The FX Bootcamp Guide to Strategic and Tactical Forex Trading E-Book

Wayne McDonell

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Trading Series
• Sprache: Englisch

Seitenzahl: 311

Veröffentlichungsjahr: 2008

Beschreibung

A straightforward guide to trading today's dynamic Forex market Written by Wayne McDonell, the Chief Currency Coach at FX Bootcamp, this book shows readers how to successfully trade the Forex market on their own. FX Bootcamp's Guide to Strategic and Tactical Forex Trading skillfully explains how to combine popular technical indicators to formulate a comprehensive market strategy. Readers will then learn how to focus on using this information to create a tactical trading plan--one that will help them pull the trigger to get in and out of a trade. Along the way, McDonell takes the time to discuss the various challenges a Forex trader faces, such as greed, fear, loss, and isolation. As a Forex trader and educator of traders, Wayne McDonell knows what it takes to make it in the competitive world of Forex. And with FX Bootcamp's Guide to Strategic and Tactical Forex Trading he shows readers how.

Leseprobe

Table of Contents

Title Page

Copyright Page

Preface

PLAN YOUR TRADES AND TRADE YOUR PLANS

WHAT IS NOT IN THIS BOOK

Introduction

WHICH DO YOU DO?

PART ONE - Basic Training

CHAPTER 1 - Lagging Indicators

MOVING AVERAGES

MOVING AVERAGE CONVERGENCE DIVERGENCE (MACD)

BOLLINGER BANDS

STANDARD DEVIATION

SUMMARY

CHAPTER 2 - Leading Indicators

PRICE SUPPORT AND RESISTANCE

FIBONACCI RETRACEMENTS

FIBONACCI EXTENSIONS

SUMMARY

PART ONE SUMMARY

PART TWO - Strategic Analysis

CHAPTER 3 - How to Gather Market Intelligence to Formulate a Trading Strategy

SPY PLANE VIEW

INFLATION SENSATION

CENTRAL BANKING

INFLATION TARGETING

COST OF MONEY

MONEY MAGNETS

INTERESTED IN VALUATION

FOREIGN EXCHANGE

DEMANDING CONSEQUENCES

HOUSE OF CARDS

NOT INTERESTED

SUMMARY

CHAPTER 4 - The Carry Trade

FREE HOUSE

SCARY CARRY

POWER YEN

SUMMARY

CHAPTER 5 - Forex and the Fed

FOREX ECONOMICS

THE FEDERAL RESERVE SYSTEM

SUMMARY

CHAPTER 6 - Commodity Correlations

COMMODITY CORRELATION: OIL

COMMODITY CORRELATION: GOLD

COMMODITY CORRELATION: EQUITIES

TRADING COMMODITIES

SUMMARY

CHAPTER 7 - Greenback Guru: Why You Should Specialize in Trading U.S. Dollars

WHAT’S YOUR USD BIAS?

CURRENCY CORRELATION COEFFICIENT

TRADING CURRENCY CORRELATION

TRADING A BASKET OF CURRENCIES

PETRODOLLARS

YET ANOTHER REASON

SUMMARY

PART TWO SUMMARY

PART THREE - Rules of Engagement

CHAPTER 8 - Market Analysis

SPEED OF THE MARKET

MOMENTUM OF PRICE

SUMMARY

CHAPTER 9 - Fundamental Analysis

ECONOMIC ANNOUNCEMENTS

GLOBAL MONEY FLOW

INTEREST RATES AND CURRENCY VALUES

MARKET BIAS

ANNOUNCEMENT CALENDAR

SUMMARY

CHAPTER 10 - Technical Analysis

SELF-FULFILLING PROPHECY

RANGE ANALYSIS

TREND ANALYSIS

PIVOT ANALYSIS

SUMMARY

CHAPTER 11 - Risk Analysis

FEAR OF LOSS

FEAR OF PROFIT

LIMITS

FX BOOTCAMPER CREDO

LIMITS FOR LOSS

LIMITS FOR PROFIT

MORE TACTICS FOR TRADE ENTRY AND EXITS

YOUR MIND’S EYE

DO NOTHING

DO YOU HAVE THE GUTS?

SECOND CHANCES IN FOREX

SUMMARY

PART THREE: SUMMARY

PART FOUR - Tactical Planning

CHAPTER 12 - Candlestick Patterns

REVERSAL PATTERNS

REVERSE AND CONTINUATION PATTERNS

TRENDING ONLY

SUMMARY

CHAPTER 13 - Range Trading

GET IN THE RING

FLOORS AND CEILINGS

OVER AND OUT

SUMMARY

CHAPTER 14 - Trading the News

Risky Business

Russian Roulette

Perfect Storm

CONSERVATIVE NEWS TRADES

SUMMARY

PART FOUR SUMMARY

PART FIVE - Psychological Warfare

CHAPTER 15 - How to Cope with Pre- and Post-Trading Stress Disorders

GOING MENTAL

COMMON THREAD

UNDERSTAND YOURSELF, UNDERSTAND YOUR TRADES

SUMMARY

CHAPTER 16 - Trade Journals

Elements of a Good Trade Journal

A Mind Game

Natural Born Traders

There Is No Spoon

Proof in the Pondering

3X THE 4X

SUMMARY

CHAPTER 17 - Target Practice

SUMMARY

CHAPTER 18 - Three-Year Plan

FX BUSINESS PLANNER

RISK MANAGEMENT

SUMMARY

PART FIVE SUMMARY

CHAPTER 19 - Closing Notes

THE GENESIS OF FX BOOTCAMP

LEAD BY EXAMPLE

ADDITIONAL SUPPORT

BOOK BUYBACK PROGRAM

Index

Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding.

The Wiley Trading series features books by traders who have survived the market’s ever changing temperament and have prospered—some by reinventing systems, others by getting back to basics. Whether a novice trader, professional or somewhere in-between, these books will provide the advice and strategies needed to prosper today and well into the future.

For a list of available titles, please visit our web site at www.WileyFinance.com.

Copyright © 2008 by Wayne McDonell. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

McDonell, Wayne, 1973- The FX bootcamp guide to strategic and tactical Forex trading / Wayne McDonell. p. cm. - (Wiley trading series) Includes bibliographical references and index.

eISBN : 978-0-470-44333-0

1. Foreign exchange market. 2. Foreign exchange futures. 3. Speculation. I. Title. HG3851.M43 2008 332.4’5-dc22 2008019685

Preface

“Planning is great matter to a general [forex trader]; it is the ground of death and of life; it is the way of survival and of destruction, and must be examined ... before doing battle, one calculates and will win, because many calculations were made.”

—A quote from The Art of War by Sun Tzu, a military general in ancient China. Scholars surmise that he lived around 600 B.C.

PLAN YOUR TRADES AND TRADE YOUR PLANS

Why is trading forex similar to war? They are both a zero-sum game. In war, this means kill or be killed. In forex trading, this means that if you make a winning trade, someone else made a losing trade against you or vice versa.

Forex is pure. There is no central exchange in currency trading like there is for equities, such as the New York Stock Exchange. It’s simply bulls vs. bears. Hawks vs. doves. Those who think a currency will gain value and those who think a currency will lose value.

Forex has no middlemen, few regulations, and is purely a global community of traders. No one controls the market.

For example, recently the central bank of New Zealand intervened to try to lower the value of the country’s currency. It worked for a few hours. Then traders pushed it back up. Traders control this market. No one else.

Why is this good?

Statistics have shown that most traders fail in forex. Some have reported less than a 10 percent success rate for new traders entering the market. However, this is great news for you:

• This means 10 percent of traders make all the money.

• Ninety percent of new traders fail because they do not acquire the skills, but more importantly, they lack the patience and discipline to trade successfully.

FX Bootcamp’s Guide to Strategic and Tactical Forex Trading will guide you on the path from failure to success. However, the journey is yours to take. The question is do you have the guts to work your butt off and get really good at trading forex?

Not clear enough? How about this?

I believe that 90 percent of amateur traders fail, not because they lack an understanding of the market, but because they are not willing or able to do the work required to become an amazing trader.

In forex trading, patience and discipline are just as important as technical and fundamental analysis.

• Are you willing to give yourself enough time to learn how to trade?

• Are you willing to do the work?

• Will you do whatever it takes to succeed?

This book will help you develop positive trading habits and give you lifelong trading skills. It’s not a silly magic system of the moment.

This book will not do the work for you. But it will teach you how to stay out of a lot of bad trades, and you will learn how to wait for the better trades. In fact, this book will to teach you how to think for yourself and trade successfully on your own.

“... this book will to teach you how to think for yourself and trade successfully on your own.”

FX Bootcamp’s Guide to Strategic and Tactical Forex Trading will help you become a part of the top 10 percent that makes 100 percent of the money. (Blood, sweat, and tears not included.)

WHAT IS NOT IN THIS BOOK

Fluff! I assume that you know what a pip is and that forex volume is over $2,000,000,000,000 per day. I’m not going to convince you to trade forex. You should be at or near that conclusion now all on your own.

This book will take care of the rest. It will teach you how the market works and how to trade it.

NOTE

For additional educational resources—including training videos, live webinars, chart examples, and more—please visit this book’s free companion web site www.fxbootcamp.com/book.

Best regards, Wayne McDonell Chief Currency Coach FX Bootcamp, LLC www.fxbootcamp.com

Introduction

Sun Tzu teaches that there are four stages of planning for victory:

1. Gather intelligence.

2. Formulate strategy.

3. Execute plan.

4. Exit plan.

Creating a trade plan will:

• Help you control your emotions.

• Help you implement your analysis.

By reading the market first and then making logical entry and exit decisions based on your thoughtful analysis in advance, you reduce the risk of making a poor trade. You simply set a trap for price. If price falls into your trap, you trade your plan. If it does not, you set another trap and wait. In other words, take the high ground and wait for your adversary to come to you. Do not fight on a level playing field.

Your strategic planning will give you a tactical advantage and you are more likely to be victorious. You are not guaranteed success, but the odds are much more favorable and less risky. By creating a plan in advance and waiting to execute it, you remove a lot of emotion from your trading. You are no longer reacting to the market, you are simply executing your plan. In fact, you will be spending more time waiting for your trade setups than trading. Inevitably, this is less stressful.

Removing emotion will help you avoid stupid trades based on greed and fear. By relying on logical plans, your trading becomes repeatable. By trading when the market is behaving in predictable ways (this is what your plan really is—your prediction of future price action based on past results), you are removing stress.

Stress is a form of risk, and you need to manage it if you are going to succeed on a long-term basis. Imagine trying to trade forex the next 30 years when every time you pull the trigger you start to sweat bullets. Trading like this, you will eventually have an emotional breakdown. Reduce stress!

Planning your trades and trading your plans will reduce a lot of risk—and stress—in your trading career. In addition, conservative, repeatable trade plans will also increase:

• Control

• Consistency

• Confidence

By virtue of the repeatability of your trade planning, you will control your emotions and bring consistency to your trading. Once you are able to trade profitably on a consistent basis, your confidence will skyrocket.

In my experience working with forex traders from more than 50 countries around the globe, I know that confident traders are much more likely to trade their plans.

When traders consistently plan their trades in advance and are confident enough to pull the trigger when they are supposed to, they have a sense of control. It may be an illusion, as the forex markets are chaotic, but think about it this way:

Who do you think the 10 percent of the traders making 100 percent of the money are?

a. The consistent and confident traders with a sense of control because they plan their trading in advance.

b. The traders who pull the trigger based on gut feeling and who react to the market.

WHICH DO YOU DO?

Imagine you are at a cocktail party. People are floating around the room and mingling. We’ve all been in situations like this.

The group next to you is talking about the latest reality TV show and you’ve never even heard of it. It sounds so incredibly stupid. What at bore!

I wonder what they would say if you jumped into the conversation with:

“Speaking about being voted off the island, how about those FOMC meeting minutes released this morning? Governor Pool voted to lower interest rates again! We should vote him off the island!”

It’s likely that no one would have a clue about what you are talking about. Your life revolves around acronyms such as CPI, PPI, NFP, PCE, GDP and such. They live lives of quiet desperation.

The next time someone approaches you and strikes up a conversation by asking, “So, what do you do?” try using my favorite response.

“I buy and sell money.”

Dumbfounded, the individual will respond with, “What?”

“I apply fractal geometry and chaos theory to profit from the global currency markets.”

Now the person will be impressed. But don’t say, “I’m a currency trader” as people equate this with “gambler” and for the 90 percent of amateur traders who lose money, they’d be correct.

But not you; you are a professional profiteer. After reading this book, you will focus less on trading and more on planning your trades in advance, as you are really seeking opportunities to profit, not to trade.

If the odds are just 50/50, you’ll pass as it will be too much of a gamble. You’ll wait for a better profit opportunity.

As Sun Tzu would recommend to a military general, I recommend to you, a currency trader:

Take the high ground and wait for your enemy to come to you. You are more likely to have an honorable victory. Even if you take the high ground and lose, because you gave yourself the best odds of winning, you will be able to consider it an honorable defeat. However, if your adversary does not fall into your trap, you simply don’t fight and live to fight another day.

In summary, strategic and tactical forex trading is not a system. It’s a conservative and repeatable methodology.

Once you have learned, developed, and refined the trade planning skills outlined in this book, you will certainly be on your way to being a part of the 10 percent who make 100 percent of the money. If you are willing to work your butt off, it will just be a matter of time.

PART ONE

Basic Training

The goal for Part One is to develop a common language that you and I can use. The rest of the book will discuss how the technical indicators highlighted in the first two chapters work together to tell a story of what is happening in the foreign exchange (forex) market.

Currency charts use candles and technical indicators to communicate. It is important for you to have a strong understanding of these building block indicators that form the foundation of the trading methodologies discussed in this book.

To learn this language as you read this book, I highly recommend that you take the time to set up your charting package with these indicators and settings so you can practice the methodology. Members of FX Bootcamp have access to a template that makes this easy. Nonmembers will just have to invest a little more time, but it will be worth the effort. Read the book, study the concepts, practice on your demo account, and develop long-term positive trading skills.

In Part One you will learn:

• The difference between a simple moving average (SMA) and an exponential moving average (EMA).

• How to trade moving average crossovers.

• How to use the moving average convergence divergence (MACD) indicator.

• How to trade MACD divergence.

• How to use Bollinger Bands.

• How to trade volatility.

• How to spot a technical reversal.

• How to identify support and resistance (S&R).

• How to trade a break or bounce of S&R.

• How to trade S&R role reversals.

• How to use Fibonacci retracements.

• How to use Fibonacci extensions.

• How to use pivot points.

CHAPTER 1

Lagging Indicators

Most technical indicators are lagging, which means they are slow. They tell you what just happened ... after the fact. However, by combining historic price action with predictive price patterns, we’ll have enough evidence to form the basis of a trade plan.

In this chapter, you will learn how to use technical analysis to read your charts. It is critically important to learn these concepts well. They are key to understanding the market’s behavior. The technical indicators we’ll discuss do not control the market, but they describe a story of how traders are trading it.

MOVING AVERAGES

A moving average (MA) is an average of a predetermined number of prices (such as closing price) calculated over a number of periods (such as 55 candles). The higher the number of candles in the average, the smoother the line is.

A moving average makes it easier to visualize price action without statistical noise. Instead of watching the up and down behavior of every candle, you are watching the relatively smooth moving average line. Moving averages are a common tool in technical analysis and they are used within all time frames: 1-minute, 5-minute, 15-minute, 30-minute, 60-minute, 120-minute, 240-minute, daily, weekly and monthly candle charts, for example.

It is important to observe that a moving average is a lagging rather than a leading indicator. Its signals occur after the new price movements, not before. Moving averages do not think ahead. They tell you what has happened, not what will happen. Nonetheless, moving averages have a critical role to play in properly planning your trades in advance. The past does not always predict the future, but it sure likes to repeat itself.

SMAs vs EMAs

There are two types of commonly used moving averages:

1. SMA: The simple moving average or arithmetic mean.

This moving average is only an average. Add up all the candles that you’d like to measure and then divide by the number of candles you added together. For example, a 21 SMA is calculated by adding the closing price of the last 21 candles and then dividing by 21. Simple, eh?

2. EMA: The exponential moving average.

The exponentially smoothed moving average takes into account more than just the previous price information of the underlying currency. It places more weight on the most recent previous candles. This makes it more sensitive to the most recent price action. For example, a 21 EMA places more weight on the last 5 candles than the first 5 candles.

The exponential moving average reacts to price changes more quickly than the simple moving average does because it pays more attention to newer candles.

I like moving averages a lot. You will see later in this book that at FX Bootcamp we use several different moving averages at once, but they offer different pieces of the puzzle when planning our trades. When the market is steadily rolling along, moving averages keep us in our trades, but if something changes, such as a moving average crossover, we’ll likely get out or trade the new direction.

Moving Average Crossovers

Moving averages are frequently used as price filters. To filter choppy price action into a more reliable indication for true price action, a short-term moving average has to cross a longer-term moving average.

The trade planning methodology we teach in the FX Bootcamp training sessions is to use several moving averages on the chart simultaneously. The most obvious use for multiple moving averages is to watch for crossovers to confirm new trends.

A crossover would consists of a short-term (21 candles) EMA that crosses a longer term EMA (55 candles). Short-term EMAs (fast) are more sensitive to price changes because they are measuring fewer candles. Conversely, longer term EMAs (slow) tend to be more flat and are less likely to whipsaw up and down.

When moving averages do cross, you should take notice. If the fast EMA crosses below the slow EMA, it likely confirms new downward price action. If the fast EMA crosses above the slow EMA, it likely confirms new upward price action. However, such crosses should not prompt you to place a trade, as it often occurs too late and will put you in the market an unfavorable risk/reward ratio. The crossover should have been part of the trade plan that you created in advance, as not every crossover is the same. Moving average crossovers are great because they are easy to see and will attract traders, but they simply do not replace the work of planning your trades.

A simple use of moving averages is using them to gauge the speed and direction of the trend. If prices are held by the 21 EMA, the trend could be considered strong. If prices break the 21 EMA, you should become more cautious. This could be the sign of a reversal or a consolidating market. New rules will apply. We’ll discuss this in more detail later in the book, as it is a key concept to trade planning.

MOVING AVERAGE CONVERGENCE DIVERGENCE (MACD)

Moving average convergence divergence, generally known as MACD (pronounced “mack dee”) is one of the most reliable and simple indicators in our toolbox. MACD is a trend-following momentum indicator, or oscillator, which shows the relationship between two moving averages of recent prices. An example is shown in Figure 1.1.

The MACD is often made up of three components:

1. MACD Line: The actual MACD line is calculated by subtracting a slow moving average (EMA) from a fast EMA. In our example we use the 21 as the fast EMA and the 55 as the slow EMA.

2. Signal Line: The signal line represents an EMA, not of price, but of the MACD. In this case we calculate the EMA of our MACD for the last eight bars.

3. Histogram: The MACD histogram is the difference between the MACD and its signal line.

MACD just might be the most popular indicator used by forex traders. That is why we recommend that you use it. However, be aware that MACD is often misused. Like any other technical indicator, you cannot rely on it for trades. It should be part of your entire trading planning process.

FIGURE 1.1 Moving Average Convergence Divergence (MACD)

Source: DealBook® 360 screen capture printed by permission. c 2008 by Global Forex Trading, Ada MI USA

How to Use MACD

There are three common scenarios to watch for:

1. Crossovers: When the MACD falls below the signal line it is a bearish signal, and indicates that it may be time to sell. Conversely, when the MACD rises above the signal line, the indicator gives a bullish signal, and suggests that it may be time to buy.

2. Divergence: When the price diverges from the MACD, it signals the end of the current trend. When the price is rising and MACD is falling (negative divergence), or vice versa, it can be considered an indication of something going on and can be used to predict changes in a trend. That’s right, the lagging indicator that is supposed to follow the price is predicting future behavior.

3. Dramatic Expansion: When the MACD expands dramatically—that is, the shorter moving average pulls away from the longer term moving average—it is a signal that the currency is overbought/oversold and may soon return to normal levels.

Once again, let me be perfectly clear. All three of these scenarios are important and should not be overlooked. However, none of them are signals to trade. They are opportunities to form trade plans based on likely outcomes commonly generated by such situations.

For example, MACD divergence is tradable only when confirmed by other indicators. It does not always yield profitable trade opportunities. Therefore, if you traded every MACD divergence, just like if you traded every moving average crossover, you would certainly lose money.

However, when planned in advance and confirmed with other technical indicators, success is much more likely. This is because several things are happening at once and each is attracting the same bulls or bears into the trade you are planning.

MACD Divergence

MACD crossovers and dramatic rises are easy to spot. However, spotting MACD divergence takes a little practice. Figure 1.2 shows some examples of charts that display MACD divergence signals.

What does this divergence mean? Just that the current price trend is running out of steam. In this case, you’d create trade plans based on reversal patterns, moving average crossovers, or other indications to consider a trade in the opposite direction. It may not happen right away, but MACD divergence can be a powerful hint that the market is changing.

FIGURE 1.2 Examles of MACD Divergence

Source: DealBook® 360 screen capture printed by permission. c 2008 by Global Forex Trading, Ada MI USA

What you are looking for is when price action and MACD do not agree. For example, if price is making a series of higher highs and MACD is making a series of lower highs, something between the two is out of sync.

I see MACD divergence as a sign that fewer and fewer traders are in the trend. No one is trading against the trend—yet, but fewer and fewer traders are in the trend. I’d guess that traders are getting nervous and slowly fading out of their trades.

When the only traders in a trade are nervous, they are likely to exit their trade at the first sign of trouble. So if MACD is diverging from a bullish trend, as soon as the bears muster up enough guts to short, the bulls will exit and the bears will take control. This is exactly why MACD divergence can be so powerful. When it works, it often works well, but it takes time to set up.

There are two powerful keys in locating possible times where divergence is likely to represent a reversal in price.

1. Support and Resistance: MACD divergence can be powerful when price is at double tops or double bottoms. Just as you are creating a trade plan based on a bounce or break of S&R, you spot MACD divergence, which is a sign that current price action is running out of steam. This would indicate that there are not enough committed traders to break S&R, so perhaps you should focus your trade plan on a rejection reversal. See Figure 1.3.

2. Exhaustion Pullback: The second is when an oscillator, an overbought /oversold indicator, has reached its overbought/oversold range and is turning back down to normal. You may often see the MACD lines extremely overbought or oversold. This is not a reason to trade. In fact, it indicates signs of strength.

Remember this: “Of course it’s overbought; everyone is buying!” Don’t confuse the overbought or oversold MACD zones as trade opportunities. However, when price reaches its extreme, where it’s gone too far too fast, you will see price exhaust and the MACD lines drop back into the normal zone. This is often a better signal. See Figure 1.4.

Combining an exhaustion MACD pullback with MACD divergence at a double top, you would have a second cross of the MACD and an opportunity to trade.

FIGURE 1.3 MACD Divergence Trending Up

Source: DealBook® 360 screen capture printed by permission. c 2008 by Global Forex Trading, Ada MI USA

FIGURE 1.4 MACD Divergence with Stochastic Trigger

Source: DealBook® 360 screen capture printed by permission. c 2008 by Global Forex Trading, Ada MI USA

Those two situations, along with your other tools can provide excellent trading opportunities. It is also important to note that divergence can be found not only on the MACD line and signal line as was demonstrated in the previous examples, but it can also be found on the histogram, as shown in Figure 1.5.

BOLLINGER BANDS

As forex traders, we rely on market volatility as a means to profit. We want to see changes in a currency pair’s price. When the market produces a consistent, repeatable move up or down, we want to earn pips from that change in price level.

Volatility is the relative rate at which the price of a currency pair moves up and down. In other words, it’s the amount of price change over a period of time. If price moves up and down rapidly over short time periods, the market has high volatility. If the price changes very little, the market is exhibiting low volatility.

As you’ve probably noticed, if you’ve stared at your charts long enough, the forex market tends to find itself in one of two basic conditions: range bound or trending. By some estimates, the market is actually range bound about 70 to 80 percent of the time. In this scenario, the bulls and bears are in a battle that neither side is really winning or losing.

FIGURE 1.5 Divergence in a MACD Histogram

Source: DealBook® 360 screen capture printed by permission. c 2008 by Global Forex Trading, Ada MI USA

Price action is back and forth, back and forth—much like a tennis match. While in a range, the market establishes a fairly consistent level of volatility. When price is trapped in this range-bound condition, we’d like to have an idea of where it is likely to reverse from up to down (or vice versa).

Eventually, volatility kicks in and the market deviates from its range-bound state.

Price is deviating from the current norm—trending beyond its recent established range. When such a break occurs, we’d like to have some sort of early-warning indication that the move above or below the recent range is a significant deviation from the norm.

Volatility Indicator

The Bollinger Bands (BB) indicator was first introduced in the 1980s by John Bollinger, a longtime technician of the market. These bands, calculated based on standard statistical theory, estimate the probable high and low price of a currency pair, given the market’s recent level of volatility. The bands are drawn at equal distances above and below a simple moving average.

Think of Bollinger Bands as an envelope indicator, projecting top and bottom lines around price. The bands act like mini support and resistance levels. The longer the time frame you are in, the stronger these bands are.

These bands are self-adjusting. When the market becomes more volatile, the Bollinger Bands expand or open up and move in opposite directions from each other. Whenever price enters a tight trading pattern, the bands respond by contracting or moving closer together. In a range-bound market, the bands are usually parallel to each another.

To better understand the story told by Bollinger Bands, consider a seismometer used to measure the seismic waves generated by movements in plates under the earth’s surface. The seismograph’s pen makes waves on a paper chart. The waves drawn vary in size relative to the size of the earth’s “quake.”

When the earth’s surface is calm, the seismograph draws small waves within a tight range, and the width of this range is relatively small—much like the narrow and parallel Bollinger Bands during a range-bound market.

When an earthquake strikes, the ground shakes, and wide curves of varying size are drawn on the chart reminiscent of the widening Bollinger Bands one sees during a fast-trending market.

How to Use Bollinger Bands

There are three different ways you can set up trades with Bollinger Bands:

1. Range Trading: When these envelope lines, or bands, are parallel to each other, they can be used to predict levels at which to enter or exit a trade. The Bollinger Bands have identified a range within which you can consider trading.

As a general rule, when price reaches the upper band, the market is considered to be overbought. When price touches the lower band it is considered to be oversold. However, a touch of the upper Bollinger Band is not in and of itself a sell signal, and a touch of the lower Bollinger Band is not in and of itself a buy signal. Remember, you’re seeking opportunities to profit not opportunities to trade!

In other words, do not predict a support or resistance level based solely on a Bollinger Band. Instead, wait for price to bounce first, and seek confirmation from other indicators before entering a trade. You may create a reversal trade plan at extreme Bollinger levels, but like any trade plan, you’ll need confirmation before execution of the plan.

After entering a trade following a reversal, your can place your stop on the other side of the Bollinger Band.

2. Breakout Trading: When prices break above or below the upper or lower band, it is an indication that a breakout and trend is about to develop. To filter out false breaks, we recommend seeking confirmation of the move using a momentum indicator, such as a 5 EMA/8 SMA cross or a stochastic cross.

If the move is a break above resistance and to the upside, you’re seeking to enter a long trade while price walks up the upper Bollinger Band. If the move is a break below support and to the downside, you’d like to enter a short trade while price walks down the lower band. In either case (going long or short), your exit would be determined a limit order or a moving average cross.

3. Tunnel Trading: When you see that Bollinger Bands have become tight and narrow, watch for a breakout to occur in the near future. The longer and more narrow the tight Bollinger Bands, the greater the breakout will likely be. It’s predictive, so pay attention. Also, this is only true when the market is moving, such as 5 A.M. to 5 P.M. London time. Tunnels during the odd hours of forex simply show you that no one is trading at all, and a breakout is not likely to happen until they return to their charts.

Some traders refer to this scenario as a “Bollinger Band Squeeze.” When the breakout occurs, a new trend, or deviation, is started and the Bollinger Bands begin to spread further apart. This is an excellent clue to plan a trade around. If the plan is successful, you have a nice Bollinger Band breakout trade, and you’ll be walking the bands into profit.

Bollinger Band Settings

Figure 1.6 shows the settings for the Bollinger Bands we display on the charts displayed during the live coaching sessions at FX Bootcamp.

The default setup on your trading platform for Bollinger Bands is likely 20 periods and 2 standard deviations and one we’ve found to work effectively on forex charts.

Omission of the Middle Bollinger Band

Why do we remove the Middle Bollinger Band from the charts we display during FX Bootcamp sessions?

We like to keep things as simple as possible in Bootcamp, and that goes for the number of lines on our charts as well. Each Currency Coach already uses several other moving averages, so we’ve chosen to omit the middle band. The middle BB is actually the 20 SMA, similar to the 21 EMA already shown on our standard chart template.

FIGURE 1.6 Bollinger Bands

Source: DealBook® 360 screen capture printed by permission. c 2008 by Global Forex Trading, Ada MI USA

Calculating the Bands

This is the simple formula for this volatility indicator:

STANDARD DEVIATION

Standard deviation is a measure of the spread of a set of numbers. More specifically, it measures how widely data values (in the case of forex charts we are measuring recent closing prices) are dispersed from the average of those values.

The larger the difference between the closing price and the average price, the higher the standard deviation and volatility of the currency pair. The closer the closing prices are to the average price, the lower the standard deviation or volatility of the currency pair.

According to statistical theory, when the market is in a range-bound condition, roughly 95 percent of recent closing prices are contained within two standard deviations of the moving average.

Think about this concept in simple real-world terms. Consider a market that is range bound and price pops above the upper Bollinger Band. Price does not belong there; it is out of its element. Under these ranging conditions, price will fall back within the standard deviation 95 percent of the time. Not an ideal time to go long.

SUMMARY

The indicators in this chapter are visual representations of various mathematical studies of price and time. MACD is nothing like stochastics. Bollinger Bands don’t have much in common with EMAs. However, they all have one thing in common: They are all lagging indicators. They study what happened in the past. Therefore, they are slow and do not tell you what is happening right now, and they certainly do not tell you what will happen in the future.