make up Fibonacci Ratios. Proliferation of Fibonacci analysis, particularly in the realm of trading, has encouraged misinterpretations and misunderstandings of how and what makes a Fibonacci ratio. Let’s look at what a Fibonacci ratio is, how it is created, and some examples of those that are not really Fibonacci ratios at all.

#### Fibonacci Ratios

The math involved behind the Fibonacci ratios is rather simple. All we have to do is take certain numbers from the Fibonacci sequence and follow a pattern of division throughout it. As an example, let’s take a number in the sequence and divide it by the number that follows it.

0 Ã· 1 = 0

1 Ã· 1 = 1

1 Ã· 2 = 0.5

2 Ã· 3 = 0.67

3 Ã· 5 = 0.6

5 Ã· 8 = 0.625

8 Ã· 13 = 0.615

13 Ã· 21 = 0.619

21 Ã· 34 = 0.618

34 Ã· 55 = 0.618

55 Ã· 89 = 0.618

Notice a pattern developing here? Starting at 21 divided by 34 going out to infinity you will ALWAYS get 0.618!

We could do this with other numbers in the Fibonacci sequence as well. For instance by taking a number in the sequence and dividing it by the number that precedes it, we see another constant number that develops.

1 Ã· 0 = 0

1 Ã· 1 = 1

2 Ã· 1 = 2

3 Ã· 2 = 1.5

5 Ã· 3 = 1.67

8 Ã· 5 = 1.6

13 Ã· 8 = 1.625

21 Ã· 13 = 1.615

34 Ã· 21 = 1.619

55 Ã· 34 = 1.618

89 Ã· 55 = 1.618

144 Ã· 89 = 1.618

Another pattern develops out of the numbers of the Fibonacci sequence. Now 1.618 actually holds even more significance because it is also called the Golden Ratio, the Golden Number, or the Divine Ratio, but I could go on for many more pages about that subject.

Here are some more examples of patterns that develop by taking numbers in the Fibonacci sequence and dividing them in a pattern with other numbers within the sequence.

Divide by 2nd following | Divide by 2nd preceding | Divide by 3rd following | Divide by 3rd preceding |
---|---|---|---|

0 Ã· 1 = 0 | 1 Ã· 0 = 0 | 0 Ã· 2 = 0 | 2 Ã· 0 = 0 |

1 Ã· 2 = 0.5 | 2 Ã· 1 = 2 | 1 Ã· 3 = 0.33 | 3 Ã· 1 = 3 |

1 Ã· 3 = 0.33 | 3 Ã· 1 = 3 | 1 Ã· 5 = 0.2 | 5 Ã· 1 = 5 |

2 Ã· 5 = 0.4 | 5 Ã· 2 = 2.5 | 2 Ã· 8 = 0.25 | 8 Ã· 2 = 4 |

3 Ã· 8 = 0.375 | 8 Ã· 3 = 2.67 | 3 Ã· 13 = 0.231 | 13 Ã· 3 = 4.33 |

5 Ã· 13 = 0.385 | 13 Ã· 5 = 2.6 | 5 Ã· 21 = 0.238 | 21 Ã· 5 = 4.2 |

8 Ã· 21 = 0.381 | 21 Ã· 8 = 2.625 | 8 Ã· 34 = 0.235 | 34 Ã· 8 = 4.25 |

13 Ã· 34 = 0.382 | 34 Ã· 13 = 2.615 | 13 Ã· 55 = 0.236 | 55 Ã· 13 = 4.231 |

21 Ã· 55 = 0.382 | 55 Ã· 21 = 2.619 | 21 Ã· 89 = 0.236 | 89 Ã· 21 = 4.231 |

34 Ã· 89 = 0.382 | 89 Ã· 34 = 2.618 | 34 Ã· 144 = 0.236 | 144 Ã· 34 = 4.235 |

55 Ã· 144 = 0.382 | 144 Ã· 55 = 2.618 | 55 Ã· 233 = 0.236 | 233 Ã· 55 = 4.236 |

89 Ã· 233 = 0.382 | 233 Ã· 89 = 2.618 | 89 Ã· 377 = 0.236 | 377 Ã· 89 = 4.236 |

144 Ã· 377 = 0.382 | 377 Ã· 144 = 2.618 | 144 Ã· 610 = 0.236 | 610 Ã· 144 = 4.236 |

As you can see, we could get many different numbers by just taking numbers within the Fibonacci sequence and developing a divisory pattern within the sequence. However, this is not the only way to come up with Fibonacci ratios. Once we have the numbers from dividing, we can then take the square roots of each of those numbers to get more numbers. See the chart below for some examples of those values.

Fibonacci Ratio | Operation | Result |
---|---|---|

0.236 | Square root of 0.236 | 0.486 |

0.382 | Square root of 0.382 | 0.618 |

0.618 | Square root of 0.618 | 0.786 |

1.618 | Square root of 1.618 | 1.272 |

2.618 | Square root of 2.618 | 1.618 |

4.236 | Square root of 4.236 | 2.058 |

The last part of making these numbers Fibonacci ratios is to simply turn them into percentages. Using that rationale 0.236 becomes 23.6%, 0.382 becomes 38.2%, etc. So looking at our analysis we can then see that 23.6%, 38.2%, 48.6%, 61.8%, 78.6%, 127.2%, 161.8%, 205.8%, 261.8%, and 423.6% are our bona fide Fibonacci ratios.

#### What about 50%?

While the 50% ratio is often used in Fibonacci analysis, it is not a Fibonacci ratio. Some say that the 50% level is a Gann ratio, created by W.D. Gann in the early 1900’s. Others call the 50% level an inverse of a “sacred ratio.” Just like the Fibonacci ratios, many people will either take the inverse or square root of the “sacred ratios” to form more values. Some examples can be found in the table below.

Sacred Ratio | Operation | Result | Inverse of Sacred Ratio |
---|---|---|---|

1 | Square root of 1 | 1 | 1 |

2 | Square root of 2 | 1.414 | 0.5 |

3 | Square root of 3 | 1.732 | 0.333 |

4 | Square root of 4 | 2 | 2.236 |

5 | Square root of 5 | 0.25 | 0.2 |

Whatever the source, the 50% ratio seems to be a rather important and relevant level when trading, so often times it is included in Fibonacci analysis as if it were a Fibonacci ratio. Some of the other numbers included in the table have been mistaken as Fibonacci ratios as well, but obviously are not.

Whatever the source, the 50% ratio seems to be a rather important and relevant level when trading, so often times it is included in Fibonacci analysis as if it were a Fibonacci ratio. Some of the other numbers included in the table have been mistaken as Fibonacci ratios as well, but obviously are not.

#### Hammers Cadlestick Formation

May act as a leading indicator suggesting a shift in bullish/bearish momentum

Completed hammers may help to either confirm, or negate, a potential significant high or low has occurred. –price drives higher or lower “hammering” out a top or bottom before closing back towards open

Significance increases with length of shadow (ideally 2-3 times the size of the body) as well as timeframe

Hammers may also help confirm, or strengthen, other reversal indicators (i.e. may occur as part of tweezer formation, or next to doji, etc.)

A hammer “fails” when new high is achieved immediately after completion (candle), and a hammer bottom “fails” if next candle achieves new low.

A hammer “fails” when new high is achieved immediately after completion (candle), and a hammer bottom “fails” if next candle achieves new low.

#### Japanese Candlesticks

Over the last few decades, traders have begun to use candlestick charts far more frequently than any other technical analysis tool. Candlestick charts have a simple, easy-to-analyze appearance, and, provide more detailed information about the market at a glance than bar or line charts.

#### The Benefits of Candlestick Charts

Candlestick charts are one of the most common tools traders use for technical analysis. Most traders prefer to use the candlestick chart because it can help them to:

Determine the current state of the market at a glance.

Just by looking at the color and length of a candlestick, traders can determine instantly if the market is strengthening (becoming bullish) or weakening (becoming bearish).

See the direction of the market more easily.

On a candlestick chart, the color and shape of the candlestick can help traders determine if an uptrend is part of bullish momentum or simply a bearish spike.

Identify market patterns quickly.

Candlestick charts display specific bullish and bearish reversal patterns that cannot be seen on other charts.

#### Flame on: Candlestick Features

When you open a candlestick chart, you may notice that it looks similar to a bar chart.

Like the bars in a bar chart above, each candlestick on the candlestick chart shows the range of a currency in a vertical line and is defined by four price points: high, low, open and close.

#### Anatomy of a Candlestick

Each candlestick is made up of a body and two shadows.

Like the bars in a bar chart above, each candlestick on the candlestick chart shows the range of a currency in a vertical line and is defined by four price points: high, low, open and close.

#### Reading Candlesticks

The appearance of the candlestick body and its shadows potentially provide a lot of information about the state of the market and where it’s going.

The length of the candlestick body shows where the majority of the trading took place. A long body suggests that the market is trading heavily in one direction, while a small body indicates lighter trading.

.The appearance of shadows can also tell you which way the market is heading. Long shadows show that trading went far past the open and close values while short shadows indicate most of the trading happened near the open and close. Typically, long shadows signify a big change in market direction while short shadows usually indicate that the market has changed little during the candle’s timeframe.

#### Morning Star

A bullish three period candlestick formation that consists of:

a long red candle followed by

a small red or green candle (or doji) that gaps below the close of the previous candle followed by

a long green candle (stronger signal if gaps up)

A leading short-term reversal indicator

#### Why is a Morning Star important?

The red candlestick confirms that the downtrend remains intact and bears dominate.

When the second candlestick gaps down, it provides further evidence of selling pressure.

The small candlestick indicates indecision and a possible reversal of trend. If the small candlestick is a doji, the chances of a reversal increase (referred to as morning doji star).

The third long green candlestick provides bullish confirmation of the reversal.

#### So how do I use it?

Since morning stars are signals of a potential bullish reversal after a downtrend they are helpful in confirming a significant bottom especially when found near support. They are most useful in stop-loss placement with stops typically placed just below the completed formation.

#### Support and Resistance

Support occurs when falling prices stop, change direction, and begin to rise. Support is often viewed as a “floor” which is supporting, or holding up, prices.

Resistance is a price level where rising prices stop, change direction, and begin to fall. Resistance is often viewed as a “ceiling” keeping prices from rising higher.

If price breaks support or resistance, the price often continues to the next level of support or resistance. Support and resistance levels are not always exact; they are usually a zone covering a small range of prices so levels can be breached, or pierced, without necessarily being broken. As a result, support/resistance levels help identify possible points where price may change directions.

#### Major vs. Minor Resistance/Support

Minor resistance or support temporarily delays rising or falling prices within a larger market trend while major resistance or support altogether stops either rising or falling prices and the larger market trend changes direction. Minor price resistance/support is an artificial horizontal line representing an area, which previously served as price support or resistance, and has now transformed to the other. For example, if it the price was previously a support level, it is now a resistance level.

#### Trend Lines

A trend is when prices move in a zigzag fashion but still follow an imaginary path or a trend in one direction. The trend can be further defined by a trend line. Trend lines connect significant lows in an uptrend and they connect significant highs in a downtrend, creating dynamic resistance. Dynamic resistance means that as time changes, so does the price of the support or resistance. For instance, in an uptrend, the level of support goes up as time progresses. In a downtrend, the level of resistance goes down as time progresses.

An uptrend is identified when there are higher highs and higher lows as time passes; A downtrend is identified when there are lower highs and lower lows.

Another thing to look for is channels. Channels are comprised of two parallel trend lines with prices bouncing between them. The typical strategy is to sell at top of the channel and buy at the bottom of the channel.

#### Why are Trend Lines and Channels important?

Usually traders look for patterns in the trend that create trade opportunities. Channels provide a context in which high-probability patterns are identified. In addition to trading with the trend, traders may sell off of the top of the channel or buy off of the bottom of the channel regardless of trend direction.

If a pattern (Gartley, butterfly, etc.) converges with a trend line, it greatly increases the probability of a successful trade opportunity.