Technical Analysis: Fibonacci Retracements and Extensions Tool
We mentioned earlier that directional trends usually stop for retracements or corrections. Corrections can take several shapes and length.
A healthy correction is usually short in time and magnitude. And retraces no more than 50 percent of the prior trend.
Fibonacci retracement percentages or ratios are used to identify where are the potential reversal levels for a correction.
A tool that help outline the main corrections ratios on chart is the fibonacci retracement tool. The fibonacci retracement tool is available in all popular charting platforms. We are using tradingview as our charting platform for this tutorial.
Without going into the details of what are Fibonacci numbers and where they come from, as this has nothing to do with the trading process. We will present the main and most important Fibonacci retracement levels.
If you want to know more about fibonacci numbers you can check this link.
Traders utilize fibonacci retracement levels to try to identify areas where the correction of the trend might end. The most popular Fibonacci levels are:
23.6 % , 38.2 , 50% , 61.8% , 78.6%
The Fibonacci levels are expected to act as resistance or support levels.
While one of them is expected to completely halt the ongoing correction.
Remember: All Fibonacci tools should be used in conjunction with other technical tools within an overall strategy.
Applying Fibonacci Retracements
This part will explain the very basics of how to apply Fibonacci retracement tool.
To apply Fibonacci retracement tool you need first to identify the trend that you want to apply the tool onto. Let’s explain this through a chart example:
This is the chart of AUDUSD recently
1- You can clearly see that the price has been trending higher. The first step is to identify the start of the main trend, then the latest swing high of the trend.
2- Start from the trend start swing low and end at the latest swing high.
3- Fibonacci retracement percentages are shown on chart now. The price is approaching the 23.6 retracement level.
4- The price broke the 23.6 percent retracement level and holds steady athe the next 38.2 percent level.
5- The 38.2 acted as a support and the price actually stopped and reversed again higher to record a new high just below the latest swing high, then reversed back lower.
6- since the price recorded a new swing high, we have to readjust the fibonacci tool towards the new swing high.
7- After readjusting to the new high as shown on image above. The price has hit the 38.2 percent retracement level again and held steady above it.
In most of the time, when trying to Identify the latest swing high, the price might only drop a little and reverses to record new highs. In this case you have to keep readjusting to the new high until a deeper correction materializes.
Let’s have a look at another chart example in a down trend:
The price was clear falling in astrong down wave. We placed our Fibonacci retracement tool starting from the high of the wave towards the latest low. As seen below.
The price then extended the downside move a bit further. Therefore, we adjusted the tool to the new low. The price then retraced towards the 23.6 percent retracement level
The retracement continued higher towards the 38.2% retracement where the price started to fall again.
The downmove accelerated to break to new lows.
The price recorded a new low then bounced, we had to adjust to this new low.
Fibonacci Retracements Confluence
As you already know, trends have many lengths and they are fractal, where shorter term trends are parts of a longer term trend.
Therefore, you will see multiple short term bearish trends within a longer term bearish trend.
Therefore, you can draw the Fibonacci retracement tool for several trends at the same time.
Also, you will usually witness confluence of fibonacci levels near the same price, and that makes that price level worth watching.
Here are some chart examples:
The price found strong support at the confluence of the 38.2% retracement level for the longer term trend and the 50% retracement level for the shorter trend.
There are three Fibonacci confluences in the above live chart for the EURUSD. The first two confluences were decisively broken hinting that selling pressure is strong and likely will continue. (This is the current live chart for EURUSD)
The next Fibonacci confluence is at the the 78.6% for the over trend and the 100% of the shorter trend. That means if the price reaches there, it would have retracted all the short term trend.
Just like retracement levels, Fibonacci extension are possible support or resistance levels. They are used by traders to project price targets as well.
They are called extension for a reason. They tell how far the price extended compared to its latest correction. Let me explain by a chart:
Lets take it a step by step,
If we had an uptrend AB, then a correction BC of trend AB. Then a new wave or trend started from point C moving higher and higher until it breaks the high at point A. We would say that the price has corrected all wave BC(100%). If the price extended further above B to reach price at point D, then the price has extended 200%.
It extended two times the length of BC correction.
Just like retracements, there are several extension ratios. However, I personally recommend to stick with the main ones. Key levels are the 1.1271 (127.1%) , 1.618 (161.8%) , 2 (200%) . You wont need more than these three ratios.
Fibonacci Based Chart Patterns
There several Fibonacci based patterns. However, according to my personal experience their reliability is minimal. Only two patterns have passed our reliability requirement and will be covered in this technical analysis tutorial. The ABCD and the Three-Drive patterns.
The ABCD Pattern
The ABCD is a three wave pattern. Two main waves and one corrective wave.
The ABCD pattern can be bearish ABCD or Bullish ABCD.
The bearish ABCD consists of an up wave AB followed by an down correction BC, and finally a upward wave CD that extends above the high of AB wave(point B). When the price reaches point D traders look to sell the price as it is expected to reverse to the downside.
In a bearish ABCD
- The correction wave BC must end at the 61.8% or 78.6% of AB.
- Then CD should end at the 127.1% or 161.8% extensions of BC.
- A reversal to the downside or a pullback should start at one of these these extension levels 127.1-161.8. And this is called the potential reversal zone of the pattern.
- Ideally, if BC ends at 61.5% then expect the potential reversal zone to be at 161.8% of BC.
- If BC ends at 78.6%, then expect the potential reversal zone to be at 127.1% extension level.
- The ideal case is not necessarily needed in my personal experience.
Remember: Never count on ABCD patterns solely. Use other technical analysis tools to confirm a reversal.
– A bullish ABCD pattern is more effective if it forms within the context of an overall bullish trend. The opposite is true for Bearish ABCD within an overall downtrend.
– If a bullish ABCD pattern forms in a downtrend, the result is usually a correction not a major reversal. The opposite is true for bearish ABCD in a an uptrend.
This is an ideal bearish ABCD with BC retracing 61.8 percent of AB, then CD extending to 161.8.
The is an example of bullish ABCD with BC retracing 78.6 percent of AB, then CD extending to 127.1 percent.
This one is a non-ideal ABCD, where the BC corrects 61.8% of AB, and the price extends only to 127.1 to reverse direction. Therefore, do not assume that the price will always reach 161% level. Keep your eye on the 127 level for signs of bearish reversal.
The following chart is a an example of two bearish ABCD patterns that formed within the context of the longer term trend. Two ABCD patterns formed within the context of a longer term bearish trend had a powerful bearish outcome.
Note: Talking about retracement and extension levels, don’t be too precise with numbers. i.e. if the price reaches near a retracement or extension level, but fails to touch it with few pips difference. That should not invalidate the pattern.
This note is valid only on time horizons above the one-hour chart. If you are trading very short term time intervals , few pips should count.
The Three-Drive Pattern
The three-drive pattern is on of my personal favorite chart patterns.
It is a 5-wave pattern. Three main waves and two corrections.
The three-drive pattern is very similar to the ABCD. The only difference is that there is a third main wave that extends above point D.
Same rules of ABCD apply to the three drives pattern. Expect reversal at point F.
Point F should be either the 127.1% or the 161.8% extension of DE corrective wave.
Don’t give too much weight to whether the pattern complies with the ideal case. The most important factors are:
- Corrections should stop NEAR either 68.1% or 78.6% levels of the prior main wave.
- Extension should stop at either the 127.1% or 161.8% of latest corrective wave.
Here is an chart example:
What do you think? According to the ideal rules, the price reversal should happen at the 161.8% extension. Because the latest correction(DE) was stopped at the 61.8% level.
Fast forwards, here is the answer:
The reversal happened at the 127.1. If you waited for the price to reach the 161.8 level you would have missed the trade.
Some more chart examples of the three drives pattern:
Technical Analysis: Candlestick Patterns
Before we dive into the Japanese candlestick patterns. An important intro is needed to put things into the right perspective.
Japanese candlesticks charting was first used in Japan a couple of centuries ago. They were used mainly on commodity market(specifically rice). In recent decades, Steve Nison, an American technician brought this charting technique to the west.
Having that in mind, most of the candlestick patterns are best used in markets that close on daily basis, like the stocks, commodity futures, and so on. And most of the patterns are either not applicable in the Forex Markets or not reliable enough.
In this section from technical analysis tutorial, we will introduce some of the most effective candlestick patterns.
So let’s get started.
We mentioned earlier the Candlesticks are a way of representing the price. Where each candle consist of the opening, closing, high and low of the period. Whether the period was a day a week or an hour.
The candlestick shape is a great visual representation of what has happended during the time period.
For example, examine the following candle.
The candlestick above shows that the price has moved noticeably higher during the period, but retreated back lower to close the period below the open price.
That indicates that the buying was more than the selling, therefore the price moved higher. But afterwards, that was reversed. The selling became more than the buying, and the price moved lower again, and the closing price of the period was below the open price. This action between buying and selling has resulted in the shape of candle you see above.
The action between buying and selling can result in different and several candle shapes. These shapes are called candlestick patterns, and we will discuss some of the most important patterns. These shapes can give indication of the next price direction.
The Doji Candlestick Pattern and its Siblings
Shape: The Doji is a small candle. Its open and close are equal or almost equal, and happen near the middle of the candle. its upper and lower shadows are short.
In reality, the open and close doesn’t necessarily have to be qual. As long as the body of the candle is very small compared to the shadows, then its a doji candle. And this rule applies to all of its variations that we will explain shortly.
Explanation: The candle suggests that trading action during the period was weak and buying and selling was in equilibrium at the end.
Indication: doji candles should be ignored as they dont have a reliable direction indication.
Remember: The price trend direction preceding the candlestick pattern is the most important factor when assessing the candlestick likely outcome(bullish or bearish).
Long Legged Doji Candlestick Pattern
Shape: The long-legged doji is a long doji. It’s a more reliable variation of the doji. As Its shape is exactly like a doji but with long upper and lower shadows, suggesting a more active period. Also , its open and close are equal or near equal.
Explanation: The long-legged doji suggests that trading was active during the period. Both buyer and sellers pushed the price in both directions in a wide trading range. But at the end the price settled near the middle indicating equilibrium.
Indication: If forms after an uptrend, the pattern suggests the buying pressure is no longer controlling. It is fifty-fifty now between buyers and sellers. Therefore, the uptrend may stop for correction or reversal. The opposite is true if the pattern forms following a down trend.
Dragonfly Doji Candlestick Pattern
Shape: The dragonfly doji is a long doji. But the opening and closing price are equal or near equal to the high of the period.
Explanation: The dragonfly doji suggests that trading was active during the period. Selling starts to push the price lower directly after the period opens. But buyers manage to regain hand, and push the price to close the period near the high and open price.
Indication: The dragonfly pattern is usually a bullish pattern. The pattern has bullish implication, unless the price breaks the low of the dragonfly candle, that would signal bearish direction likely.
Gravestone Doji Pattern
Shape: The gravestone doji is a long doji. But the opening and closing price are equal or near equal to the low of the period.
Explanation: The gravestone doji suggests that trading action was strong during the period. Where buying starts to push the price higher directly after the period opens. But sellers manage to regain and push the price to close the period near the low and open price.
Indication: The gravestone candlestick pattern is usually a bearish pattern. Unless the price breaks the high of the dragonfly candle. In such case expect bullish direction.
Hammer and Hanging Man Patterns
Hammer Candlestick Pattern
Shape: The hammer candle looks like a dragonfly candle, with a small difference. In a hammer the opening and closing of the period are not equal, and can happen anywhere in the upper third of the candle body. The body can be white or black.
Explanation: The hammer candle suggests that trading action was strong during the period. Where selling pushes the price lower. But buyers manage to regain and push the price to close the period near the open.
Indication: The hammer candlestick pattern must be preceded by down trend. It has a bullish indication. Unless the price breaks the low of the hammer candle.
Remember: The body should be smaller relative to the shadows. A general rule of thumb is that the shadow must be at least twice the size of the body.
If the same shape of the a hammer forms in an uptrend, it’s called a hanging man.
Hanging Man Candlestick Pattern
Explanation: The hanging man candle suggests that trading action was strong during the period, as the trend is up. Where selling pushes the price lower. But buyers managed to regain and push the price to close the period near the open.
Indication: The hanging man candlestick pattern must be preceded by an up trend. The pattern has bullish indication. Unless the price breaks the low of the hanging man candle.
Shooting Star and Inverted Hammer Patterns
Shooting Star Candlestick Pattern
Shape: The shooting star candle look like a gravestone candle with a small difference. In a shooting star, the opening and closing of the period are not equal, and can happen anywhere in the lower third of the candle body.
Explanation: The shooting star candle suggests that trading action was strong during the period. Where buying push the price significantly higher. But sellers manage to regain and push the price to close the period near the low and open price.
Indication: The shooting star pattern must be preceded by an uptrend. The pattern has bearish indication. Unless the price breaks the high of the shooting star candle.
In the above chart example, the first shooting star didn’t result in a bearish reversal, only a narrow sideways correction(called consolidation).
Above chart is a clear illustration of how you can use candlestick patterns to trend trade. As the price was trending down, before moving for a couple of days higher in a pullback. That was followed by the shootings star pattern, signalling a possible sell trade in the direction of the main down trend.
If the same shape of the shooting star forms in a downtrend, its called inverted hammer:
Inverted Hammer Candlestick Pattern
Explanation: The inverted hammer candle suggests that trading was active during the period. Where buying push the price significantly higher. But sellers manage to regain and push the price to close the period near the low and open price.
Indication: The inverted hammer candlestick pattern must be preceded by an downtrend. The pattern has bearish indication. Unless the price breaks the high of the inverted hammer candle.
Engulfing Candlestick Pattern
The engulfing is a long candle with a body that covers the preceding candle body. It engulfs the prior candle or candles bodies(ignore shadows).
Bullish Engulfing Candlestick
Shape: The candle open at the price of the close of the prior candle, and closes above the open price of the prior candle.
Explanation: The bullish engulfing candle suggests that trading was active during the period. Where buying was in control and pushed the price higher to surpass prior candles open to close range.
Indication: The bullish engulfing pattern indicates that the prior down trend could be reversing.
Bearish Engulfing Candle
Shape: the exact opposite of a bullish engulf. The candle is a down red candle that opens at the close of prior candle and closes below the open of prior candle.
A a more reliable variation of the bullish and bearish engulfing candles, is when the candle not only covers the prior candle body, but also the shadow.
Tweezer Top And Bottom Candlestick Patterns
Shape: Tweezer patterns consist of two successive candlesticks that have equal, or very near to equal highs (for tweezer top) or lows (for tweezer bottom).
In a tweezers top, first candle is white and second black. And the opposite for a tweezer bottom.
Explanation: In a tweezer top, the price is in an uptrend and records the high on the first candle of the pattern. Afterwards, the price tries to break that high but fails and finds selling pressure moving back lower.
Indication: The tweezer top pattern suggests a downside reversal or pullback.
The exact opposite is true for tweezer bottoms.
– ALL candlestick patterns MUST be preceded by a directional trend or wave to be valid.
– A general rule of thumb: the longer the candle the better the quality of the pattern.
Technical Analysis: Momentum and Volatility
Momentum and volatility are two characteristics of the price. They indicate the price behavior. Studying momentum and volatility of the price helps traders make better decisions.
Momentum is a fancy word for speed. Yes. Momentum equals speed.
Momentum is change over time.
Let me explain,
We calculate the speed of any moving object like a car by dividing distance over time.
Speed = distance/time.
So, if am driving my car with a speed of 60 miles per hour, that simply means I would cover 60 miles distance in an hour.
Same concept is momentum. Momentum is the speed of price.
i.e. if the price opened at $1 and closed at $2 today. Then it moved 1$ per day. +$1 is the momentum of price.
What if the next day the price opened at $2 and closed at $3? momentum is still +$1 per day.
But what if the price moved from $3 to $5 the day after? I am sure you guessed it.
Momentum now is +$2 for the last day, so momentum has accelerated to +$2 per day from +$1 per day.
Now, since we have three days value. We can divide their sum by 3 to get the average for the three days.
(1+1+2)/3= $0.75 per day is the average of momentum for the past three days.
If we continue to calculate this value for each day for the next 27 days and draw a line that connect them. Then we have a momentum indicator with a period of 30.
If the line is sloping upwards then the average momentum is increasing, and if it is sloping downwards it is decreasing.
And this is the basic concept of how momentum indicators function.
All technical indicators, including momentum indicators take the prices and process it in a mathematical equation. Then produce the result on a chart.
Why Momentum Can be Useful?
Momentum indicators can indicate when an upwards or downward move in the price is decelerating. Prices are rising or falling at a slower speed. And this could be an early sign of price reversal.
That’s why momentum indicators are called leading indicators. They can give signals before the actual price change.
Also, momentum indicators can give indication if the price momentum is at extreme levels. One of the momentum indicators that can indicate that is the Relative Strength Index. Which we will explain right after the concept of divergence.
The Concept of Divergence
Divergence is simply when the momentum indicator diverges from price. i.e., when the price is rising but momentum is not rising at a similar pace (called bearish divergence). Or when the price is falling but momentum is not falling at a similar pace (bullish divergence).
The bullish divergence signals that the price might reverse higher. The opposite for a bearish divergence.
We will discuss further how to use divergence in the following section about momentum indicators and oscillators.
Popular Momentum Indicators (Oscillators)
Relative Strength Index (RSI)
The RSI is a momentum indicator that measure the strength of the current price movement on a scale from 0 to 100.
The RSI is calculated by this formula:
RSI = SI = 100 – [100 / (1 + (Average of Upward Price Change / Average of Downward Price Change) ) ]
The calculation formula for “average upward and downward moves” is complex and lengthy. And not needed at this stage.
What you need to know is that the average of upward prices and downard prices are calculated for a period you specify in the settings of the indicator.
The default period in most charting platforms is 14. But you can change it to what you prefer. I personally prefer 9 for RSI.
How to Use RSI (General Guidelines)
- Just like the price, the RSI can form chart patterns or support and resistance levels. Therefore, some practitioners use the RSI line solely to generate trading signals.
- The RSI is used as an indicator of momentum extremes up or down. Where if the RSI exceeds 70, that suggests the price is overbought and could be reversing down soon. On the other hand, if the RSI falls below 30, that suggests the price is oversold and could be reversing upwards soon.
- The 50 level in RSI is the like ZERO. If RSI above 50 then momentum is positive. If RSI is below 50 then momentum is negative. If the RSI crosses above 50 then it is a buy signal. And if the RSI crosses below 50, it is a sell signal.
- Another way to use the RSI or many other momentum indicator is through divergences. Bullish and bearish divergences.
Remember: Using the RSI, whatever was the method, to trade in the opposite direction of the longer term trend will probably result in a negative outcome. We will explain now the best ways to use these signals. Note the following chart.
How to Use the RSI (Practical Guide)
To use the RSI effectively you must first define the current price trend.
If in sideways trend:
If the price is moving sideways, usually, overbought and oversold signals are reliable.
- Consider selling near the resistance of the sideways trend if RSI is overbought.
- Consider buying near the support of the sideways trend if RSI is oversold.
- Consider buying near support if RSI shows bullish divergence.
- Consider selling near resistance if RSI shows bearish divergence.
If the price is moving in an uptrend:
Remember: In a strong trend, the corrections are usually shallow and short-lived. Therefore RSI does not reach oversold in an uptrend, or overbought in a down trend. That’s why you may consider using a shorter time period instead of the default 14 period.
Another choice would be not to wait for the RSI to reach oversold or overbought. In a strong uptrend, if the RSI falls below 50 as the price corrects, you might start considering long trades. And the opposite for a downtrend.
- Consider buying if RSI is oversold or near oversold.
- Consider buying if RSI shows bullish divergence.
- Consider buying if RSI completes a pattern or breaks resistance.
If the price is moving in a downtrend:
- Consider selling if the RSI is overbought or near overbought.
- Consider selling if RSI shows bearish divergence.
- Consider selling if RSI completes a pattern or breaks support.
The stochastic oscillator measures the position of the latest closing price relative to the high and low of the security over a period of time. Its plotted on a scale from 0 to 100.
Stochastic is based on the fact that the price trends to close each period near the highs when in an uptrend, and near the lows when in a downtrend. As it compares the current closing price with the highest high and the lowest low of the period you specify. If the stochastic fails to move higher in an uptrend, that would suggest that the price is not closing higher enough to confirm the trend. And the opposite is true in a down trend.
Stochastic formula has three variables; %K, %D and N
You set the values for these variables through the indicator settings.
For example, the default settings are:
%K= 14 %D= 3 N(smoothing)= 5
%D = 3-period simple moving average of %K .
The equation of to calculate %K will be :
%K = [(Current Close – Lowest Low in the last 14 periods)/(Highest High in the last 14 period – Lowest Low in the last 14 periods) x 100]
%K is then multiplied by 100 to get the value in percentage form( from 0 to 100)
Then a 5-period Simple moving average is applied to %K.
How to Use Stochastic (General Guidelines)
- Just like the RSI, the Stochastic is used as an indicator of momentum extremes up or down. Where if the Stochastic exceeds 80, that suggests the price is overbought and could be reversing down soon. On the other hand, if the Stochastic falls below 20, that suggests the price is oversold and could be reversing upwards soon.
- When Stochastic is in overbought, wait for line K to cross below D for a sell signal.
- When Stochastic is in oversold, wait for line K to cross above line D for a buy signal.
- When Stochastic show a bullish or bearish divergence with the price.
- Bull and Bear divergences (also called hidden divergences).
A hidden divergence is the exact opposite of normal divergence. i.e. the price is making lower highs but Stochastic is making higher highs. Or, the price is making higher lows but stochastic making lower lows.
Remember: You should not give hidden divergence that attentions or use them solely. As they are weak trading signals.
How to Use Stochastic (Practical Guide)
Just like the RSI, to use the Stochastic effectively you must first define the current price trend.
If in sideways trend:
If the price is moving sideways, usually, overbought and oversold signals are reliable.
- Consider selling near the resistance of the sideways trend if Stochastic is overbought and slow line %D cross to below %K.
- Consider buying near the support of the sideways trend if Stochastic is oversold and slow line %D crosses to the upside fast line %K.
- Consider buying near support if Stochastic shows bullish divergence.
- Consider selling near resistance if Stochastic shows bearish divergence.
- Consider buying if near support and Stochastic completes a bullish pattern or breaks resistance.
- Consider selling if near resistance and Stochastic completes a bearish pattern or breaks support.
If the price is moving in an uptrend:
- Consider buying if Stochastic is oversold or near oversold and completes a crossover.
- Consider buying if Stochastic shows bullish divergence.
- Consider buying if Stochastic completes a bullish pattern or breaks resistance
If the price is moving in a downtrend:
- Consider selling if the Stochastic is overbought or near overbought and completes crossover
- Consider selling if Stochastic shows bearish divergence.
- Consider selling if Stochastic completes a bearish pattern or breaks support.
A Word on Momentum Indicators:
Most indicators are based on the same concept. Their developers examined the price action and behavior to conclude some assumptions or facts about the price. They then used these assumptions to implement their indicators.
For example, George Lane the creator of stochastic, assumed the price tend to close near the highs in an uptrend, and near the lows in a downtrend. Then based on this assumption, he created the formula for the stochastic that reflects this assumption.
You can have your personal assumptions about the price, and then derive your personal indicator. This is the main principle of mechanical system building.
There are dozens of indicators, these indicators are a mere representation of the price.
The prices do not move in straight line. They fluctuate while moving.
Simply, volatility is a measure of how much the price fluctuates OR move in a specific period of time.
For example, if the price of Crude Oil Futures moves 2 percent up then 2 percent down in few hours. Then this is very volatile!
Also, if it’s normal for Apple shares price to move 3% on average per day(this is not true, just for illustration) , then it’s a volatile.
Some securities, like Oil and Silver, have higher tendency to fluctuate or move more than other instruments like the EURCHF pair.
Observe this hypothetical example,
If the price of “A” has closed around $3 for the past 3 days. 1.90 for day one, $2 for day 2 and $2.1 for day 3.
To calculate the average also called the mean, we add the three values and divide by 3.
Average closing =(1.9+2+2.1)/3= $2.
To calculate how much the price deviated from the average. We subtract each value from the mean and find their average.
Deviation for A= (0.1 + 0.1) / 2 = $0.1.
Now, If the price of “B” has closed at $1 for the first day, 2 for the second day and 3 dollars for the third day. The average or mean for the price is also $2.
But the deviation of price is totally different.
Deviation for B= (1+1) / 2 = $1
For instrument A the deviation is narrow only $0.1, when compared with the price deviation of instrument B.
This is a measure of volatility. B is much more volatile because it can spread or deviate on a wider range around the price average.
Bollinger Bands are a volatility indicator that’s constructed based on the standard deviation calculation.
Bollinger Bands is a volatility indicator. It is constructed by plotting a X-period simple moving average of the price. Then, two lines are plotted X standard deviations above and below the moving average.
The default Bollinger’s setting and the one widely used, is a 20-period simple moving average for the mid band. And two standard deviations for the upper and lower bands.
2 standard deviation is added to the 20-SMA to plot an upper band. And the lower band is constructed by subtracting two standard deviations from the 20-SMA.
The bands adjusts with the price volatility. It automatically become wider during periods of substantial price changes, and narrow(squeeze) when the price volatility drops.
The squeeze is the most important concept of Bollinger Bands. When the bands narrow it is called a squeeze. A squeeze signals a period of low volatility and is considered a sign of future increased volatility and possible directional breakout or a substantial move.
– Bollinger bands represent the price direction through the 20-period SMA. And the price volatility through the upper and lower bands .
– The bands contain more than 80% of price action. Therefore, a break above or below the bands following a period of low volatility(squeeze) has some indicative value. It can be used in junction with other technical tools in your analysis strategy.
The Average True Range (ATR)
The ATR aims to provide the trading range for the instrument under analysis for a specified period. It gives indication how much the price tends to change. For example, the ATR for the EURUSD for the past 7 days is 125 pips. That means that the EURUSD had a trading range average of 125 pips for the past 7 days.
The ATR is an average of the true range of each candle. And the true range is the greatest value of the following:
- The difference between the current candle high and low
- The difference between the prior candle close and the current candle high(absolute)
- The difference between the prior candle close and the current candle low (absolute)
Absolute means : ignore the negative sign.
In order to provide a better representation of volatility. We get the Average True Range of all the true range values for the period specified,
For example, Average true range with 14 period equals
(TR for day 1 + TR for day two +…. TR for day 14) / 14
But, to smooth the data even further, the creator of the indicator, Mr. Wilder, incorporated the previous period’s ATR value.
Current ATR = [(Prior ATR x 13) + Current TR] / 14
Remember: ATR is not a directional indicator like Stochastic or RSI. It reflects the volatility of the price in the specified period. See the following chart.
Note how the price is rising in a steady uptrend but volatility(ATR) is falling. The price is moving in an uptrend but with low volatility.
How Can the ATR Help
Using the ATR for Breakout Filtering
The ATR can help us optimize and reduce trading false breakouts.
A highly volatile security will have a wider filter, to reduce its likelihood of making a false breakout.
On the other hand, a slow security that has few sharp moves will have a narrow filter.
In the above chart, the price of USDCAD has closed below a horizontal support at 1.32635. That is a legitimate closing basis breakout for many traders.
Let’s say we are using 0.5 the 14-period ATR as a filter. The ATR reading at the time of breakout was 80 pips. In this case the price has to close at least 40 pips below the support level to be confirmed, and that didn’t happen. So if you have incorporated the ATR in as a filter, you would avoid this breakout.
Here is the result after forwarding in time
Using ATR for Stop Loss Placement
ATR can also help optimize stop loss placement. As it i will take into account the recent market volatility.
Using the same above example, if we decided to buy the USDCAD at that support at 1.3263 and used the 1 ATR as our stop loss. Then our stop will be 80 pips below that support at 1.3183. The low of the next candle was at 1.3223. Thus, that helped us avoid getting stopped out from the trade before the price headed back higher in our expected direction.
The ATR can also be used in trailing stops, particularly useful if you want to ride a trend and catch a big move. Instead of getting out at a specific price.
After initiating a trade and setting your initial stop. The price moved in your expected direction, you can adjust your stop loss 2 or 3 ATR below the live price if you are buyer, and above it if you are a seller .
let’s say that we bought gold at $1280, and put our initial stop loss at $1273. We planned to start trailing stop if the price reaches above $1290, because we expect big upside potential if the price breaks $1290.
The price has reached $1290 and the ATR was $2.15. We decided to move the stop loss price to 3 ATR below the live price. The live price was at $1291.63.
Our new stop loss is at $2.15×3= $6.45 below 1291.63.
The ATR changes with the price, so if volatility picks up, ATR will have a larger value, and therefore you can adjust your stop loss every day based on the new ATR value.
You can see that ATR has risen to 3.04 at the live price of 1306.27. So we adjusted our stop loss to 3×3.04= $9.12 below 1306.27. So our stop loss is now at 1297.15.
Eventually, the price will fall towards our stop to close our order.
ATR Spikes as Reversal Signals
Unusual spikes in ATR can be an indication of a near reversal in direction.