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An Introduction to Chart Reading

The markets represent the struggle between two opposing force - the bulls, who want to push the price higher, and the bears, who wish to push it lower. As each side tries to overpower the other, they leave footprints behind. The advantage with technical analysis is that patterns often repeat themselves. Therefore, this can be very useful in predicting future price movements in the commodity market.

Technical analysis is the art and science of reading a price chart to determine who is stronger, and who may win the struggle in the future.

Chart Types:

There are three types of charts commonly used for the technical analysis of the commodity market.

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Line charts:

The line chart is the simplest form of charting. It displays the closing price for any given time period. However, it does not tell you very much about the opening price or price fluctuations during that period.

Bar charts:

In bar charts, the vertical bar displays the extremes. That is the highest and the lowest prices reached during a particular period. The short ticks on the sides of the bar chart depict where the period opened and closed. The bigger the bar, the wider the range of the struggle. The smaller the bar, the more agreement and consensus there was on the price. You can also see if the open and the close of the period occurred closer to the lowest price, the highest price, or somewhere in the middle.

Candlestick charts:

Candlestick charts were first used in Japan in the 12th century in an attempt to predict rice prices, and yielded remarkable accuracy. Like a bar chart, they display the open, close, high and low of any given period. Besides just answering the question "who is winning?", they also indicate "who is stronger?" This is due to some easily recognizable characteristics such as the size of their bodies, the length of their wicks and their overall coloring.

Candlesticks on charts have wicks at both ends. The wick depicts the extremes, that is, the highest and lowest prices during that period. The candle body displays the opening and closing prices. Additionally, the color of the candle depicts who ultimately won. Green candles represent a higher close than open, while red candles represent a decline in the closing price from the open.

In the example on the right, you can see that the most recent candle opened at 1.4830, then dropped as low as 1.4820. It then went on to rise as high as 1.4860, and finally settled at the present closing price of 1.4850. This is 20 pips above where it started its journey.

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In this manner, each candlestick tells us a complete story of what happened in the power struggle between bulls and bears during that particular period of time. Also, candlestick charts give us clues about who is growing stronger and who is weakening.

There is a special kind of candle called a "doji" - this is a candle where the open and closing price were the same, leaving the candle without a body at all. These candles look like a "+" and represent a moment of consensus - an agreement between buyers and sellers in the market, but also a moment of indecision as to the next direction.

In the chart to the left, you can see the bulls' gradually losing strength as the rally comes to an end at the top, as evidenced by the shrinking candle body. Then a doji prints and we begin to see the bears slowly overpower the bulls as price begins to move back downward.

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Timeframes

Each candle or bar on a chart represents a specific time period. This can be 1 minute, 5 minutes, 15 minutes, 30 minutes, an hour, 4 hours, a day, week, or an entire month. The timeframe refers to the amount of time it takes to print one candlestick on your chart.

Both of the charts on the right show the same time period, and the same price movement from 1.4710 up to 1.4840

The first chart is a longer timeframe, where each candle takes 1 hour to form. The second chart is a shorter timeframe, which shows the same move, but in 5-minute increments.

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The timeframe you choose to use depends on the type of trade you want to execute. A long-term trend follower is likely to use a longer timeframe, a swing trader something in the middle, and a day trader or scalper more likely to choose one of the shorter timeframes.

Trading with Multiple Timeframes

One strategy for trading is to use multiple timeframes. In order to do this, you need to first identify the best chart to use for your particular style of trading. This will be your lower time frame. Then choose another chart for the higher one. The goal is to choose two charts that are far enough apart (a factor of 5 or as close to that as possible).

A long-term trader who uses a daily chart as the lower timeframe, for example, may occasionally glance up at a weekly chart as the higher one (since there are 5 days in 1 week). A day trader who uses a 5-minute chart as the lower timeframe would most likely use a 30-minute chart for the higher one (since a 15-minute chart is only a factor of 3, and may not provide a different enough perspective).

On the higher timeframe, you can decide if you wish to be a bull or a bear in regards to that particular currency pair (or you can also decide to stand aside and look for another pair if the market is sideways and showing no clear direction). Then you can switch to the lower timeframe and take entry signals as normal, but only in the direction you decided upon in the higher timeframe. A bull would be looking for long signals in order to buy, while disregarding any short signals. A bear would be looking to sell short and would disregard any long signals.

Trends do change direction eventually, but generally they tend to do so gradually. You can change your mind and choose a different direction, but only on the higher timeframe, not on the lower one. The idea behind multiple timeframe analysis is to reduce the number of false trades and to avoid the temptation to trade randomly in both directions at once.

Support Resistance and Moving Averages

As a price moves up and down on charts, it encounters "barriers" along the way. If a barrier acts like a floor and keeps the price from dropping any lower, then it is known in trading terminology as support. When it acts more as a ceiling and stands in the way of upward moves, it is called resistance.

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What Causes Support & Resistance?

When a price is moving up, it means that more people are buying than selling. These bulls eventually need to take their profits. Likewise, bears that are waiting in the wings and looking for an opportunity to enter short, are more likely to do so the higher the price gets. When the amount of sellers eventually overpowers the buyers, a resistance level is formed (as shown in the illustration above when the price reached 1.4862).

Similarly, when a price is moving down, there are more sellers than buyers. The sellers will eventually need to cover their short positions and take profit. Likewise, if there are bulls waiting to buy, then the lower the price goes, the more tempting it becomes for them to enter into new long positions. Eventually, the number of buyers will overpower the sellers, creating a support level.

Since many traders use pending orders set at a specific level, the same level is likely to act as support or resistance multiple times until it finally breaks (as seen in the example above as we approach 1.4848 for the second time, now to test it as support).

There can be many different support and resistance levels at any given time, and the wise trader tries to be aware of as many of them as possible so as not to be caught by a surprise reversal. As the price approaches each of these levels, it will either break it and go on to the next, or it will bounce and reverse itself.

Moving Averages (MAs)

Additional levels of likely support and resistance can be identified by drawing moving averages. A moving average is simply a line chart that depicts the average value of a series of period.

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There are several different kinds of moving averages. Most are an average of the closing price, though they are sometimes also calculated on the high or the low of the periods being averaged.

When the value being plotted is a straight average with no modifications, we refer to it as a simple moving average. The blue line in the chart above represents a 21-period simple moving average (21 SMA). At any given time, its value reflects an average of the closing prices of the previous 21 candles.

Since the blue line is an average, it is by its very nature slow to respond to sudden movements in price. The red line in the chart above is an exponential moving average for the same 21 periods (21 EMA). Here, there is more value placed on the most recent candles. As you can see, it responds a bit faster to both the sudden drop in price, as well as the rally that follows. Both kinds can have advantages and disadvantages, depending on the situation.

As depicted in the above example, moving averages can act as both support and resistance when a price approaches them. But unlike regular support and resistance levels, they do not remain at one stationary level and can also move on your chart.

Common MA Strategies

People use moving averages in multiple ways. Traders will often check to see whether a price is trading above or below its moving average to decide if they are a bull or a bear (especially on a longer time frame).

As price gets closer to the moving average, traders look closely to see whether it will bounce back away from it or break that barrier, just as with any other support and resistance level. As the price moves further away from its moving average, the trade becomes ever more risky as price is thought to be out at an "extreme" (since the moving average is still an average, logic suggests that eventually it will meet again with the price at the same level).

Some people even use crosses of various different moving averages back and forth over one another to signal entries and exits.

Going Further

Advanced tools that can help us identify other likely support and resistance levels include pivot points and Fibonacci retracements and extensions. The common factor among all support and resistance levels is their likelihood to either break or bounce when the price reaches them, which is why it pays to be aware of them.

Avoiding False Breakouts: the Re-test

When the price breaks below a trendline that has been acting as support, it will typically come back up to test that same level again - but this time as resistance. The best short entries are not taken on the initial break, but rather on the second move downwards, following this "re-test" of the level in question.

A successful re-test is defined as a candle body closing outside that level. In the example below, we can see that price broke below the support, failed the first re-test as resistance, and then continued to successfully pass on the second attempt. This pattern is also known as a "good-bye kiss".

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The same scenario can be reversed when the price breaks above a trendline that previously acted as resistance. In this case, we look for that same trendline to be re-tested as support prior to taking a long position.

The Trend line Break System

One of the simplest trading systems can be formed simply by using trendlines. In an uptrend, we connect the bottoms of the candle bodies. If we are long from before, we look to exit the trade as soon as the price breaks to the downside. If at the moment, we are absent from a trade, then we may think about taking a short position at this point.

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Similarly, in a downtrend, we connect the tops of the candle bodies. If we are short from before, we look to exit our trade as soon as the price breaks to the upside. If we are not yet in a trade, we may consider taking a long position at this point.

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Trends and Trend lines

There are three directions that trends can move in: up, down and sideways. An uptrend is defined as having higher highs and higher lows. Similarly, a downtrend is defined as having lower highs and lower lows. When a trend moves sideways, the price is said to be in a range.

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Trendlines

Trendlines are created by drawing lines connecting the tops of support levels, as well as the lows or resistance levels. As shown in the Uptrend and Downtrend examples above, the highs and lows are used to mark support and resistance.

By connecting the prior tops and extending the line, traders can get an idea of where the resistance is likely to be in the future. Future support levels can be estimated by connecting the prior lows.

As long as price continues to obey these levels, we can continue to trade inside the range. This is under the condition that we remain aware of the other support and resistance levels that may be found inside of the range. The trendlines themselves become additional support and resistance levels.

When the price breaks past the support or resistance levels defined by a trendline, we look to make a trade in the same direction as the breakout. However, as 81% of all breakouts are usually false breakouts, there is a need for caution and an additional step is required to confirm them.

Avoiding False Breakouts: the Re-test

When the price breaks below a trendline that has been acting as support, it will typically come back up to test that same level again - but this time as resistance. The best short entries are not taken on the initial break, but rather on the second move downwards, following this "re-test" of the level in question.

A successful re-test is defined as a candle body closing outside that level. In the example below, we can see that price broke below the support, failed the first re-test as resistance, and then continued to successfully pass on the second attempt. This pattern is also known as a "good-bye kiss".

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The same scenario can be reversed when the price breaks above a trendline that previously acted as resistance. In this case, we look for that same trendline to be re-tested as support prior to taking a long position.

The Trendline Break System

One of the simplest trading systems can be formed simply by using trendlines. In an uptrend, we connect the bottoms of the candle bodies. If we are long from before, we look to exit the trade as soon as the price breaks to the downside. If at the moment, we are absent from a trade, then we may think about taking a short position at this point.

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Similarly, in a downtrend, we connect the tops of the candle bodies. If we are short from before, we look to exit our trade as soon as the price breaks to the upside. If we are not yet in a trade, we may consider taking a long position at this point.

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Indicators part I The Trend Followers

An indicator, also called a study, is a tool that can be used to analyze price movements. Indicators usually fall into two main groups: trend-following and oscillating indicators. Trend-following indicators are the most useful when the price is trending in one direction or the other. Oscillating indicators are useful when a price is consolidating into a range. It is important to know which group the indicator you are using falls into, and to choose the correct indicator for every scenario.

Some common trend-following indicators include:

ADX

The Average Directional Index is a special type of trend-following indicator that can also help a commodity trader decide whether a trend follower is, in fact, the best tool for the job at that particular moment. Trend-following indicators will function best when the ADX is over 30. When it is below 30, then an oscillating indicator may be a better choice.

When the ADX is rising, this indicates that the trend is gaining in strength. When it begins to decline, it is a sign that the trend is losing steam and a trading range may soon develop. Likewise, when ADX begins rising again it indicates that the price is breaking out of its range and a new trend may emerge. However, the ADX only indicates the strength of the trend and does not show the direction in which it is going (up or down).

In the example below, note how the ADX starts off low as the price is trading within a range near the left side of the chart. Then, as the price starts to drop, the ADX rises above 30 to indicate a trend in progress. The ADX also confirms that the trend is over by beginning to decline once again. Then when it finally drops below 30, we find ourselves trading once again in a tight range.

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MACD

Moving Average Convergence Divergence measures the difference between a short-term and longer-term moving average. When the red line crosses above the blue line, it indicates an uptrend and when the red crosses below the blue line, it indicates a downtrend.

Additionally, the green bars (called the MACD histogram) give us an indication of the trend's strength or weakness. Unlike the ADX, they also show us the overall direction of the trend. Longer bars indicate increasing strength and shorter bars indicate decreasing strength.

In the following example, we can see that the red MACD line falls below the blue one as the price begins its move downward. The green bars in the histogram are increasing in length as well, indicating that the down-trend is gaining momentum. When price reverses to move up, the histogram reflects a loss of downward strength. Downward strength resumes as the next long red candle posts on the chart. However, it is important to note that while the price made a lower low, the histogram did not make it quite as far down. This is known as a bullish divergence and indicates that the trend will soon end and be followed by a reversal.

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Indicators part II The Oscillators

Oscillating indicators get their name due to their tendency to oscillate within a range of values. They can signal when a price is at extreme levels and due for a reversal.

Some common oscillating indicators include:

Stochastics

Stochastics consist of a fast line and a slow line, and oscillate between 0 and 100. Levels above 80 are said to be over-bought and levels below 20 are referred to as over-sold. When the red line crosses above the blue, we know that the bulls are overpowering the bears. On the other hand, when the red line crosses below the blue, we know that the bears are beginning to overpower the bulls.

It is best to enter long positions when stochastics first cross above 20, returning from over-sold conditions. This indicates the greatest amount of "room" left for an upward move. As stochastics near 80, we know that we are closer to the end of the move rather than the beginning of it, and may consider staying out of the trade (if not already in it). As the stochastics begin to turn and cross, we are given a signal to close any remaining long positions.

As they cross back below 80 and return from over-bought conditions, we may look to enter short. If the stochastics are closer to 20 than to 80, we may wish to think twice about entering into any new short positions. Once they cross, we would also look to close any short positions already open from before. Then, as the stochastics break above 20, the cycle repeats and we begin looking to enter long once again.

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RSI

The Relative Strength Index is similar in its function to stochastics, except it uses 30 to indicate over-sold conditions and 70 to indicate over-bought.

RSI signals a potential long when it breaks above 30 and a potential short if it comes from above and breaks below 70. In addition, levels above 50 confirm an uptrend, while levels below 50 indicate a downtrend.

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CCI

The Commodity Channel Index is another oscillator but unlike the others it has 0 in the middle and ranges from -300 to +300. Levels above +200 are thought to be over-bought, while levels below -200 are considered as over-sold.

An fx trader can consider entering long when the CCI hooks up from any level that is below -200, or going short when it hooks down from above +200. In addition, if the CCI drops towards 0 but bounces back up from it instead of crossing below, then look to enter long. Likewise, if the CCI is rising up towards 0 from underneath it and then bounces back down without crossing above, that usually signals a potential short. These are known as continuation patterns.