FX101: Basics of Foreign Exchange Trading

by Six Capital
1st Edition
Copyright 2012 by Six Capital Pte Ltd. All rights reserved.
No part of this book may be reproduced, in any form or by any means, without permission
in writing from the author. The author disclaims any liability, loss, or risk resulting directly or
indirectly, from the use or application of any of the contents of this book.
This book is distributed to subscribers of Trade with Chief provided by Six Capital and is not
for resale.

................................................................................................................................................................ 1
.............................................................................................................................................. 6
....................................................................................................... 8
Definition What is Foreign Exchange? ............................................................................................. 8
Why Trade FX? .................................................................................................................................... 9
Huge Liquidity ................................................................................................................................. 9
High Volatility ................................................................................................................................ 10
24-Hour Decentralized OTC Market.............................................................................................. 11
High Leverage Allowed.................................................................................................................. 12
Short-selling is Allowed ................................................................................................................. 12
Growth of Online Brokers ............................................................................................................. 13
What Affects the FX Markets? .......................................................................................................... 14
Fundamental Factors .................................................................................................................... 14
Technical Factors........................................................................................................................... 16
Market Psychology and Sentiment ............................................................................................... 17
Chapter Review ................................................................................................................................. 18
.......................................................................................................... 20
Trading Sessions ................................................................................................................................ 20
Sydney Opens................................................................................................................................ 20
Tokyo Comes In ............................................................................................................................. 21
Frankfurt and London Comes In.................................................................................................... 21
New York Comes In ....................................................................................................................... 21
London Closes ............................................................................................................................... 22
Bank Holidays ................................................................................................................................ 22
Currency Quotes ............................................................................................................................... 23
Buying and Selling Simultaneously ............................................................................................... 23
Currency Pairs ............................................................................................................................... 23
Base and Counter Currencies ........................................................................................................ 25
Direct and Indirect Quotes............................................................................................................ 26
Long, Short or Square ................................................................................................................... 27

Keeping Track of Profit and Loss (P&L) ............................................................................................. 27

Position Size (Lot Size)................................................................................................................... 28
Leverage ........................................................................................................................................ 28
Pips ................................................................................................................................................ 30
Bid-Ask Spread .................................................................................................................................. 31
Common Trade Orders ..................................................................................................................... 32
Entry Orders .................................................................................................................................. 32
Take-Profit Orders (TP) ................................................................................................................. 32
Stop-Loss Orders (SL) .................................................................................................................... 33
Market Orders ............................................................................................................................... 33
Conditional Orders ........................................................................................................................ 34
Other Common Orders ................................................................................................................. 36
Suggested Orders to Use............................................................................................................... 37
Chapter Review ................................................................................................................................. 38
...................................................................................................................... 40
What is Technical Analysis? .............................................................................................................. 40
Key Assumptions ............................................................................................................................... 40
Price is Determined by Supply and Demand................................................................................. 40
The Market Discounts Everything ................................................................................................. 40
Price Moves in Trends ................................................................................................................... 40
History Tends to Repeat Itself ....................................................................................................... 41
Patterns are Fractal in Nature ....................................................................................................... 41
Price Action ....................................................................................................................................... 42
Line Charts .................................................................................................................................... 42
Bar Charts ...................................................................................................................................... 43
Candlestick Charts ......................................................................................................................... 44
Price Spikes ................................................................................................................................... 47
Price Gaps ..................................................................................................................................... 48
Support and Resistance ................................................................................................................ 49
Trends ........................................................................................................................................... 51
Consolidations, Breakouts and False Breaks................................................................................. 58
Elliot Wave Theory ........................................................................................................................ 59
Fibonacci Retracements ................................................................................................................ 60
Fractal Nature of Price Action ....................................................................................................... 62
4

Six Basic Chart Patterns..................................................................................................................... 63

1.

Continuation Patterns: Triangles .......................................................................................... 63

2.

Continuation Patterns: Flags ................................................................................................. 66

3.

Key Reversal Patterns: Double Tops and Double Bottoms ................................................... 67

4.

Key Reversal Patterns: Head & Shoulders and Inverted Head & Shoulders ......................... 69

5.

Consolidation Patterns: Triangles ......................................................................................... 73

6.

Consolidation Patterns: Rectangles ...................................................................................... 74

Chapter Review ................................................................................................................................. 75

In this book, we aim to provide you with a basic but comprehensive overview of what
constitutes foreign exchange. Also, we will go through all the common concepts and
terminologies that you will encounter, as well as introduce to you various methods of
trading foreign exchange. If you have some prior trading experience, it is possible that you
might already know everything that we are going to discuss. Still, we urge you to continue
reading on, as you might be able to pick up something that you did not know before, or
perhaps gain a little extra insight on the stuff you already knew.
Do take note that this book is not intended to provide an in-depth discussion of how to
trade foreign exchange. It will, however, provide you with a very strong foundation for
subsequent learning.

Definition What is Foreign Exchange?

Before we can learn more about foreign exchange
trading, we need to ask ourselves the most basic
question: What exactly is foreign exchange?
Simply put, foreign exchange is the simultaneous
buying of one currency and selling of another
currency. Two currencies are always involved, thus
the use of the term exchange. Foreign exchange is
also commonly abbreviated as Forex or FX, and the
international network of buyers and sellers of
currencies is known as the Foreign Exchange Market.

Figure 1.1: Foreign Exchange

As we can thus see, FX trading is basically currency trading. FX traders take views on
whether currency exchange rates (or in other words, currency prices) will go up or go down,
and they profit if their analysis and views are correct.
Like all other forms of trading or investment, FX trading is a serious activity requiring
dedication and commitment. An aspiring FX trader first needs to be willing to put in
significant resources, to build up a strong foundation in both his basic knowledge and skill
set, as well as to train his mind and emotions to be both stable and disciplined. Just as a
doctor or lawyer would need to be trained for years before they can develop mastery of
their skills, there is simply no shortcut to mastering FX trading.

MIND

EMOTIONS

Figure 1.2: FX training is the training of the mind and emotions

We feel the need to emphasize this right from the beginning, because having the right
learning attitude is of extreme importance. Some people learn FX trading hoping that it can
be a get-rich-quick scheme. Some hope to make immense profits, without having to put in
any hard work. Some just want to focus on the profits, and do not want to first think about
how to manage any potential losses. These people are all likely to fail, because their attitude
is wrong in the first place. But for those who are willing to put in their time, effort and
resources into learning FX trading properly, it can be very rewarding. FX trading has risen
8

tremendously in popularity in recent years, as it has certain advantages over other forms of
trading. We will discuss more about these advantages in the next section.
As we can see, the FX market provides an important trading vehicle for the global
trading community. But beyond allowing trading for profits, the FX market is even more
important in that it serves as the avenue for international capital flows among businesses,
corporations and investors. When trade or investment occurs across borders, different
currencies must be bought and sold in exchange for these goods, services or assets. These
currency exchanges are often conducted through banks, and thus the FX market is also
frequently described as an interbank market. As the world becomes even more globalized
and international trade and investment becomes ever more common, we will see an
increasing volume of currency exchange as the FX market grows larger and larger. These
developments suggest that FX trading is going to become more and more important in the
years ahead.

Why Trade FX?

Most people are more familiar with traditional asset classes such as stocks, bonds and real
estate. In comparison, for many years, FX trading was the domain of banks, hedge funds,
multinational corporations and wealthy individuals. But that has changed in the past decade
or so, with the rise of the Internet. As more and more online FX brokerages appear, the cost
of FX trading has come down and the trading of currencies as an asset class has
correspondingly risen in popularity among retail investors. Here are some of the reasons for
the growth in popularity.

Huge Liquidity
$5 Trillion

$20 Billion

Daily FX Market Volume

Daily NYSE Volume

Figure 1.3: Daily volume of the FX Market dwarfs the NYSE

Every day, USD$5 trillion worth of currencies change hands in the FX market. This
is 200 times bigger than the US$20 billion daily trading volume of the New York
Stock Exchange (NYSE) and makes the FX market by far the most liquid financial
market in the world.
When we talk about liquidity, we are referring to the amount of ready buyers
and sellers in an asset. The keyword here is ready, which means the buyers and
sellers must be able and willing to buy or sell the asset, at or near the current
market price. A liquid asset is one which can be bought or sold easily, without its
price being negatively affected. In contrast, an illiquid asset is one where it may
require a significant time or cost to find a buyer or seller. Because of the lack of
buyers and sellers, you would need to buy at a significant premium or sell at a
significant discount if you wish to transact your full desired amount immediately.
For example, real estate is generally considered as an illiquid asset. Its not
easy to quickly find a buyer if you are trying to sell a house. If you wish to sell the
house quickly, you probably can, but you would need to sell it at a significant
discount in order to attract buyers quickly. In contrast, there are usually a high
number of ready buyers and sellers in the FX market, and we say the FX market
has good depth. We thus face less of these liquidity issues when buying or selling
currencies. Millions of dollars can change hands instantly with hardly a blip in the
market prices.
The tremendous amount of liquidity in FX relative to other markets thus
makes it ideal for trading, as we are able to easily execute even very large orders,
and prices are not easily distorted simply because we wish to buy or sell a huge
amount.

High Volatility
Volatility refers to the degree of variability and uncertainty in an assets price.
Traders embrace volatility, as the very essence of trading is based on profiting
from changes in prices.
As the world becomes more connected and globalized, we find a growing
fluctuation of currency prices. This is especially so as countries compete to
devalue their currencies to gain a competitive edge for their exports. It is not
unusual to see currencies fluctuating by 10% to 30% every 3 to 6 months.

10

Figure 1.4: Fluctuations of the EUR/USD over the past 3 years

At the same time, with the weak growth of global stock markets and
historically low interest rates, people are increasingly looking for new sources of
investment return, and the volatility of the FX market provides lots of potential
for profit making.

24-Hour Decentralized OTC Market

The FX market is unique in that it is a market without the presence of a physical
location or a centralized exchange. When we trade stocks, there is usually a
centralized location where the trading takes place, e.g. the New York Stock
Exchange or the Singapore Exchange. If we trade options or futures, we may do so
on the Chicago Board of Trade (CBOT), using a set of highly standardized trading
contracts.
In comparison, the FX market has no such exchange. Instead, the FX market is
what is called an over-the-counter (OTC) market, where a network of buyers and
sellers trade directly with each other. Contracts are non-standardized, and are
tailored and customized according to the needs of the two parties. Traditionally,
the two parties involved are usually banks, thus the FX market is also known as an
interbank market.
Because trading occurs over a decentralized OTC network, there is no daily
open or close of any centralized exchange, and thus trading can happen over 24
hours. A trading week starts on Monday morning with the open of the New
Zealand and Australian markets, and only ends with the closing of the New York
markets on Friday.

11

The 24-hour nature of the FX market means that no matter which part of the
world you are trading from, you are likely to be able to find a convenient time to
trade according to your lifestyle. You may come and go as you like, and trade for
as long a time or as short a time as you wish. You can keep a day job and trade FX
at night. Or, you can be a full-time trader trading any time you want.

High Leverage Allowed

Yet another characteristic of FX trading is
that compared to many other assets, FX
trading allows a much higher degree of
leverage. In simple terms, leverage is the
ability to use borrowed capital with only a
small initial outlay, therefore multiplying
your trading gains or losses. When trading FX,
its common to be able to obtain leverage of
25 times to 100 times or even higher.

Figure 1.5: Leverage allows the

multiplication of gains and losses

As an example, if you apply a leverage of 100 times to an initial capital of

$1,000, it means you can now trade a position size of $100,000 instead, and
effectively multiply your trading gains or losses by 100 times.
It should be obvious by now that leverage is clearly a double-edged sword
that can lead the rash and reckless towards quick financial ruin. But if leverage is
properly applied and controlled, it is actually a very useful tool, allowing traders to
control their profits and losses with little initial capital required. It is because of
the leverage we can get in FX trading, the lack of capital is usually not the limiting
factor. In FX trading, the critical factor is instead the trading skill and ability.

Short-selling is Allowed
Many traditional asset markets, for example stocks or real estate, allow traders to
take on long positions only. Taking a long position means to buy an asset, on the
expectations that the price of the asset will rise in the future. However, if the
trader holds a view that asset prices will drop in future, he is usually limited in
what he can do, beyond ensuring that he has no long position in the asset.
In the FX market, however, a trader is allowed to take a short position in the
asset, with absolutely no restrictions. Taking a short position essentially means
that the trader agrees to sell an asset at its current price, on the expectations that
the price will go down subsequently. For example, a trader can sell an asset now
at $50. To satisfy delivery of the sale, he will first borrow the asset from a third
12

party, with a promise to return it after a certain period. If now lets say that the
price of the asset goes down to $47, the trader can then buy the asset from the
open market at this lower price, and use it to return what he had previously
borrowed, thus pocketing the difference of $3. This process is also known as
short-selling.
Because FX trading always involves the exchange of one currency for another
currency, we will see that on average, currency exchange rates go down as often
as they go up. As shorting is allowed with no restrictions in the FX market, a FX
trader will have many trading opportunities, regardless whether the market
moves up or down.

Growth of Online Brokers

Although FX trading used to be confined to the realms of banks, institutional
funds or wealthy investors, the rise of online brokers has provided retail traders
with convenient access to FX trading. Besides trading platforms, they also provide
access to real-time prices and a variety of tools such as charts and indicators.
With their cheaper costs of operations, and the intense competition between the
brokers, trading costs have also been lowered dramatically, making FX trading
possible even for retail traders with small trading accounts.
As the industry blossoms, we can probably expect trading costs to be lowered
even further, and a greater variety of tools and platforms to allow us to trade with
more information and confidence.

Figure 1.6: Example of an online trading platform

13

What Affects the FX Markets?

One of the most basic economic theories is that the price of any good is the result of the
interaction between supply and demand.

Figure 1.13: Supply and Demand Curve

If the demand for the good is higher than the supply at that time, then prices will have
to go up. As prices go up, more people will sell their good as it now fetches a better price,
thus increasing the supply to match the higher demand. Conversely, if the supply of the
good increases while the demand drops, then prices will have to fall. At the lower price, less
people will be willing to supply the good, while more people would be willing to purchase it.
This allows supply and demand to reach a new balance.
Price is thus the mechanism to balance supply and demand, and price movements are a
reflection of the underlying supply and demand. It is useful to see the FX market as a
battlefield between the bulls and the bears, with prices the outcome of their fight. The bulls
would like to see prices go up, whereas the bears would try to make prices go down.
At any one time, the relative balance of bulls versus bears directly influences the supply
and demand for the currencies. The relative balance of bulls and bears is determined by
their expectations of where prices may move, which is derived from their analysis of the
stream of information that they receive. This information can be categorized into
fundamental factors or technical factors.

Fundamental Factors
Fundamental factors refer to the broad category of economic and political
information that can affect the economy of a country as well as the demand for
14

that countrys currencies. Bullish fundamentals exert an upward pressure on the

prices of the affected currencies, while bearish fundamentals would tend to drive
their prices down.

Monetary Policy. One of the key things that market participants pay
attention to are the monetary policies of the major economies. Changes in
the monetary policy of a country will directly impact its economy, as well
as the supply and demand of that countrys currency. It is not uncommon
to see currency exchange rates moving significantly after a central bank
announces changes to its monetary policy. In particular, markets
participants pay close attention to the monetary policies set by the major
economies, such as the U.S., the eurozone and Japan.

Interest Rates. Related to the monetary policy of a country is the level of

interest rates in that country. Interest rates have a strong influence on
exchange rates, as they directly impact the direction of capital flows from
one currency to another. For example, investors will usually invest in
economies that provide a better return through higher interest rates. The
demand for the currencies of those economies will thus be higher.
Just as important as the actual interest rates are the interest rates
expectations themselves. If market participants expect the interest rates
and thus the demand for a currency will go up in the near future, they will
often start buying the currencies first in anticipation, making the currency
values go up.

Economic Data. All major economies publish economic data on a periodic

basis, and market participants will often use the data to gauge the strength
of the economy and react accordingly. In general, currencies of strong
economies are desirable, while currencies of countries with weaker
economies will be in less demand.

15

Geopolitical Risks. Market participants will look out for geopolitical news
in deciding the demand and supply for a currency. For example if there is a
threat of war in a region, capital will flee from the affected region, and
flock into safe-haven currencies like the U.S. Dollar. This flow of capital will
affect the supply and demand for the currencies, and thus their exchange
rates.

Technical Factors
Technical factors refer to information that is directly or indirectly derived from the
price movements themselves. As with fundamentals, bullish technical factors will
drive currency prices up, while bearish technical factors will drive prices down.

Price Action. The first category of information will be the price action that
can be seen directly from the price charts. This will include the price
movements on the charts, the levels of support and resistance that prices
encounter and the chart formations that appear.
Price is basically the reflection of the relative supply and demand of
buyers and sellers at that moment. By paying close attention to how prices
are moving and the patterns that emerge, we can have a gauge of the
current supply and demand and thus predict how prices may move.
Besides, most market participants pay close attention to price action and
react to what they see. For instance if a bullish price formation appears,
market participants will tend to buy in anticipation of rising prices. This
creates a self-fulfilling prophecy, as the increased demand directly
contributes to prices rising.
Market bulls and bears will often pick their fights at strategic spots, so
as to engineer classical chart formations and price action in their favor. For
instance, if the bulls manage to move prices through their buying to form a
clear and visible bullish formation, then the rest of the market that are
undecided will join in the buying, overwhelming the bears.
Thus the understanding of price action, as well as how market
participants interpret price action, are important keys to predicting
currency price movements.

16

Technical Indicators. Another category of technical information is

information that is indirectly derived from prices, or from other factors like
momentum or trading volume. They are also commonly known as
technical indicators. Examples of indicators include moving averages,
momentum indicators such as Relative Strength Index (RSI) and volatility
indicators like Bollinger Bands. They are basically quantitative analysis of
simple data into more complex summaries, and they are appealing to
many traders as they allow the traders to apply objective trading rules and
strategies.
While we now know that prices in the FX market are influenced by information that are
fundamental or technical in nature, information flow alone do not fully explain how and why
currency prices move.

Market Psychology and Sentiment

The third and final determinant of currency prices is the market psychology and
sentiment of market participants. Whereas fundamental and technical factors
focus on events, data, numbers and price movements, market psychology and
sentiment focuses on the market participants themselves, and how they interpret
the constant flow of information they receive.
Psychology research has shown that market participants are not as rational
as initially thought, and are often affected by biases. Different people will react to
the same information differently, and the same people facing the same
information can also react differently at different times.
For example, in a bullish environment where most people are bullish, market
participants tend to get sucked into groupthink and herd behavior. They will
continue buying because the consensus of opinion is that prices will keep going up,
and there is a strong unconscious pressure to conform to the norm. However, we
all know that prices cannot keep going up forever. In fact, by the time that
everyone gets on the train and the entire market sentiment is bullish, prices are
usually already near the top and primed for a reversal.
Thus in analyzing the FX market and predicting currency prices, we must
consider not just the fundamental and technical factors, but also account for the
effects of market psychology and sentiment. You can be spot on about the
underlying fundamentals and technicals, but if everyone disagrees with you, you
will end up losing a lot of money before you are eventually proven correct.

17

Figure 1.14: Panic can grip the collective investor

sentiment in a crashing market

Chapter Review
Let us recap what we have learnt in this chapter. We have learnt to:

1. Define Foreign Exchange.

2. Explain the common advantages for trading FX.
i. Huge liquidity.
ii. High volatility
iii. 24-hour decentralized OTC market
iv. High leverage allowed
v. Short-selling allowed
vi. Growth of online FX brokers
3. Explain the three factors that affect the FX market.
i. Fundamental factors
ii. Technical factors
iii. Market psychology and sentiment

18

Trading Sessions
Recall that the FX market is a 24-hour round the clock market from Mondays to
Fridays. However, that does not mean that it is active the whole day, and a trader
will find it difficult to make money if he is trying to trade when the market is hardly
moving.
By convention, the FX market can be broken up into several trading sessions. It
is important for a trader to be familiar with all the trading sessions and their
characteristics, as the liquidity and trading conditions during each session can be
quite different. As much as possible, a trader should only trade when the market has
lots of liquidity and volatility. Note that the timings discussed in the following
sections may shift by 1 hour depending on the relevant Daylight Savings Time.

Sydney Opens
At the beginning of the trading week, the FX market starts with the open
of the New Zealand market in Wellington as well as the Sydney market
shortly after. This corresponds to 5am in Singapores Monday morning
(Singapore Time - SGT), 9pm Sunday night in Greenwich Mean Time (GMT)
and 4pm Sunday evening in New York (Eastern Standard Time EST).
This would be the first opportunity for the FX market to digest and
react to any news or events that happened over the weekend, and prices
may open at very different levels compared to when it closed on Friday
evening. We say that prices have gapped up or gapped down if there is this
sudden change in prices from Friday close to Monday open. This is a risk
that a trader would have to be prepared for, if he chooses to keep an open
position over the weekend.
Note that liquidity is usually very poor during the first hour, as only
the Wellington trading desks as well as the 24-hour trading desks are
active. This means that prices are thinly traded, with a low volume of
transactions. Thus we should try to avoid trading during these timings.
Sydney will remain open until 2pm SGT.

20

Tokyo Comes In
As Tokyo comes in at 7am SGT, or 11pm GMT or 6pm EST, liquidity picks
up significantly. Tokyo is the third largest FX trading center of the world,
and the Asian trading session revolves around it. News and events
happening in the Asia-Pacific, as well as in Japan and China, would be
heavily influencing currency prices over the next few hours. Tokyo would
remain open until 4pm SGT.

Frankfurt and London Comes In

In the second half of the Tokyo trading day, Frankfurt and London will
come in to bring in the European participants. Frankfurt and London opens
at 3pm SGT (7am GMT and 2am EST).
The European session overall enjoys the best liquidity, as the
European morning session overlaps with the second half of the Tokyo
session, while the European afternoon session overlaps with New York
coming in. Market participants will be digesting earlier news and events
from the Tokyo session, while taking note of news and developments in
the eurozone that are just streaming in. Thus a lot of the liquidity and
volatility of the FX market will happen during this time. This is a good time
for FX trading. This unique time zone advantage of London is partly the
reason why it is the biggest FX financial center of the world. London will
continue trading until 11.30pm SGT.

New York Comes In

After London returns from lunch, New York will get ready to come in at
9.30pm SGT (1.30pm GMT or 8.30am EST). As London and New York are
the two biggest financial centers, their overlap sees the greatest liquidity
and usually the biggest and most meaningful price movements. New York
morning is also when most of the US data and announcements are
released. This period is arguably the best time for FX trading.

21

London Closes
As London closes at 11.30pm SGT (3.30pm GMT or 10.30am EST), we start
to experience a drop off in liquidity. There may sometimes be some final
flurry of activity, as London traders unwind or close down their positions
for the day.
New York afternoon will usually see reduced liquidity, unless there are
major news and announcements scheduled. The reduced liquidity will
usually lead to slow and sluggish price movements, though at times it can
also allow huge and fast movements due to the relative lack of market
participants. By late New York afternoon, Wellington and Sydney would be
opening, signifying the start of a new trading day, where the cycle repeats
itself.
Here is a table of the trading sessions in terms of Singapore timing. Again be
reminded that the timings can vary by 1 hour due to changes from Daylight Savings
Time throughout the year.

9 10
Sydney

11

12

13

14

15

16

17

18

19

20

21

22

23

Tokyo
London
New York

New York

Figure 2.1: Trading sessions in terms of Singapore time (24-hour clock)

Bank Holidays
Besides being familiar with the timings of the various trading sessions, FX
traders should also keep track of the public holidays, also known as bank
holidays, of the major financial centers of Tokyo, London and New York.
For example, if New York is having a bank holiday and all the New
York traders are not working, liquidity will tend to be significantly lesser
during the New York trading session. In fact, London traders trading the
London session will be aware of the fact, and may trade less too for fear of
a thin and illiquid market. As retail FX traders, we also need to be aware of
these situations and adjust our trading accordingly.

22

24

Currency Quotes
Buying and Selling Simultaneously
Many people with trading experience are used to the concept of the
buying or selling of an asset. If you bought the asset and the asset price is
rising, you profit. But in the FX market, currencies do not move in isolation
and are always associated in pairs. If someone says that the U.S. Dollar is
rising, then the next question will always be, rising against what? Currency
movements must always be related in pairs.
Once we think more about it though, it is actually not so different
from the other asset classes that we are used to. For example, if you buy
100 shares of ABC Company, you are basically selling U.S. Dollars to
purchase the shares. If the share price goes up, it is basically going up
against the U.S. Dollar, so you can sell the shares at a profit to buy back
U.S. Dollars.
The same scenario applies when we are buying and selling currencies,
just that it seems slightly more confusing as now two currencies are
involved simultaneously. For example, you could be buying U.S. Dollars
against the Euro, or you could also be buying U.S. Dollars against the Yen.

Currency Pairs
When quoting currency pairs, there is a fixed set of international
conventions. Below is a table of the 3-letter abbreviation of some common
currencies. Generally, the first 2 letters stand for the countrys name (e.g.
U.S.), while the 3rd letter is derived from the currency name (e.g. dollar).
List of Abbreviations of Common Currencies
Abbreviation

Country

USD
EUR
JPY
GBP
CHF
CAD
AUD
NZD

U.S.
Eurozone
Japan
Great Britain
Switzerland (Confoederatio Helvetica)
Canada
Australia
New Zealand

Currency
Name
Dollar
Euro
Yen
Pound
Franc
Dollar
Dollar
Dollar

23

Major Pairs. As one may imagine, the bigger and more powerful
the economy of a country, the more that its currency will be
required for international capital flow. Thus, most of the FX trading
action occurs in the currency pairs of the major economies of the
world.
The U.S. has the biggest economy of the world and thus the
USD enjoys a special status. The USD is seen as the reserve
currency of the world after the end of World War Two. Many
countries hold a significant part of their foreign currency reserves
in terms of USD and U.S. government debt. Thus we also see that
many commodities like gold or oil are also priced in terms of USD.
Any fluctuation in the USD will thus have a knock-on effect on the
price volatilities of these commodities.
As an accepted convention, the pairings of the USD against the
following currencies of major economies are known as the major
pairs. Major pairs are among the most liquid and widely traded
currency pairs.

List of the Major Pairs

Currency Pair
EUR/USD
USD/JPY
GBP/USD
USD/CHF
USD/CAD
AUD/USD
NZD/USD

Name
Euro-dollar
Dollar-yen
Sterling-dollar
Dollar-swiss
Dollar-canada (Dollar-loonie)
Australian-dollar (Aussie-dollar)
New Zealand-dollar (Kiwi-dollar)

Notice how the USD is quoted first against the JPY, CHF and
CAD, and quoted second against the EUR, GBP, AUD and NZD? The
international convention when quoting currency pairs is to rank
currencies in the following order of importance: EUR, GBP, AUD,
NZD, USD, CAD, CHF, JPY.
Some people prefer to term the USD/CAD, AUD/USD and
NZD/USD as minor pairs instead of major pairs. The CAD, AUD and
NZD are also known as commodity currencies, and we will talk
more about them later.

24

Cross Pairs. Cross pairs refer to currency pairs where neither

currency is the US Dollar. The exchange rate of cross pairs can be
calculated if we know the exchange rates of the two currencies
against another common currency. For example, if we know the
exchange rate of the EUR/USD and the USD/CHF, it is possible to
derive the exchange rate of the cross pair of the EUR/CHF.
Among the most important of the cross pairs is the EUR/JPY,
as the eurozone and Japan are two of the worlds biggest
economies. Below is a table of some other common cross pairs.

List of Some Commonly Traded Cross Pairs

Currency Pair
EUR/JPY
EUR/CHF
EUR/GBP
GBP/JPY
CHF/JPY
AUD/JPY

Name
Euro-yen
Euro-swiss
Euro-sterling
Sterling-yen
Swiss-yen
Aussie-yen

Exotic Pairs. Exotic currency pairs refer to currency pairs of smaller,

less-developed emerging market economies such as the Turkish lira
(TRY) or the Mexican peso (MXN). Exotics tend to be much more
illiquid when compared to the major pairs or the common cross
pairs, so FX traders should stay away from them.

Base and Counter Currencies

When we quote a currency pair, for example the EUR/USD, the first
currency (in this case EUR) is known as the base currency, while the
second currency (in this case USD) is known as the counter currency or
quote currency.

Figure 2.2: The first currency is the base currency while the second currency is the counter currency

25

If we say that the EUR/USD rate is 1.30, it means that each Euro is
worth US$1.30, and can be converted to USD at that rate. If the EUR/USD
rate goes up to 1.35, it means that the value of the Euro has appreciated or
gone up relative to the USD. Specifically, the value of each Euro has gone
up by US$0.05. Alternatively if the Euro weakens or depreciates, we will see
the EUR/USD rate drop.
In other words, the base currency is always the currency of interest in
a currency pair. When you are buying EUR/USD, you are basically buying
Euros, which is the base currency. If the currency exchange rate goes up, it
means that the value of the Euro has gone up. In contrast, the counter
currency is the currency in which your profits or losses will be
denominated in. If you are trading EUR/USD, your profits or losses will be
in terms of USD.
It is important to understand this concept so lets look at another
example. Lets say the current USD/JPY rate is 78. In this case, USD is the
base currency and rate of 78 means that one USD is equivalent to 78 JPY. If
the USD/JPY rate goes up, it means that the value of the USD has gone up
relative to the JPY, and vice versa if the price goes down. Any profits or
losses we make will be denominated in JPY, which can then be converted
back into USD at the prevailing exchange rates.

Direct and Indirect Quotes

You may sometimes encounter the terms direct quotes or indirect
quotes. Taken from the U.S. perspective, a direct quote is any currency
quote where the USD is the counter currency. In contrast, any currency
quote where the USD is the base currency is known as an indirect quote. Is
this confusing to remember? The logic is actually very simple.
Lets imagine you are living in the U.S. Most goods or services that you
encounter will be priced in terms of USD. For example, the price of one
cup of coffee may be US$3, while the price of one haircut may be US$10.
Currency quotes with the USD as the counter currency are similar in that
they are also priced in terms of USD. For example, if the EUR/USD rate is
1.30, it means that the price of one Euro is US$1.30. Thus such a currency
quote is known as a direct quote, as it is consistent with the way how most
other goods and services are priced in the U.S.

26

In contrast, look at the USD/JPY rate of 78. It means that one USD is
worth 78 JPY, or put differently, that the price of 78 JPY is US$1. As this
method of notation is inconsistent with how other goods and services are
priced in everyday life, such a currency quote is known as an indirect
quote from the U.S. perspective.

Long, Short or Square

As mentioned earlier, currencies are always denoted in pairs, so you must
always buy one currency and sell another simultaneously. We take the
base currency as the currency of interest. So, for example, if you believe
that the rates for EUR/USD will go up and you buy EUR against the USD,
then we say that you are long on the EUR/USD. If you instead believe that
the rates for EUR/USD will go down, and you sell EUR against the USD, we
will say that you are short on the EUR/USD. Or more simply, that you are
short EUR.
As mentioned previously, some traders who only had experience with
other traditional asset classes may be unfamiliar or uncomfortable with
the idea of selling something first and buying it back later. However, due
to the bidirectional nature of the FX market, going short is just as natural
and common as going long, so it is critical to get used to the concept.
If you have entered the market to buy or sell EUR/USD, we say that
you have an open position, as you now have a net currency position. The
position is termed open, as any changes to the EUR/USD will affect your
potential profit or loss. You can choose to close your open position by
selling off your long position if you were long, or buying back your short
position if you were short instead. This is called squaring up. With no net
currency position remaining, you are no longer exposed to the risk of
further exchange rate movements and this is known as being square or
being flat.

Keeping Track of Profit and Loss (P&L)

The very purpose of trading is to generate profits, so it is critical that you clearly
understand how profits and losses work in FX trading. We start with explaining the
concept of position size, also known as the lot size.

27

Position Size (Lot Size)

Position size is the amount of the base currency that you buy or sell in the
transaction. For example, if you buy 1 million Euros at the EUR/USD rate of
1.30, then your position size would be 1 million Euros. Needless to say, the
bigger the position size that you are trading, the greater the potential
monetary value of your profits or losses. A FX trader needs to be always
alert to the position size he is currently trading.
Position sizing is one of the most important concepts in FX and
understanding what it is all about can save you much losses and grief. For
example, there may be times when we assess that the risk of a particular
trade is relatively higher. If we still wish to enter the trade, one way to
mitigate the higher risk is to reduce our position size. That way, even if it
ends up to be a losing trade, the monetary value of the loss will still be
lower than if we had traded at our usual position size.

Leverage
Leverage, also known as gearing, refers to the ability to borrow trading
capital from your broker to trade a bigger position. The greater the
leverage, the greater the ability to multiply your gains or losses. Compared
to other asset classes, FX brokers typically offer a high level of leverage to
their clients.

Margin and Equity. For instance, some brokers allow you to open a
trading account with just US$1,000. This is known as your initial
collateral, or your initial margin. The broker may allow you a
maximum leverage of 100:1, which means that you can trade a
maximum position size that is 100 times bigger than the margin
amount that you have put up. In this case, it would mean that you
can trade a position size of US$100,000 with just US$1,000 in
margin.

The amount of margin you possess will change as you start

trading and make profits or losses. The current amount of margin
you possess is also known as your equity. If you make profits, they
will be added to your equity, and your free trading line will then be
increased proportionately based on the maximum leverage.
However, if you make losses, they will be deducted from your
equity, decreasing the maximum amount that you can now trade.
28

Mark-to-Market Values. The equity also accounts for any potential

profits or losses from open positions. For example, an open
position may be currently profitable and would net US$10,000 of
profits if closed immediately at the market price. These are known
as unrealized profits, as they have not been locked in, and are only
paper gains. The paper values based on the current market values
are known as mark-to-market values. The equity you possess takes
into account these unrealized profits or losses based on mark-tomarket values, and is updated in real-time as the values of your
open positions change.

Margin Calls and Margin Cuts. If the amount of leverage employed

is too high, any losses will eat into the equity very significantly and
rapidly. When the equity drops to a level that is insufficient to
support potential losses in the open positions, the broker will need
to manage its risk by contacting the client to top-up the margin
immediately. This is known as a margin call.
FX brokers usually do not issue margin calls if the margin is
insufficient. They may instead perform a margin cut, closing the
losing open positions immediately at their market values to
prevent potentially higher losses. Do not ever trade at such high
leverages to allow such a thing to happen to you.
As we can see, leverage is clearly a double-edged sword. It
allows you to multiply your profits by 100 times, though it can just
as easily multiply your losses by 100 times, too. When leverage is
employed by reckless traders who ignore basic trading foundations
and discipline, it can quickly lead them to over-extend, and their
entire capital can be eaten up within a short period of time. In fact
with leverage employed, it is possible to lose more than the capital
that you have put up, at which point the broker may pursue legal
measures to reclaim the losses incurred. However, when leverage
is used correctly and prudently, it can be a powerful tool. It allows
the trader to pursue higher gains without requiring or locking up a
substantial amount of their capital.
As a FX trader, remember that just because a broker offers us
100:1 leverage, does not mean that we should use 100:1 leverage.
Employing a lower leverage would allow us to withstand volatile
market movements and sustain losses better, and is often the
smarter choice.
29

Pips
FX markets are unique in that the most common way to denote profits and
losses are in terms of something known as pips. A pip is an abbreviation
for percentage in points, and it represents one standard unit of movement
in currency exchange rates.
A pip usually refers to the fourth digit behind the decimal point in a FX
quote. For example, if EUR/USD rises from 1.3020 to 1.3035, we say that it
has gone up by 15 pips. For JPY quotes, they are different in that a pip is
the second digit behind the decimal point. For example, if USD/JPY drops
from 78.00 to 77.98, we say that it has gone down by 2 pips.
As we can thus see, profits and losses (P&L) can be denoted in terms
of either pips or in terms of monetary values of dollars and cents. The
monetary value of the P&L is a function of both the number of pips moved
and the position size traded. For example, if I bought one million Euros of
EUR/USD and made a profit of 3 pips, then the monetary value of my
profit is 1,000,000 X 0.0003 = US$300.
Instead of doing the calculations the long way, we can also memorize
that at a micro lot size of 1,000, one pip is worth US$0.10. At the mini
lot size of 10,000, one pip is worth US$1. At the standard lot size of
100,000, one pip is worth US$10. And at a lot size of 1 million, one pip is
worth US$100. Note that the P&L is in terms of USD, as USD is the counter
currency of the EUR/USD pair.
As an FX trader, it is better to focus on pips when thinking of profits
and losses. This is because the amount of pips of profit we get is based on
our trading ability and skill. Our emphasis should be to train ourselves such
that we can earn a certain amount of pips in a consistent and repeatable
manner.
In contrast, the monetary value of our profits is a function of both the
pips and the position size. For example, we can try to make US$1,000 by
making 1,000 pips at the 10,000 lot size, or we can do so by making 10
pips at the 1 million lot size. Clearly, it is much easier to try to make 10
pips from the market instead of 1,000 pips. The caveat, of course, is that
you will first need to acquire the consistency in trading in order to have
the confidence to trade larger.
As we can thus see, the monetary value of our profits can be
increased by simply scaling up our position size, and that can come easily
after we have honed our trading ability and skills.
30

Bid-Ask Spread
So far, we have discussed FX trading as if there is a single exchange rate at any one
time for each currency pair. But when you go to the money changer to change
money, you will realize that there are always two exchange rates being quoted. You
will have to buy the currency at the higher rate, and if you are selling the currency,
you will have to do so at the lower rate. Similarly, there are two prices when trading
FX on your online broker. The price you sell at is known as the Bid price, and it is the
lower price. The price you buy at is known as the Ask price, or the Offer price, and it
is the higher price.

Figure 2.3: Example of a Bid and an Ask

For example, if the EUR/USD Bid price is 1.2902 and the Ask price is 1.2903, then
the currency pair can be quoted as 1.2902/03.
So far, we have discussed Bid and Ask prices from the perspective of a retail FX
trader. Depending on whether you are the broker quoting prices, or the trader taking
prices, Bid and Ask prices can mean different things. For example, the Bid price
would be the price that the trader sells at, and the price that the broker buys at. In
order not to confuse yourself, remember the following rules.
1) The Bid price is always lower than the Ask price.
2) If you are quoting prices to others, you will get to buy at the lower Bid
price and sell at the higher Ask price.
3) If you are taking prices from others, you will always need to buy at the
higher Ask price and sell at the lower Bid price.
As retail FX traders, we are usually price takers. We cannot set the prices we
wish to trade at, but we have the flexibility to choose when we enter the trade, or if
we would even enter the trade at all. Therefore, we sell at the lower Bid price and
buy at the higher Ask price. The difference between the two prices is known as the
Bid-Ask Spread, or more simply, as the spread.
The spread can vary at any moment, depending on the relative liquidity of the
market at that time. For instance, in the early hours when Wellington just opens,
there is a lack of market liquidity and the spread is usually higher. Or in another
31

scenario, if market participants know there is a major news announcement coming

up immediately, they may choose to stay out of the market to digest the news first.
In such cases, the spreads will also be momentarily higher.
The spread can be seen as a form of trading cost, and many brokers earn the
difference between the Bid and the Ask. But the spreads purpose is not just to cover
the cost of operations of the broker and to allow it to earn a small profit. The spread
is absolutely essential, as it compensates the broker for the risk it takes on in
providing the liquidity. Take the case of the money changer. Lets say he bought
100,000 from customers at the Bid price of US$1.3000. If in that very afternoon, a
major earthquake happens in Europe that makes the EUR/USD drop by 200 pips,
then the money changer would be stuck with 100,000 that it now has to sell at a
loss. Thus we can see how the spread is necessary to compensate the broker for the
risk it has to take on. The greater the potential risk exposure, the bigger the spread
required.
With increasing competition among the various online brokerages, spreads can
be quite tight, and they tend to move in intervals of 0.1 pips (also known as a
pipette). This has greatly reduced the costs of trading for retails FX traders.

Common Trade Orders

Now that we have understood currency prices in the form of the Bid, Ask and the
spread, lets take a look at how we can execute trades to buy or sell these currencies.
We execute trades by submitting trade orders to our brokers, and there are different
ways of classifying and categorizing orders.

Entry Orders
The first kind of order that we should familiarize ourselves with is the
entry order. As the name suggest, an entry order allows us to enter an
open position. An entry order can be a buy order to go long or a sell order
to go short.

Take-Profit Orders (TP)

Once we have an open position however, we need to think of a way to exit
and close the position. A Take-Profit (TP) order is an order that is tagged to
our Entry order. It will be executed to reverse the Entry order and close
the open position, once certain preset profit conditions are met. This locks
in and realizes the profits.
32

Stop-Loss Orders (SL)

Not all trades end up profitable. Thus it is important to also have a StopLoss (SL) order. Like a Take-Profit order, a Stop-Loss order is tagged to the
Entry order, and when executed, it will reverse the Entry order to close the
open position. The difference is that the Stop Loss is executed when
certain preset loss conditions are met, and kicks in to close the position
before further bigger losses can be incurred.

The concept of an Entry order accompanied by a Take-Profit and Stop-Loss order is

the basic format of most trades. In fact, the discipline of always having a Stop-Loss
order is very important, and there is really no good reason for any trader to enter a
trade with no accompanying Stop-Loss. Beyond the basic concept of the Entry, TakeProfit and Stop-Loss order, however, let us look at some other ways that orders can
be further classified.

Market Orders
The first kind of order is known as a market order. They are the simplest
kind of order, where we specify to buy or sell a fixed amount of currency
immediately at the best possible price. Entry, Take-Profit and Stop-Loss
orders can all be executed using market orders.

Slippage. Despite their apparent simplicity, there are still some

complications of using market orders that we must understand.
The first is that immediate market orders arent really executed
immediately. There is a slight delay for us to move our mouse and
click on the trigger button, after which there is a delay for the
electronic order to travel from our computer terminal to the
servers of the broker, where it is finally executed.
This ping delay can be quite substantial, as in the fast-moving
world of FX, currency prices may have changed quite a bit since
then. For instance, we may wish to purchase Euros at a certain
price, but by the time the order is being executed, prices would
have moved and the original price is no longer available. The
market order may thus be executed one or two pips higher than

33

we originally desired, and this difference between the expected

price of a trade and the actual filled price is known as the slippage.
Slippage tends to be higher during periods of higher volatility.
Higher slippage during entry would eat into your profits, and can
thus be an issue. Some broker platforms allow you to set the
maximum slippage that you will allow for each trade. If the slippage
is more than the preset maximum, then the trade will not go
through.

Conditional Orders
Instead of using market orders, another way to execute trades is to submit
conditional orders beforehand. Unlike market orders, conditional orders
are already residing in the brokers servers pending execution once the
preset conditions are met. As the delay is greatly minimized, conditional
orders suffer less from the issue of slippage. Entry, Take-Profit, and StopLoss orders can all be executed using conditional orders.

Stop Orders. The first kind of conditional order is known as the

stop order. A stop order is an order to buy or sell once prices
surpass a preset point. Once the condition is met, a stop order is
converted into a market order for immediate execution.
Stop orders to buy have to be placed above the current
market price, so that we would only buy once prices go up to our
preset level. Similarly, stop orders to sell have to be placed below
the current market price, so that we sell when prices drop to the
level we have set beforehand. For example, if the current market
price of EUR/USD is 1.3050, then I can only place a stop order to
buy EUR/USD above 1.3050. Say if I place a stop order to buy at
1.3060, then the stop order will be executed once prices advance
and rise to 1.3060.
Note that the executed price of the stop order need not be
exactly 1.3060. There will usually be some slippage, with the
position being entered slightly above 1.3060. In very rare cases,
there can also be negative slippage, with the position being
entered slightly below 1.3060.

34

Now lets look at an example for selling. If I wish to sell

EUR/USD, I would have to place a stop order below the current
market price of 1.3050. Say if I place a stop order to sell at 1.3040,
then the stop order will be executed once prices drop and hit
1.3040. Again, there will be some price uncertainty involved in the
actual price of execution, as stop orders are basically converted
into market orders once the preset conditions are met.
Stop orders can be used for entry, and are useful for trend
following. With stop orders, we would be buying when prices are
rising, and selling when prices are falling. Stop orders are not just
used for entry though. Stop-Loss orders are basically stop orders,
and are executed once the market price moves to a predetermined level. Note that because slippage is involved, we may
be stopped out at a price less favorable than what we have set.

Limit Orders. A second kind of conditional order is known as the

limit order. A limit order is an order to buy or sell only at a preset
price or better. Limit orders are used to buy below the current
market price, and sell above the current market price.
For example, if the current market price of EUR/USD is 1.3050,
then I can place a limit order to buy EUR/USD at 1.3040. The order
will be executed only when prices drop to that level or lower,
ensuring that I buy at that price or cheaper. Notice that unlike stop
orders, limit orders provides us with a greater degree of price
certainty. The limit buy order can only be executed at 1.3040 or
cheaper. If the final execution price is above 1.3040, the order will
not go through.
Limit orders can also be used to ensure that we sell at a preset
price or higher. For example, if the current market price of
EUR/USD is 1.3050, then I can place a limit order to sell EUR/USD at
1.3060. The order will only be executed when prices hit 1.3060,
and can only execute at that price or higher.
You should have noticed by now how the limit order is
essentially the opposite of the stop order. A stop order is used for
trading with the trend, while a limit order is used to catch the
bottom to ensure we buy at a cheap price, or to catch the top to
ensure that we sell at a high price.
35

Also, limit orders provides greater price certainty in that they

can only be executed at the preset prices or better. In contrast,
stop orders will be executed once the preset conditions are met.
The actual executed price may end up higher or lower than the
preset level. Limit orders are thus useful for entering Take-Profit
orders, as unlike Stop orders, they ensure the price of execution
and thus the minimum profits that we will receive.

Other Common Orders

Other common order terminologies you may encounter are OCO orders,
OTO orders, GTC orders and trailing stops.

OCO Orders. OCO orders stand for one-cancels-the-other orders.

For example, Take-Profit and Stop-Loss orders are often OCO
orders, as only one of them needs to be executed. For example if
the Take-Profit has been executed, then the Stop-Loss order is no
longer meaningful or necessary, and would be cancelled
automatically.

OTO Orders. OTO orders stand for one-triggers-the-other orders,

also known as contingent orders. For example, Take-Profit and
Stop-Loss orders are often tagged to the corresponding Entry order.
Once the Entry order is triggered, they will also be entered into the
system pending execution. If the Entry order is not triggered, the
two orders will not be entered into the system.

GTC Orders. GTC orders stand for good-till-cancelled orders. They

will remain active until you decide to cancel them. This is in
contrast to time-based orders, which are valid only for a preset
amount of time, after which they will be automatically cancelled.

36

Trailing Stops. Trailing stops are a kind of Stop-Loss order that

automatically moves along with the market price, locking in a
better Stop-Loss price as it advances. For example, you may have
bought EUR/USD at 1.3050, with Stop-Loss 20 pips away at 1.3030.
As the market price moves up from 1.3050 to 1.3090, the Stop-Loss
will automatically move up accordingly by 40 pips to 1.3070. If
prices reverse back down, the Stop-Loss remains at its latest level
of 1.3070 and would be executed, but you would have made 20
pips. A trailing stop thus locks in better and better prices as it
advances, and can even allow us to Stop-Loss at a profit.
On a related note, it is possible to shift your Take-Profit levels
to Take-Profit at a loss. Sometimes you may wish to do that in
order to close your open position at a small loss. The advantage of
exiting a position with a Take-Profit order is that because it is a
limit order, it allows us price certainty of the exit price. Compare
this with closing the position with a market order. If momentarily
the price spikes further away, and we got executed during the
spike, then we would have suffered a greater loss than was
necessary. Trailing stops often used for strategic position trading,
in cases where the trader is not willing or able to monitor the
position continuously.

Suggested Orders to Use

At Six Capital, we mainly use conditional orders such as stop orders and
limit orders for our spot trading. Stop orders are used for entry and for the
Stop-Loss, while limit orders are used for the Take-Profit.
The use of conditional orders requires that a trader does sufficient
planning of his trades. In other words, every trade which uses conditional
orders has been strategically thought out and planned beforehand. This
encourages a trader to be very diligent in the planning of his trades. We
tend not to use market orders, as the high level of slippage and price
uncertainty involved makes it unsuitable for our method of trading.

37

Chapter Review
Let us recap what we have learnt in this chapter. We have learnt to:

1. Describe the characteristics of the various trading sessions.

2. Differentiate between major pairs, cross pairs and exotic pairs.
3. Differentiate between a base currency and a counter currency.
4. Differentiate between a direct quote and an indirect quote.
5. Understand the meaning of going long, going short and being square.
6. Understand the meaning of position size, leverage, margin, mark-tomarket, and pips.
7. Interpret a Bid-Ask spread.
8. Understand how to use various common orders (entry, take profit, stop
loss, market orders, conditional orders, stop orders, limit orders, etc.).

38

What is Technical Analysis?

As mentioned earlier, technical analysis is the study of prices as well as other
statistics generated by market activity, for the purpose of making profitable trading
or investment decisions. Before going further into this study, lets first look at some
of the basic key assumptions of technical analysis.

Key Assumptions
Price is Determined by Supply and Demand
Similar to fundamental analysis, technical analysis believes in the
economic theories of supply and demand. Supply and demand is
significantly influenced by buyer and seller expectations, thus market
psychology and sentiment plays a key role.
As we have learnt earlier, expectations can be different between
different parties, because they receive new information at different
speeds, or perceive the same information differently. Expectations can
also be shaped by human emotions like greed and fear, as well as be
affected by cognitive limitations like behavioural biases and faulty thinking.
All these will influence the supply and demand, and thus, prices.

The Market Discounts Everything

Technical analysts believe that the market is always correct. Instead of
trying to consider all the fundamental factors that may influence the
supply and demand of currencies, they believe that all the dynamics are
already factored into the currency prices themselves. Thus the focus and
emphasis is on what happens within the markets, instead of what happens
outside.

Price Moves in Trends

A trend is a directional movement of prices that remain in effect long
enough for it to be identified, and profited from. Trends result from supply
and demand. For example, if a bullish piece of news emerges, it will filter
to the market participants at different speeds. As more and more people

40

receive and interpret the bullish information, demand increases and we

see an uptrend of higher and higher prices.
At the same time, the market creates an
emotional feedback loop with its participants. If
I bought a currency and its price rises, I will be
happy, and may buy more again, or I may tell
others to buy too. Others who missed out on
the buying earlier will also notice the up-move,
and may join in the buying on expectations that
prices will rise further. All these buying causes
prices to actually rise, creating a feedback loop.
Excessive feedback can sometimes create
irrational exuberance though, leading to the
formation, and bursting, of bubbles.

Figure 3.1: Ex-Fed Chairman

Alan Greenspan coined the
term irrational
exuberance in a speech in
1996, to warn of the bubble
in stock markets

Technical analysis assumes that after a trend has been established,

the future price movement is more likely to be in the same direction as the
trend than to be against it. However, prices will always eventually revert
back to the mean. Most technical trading strategies are based on these
basic beliefs.

History Tends to Repeat Itself

The fourth assumption is that history tends to repeat itself, and that
humans tend to behave similarly to how they have in the past under
similar circumstances. To quote famous author Mark Twain, History
doesnt repeat itself, but it does rhyme.
The repetitive nature of price movements forms recognizable patterns
that tend to have predictable results. The patterns are never identical
though, and thus are subject to personal interpretation and biases from
the technical analyst.

Patterns are Fractal in Nature

Fractals refer to patterns that are similar at every scale. In other words,
they look the same from near as from far. Fractals are common and
naturally occurring in the world we live in.
For instance coastlines are fractal. From a satellite image, the coast
will look incredibly jagged, but if we zoom in, smaller jagged edges emerge
41

from each jagged edge. Go progressively

deeper and the complexity of the jags shows
itself more.
Similarly, market prices follow a fractal
nature. For example, if you look at a longterm price chart over 10 years, and compare
it to a short-term price chart over 10 weeks,
you will not be able to differentiate them. In
fact, you can zoom in further to shorter and
shorter time frames, and the patterns will all
look similar. Thus when analysing trends, the
length of the trend is irrelevant. The basic
technical principles can be applied to all time
frames.

Figure 3.2: Both coastlines

and price movements
display a fractal nature

Price Action
After understanding the key assumptions of technical analysis, let us now cover one
of the most important topics in technical analysis: price action. Price action is
basically how prices move, and price action analysis works best in markets where
liquidity and volatility are highest, like the FX market. At Six Capital, price action
trading is the method that we focus on, so it is important that you understand this
topic well. We shall begin our discussion on price action with an introduction to price
charts.
Price charts are graphical displays of the underlying reality of actual price
movements. Price charts are very useful, because they aid us in recognizing patterns
and trends. Of course, the recognition can be quite subjective at times, so it is
important for the trader to accumulate experience and hone up his skills.

Line Charts
The most basic form of price chart is the line chart. The simply chart
provides information about two variables, price and time, with price
usually referring to the closing price of each period. In a daily chart for
instance, the price points will be plotted based on the daily closing price.
The closing price is preferred by some traders, as they do not care
about the price fluctuation during a time frame and only the closing price
is important for them. This is especially so for higher timeframes of at least
a day, on markets which do physically open and close (e.g. the stock
42

market). Line charts represent price changes with a line, and thus allow us
to see patterns and trends in a clear and uncluttered manner.

Figure 3.3: A line chart of the EUR/USD pair

Bar Charts
A more complicated form of chart is the bar chart. Each bar represents a
fixed time frame of our choice. For example, a bar would represent 10
seconds in a 10-second chart and a day in a daily chart.
A bar chart contains more information than a line chart, as it shows
the opening, high, low, and closing prices of a period. These four pieces of
information is often referred to as OHLC, for Open, High, Low and Close.
Each bar is a vertical line showing the range (high and low). A long line
represents a wider trading range while a short line represents a narrow
trading range. A short horizontal line on the left of the bar indicates the
opening price, while the closing price is denoted by a short horizontal line
on the right.
If we look at the chart bar by bar, we can obtain a lot of quick
observations about the price action during those bars. As we look at more
bars, patterns can emerge that give a broad picture of the price action
across the entire time frame.

43

Figure 3.4: A corresponding bar chart of the EUR/USD pair

Candlestick Charts
Candlestick charts originated in the seventeenth century in Japan, where
they were used to trade rice futures. They remained out of sight of most of
the Western world, until Steve Nison wrote a book in 1991 introducing
candlestick analysis to Western traders. Today, practically all brokers
include candlestick charts in their platforms, and the charts have grown
very popular because of their ease of visual interpretation.

Figure 3.5: A corresponding candle chart of the EUR/USD pair

Candlestick charts are essentially similar to bar charts, in that they

represent information of the OHLC. Like bar charts, each candle represents
price action over one specific chosen period (e.g. one minute or one day).

44

Figure 3.6: Reading a candlestick

The top and bottom of a rectangular box is used to show the open
and close price. The box is usually referred to as the real body. If prices
went up over the period, the close will be above the open, and the body is
shown in white (or commonly, green). If prices went down over the period,
the close will be below the open, and the body is shown in black (or
commonly, red).
The length of the candles will tell us the difference between the open
and the close, with long candles indicating that prices closed significantly
higher or lower. If the open or close is the same or very similar, the body
can be so short that it shows up as just a horizontal line.
The high and low of the period is represented by thin vertical lines
extending out from the body. These lines are known as shadows, or wicks.
The shadow above the body is called the upper shadow, and it shows
where the high of the period reached. The shadow below the body is
called the lower shadow, and it shows where the low of the period was.
Long shadows would indicate significant volatility during the period, as the
trading range during the period was large.
Part of the reason why candlesticks are so popular nowadays is that
there are many candlestick patterns with interesting and novel names.
Candlestick patterns are an extensive topic in itself, so we will only go
through a few of the popular candlestick patterns below to provide a
flavour.

45

Doji. A doji pattern is formed when the open and close are at the
same, or very similar prices. This creates a candlestick with a real
body that looks like a horizontal line. A doji suggests that the
market is in equilibrium and is caught in indecision. If found within
a trend, it can be a warning signal that the trend is stalling and may
reverse.

Figure 3.7: Variants of doji candlesticks

Harami. A harami pattern is a two-candlestick pattern. The first

candle has a large body of either colour, and it is followed by a
candle with a small body completely within the boundaries of the
large body. The focus of the harami is on the body of the second
candle being within the body of the first candle, the shadows are
not so important.
A harami indicates a contraction in volatility. Depending on
how prices subsequently break, it may signify the reversing of a
trend, or an increase in the velocity of the existing trend.

Figure 3.8: Variants of harami candlestick patterns

Morning Star and Evening Star. A morning star is a threecandlestick pattern that occurs at market bottoms. It begins with a
downward candle, with the second candle being a star, meaning
that prices opened lower and its body lies completely below the
body of the first candle. However, the third candle rises, and closes
well within the range of the first candle. Ideally, the body of the
third candle would not touch the body of the star.
A morning star signifies that the downtrend is likely reversing.
An evening star is similar to the morning star, except that it
46

appears at market tops, and signifies that the uptrend is likely

reversing.

Figure 3.9: Morning Star and Evening Star patterns

Price Spikes
Now that we have an understanding of the different charts, we can move
on to understand some common patterns we will encounter and what
they potentially mean.
Sometimes, you will notice that the market delivers a candle that
looks like the trading activity went crazy. This creates a price spike
(sometimes known as a tail), where the shadow is abnormally long, and
the high or the low is very far away from the preceding trend.

Figure 3.10: Example of a price spike

In some cases, a spike can turn out to be an anomaly. A spike

downwards suggests that some people panicked and were selling at such a
high quantity and at such a frantic pace that the few buyers around were
able to buy at abnormally low prices. Conversely, a spike upwards suggests
that some people were buying at such a high quantity and at such a frantic
47

pace that the few sellers around were able to sell at abnormally high
prices. Subsequent candles will show the price resuming its prior trend
with a normal trading range. Such situations are especially likely to happen
when the liquidity of the market is low, for example when significant news
announcements are to be released very shortly.
In other cases, a spike can signify the start of a trend after a breakout,
or the end of a trend. For example, at the end of an accelerated trend, the
final candle may be a huge spike indicating the last burst of buying before
exhaustion sets in. This is also sometimes known as the climax.
As we can thus see, spikes have to be analysed and interpreted based
on the context in which it is happening. Because of their potential
significance, they should serve as a signal for us to look closer into the
current price action. Some traders will pay especial attention to where the
spike closed, as it sums up the market sentiment after the entire trading
period of the candle.

Price Gaps
A gap is an empty space between a trading period and the following
trading period. This occurs when there is a large difference in prices
between two sequential trading periods.

Figure 3.11: Example of a price gap

For example, if the EUR/USD closed at 1.4264 for one trading period
and the next period opens at 1.4201, there will be a large gap on the chart
between these two periods. The gap created in the price history indicates
a price range where no transactions occurred.
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Gap price movements can be found on bar charts and candlestick

charts but will not be found on the basic line charts. They may or may not
be significant, depending on the context. For example, gaps tend to appear
in illiquid markets. We will observe them in thinly traded currency pairs, or
during portions of trading sessions where few market participants are
around.
Gaps can also happen when there is a substantial time delay between
the close of a trading period and the open of the next period on a price
chart. For instance during weekends, new information may emerge that
impact currency prices. When the FX market opens on Monday, the first
candle may open significantly away from the Friday close.

Breakaway Gaps. Breakaway gaps happen at the start of trends,

when prices suddenly break through a formation boundary and a
major trend begins. The strength of the trend is usually associated
with the size of the gap. However, false gaps do happen, and if
prices return to fill the gap, then the pattern is no longer indicative
of the start of a new trend.

Runaway Gaps. Runaway gaps occur along trends, and they usually
appear in strong trends that just keep moving in one direction.

Exhaustion Gaps. Another kind of gap is the exhaustion gap, which

happen at the end of trends. They appear similar to runaway gaps
when they first happen, but the gap will soon be filled, signifying a
potential trend reversal. Exhaustion gaps can appear as morning
stars or evening stars on candlestick charts.

As we can thus see, gaps are similar to spikes in many ways. Their
interpretation is dependent on the context though, so subjective bias can
emerge when traders are analysing them.

Support and Resistance

Next we will learn about one of the most important topics in price action:
support and resistance. Support and resistance represent key junctures
49

where the forces of supply and demand meet. As we have learnt, prices
are driven down by excessive supply and driven up by excessive demand.
When supply and demand are equal, prices move sideways as bulls and
bears slug it out for control.
Support is defined as the price level where there is buying interest
that could overcome previous selling pressure. Traders are more willing to
buy at these levels. Whenever price falls to a support level, more buyers
come in. Because demand now exceeds supply, the price is pushed back
up.

Figure 3.12: Buying interest comes in at support

Conversely, resistance is defined as the level where there is selling

interest that could overcome previous buying pressure. Traders are more
willing to sell at these levels. Whenever buyers push the price up to a
resistance level, sellers will come in to sell. Because supply exceeds the
demand at this level, prices fall back down.

Figure 3.13: Selling interest comes in at resistance

So, how do we find these support and resistance levels? For support
levels, we simply need to join the lows with other lows using a straight
horizontal line. At Six Capital, we draw support levels using a blue line as a
convention. For resistance levels, we join the highs with other highs, also
using a straight horizontal line. As a convention we draw resistance levels

50

using red lines. As price patterns are fractal, the techniques for drawing
support and resistance applies to any chart on any timeframe.
So far, we have learnt that support and resistance are psychological
barriers for prices that traders remember. However, these barriers cannot
hold forever. A break below support signals that the bears have won out
over the bulls. It indicates a new willingness to sell and/or a lack of
incentive to buy. The market has reduced its expectations and is willing to
sell at even lower prices. Once support is broken, another support level
will have to be established at a lower level.
Sometimes, though, price movements can be volatile and prices can
dip below support or break above resistance briefly. Therefore, some
traders establish support and resistance zones instead of exact support
and resistance levels.

Figure 3.14: Support and resistance levels can be drawn for any timeframe

Trends
The trend of a market is the general direction of its price. In order to
determine the trend, we refer to the direction of price action built up to
give us an idea of the trend in the market.
One of the key mindsets a trader must have is that the trend is your
friend. It is far easier to be profitable when you are trading with the trend.
In the trading methodology of Six Capital, we always stick to Direction,
Level and Timing in our trading analysis. Therefore, to be able to trade
successfully, we must first identify the direction of the market in the form
of the trend.
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Types of Trend. An uptrend describes a market where the general

direction of price is upwards. It is characterized by the formation of
a series of higher highs and higher lows.
In this example, we can see a formation of a series of higher
highs and also higher lows. This forms a bullish trend where the
general direction of price is upwards. This is called an uptrend.

Figure 3.15: An uptrend is characterized by higher highs and higher lows

A downtrend describes a market where the general direction

of price is downwards. It is characterized by the formation of a
series of lower highs and lower lows. In this example, we can see a
formation of a series of lower highs and also lower lows. This forms
a bearish trend where the general direction of price is downwards.
This is called a downtrend.

Figure 3.16: A downtrend is characterized by lower highs and lower lows

52

A ranging market describes a market with no clear direction.

There is no indication of an uptrend or downtrend. It is
characterized by the lack of any significant highs or lows. In this
example, we can see that there are no significant highs and lows.
This forms a market where there is no clear direction of price
upwards or downwards. This is called a ranging market.

Figure 3.17: A range-bound market has no significant highs and lows

Trendlines. When describing trends, it is possible to draw

trendlines to box in the price action. Trendlines are like support
and resistance levels, just that they are sloping instead of
horizontal lines.
Now lets learn what constitutes a trendline. In our trading
methodology, we always adopt a three point trendline. The
trendline must constitute the incident, coincident and trend in
order to confirm a trendline.
The incident of a trendline is the first occurrence point formed
at the bottom of a potential up channel, or the top of a down
channel. It is simply a price level where a new trend starts to form.
The coincident of a trendline is the first higher low in an
uptrend, or the first lower high in a downtrend. The incident and
coincident forms a tentative trendline, and they are connected
using a dotted line. We use a blue dotted line for a tentative
uptrend, and a red dotted line for a tentative downtrend.
The trend is formed as the next higher low in an uptrend, or
the next lower high in a downtrend. When the trend is confirmed,
all 3 points are connected using a solid line.
53

Figure 3.18: A trend is confirmed when all 3 points are formed

Acceleration and Deceleration. Sometimes, trends can accelerate

or decelerate. Acceleration is defined as an increased buying or
selling interest of a market in a trend. Hence, price starts moving in
a steeper channel.

Figure 3.19: Acceleration of an uptrend happens when there is increased buying interest

Generally, price can accelerate because in an uptrend, buyers

cannot wait to buy, while in a downtrend, sellers cannot wait to sell.
Therefore, the market adopts a steeper channel based on the
market interest. When there is deviation away from the initial
trendline as a result of an acceleration, it does not mean that the
trend has changed. Instead, an accelerated channel is actually an
extension of the initial trendline.
Deceleration is defined as the decline in the strong buying or
selling momentum of the market. Deceleration occurs because the
increased buying or selling interest that was present in an
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acceleration is no longer sustainable. As a result, the accelerated

channel that had occurred will break down and the market would
continue to trade along the initial trendline.

Figure 3.20: The downtrend decelerates from its initial acceleration

Channels. Recall that for an uptrend, the trend line is plotted by

connecting the higher and higher lows, while for a downtrend, the
trend line is plotted by connecting the lower and lower highs. In
other words, for an uptrend, the price action would lie above the
trend line, while for a downtrend, the price action would lie below
the trend line. However, sometimes, we can draw a channel for the
trend. The channel would appear to contain the price action, and
prices bounce between the upper and lower boundaries of the
channel.

Figure 3.21: The up channel breaks out of the prior down channel

55

To draw the channel of an uptrend, we first plot a trendline

based on the lows. Then we draw a line parallel to the trendline,
above the highs of the trend, trying to connect as many points as
possible. To draw the channel of a downtrend, we do the same
thing, drawing a parallel line to the trendline to contain the price
action.
Channels can give us a clue of where prices may trade. For
example, in an uptrend, if prices are at the top of an established
channel, then it will not be so easy for prices to rise further and
break the channel. Note though, that it is possible for prices to
move out of the channel, especially when prices are accelerating or
reversing.

Retracements. As we can see so far, prices hardly ever move in a

straight line. Trends will almost always include smaller
countertrends, as they trend up or trend down in a zigzag manner.
Retracements are thus basically corrections to the main trend.
For example, in an uptrend, as prices go higher, new sellers would
appear to sell at the higher prices, and some of the previous buyers
may also sell their current holdings to take profit. This causes prices
to move back down. However, as the overall trend is bullish, there
will still be a lot of ready buyers. As prices retrace to cheaper levels,
market participants who missed the earlier up-move will take
advantage of the opportunity to enter the market. Previous buyers
who had taken profit, or who may still be holding on to their open
positions, can also take this chance to buy again. Thus prices will
move up again, essentially forming a higher low. If the demand is
strong enough, prices can actually break past the previous high to
form a higher high.
Retracements can be analysed in the same way as how we
would analyse a bigger trend. They are a manifestation of the
fractal nature of trends. How prices retrace can also tell us a lot
about the bigger trend. For instance in an uptrend, if the bullish
sentiment is very strong, we would expect the downward
retracement to be short, before prices start moving up again.

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Pullbacks and Throwbacks. A special case of a retracement

is a pullback or a throwback. Sometimes when prices break
a support level, they will quickly retrace back to the former
support, before continuing their downward move. This is
known as a pullback to the former support.
You will realize that once a key support level is broken,
it will often reverse roles and become a resistance level for
subsequent price action. The market psychology behind this
is that when a support is broken and prices go down, the
bulls are stuck with long positions that they may want to
get out off. When prices retrace back to the former support,
these traders will then take the opportunity to sell off their
long positions at breakeven cost or a small loss. Thus the
former support now becomes a resistance that exerts
downward pressure on prices.
When prices break a resistance level and retrace to the
former resistance, the same thing happens, and we call that
a throwback.

Figure 3.22: Prices retrace back to the former

resistance, before resuming the uptrend

Reversals. Retracements are basically minor corrections in a larger

trend before the trend resumes. But sometimes, instead of a minor
correction, the entire trend reverses. This is called a reversal.
Reversals and retracements can look quite alike in the early
stages. We will discuss more about differentiating retracements
from reversals in the subsequent sections.

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Consolidations, Breakouts and False Breaks

We have just discussed at length the most fundamental concept of all
technical analysis the trend. Recall that markets can be trending upwards,
trending downwards or ranging.

Consolidations. A ranging market is also termed as a consolidation.

It is a period of indecision, as the market sorts out where it will go
next. Consolidation can lasts for minutes, days or months,
depending on the timeframe we are looking at.

Breakouts. In a consolidation, price action coils up between the

support and resistance levels, like a spring storing its energy.
Usually, the longer the consolidation, the more energy is stored.
Eventually a breakout occurs when prices break out from the
prior established support or resistance. A breakout is a significant
event, as it reflects a significant change in the balance of supply
and demand. Breakouts usually mean a new trend is starting.
Breakouts need not just happen in a consolidating range. A
breakout can also be from an established trendline, suggesting that
the trend no longer holds and may retrace or even reverse.

Figure 3.23: Prices breakout from the consolidation on the downside

58

False Breaks. Sometimes, prices break out from a consolidation,

only to quickly return back to the consolidation. These momentary
breaks are sometimes in the same direction of the eventual real
breakout. If so, they are termed as premature breakouts. If they
are in the opposite direction to the eventual real breakout, then
they are termed as false breakouts. With hindsight, it is possible to
differentiate the two, but at the time when they are occurring, it
may be tough to tell which kind of breakout it is.

Elliot Wave Theory

We know by now that prices move in zigzag patterns. A trend will often
contain counter-trends within, and the counter-trends themselves can
contain counter-counter-trends. That is the fractal nature of price
movements. The zigzag nature of trends is described by the Elliot Wave
Theory (EWT), which was first proposed by Ralph Nelson Elliot.
Born in 1871, Elliot worked as a railroad accountant for most of his life.
After his retirement, Elliot started analysing the stock markets, and he
observed that stock markets seem to move in a certain special way. In
1938, at the age of 67, he published his first book called The Wave
Principle. Within the book, Elliot argues that market psychology moves
between optimism and pessimism in natural sequences. These mood
swings create patterns in how markets trend.

Figure 3.24: Markets move in zigzag waves, with each wave comprising of smaller wavelets

59

According to EWT, in a main uptrend, Waves 1, 3 and 5 are in the

direction of the trend, and they are corrected by the retracements of
Wave 2 and 4. Think of the EWT pattern as being three steps forward,
two steps back. It is possible to zoom in one step further. As Waves 1, 3
and 5 are in the direction of the trend, they will consist of 5 sub waves.
Waves 2 and 4 are shorter, and will only have 3 sub waves. We can
continue zooming in to find that Wave 1, 3 and 5 actually consists of 21
smaller waves, while Waves 2 and 4 contains 13 smaller waves. Refer to
the image above for a graphical representation of this.
EWT contains many other rules and guidelines, the scope of which is
beyond this discussion. Some traders feel that Elliot analysis can be
difficult to apply, as it is not easy to interpret the waves while they are
occurring. Still, it can help us get a feel for the rhythm of the market, and
in obtaining an awareness of how the market looks in different timeframes.

Fibonacci Retracements
Leonardo of Pisa, also known as Fibonacci, was an Italian mathematician
born in 1170. In his book Liber Abaci, Fibonacci wrote about a number
sequence where each number is the sum of the previous 2 numbers, with
the sequence starting with 0 and 1. These numbers are known as Fibonacci
numbers, and the sequence goes like this:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987 ...
Fibonacci numbers are interesting, because they allow us to derive
what is termed as the golden ratio. Except for the first few numbers in the
sequence, if we divide any Fibonacci number with the preceding number
in the sequence, we always get the ratio 1.618 (e.g. 987 / 610 = 1.618). If
we divide any Fibonacci number with the next number in the sequence,
we always get the ratio 0.618 (e.g. 610 / 987 = 0.618). If we divide
alternate Fibonacci numbers, we get the ratio 0.382 (e.g. 377 / 987 =
0.382). The higher up we go in the sequence, the closer the ratios get to
1.618, 0.618 and 0.382.
Mathematicians and scientists find Fibonacci ratios fascinating,
because they contain some intriguing properties. For instance, you may
realize that 0.382 and 0.618 add up to 1. 1.618 and 0.618 are also
reciprocals of each other (i.e. 1 / 1.618 = 0.618; 1 / 0.618 = 1.618).
More importantly, Fibonacci ratios are found to occur everywhere in
nature, for example in galaxy spirals, spider webs, flowers, ocean waves,
60

and even in our fingers when curled. Fibonacci ratios are also frequently
used in architecture, and have been used since ancient times in the
building of the pyramids.

Figure 3.25: Fibonacci patterns are found commonly in nature, for example in this flower above

Traders believe that the market also tends to follow the Fibonacci
numbers. Recall from the Elliot Wave Theory that prices move in waves,
and every trend will usually contain retracements. It is believed that when
the market retraces, the retracements will usually hold at the key
Fibonacci levels of 0.382, 0.500 or 0.618, before resuming the main trend.
Lets elaborate using the example of an uptrend. To obtain the
Fibonacci levels, we need to identify the start of the uptrend, as well as
the highest point reached in the trend. To identify the start of the trend,
we choose the lowest candlestick at the start of the trend of interest. This
is known as the swing low. To identify the highest point, we will need to
wait for the market to be obviously retracing from a highest point, and
then we take the highest candlestick. That is known as the swing high.
Most charting tools on trading platform will then automatically plot out
the Fibonacci levels for you. If prices retrace to the 0.382 level, it means
the market has retraced 38.2%. While if prices retrace to the 0.500 level, it
means prices have retraced 50% since the beginning of the uptrend.
As market participants anticipate the Fibonacci levels, the levels will
tend to act as support or resistance levels. We can thus get a clue to the
strength of the bullish sentiment of the main uptrend, by seeing where the
retracements hold. For example, if prices retrace to 38.2% and then
resume the main uptrend, then the market has to be quite bullish. Even if
prices retrace to 50% or 61.8%, they are still bullish indicators, as they are
within the normal range of retracement.

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Figure 3.26: Prices retrace to the 38.2% Fibonacci level before resuming the upward trend

However, if prices fail to hold at 61.8% and go down further, this may
signal two possibilities:
a) Firstly, it may mean that the market is no longer bullish. We may
see a 100% retracement of the main uptrend.
b) Secondly, we may be seeing a trend reversal. If price retraces more
than 61.8% in the main uptrend, many buyers may turn into sellers,
and turn the main trend from an uptrend into a downtrend.
One key thing to remember though is that Fibonacci levels do not
always hold true. They are a useful tool for the trader, but they must serve
as only one out of the many tools that the trader uses.

Fractal Nature of Price Action

Due to the fractal nature of trends, all the lessons that we have learnt so
far can be applied to any time frame. Depending on the timeframe we are
looking at, we will see different things. For example, on the 1-minute chart,
it may be an uptrend for the past three hours; while on the 10-minute
chart, we may be stuck in a ranging market for the past day. If we zoom
out further to the hourly chart, we may actually be on a downtrend for the
past week.
Which timeframes of the market we look at is determined by the
kinds of trades that we are intending to do. For example, if we are
intending to enter and exit our trades within minutes, then it may not
make sense to focus on the hourly chart, where trends can take days to
materialize.
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That being said, we should still monitor the market over multiple
timeframes, as we have learnt from Elliot Wave Theory that the waves we
are analysing need to be evaluated in the context of the bigger waves.

Six Basic Chart Patterns

Through experience, traders have identified various common chart patterns that are
useful for describing the price action and for helping us to identify the underlying
dynamics of the market. Here, we will introduce six basic chart patterns that are the
most useful.
The 6 basic chart patterns are grouped into 3 main categories continuation
patterns, key reversal patterns and consolidation patterns. Firstly, continuation
patterns consist of triangles and flags. Secondly, there are the key reversal patterns.
They consist of the double top and double bottom, as well as the head and shoulders
and the inverted head and shoulders. Thirdly, consolidation patterns consist of
triangles and rectangles. At Six Capital, we mainly use these six basic chart patterns
to analyse price action, so you may wish to pay closer attention to the upcoming
discussion.

1. Continuation Patterns: Triangles

A continuation pattern is defined as a temporary diversion in the
behaviour of a market, which will eventually continue its existing trend. In
other words, in a trending market, a continuation pattern is a brief pause
or consolidation, before the market continues the precedent trend. As we
have learnt before, the trend is your friend. Therefore, in trading, we can
use such patterns to help us identify opportunities to enter trades in the
direction of the trend.
Triangles are continuation patterns that form mid-trend as a result of
price consolidation. They are usually short term chart patterns on the 10minute and 1-minute timeframes that occur after a sharp rally or drop.
The market continues the precedent trend after the completion of the
triangle pattern. Triangles are formed when price action tightens into a
coil. The highs and lows form smaller ranges as price moves towards the
apex of the triangle.

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Symmetrical Triangles. A symmetrical triangle consists of two

converging trendlines, that join a series of lower highs, and higher
lows, with the apex formed near the centre of the price. Both the
buyers and sellers are uncertain as to where the market is headed.

Figure 3.27: Symmetrical Triangle

Ascending Triangles. An ascending triangle consists of an upward

slope formed by connecting the higher lows, and a flat top as the
highs are not significantly higher. The price should also hit both
lines at least twice. In this pattern, the buyers are more aggressive
than the sellers.

Figure 3.28: Ascending Triangle

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Descending Triangles. A descending triangle consists of a

downward slope formed by connecting the lower highs, and a
flat bottom as the lows are not significantly lower. The price
should also hit both lines at least twice. In this pattern, the
sellers are more aggressive than the buyers.

Figure 3.29: Descending Triangle

Measuring Objectives and Minimum Objectives. With a confirmed

chart pattern, we can have a price target of where the market is
likely to head, based on that specific chart pattern. We first
calculate the length of the measuring objective, based on the
dimensions of the chart pattern that is forming. The measuring
objectives of triangle formations are measured as below. We will
simply measure from the first significant low to the top of the
triangle, or from the first significant high to the bottom.

Figure 3.30: Measuring Objective of Triangles

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To derive the price target after the pattern breaks out, we will
add the distance of the measuring objective to the point of
breakout. This price target is known as the minimum objective.

2. Continuation Patterns: Flags

Flags are continuation patterns that form mid trend as a result of price
consolidation. Similar to triangles, they are usually short term chart
patterns on the 10-minute and 1-minute timeframes that occur after a
sharp rally or drop. The market continues the precedent trend after the
completion of the flag pattern.
In order for a flag pattern to start forming, it must first have a flagpole.
The flagpole is the sharp rally or drop that precedes the flag itself. The
magnitude of the flagpole is measured from the low swing to the top of a
bullish flag, or from the high swing to the bottom of a bearish flag. The flag
itself should only retrace to a maximum of 50% of the initial move, if it is
to continue the precedent trend.
A bullish flag consists of two parallel trendlines that join a series of
lower highs, and lower lows. It is preceded by a bullish rally, and results in
a break out to the upside. The measuring objective is the length of the
flagpole.

Figure 3.31: Bullish Flag

A bearish flag consists of two parallel trendlines that join a series of

higher highs, and higher lows. It is preceded by a bearish decline, and

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results in a break out to the downside. Similarly, the measuring objective is

the length of the flagpole.

Figure 3.32: Bearish Flag

3. Key Reversal Patterns: Double Tops and Double Bottoms

Double Tops
A double top is a key reversal pattern that forms at the end of an uptrend,
after an extensive rally. Price tests a resistance level twice, before going
into an extended decline. The breakout happens in the direction of a
downtrend. A double top is formed when price first forms a high, pulls
back from it and retests the high. The low formed by the pullback marks
the neckline of the double top.
Like all chart patterns, the double top has a minimum objective. For
the double top, the measuring objective is the vertical distance measured
from the top to the neckline. The minimum objective is then found by
projecting the measuring objective down from the neckline. The double
top is said to have materialized when the neckline is broken convincingly
with a lower low. Let us take a look at an illustration of a double top.

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Figure 3.33: Double Top

The preceding trend is bullish, as higher highs and higher lows are
formed until here, where the high reaches almost the same level as the
previous high.
Neckline. At this point, the low formed by the pullback is a
significant support level, as any significant break below that level
will breach the trend and result in the formation of a lower low.
This significant support level is commonly known as the neckline,
and the double top is materialized once this support is broken
convincingly.
The neckline is also used to determine the minimum objective
of the move, which is measured from the tops to the neckline and
then projected down from the neckline. Usually, after a break, the
market will pull back and find resistance at the neckline, before it
continues its move down to the objective.

Double Bottoms
Double bottoms are exactly like double tops, except that they form at the
end of a downtrend, after an extensive decline. The breakout happens in
the direction of an uptrend. A double bottom is formed when price first
forms a low, pulls back from it and retests the low. The high formed by the
pullback marks the neckline of the double bottom.
For the double bottom, the measuring objective is measured from the
bottom to the neckline. The minimum objective is found by projecting the
measuring objective up from the neckline. The double bottom is said to

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have materialized when the neckline is broken convincingly with a higher

high. Let us take a look at an illustration of a double bottom.

Figure 3.34: Double Bottom

The preceding trend is bearish, as lower highs and lower lows are
formed until here, where the low reaches almost the same level as the
previous low.
Neckline. At this point, the high formed by the pullback is a
significant resistance level, as any significant break above this
resistance will breach the trend and result in the formation of a
higher high. This resistance level is known as the neckline, and the
double bottom is materialized once this resistance is broken
convincingly.
The neckline is also used to determine the minimum objective
of the move, which is measured from the bottom to the neckline
and then projected up from the neckline. Usually, after a break, the
market will pull back and find support at the neckline, before it
continues its move up to the objective.

4. Key Reversal Patterns: Head & Shoulders and Inverted Head &
Shoulders
Head & Shoulders
Head and shoulders is a reversal pattern that forms at the end of an
uptrend, after an extensive rally. Price will then form a peak, then a higher
peak, followed by a lower peak, before going into an extended decline. A
head and shoulders pattern forms when price tests a first high, pulls back
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to a support level, then tests a higher high. Price pulls back to the support
level again, and then forms a lower high. The lows formed by the pullback
marks the neckline of the head and shoulders pattern.
As with all chart patterns, the head and shoulders has a minimum
objective. The measuring objective of the formation is the vertical distance
from the head to the neckline. The minimum objective can be found by
projecting the measuring objective counter trend from the neckline of the
formation. The head and shoulders formation is said to have materialised
when the neckline is broken convincingly. Let us take a look at an
illustration of a head and shoulders key reversal pattern.

Figure 3.35: Head and shoulders formation

The preceding trend is bullish, as higher highs and higher lows are
formed. At the resistance level, there is significant selling interest that
pushes price down to the support level at the previous low. Now, we can
see the left shoulder and head forming. At the support level, there is some
buying interest. However, the sellers cannot wait to sell, hence a lower
high is formed.
Neckline. At this point, the lows formed by the pullbacks rests on a
significant support level, as any significant break below that level
will breach the trend and result in the formation of a lower low.
This support level is known as the neckline, and the head and
shoulders is materialised once this support level is broken
convincingly.

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The neckline is also used to determine the minimum objective

of the move, which is measured from the head to the neckline.
Usually, after a break, the market will pull back and find resistance
at the neckline, before it continues its move to the objective.

Inverted Head & Shoulders

An inverted head and shoulders is basically the opposite of a head and
shoulders key reversal pattern. It forms at the end of a downtrend, after
an extensive decline. Price will then form a low, then the lower low,
followed by a higher low, before going into an extended incline. An
inverted head and shoulders pattern forms when price tests a first low,
pulls back to a resistance level, then tests a lower low. Price pulls back to
the resistance level again, and then forms a higher low. The highs formed
by the pullback marks the neckline of the inverted head and shoulders
pattern.
The measuring objective for the inverted head and shoulders key
reversal pattern is similar to the measuring objective of an ordinary head
and shoulders pattern, except in the opposite direction. The measuring
objective of the formation is from the head, in this case the lowest low, to
the neckline. The minimum objective can be found by projecting the
measuring objective counter trend from the neckline of the formation. The
formation is said to have materialised when the neckline is broken
convincingly. Let us take a look at an illustration of an inverted Head &
Shoulders key reversal pattern.

Figure 3.36: Inverted head and shoulders formation

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The preceding trend is bearish, as lower lows and lower highs are
formed. At the support level, there is significant buying interest that
pushes price up to the resistance level at the previous high. Now, we can
see the left shoulder and inverted head forming. At the resistance level,
there is some selling interest. However, the buyers cannot wait to buy,
hence a higher low is formed.
Neckline. At this point, the highs formed by the pullbacks rests on a
significant resistance level, as any significant break above that level
will breach the trend and result in the formation of a higher high.
This resistance level is known as the neckline, and the inverted
head and shoulders is materialised once this resistance level is
broken convincingly.
The neckline is also used to determine the minimum objective
of the move, which is measured from the Head to the neckline.
Usually, after a break, the market will pull back and find support at
the neckline, before it continues its move to the objective.

Key Reversal Variant: Triple Tops and Triple Bottoms

Triple tops are reversal patterns that form at the end of an uptrend. Price
tests a resistance level 3 times, before going into an extended decline.
Triple bottoms are simply the opposite. When compared to a double top
formation, a triple top is formed when the highs are tested thrice instead
of twice. When compared to a head and shoulders formation, the 3 tops
are at equal levels instead of the head being the extreme. The minimum
objective and breakout is similar to a double top formation. Lets look at
an example.

Figure 3.37: Triple top

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In this uptrend, price failed to break the resistance for the second
time forming a double top, and finds support at the previous low. As the
double top formation failed to materialize, price retests the resistance
level again, but fails to break for the third time. As a result, a lower low,
and a lower high at the previously supported level is formed. A trend
reversal has taken place, and the triple top formation is complete, with the
minimum objective level met.

5. Consolidation Patterns: Triangles

A consolidation is a chart pattern that indicates market uncertainty.
Depending on the side which the chart pattern breaks out, it can either be
a continuation or reversal pattern. In the trading methodology of Six
Capital, we focus on two types of consolidation patterns: triangles and
rectangles. Let us first learn about triangles.
Triangle consolidation patterns are bigger in size as compared to
triangle continuation patterns. Also, they need not be formed after a sharp
move. Depending on the side which the chart pattern breaks out, it can
either be a continuation or reversal pattern. The pattern is said to have
materialised when price breaks out convincingly.
Triangles are formed when price action tightens into a coil. The highs
and lows form smaller ranges as price moves towards the apex of the
triangle. This is caused by the fight between the buyers and sellers. Like all
chart patterns, there is a minimum objective for a triangle consolidation
pattern. The measuring objective is simply the height of the pattern. The
minimum objective can be found by projecting the measuring objective
from the breakout point.

Figure 3.38: Triangle consolidation

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6. Consolidation Patterns: Rectangles

A rectangle consolidation pattern is formed when price tightens to trade
within a horizontal support and resistance. Unlike the triangle
consolidation pattern, the price does not converge over time. The pattern
is said to materialise only when it breaks either the support or resistance
convincingly.
The formation of a rectangle consolidation pattern can be easily
identified when price stays between a support and resistance for a
considerable amount of time. Like all consolidation patterns, it does not
need to be formed after a sharp move. It can be either a continuation or
reversal pattern, depending on the market conditions. The rectangle
consolidation pattern is said to have materialised when price breaks out to
one side convincingly. The measuring objective is measured from the
support to the resistance of the rectangle. The minimum objective level
can be found by projecting the measuring objective from the breakout
point.

Figure 3.39: Rectangle consolidation

We have learnt extensively about price action, as well as the various ways to analyse
price action. Next, let us learn about indicators.

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Chapter Review
Let us recap what we have learnt in this chapter. We have learnt to:

1. Evaluate the key assumptions of technical analysis.

2. Differentiate between line charts, bar charts and candlestick charts.
3. Identify price spikes and price gaps.
4. Understand support and resistance.
5. Understand trends, trendlines, acceleration, channels, retracements and
reversals.
6. Understand consolidation, breakouts and false breaks.
7. Explain the Elliot Wave Theory.
8. Explain Fibonacci Retracements.
9. Understand and interpret the six basic chart patterns.
i. Triangle continuation
ii. Flag continuation
iii. Double top / Double bottom
iv. Head and shoulders / Inverted head and shoulders
(Triple top / Triple bottom)
v. Triangle consolidation
vi. Rectangle consolidation
10. Understand and interpret the six basic chart patterns.

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