How to Identify High Probability Set-ups

In the previous two installments of this ongoing series of FX Trading Basics I outlined the methods I use for determining the trend (read part I and part II here). In today’s installment I want to discuss, how I combine multiple time frame analysis and stochastics in identifying high probability set-ups versus low probability set-ups.

First, some bullet points to outline my thoughts:

1. Higher time frames, generally, but not always, take precedent over lower time frames.
2. Stochastics, for me, are a filtering mechanism; not a timing. mechanism.

To review, I use three primary time frames in day-to-day analysis:

• 60-minute
• 240-minute
• Daily chart

I do use a weekly chart to identify key support and resistance levels, rarely as a timing mechanism.

Identifying the trend is simply but one piece to the puzzle, once the trend is correctly identified, you then need to determine whether or not prices will continue to exhibit the trend. There are many times when the trend is easily identified, but is actually on the verge of changing trend direction. For purposes of this article, let’s assume that the time frame that we do the primary analysis (i.e. the time frame we will execute on) is the 60-min chart.

The charts below are the 60 & 240-min of EUR/USD. On each chart, the trend is quite clear. If we then defer to bullet point # 1 above -- Higher time frames, generally, but not always, take precedent over lower time frames -- we would have to resist the temptation to short EUR/USD based on the 60-min chart.

However, this simple analysis, will often lead you to miss trades. In order to make a proper assessment, you need to add one more indicator to your chart in order to conclusively know to not short EUR/USD based on the 60-min chart -- stochastics.

In this case, the stochastics simply confirm the conclusion we drew from looking at the first 2 charts we posted without the stochastics. However, there are many times when this will not be the case.

In the next installment, I will provide several examples of how to properly use stochastics and inflection points in order to properly identify high probability trade entries.

MACD - Moving Average Convergence/Divergence

What is it?

MACD is one of the most commonly used technical indicators for market price and it is relatively simple to apply and understand. It uses 2 sets of moving averages to determine trend characteristics. Momentum is determined by subtracting the longer moving average from the shorter moving average and plotting the results, which may be above or below zero, as a line. The standard model uses a 12 day exponential moving average and a 26 day exponential moving average. A positive MACD indicates that the 12 day moving average is trading above the 26 day moving average and conversely a negative MACD indicates that the 12 day moving average is trading below the 26 day moving average.

Bullish Trend:

If MACD is positive and rising, then the 12 day moving average is increasing at a faster rate than the 26 day moving average and the gap between the two is widening. Positive momentum is gathering pace. This trend is considered bullish - a signal that the price is going up.

Bullish Signals:

1) Positive Divergence

Positive divergence occurs when MACD advances upwards at a time when the price is still in a down trend. MACD forms a sequence of higher lows (each low higher than the previous day or period). Positive Divergence is the least common of the 3 bullish signals but it is the most reliable and leads to the greatest price moves.

2) Bullish Moving Average Crossover

This occurs when MACD moves above its 9 day EMA or trigger line. These are the weakest of the 3 bullish signals, are very common and are not very reliable as market signals in their own right. They should never be used in isolation.

3) Bullish Centreline Crossover

This occurs when MAC moves upwards from a negative value and crosses the 0 axis to a positive value. Of the 3 bullish signals, a centreline crossover is the second most common. It is generally regarded as a confirmation signal.

Bearish Trend:

If MACD is negative and decreasing, then the 12 day moving average is falling at a faster rate than the 26 day average and the gap between the two is expanding. Downward momentum is accelerating. This trend is considered bearish - a signal that the price is falling.

Bearish Signals:

1) Negative Divergence

Negative divergence occurs when the price advances or moves sideways and MACD declines. The divergence can either take the form of a lower high or a straight decline. Although this is the least common of the 3 bearish signals, it is the most significant and reliable one.

2) Bearish Moving Average Crossover

This is the most common signal. It occurs when MACD falls below its 9-day EMA signal level. Be warned! These signals are so common that they often produce false signals. The moving average crossover should be read in conjunction with other signals to avoid expensive mistakes.

3) Bearish Centreline Crossover

This occurs when MACD moves below the zero line and into negative territory. It is a clear indication that the momentum has shifted from positive to negative and from a bullish to a bearish trend. This signal can be a confirmation on its own or may be used as a confirmation together with negative divergence or a bearish moving average crossover. Either way, once MACD is negative, it means the trend has become bearish, even if it is short-lived.

MACD Rules of thumb:

1. Buy/Sell when MACD goes above/below the signal line (9 Day EMA).
2. Buy/Sell when MACD goes above/below zero.
3. When MACD crosses the signal line it is an indication of a strong market.
4. When MACD rises dramatically, i.e. pulls away from the 9 day EMA, it is an indication that the price is over-extended and that the market is either overbought or oversold and will soon return to more realistic levels.

How I Trade Using Multiple Timeframes

Confluence on Three Time Frames Indicates Solid Short Set-Up

One of the topics I will be addressing in an upcoming segment of my ongoing FX Tutorials is combining multiple time frames looking for 'confluence' areas where the technical picture becomes very clear.

The charts below of CHF/JPY outline a very basic, yet effective, example of several resistance an support areas coming together at the same time that may well result in a solid short

Key Points:

- the 60-min chart finds resistance at a low from back on April 30th

- the 240-min chart has fib resistance at roughly the same area, 91.35

- the daily chart has failed at trend-line resistance and is now set to push below bull trend-lines (yellow highlighted area)

- momentum, as defined by the stochastics is bearish, although the 240-min chart exhibits a bit of upside price pressure