Forex Journal

Trading is simple but it is not easy.  For 2011, the foreign exchange markets became particularly hard on those who do not use technical analysis. Unlike 2007 through 2010 when the markets were trending for long periods of time mostly against the U.S. dollar, 2011 saw some wild swings in most all of the major cross rates.  Only the Japanese yen and Swiss franc remain strong but even they had some wild swings particularly the Swiss franc, which was effectively devalued by about 20% by the Swiss National Bank in early August 2011. 

The age-old question of which is better – technical analysis or fundamental analysis – will probably be with us in the foreseeable future, if not forever.  For some reason, investors do not trust charts.  It has only been within the last 12 years or so that more chart patterns are being illustrated in the financial press across the globe.  In this article, we are going to explore several techniques that can be used in the Forex market as well as futures markets, stock markets and bond markets. 

We selected the U.S. dollar because so much interest has been focused in Forex over the past decade. Forex is a relatively new market to the public although it has been around for many years. The Forex market offers the epitome of liquidity, volatility and leverage making it arguably the best trading vehicle on the planet. 

We are going to break the chart down into three technical components. First, we are going to explore pattern recognition. Next, we will look at the ratios of the Fibonacci summation sequence. Third, we are going to examine how the use of cycles can be implemented in the Forex market.

Pattern Recognition

In April 2000, Dr. Andrew Lo from the Massachusetts Institute of Technology wrote a paper about the advantages of pattern recognition. The article appeared in BusinessWeek on April 17, 2000.  The article received a great deal of attention in the United States and later Dr. Lo published a book entitled The Non-Random Walk Down Wall Street.  In this epic book, Dr. Lo proves the value of pattern recognition by looking at over 800,000 patterns over 32 years of the U.S. stock market. His work empirically proves that pattern recognition is a leading indicator because it is predictable within limits and it repeats in regular intervals. Armed with these two features, pattern recognition can be a powerful tool in the hands of the technician for Forex trading. 

The first pattern we are going to look at is the ‘lightning bolt pattern’ commonly referred to as the AB = CD pattern. This pattern is an integral part of all price charts and the reason behind it is quite simple. Prices can only move in three directions – up, down, or sideways. It is the job of the technician to determine what the trend is by looking at higher highs and higher lows or lower highs and lower lows.  

The chart in Figure 1 is the USD/JPY and it shows this pattern over a one-year timeframe illustrating its use. Starting at the January top the market completes a high followed by the AB = CD pattern completing in May of 2011. What is interesting is that the CD leg of the pattern was exactly 1.618 in price of the AB leg. Following the bottom in May, the U.S. dollar rallied for several months completing another lightning bolt pattern i.e. ab = cd. There are many of these lightning bolt patterns throughout the chart. However, in order to keep things simple, we want to highlight the ones that define the trend best for 2011. 

The Gartley pattern which is a combination of the thunderbolt pattern i.e. AB = CD along with a longer swing to get a selling point or a buying point. H.M. Gartley described this pattern in his 1937 classic book, Profits in the Stock Market. He spent a great deal of time describing this pattern because he felt it was not necessary to pick a top or bottom in the market, but rather wait for the first correction after the top was in and then be in a selling position. The exact opposite is true for the buying position. The Gartley pattern is nothing more than the AB = CD pattern coming at a lower level in the sell position and at a higher level in the buy position 

Fibonacci Ratios

This area of technical analysis is probably the most misunderstood. There are many numbers within the Fibonacci summation series. In order to make the tool usable, we feel it is necessary to limit the number ratios that you use when trying to define market movements. For the contraction ratios, we use 50%, 61.8%, and 78.6%. For the expansion ratios we use 127% in 1.618 percent. This narrows down the decision-making process and gives a better indication of how to keep a seemingly difficult concept from getting out of control. When markets contract, we look for the retracement patterns and when markets expand we look for the expansion numbers on the upside. It is important that you have a combination of numbers i.e. swings from different ratios to give you points where you believe the Forex market is ready to turn. 

This is an excerpt from Dec 2011 issue of Forex Journal.