EMA's: Where They Belong in Your Trading Toolbox

The exponential moving average (EMA) is a less popular but more sophisticated version of the simple moving averages. You need a computer trading program such as FutureSource to employ an EMA indicator. With the EMA, more importance is put on the recent price action, but all the price data in the futures contract is used. I'll define the EMA below and then I'll discuss how I use and rank this trading tool in my "Trading Toolbox."

An EMA is another type of moving average. In a simple moving average, the price data have an equal weight in the computation of the average. Also, in a simple moving average, the oldest price data are removed from the moving average as a new price is added to the computation. The EMA assigns a weight to the price data as the average is calculated. Thus, the oldest price data in the EMA are never removed, but they have only a minimal impact on the moving average. The EMA calculation is achieved by subtracting yesterday's exponential moving average from today's price. Adding this result to yesterday's exponential moving average results in today's moving average.

The main use of the EMA indicator is its smoothing out function. In this way, the moving average removes short-term fluctuations and leaves to view the prevailing trend. This can be important because simple moving averages tend not to work well in choppy trading conditions.

Many trading programs display the EMA as a crossover trading system. For a crossover system, you may insert three different exponential moving averages. Generally, the lengths for these moving averages are short, intermediate, and long term. A commonly used system is 4, 9, and 18 intervals. An interval may be in ticks, minutes, days, weeks, or months; it is a function of the chart type. The closing price is used by most systems when calculating the exponential moving average. On many systems, however, you may specify a different price to use in the calculation (open, high, low, close, midpoint, or average price) by changing the computation of the EMA.

If the EMA crossover trading system is used, a buy signal occurs when the short- and intermediate-term averages cross from below to above the longer-term average. Conversely, a sell signal is issued when the short- and intermediate-term averages cross from above to below the longer-term average. Another trading approach is to use the "current price" method. If the current price is above the exponential moving averages, you buy. Liquidate that position when the current price crosses below your selected moving average. For a short position, sell when the current price is below the EMA. Liquidate that position when the current price rises above the EMA.

I use the EMA as one more "secondary" trading tool, along with most other computer-generated technical indicators that fall into that category. I use the EMA less often than simple moving averages. I use "secondary" trading tools to help confirm my ideas that are derived from my "primary" trading tools, which include trend lines, chart patterns, market psychology and fundamental analysis.

Trend Lines - They May Look Simple But Think Again

Most traders make a hash out of drawing trend lines

I talk about this subject quite a bit. Many traders think I'm nuts. After all, trend lines are the most simple of all analysis techniques aren't they? You don't need training to draw a trend line.

Well, if that was the case then you wouldn't see so many technical analysts making a complete pig's ear of them.

This is the sort of chart I am used to seeing:

Most traders seem to work on a hit and miss basis, drawing as many lines as they can and hoping that one of them will work. The mistake they generally make is that they don't actually draw trend lines. They only draw lines and on that basis, since they are not drawn on a trend, they will fail.

There is no benefit from drawing lines without any logic to them. When they are drawn correctly they provide significant benefit and often great trading opportunities. However, these occur very infrequently.

So how should a trend line be drawn?

First of all, before providing examples, let's just consider the word "trend". Just what is a trend? Well, by definition a trend is a sustained move in one direction and is accompanied by a very simple concept:

• Up Trend = A series of higher highs and higher lows
• Down Trend = A series of lower lows and lower highs

Note that in an uptrend both lows and highs move higher. It is common but not a rigid rule for a support line to be drawn across the rising lows.

Note that in a down trend both lows and highs move lower. It is common but not a rigid rule for a resistance line to be drawn across the declining highs.

Now look back at the first chart and see how many times the lines were drawn on trends... Perhaps once it occurred.

When drawn correctly this is what will happen...

You can see how in this chart of USDJPY how both highs and lows were declining and once price reversed back above the line we saw a sustained reversal.

However, in many cases the break of the trend line will occur followed by a retest of the trend line. The retest will provide an excellent opportunity to establish a position on that test.

The other tip is not to necessarily draw trend lines from the lowest low or the highest high on the chart. Quite often the lines that provide the best signals can be drawn across what I term an "intermediate trend." What I mean by this is that quite often a trend will occur within a particular wave pattern. Without getting too deep into the topic of Elliott Wave, consider an entire trend will come from the 5-wave sequence of 1, 2, 3, 4, 5 and possibly the trend can be drawn on Wave 5 only. This can be the provider of the final retest on which you can establish a position.

An example of this is shown in the chart here.

First most traders will draw the line in red. Invariably this will rarely provide any profitable signal so only draw these lines once you have been able to identify the line having touched price a minimum of three times.

Note that price declined in three sections which I have labeled (a), (b) and (c). Across the declining peaks in the move lower in (c) I have drawn a resistance line which has touched price three times (the minimum I will accept before I consider the trend line as valid.)

Note how price has subsequently broken above the trend resistance line and after the first move higher it reversed to retest the trend line which provided an excellent buying opportunity.

When a trend line is broken the retest is quite common and is a useful feature of a trend line that has been drawn correctly. By breaking above the last peak in the decline (at touch number 3) we can confirm that the trend in (c) is complete and should then trigger a deeper pullback.

By adhering to these guidelines the results you get from you trend lines will be much more profitable and you will be able to have more confidence that the line has a greater chance of providing a solid signal.

However, I should add that in my daily analysis across several currency pairs I often have no valid trend lines drawn. In reality they occur very infrequently but are more productive when applied accurately.

A Simple Tool to Help in Identifying Trend Reversal

There is a great deal of nonsense written about trends and using trend lines. Quite often - and maybe even the majority of the time trend lines aren't even drawn on a trending move and traders then cry when they lose money because of a trade they had based on the break of their line.

To be honest the concept of a trend is really one of the most simple tools in a trader's toolbox but the definition of a trend is normally forgotten and could actually help your trading considerably. Let us just cover the definition of a trend:

• Up trend A sequence of higher highs and higher lows
• Down trend A sequence of lower highs and lower lows

It really couldn't be much simpler than that.

Sometimes - and in spite of the number of lines that traders draw - this doesn't happen very often, a supporting line can be drawn across the lows in an up trend or above the highs in a down trend.

In most cases you can consider trading a break of the trend line. At this point you do have to be a little careful since if the previous low in an up trend (previous high in a down trend) is not exceeded there is still chance that price can go and retest the trend line and occasionally this can be at a new extreme.

You can see in this example how even though the trend line was broken the prior low in the sequence of higher lows was not penetrated. Following this price rallied to retest the trend line twice, the second time at a new high before it finally broke lower. You would normally expect momentum indicators to be showing a divergence at this point.

How can this be used in a practical way?

Well recently in Pro Commentary I had identified a peak in EURUSD that stalled at 1.2902 and I forecast a retracement to below 1.2800 with a favored target at 1.2745. In fact it only moved down to 1.2761. At these times when it is uncertain whether the correction is complete or whether price will move lower to target it is possible to consider the concept of a trend. Here is the 2-hour chart:

Following the break of the sequence of lower highs I confirmed to readers that they should expect to see the up trend resume with support between 1.2790-1.2805 holding and would eventually reach the 1.2976 high and probably later to 1.3180.

While identifying targets of where to find support or resistance requires knowledge of how price develops and the relationships in those moves followed by what sort of correction to expect, the concept of when the correction is complete is actually quite a simple process.

You can use this very simple tool with great effect.

Using Average Directional Index - A useful addition to your toolbox

Many traders concentrate on the popular momentum indicators looking for overbought and oversold signals and possibly even price/momentum divergence at the end of a trending move.

Let us just look at how Rapid RSI performs in identifying overbought and oversold signals in the daily chart for the US Dollar vs Japanese Yen:

Very clearly it has been very successful and if this is your first experience of using momentum indicators you may start imagining buying your first yacht! However, as with just about any technique in technical analysis it is never quite that simple. Let us take a look at a different section of price action:

Quite clearly while the first two signals (first a sell signal followed by a buy) were very successful.

However, following this Rapid RSI issued constant sell signals but price continued directly higher.

What has happened?

Very simply, momentum indicators will provide good overbought/oversold indications within a consolidating and freely swinging market. However, this breaks down when the market begins to trend - and this is what happens in USDJPY.

During a trend momentum indicators will spend most of the time oscillating around the overbought or oversold extreme and will never provide a signal in the direction of the trend. At these times we need to ignore momentum signals. What we need to try and organize is a method of recognizing when price begins to trend. This can be managed by using another Welles Wilder indicator, Average Directional Index - or ADX.

Let us apply this on the same chart.

On this chart I have added in ADX (in green) along with +DI and -DI in blue and red respectively.

+DI and -DI display the individual positive and negative movement seen and when price direction is higher it can be seen that the +DI line crosses above the -DI line and vice versa.

ADX is the Average Directional Movement of both positive and negative moves. It can be seen that when price moves consistently in one direction (ie there is a trend - this may be an uptrend or downtrend) ADX rises above the 30 line to indicate that a trend is under development.

I have marked on the chart when this occurs approximately. Then, while ADX is rising above 30 it is possible to ignore the RSI signals.

However, ADX is a lagging indicator by definition and there will always be a period before it moves above the 25-30 area when the momentum indicator moves into the overbought or oversold area. How can we manage that situation?

Well first of all, just because the momentum indicator has moved into the extreme area, it is not an automatic trading opportunity. In this case, when Rapid RSI moves into overbought territory we should be examining price action in not only the daily chart as shown, but also the intraday market.

In this case I have taken the lead-up to the point until ADX crosses above the 25-30 area. What is very evident is that it is following the very basis of a trend - that is swing highs and moving higher as well as swing lows moving higher.

The picture above shows an uptrend where both peaks and troughs are rising and when one of the troughs is broken then we are on warning that a reversal in trend is possible.

In the case of the USDJPY daily chart it is quite clear from the inset that we never saw break of one trough and therefore we should be staying with the move higher even though ADX hasn't yet registered this mathematically as a trend.

We have been able to draw a supporting trend line across several troughs and when this breaks we can say that the trend is probably complete. There is a small risk of moving back to retest the trend line after breach and this does occasionally occur at new high, but given that ADX has already begun to decline we can more safely assume the uptrend is complete and can look for Rapid RSI to provide overbought and oversold signals.

So look to add ADX into the list of indicators you use to provide an objective view of when a trend is in place. It is a good addition to your tool box, adding information instead of duplicating with yet another momentum indicator.

At less obvious time you can refer to Pro Commentary for information on projected targets and yet another objective view on the market.

Keltner Channel for Forex Trading

Forex support and resistance indicator based on volatility

The Keltner Channel plots two bands around a central modified moving average and is similar to Bollinger Bands in the way the distance of the upper and lower bands from the average will vary according to the underlying volatility of price. As opposed to Bollinger Bands, which use standard deviation in the calculation, Keltner bands use Average True Range.

True Range was developed by J Welles Wilder Junior to represent the real highs and lows of the day to include possible gaps from the prior bar's close to the current bar's open. This is a tool that was intended more for the futures and equities markets where there is a significant time gap between the close and the following day's open. In this way, True Range is calculated by taking the maximum of:-

1. High - Low
2. The prior bar's close - Low
3. High - the prior bar's close

However, it is very unusual for these gaps to occur in the forex market since there is no time difference between one day's close and the next day's open. Thus a gap can only really effectively occur over weekends or during volatile market conditions.

A modified average is then taken of a series of True Range calculations. Clearly, if there has been a significant level of high range bars the upper and lower bands will move away from the average while a series of low range bars will cause the bands to move inwards towards the average. Thus Keltner Bands will automatically expand and contract as the market volatility rises and falls respectively.

Basic usage of the Keltner channels are two-fold:

1. In consolidating markets the upper and lower bands may be considered as approximate support and resistance where trades may be considered to take advantage of range trading.
2. Where price breaks cleanly through and closes outside one of the bands there is a higher risk of a trend in the direction of the break developing.
3. The central moving average may be used as a trailing stop when in a trending move

It is always recommended that trades are not initiated on the basis of one indicator only and utilizing other techniques such as momentum indicators (i.e., RSI, Stochastics, etc…) may be used in order to help confirm or deny the entry signals. Reference to price patterns is also preferred.

Parameter Defaults: Period = 12 (controls the measurement period for the average)
Factor = 1 (controls the placement of the bands around the average)

Plots:

Upper KC Upper Band line
Mid KC Central Moving Average
Lower KC Lower Band line

Formula:

Mid KC = "Period" length modified moving average
Upper KCv = Mid KC + "Period" length Average True Range x Factor
Lower KC = Mid KC - "Period" length Average True Range x Factor

Keltner Channel for Forex Trading

Forex support and resistance indicator based on volatility

The Keltner Channel plots two bands around a central modified moving average and is similar to Bollinger Bands in the way the distance of the upper and lower bands from the average will vary according to the underlying volatility of price. As opposed to Bollinger Bands, which use standard deviation in the calculation, Keltner bands use Average True Range.

True Range was developed by J Welles Wilder Junior to represent the real highs and lows of the day to include possible gaps from the prior bar's close to the current bar's open. This is a tool that was intended more for the futures and equities markets where there is a significant time gap between the close and the following day's open. In this way, True Range is calculated by taking the maximum of:-

1. High - Low
2. The prior bar's close - Low
3. High - the prior bar's close

However, it is very unusual for these gaps to occur in the forex market since there is no time difference between one day's close and the next day's open. Thus a gap can only really effectively occur over weekends or during volatile market conditions.

A modified average is then taken of a series of True Range calculations. Clearly, if there has been a significant level of high range bars the upper and lower bands will move away from the average while a series of low range bars will cause the bands to move inwards towards the average. Thus Keltner Bands will automatically expand and contract as the market volatility rises and falls respectively.

Basic usage of the Keltner channels are two-fold:

1. In consolidating markets the upper and lower bands may be considered as approximate support and resistance where trades may be considered to take advantage of range trading.
2. Where price breaks cleanly through and closes outside one of the bands there is a higher risk of a trend in the direction of the break developing.
3. The central moving average may be used as a trailing stop when in a trending move

It is always recommended that trades are not initiated on the basis of one indicator only and utilizing other techniques such as momentum indicators (i.e., RSI, Stochastics, etc…) may be used in order to help confirm or deny the entry signals. Reference to price patterns is also preferred.

Parameter Defaults: Period = 12 (controls the measurement period for the average)
Factor = 1 (controls the placement of the bands around the average)

Plots:

Upper KC Upper Band line
Mid KC Central Moving Average
Lower KC Lower Band line

Formula:

Mid KC = "Period" length modified moving average
Upper KCv = Mid KC + "Period" length Average True Range x Factor
Lower KC = Mid KC - "Period" length Average True Range x Factor

Why is Elliott Wave so Useful?

The most accurate method of forecasting

The first time I came into contact with Elliott Wave was in my first seminar on technical analysis by a U.K. analyst. After the two day introductory course to analysis I returned to my trading room full of enthusiasm, armed with all the patterns and techniques this guru had imparted upon the fledgling analysts, ready to take the market by storm.

However, he clearly he didn't think very much about the principal since his only comment was "wave bye-bye to Elliott Wave."

So what did I have left?

• Golden crosses and dead crosses. Tried those - they were almost 100% the opposite of what he taught.
• Overbought & oversold momentum. Well good but they don't tell you where price is going and perform so badly in a trend.
• Reversal patterns and continuation patterns. Well they didn't happen that frequently and what were you meant to do in the meantime? My traders wanted to know where price was going to go.

I began to read more. Ah! Fibonacci! 38.2% and 61.8% - wow they worked really well… I thought I found the secret elixir to the fountain of profits… Then they suddenly didn't work.

Desperate for clues I read other analysts' commentary on the data vendor platforms. Some provided anemic comments while others actually forecast exact targets and how it would reach there. Some were ok, some were bad (but enthusiastic) and some were actually pretty good. This fascinated me. Who were these guys that were actually forecasting where price would go? How did they do that? The answer was Elliott Wave and it was these services that actually provided real information and had the greatest rate of success.

So I decided to read about Elliott Wave and tried to teach myself. Of course I didn't tell my guru - I didn't want to incur his wrath.

I can guess what some of you are thinking, "yeah, yeah, 12345 ABC." Well basically, yes. But it is a lot more. I bought a couple of books, devoured them and went to my charts to decipher and scribble numbers and letters all over them. It wasn't as easy as the books made them out to be. It was a struggle trying to decide where waves started and ended and how far they would move and I did give up for a period but the problem was that nothing else really gave true forecasting techniques.

So I persisted. I did my analysis and I read other banks' forecasts and tried to work out why they were right - or indeed, why they were wrong. I have to say it took me around 18 months before I felt comfortable using the principal to forecast, and even then it was still a little hit & miss.

As with any form of analysis there are good points about Elliott Wave and there are bad points. The bad points are:

• The counting of waves can be very subjective. There is a common joke that says: "Place 5 Ellioticians in a room with 1 chart for one hour and they'll come out with 20 different wave counts". True…
• The development of individual waves can vary dramatically
• The experience required to recognize the type of variation takes a good few years and a great deal of patience to acquire
• Sometimes waves are impossible to recognize
• Filtering wave counts to obtain the most likely ones can be difficult
• Elliott's description of the wave structure is actually incorrect for Foreign Exchange - a fact that took me many years to realize
• Once you start using the principal it is impossible to look at a chart without counting waves…
• It can cause you to make incredibly inaccurate forecasts if not utilized properly. (I recall one analyst that called USDDEM higher from 1.72 to 2.46 and 3.46… it actually went down to 1.44…)

Against that the good points are:

• Elliott Wave can predict market moves to the point at times - nothing else can
• Waves are related and thus you can use Fibonacci relationships to recognize waves, where they started and where they have greatest chance of ending
• It tells you how a move will occur. This is vital
• It will warn you that your wave count may be breaking down if the wave development doesn't go as planned
• It is the only form of analysis (that I know of) that gives you an understanding of market behavior as if it is an extension of a living force
• The principal helps an analyst/trader to understand the structure of a market from monthly charts down to 1 minute charts, a reflection of the fractal nature of markets.
• It can provide incredibly easy trades from time to time just using basic guidelines

The biggest element to success with Elliott Wave, apart from several years of experience, is understanding how to filter your wave counts. The very best way is to understand the cyclical nature of the market forces. If the analyst who had predicted USDDEM to move higher to 2.46 and 3.46 had incorporated cyclic analysis he would have seen that the major cyclic pressure was still lower. That in itself will keep you closer to the right count. Cycles have assisted me in recognizing direction to moves and when they should reverse - which combined with Fibonacci projections to structures can allow precise forecasting.

Momentum analysis can help you recognize when the pattern you have been following is breaking down and become more complex. Even a basic guidelines that the last Wave B will provide approximate support or resistance on retest can produce excellent trading opportunities.

So now what are you waiting for? Go pick up a book on the Principal but remember nothing is easy in this market and it will take time and dedication. If there was a simple solution then everyone would use it. If everyone used it, then it probably wouldn't work so well…