Generating Signals from RSI

RSI signals that are not derived from overbought or oversold

Ever wondered how you can generate signals from RSI apart from the usual overbought and oversold levels? It can be done although personally I wouldn't trade on signals that do not include an input from price. Let's face it RSI can be very frustrating when it fails to reach overbought or oversold for long periods of time. Well, let's just consider what RSI is telling us and whether we can use that concept in another way.

In fact RSI is calculated by measuring the sum of the higher closes and also the sum of the lower closes and normalizing the ratio of the result within a band of zero to 100. Clearly, when price rises then the sum of the positive close movement is larger than that of the negative close movement and thus RSI moves higher. The opposite is also obviously true.

Therefore RSI is reacting to sustained directional moves in one direction. What we need try and obtain from that information is when the RSI moves sufficiently in one direction is there risk of follow-through. We actually do this type of thing with price by placing Bollinger Bands around price and looking for breaks of the upper or lower bands. It is possible to do just that with RSI. It will look like this:

The bands are based on a 9 period average with a standard deviation of +/- 1. The idea I am investigating is whether breaks of either band by the RSI constitutes a valid signal. However, without even looking at price I can see that the number of occurrences where the band is broken but does not sustain a movement in that direction is quite frequent.

One of the most important factors, in my opinion, when trading is to match a signal generated by a technical indicator with price. Too often the movement in price that generates a break in an indicator fails to follow through. Because of that I like buying breaks of resistance or selling breaks of support. Therefore I can include both conditions in my trading.

In this way, when RSI breaks above the Bollinger high then I will only trade if price also breaks above resistance. What I tend to look at are swing bars - that is where a peak is formed and has at least 1 or 2 lower highs surrounding it (and vice verse for a trough.) So when RSI breaks above the upper band I will want to buy at the level of the swing high. If RSI breaks below the lower band I will want to sell at the level of the swing low.

The following shows how this may look:

Let's look at what we can generate from these combined signals one by one. I have marked swing highs and lows with a small red horizontal line:

1. RSI dips below the lower Bollinger Lower Band. However, by the time it has confirmed this (at the close of the bar) price has already dipped below the swing low - it is too late to trade.
2. RSI breaks above the Bollinger Higher Band. However, price fails to follow through above the swing high. No trade is seen.
3. RSI breaks above the Bollinger Higher Band and on the next bar price confirms this move by penetrating the swing high. We buy at the swing high level. Price continues higher and then pulls back. In order to provide a trailing stop I have also entered a fairly fast SAR/Parabolic and we square on the 9th bar of the trade at the Parabolic level for a modest profit.
4. RSI breaks below the Bollinger Lower Band. However, price does not break below the swing low. No trade.
5. RSI once again breaks below the Bollinger Lower Band. However, price does not break below the swing low. No trade.
6. RSI breaks above the Bollinger Higher Band and on the next bar price confirms this move by penetrating the swing high. We buy at the swing high level. Price continues to rally and to the right of the chart the position is still open having remains above the Parabolic.

Quite clearly the benefit of combining a signal from an indicator and from price appears to be working well, filtering out the bad indicator signals.

It is quite easy to have Bollinger Bands plotted on the RSI by writing a new indicator in the Chart Studio using CTL. To do this open up your Chart Studio and then in the system modules (click on the tab at the bottom left of the screen) and then scroll down to find “Relative Strength” and double click on it. This will open the coding for the RSI which is shown below. You will need to make some minor changes or just copy and paste the following into a new page:

indicator RSIandBollingerBands;
input price = close, period = 14, SD = 1, BollPeriod = 9 ;
draw line("RSI"), BBhigh("Bollhigh"), BBlow("BollLow");
vars i(number), u(series), d(series), au(series), ad(series), dif(number), f(number),RS(series);
begin
f := front(price);
u[f] := 0;
d[f] := 0;
for i := f + 1 to back(price) do begin
dif := price[i] - price[i - 1];
if dif > 0 then begin
u[i] := dif;
d[i] := 0;
end else begin
u[i] := 0;
d[i] := -dif;
end;
end;
au := mma(u, period);
ad := mma(d, period);
RS := 100 * au / (au + ad);
line := RS ;
BBhigh := SMA(RS,7) + SD * stddev(RS, Bollperiod) ;
BBlow := SMA(RS,7) - SD * stddev(RS, Bollperiod) ;
end.

• From the menu bar select “Build” and then “Verify Module.”
• You will be prompted to save the file. Name this “RSI and Bollinger Bands”
• Against select “Build” and then “Verify Module.”
• Finally once again select “Build” but this time “Install Module.”

You should find that the indicator appears in the “User Modules” window at the left of the screen. When you go back to your charting area and insert an indicator you will find “RSI and Bollinger Bands” will be available to insert into the chart.

Using Fibonacci Levels to Detect Range Bound and Trending Markets

Why we shouldn't buy breakouts

The FX-market oscillates on a regular basis between range bound and trending markets. In range bound market conditions, traders typically adopt a simple buy low, sell high approach, where as trending market climates call for traders to trade with the trend. However detecting whether the market is currently in a range bound or trending environment can be tricky, and costly if applied inaccurately. With that said, the Fibonacci levels can provide a valuable insight to the current market climate and the appropriate trading approach.

The first chart below shows a significant rally to the upside, as the trend reversed direction, the market then passed through all 3-commonly used Fibonacci levels; 38.2%, 50%, & 61.8%. Due to the fact that not one of our Fibonacci levels established our new support, we can extrapolate that a trend is not probable. It is important to keep in mind that trends exist when there is an uneven distribution of buyers and sellers, forcing the market to new high/low prices. However due to the fact that the market fell back below every Fibonacci line, indicates that the buyers were not in fact in control of the marketplace. Finally note how the market then accomplished a 'slightly' new low before reversing once again back to the upside. If we were to sell short the market at its slightly new low price, we would have certainly exited the trade at a loss.

We may now see how the market rallied back to the upside, and found a new (lower) resistance at the 50% Fibonacci level; measured now from our recent high to low prices. Due to the fact the market's progress was then halted at a specific Fibonacci level tells us that at that moment in time, the sellers had in fact gained control of the marketplace as they will not allow the buyers to force us back to recent highs, and an ensuing downtrend is now more probable.

These observations also teach us a valuable lesson against the practice of buying new highs or selling new lows. Conventional wisdom dictates that if the market accomplishes a new high price, the short (stops) will be triggered, in turn will compel the market to even higher highs. However upon careful study of the two aforementioned charts, we learn that if a new trend is intact, the market 'should have' found a new support/resistance level at one of the previous Fibonacci lines. After the first rally to the upside was complete, and as the market retreated back to recent lows, the fact that the market did not find a new (higher) support at one of our Fibonacci levels tells us that the buyers were not in fact, in control, and a relatively equal distribution of power remained between the buying and selling forces which have a greater chance of keeping us in a perpetual range bound market environment. On the other hand, due to the fact that the market found new lower resistance at a Fibonacci level indicates stronger selling pressure, and a greater likelihood of a new trend to the downside will now emerge.

Enhancing Currency Trading with the Elliott Wave Analysis

One of the most common topics of conversation for traders is Elliott Wave analysis. Ironically, few traders actually apply this method because many are unsure about the intricacies of the Elliott Wave. In truth, correct analysis and counting of the waves can be a daunting task. However, even without the help of electronic wave analysis, traders should be able to enhance their profitability with a disciplined use of Elliott's method.

How It All Started

In the first half of the 20th century, Ralph Nelson Elliott concluded that financial markets have a striking resemblance to a basic harmony found in nature and postulated that price movements in financial markets follow patterns but not necessarily in time or amplitude. Elliott set up the Wave Principle on empirically derived rules for interpreting the price action.

Basics of Wave Analysis

Elliott postulated that financial prices unfold according to a basic rhythm or pattern: five waves in the direction of the trend and three waves counter trend. He named the five-wave upward movement an impulse wave, and the three-wave counter trend- a corrective wave.

Within the five-wave bull move, waves 1, 3 and 5 are called impulse waves. They are subdivided into five waves of smaller scale. The subwaves of impulse sequences are labeled with numbers. Waves 2 and 4 are corrective waves, subdividing into three smaller waves each. The subwaves of corrections are labeled with letters.

Waves of any degree in any series can be subdivided and then subdivided again into waves of a smaller degree, as follows:

IMPULSE CORRECTIVE CYCLE
Waves 1 1 2
First subdivisions 5 3 8
Second subdivisions
Subdivisions 21 13 34
Third subdivisions
Subdivisions 89 55 144

Elliott's Rules of Interpretation

Elliott identified three essential rules of interpretation of his wave principle:

Wave 2 may never retrace more than 100% of wave 1.
Wave 3 is never the shortest; most of the time the longest.
Wave 4 can never enter the price range of wave 1.

Characteristics of the Waves:

• Wave 1.
  Wave 1 is difficult to identify because it appears to be more of a correction. It is often the shortest of the impulse waves.
• Wave 2.
  Wave 2 should be easier to identify due to its three-subwave structure. It tends to retrace by about .618% of the first wave.
• Wave 3.
  Wave 3 is usually the longest and it is never the shortest. It has a dynamic move, and the penetration of the top of Wave 1 attracts more demand in a bull market. Naturally, this makes for a good volume and fundamentals support the move.
• Wave 4.
  According to the rule of alternation, if wave 2 is complex, then wave 4 tends to have a less complex pattern and vice versa. Of course, Wave 4 can never enter the price range of Wave 1.
• Wave 5.
  Wave 5 can be dynamic and extended, as Figure 8 shows. By now everyone has figured out the long-term trend and these conditions can create a good overshooting scenario.
• Wave A.
  Wave A is difficult to catch through all the euphoria. A good hint comes from the break into five subwaves.
• Wave B.
  Wave B may be of different complexities and lengths since the last bulls are making their final mark in a previously rising market and the bears are testing the waters and starting to go short.
• Wave C.
  Wave C puts the stamp on the end of the trend. Following a bull market, wave C should fall below the bottom of wave A.

Impulse Waves - Variations

Elliott Wave identifies several extensions, which are not easy to use. In the five-wave sequence, one of the three impulse subwaves tends to generate an extension. These subdivisions are of nearly the same amplitude and duration as the larger-degree waves of the main impulse sequence, giving a total count of nine waves of similar size rather than the normal count of five for the main sequence.

Extensions can be useful guides to the lengths of future waves. Most impulse sequences contain extensions in only one of their three impulsive subwaves. Therefore, if the first and third waves have about the same magnitude, the fifth wave will probably be extended. Extensions may also occur within extensions. Although extended fifth waves are not uncommon, extensions of extensions occur most often within third waves.

FAILURES OR TRUNCATED FIFTHS

Elliott called failure any impulse pattern in which the extreme of the fifth wave fails to exceed the extreme of the third wave.

Corrective Waves

Market swings tend to move easier with the trend of a larger degree than against it. Therefore, corrective waves can be highly complex, choppy and often difficult to interpret before completion.

The most important characteristic about corrections is that they never consist of five subwaves. Only impulse waves consist of five subwaves.

Elliott identified the following four corrective patterns:
1. Zigzags (5-3-5)
2. Flats (3-3-5)
3. Triangles (3-3-3-3-3)
4. Combined structures

Zigzags are simple three-wave patterns, subdivided into 5-3-5 structures, in which the extreme of wave B remains a significant distance from the beginning of wave A. Occasionally, a double zigzag formation may occur.

FLATS - Flat corrections have a 3-3-5 structures. The original movement of wave A lacks the momentum to develop into a full five waves, as in a zigzag. Wave B also lacks countertrend pressure and often ends at or beyond the start of wave A. Wave C usually finishes near the extreme of wave A, rather than significantly beyond it, as in a zigzag. Elliott identified four types of flats: regular, expanded, irregular and running.

TRIANGLES - Triangles tend to occur just before the final rally in the direction of the trend. They tend to be extended because of low volume and low volatility during a consolidation period. Triangles consist of five waves, labeled A-B-C-D-E, subdivided into three waves each. The four types of triangles are symmetrical, ascending, descending and expanding. After completion of a triangle, the final impulse wave of the larger trend is usually swift and has a price objective equal to the base of the triangle. This movement is called a thrust.

COMBINED STRUCTURES - In Elliott Wave analysis, zigzags and flats are often called threes. These combined structures consist of two or more threes separated by smaller three-wave movements, labeled X waves. For example, a double three may consist of a flat, a smaller zigzag-forming wave X and a second flat, or it might contain a zigzag , a smaller flat in wave X and a second zigzag. The combined structures are generally sideways formations reflecting market hesitation.

Conclusion

A disciplined analysis and a trained eye should help you get a good grip on Elliott's method. While it can be complex and time consuming, it is also an excellent approach to true forecasting.

Enhancing Currency Trading with the Elliott Wave Analysis

One of the most common topics of conversation for traders is Elliott Wave analysis. Ironically, few traders actually apply this method because many are unsure about the intricacies of the Elliott Wave. In truth, correct analysis and counting of the waves can be a daunting task. However, even without the help of electronic wave analysis, traders should be able to enhance their profitability with a disciplined use of Elliott's method.

How It All Started

In the first half of the 20th century, Ralph Nelson Elliott concluded that financial markets have a striking resemblance to a basic harmony found in nature and postulated that price movements in financial markets follow patterns but not necessarily in time or amplitude. Elliott set up the Wave Principle on empirically derived rules for interpreting the price action.

Basics of Wave Analysis

Elliott postulated that financial prices unfold according to a basic rhythm or pattern: five waves in the direction of the trend and three waves counter trend. He named the five-wave upward movement an impulse wave, and the three-wave counter trend- a corrective wave.

Within the five-wave bull move, waves 1, 3 and 5 are called impulse waves. They are subdivided into five waves of smaller scale. The subwaves of impulse sequences are labeled with numbers. Waves 2 and 4 are corrective waves, subdividing into three smaller waves each. The subwaves of corrections are labeled with letters.

Waves of any degree in any series can be subdivided and then subdivided again into waves of a smaller degree, as follows:

IMPULSE CORRECTIVE CYCLE
Waves 1 1 2
First subdivisions 5 3 8
Second subdivisions
Subdivisions 21 13 34
Third subdivisions
Subdivisions 89 55 144

Elliott's Rules of Interpretation

Elliott identified three essential rules of interpretation of his wave principle:

Wave 2 may never retrace more than 100% of wave 1.
Wave 3 is never the shortest; most of the time the longest.
Wave 4 can never enter the price range of wave 1.

Characteristics of the Waves:

• Wave 1.
  Wave 1 is difficult to identify because it appears to be more of a correction. It is often the shortest of the impulse waves.
• Wave 2.
  Wave 2 should be easier to identify due to its three-subwave structure. It tends to retrace by about .618% of the first wave.
• Wave 3.
  Wave 3 is usually the longest and it is never the shortest. It has a dynamic move, and the penetration of the top of Wave 1 attracts more demand in a bull market. Naturally, this makes for a good volume and fundamentals support the move.
• Wave 4.
  According to the rule of alternation, if wave 2 is complex, then wave 4 tends to have a less complex pattern and vice versa. Of course, Wave 4 can never enter the price range of Wave 1.
• Wave 5.
  Wave 5 can be dynamic and extended, as Figure 8 shows. By now everyone has figured out the long-term trend and these conditions can create a good overshooting scenario.
• Wave A.
  Wave A is difficult to catch through all the euphoria. A good hint comes from the break into five subwaves.
• Wave B.
  Wave B may be of different complexities and lengths since the last bulls are making their final mark in a previously rising market and the bears are testing the waters and starting to go short.
• Wave C.
  Wave C puts the stamp on the end of the trend. Following a bull market, wave C should fall below the bottom of wave A.

Impulse Waves - Variations

Elliott Wave identifies several extensions, which are not easy to use. In the five-wave sequence, one of the three impulse subwaves tends to generate an extension. These subdivisions are of nearly the same amplitude and duration as the larger-degree waves of the main impulse sequence, giving a total count of nine waves of similar size rather than the normal count of five for the main sequence.

Extensions can be useful guides to the lengths of future waves. Most impulse sequences contain extensions in only one of their three impulsive subwaves. Therefore, if the first and third waves have about the same magnitude, the fifth wave will probably be extended. Extensions may also occur within extensions. Although extended fifth waves are not uncommon, extensions of extensions occur most often within third waves.

FAILURES OR TRUNCATED FIFTHS

Elliott called failure any impulse pattern in which the extreme of the fifth wave fails to exceed the extreme of the third wave.

Corrective Waves

Market swings tend to move easier with the trend of a larger degree than against it. Therefore, corrective waves can be highly complex, choppy and often difficult to interpret before completion.

The most important characteristic about corrections is that they never consist of five subwaves. Only impulse waves consist of five subwaves.

Elliott identified the following four corrective patterns:
1. Zigzags (5-3-5)
2. Flats (3-3-5)
3. Triangles (3-3-3-3-3)
4. Combined structures

Zigzags are simple three-wave patterns, subdivided into 5-3-5 structures, in which the extreme of wave B remains a significant distance from the beginning of wave A. Occasionally, a double zigzag formation may occur.

FLATS - Flat corrections have a 3-3-5 structures. The original movement of wave A lacks the momentum to develop into a full five waves, as in a zigzag. Wave B also lacks countertrend pressure and often ends at or beyond the start of wave A. Wave C usually finishes near the extreme of wave A, rather than significantly beyond it, as in a zigzag. Elliott identified four types of flats: regular, expanded, irregular and running.

TRIANGLES - Triangles tend to occur just before the final rally in the direction of the trend. They tend to be extended because of low volume and low volatility during a consolidation period. Triangles consist of five waves, labeled A-B-C-D-E, subdivided into three waves each. The four types of triangles are symmetrical, ascending, descending and expanding. After completion of a triangle, the final impulse wave of the larger trend is usually swift and has a price objective equal to the base of the triangle. This movement is called a thrust.

COMBINED STRUCTURES - In Elliott Wave analysis, zigzags and flats are often called threes. These combined structures consist of two or more threes separated by smaller three-wave movements, labeled X waves. For example, a double three may consist of a flat, a smaller zigzag-forming wave X and a second flat, or it might contain a zigzag , a smaller flat in wave X and a second zigzag. The combined structures are generally sideways formations reflecting market hesitation.

Conclusion

A disciplined analysis and a trained eye should help you get a good grip on Elliott's method. While it can be complex and time consuming, it is also an excellent approach to true forecasting.

Dual Moving Averages ... the Market's Favorite…

Why moving averages are my least favored trading tool

"What moving averages do you use?"

Isn't that a common question? Is there and answer? Of course, many traders use moving averages. Which are the best periods to use then?

My answer: "Depends on how much money you want to lose."

I am fascinated by the market's fascination with moving averages. Why? Am I missing something? I have seen all sorts of strategies using moving averages but have never seen a strategy that is stable and makes steady profit with a low drawdown.

Let's take a look at a simple dual moving average strategy that simply buys when they cross higher and sells when they cross lower. I used this on a chart of the Euro against the Dollar and to begin with I have limited this to a period of five years from the introduction of the Euro in January 1999.

Just to speed up the process I optimized the two periods which ended up as 9 periods for the short moving average and 35 for the long moving average.

Capital	$20,000	Leverage 5x	EUR 80,000
Total Net Profit	0.4918	Gross Profit	0.8088
		Gross Loss	(0.3170)
Total # of trades	38	Percent profitable	55.26%
Number winning trades	21	Number losing trades	17
Max intraday drawdown	(0.0908)	As a % of capital	(36.32%)
Largest winning trade	0.1046	Largest losing trade	(0.0442)
Average winning trade	0.0385	Average losing trade	(0.0186)
Ratio avg win/avg loss	2.0654

1999	0.0983	39.32%
2000	0.1355	54.20%
2001	0.0396	15.84%
2002	0.0759	30.36%
2003	0.1425	57.00%
TOTAL	0.4918	196.72%

Let's look at these numbers.

First of all I took an average rate of 1.25 for the EURUSD rate and came to a position size on a 5x leverage of EUR 80,000. This is probably a bit high, but for the sake of examining just how good a strategy is it will suffice.

Well, we have see 55.26% of the trades make profit and the ratio of profit to loss is over 2:1. That is quite good. The total net profit over the 5 years is 0.4918 – so very nearly 0.1000 per annum. Looking at the results for each year we see the lowest return was 15.84% (2001) and the highest was 57.00% (2003). I'd be happy with that. We've almost trebled our capital in that time although we would have had to have gone through something like a 36.32% drawdown in capital at some point.

These numbers are good!

So on the 1st January 2004 we can start trading… and these would have been the results since then:

Capital	$20,000	Leverage 5x	EUR 80,000
Total Net Profit	(0.0922)	Gross Profit	0.2704
		Gross Loss	(0.3626)
Total # of trades	27	Percent profitable	22.22%
Number winning trades	6	Number losing trades	21
Max intraday drawdown	(0.1480)	As a % of capital	(59.20%)
Largest winning trade	0.0889	Largest losing trade	(0.0379)
Average winning trade	0.0451	Average losing trade	(0.0173)
Ratio avg win/avg loss	2.6100

2004	(0.0073)	(2.92%)
2005	(0.0416)	(16.64%)
2006	(0.0128)	(5.12%)
2007	(0.0130)	(5.20%)
TOTAL	(0.0747)	(29.88%)

Suddenly the numbers don't look quite so good… Every year has recorded a loss and the maximum drawdown was almost 60% of capital. Only 6 out of the 27 trades made profit over the 3.25 years.

Was there something wrong with the optimization? How could the same moving average periods lose so much money?

I have news… this is very, very common.

The next question is normally "Can I add a money management stop, trailing stop or take profit."

Of course you can but do remember there are two risks involved. To be honest a money management stop should always be employed. However, there can be a downside in that when set to a level with which you feel comfortable it can actually increase the drawdown. What can happen especially with simple moving average systems is that since they provide a lagging entry signal, the subsequent pullback is so deep it will catch the money management stop. This often takes a loss on a position you may have profited from without the stop and if there are too many of these it can actually cause the drawdown much higher.

Trailing Stops and Take Profit Stops are also valid methods to take more control over positions. Here however you will need to avoid optimizing them. If anything they should be set to a non-fixed amounts but reflect market volatility through using volatility. Optimizing these is not recommended. The more variables you put into your system the more unstable it becomes.

The final question is then usually asked. "Is there any way to more thoroughly check whether the optimization has provided a stable result?"

The answer is most definitely yes. Look at the profit results of all the optimized periods. For example, let's look at the strategy above. After optimization the moving average periods used were 9 and 35. Each of these should be examined to observe how stable the results are around the optimum period. Look at the following graphs of results:

On the left are the results of all lengths in the short moving average period from 5 to 12 while on the right are the results of all lengths in the long moving average period from 30 to 40.

Note on the left that around the optimum 9 period average the next best results are around 1,000 points lower and going out to the extremes these move down to 2,000 points lower. Equally, on the right we see a similar result.

It must be understood that when optimizing the chances of seeing profits as high as suggested by the optimum periods are very, very low and thus do not even begin to think that your trading results will be any where close. The best type of result you should be looking for in a type of flat bell curve which sees limited reductions in profit either side of the optimum. Even then, the more variable parameters you utilize the more chance there is of these causing an exponential reduction in profitability in your strategy.

What I have pointed out here with two moving averages is common of a poor strategy but very common using moving averages. They are really not good trading tools.

Moving Averages as a Forecasting Indicator

There is reason for caution when analysts tell you that moving averages forecast price movement

Many analysts still claim that moving averages can be used to forecast the subsequent day's movement. I'm not sure why this is considered true as none of the tests I have ever done suggest that they are anything less than poor at the role. In fact, almost certainly they would lose money when used in this fashion.

Let me go through a test to highlight the numbers and the risk of loss.

The first test is a simple trading strategy. If the moving average closes higher then the strategy will buy at the next day's opening price and exit at close. In fact, just to try and discover the best parameter for Dollar-Yen I optimized the period used on a daily chart over 5 years from 2002 to 2006 and fount the very best period was a 7 day exponential moving average. The results can be summarized as follows:

Year Profit (in points)
2002: 1,299
2003: (664)
2004: 1,775
2005: (224)
2006: (840)

Total: 2,568

Maximum drawdown: 1,343 points (maximum loss from the equity high point)
% of winning trades: 50.89%
Average Profit: 50 points
Average Loss: 48 points
Ratio of profit/loss: 1 : 1.04

Let's just look at the numbers. First of all the net total over 5 years represents about 500 points a year. If we use a conservative 5x leverage it will represent an approximate 22.5% return a year on average. Not too shabby.

Now let's look at the maximum drawdown, a massive 1,343 points which using the same leverage would have lost you 61% of your capital and would have severely restricted your ability to trade at the same leverage, not even to mention whether you would have just plain given up.

Let's look at something more damning. By necessity chart prices are constructed using the bid price only and thus you should always look at allowing for the 3 point spread. Let me add in a 3 point slippage. The figures now look like this:

Year Profit (in points)
2002: 537
2003: (1,435)
2004: 992
2005: (553)
2006: (840)

Total: (1,299)

Maximum drawdown: 2,181 points (maximum loss from the equity high point)
% of winning trades: 48.25%
Average Profit: 50 points
Average Loss: 48 points
Ratio of profit/loss: 1 : 1.03

Clearly in reality we would have probably made a loss just because of the bid/offer spread! What is more, the maximum drawdown of 2,181 points would have implied a loss of 99% of our capital!

I think that clearly shows that moving averages simply do not forecast the next day's movements. However, in addition to the above the results shown are from using the optimized period. In reality we wouldn't know the optimum period until after the fact and would have to hope that the period chosen would continue to make the same level of profits. I have met many traders who think this is a reasonable assumption.

Well, to dispel any such ideas let me show you the graph of the profit/loss across the range of optimization periods which I organized from 3 to 30:

Out of 28 periods used only 9 actually produced profit. The 7 period average made the most at 2,568 points (before allowing for the spread) while the next best profit was the 6 period average which only made 1,620 points. When allowing for the spread no period of moving average made any profit at all.

I hope this puts to rest the claim that moving averages can be used to forecast price.

Using Support and Resistance Levels

A guide to determining approximate reversal levels

Support and resistance is a tool which is often used but quite often the source of the support and resistance levels are not often completely obvious. There are several ways to derive these levels:

1. Previous support remains supportive until broken and vice versa
2. Previous support becomes resistance and vice versa in pivot levels
3. Fibonacci derived support and resistance either by retracement or projections

The third method is the most accurate but the process of learning how to calculate these using the right levels requires a large degree of experience and skill using Elliott Wave. I shall therefore concentrate on the first two in this article.

In the image above the upper chart is of daily Dollar-Yen while the lower is the weekly chart.

Now the first thing to remember is that trends are developed when (in an uptrend) highs are moving higher and lows are moving higher. In a downtrend the lows are moving lower while the highs are also moving lower.

Thus when in an uptrend the most recent low is broken we need to decide where price might finally make a corrective low.

For example, we can see in the daily chart that price rallies to the 121.38 high at point (1). It then reverses, breaking below previous lows in the uptrend. So now we know the uptrend is reversed but where will the decline reach?

In the weekly chart we can see two prior lows around 115.50 which also provided resistance in an earlier correction. It is this pivot area where the first decline to point (a) completes. The correction to point (b) can often be measured by Fibonacci retracements and in the case it was 76.4%.

The next decline in the daily chart to point (2) reaches 108.96. This is just 26 points above the last major low at 108.70 before the rally to 121.38. It is very frequent that the first retracement will move to the most recent major low (after a rally) or the most recent high (in a decline). A horizontal line has been marked on the weekly chart to show this support area.

Now that we have identified the approximate area of the low and we see a recovery we can begin to look at where this may reach. We should remember the pivot area around 115.50 although while it did see a reaction for a few days price quickly broke through and we then need to look for the next resistance.

Here is a little tip that can be useful. Where you see a very distinctive 3-leg move as we did from the 121.38 high down to 108.96, the retracement will quite often move to the extreme of the middle correction - in this case at point (b). The high was at 119.38 and the rally to Point (c) ended at 119.87 - just 50 points above.

From the 119.87 peak we can see how price then declined and penetrated the series of supporting lows so we then look at the 115.50 pivot area again but since this didn't hold too well on the way up we can begin to look at the series of lows that spread across from the 113.41 low at Point (a) and the last major low which was at 113.95. We should expect the correction lower to find a correction close to the 113.41-95 area. In the end the correction ended at 114.42 at Point (3).

The next rally then moves up to retest and break the 121.38 high at Point (4). We may have been tempted to call price higher then but the break below the corrective lows signaled a reversal lower which has been declining back towards the 113.41-114.41 lows and still may just get there.

Of course, using support and resistance areas in this way is an approximation and it should not be expected to find accurate or final support or resistance levels but can be useful in determining the basic direction. Certainly as price approaches these levels you should always be looking at the lower time-frame chart to spot reversal patterns or breaks of short time-frame trend lines and also of the most recent lows/highs that would indicate a reversal.