Technical Analysis III: Support and Resistance

What are support and resistance?

Support levels are prices where buyers have shown or are likely to show strength. Resistance levels are prices where sellers are likely to be strong.

Support

Support levels essentially give the market a 'floor', since they are areas where buyers tend to be strong. If the price falls to a strong support level, traders should expect buyers to step in and drive the price up, or at least keep it from moving any lower.

Because support levels are prices where buyers are supposed to be strong, if the price falls below a support level, this is a signal for the market. It shows that there is more selling pressure (or less buying) pressure than previously thought, and it often leads more traders to exit long positions and take short positions.

Resistance

Resistance levels perform the opposite function of support, which provide a 'ceiling' to the market. If the price rises to a strong resistance level, short sellers should be expected to enter the market and traders in long positions may cover their positions to take profits. This combination of selling pressure will often drive the price lower.

Resistance functions in the same manner as a safety net for short positions and an entry point for traders looking to buy on a breakout.

When a price breaks through a resistant level, it often triggers a large number of stop orders and makes for even greater buying power. Often the stronger the resistant level, greater the number of stops that are triggered and the larger the move above resistance.

Unfortunately, not every breakout is valid. Because they know that many traders place stops to sell just above resistant levels, some large institutional traders attempt to drive the price higher in the short term just to trigger these stops. Without any real force behind the move higher, the price can fall back to resistance. The same dangers of false breakouts apply to support levels as well.

Types of Orders in Forex

The forex market provides different kinds of orders for trading. The following are some major types of orders that can be found on forex trading stations.

Market orders - A buy or sell order in which the forex firm is to execute the order at the best available current price. It is also called at the market.

Entry orders - A request from a client to a forex firm to buy or sell a specified amount of a particular currency pair at a specific price. The order will be filled once the requested price is hit.

Stop Loss orders - An order placed to close a position when it reaches a specified price. It is designed to limit a trader's loss on a position. If the position is opened with buying a currency pair, the stop loss order would be a request to sell the position when the price fall to the specified level. And vice versa. Traders are strongly recommended to use stop loss orders to limit their losses. It is also important to use stop loss orders when investors may enter a situation where they are unable to monitor their portfolio for an extended period.

Take Profit Orders - An order placed to close a position when it reaches a predetermined profit exit price. It is designed to lock in a position's profit. Once the price surpasses the predefined profit-taking price, the take profit order becomes market order and closes the position.

Good Until Cancelled (GTC) - In online forex trading, most of the orders are GTC, meaning an order will be valid until it is cancelled, regardless of the trading session. The trader must specify that they wish a GTC order to be cancelled before it expires. Generally, the entry orders, stop loss orders and take profit ordersin online forex trading are all GTC orders.

The above are the basic orders types available in most of them trading systems. Some trading systems may offer more sophisticated orders. Traders should be familiar with the different orders and make the most of them during trading.

How much money (trading capital) do you need to trade?

Not everyone is going to have the same amount of money to start with. The amount of money you have – the size of your trading capital – will determine the position size that you are able to trade with.

The position size is essentially the amount of money you put into the market – in other words the amount that you trade. The larger the position size, the more money you will make if the trade wins. However, this also means you can lose more money. This is why using the correct position size is so important, because you can keep within the correct limits of money management and protect your capital from losing trades.

So how do you determine how much you should risk?

As you know, you should never risk more than 1-2% of your trading account on any single trade, which is why your trading capital will determine how much money you can trade with. However, the size of your stop loss will also determine the size of your position, because whatever your trading capital is, the larger the stop loss, the more you will have to reduce your position size to make sure that you keep within the correct limits of money management.

The different types of position sizes

When trading forex, there are three different types of position sizes that are usually available to you:

• Standard lot
• Mini lot
• Micro lot

Each one requires a different amount to trade, depending on your stop loss. We will first explain the difference between them using an example of a trade with a fixed 20 pip stop loss.

Standard lot

 

 

In forex, a standard trading contract equates to 100,000 units of the base currency. This is known as a standard lot. This means that one standard lot has a value of roughly $10 per pip (depending on the currency pair you are trading), so if the market moves 1 pip in your favour, you make $10; if the trade moves against you, then you will lose $10 per pip. If you open a trade and the market moves against you by 10 pips, this equates to $100.

A standard lot equates to 100,000 units of currency. This means that a standard lot has a value of roughly$10 per pip.

In order for a trader to be able to trade a standard lot, you would need a large enough account to withstand a losing trade at $10 per pip.

If you open a trade that has a 20 pip stop loss; this means that a losing trade on a standard lot is $200.

In this case, you must have an account of at least $10,000 – 2% of $10,000 is $200.

Mini lot

 

Some people do not have a trading capital of $10,000 and so brokers are able to offer a different position size for traders with less capital to start with. They do this by subdividing the standard lot contract into ten; this is known as a mini lot.

A mini lot equates to 10,000 units of the base currency.This means that a mini lot has a value of roughly $1 per pip.

A mini lot is equal to 10,000 units of currency. This means that instead of each trade having a value of $10 per pip, each trade will now have a value of $1 per pipand you can start with less than $10,000.

If you open a trade with a 20 pip stop loss; this means that a losing trade is $20.

In this case, you could trade quite comfortably with an account of $2,000 – 2% of $2,000 is $40.

Micro lot

 

Some people, however, do not have or do not want to start with a trading capital of $2,000. Brokers have therefore introduced the micro lot that divides the mini lots further by ten.

A micro lot equates to 1,000 units of the base currency. This means that a micro lot has a value of roughly $0.10 per pip.

This means that each contract traded is 1,000 units of currency and gives each pip the value of $0.10.

A trade with a 20 pip stop loss will result in a $2 loss.

In this case, someone can start trading with as little as$500 or even $150 – 2% of $150 is $3.

Determine the maximum position size you want trade with depending on your account

Of course, not every trade is going to have a stop loss of 20 pips and so it is important for you to determine the position size for each trade.

In order to do so, you can apply the following formula that will tell you how much you can trade depending on the size of your trading account and the size of the stop loss:

Position Size in Lots = (Account Size X the % risk per trade) / (Stop Loss in Pips X Loss per Pip per Lot)

Lets say that you have a $5,000 trading account and you have a 15 pip stop loss. You only want to risk 2% of your account. Assuming that you are trading with US dollars, where each standard lot traded means that a pip movement is $10, the position size is calculated as follows:

Position size = ($5,000 x 2%)/ (15 x 10) = 0.66

You always round the result down. This means that you can trade 0.6 lots, or 6 mini lots for this trade.

So, in order to trade comfortably with 6 mini lots, you need an account size of $5,000 to stay within a 2% limit risk.

Be careful when using the formula to make sure that the currency of the numerator and denominator are the same – if not, convert one into the other at the current market price.

Summary

So far, you have learned that ...

• ... the amount you can trade with depends on the amount of trading capital you have and the size of the stop loss on the trade.
• ... the different position sizes in the forex market are a standard lot, where each pip moment is worth $10, a mini lot, where each pip movement is worth $1 and a micro lot, where each pip movement is worth $0.1.
• ... in order to calculate the exact position size you can use the formula: 
  Position Size in Lots = (Account Size X the % risk per trade) / (Stop Loss in Pips X Loss per Pip per Lot).

Chart Your Course with Technical Analysis

Technical Analysis uses charts to try to forecast future currency prices by studying past market movements. Using this technique, a trader has the ability to simultaneously monitor multiple currency pairs by evaluating how others are trading a particular currency. In our experience, because so many traders use technical analysis, and their reaction to market activity tends to be similar, the validity of this technique is strengthened. It becomes a self-fulfilling prophecy that feeds on itself, increasing the reliability of the signals generated from this analysis.

Support & Resistance

Perhaps the most effective and therefore the most popular form of technical analyses is the use of "support" and "resistance". Support is the "floor" or lower boundary that a currency pair has trouble breaching. Resistance, on the other hand, is simply the opposite: it is the upper boundary that a currency pair has trouble penetrating.

Support and Resistance are important in range bound markets because they indicate the boundaries where the market tends to change direction. When and if the market breaks through these boundaries, it is referred to as a "breakout" and is usually followed by increased market activity.

Using Support & Resistance

We can use these support and resistance levels in many ways. A range trader would want to buy above support and sell below resistance while breakout. Trend traders, on the other hand, would buy when the price breaks above a level of resistance and sell when it breaks below support.

The concept is still the same as we stated earlier. We want to buy a currency pair if we anticipate the market moving up and then sell it at higher price. We can also sell a currency pair if we anticipate the market moving down and then buy it at a lower price.

Be aware that trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial advisor if you have any doubts.

Quote For the Day

Choose Your Approach in Forex

There are two basic approaches to analyzing the Forex market. It is important to understand how they can be used successfully.

Technical Analysis

Technical Analysis focuses on the study of price movements, using historical currency data to try to predict the direction of future prices. The premise is that all available market information is already reflected in the price of any currency, and that all you need to do is study price movements to make informed trading decisions.

The primary tools of Technical Analysis are charts. Charts are used to identify trends and patterns in an attempt to find profit opportunities. Those who follow this approach look for trending tendencies in the Forex markets, and say that the key to success is identifying such trends in their earliest stage of development.

Fundamental Analysis

Fundamental Analysis focuses on the economic, social, and political forces that drive supply and demand. The premise is that macroeconomic indicators such as economic growth rates, interest rates, inflation, and unemployment can be used to make informed trading decisions. Information about economic data can be found using XE Forex News, which is free to use.

There is no single set of beliefs that guide Fundamental Analysis. Different traders look to different indicators, and weigh various indicators in different ways.

What should I use - Technical or Fundamental Analysis?

Traders using Technical Analysis follow charts and trends, typically following a number currency pairs simultaneously. Traders using Fundamental Analysis must sort through a great deal of market data, and so typically focus on only a few currency pairs. For this reason, many traders prefer Technical Analysis.

In addition, many traders choose Technical Analysis because they see strong trending tendencies in the Forex market. They look to master the fundamentals of Technical Analysis and apply them to numerous time frames and currency pairs.

Be aware that trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial advisor if you have any doubts.

Leading vs. Lagging Indicators

We’ve already covered a lot of tools that can help you analyze potential trending and range bound trade opportunities. Still doing great so far? Awesome! Let’s move on.

In this lesson, we’re going to streamline your use of these chart indicators.

We want you to fully understand the strengths and weaknesses of each tool, so you’ll be able to determine which ones work for you and which ones don’t.

Let’s discuss some concepts first. There are two types of indicators: leading andlagging.

A leading indicator gives a signal beforethe new trend or reversal occurs.

A lagging indicator gives a signal afterthe trend has started and basically informs you “Hey buddy, pay attention, the trend has started and you’re missing the boat.”

You’re probably thinking, “Ooooh, I’m going to get rich with leading indicators!” since you would be able to profit from a new trend right at the start.

You’re right.

You would “catch” the entire trend every single time, IF the leading indicator was correct every single time. But it won’t be.

When you use leading indicators, you will experience a lot of fakeouts. Leading indicators are notorious for giving bogus signals which could “mislead” you.

Get it? Leading indicators that “mislead” you?

Haha. Man we’re so funny we even crack ourselves up.

The other option is to use lagging indicators, which aren’t as prone to bogus signals.

Lagging indicators only give signals after the price change is clearly forming a trend. The downside is that you’d be a little late in entering a position.

Often the biggest gains of a trend occur in the first few bars, so by using a lagging indicator you could potentially miss out on much of the profit. And that sucks.

It’s kinda like wearing bell-bottoms in the 1980s and thinking you’re so cool and hip with fashion….

For the purpose of this lesson, let’s broadly categorize all of our technical indicators into one of two categories:

1. Leading indicators or oscillators
2. Lagging, trend-following, or momentum indicators

While the two can be supportive of each other, they’re more likely to conflict with each other. We’re not saying that one or the other should be used exclusively, but you must understand the potential pitfalls of each.

TOP 5 FOREX INDICATORS AND HOW TO USE THEM

Top 5 Forex Indicators

Moving Averages

Type: Trend Following 

Best used: In combination

To start off, a simple moving average shows the average value of price over a certain period of time. 

Moving averages is known or commonly used to highlight the direction of a trend and smooth out price to avoid 

false breakouts, and noise. The best way to utilize moving averages is by combining it with another one. 

For example, when the 50 day moving average crosses above the 200day moving average this is considered a 

“golden cross” the upward momentum was confirmed once the short term moving average (50-day) crossed above the longer term moving average (200-day) When the opposite occurs and the 50 day moving average crosses below the 200 day moving average this is considered a death cross as the momentum in price action is declining. Here are a few examples of moving average crossovers. 

EURUSD 50sma crosses below the 200sma signaling a death cross. Price fell over 200 pips before closing back

over the 50sma. 

EURJPY 50sma crossed above the 200sma indicating the trend is bullish with a golden cross. Price action climbed

over 500 pips before falling back below the 50sma

2 )   MACD (Moving Average Convergence Divergence)

       Type:  Trend Strength/New Trend

       Best Used: For confirmation with other indicators

The MACD is best used as a confirmation indicator. What I mean by that is that it should be combined with other

indicators to maximize its potential.  The MACD has 3 main parameters, 12 (which represents the previous 12 bars

of the faster moving average) 26 (which represents the previous 26 bars of the moving average) and 9 (which

represents the previous 9 bars of the difference between the two moving averages, this is plotted as a histogram. 

In essence when the faster moving average crosses above or below the slower moving average it indicated a new

bullish  or bearish trend is forming. Sounds familiar? This is similar to our moving averages crossovers that we

discussed previously. Now to best use MACD is to look for a bullish or bearish crossover with the moving averages,

once we confirm a crossover we are looking to confirm the trend with a MACD crossover above or below the 0 line

with the histogram in favor of our trend. Here are some examples of combining the two to make for a dual threat.

After receiving a bearish crossover with the moving averages we also received confirmation of the downtrend after the MACD crossover to the downside below the 0 line adding further strength to a short position. 

AUDJPY shows an early MACD bullish crossover hinting at the possibility of a new trend. Later we received a

bullish crossover when the 50sma crossed above the 200sma. To confirm the uptrend the MACD gave us another

bullish crossover which occurred above the 0 line. 

3) RSI (Relative Strength Index)

     Type: Overbought/Oversold measurement

     Best Used: Pick Tops/bottoms /Profit taking

The RSI is similar to that of the Stochastic. It is a price following oscillator that ranges between 0 and 100. There are 

3 main zones with the RSI (Upper overbought zone ranging from 70%-100%, Lower oversold zone ranging from

0%-30% and middle or neutral zone ranging from 30%-70%. We can help use these zones to pick up potential tops

and bottoms depending on the market being in an overbought or oversold position.  Along with determining tops and

bottoms the RSI can also be used to locate and confirm a trend. Here are a few examples on how to use the RSI.

EURUSD shows price dropping impulsive manner causing the RSI to dip below 30 signaling that there might be no

more sellers left in the market and the impulsive move could be over. Price action then reversed and headed towards its bullish direction. This happen twice showing the effectiveness of the indicator.

After GBPUSD made a new high it also showed the RSI in overbought territory indicating the possibility of a decline. We received the decline in price action in conjunction with a bearish trend line keeping sellers in the trade as price

dropped over 500pips

4) Bollinger Band

     Type: Measures Volatility

     Best used: When Market Consolidates and breakouts

Bollinger bands consist of an upper band, middle band, and lower band. When the Bollinger bands tighten and

contract the pair is trading under low volality and when it expands there is a great deal of money being pumped into

the pair.  Bollinger bands differ in the way you can use them in your trading plan here are a few examples on how to

trade with Bollinger bands.

BOLLINGER BOUNCE

Traders can look to buy and sell at the top and bottom Bollinger bands. This method is most effective when the

market lacks a trend. Look for the wick of a candle to bounce off one of the Bollinger bands.

BOLLINGER SQUEEZE

Once we see bands squeeze together we look for a breakout with an impulsive candle. Price broke above the top

band and continued climbing to the upside giving traders a chance to catch the trade as early as possible. 

5) Parabolic SAR

     Type: Identify end of Trend

     Best Used: Exit Strategy/Stop Loss

Parabolic SAR is a simple tool to use, when the dots are below the candle it is considered a buy signal and when

the dots are above the candle it is a sell signal. It is best to combine the Parabolic SAR with another indicator and

avoid using it during a choppy market. The indicator is best used when the market is trending.

5) Parabolic SAR

     Type: Identify end of Trend

     Best Used: Exit Strategy/Stop Loss

Parabolic SAR is a simple tool to use, when the dots are below the candle it is considered a buy signal and when

the dots are above the candle it is a sell signal. It is best to combine the Parabolic SAR with another indicator and

avoid using it during a choppy market. The indicator is best used when the market is trending.