The best chart to use for studying market environments is the bar chart. Bar charts are also the best backbone tool a trader can use, although the traditional interpretation patterns such as pennants and head-and-shoulders are essentially worthless nowadays.
Price charts are simply visual records of price movements. They allow you to see prices over an extended period of time. Each type of chart—bar, point and figure, candlestick, and swing—has its own specific characteristics and advantages. But they all perform primarily as recording devices.
Bar charts are the most popular. They are widely used on FOREX bro- ker/dealer trading platforms and are the most commonly used and discussed in
the literature of the market. Candlesticks are second in popularity, with point and figure and swing charts a distant third and fourth.
A single vertical bar on a bar chart represents the range of prices for a specified period of time, from the highest price during that time period to the lowest price.
Charlie always said, “Keep it simple,” but he could just as well have said,
“Keep it visual.” To be close to the market’s pulse, you need tools directly de- rived from market data; in the case of FOREX, that means prices.
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FIGURE 5.5 Rhythm.
This market has both time and price rhythm. Watch for both types of rhythm, and rhythm for peaks/primary-valleys/secondary (in up markets) and valleys/primary-peaks/secondary (in down markets). Watch for rhythm in all three of your chart price scales.
Futures and option traders use volume and open interest figures to analyze markets. Volume is a continued total number of futures option contracts that have traded during a specified trading session. Open interest is the number of futures or option contracts open at any given time.
Because there is no central clearinghouse for FOREX, currency traders do not have access to these useful tools. It is possible to synthesize volume and open interest using price data. See the FOREX Propensity Index on www.fxpraxis.com.
Volume and Open Interest
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Each time data is translated—for example, to create an indicator—it be- comes more difficult to use. Each translation or conversion also tends to lower the clarity of the information. We all know what happens when a picture or graphic is copied and then the copy is copied again. It loses resolution and eventually you cannot recognize the image itself. The same is true of data gen- erally and market data specifically. See Figure 5.6.
Bar charts typically now indicate the opening price for that time period as well as the closing price. These are represented by small horizontal dashes at- tached to the main vertical bar. See Figure 5.7.
The time period selected for a bar chart may vary enormously. In FOREX, bar charts may be used for time frames of seconds (5, 10, 30), min- utes (1, 5, 10, 30), or even days or weeks. Most broker-dealer trading platforms offer a wide variety of time frames. Properly used, these can be an enormous benefit to the FOREX trader. (See Figure 5.8.) The time period(s) you select for your codex will be determined by your trader profile. The shorter term you trade, the shorter term will be the time frames of your bar charts.
FIGURE 5.6 A Bar Chart.
A bar chart connects the high to the low price on a specified time unit. Bar charts may be used with any time unit from five seconds to monthly or even yearly. Most bar charts add a small horizontal bar to indicate closing and sometimes opening prices.
Bar charts, point and figure charts, and swing charts are all refractive. This means that without seeing the time and price legends, it is impossible to tell a five-minute chart from a weekly chart in most cases. The useful corollary of this is that trading techniques used on one time frame can be used on all others.
This is an important feature of technical analysis and also of great value to the FOREX trader.
Popular Bar Chart Patterns
Traditional bar-chart interpretation looks for specific formations within the chart.
There are many so-called patterns, but the following are the ones most commonly watched for and used. For more information, see Encyclopedia of Chart Patternsby Thomas Bulkowski (New York: Wiley Trading, Second Ed., 2005).
• Head and shoulders
• Pennant
• Flag
• Double bottom/double top
• V-top/V-bottom
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FIGURE 5.7 A Completed Bar.
Many traders find value in the relative locations of all four values: high, low, open, and close. The relationship between open and close is especially well scrutinized, and a variety of indicators have been designed to analyze their relative values.
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I do not recommend trading using these patterns as they are too popular and the market tends to anticipate them, which prevents them from working very well. It is useful to watch for them if only to know what many other traders might do in reaction to them.
These patterns are very well known because they have been popularized over many years in many books and other market instruction. For this reason I do not believe they are effective over the longer term. You may certainly find one that works according to plan, but for each one that works, several will fail.
As an example, see Figure 5.9.
Traditional bar-chart patterns also tend to be backward-looking, and the markets are always forward-looking. If you look at a bar chart, you will easily see many of these patterns after the fact, after they have been completed. Those won’t help you make a successful trade; it’s too late! Keep in mind the differ- ence between a tool being descriptive or predictive. A descriptive tool is not much use unless you have a time machine.
Figure 5.10 shows a bar chart pattern. But hold a piece of paper over the chart and then move it one time frame at a time to the right (as prices progress).
At what point would you execute a trade based on the pattern visible so far? Re- member, you haven’t seen the entire pattern because it hasn’t yet formed.
Daily Weekly Monthly
FIGURE 5.8 Time Frames.
Time frames, or time scales, are a very valuable tool to the currency trader.
Each gives a different perspective on a market, and the relationships between the frames are useful. Typically you will select markets off the middle frame, and use the larger frame for long-term perspective and the smaller from for entry and exit timing.
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FIGURE 5.9 Failure of a Bar Chart Formation.
The two circled points connected by the horizontal sloped line is the
“neckline” of a head and shoulders formation. According to the theory, once the neckline is broken by downward-moving prices, a sharp downward trend will continue. Often, however, prices will break the neckline, only to head back up.
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FIGURE 5.10 Descriptive or Predictive?
This trend line appears to be very tradable. But was it predictive or simply descriptive?
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If you review a large number of charts you will see many head and shoul- ders formations that worked. The problem is these patterns tend to be descrip- tive rather than predictive. To accurately measure reliability cover a chart with a plain piece of paper, then move it one frame at a time and attempt to predict a head and shoulders. Your results will differ substantially! Beware of tools that are descriptive (you can see them work after the fact) but are not predictive.
The codex approach does not use these patterns, but it is useful to be able to recognize them. In Part Three I show you how the codex trader uses them to their greatest effectiveness.
Another issue with traditional patterns is that because so many traders follow them, they simply cannot work. The market will not let them work or else everyone would win, which is impossible.
I once acted as an expert on an Internet FOREX forum. The moderator gave me the boot because my ideas about chart patterns were not mainstream.
But mainstream doesn’t win in the markets—stocks, futures, orFOREX.
In the old days, traders created their own bar charts by hand. This was very time consuming but it also had advantages. The very act of making the chart helped the trader tune in to the markets. Because you will be trading multiple markets with very short time frames this is, unfortunately, a luxury no longer affordable.
My mentor, Charles B. Goodman, used what he called bathtub analysis. He would take a book of charts into the bath and analyze them. By analyze he meant asking questions, making hypotheses, and testing them. If you don’t look for something, you can rarely find it. On the other hand, if you test for even the wildest hypotheses you will often find yourself hot on the trail of something very useful.
Be sure to cover charts with a plain piece of paper and move it slowly to the right to duplicate the market as it happened.
Bathtub Analysis
All the major FOREX broker/dealer trading platforms offer customizable bar charts. You can keep multiple charts on multiple pairs with multiple time frames!
This advantage easily surpasses any to be had from drawing your own charts. Most of the charts in this book are from the Intellicharts FxTrek service, www.fxtrek.com.