Candlesticks and Ichimoku Strategies

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Candlesticks and Ichimoku Strategies


part 1



INTRODUCTION


Ever since the rapid development in internet world, online trading in foreign
exchange is getting more and more popular, with narrower spreads provided by
majors internet brokers, countless numbers of investors have been attracted to
participate in day to day forex trading.

Methods used by individual investors to analyze the forex markets and make
trading decisions include fundamental analysis and technical analysis. In view of
the enormous trading volume (way beyond all stock markets of the world, forex
markets trade about US$ 4 trillion per trading day), we believe the forex market
is a perfect place (some consider the forex market as the closest example of a
perfect market condition described in economics) to apply technical analysis to
enhance your trading profitability.


you will learn basic technical analysis techniques such as trend analysis, pattern recognition and Fibonacci percentage of retracements and projections. In addition, focus is on two technical charting tools both invented by Japanese people, the Candlesticks and the Ichimoku Kinko Hyo. These two methods works amazingly well in forecasting the market movements especially in recent very volatile market condition.

We will use recent examples in describing how to use these tools to formulate
objective trading strategies.

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CHAPTER 1


Chart Analysis in Currency Trading

1.1 - Importance of chart analysis in currency trading


Basically, there are two major types of analyzing methods in predicting price or
movement of currency in the forex market, i.e. Fundamental analysis and
Technical analysis / chart analysis. Fundamental analysis involves the studies of
the economic conditions of the country, for example the balance of trade, current
account, GDP, unemployment rates and inflation index, government monetary
and fiscal policies, interest rates, even social and political forces. Some investors
rely on their analyses on these economic indicators, news and announcements to
set their trading strategies.

Whilst we must admit that all these financial and non-financial factors are the
actual reasons behind most the long term currency fluctuations, in other word is
the reasons or causes about the movements, when it comes to short-term day to
day trading, the role of technical analysis becomes much more important (and
what is actually the reason does not really matter). In technical analysis, traders
make forecast of price movements or future market directions by studying
various types of charts of past market actions, the purpose of technical analysis is
to identify a trend in its early stage so as to trade in the direction of that trend.
Technical analysis is a very powerful method of forecasting, as the analyst is not
influenced by prevailing market sentiment and he can make a more objective
judgment of which way and how far the price is likely to move in the future.

Since forex market is the largest financial market in the world and is also highly
leveraged, even minor price movements can have a dramatic effect on your
trading performance, so traders need some effective plans and methods to set
precise entry and exit points and this is also another very important aspect in
technical analysis. By using certain technical indicators (e.g. moving averages or
Ichimoku) and calculation techniques (e.g. Fibonacci percentage of retracements
and projections) when formulating his/her trading strategies, one can identify
more objective levels for setting entry, exit and stop-loss prices, which
fundamental analysis is not capable of in providing such levels.

In short, technical analysis is not only an effective method in price-forecasting
process helping traders to predict future market directions, it is also an
indispensable analysis technique in order to find clear and precise timing and
level of entry and exit in day to day trading, therefore, chart analysis or technical
analysis is a very valuable principle in formulating trading strategies.

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1.2 - Basic chart analysis


Chart analysis also known as technical analysis is the study of market action, by
using price charts (e.g. line chart, bar chart or candlesticks chart) to examine the
past movements and level of supply and demand in the underlying market, to
forecast future price direction or trend. Although technical analysis cannot tell
you what are the reasons behind the moves (as it really does not care about the
so-called value of the underlying product), it is a useful tool to help investors to
predict where the price of certain stock or currency pair will move.

Whilst there are so many different types of technical analysis methods, such as
chart patterns, technical indicators and oscillators, candlesticks and wave theory,
all technical analysis philosophy are utilizing history price and volume data in
order to study the supply and demand, hence in the field of chart analysis, it is
based on three assumptions:

1. The market price discounts everything

Some people consider technical analysis is simply a short cut form of
fundamental analysis as it assumes that all relevant information (e.g.
fundamental factors of a country’s economy) is already reflected in the price
actions, most die hard technical analysts believe it is just not necessary to
analyze the fundamental factors as at any given time, the overall economic
elements and market psychology are all discounted into the past movements in
price, which makes the job of studying fundamentals redundant and just pay
attention to the relationship between the supply and demand will be enough.

2. Prices move in trends.

Chart analysts believe that price movements follow trends, markets tend to trend
up, down or sideways, therefore, one major task in technical analysis is to
identify the market trend at an early stage as once a trend has been established,
the future price movements are more likely to be in the same direction as the
prior trend than the opposite.

3. History Tends To Repeat Itself

As all the participants in the financial markets are human, technicians also
believe that it is a human behavior that they collectively repeat what action they
took preceded themselves. Since investor behavior repeats itself so often,
chartists tend to think that certain chart pattern will develop and end with
similar result. For example, after a continuation pattern is formed, the previous
trend will resume in the same direction due to the repetitive nature of price
movements and market participants tend to make a consistent reaction to
similar market stimulations over time.

In short, technical analysis or chart analysis tries to understand the emotions in
the market by studying past price action instead of the cause of the movements.

There are numerous technical analysis methods but after discussing some basic
charting tools like trend analysis, support and resistance, pattern recognition, we
will keep our focus on the application of Fibonacci retracements and projections;
use of Candlesticks chart pattern; the Ichimoku Kinko Hyo and finally how to
put them all together to form an objective trading strategy in order to enhance
profitability.

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1.2a) Trend analysis

There is a very popular phrase that investors use in the financial market - “Trend
is your friend”, so one can see the importance of identifying the market trend.
Actually, this is one of the most basic yet essential concepts in chart analysis, in
fact the concept itself is quite simple and easy to understand. In general, there
are 3 major types of trend and they are:

Uptrend:

A series of higher highs (each successive peak/resistance must be higher than the
preceding one) and a series of higher lows (each successive trough/support must
be higher than the preceding one).




Downtrend:

A series of lower lows (each successive trough/support must be lower than the
preceding one) and a series of lower highs (each successive peak/resistance must
be lower than the preceding one).




Sideways

A sideways trend (aka horizontal trend) is in a certain period of time when price
traveling between levels of support and resistance.



Whilst it is quite easy to understand the concept of trend, one must keeps 2
things in mind in trend analysis: To identify the market trend at an early stage,
get in as soon as possible and stay with the trend as long as possible.

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To identify your own trading time frame.
Let us look at the following chart:



From point A to point B, this is an obvious uptrend, with a series of successive
higher highs and higher lows, a short-term or intra-day trader might look to
enter a long position once the uptrend is detected (most likely after the second
set of high and lows were formed). Having said that, the above chart is an hourly
chart and if we look at the daily chart below:



The co-called uptrend on the previous chart is merely a rebound in a major
downtrend (last for almost a year) and a position taker should use this as a
selling opportunity to join the subsequent selloff which brought cable to as low

as 1.3500.

Therefore, it is very important for a trader/investor to identify his/her own
trading time frame so that he/she can select the appropriate chart for doing
analysis.

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A short-term player who takes position once or twice a day and may run position
for a day or longer shall focus on an hourly chart, as this chart will cover the
price action over last 1-2 weeks and use daily chart to identify the market trend.
Whilst for an intra-day trader, he/she may use the 15 minute chart to analyze the
market and use hourly chart to decide the major trend. For long term investors,
one shall focus on weekly and monthly charts to spot long-term trends and
forecast long-term price movements. We highly recommend one should use the
approach of combining a long-term and short-term charts (a multi-time frame
approach) as the long-term charts can provide a broader perspective of the
historical price movements whilst the more near term chart can be used to fine
tune the entry and exit levels.

1.2b) Support and Resistance

There are many tools available to help in identifying the market trend, some of
them can also assist in pre-empting a change in trend. One of these tools, which
is perhaps the simplest and most valuable one, is trend line. However, before we
go into details of the use of trend line, one must have a better understanding of
the concept of support and resistance.

Support

A support is a price level where buying interests (demand) exceeds selling
pressures (supply), when price is going down, decline shall be contained here
and price tends to find support and is more likely to rebound off this level
instead of breaking it. However, once this level is broken, i.e. supply exceeding
demand, then the fall should continue until it finds another support level.

Resistance

A resistance is the opposite of a support. It is a price level where selling pressure
(supply) exceeds buying interest (demand), when price is moving higher, rise
shall be capped here and price tends to meet obstacle and is likely to retreat from
this level rather than breaking it. However, once this level is penetrated, i.e.
demand exceeding supply, then the upmove should continue to head north until
it finds another resistance level.

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Understanding support and resistance levels

The more often a support level or resistance level is tested (but not broken), the
stronger and more significance is this particular level.

The more recently the support or resistance level is formed, the more important
is the level in terms of impact on the subsequent market movements.

Support and resistance levels reverse roles once they are broken. If a price drops
below a support, that level often turns into a new resistance level and vice versa.
The logic is that the break of support signals the supply have overcome demand
and therefore, if the price bounces back to this level, there is quite likely to see an
increase in supply, and at the same times those who have bought before the
support was broken tend to look to square their position on such a move, hence
increasing supply as well. Similar principle also applies to the concept of
resistance turning into support.



Not only a support can turn into a resistance as you can see in the chart above, it
could also apply to support line and resistance line. By joining several resistance
points, one can get a resistance line and once this line is penetrated, it would
turn into a support line.

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Trendline

One of the basic assumptions in Technical Analysis is that prices move in trend
and the use of trendline is an important tool in chart analysis not only to
indentify trend but also to pre-empt a change in trend.

A trendline is a diagonal straight line formed by connecting two or more price
pivot points (support or resistance levels) and then extending it into the future
(right limit of the chart). An up trendline occurs in a rising market with a
positive slope and is drawn by joining the support points whilst a down trendline
appears in a falling market with a negative slope and is drawn by joining several
resistance points. The more pivot points that the trendline is connected with; the
stronger is this support or resistance line going to be.

Resistance trendline (Down trendline)



Support trendline (Up trendline)



One function of trendline is to track the trending move, therefore, one can use it
to estimate entry and exit timing as up trendline and down trendline provide
support and resistance respectively, hence one can use an up trendline to join the
upmove and put stop-loss below the line. It is quite common to use a break of
trendline to indicate a change in direction, e.g. a break below the up trendline
signals the condition of increasing net demand (demand exceeding supply) has
altered which inevitably imply a change in trend is imminent.

In the above chart, it illustrates another feature of trendline is that once the
support trendline is broken; it would also become a resistance line and vice versa
for a resistance trendline.

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1.2c) Pattern Recognition

One very traditional use of technical analysis is the chart patterns which can be
categorize in continuation patterns and reversal patterns and they all have
predictive function.

From time to time, market forces of supply and demand struggle among each
other, basically the chart patterns is a pictorial record to reveal all buying and
selling activities and the patterns show the relationship between the various
support and resistance. By studying different patterns, one can gauge which side
of the forces, bulls and bears, is winning, hence help to predict the next possible
direction.

Chart patterns are extremely useful and essential to keep investors or traders on
the right side of the market and can be used in both short term and long term
forecasts. There are 2 major types of chart patterns:

Continuation patterns

A continuation pattern usually represents temporary pauses in the existing trend
and most likely the pattern will end with a resumption of the previous direction.
In general, continuation patterns take less time to form when comparing to
reversal patterns, however, it is more common to see continuation patterns than
reversal patterns (along a trend, there could be several continuation patterns
whilst only one or maximum two reversal patterns will appear).

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There are several commonly found continuation patterns, including triangles,
flags, pennants, rectangles and the triangle pattern is considered the most
reliable among the other continuation patterns. There are also few different
triangles named according to their appearance, they are symmetrical triangle,
ascending triangle and descending triangle, here we would focus on the
symmetrical triangle.

Triangle

The symmetrical triangle normally forms during a trend and is exhibiting a
temporary pause of the prevailing move which will eventually continue on its
existing direction. The pattern is characterized by a contraction in price range
and there are usually at least two lower reaction highs and two higher reaction
lows inside the pattern, hence when these resistance points and support points
are connected, the lines converge which shape up as a the symmetrical triangle
with the widest part at the beginning and narrowing over time.

During the formation of the pattern, sideways trading takes place with price
fluctuating between the two contracting lines, the resistance line and the support
line. In a downtrend, the support line becomes the signal line or the trigger line
whilst in an uptrend, the resistance line becomes the signal line. Once this line is
broken, this would confirm the end of the formation and price should head
towards the direction of the prevailing trend.

The time of this breakout should ideally occur between the 50% to 75% of the
time span of the entire pattern (i.e. horizontal distance measuring from the start
of the pattern to the point where the 2 lines meet at the right, the apex), the
timing of the breakout will affect the subsequent impact, if it occurs before
halfway, this means it is too premature (not enough time for the formation). If
the breakout takes place too close to the apex, then it may be an insignificant one
and the effect tends to be limited.



In a downtrend, once the support line (aka signal line) is broken, this provides
an early confirmation of the resumption of the decline.