The Interbank Market

Forex education empowering you to trade with confidence

The Interbank Market

20Images/Images%20and%20Icons%20220×186/orari%20negoziazione453c.jpg?w=220 /%

The first foreign exchange brokers came on stage in the mid 70’s to offset a significant customer foreign exchange business for medium and small banks, which needed continuous exchange rates in the major currencies.

Initially the foreign exchange brokers installed direct lines to all the banks willing to participate. Generally a major bank made a rate and the brokers showed the rate to all the banks at about the same time. The first bank to deal on the rate completed a transaction. The others waited for the next rate. Any bank could make a rate; show a bid or an offer. Soon, with the aid of new technologies, the brokers became quite sophisticated and efficient at putting together a continuous two-way price and using the banks as their primary liquidity providers.

When speaking of Forex at a governmental level (central banks) and institutional level (commercial and investment banks), we refer to a market which, nowadays, negotiates 4 trillion Dollars a day. At this level, exchanges of 5 to 10 million are frequent, but also amounts of 100 to 500 million are traded between major participants.

It’s an interbank or over the counter market (OTC) and spot market. meaning it is not done through an exchange. Unlike most other exchanges, the Forex market is not a centralized market where each transaction is recorded by price dealt and volume traded. There is no central place back to which all trades can be traced and there is not one market maker but many.

Each market maker records his or her own transactions and keeps it as proprietary information. The primary market makers who make bid and ask spreads in the currency market are the largest banks in the world. That literally means banks constantly dealing with each other either on behalf of themselves or their customers. This is why the market on which banks conduct transactions is called the interbank market.

Larger speculators also operate in the interbank market where they can execute multimillion dollar trades with ease.

Individual traders, who generally trade in much smaller sizes, primarily do so through brokers and dealers.

Geographic and Time Zones

The volume negotiated is particularly focused in London, but also in New York and Tokyo. These cities are also major trading and decision centers for monetary matters because of their sheer size in turnover, and number market participants also because the happenings in these places tend to influence other dealing centers around the world. Other important locations at this level are Sydney, Switzerland, Frankfurt, Singapore and Hong Kong.

Many of today’s major currencies fluctuate freely between each others and are negotiable virtually throughout the world. This has resulted in increased speculation by banks, hedge funds, brokers and individuals. Central banks occasionally intervene with the intention to move the currency towards desired levels, however, the underlying factor that leads the Forex market are the forces of supply and demand .

The lack of physical change enables the exchange market to operate 24 hours a day, 5 days a week, covering different areas across the most important financial centers. Its tremendous volume of transaction makes it very liquid and therefore highly desirable to trade. Currencies are the most traded assets in the world — any commercial or financial flow across borders may involve a currency exchange.

20Street/Module-1-images/mod1-1.png /%

Map with the different trading sessions times frames (GMT is Greenwich Mean Time, EST is Eastern Standard Time)

Link Box — In order to check opening and end of trading sessions as per time zones, we recommend you to use the Market Timeline (see below).

At this point it’s interesting to note that the trading activity of each financial center will determine the behavior of the market. Thus when the London markets open and the session starts, it’s still overlapped with the last two hours of activity in Tokyo. Position openings done by London traders and the closure of positions in Tokyo coinciding in a interval of two hours may explain the increase in activity and volatility around this time. Later the European and the US session match during 4 hours in a combination of players, significantly increasing liquidity.

Edge Box — Price actions like breaks of previous high or low levels and intraday trends are usually more significant at the start of the London session and during the overlapping period of the European and American sessions. At the end of the American session and during the Asian session, be careful since lower volume conditions may result in false breakouts and false technical signals.

Link Box — It’s worth mentioning the importance for the retail trader to be aware of the most recent leading center’s trading activity. This applies not only to market activity, such as the announcement of economic data, but also inactivity. So if these centers are together or separately on holiday, do not be surprised when trading tends to go quiet. Hence it’s a good idea to check the Economic Calendar for major international holidays when doing your market research and planning particular trades.

Why trade Forex?

24 Hour Market

FX is a global market that never sleeps. It is active 24-hours a day for almost 7-days a week. Most activity takes place between the time the New Zealand market opens on Monday, which is Sunday evening in Europe, until the US market closes on Friday evening.

Psycho Box — It’s not a requisite to spend time watching the market during 24 hours- it’s even not advisable. The market never sleeps, but you should. With Forex, though, one could theoretically day trade in the evenings after work or in the mornings beforehand. This is very desirable, specially if you are starting out and want to trade on a part-time basis, because you can choose when you want to trade: morning, noon or night.

Superior Liquidity

The FX market is huge and it is still expanding. According to the authoritative Triennial Central Bank Survey from Bank for International Settlements in 2010, Basel, daily average volume now reaches US$ 4 trillion. Technology has made this market accessible to almost anyone and retail traders have flocked to FX.

With such a tremendous daily trading volume, the Forex market can absorb trading sizes that dwarf the capacity of any other market. This means a lot of trading liquidity and flexibility specially at London time, New York and Tokyo (in this descending order).

There are always participants willing to buy or sell currencies in the Forex market. Its liquidity, particularly in major currencies, helps ensure price stability and market efficiency. Traders can almost always open or close a position at a fair market price

Over-The-Counter Market

While it is true that there is exchange-based Forex trading in the form of futures, the opposite condition occurs in the OTC market via the spot market.

The Forex market is an ‘over the counter market’ (OTC), which means that there is no physical location and no central exchange and clearing hours where orders are matched. Instead, it operates 24-hours a day via an electronic network of banks, corporations and individuals trading one currency for another.

FX traders constantly negotiate prices between one another and the resulting market bid/ask prices are then fed into computers and displayed on official quote screens. Forex exchange rates quoted between banks are referred to as Inter-bank Rates.

At first glance, this ad-hoc arrangement can look like the wild west to investors who are used to organized exchanges. But be reassured, this arrangement works exceedingly well in practice: because participants in Forex must both compete and cooperate with each others, they provide very effective control over the market .

Leverage

Leverage trading means, in short, that you are permitted to trade many times the size of your margin deposit. This is primarily attributed to the higher levels of liquidity explained before.

For instance, a leverage of 1:100 means, in order to buy and benefit from one lot of 10,000 US dollars you only have to commit your 100 dollars, the rest of the amount is leveraged by the broker.

While certainly not for everyone, the substantial leverage available with most online retail brokers in the Forex market is an essential attribute of this market. Rather than merely loading up on risk as many people incorrectly assume, leverage is essential in the Forex market. This is because the average daily percentage move of a major currency is less than 1%, whereas a stock can easily have a 10% price move on any given day.

Leverage is a both way weapon: on one hand it lets traders profit from a lot size much larger than their investments. But on the other hand, it exposes them to losses of equal magnitude. You can win or lose quicker — that’s right — but that’s not all: a too small leverage can be equally dangerous as you will learn in Exam Module A [link ].

The most effective way to manage the risk associated with leveraged trading (also called margin trading) is to diligently implement risk management in your trading plan. You have to devise and adhere to a system where your controls kick in when emotion might otherwise take over.

Narrow Spreads

Spreads, the difference between the bid and offer price, in FX are miniscule. Just compare a 2-pip price in EUR/USD with a price in even the most active and liquid equity issue. Furthermore, FX prices are typically good for far larger amounts than in equity. The spread is the hidden, intrinsic cost of dealing and in FX it is minimal.

Because of the currency market round-the-clock liquidity, superior technology and the competition among market makers, you receive tight, competitive spreads both intra-day and night.

No Commission or Transaction Costs

The over-the-counter structure of the Forex market eliminates exchange and clearing fees, which in turn lowers transaction costs.

Alert Box — The question if it is more cost-efficient to trade Forex in terms of both commissions and transaction fees depends not only on your broker’s conditions but also on your trading style. Forex is more efficient if you know how to balance the number of trades and the earnings ratios. The usual lack of commissions is another factor that, despite being an advantage, has to be well understood to make it work in your benefit.

Profit Potential Regardless of Market Direction

Conventional investing is based on the notion of one-sided ownership: you buy (go long), you sell (go short). Currency markets, in contrast, place equal value on buying and selling.

Every open Forex position has two sides because currencies are quoted in terms of their value against each other. This is because currencies are traded in pairs (for example, US dollar vs. Japanese yen or US dollar vs. Swiss franc), one side of every currency pair is constantly moving in relation to the other.

When a trader is short in one currency he/she is simultaneously long on the other. A short position is one in which the trader sells a currency in anticipation that it will depreciate. This means that potential exists in a rising as well as in a falling market.

Info Box — We will spend a lot more time instructing you in the mechanics -about pairs, pips, spreads and leverage- so don’t worry if it sounds complicated here.

Equal Access to Market Information and Transparency

Despite the introduction of best execution regulations in Europe and the US, few would disagree that professional traders and analysts in the equity market have a huge competitive advantage in comparison to individual traders. In FX, perhaps the only advantage the big banks have is flow information. But FX is a democratic market where virtually all participants have access to the same market moving information as everyone else .

Given the multimillion dollar exchange that takes place every day in the currency markets, manipulation of the price is rather nonexistent compared to other less liquid markets. However combined actions may occur in which several of the major participants — like central banks — force the market in a certain direction. That being said, this is not a rule but rather an exception.

The Purpose of Technical Analysis

The purpose of technical analysis is to carry out price forecasts. By processing historical market data of any instrument, you can try to anticipate how it should be traded. There are several premises in favor of the reliability of technical analysis that are based on the experience and prolonged observation. These premises are the following:

1. A market trend in motion is more likely to persist than to reverse.

This is obvious by simply looking at any price chart. Of course the aim of any trader is to be aware of the overall market direction, to lock into the prevailing trend and trade it for profit.

2. Markets are discounting mechanisms.

In other words, technical analysts assume that market fundamentals are already represented in the price so what you perceive in the charts is a reflection on any fundamental variable impacting the market. Nowadays, with instant communications this is truer than ever.

Either the unidirectional price move during a trend or the rapid reaction to any new fundamental data throws evidence that markets show up human behavior. From the above premises we can derive that human psychology is always at work in the markets and that technical analysis aims to visualize and quantify it.

3. What has happened in the past will happen again.

This third premise is based on the assumption that human behavior as well as human psychology never change, and that price will reflect it through the repeated emergence of certain price action patterns and trends.

Price action, as a result of human decision making, can be thus considered as being purposeful. Although some people believe that price movement is completely random and unpredictable, technical analysts are always prone to identify and quantify those behavior patterns by examining past markets. While markets are unpredictable in essence, market participants are typically considered to adhere to certain habits, which are rarely broken. As a trader, your goal is to make use of this information in order to gain a slight advantage over the eventual unpredictability of the market.

Drawbacks of Technical Analysis

Despite the fact it represents a true edge for the trader, technical analysis presents some disadvantages. Those who oppose technical analysis point out several problems related to the application of its methods.

1. The failure to know the underlying fundamentals.

A common argument is that technical analysis is aimed at predicting a certain outcome for a chart pattern, ignoring the reasons of the movements which are due to fundamental factors. This is an obvious limitation of technical analysis and any trader feeling uncomfortable with this handicap should find support in the next Module dedicated to fundamental analysis.

2. The lack of scientific objectivity.

Although some theories offer a certain objectivity to the analysis, other studies may not necessarily lead to an objective interpretation. That is why technical analysis is sometimes referred to as being more an art than a science. It is also where individual and mass biases come into play.

In the previous Module [link Module 3]. we wrote about the self-fulfilling prophecy referring to the fact that the more people approaching markets with technical analytical methods, the more likely the expected move in price occurs. This is a common argument that points out the lack of a proven thesis. The fact that traders operate with different time horizons, different expectations and risk profiles makes it difficult to find a common approach to the self-fulfilling prophecy.

3. The uniqueness of the pattern occurrences.

Another legitimate argument in favor of the unreliability of technical analysis is based on the true observation that past price action upon which technical methods are based does not often repeat exactly the same way. This can lead to incongruities in the analysis and to inconsistency in the methods.

20Street/Module-4-images/mod4-1.png /%

At this point, however, you should ask yourself whether these arguments can be dealt with in order to make money in the markets. Of course they can, and we are going to show you how!

It’s true that traders will never be 100% correct when using any strategy based on technicals. However, more often than not technical studies do create a positive expectancy.

A valuable lesson is undoubtedly that analysis doesn’t make the whole trading plan. A proper money management and a trained attitude to stick to the rules are elements which offer additional edges to include in the trading plan. Therefore, don’t worry excessively about the above mentioned drawbacks — technical traders have learned how to deal with them.

2. Technical Indicators

There is no reason to complicate things when learning technical analysis. That is the reason why we will study only a few common indicators. This, in turn, will allow us to study their nature in depth and see what implementations and parameters make them more effective.

You don’t need to devote your time collecting price data to make use of technical indicators. Through Swissquote’s Trading Platform, any trader can access numerous technical tools.

Just open the navigator window and click and drop the indicator on the desired chart window.

Moving Averages

Moving averages are one of the most popular technical indicators. They are very convenient for smoothing out price data series and making the identification of the direction of trends easier, something that is especially helpful in volatile markets as the Forex. Because past price data is the core variable of their formula, they are considered as lagging indicators. Therefore, Moving averages better suit for trend following purposes than to predict when a trend is starting or is coming to an end.

With this characteristics in mind, we should first consider moving averages for what they are able to do. This process does not have to be a scientific examination — at least not at this stage. Usually, a simple visual assessment of the moving average can determine if it has the characteristics we need to apply our trading strategy.

The most popular types of moving averages are the simple moving average (SMA), the exponential moving average (EMA) and the weighted moving average (WMA). The first is formed by computing the average price of a currency pair over a specified number of periods. Most moving averages are created using the closing price although it’s possible to create moving averages from the open-, the high-, and the low prices.

20Street/Module-4-images/mod4-2.png /%

The above illustration highlights the fact that the indicator lags price action, that is, it’s always behind the price. Therefore, when prices are not trending, moving averages can give misleading information. In order to reduce the lag, technicians created an array of other moving averages, the most common being the mentioned exponential and the weighted moving average. EMAs reduce the lag by applying more weight to recent prices relative to older prices, and the WMAs put more weight on the most recent data and less weight on the older data .

At a first glance, the difference between an exponential moving average and a simple moving average looks minimal. Nevertheless, the exponential moving average is consistently closer to the actual price when it is trending.

20Street/Module-4-images/mod4-3.png /%

Which moving average to use will depend on the concept you base your trading method on, as well as how the specific currency pair has reacted to it in the past. The simple moving average obviously has a lag, but the exponential and the weighted moving average may be prone to more volatility and will generate more false alerts. So your role is to take these aspects into account or even think about ways to take advantage of it. Some traders prefer to use exponential moving averages on shorter time frames to capture incipient trends, while others prefer simple moving averages over large time spans for longer positions.

A perfect moving average should therefore have a minimal lag when the price starts trending and at the same time be smooth enough when price action is range bound. But there is no such perfect moving average and we need to favor one attribute at a time: either smoothness or sensitivity. In fact, there is no perfect technical indicator, all of them produce the so called false signals.

As a first approach to any indicator you should experiment with it by plotting it on a chart and play with different settings in order to get a feel between the sensitivity of the indicator for a specific currency pair and its reliability as signal generator. Let the dilemma of the sensitivity and the reliability for the analysts: as a trader, your purpose is to find a tool which can help you interpret what you are already seeing in the price action.

20Street/Module-4-images/mod4-4.png /%

The above EUR/CAD chart doesn’t tell you much? Indeed, a moving average alone is probably not the best choice to build a trading strategy. Prior to the decline, the price gyrated above and below its moving average. After the decline, the pair continued its erratic behavior without developing much of a trend, giving no clear signals on what to do and how to profit from the price action.

What about adding a 50 EMA to the chart and use the two moving averages in order to provide entry signals?

20Street/Module-4-images/mod4-5.png /%

Keeping the same chart, we can see the exchange rate trending in-between periods of consolidation. It is sometimes difficult to determine when a trend will stop and a trading range will begin. But notice the trading range periods, the breakouts (both up and down) and the trending periods. Also observe the direction of the moving average crossovers and how they could have been used to point to the direction of the trend.

The faster moving average, which is measured over the shorter period of time, may be used as proxy for price and thereby eliminate the short-term fluctuations in price action. Technical analysts consider the crossover of the fast average above the slow average as a bullish signal and the crossover of the fast average below the slow average as a bearish signal .

Moving averages also form the building blocks for many other technical indicators. This is the case of our next indicator, the moving average convergence divergence (MACD).

en.swissquote.com/fx/news/daily-fx-news

Oscillators: the MACD

The MACD may be interpreted similarly to other moving averages and used as a trend-following indicator. That is, when the MACD crosses above the MACD signal line, it’s a bullish signal, and conversely, when the MACD crosses below the MACD signal line, a downtrend may be beginning and the signal is bearish .

Its default settings are usually 26, 12, 9 and these are its components:

1. The MACD line takes a short length and a long length exponential moving average (defaulted to 12 and 26) and calculates the difference between these two averages. (Note: the images herewith displayed use a custom MACD to evidence its lines, whereas the MACD is by default plotted as a column and line combination.)

2. A signal line is an exponential moving average of the MACD line. This is plotted as the MACD signal.

20Street/Module-4-images/mod4-6.png /%

3. The third element is the median line also called zero line or center line.

The MACD moves around a center line and it has not upper or lower limits as other oscillators have (the RSI, for instance). It is thus called an open oscillator. The median line represents the point at which the moving averages are equal.

If the EMAs which compose the MACD cross a bearish signal, the indicator translates it into a simultaneous bearish crossing of the MACD line with its median line. And vice versa, when the MACD line crosses its median line to the upside, this means the two EMAs built in the indicator are crossing upwards.

20Street/Module-4-images/mod4-7.png /%

4. Finally, the difference between the MACD and the MACD signal line is calculated and plotted in a histogram.

20Street/Module-4-images/mod4-8.png /%

If you are going to use the MACD, consider including the histogram as well. On occasion, the MACD itself may be following the price nicely, but the histogram can alert the trained analyst that a turn in price is in the air by giving signs of divergence. What a divergence is will be explained further below.

The same dilemma as for the moving averages applies for the MACD: shorter moving averages will be more sensitive and generate more crosses, and longer moving averages will always lag price and generate fewer signals.

Why then not change its default settings and do something creative with the MACD? The signals provided with the settings 36,81,18 may be few, but are they therefore less reliable? Note how the below settings evidence the start of a trend when the MACD line crossover is close to its median line. You may ask where this weird numbers are coming from. The answer is that they are multiples of 9.

20Street/Module-4-images/mod4-9.png /%

The MACD is based on the concept of convergence-divergence. But what is the convergence-divergence of a moving average? We have said the MACD consists of two exponential moving averages that range around the median line. The result is an indicator that oscillates above and below that line.

When the MACD is above the median line, this means the 12-period moving average is above the 26-period moving average, indicating that recent prices are higher than the previous ones.

Conversely, when the MACD is below the median line, it means the 12-period moving average has a value of less than 26 periods, indicating that prices are falling.

In other words, the bigger the spread between the two EMAs taken into the equation of the MACD line is, the more distance the indicator will print to its median line.

When a currency pair is volatile, the MACD shows broad movements on both sides of the median line. However, when the market is calm, its moving averages converge and the MACD line takes a break close to the median line.

This feature makes the MACD indicator useful to measure the speed and volatility. Notice how each volatility boost starts after a period of consolidation.

20Street/Module-4-images/mod4-10.png /%

The MACD indicator is an open indicator which means that overbought and oversold conditions are relative to previous highs and lows of the MACD line.

Being an open indicator implies that, unlike other oscillators with values ranging from 0% to 100%, in the MACD there is no maximum or minimum value. Since the EMAs forming MACD can’t theoretically distance from each other ad infinitum. there is logically always a return of the lines towards the median line. To identify periods of overbought and oversold conditions, we must look at past figures in the range of values which the MACD has registered.

20Street/Module-4-images/mod4-11.png /%

Technical indicators work particularly well when combined with each other. Besides, they also perform well with different settings than the default ones. A proof of it is the below illustration.

A 200 SMA has been displayed on the chart, combined with a MACD using the following settings: 21, 55, 8. If you are wondering where these weird numbers are coming from, the answer is: they belong to the Fibonacci sequence. The next section will cover the sequence in more detail, but for now just observe how the ascending angle of the 200 SMA acted as a confirmation for the signals generated by the MACD crossovers. The purpose was to go with the trend, therefore no MACD bearish cross was taken as valid.

Do you conceive the MACD or even moving average crossovers as the only way to determine the overall trend in your analysis? It’s true these are great methods, but they always produce series of losses, specially when the market is reversing.

There is a method which enables traders to profit from reversal movements, and it consists in identifying divergences between price and the MACD lines.

Convergences

One of the things traders look for are signs of convergence and divergence between price action and the indicator. A convergence is when the indicator and the price action are hinting a similar signal and, therefore, reinforcing their signals. But when the indicator and the price are telling a different story, there is a divergence, showing that price is not supported by the indicator.

There are basically four types of divergences, which can be identified with the MACD or any other oscillator (Stochastic, Momentum, RSI, CCI, etc.). Divergences, like its name suggests, happen when the price and the oscillator go in opposite directions, hence diverging from each other .

20Street/Module-4-images/mod4-13.png /%

The four types of divergences are:

A regular divergence simply means one of two things — that price has made higher highs while the oscillator has made lower highs (this is the case of a regular bearish divergence), or that price has made lower lows while the oscillator has made a higher low (a bullish divergence).

A regular bearish divergence is a sign that an upside momentum may be failing and that there may be an impending downturn, while a bullish divergence, on the other hand, is a sign that downside momentum may be exhausted and may be interpreted as a warning of weakness of the trend.

Hidden divergences, in turn, are signs of trend strengthening: when price has made a higher low while the oscillator has made a lower lows (this is the case of a hidden bullish divergence), or that price has made lower highs while the oscillator has made a higher high (a bearish hidden divergence).

The MACD histogram, which is the difference between both MACD lines, can also be used to confirm MACD divergences. As such, if it is divergent to price, it can suggest the move is running out of steam.

20Street/Module-4-images/mod4-14.png /%

Edge Box — Use the MACD and the histogram to find divergences. A double confirmation provided by both indicators will filter out some false signals and enhance the odds in your favor.

The GBP/USD plays out regular divergences very frequently. An observed pattern takes place on Friday afternoons when the London session is about to close. London session traders closing their positions and taking profits on Friday afternoon makes the pair trigger regular divergences against the prevailing weekly trend.

Alert Box — Divergences should not be seen as all-encompassing, self-sufficient trading strategies. They can certainly be reliable alerts (not to be confused with buy and sell signals) but they should only be used in tandem with another confirming factor such as S&R analysis or another technical indicator, in order to get firm confirmations of market reversals.

Fibonacci

Leonardo Fibonacci explained the exponential growth in nature through a well-known number sequence. In this sequence each number is the sum of the previous two consecutive numbers.

The sequence starts with 0 and 1 and goes on with: 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987, 1597, 2584, etc.

Fibonacci proved that this sequence can be manifested in the evolution of a natural growth phenomenon, as a solution to a mathematical problem based on the reproduction process of a pair of rabbits. However, the utility of the sequence lies in its fundamental properties, discovered in the eighteenth century:

1. When dividing the consecutive numbers of the sequence, ie: 1/1, 1/2, 2/3, 3/5, 5/8, 8/13, etc. the result tends to approach the number 0,618.

2. When dividing the non-consecutive numbers of the sequence, ie, 1/2, 1/3, 2/5 3/8, 5/13, 8/21, etc. the result is the number 0,382.

3. The ratio of any number of the sequence in relation to the next lowest number, ie: 21/13, 13/8, 8/5, tends to be 1,618.

4. The ratio of any number of the sequence in relation to the next lowest non-consecutive number, ie: 21/8, 13/5, 8/3, tends to be 2,618.

The difference between the ratios and the result of the equation is greater when the the numbers used in the series are smaller. For example:

144/233 = 0,618: the result of the equation is a precise Fibonacci ratio.

144/89= 1.6179: with a smaller number the result of the equation only comes close to the Fibonacci ratio.

The 1,618 ratio and its inverse, the 0,618, were called by the ancient Greeks the ‘golden ratio’.

Traders are not so interested in the numbers of the sequence as in the ratios between the numbers. These ratios can be used to identify support or resistance levels, find the targets for price movements, or even to determine the time period that a movement will last.

The most popular levels or ratios are:

23.6%, 38.2%, 61.8% and 161,8%

The 100% which is the full size of the movement to be analyzed and its half, the 50%. are commonly added to the Fibonacci levels, although they are not ratios of the sequence.

It’s common to see a price correction towards a Fibonacci level after a clear trend has been developing. This doesn’t mean that a price correction is to halt accurately at these levels, but most of the time price will slow down or interrupt the directional move and find temporary support and resistance at a Fibonacci level.

Although very useful, Fibonacci ratios are not less subjective than any other tool used in technical analysis because it leaves some room for interpretation and personal preferences. However, this subjectivity is relatively easy to handle, and the charts below illustrate this flexibility and adaptivity.

In this daily USD/CHF chart, the Fibonacci tool is anchored in the extremes of a trend that lasted about a month in late 2006. For nearly a year, prices were consolidated at the 23.6%, 38.2%; 61.8% levels. The 50% level has been omitted here for more clarity, but we encourage you to include it in your toolbox.

20Street/Module-4-images/mod4-15.png /%

In the next chart, the anchorages of the Fibonacci tool were moved when the price reached new highs and lows. Observe how the old consolidation levels are mostly coinciding with the new levels, despite the fact they are dislocating the tool.

20Street/Module-4-images/mod4-16.png /%

In the next chart, the upper anchorage is simply displaced in time but remains at the same price level. In contrast, the lower anchor has been placed at the new low reached by the price. Again, observe how the price takes into account the new Fibonacci levels.

By moving the tool to the newest extremes, we are also segmenting the chart into smaller sections, which in turn can be used as entry or exit points, or just as levels to adjust a trade size.

20Street/Module-4-images/mod4-17.png /%

In the next chart, despite the Fibonacci tool has been displaced down, the previous consolidations match with the new levels — what was before 23.6% is now 38.2%, for example.

This is not a coincidence, but rather how this analysis works and how the price tends to respect the Fibonacci ratios. Specially stronger consolidations tend to remain clustered at key Fibonacci levels.

20Street/Module-4-images/mod4-18.png /%

Pivot Points

As a definition, a pivot point is a turning point or condition. that is, a point is a level in which the sentiment of the market changes from bullish to bearish or vice versa. If the market breaks this level to the upside, then the sentiment is said to be bullish and it is likely to continue its way up. Conversely, if the market breaks this level down, then the sentiment is bearish, and it is expected to continue its way down. At pivot points, the exchange rate is expected to show some kind of support or resistance in the form of bounces and reversals.

The great advantage of a technique based on pivot points is the fact that this tool is based on price action (high, low and close of the day) and doesn’t lag price as most technical indicators do. For some strategies, the signal of any lagging indicator could come too late, when the motion to capture is already accomplished. As a disadvantage, one could see this tool’s inability to adapt to price changes throughout the day since its the previous day’s data which establishes the pivot point for the next day.

Pivot Points can be applied to any time frame, but they are mainly used to identify the intraday directional bias as well as significant support and resistance levels. For that reason they are best visualized on intraday time frames. Although pivots are calculated based on the previous day, they may be calculated on weekly or monthly data.

20Street/Module-4-images/mod4-19.png /%

Here, S represents the support levels, R the resistance levels and P the pivot point. High, low and close are represented by the H, L and C respectively.

Since the Forex is a 24hr market there is an eternal debate on deciding at which time the open, the close, the high and the low from each 24-hour cycle should be taken. Nevertheless, the majority of traders agree that the most accurate predictions are achieved when the pivot point is adjusted to the GMT time. That is made by taking the open at 00:00 GMT and the close at 23:59 GMT, or by taking the open at 00:00 EST and the close at 23:59 EST.

Info Box — Swissquote’s platform is located on a server with CET (Central European Time), which is just one or two hours ahead of GMT (depending on the time of the year). This makes the platform ideal to plot pivot points on intraday charts. Test it out and see the difference! [link download demo]

Facts Box — There is a reason why pivot points work so well in today’s electronic markets, even if they were originally created in a time when such devices didn’t existed: the numbers worked so well when they first came out in the first half of the 20th century. What happened then is that everybody started using them thinking that they were going to predict the high or low of the day and that improper use make it lose some of their strength. This just caused more opportunities for the floor traders to fade these levels where the public would buy or sell blindly on these numbers. Today, with literally hundreds of indicators to look at, the idea of too many people using one tool is not as likely. For this reason some of the more traditional studies are starting to work well again.

Price Action Supported by Technicals

Let’s start this section with a quick reminder of a previous lesson from Module 3: support and resistance levels are those levels where the exchange rate experiences upward or downward pressure. A support level is usually a low point in any displayed chart pattern, whereas a resistance level is a peak point in the chart. These points are identified as support and resistance when they show a tendency to reappear.

Once these levels are broken, they tend to become the opposite obstacle. Thus, in a rising market, a resistance level that is broken could serve as a support for the upward trend; whereas in a falling market, once a support level is broken, it could turn into a resistance.

Before we go on with technical indicators, we have to keep in mind that most technical indicators boil down to price, as they are simply an equation or formula that is applied to the price.

A moving average is a good example, as it consists of the average — or mean price — of a trading vehicle over a designated period of time. Oscillators, such as stochastic or RSI, measure the difference between the current price and recent prices to determine if a currency pair is overbought or oversold.

Raw price information is thus of utmost importance for traders because unlike most indicators, support and resistance levels tell us where the buyers and sellers have set up camp. In fact, many of the large market players, like hedge funds and market maker banks, forecast price movements and plan their positions by looking primarily at raw market-generated data, that is, price action.

In this regard, indicators should serve as means to confirm what price action is signaling as evident. Let’s see some ways of measuring the strength of supply and demand with the help of technical indicators.

Oscillators and Price Action

Consider the price action sequence in the graph below in which we rely on the RSI to get a sell signal. The downtrend hits an already existing support level and stagnates for a while. Finally demand is exhausted and supply gains ground, leading to a breakout at point 1.

However, during the consolidation phase, the RSI was most of the time below the 50% level (and even went below the oversold level at 30%). Thereafter a breakout occurs followed by a return to the former support area which, once broken, remember, turned into a resistance.

20Street/Module-4-images/mod4-20.png /%

When price breaks down for the second time at point 2, the RSI is much closer to the 50% territory, having actually exceeded the overbought level of 70%. If the price has not been able to break the resistance level during the overbought condition, then we can conclude that the demand was low comparatively to the supply.

As usual, when price records a breakout, a pullback (or throwback) follows. In this 4H time frame the dimension of the pullback is almost of 200 PIPs and takes 3 days to form. Only then, the bearish trend resumes its course. The pullback at point 3 indicates the best entry, when the RSI turns slightly above the level 50 to revert back down immediately towards negative territory.

The chart below displays the same price action interpreted with the Stochastic. In this particular case, the indicator provides an even more precise reading: in the first two breakouts, the oscillator shows some fatigue, while after the pullback the oscillator returns, full of strength, from overbought territory.

20Street/Module-4-images/mod4-21.png /%

By means of these two examples, you’ve seen that breakouts, and especially the pullbacks (or throwbacks), are very reliable prints of low risk trading opportunities.

This emphasizes the importance of the price action to obtain the first evidence of what is happening in the market, and categorizes the indicators as a tool to confirm what is already visible on the chart. Oscillators, in this case, can be used to confirm breakouts because they measure the strength of supply and demand.

When developing a trading method, it’s important to think of all the arguments at disposal, whether these are given by trendlines, candle patterns or technical indicators. When confronted with contradictions, you must simply wait for these contradictions to disappear.

Alert Box — If, for instance, the oscillator shows an overbought condition, and price reaches a support level (remember: support means demand), then be careful! It could be a trap, and support may not work. Analytical tools must be used in unison with price action.

Psycho Box — No indicator will reveal completely what the market is doing. But there is something you can do to avoid entering trades based solely on technical indicators: use your judgment. You are not a robot and you will never become one. The better you learn to optimize that judgment through simplicity, practice and record keeping, the better the results will be. Preferably, settle on a strategy (a set of trading tactics) that suits your personality and thinking patterns. But first, start by observing price, and confirm its actions with one or two technical indicators that you understand well.

The use of too many technical indicators is an often underestimated peril when applying technical analysis. When you accumulate to many indicators on a price chart, you lose simplicity. Because technical indicators abound and are so readily at hand through charting platforms, unprepared traders often gravitate to them as the easy solution for their trading. The first experience of knowledge and control can quickly change into a paralysis. This can actually be a major inconvenient in the use of an otherwise useful tool.

20Street/Module-4-images/mod4-22.png /%

If you apply technical indicators knowing that they are mere representations of price action, but not price action itself, you will focus on making better trades.

Moving Averages Combined

The location of the price relatively to the moving average can be used to identify the trend. If the price is above the moving average(s), the trend is considered to be up. If the price is below the moving average(s), the trend is considered down. This is a pretty straightforward technique.

The following EUR/USD chart shows that buy and sell signals could be generated by crosses above and below the moving average. But that would be too simplistic. Let’s filter out some signals with the RSI oscillator. In the example below the goal was to find breakouts of the 200 simple moving average, confirmed by pullbacks. The RSI confirmed those pullbacks by retracing to its 50% line. The first two breakouts of the SMA were short-lived, but the third was a clear winner. All the breakouts which were not confirmed by price action and sustained by the RSI were simply ignored.

20Street/Module-4-images/mod4-23.png /%

Another technique for trend identification is based on the location of the shorter moving average in relation with to the longer moving average. If the shorter moving average is above the longer moving average, the trend is considered up. If the shorter moving average is below the longer moving average, the trend is considered down. In the example below, the 21 SMA acted as a filter reducing the number of signals from 3 to 2.

20Street/Module-4-images/mod4-24.png /%

The classical uses of moving averages need to be carefully considered: moving averages are trend following indicators. However, currency pairs spend a great deal of time in trading ranges, which can render moving averages ineffective if only used to identify trends. This is not a problem though, then there is another reason why moving averages are widely used indicators: they behave very well as support and resistance levels .

This is usually accomplished by identifying past S&R levels and match them with the current moving average location. The 800 period simple moving average may seem very static on any chart — but still it acts very well as S&R.

In the illustration below, the pair tested the 800 simple moving average support before breaking out. Therefore, the moving average acted as a confirmation of resistance-turned-support. The break of the support made by the moving average would serve as a warning that the pair may resume the trend.

20Street/Module-4-images/mod4-25.png /%

As with most tools of technical analysis, moving averages should not be used on their own, but in conjunction with other tools that complement them. Using moving averages to confirm other indicators and analysis can greatly enhance your technical analysis skills.

Combining Pivot Points with Chart Patterns

Chart patterns may be used in combination with most indicators, especially with those based on price action such as the pivot points. The figure below shows an head and shoulder framed with pivot points.

20Street/Module-4-images/mod4-26.png /%

In Forex, the most price ranges are bounded by horizontal lines with enough height in pips to make trading them worthwhile from a reward to risk perspective. The above chart is a good example, where two approximately equal touches of a price level on a bottom and a breakout failure of a price level on the top create a potential head and shoulders pattern the following day. Notice how price advances are shortly interrupted by those pivot point supports and resistances.

Time Frames: a Matter of Scope

There is an old saying which states that Time is nature’s way of making sure everything doesn’t happen at once. Regardless of whether you are measuring a trend in a one minute time frame or observing a major pullback on the daily chart, the same indicators and techniques can be applied. It all comes back to behavior patterns which are not time frame dependent. It is just a matter of scope.

At any time the market is filled with participants who have different opinions of which way the market shall be moving. One of the reasons they sustain different beliefs about what price could be doing next is probably derived from the time frame they are looking at and interacting with. A trader who looks at daily charts may think an uptrend is in process, while a trader who looks at a 60 minute chart may think the market is trending down. The fact is that they may both be right in their analysis. So when it comes to discussing a trading opportunity, the goal is not to find out who is right, but rather understanding where the technical argument comes from.

Time frames: Correspondences Between Moving Averages

One of the biggest reasons why so many traders, especially those with a short-term time horizon, flock to technical analysis is the synchronicity between indicators displayed across different time frames. The table below shows several simple moving averages and their correspondence across different time frames.

The 800 SMA, for instance, corresponds to the 200 SMA on a 60 minute chart and to the 50 SMA on a 240 minute chart.

SMAs & Charts