An Introduction to Technical Analysis Beginner Level Objectives

At the completion of this module, you will understand: The basics of technical analysis including charts and market trends Support and resistance levels Various indicators including MA, MACD, RSI and Stochastic Oscillators Please do not hesitate to contact one of our sales staff should you have any questions.

Introduction
Technical analysis is one of the most common tools used by traders in monitoring, analysing and trading the markets as it confines itself exclusively to the study of either market price action or volumes. This module aims to introduce you to the markets and to an alternative form of financial market analysis. It is not designed to turn you into a market analysis guru or gun trader. It is designed in as quick a timeframe as possible to show the various avenues for further self development that are required to improve ones analytical and trade planning.

Introduction to technical analysis

What Technical analysis is not about:
As with many things to do with financial markets, the name technical analysis sounds like other forms of analysis presented to observers and participants of the matters. Careful! There are many forms of analysis and they are not all the same. Do not confuse technical analysis with forecasting or for that matter economics or fundamental analysis. Technical analysis is none of these. Technical analysis confines itself exclusively to the study of either market price action or volumes. Therefore any analysis which relies on anything else to form a view on the financial markets or prospects is NOT technical analysis and beyond the scope of this session and indeed technical analysis in general. It goes without saying, like all life and behavioural sciences, it is not perfect. Not all patterns will work to plan, indicators do not have a 100 per cent success ratio, trade plans are not perfect and come to think of it, neither are analysts!

Types of price charts available

Price charts are the essential tools in the technical analysis of a market price, and the ability to form a view from observing a price chart is a critical skill in the technical analyst and dare it be said also of the trader in preparing a well reasoned trade plan. The main and generally accepted charts in use are presented in the following examples and include: :: :: Bar charts Close only

:: :: ::

Japanese candle sticks Point and figure Market profile

Bar Charts are the most familiar, common and popular market price charts and are universally available from data vendors and software providers. Each plotted bar represents the combination of the opening, the highest price of the day, the lowest price of the day and the closing price plotted on a graph with vertical axis representing price magnitudes and the horizontal being that of time (periods), usually (but not always and not necessarily) daily time frames. Theoretically, then a daily bar would be shown thus:

figure 2.1 An example of a daily bar The difference between the highest (price high) and lowest price (low) is also known as the range of the day. Note some bar charts may not have the tick on the right hand side of the range (ie they may not show the days opening price), this is still a legitimate bar chart presentation of price action, as shown in figure 2.2 next page. Close only (or line charts) is the simple plotting of the period closes. The following example shows the bar chart example as a line chart.

figure 2.2 a practical example of a bar chart Euro v USD

figure 2.3 A practical example of a line chart Euro v USD Japanese candlestick charts are a form of graphical technical analysis popular in Japan for the last 400 years or so. It only became popular in the West in recent decades. It is fundamentally similar to bar charts in that generally each bar is presented as either a white (so called Yoh) or a black (Inn) candle stick, depending on whether the open is above the close (Inn) or below the close (Yoh) of the same period being measured. The so called main body or wax is the portion of range of the day between the opening and closing price that is either coloured white (Yoh) or black (Inn). The other aspects of the range are called shadows. Many of the techniques and conclusions of bar charts overlap greatly with the Japanese candlesticks with some nuanced differences. Here we introduce the chart form for your information and as a first point for your further study. Like bar charts, the length of the bar (or stick) will be dependent on the traded range of the day, while the size of the wax will be dependent on the distance (if any) between the opening and closing price, and the colour of the wax will be in respect of their high and low combination. The following example shows the previous bar (and line) chart example presented in Japanese candlestick terms. As you will notice from the Figure 2.4, the pattern impression should in theory be little different from a bar chart (as indeed it appears) and with the added advantage that it allows the reader to see (via the colour coding of black and white bars) the sequence of otherwise bad or good trading days for price. Point and figure charts are a peculiarly different way of representing price in that unlike all the other chart forms mentioned here, it is the only price chart method where time is ignored. That is to say, the chart it presents is pure price action. It is particularly suited to short term traders with whom timeframe distinctions have little importance to their analysis or trading.

It attempts to track only significant moves (and turns) in price. It does this by filtering price. The chart does this by restricting prices to be tracked by a minimum box size. (A box size being a given magnitude in price). A sequence of rising prices is denoted by a vertical x column, where as a sequence of declines in price by a vertical column 0. Changes in direction in price by more than one box magnitude then necessitate a change in column type, be it from X to 0, if price moves from falls (by more an a box price magnitude) after a series of rises or alternatively 0 to X, where price has risen after a series of falls. If price does not move by this minimum (box) move, it is simply not recorded. Indeed if price does not move beyond the minimum box size, then regardless of the time frame, nothing would be recorded. Thus, the focus of planning and analysis is on moves of concern (and not anything smaller). 2 Murphy, J.J. Technical Analysis of the Financial Markets, (2nd ed) New York Institute of Finance, New York, 1999, pp.297317. For starters!

figure 2.4 a practical example of a Japanese Candle stick chart Euro v USD figure

2.4 a practical example of a point and figure chart Euro v USD By ignoring the component of time and thus the traditional frames of reference for most analysts and traders, this form of analysis becomes a highly specialised form of analysis. Due to the nature and scope of this module and in the interest of time, this is best left to study later when one is firmly acquainted with the traditional bar chart or Japanese candle sticks. The Market Profile method of graphical analysis is a highly specialised technique in the field of technical analysis and is best approached when one has familiarised oneself with conventional price chart forms mentioned previously. It will be referred to in a later session and for those who are interested, there is a reference to the seminal work in the footnotes. Note the examples to be used in the course notes will rely mainly on bar charts for educational purposes. They should not be viewed as the only method as this module is purely an introduction to technical analysis.

Timeframes for FX, stocks and commodities

In these course notes a lot of the examples we present are as daily charts for analysis. Nothing in these course notes should be read as preventing you from using technical analysis techniques for smaller (eg hourly or five minute or even tick data) or larger time frames (eg weekly and monthly). Ideally the good analyst and/or trader will use these charts of different time frame in combination. Each particular time perspective of a market price gives a unique insight to the prices magnitudes of trend, range and risk characteristics of a particular time perspective AND price range perspective.

figure 3.1 a five year bar chart Euro v USD notice the uptrend between 2002 and 2005.

Take for instance the case of the Euro v USD chart. If one was to take a five year perspective in figure 3.1, one would notice it has in the last 23 years been in a pronounced uptrend of an approximately 50 big figure magnitude (approx 0.8650 to 1.3650. (We will explain what an uptrend technically is in a later section). But if one were to look at a one year perspective (in figure 3.2), one will notice it had gone up to a peak near 1.3650 in December 2005 and had since come down, establishing a sideways range above 1.2655. Logically the Euro cannot be going up and down and sideways all at the same time. However, in technical analysis, it is possible to have several timeframes giving the same or a different analytical conclusion as to direction in its own timeframe compared to other frames. In the examples above, we could have gone further and have examined hourly charts as well to obtain a possibly different conclusion again.

figure 3.2 a one year bar chart Euro v USD notice the sideways range since March 2005, above the 1.2655 level.

For our purposes, it is sufficient to note that, at the time of writing, the Euro had done the following: 1. Shown a weekly up trend in motion since early 2002 of a 50 figure magnitude and 2. Temporarily peaked in March 2005 3. Shown that the daily trend since then has been to a 7 big figure range sideways roughly bounded by the 1.1750 level on the lower side and 1.2450 on the upper side in a range 4. Shown that it is possible for a market to have several (often contradictory) trends occurring simultaneously (if viewed from several perspectives of different price and/ or time frames). In this introductory discussion of timeframes and their interlinking nature, be aware that an analysis of trends is critical to arriving at a technical view of the markets in different timeframes. We will discuss this in the next section.

Trends key to direction and winning

As Murphy says, the concept of trend is absolutely essential to the technical analysis of market price action3. If you dont know the trend of price, failure in your analysis and trading is guaranteed. Trend recognition is a key reason for both graphical and mathematical analysis and a critical ingredient in the success of any trade plan. The basic definition of an uptrend is simple, but rigorous. It is simply a succession of higher highs (or Peaks) AND higher lows (or Troughs). See figure 4.1 for a theoretical graphical representation. An uptrend is considered intact as long as the substantial reactions (or price dips) against the uptrend terminate at higher levels (lows) than previous reactions. This can be seen in a practical example in figure 4.2 with the weekly uptrend in the Euro (since early 2002) showing a steady progression of higher highs and higher lows. As at the end of the chart we can conclude then technically that the uptrend for the Euro v USD is in fact intact.

figure 4.1 Peaks and Troughs in an Uptrend

The basic definition of a down trend is also simple, and it is rigorous too. It is simply a succession of lower highs (or Peaks) AND lower lows (or Troughs). See figure 4.3 for a theoretical graphical representation. A down trend is considered intact as long as the substantial reactions (or price rally/rises) against the prevailing down trend terminate at lower levels (ie a lower high) than previous reactions as shown. This can be seen in a practical example in figure 4.2 with the weekly uptrend in the Euro (up until mid 2008) showing a steady progression of lower highs and lower lows. As at the end of 2001, (not the chart as a whole), we can conclude technically that the (then) down trend for the Euro v USD was intact. You will note that from the same weekly Euro v USD chart in this section we have been able to observe (in sequence) a downtrend market and an uptrend market. This is a perfectly natural occurrence and should be remembered, no trend lasts forever, and that a good technical analyst, must be prepared to change his/her outlook and view if market price action suggests. The actual criteria and definition of how a market turns from one trend to another will be covered in another module. For our purposes, it must be remembered that in order to be successful in analysis and planning, one must critically get the trend right!

figure 4.3 Peaks and Troughs in a down trend 3 Murphy, J.J. Technical Analysis of the Financial Markets, (2nd ed) New York Institute of Finance, New York, 1999, p.49.

figure 4.2 Peaks and Troughs in an up trend a practical example Euro v USD

figure 4.4 Peaks and Troughs in a down trend HBOS

Support and resistances

Cornerstones of Technical Analysis
In the previous section it became clear that in order to ascertain the trend structure of a market price we needed to identify key peaks and troughs in a trend sequence. These peaks and troughs have a more technical name (and meaning) in technical analysis. They are respectively called support (troughs) and resistance (peaks). The concept of support and resistance are central to understanding the graphical interpretation of market price action. Thus the theoretical trend figures in section 4 are replicated in figures 5.1 and 5.2 with the new technical names of the normally observed price trend phenomena of peaks and troughs.

figure 5.1 Support and Resistances in an up trend

Support, as the name implies indicates a price level or area on the chart under the market price where buying interest is sufficiently strong to overcome selling pressure and to push price action back up to higher levels. As a result, a decline in price is halted and prices are turned back up again. Resistance is the opposite of Support. It represents a price level or area above the current market price where selling pressure can or is likely to overcome buying pressure and which would turn back (down) a price uptrend or advance. It should be emphasized that a prior high does not imply that subsequent rallies will fail at or below that high with pin point accuracy, but rather that resistance can be anticipated in the general vicinity.

figure 5.2 Support and Resistances in an down trend

Practical Rules for finding Support and Resistance:

It is probably dawning on you by now that the central task of finding and defining a support or resistance is not so easy in this discipline of technical analysis. It is the method of determining what critical prices define the trend (or range) structure and are more important over and above other prices in the technical analysis of price and (importantly) in the minds of participants in the markets. Fortunately it is not as artistic as some would fear. There are guides and rules for determining the legitimacy (and strength) of a price level irrespective of whether it is a support or resistance. These include: Times tested where a price level has been tested (traded) at or near several times, it tends to be remembered by participants and traders would tend not (for instance) to sell into a low or trough. Volume spent following on from the above point, if large amounts of volume has been transacted at/near a certain level; this too tends to be respected and noted by traders and participants in the market. Recent trading it goes without saying that the more recent the trading at a certain level, the more relevant is the level to an analysis of market price.

Round numbers for reasons more to do with psychology than anything else, traders (and people in general) tend to remember round numbers. Resistance Support Support Resistance Let us now show some examples of support and resistance in figure 5.3 of the NZD v JPY. As a separate exercise, you should try this out on your own market chart. Can you find the major support and resistances of your market?

figure 5.3 Support and Resistances in the NZD v JPY.

Technical Uses of Supports and Resistances

Any student of technical analysis must be made aware that support and resistance determination is not just a descriptive exercise. Defining support and resistance forms the backbone of ones trading and investing framework when approaching the markets. It is not an academic exercise. Real money (and risk!) is applied to the analysis conclusions. Some of the practical uses (and these points should be taken as starting points, there are many more uses which space does not allow here at the moment), include Take profit. Area towards which one takes profit on a position. That is, as price approaches a support (from above), short sellers should take profits on their positions. Conversely as price approaches a resistance (from below), long traders should have a tendency to take profits. :: Establish a new position (near an unbroken level), When price approaches the support level, a technically driven trader would tend to pitch buy orders near and above a defined support and conversely would pitch selling orders near and just under resistance levels. :: Establish a new position (on a break of a level). When a support breaks, one can initiate a short position (in the technical expectation that prices will then go onto the next (lower) support level. Conversely, should a resistance break, one should buy in the expectation that prices will move on to the next (higher) resistance.
Stop Loss setting. A breach of a level (and analogous the bullet point above) can be used to limit loss. Rather than using a break of a support or resistance level as an opportunity to establish a new position, can also in this case be used to avoid loss, a losing position should be immediately exited. The signal as such coming from the breach of the support or resistance. :: Once broken, they reverse roles. This is a key aspect of support and resistance identification. In that once a level identified (whether support or resistance) is broken, the technical characteristic of the level is reversed. That is, a broken support now becomes a resistance and a broken resistance now becomes a support. Note we can observe

this happening in the case of figure 5.3 where participants should be able to see that the 77.30 area acted as a support November 2006Aug 2008. The uses outlined above will become clearer in the next section of this module. Suffice to say that the importance of support and resistance identification (particularly in graphical analysis) is critical to analysing the technical conditions of market, and from there to framing an appropriate plan of approach and trading. You cannot do enough exercise in this field of technical analysis (often neglected in a world dominated by computer screens and mathematical trading formulae). Those wanting a deeper understanding of this aspect of technical analysis should read the book Technical Analysis of Stock Trends4 by Edwards and Magee, (Dont be put off by the title if you are not a stock trader or analyst), the methodology applies to ALL markets and forms of graphical technical analysis.

Technical analysis in ranges

Sketching out the plan
Once we have worked out the basic trend of price and important support and resistance price levels, then we can begin the next step sketching out the plan. A good place to start is with your initial support and resistance levels around the current market price. This is often called the range. Let us see how technical analysis can transform ordinary action into a framework for trade planning and decision making.

figure 6.1 An example of a generic range price pattern

4 Edwards,

R.D & Magee, J,Technical Analysis of Stock trends, (5th ed) John Magee Inc, Boston, 1966. (This is a classic specifically of graphical technical analysis and there are more recent reprints and editions of this text and is highly recommended for the library of any student of technical analysis).There are of course many texts that go into equal detail see the back of the course notes under references for details of where to start.

The first step is to identify the support and resistance that bound our current and recently observed price action. (This material we covered in topics 4 and 5). Once this is done, we can then pitch our buy and sell orders (as appropriate near and above our support and near and just under resistance levels respectively). After this is done, it is prudent practice to apply stoploss (ie exit orders) to the buy (or sell) orders initially applied as appropriate. Figure 6.2 shows the plan as just outlined.

figure 6.2 A generic range price pattern with support and resistance and stop loss order

Thus we have designed a trade plan, with a planned limited risk (ie the difference between our orders and the exit) for a (hoped for) return. We are now technically prepared for two possible scenarios that may follow from the plan. Assuming, we carry out our plan in figure 6.2, and that in this case we initially went short (ie we initially sold), we will have either of two events. They are outlined in figure 6.3 and 6.4. Figure 6.3 shows us the scenario we hope for. That we sell at the top of the range (near the high and resistance level, not forgetting the stoploss on the other side of resistance). From our selling point, price falls back to the lower end of the range and our buy order (near support) is triggered and we exit with a profit. (At this point we should cancel BOTH stoploss orders we have in place, as our plan has been successfully carried out). Figure 6.4 shows us the scenario we fear, but must prepare for. That is, we sell at the top of the range (near the high and resistance level, not forgetting the stoploss on the other side of resistance). From our selling point, price instead of falling, rises back to and through the upper end of the range. In doing so, it hits and triggers our exit order or stoploss. We then exit with a loss. The remaining orders should then be cancelled as well, as our unsuccessful plan is now redundant. Note Participants should be aware this is a very basic outline of possible trade planning. There is much, much more study to be done in the area. The learning and exercise here never stops.

figure 6.3 What happens if the price goes down? (And you had short sold)

figure 6.4 What happens if the price goes up? (And you had short sold)

We have now seen a theoretical example of a trade plan, driven by: 1) identification of support and resistance, 2) the application of buy and sell orders based on point 1 and 3) the application of stoploss measures limit risk and safe guard performance. Let us have a look at the schematic method shown in Figures 6.3 & 6.4, applied a practical (but historic) trading plan and market.

Sketching out the plan, a practical example:

Using the Euro v USD chart, (Figure 6.5 as an example only), you will notice the parallel lines about the 1.5274 and the 1.6015 levels define our support and resistance. Taking these technical levels as a start, you will notice the example strategy is to sell a break of the break of support at about the 1.5274 level, with an expectation of a move to (what has been called a target of about 1.4550 and where our buy order should await) is implicitly a lower support level. (Note it was a resistance prior to March 2008, when it was broken.) As we always must (prepare for the worst case scenario), we have placed a stoploss on the other side of the range/resistance level, above 1.6015.

figure 6.5 Range is defined by support and resistance Target of move (down) Sell Order Stoploss (buy) order

The strategy is now set. What actually happened subsequent to our plan transpires in figure 6.6.

As you can see from figure 6.6, and the resultant price action, that price first went through the support level (of about 1.5274), triggering our sell order placed just below the support. The price then went lower towards (and beyond) our target and initial support level around the 1.4306 mark, presumably we would have taken profits. The trade then appears to have concluded in this case successfully. (This may not always be the case).

figure 6.6 Outcome of NZD v JPY plan outlined in figure 6.4

Thus we can see that the identification of support and resistance is a necessary prerequisite for the establishment of an effective (if not always) and successful trading plan framework. Not forgetting its implicit role in providing not only entry levels to the taking of a trade opportunity, but also in providing critical exit levels for minimising risk and loss that comes with the trading and investing process. We will briefly review other patterns in the following section, but it should be made clear that there are many more that exist and one should be prepared for a long acclimatisation process in this more complex area of technical analysis. References already noted, will certainly help you in your learning.

Some Key Patterns to look for

Within the examples we have just covered is a range pattern called a rectangle. This is quite a basic and standard structure in that the support and resistance levels are horizontal and thus fixed for the purposes of analysis and trade planning. There are other more famous (and complex) patterns that are outside the scope of this course. Some patterns are similar but analysts may differ on pattern interpretation. For example, sometimes, analysts may seek to refer to the pattern in figure 6.7 as a double top. That is, a range pattern, where there are two distinct tests of resistance, which is then followed by a fall in price back down to the support level of the defined range which is then breached/cut as what occurred in this case. Note, the name of the pattern is not so important as the fact that a key identified level (in this case a support) was cut.

There are elaborations of such patterns. If for instance, there were three distinct tests of the topside (or resistance), followed by a price fall that actually breaks the support of the range, technical analysts unsurprisingly call it a triple top. Conversely it follows, in the case of three (failed) tests of support, where support has not been breached, and is followed by a break back over the initial resistance, we have a triple bottom. As shown in figure 6.8 in the daily timeframe in the GBPAUD chart.

figure 6.7 The double top referred to in the HBOS chart shown in figure 6.4

Disciplined analysts would however only call a pattern as confirmed, once the support or resistance levels are broken. Otherwise it is only a probable or provisional pattern. You will see later in this series of lessons that confirmation is an important discipline in technical analysis thus avoids guesses intruding into the analysis. This brief review of the role of patterns cannot be taken as exhaustive by any means and it is highly recommended that you start your own course of inquiry into the multiplicity of possible graphical patterns both of a short and a long term nature5.

figure 6.8 A possible triple bottom in the GBPUD weekly timeframe. 5 Edwards, R.D & Magee, J,Technical Analysis of Stock trends, op.cit.

You should also at this stage not get too concerned about learning the names of these patterns. As your experiences will eventually show you, the critical aspect to these various patterns is not the learning of their name or their nuanced behaviour, but in the fact they implicitly define and recognise support and resistances. It is the recognition of key price levels as an aspect of the methodology of your analysis that is the critical element to the success and accuracy of your trading plan.

Moving averages
The Beginnings of Mathematical Technical Analysis
At this point you would have realised that technical analysis involves a high degree of familiarity with graphical patterns and which can be accused of being subjective and very much in the eye of the beholder no matter how many rules one were to put in place in analysing a graph of price action. Here with mathematical technical analysis we (as analysts and/or traders) are trying to overcome this shortcoming.
Note This is only the start of a significant body of knowledge of which this section can be taken as an

introduction. Please see the references at the back of this course notes for further study.

The Moving Average

The most commonly used average by technicians and traders is the simple (or single) moving average. This average, like all moving average trading systems is called a trend following system so stylised as they perform best in a trending market, that is where price is either in an up trend or a down trend. Buy and sell signals are very straight forward. When price closes above the simple moving average you have a buy signal. If price closes below the simple moving average you have a sell signal.

figure 7.1 an example of a chart with a single Moving Average with buying and selling signals

The Double Moving Average

The double moving average method is also known as the double cross over method. Rather than use price in the case of a single moving average to trigger a buy or sell signal, DMA utilises another (faster) average cross over of an average. This technique lags the market price action more than that of a single moving average (thus theoretically misses more of a profitable move), but also it has the advantage that it tends to have fewer whipsaws (ie false or losing signals). In the double moving average, buy signals are generated when the faster average crosses from below to above the slower moving average. Whereas sell signals are generated when the faster average crosses from above to below the slower moving average. The technique is shown in figure 7.2.

figure 7.2 an example of a chart with a double Moving Average with buying and selling signals shown

The Triple Moving Average

Another robust mathematical trend following system is the triple moving average method, otherwise known as the triple cross over method. It is three double moving averages used in combination. Popular combinations include 51530 or 51334 day combinations but there are an infinite variety of combinations that can be used. The key criteria being the best one is the one most successful to your market and your needs. For our purposes, we will confine ourselves to the basic interpretation and features unique to this system (in comparison to the double and single moving average

Interpreting the Triple Moving average (TMA)

The only time you are allowed under this system to buy or to be long the market is when the TMA is aligned such that your fastest average is above your second fastest average in value, which in turn is above your slowest average. In the case of a 51530 combination, the 5 day average must be higher in value than the 15 day average, which in turn will be higher than your 30 days average. Conversely, under this system to sell or to be short the market is when the TMA is aligned such that your fastest average is below your second fastest average in value, which in turn is below your slowest average. In the case of a 51530 combination, the 5 day average must be lower in value than the 15 day average, which in

turn will be lower than your 30 days average, as shown in figure 7.3.

figure 7.3 an example of a chart with a triple Moving Average, selling signals

The unique feature of the triple moving average compared to our previous two models is that it allows you not to have a position in the market place or as we say square, (you do not have a trade risk in the market place). This occurs when neither the conditions for a buy/ long or a sell/short signal exist. As such you are kept out of the market for practical purposes when the market is in a range or in effect going sideways. This is a key facet of the model which allows the professional trader and analyst to utilise it at a more advanced level and which will be discussed later.

figure 7.4 an example of a chart with a triple Moving Average squaring signals

figure 7.5 an example of a chart with a triple Moving Average buying

RSI: the relative strength indicator

The RSI concept
The Relative Strength Indicator was developed by J.Welles Wilder, Jr, back in the 1970s and was published in his book New Concepts in Technical Trading systems (a recommended reading). It is now a standard trading system found in almost all mathematical analysis software packages. The RSI measures strength of a market price by monitoring changes in its closing prices. At an introductory stage of your learning, it must be emphasised that knowledge of the precise formula is not as important as learning and recognising the precise interpretation of the RSI. Knowing what the RSI is saying, rather than how it says it.

The formula

figure 8.1 an example of a chart with an RSI study at the bottom GBP v USD

How the RSI is presented

The RSI is a number (reading) that fluctuates between 0 and 100. As such it is plotted against a vertical scale and is usually presented at the bottom of your market price chart that is being analysed for ease of comparison. (See figure 8.1). You will also notice that there are horizontal lines placed at the 30 and the 70 mark. These two lines correspond to and define over sold and over bought readings on the RSI.

How to use it: Interpreting the RSI Signals

Now given the area below the 30 RSI reading is defined as an over sold zone and the area above the 70 RSI reading is defined as an over bought zone, traders and analysts have been known to use these levels to generate buy and sell signals. Both of these zones should be regarded as Danger zones for both the analyst or trader and that RSI levels entering these zones usually (though not always) warn that a change in trend is approaching.

figure 8.2 a practical example, showing RSI signals at the bottom GBP v USD

Buy signals occur when the RSI reading drops below the 30 RSI level and then crosses back above it. Conversely Sell signals occur when the RSI reading moves over the 70 RSI level and then crosses back below it. For an example of buy and sell signals generated by RSI, see figure 8.2 Note one does not sell when the RSI gets over bought, but when the RSI reading exits the overbought zone. Same too for buy signals: one does not buy when the RSI readings enter the over sold zone, but when the RSI readings exit it. Note There are other more advanced buy/ selling decision criteria that you can use with the RSI, (in relation to so-called Divergences and Failure swings) that will be discussed in the intermediate and advanced modules of the course.
Sell signals Buy signals

Best market condition to use the RSI

The RSI has been found to perform better in stable or ranging market conditions. One should expect poor trading and analysis results from a market in a trending condition and one is trying to interpret the results of the RSI to it.

Stochastic oscillators
The Stochastic Concept
The stochastic is a mathematical trading system first popularised by George Lane in the early 1970s. It is based on the concept that the latest closing prices tend to cluster at the high end of recent price ranges in an uptrend and at the low end of ranges in a downtrend.

The formula The formula is more complex than the RSI (but interpretation is not much different as we will see
later) and involves the subtraction of the lowest low of the recent n days range from todays closing price, divided by the absolute range of the previous n days (which is derived by the taking the lowest low away from the highest high). Thus the formula looks something like this:

How the Stochastic is presented

The Stochastic, like the RSI, is an indicator with numbers (readings) that fluctuates between 0 and 100. As such it is plotted against a vertical scale and is usually presented at the bottom of your market price chart that is being analysed for ease of comparison. (See figure 9.1). You will also notice that there are horizontal lines placed at the 30 and the 70 mark. These two lines correspond and define over sold and over bought readings on the Stochastic.

How to use it: Interpreting the Stochastic Signal

Now given the area below the 30 Stochastic reading is defined as an over sold zone and the area above the 70 Stochastic reading is defined as an over bought zone, traders and analysts have been known to use these levels to generate buy and sell signals. Both of these zones should be regarded as Danger zones for both the analyst or trader and that Stochastic levels entering these zones usually (though not always) warn that a change in trend is approaching. Buy signals occur when the Stochastic reading drops below the 30 Stochastic level and then crosses back above it. Conversely Sell signals occur when the Stochastic reading moves over the 70 Stochastic level and then crosses back below it. Note one does not sell when the Stochastic gets over bought, but when the Stochastic reading exits the overbought zone. The same for buy signals: one does not buy when the Stochastic readings enter the over sold zone, but when the Stochastic readings exit it. Examples are showed in the above diagrams. Note There are other more advanced buy/selling decision criteria that you can use with the Stochastic, (in relation to so-called Divergences and Failure swings) that will be discussed in the intermediate and advanced modules of this course.

figure 9.1 A stochastic indicator applied to the US30

Best market condition to use the Stochastic

Like the RSI, the Stochastic has been found to perform best in stable or ranging market conditions. One should expect poor trading and analysis results from a market in a trending condition.