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Trending & Indicators (a quick guide)

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#1 TTHQ Staff

TTHQ Staff


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Posted 16 April 2008 - 08:31 AM

As many experienced traders are well aware, technical analysis can be a great tool for market timing. However, traders need to choose their indicators carefully, as some lagging tools may fail to maximize overall profitability. In this article, I’ll outline a methodology that “fuses” Western indicator signals and Fibonacci trading tactics, in order to identify key reversals in advance, which in turn will help identify “best price” entry and exit points. First we’ll take a look at some traditional Western indicators, before outlining how these can be combined with Fibonacci strategies for an overall entry/exit strategy.

There are many different charting tools and strategies in the technical trading world. However, while some tools such as moving averages, percentage retracements and trendlines offer good market-timing signals, they actually can fail at generating consistent profits. Why? Simply because these lagging indicators generate trend reversal signals after a market has already turned. The result is an average trade, which could have been better if more precise entry and exit points had been utilized.

One of the basic tenets of technical analysis is the concept of confirmation. No trading signal should be taken in a vacuum. Traders should look for confirmation by another indicator or method before taking any position. When several indicators all point in the same direction, this helps generate confidence in a trading position. Once in the trade, taking profits on a winning position can be difficult if a trader is not working with a specific price objective. And “trader’s remorse” waits in the wings to punish those who exit early and leave profits on the table. Traders who use a technical strategy that clearly identifies price targets can close out a profitable position more confidently.

Solid trading strategies work well across all markets. However, the technique I will introduce requires liquidity, so traders should avoid markets with low trading volume. My strategy not only warns of pending market reversals, but also instills confidence to “stay in” after a price target has been achieved. The result is a more productive trade, one where profits are truly allowed to run – but only to a point.

Know Your Indicator

Not all indicators are created equal. Some change their appearance as price data enters the chart over time. Momentum indicators such as the moving average convergence/divergence (MACD) demonstrate this behavior. This happens whenever the upper and lower ranges of an indicator are not fixed. These types of indicators are not “normalized” because they aren’t consistently confined between two values (typically zero and 100).

Consistency is an important factor, and I prefer to use a normalized indicator with more consistent performance. While several indicators fit the bill, one in particular was formulated to solve this very problem. Wilder’s relative strength index (RSI) is a pure range bound, “normalized” indicator. It gives me the consistency I need, adding overbought and oversold signals at predetermined levels. The most widely accepted values are 70 for overbought and 30 for oversold.

Bullish and Bearish Divergences
Momentum indicators, such as the RSI, derive their value from price action. This can offer clues to overall market strength in the form of bullish and bearish divergences. For those who are unfamiliar with these concepts, a bullish divergence occurs when price hits a new low during a downtrend, but the RSI fails to make a new low. Conversely, a bearish divergence emerges on the chart when price scores a new high in an upmove, but RSI fails to confirm with a new high reading in that indicator. This negative divergence warns that the uptrend may be over. I heed this powerful signal and avoid taking new positions, even raise my stop losses to protect profits or exit altogether. The same holds true for lower prices in bear markets, absent accompanying new lows in RSI. This positive divergence forewarns the downtrend may be ending.

Positive and Negative Reversals
A lesser-known reversal signal, similar to yet different from divergences, helps traders identify situations where the trend will continue. When RSI makes a new low in a bullish market, yet price action does not follow, a condition known as “positive reversal” occurs. The pattern forecasts new highs ahead and lends greater confidence to add to winning positions. The opposite is true in a bear market when RSI makes new highs, but price does not follow. This negative reversal forecasts lower prices.

Plot Support and Resistance on the Indicator Itself
There is also another effective way to utilize RSI and that is by plotting support and resistance levels on the actual indicator readings. (See the lower portion of Figure 1 for an example.)

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Traders can monitor the indicator’s action around those support and resistance levels, drawn on the actual RSI itself. This also can be a helpful tool in pinpointing potential market reversals.

As mentioned earlier, traders should always look for confirmation among a variety of signals before pulling the trigger on an entry or exit. The bottom line is that none of these signals should be taken in isolation. Two or more signals occurring simultaneously increases my confidence in taking the trade. In its most powerful form, this occurs at an identified price target. Later, I’ll show you how combining RSI signals with price targets can act as your secret weapon in entering and exiting positions for maximum gains.

Fibonacci Trading Tactics
Now, let’s take a look at how we can combine Western indicators with help from Fibonacci. First, here’s a little background on the man behind the numbers. Leonardo Fibonacci was the mathematician son of an Italian merchant. An established trader of his era, the elder Fibonacci took his son abroad to learn the family business. It was during one such trip that Leonardo Fibonacci discovered Arabic mathematics, detailed in his book Liber Abacus (The Book of Calculation). He is widely credited with introducing Europe to the decimal system – the concept of beginning the counting sequence with zero before one. For most traders, Fibonacci simply represents a set of retracement values. Traders use these numbers to achieve a better price when taking new positions following a market move. Few, however, use Fibonacci numbers in determining price targets. Combining these two techniques results in “best price” on the entry and the exit.

The Mystery Behind the Numbers
The origin of Fibonacci retracement values is a mystery to many traders. The values are derived from a mathematical routine applied to a sequence of numbers. The sequence (0, 1, 1, 2, 3, 5, 8, 13, 21, etc.) is created by adding the preceding number to the current value – the result being the next number the sequence. Thus, 1 plus 1 equals 2; 1 plus 2 equals 3; 2 plus 3 equals 5; 3 plus 5 equals 8 and so on.

Fibonacci retracement values are derived from another mathematical relationship. Neighboring numbers in the sequence (e.g., 5 and 8) are related one to the next by a ratio of .618. This happens with increasing accuracy as the sequence evolves to infinity. Anyone who uses retracements recognizes this as 61.8 percent – a widely accepted Fibonacci number. Values separated by a middle number in the sequence (e.g., 5 and 13) also relate to one another by a .382 ratio – or 38.2 percent. Last, .618 is also the square root of .382, further anchoring the intricacy of the relationship. Plotting the retracement tool between two extreme pivot points displays the two retracement values familiar to all Fibonacci traders.

Take It A Step Further
As experienced technical traders are well aware, many in the marketplace routinely use Fibonacci retracements to improve their entries on corrective pullbacks following important market swings. Fibonacci retracements are often simply used as percentage corrections of price swings (usually 38.2 and 61.8 percent) between zero and 100 percent of an overall market move. Unfortunately, this narrow view, restricting percentages to values between zero and 100 percent of the price range, limits their potential. If extension values – those beyond zero and 100 – are used, price targets can be found above and below the two extreme pivot points.

Fibonacci Extensions: Finding Price Targets
Adding 1.27 (square root of 1.618) and 1.618 (inverse of .618) to the Fibonacci retracement tool (on one’s trading software) yields price extension targets. By displaying 127 percent and 161.8 percent respectively, “reversal extensions” (retracements in excess of 100 percent) identify price targets beyond the previous swing low in a bullish market/swing high in a bearish market. Retracements can also be negative values (those surpassing a zero percent correction), so I also add -27 percent and -61.8 percent to my Fibonacci trading tool. These “continuation extensions” reveal price targets beyond the previous swing high in a bullish market/swing low in a bearish market. This entire process converts my traditional Fibonacci retracement tool to an extension tool as well, revealing the full range of price targets for entry or exit, short or long. See Figure 2 for an example.

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As with indicators, Fibonacci numbers should not be acted upon in isolation. Prices may pivot at retracement and extension values, but underlying momentum may drive the market even further. Premature exits unwittingly reduce the overall reward-to-risk ratio of every trade. To maximize the performance of both RSI signals and Fibonacci trading tactics, I “fuse” them together into a single system.

Bringing it All Together
Indicators are good for determining overbought and oversold conditions, and RSI is particularly helpful in assessing overall trend strength. By comparison, Fibonacci retracement and extension values provide price targets for both entry and exit. Yet neither approach instills complete confidence that I’ve entered or exited at the right time. My trade may have hit a confirmed price target, but I’ll leave money on the table if I exit a market with continued underlying strength.

Great trades don’t come around every day, so I want to make the most of my profitable positions. What I need is a system that improves my overall confidence. I need a system that tells me that, despite hitting a price target, it’s not time to enter or exit – at least not yet. Indicators tell me when the market is poised to reverse, but they don’t tell me what price to expect. Fibonacci numbers give me clear price targets, but they don’t tell me which value represents the best entry or exit price! “Fusing” individual RSI and Fibonacci techniques gives me the best of both worlds – better entry and exit prices, with improved timing and confidence.

The Strategy
I use RSI in a unique way. First, I modify Wilder’s overbought and oversold principle by plotting support and resistance levels for every market I trade. I’ve found at least 1,000 bars worth of price history yields the best results. Next, I’m always on the lookout for RSI divergence from price, as well as any positive or negative reversals. Finally, I look for these signals to occur at or near historical support and resistance levels.

I also use a modified Fibonacci trading system. By combining Fibonacci retracements and extensions, I identify a series of potential price targets with greater confidence. Prices typically fall back to 38.2 percent following a bullish move, subsequently “bouncing” off this level. If the ensuing rally fails to make a new high, continued selling follows to the 61.8 percent retracement. If prices resume their upward trend from this pivot low, the ensuing rally should target the — 27 percent and -61.8 percent extensions respectively. Having a legitimate price target gives me courage to go long despite intermediate lower prices, more so than if I acted based upon uptrend alone.

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For greater accuracy, I combine both techniques. The “fusion” of RSI and Fibonacci forms a complete trading system – one in which the “right price at the right time” is more consistently identified. To recap, traders should begin by determining historical RSI support and resistance levels for the market, and then plot Fibonacci retracements and extensions between significant pivot points, updating them as price action evolves. The system signals a decision when the market hits a Fibonacci price target, but don’t act unless there’s an RSI signal present.

Ideal Long Trade
The ideal long results from an initial bullish swing. Using the Fibonacci retracement tool, I identify the 38.2-percent and 61.8-percent price levels. As prices correct, I watch for a weak rally at the 38.2 percent level. If the rally is weak, I anticipate prices falling to 61.8 percent. When the market hits 61.8 percent, I take the trade if RSI supports the decision. The best RSI signal is a positive reversal at an identified support level – each reinforcing the other. Assessing the risk, I measure the potential reward using the - 27 percent and - 61.8 percent Fibonacci continuation extensions. If the trade meets my reward-to-risk standards (typically three to one), then I take the trade; if not, I pass. Although I could trade using RSI or Fibonacci alone, the odds of success increase dramatically by waiting for the “fusion” of both signals.

Maximizing profits requires a confident exit strategy. My ideal exit is similar to the entry. In a successful long trade, I watch RSI as the market approaches the - 27 percent continuation extension. Based on RSI behavior, I’ll either liquidate or hold out for the - 61.8 percent continuation extension. I hold the position if RSI continues to make new highs and hasn’t diverged at a historical resistance level; I exit only after recognizing negative divergence at or near resistance. Managing the trade improves my overall reward-to-risk ratio and results in greater, more consistent profits.

The Fusion
Many traders have a good system for establishing new positions. Too many techniques rely too heavily on lagging indicators of market sentiment. Because these techniques take time to signal action, traders lose profits on both sides of the trade. Using either RSI signals or Fibonacci trading tactics alone can improve trading performance. By fusing both techniques together, traders can enter and exit trades with greater confidence – and greater profit.