fx101 basics of foreign exchange trading

8/16/2019 FX101 Basics of Foreign Exchange Trading

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FX101: Basics of Foreign Exchange Trading

by Six Capital

1st Edition

Copyright © 2012 by Six Capital Pte Ltd. All rights reserved.

No part of this book may be reproduced, in any form or by any means, without permission

in writing from the author. The author disclaims any liability, loss, or risk resulting directly or

indirectly, from the use or application of any of the contents of this book.

This book is distributed to subscribers of Trade with Chief provided by Six Capital and is not

for resale.


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................................................................................................................................................................ 1

.............................................................................................................................................. 6

....................................................................................................... 8

Definition – What is Foreign Exchange? ............................................................................................. 8

Why Trade FX? .................................................................................................................................... 9

Huge Liquidity ................................................................................................................................. 9

High Volatility ................................................................................................................................ 10

24-Hour Decentralized OTC Market .............................................................................................. 11High Leverage Allowed.................................................................................................................. 12

Short-selling is Allowed ................................................................................................................. 12

Growth of Online Brokers ............................................................................................................. 13

What Affects the FX Markets? .......................................................................................................... 14

Fundamental Factors .................................................................................................................... 14

Technical Factors........................................................................................................................... 16

Market Psychology and Sentiment ............................................................................................... 17

Chapter Review ................................................................................................................................. 18

.......................................................................................................... 20

Trading Sessions ................................................................................................................................ 20

Sydney Opens ................................................................................................................................ 20

Tokyo Comes In ............................................................................................................................. 21

Frankfurt and London Comes In.................................................................................................... 21

New York Comes In ....................................................................................................................... 21

London Closes ............................................................................................................................... 22

Bank Holidays ................................................................................................................................ 22

Currency Quotes ............................................................................................................................... 23

Buying and Selling Simultaneously ............................................................................................... 23

Currency Pairs ............................................................................................................................... 23

Base and Counter Currencies ........................................................................................................ 25

Direct and Indirect Quotes ............................................................................................................ 26

Long, Short or Square ................................................................................................................... 27


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Keeping Track of Profit and Loss (P&L) ............................................................................................. 27

Position Size (Lot Size) ................................................................................................................... 28

Leverage ........................................................................................................................................ 28

Pips ................................................................................................................................................ 30

Bid-Ask Spread .................................................................................................................................. 31

Common Trade Orders ..................................................................................................................... 32

Entry Orders .................................................................................................................................. 32

Take-Profit Orders (TP) ................................................................................................................. 32

Stop-Loss Orders (SL) .................................................................................................................... 33

Market Orders ............................................................................................................................... 33

Conditional Orders ........................................................................................................................ 34

Other Common Orders ................................................................................................................. 36

Suggested Orders to Use ............................................................................................................... 37

Chapter Review ................................................................................................................................. 38

...................................................................................................................... 40

What is Technical Analysis? .............................................................................................................. 40

Key Assumptions ............................................................................................................................... 40

Price is Determined by Supply and Demand ................................................................................. 40

The Market Discounts Everything ................................................................................................. 40

Price Moves in Trends ................................................................................................................... 40

History Tends to Repeat Itself ....................................................................................................... 41

Patterns are Fractal in Nature ....................................................................................................... 41

Price Action ....................................................................................................................................... 42

Line Charts .................................................................................................................................... 42

Bar Charts ...................................................................................................................................... 43

Candlestick Charts ......................................................................................................................... 44Price Spikes ................................................................................................................................... 47

Price Gaps ..................................................................................................................................... 48

Support and Resistance ................................................................................................................ 49

Trends ........................................................................................................................................... 51

Consolidations, Breakouts and False Breaks ................................................................................. 58

Elliot Wave Theory ........................................................................................................................ 59

Fibonacci Retracements ................................................................................................................ 60

Fractal Nature of Price Action ....................................................................................................... 62


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Six Basic Chart Patterns..................................................................................................................... 63

1. Continuation Patterns: Triangles .......................................................................................... 63

2. Continuation Patterns: Flags ................................................................................................. 66

3. Key Reversal Patterns: Double Tops and Double Bottoms ................................................... 67

4. Key Reversal Patterns: Head & Shoulders and Inverted Head & Shoulders ......................... 69

5. Consolidation Patterns: Triangles ......................................................................................... 73

6. Consolidation Patterns: Rectangles ...................................................................................... 74

Chapter Review ................................................................................................................................. 75


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In this book, we aim to provide you with a basic but comprehensive overview of what

constitutes foreign exchange. Also, we will go through all the common concepts and

terminologies that you will encounter, as well as introduce to you various methods oftrading foreign exchange. If you have some prior trading experience, it is possible that you

might already know everything that we are going to discuss. Still, we urge you to continue

reading on, as you might be able to pick up something that you did not know before, or

perhaps gain a little extra insight on the stuff you already knew.

Do take note that this book is not intended to provide an in-depth discussion of how to

trade foreign exchange. It will, however, provide you with a very strong foundation for

subsequent learning.


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Definition – What is Foreign Exchange?

Before we can learn more about foreign exchangetrading, we need to ask ourselves the most basic

question: What exactly is foreign exchange?

Simply put, foreign exchange is the simultaneous

buying of one currency and selling of another

currency. Two currencies are always involved, thus

the use of the term ‘exchange’. Foreign exchange is

also commonly abbreviated as ‘Forex’ or ‘FX’, and the

international network of buyers and sellers of

currencies is known as the ‘Foreign Exchange Market’.

As we can thus see, FX trading is basically currency trading. FX traders take views on

whether currency exchange rates (or in other words, currency prices) will go up or go down,

and they profit if their analysis and views are correct.

Like all other forms of trading or investment, FX trading is a serious activity requiring

dedication and commitment. An aspiring FX trader first needs to be willing to put in

significant resources, to build up a strong foundation in both his basic knowledge and skill

set, as well as to train his mind and emotions to be both stable and disciplined. Just as adoctor or lawyer would need to be trained for years before they can develop mastery of

their skills, there is simply no shortcut to mastering FX trading.

We feel the need to emphasize this right from the beginning, because having the right

learning attitude is of extreme importance. Some people learn FX trading hoping that it can

be a get-rich-quick scheme. Some hope to make immense profits, without having to put in

any hard work. Some just want to focus on the profits, and do not want to first think about

how to manage any potential losses. These people are all likely to fail, because their attitude

is wrong in the first place. But for those who are willing to put in their time, effort andresources into learning FX trading properly, it can be very rewarding. FX trading has risen

EMOTIONS MIND

Figure 1.1: Foreign Exchange

Figure 1.2: FX training is the training of the mind and emotions


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Every day, USD$5 trillion worth of currencies change hands in the FX market. This

is 200 times bigger than the US$20 billion daily trading volume of the New York

Stock Exchange (NYSE) and makes the FX market by far the most liquid financial

market in the world.

When we talk about liquidity, we are referring to the amount of ready buyers

and sellers in an asset. The keyword here is “ready”, which means the buyers and

sellers must be able and willing to buy or sell the asset, at or near the current

market price. A liquid asset is one which can be bought or sold easily, without its

price being negatively affected. In contrast, an illiquid asset is one where it may

require a significant time or cost to find a buyer or seller. Because of the lack of

buyers and sellers, you would need to buy at a significant premium or sell at a

significant discount if you wish to transact your full desired amount immediately.

For example, real estate is generally considered as an illiquid asset . It’s not

easy to quickly find a buyer if you are trying to sell a house. If you wish to sell the

house quickly, you probably can, but you would need to sell it at a significant

discount in order to attract buyers quickly. In contrast, there are usually a high

number of ready buyers and sellers in the FX market, and we say the FX market

has good depth. We thus face less of these liquidity issues when buying or selling

currencies. Millions of dollars can change hands instantly with hardly a blip in the

market prices.

The tremendous amount of liquidity in FX relative to other markets thusmakes it ideal for trading, as we are able to easily execute even very large orders,

and prices are not easily distorted simply because we wish to buy or sell a huge

amount.

High Volatility

Volatility refers to the degree of variability and uncertainty in an asset’s price.

Traders embrace volatility, as the very essence of trading is based on profiting

from changes in prices.

As the world becomes more connected and globalized, we find a growing

fluctuation of currency prices. This is especially so as countries compete to

devalue their currencies to gain a competitive edge for their exports. It is not

unusual to see currencies fluctuating by 10% to 30% every 3 to 6 months.


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At the same time, with the weak growth of global stock markets and

historically low interest rates, people are increasingly looking for new sources of

investment return, and the volatility of the FX market provides lots of potential

for profit making.

24-Hour Decentralized OTC Market

The FX market is unique in that it is a market without the presence of a physical

location or a centralized exchange. When we trade stocks, there is usually a

centralized location where the trading takes place, e.g. the New York Stock

Exchange or the Singapore Exchange. If we trade options or futures, we may do so

on the Chicago Board of Trade (CBOT), using a set of highly standardized trading

contracts.

In comparison, the FX market has no such exchange. Instead, the FX market is

what is called an over-the-counter (OTC) market, where a network of buyers and

sellers trade directly with each other. Contracts are non-standardized, and are

tailored and customized according to the needs of the two parties. Traditionally,

the two parties involved are usually banks, thus the FX market is also known as an

interbank market.

Because trading occurs over a decentralized OTC network, there is no daily

open or close of any centralized exchange, and thus trading can happen over 24

hours. A trading week starts on Monday morning with the open of the New

Zealand and Australian markets, and only ends with the closing of the New York

markets on Friday.

Figure 1.4: Fluctuations of the EUR/USD over the past 3 years


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party, with a promise to return it after a certain period. If now let’s say that the

price of the asset goes down to $47, the trader can then buy the asset from the

open market at this lower price, and use it to return what he had previously

borrowed, thus pocketing the difference of $3. This process is also known as

“short-selling”.

Because FX trading always involves the exchange of one currency for another

currency, we will see that on average, currency exchange rates go down as often

as they go up. As shorting is allowed with no restrictions in the FX market, a FX

trader will have many trading opportunities, regardless whether the market

moves up or down.

Growth of Online BrokersAlthough FX trading used to be confined to the realms of banks, institutional

funds or wealthy investors, the rise of online brokers has provided retail traders

with convenient access to FX trading. Besides trading platforms, they also provide

access to real-time prices and a variety of tools such as charts and indicators.

With their cheaper costs of operations, and the intense competition between the

brokers, trading costs have also been lowered dramatically, making FX trading

possible even for retail traders with small trading accounts.

As the industry blossoms, we can probably expect trading costs to be lowered

even further, and a greater variety of tools and platforms to allow us to trade with

more information and confidence.

Figure 1.6: Example of an online trading platform


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What Affects the FX Markets?

One of the most basic economic theories is that the price of any good is the result of the

interaction between supply and demand.

If the demand for the good is higher than the supply at that time, then prices will have

to go up. As prices go up, more people will sell their good as it now fetches a better price,

thus increasing the supply to match the higher demand. Conversely, if the supply of the

good increases while the demand drops, then prices will have to fall. At the lower price, less

people will be willing to supply the good, while more people would be willing to purchase it.

This allows supply and demand to reach a new balance.

Price is thus the mechanism to balance supply and demand, and price movements are a

reflection of the underlying supply and demand. It is useful to see the FX market as a

battlefield between the bulls and the bears, with prices the outcome of their fight. The bulls

would like to see prices go up, whereas the bears would try to make prices go down.

At any one time, the relative balance of bulls versus bears directly influences the supply

and demand for the currencies. The relative balance of bulls and bears is determined by

their expectations of where prices may move, which is derived from their analysis of the

stream of information that they receive. This information can be categorized into

fundamental factors or technical factors.

Fundamental Factors

Fundamental factors refer to the broad category of economic and politicalinformation that can affect the economy of a country as well as the demand for

Figure 1.13: Supply and Demand Curve


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Technical Indicators. Another category of technical information is

information that is indirectly derived from prices, or from other factors like

momentum or trading volume. They are also commonly known as

technical indicators. Examples of indicators include moving averages,

momentum indicators such as Relative Strength Index (RSI) and volatilityindicators like Bollinger Bands. They are basically quantitative analysis of

simple data into more complex summaries, and they are appealing to

many traders as they allow the traders to apply objective trading rules and

strategies.

While we now know that prices in the FX market are influenced by information that are

fundamental or technical in nature, information flow alone do not fully explain how and why

currency prices move.

Market Psychology and Sentiment

The third and final determinant of currency prices is the market psychology and

sentiment of market participants. Whereas fundamental and technical factors

focus on events, data, numbers and price movements, market psychology and

sentiment focuses on the market participants themselves, and how they interpret

the constant flow of information they receive.

Psychology research has shown that market participants are not as rational

as initially thought, and are often affected by biases. Different people will react tothe same information differently, and the same people facing the same

information can also react differently at different times.

For example, in a bullish environment where most people are bullish, market

participants tend to get sucked into groupthink and herd behavior. They will

continue buying because the consensus of opinion is that prices will keep going up,

and there is a strong unconscious pressure to conform to the norm. However, we

all know that prices cannot keep going up forever. In fact, by the time that

everyone gets on the train and the entire market sentiment is bullish, prices areusually already near the top and primed for a reversal.

Thus in analyzing the FX market and predicting currency prices, we must

consider not just the fundamental and technical factors, but also account for the

effects of market psychology and sentiment. You can be spot on about the

underlying fundamentals and technicals, but if everyone disagrees with you, you

will end up losing a lot of money before you are eventually proven correct.


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London Closes

As London closes at 11.30pm SGT (3.30pm GMT or 10.30am EST), we start

to experience a drop off in liquidity. There may sometimes be some final

flurry of activity, as London traders unwind or close down their positions

for the day.

New York afternoon will usually see reduced liquidity, unless there are

major news and announcements scheduled. The reduced liquidity will

usually lead to slow and sluggish price movements, though at times it can

also allow huge and fast movements due to the relative lack of market

participants. By late New York afternoon, Wellington and Sydney would be

opening, signifying the start of a new trading day, where the cycle repeats

itself.

Here is a table of the trading sessions in terms of Singapore timing. Again be

reminded that the timings can vary by 1 hour due to changes from Daylight Savings

Time throughout the year.

Bank Holidays

Besides being familiar with the timings of the various trading sessions, FX

traders should also keep track of the public holidays, also known as bank

holidays, of the major financial centers of Tokyo, London and New York.

For example, if New York is having a bank holiday and all the New

York traders are not working, liquidity will tend to be significantly lesser

during the New York trading session. In fact, London traders trading theLondon session will be aware of the fact, and may trade less too for fear of

a thin and illiquid market. As retail FX traders, we also need to be aware of

these situations and adjust our trading accordingly.

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 22 24

New York

Sydney

23

Tokyo

London

21

New York

Figure 2.1: Trading sessions in terms of Singapore time (24-hour clock)


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Currency Quotes

Buying and Selling Simultaneously

Many people with trading experience are used to the concept of the

buying or selling of an asset. If you bought the asset and the asset price is

rising, you profit. But in the FX market, currencies do not move in isolation

and are always associated in pairs. If someone says that the U.S. Dollar is

rising, then the next question will always be, rising against what? Currency

movements must always be related in pairs.

Once we think more about it though, it is actually not so different

from the other asset classes that we are used to. For example, if you buy

100 shares of ABC Company, you are basically selling U.S. Dollars to

purchase the shares. If the share price goes up, it is basically going up

against the U.S. Dollar, so you can sell the shares at a profit to buy back

U.S. Dollars.

The same scenario applies when we are buying and selling currencies,

just that it seems slightly more confusing as now two currencies are

involved simultaneously. For example, you could be buying U.S. Dollars

against the Euro, or you could also be buying U.S. Dollars against the Yen.

Currency Pairs

When quoting currency pairs, there is a fixed set of international

conventions. Below is a table of the 3-letter abbreviation of some common

currencies. Generally, the first 2 letters stand for the country’s name (e.g.

U.S.), while the 3rd

letter is derived from the currency name (e.g. dollar).

List of Abbreviations of Common Currencies

Abbreviation CountryCurrency

Name

USD U.S. Dollar

EUR Eurozone Euro

JPY Japan Yen

GBP Great Britain Pound

CHF Switzerland (Confoederatio Helvetica) Franc

CAD Canada Dollar

AUD Australia Dollar

NZD New Zealand Dollar


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Cross Pairs. Cross pairs refer to currency pairs where neither

currency is the US Dollar. The exchange rate of cross pairs can be

calculated if we know the exchange rates of the two currencies

against another common currency. For example, if we know the

exchange rate of the EUR/USD and the USD/CHF, it is possible to

derive the exchange rate of the cross pair of the EUR/CHF.

Among the most important of the cross pairs is the EUR/JPY,

as the eurozone and Japan are two of the world’s biggest

economies. Below is a table of some other common cross pairs.

List of Some Commonly Traded Cross Pairs

Currency Pair Name

EUR/JPY Euro-yen

EUR/CHF Euro-swiss

EUR/GBP Euro-sterling

GBP/JPY Sterling-yen

CHF/JPY Swiss-yen

AUD/JPY Aussie-yen

Exotic Pairs. Exotic currency pairs refer to currency pairs of smaller,

less-developed emerging market economies such as the Turkish lira

(TRY) or the Mexican peso (MXN). Exotics tend to be much more

illiquid when compared to the major pairs or the common cross

pairs, so FX traders should stay away from them.

Base and Counter Currencies

When we quote a currency pair, for example the EUR/USD, the firstcurrency (in this case EUR) is known as the base currency, while the

second currency (in this case USD) is known as the counter currency or

quote currency.

Figure 2.2: The first currency is the base currency while the second currency is the counter currency


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If we say that the EUR/USD rate is 1.30, it means that each Euro is

worth US$1.30, and can be converted to USD at that rate. If the EUR/USD

rate goes up to 1.35, it means that the value of the Euro has appreciated or

gone up relative to the USD. Specifically, the value of each Euro has gone

up by US$0.05. Alternatively if the Euro weakens or depreciates, we will see

the EUR/USD rate drop.

In other words, the base currency is always the currency of interest in

a currency pair. When you are buying EUR/USD, you are basically buying

Euros, which is the base currency. If the currency exchange rate goes up, it

means that the value of the Euro has gone up. In contrast, the counter

currency is the currency in which your profits or losses will be

denominated in. If you are trading EUR/USD, your profits or losses will be

in terms of USD.

It is important to understand this concept so let’s look at another

example. Let’s say the current USD/JPY rate is 78. In this case, USD is the

base currency and rate of 78 means that one USD is equivalent to 78 JPY. If

the USD/JPY rate goes up, it means that the value of the USD has gone up

relative to the JPY, and vice versa if the price goes down. Any profits or

losses we make will be denominated in JPY, which can then be converted

back into USD at the prevailing exchange rates.

Direct and Indirect Quotes

You may sometimes encounter the terms “direct quotes” or “indirect

quotes”. Taken from the U.S. perspective, a direct quote is any currency

quote where the USD is the counter currency. In contrast, any currency

quote where the USD is the base currency is known as an indirect quote. Is

this confusing to remember? The logic is actually very simple.

Let’s imagine you are living in the U.S. Most goods or services that you

encounter will be priced in terms of USD. For example, the price of one

cup of coffee may be US$3, while the price of one haircut may be US$10.

Currency quotes with the USD as the counter currency are similar in that

they are also priced in terms of USD. For example, if the EUR/USD rate is

1.30, it means that the price of one Euro is US$1.30. Thus such a currency

quote is known as a direct quote, as it is consistent with the way how most

other goods and services are priced in the U.S.


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Mark-to-Market Values. The equity also accounts for any potential

profits or losses from open positions. For example, an open

position may be currently profitable and would net US$10,000 of

profits if closed immediately at the market price. These are known

as unrealized profits, as they have not been locked in, and are onlypaper gains. The paper values based on the current market values

are known as mark-to-market values. The equity you possess takes

into account these unrealized profits or losses based on mark-to-

market values, and is updated in real-time as the values of your

open positions change.

Margin Calls and Margin Cuts. If the amount of leverage employed

is too high, any losses will eat into the equity very significantly andrapidly. When the equity drops to a level that is insufficient to

support potential losses in the open positions, the broker will need

to manage its risk by contacting the client to top-up the margin

immediately. This is known as a margin call.

FX brokers usually do not issue margin calls if the margin is

insufficient. They may instead perform a margin cut, closing the

losing open positions immediately at their market values to

prevent potentially higher losses. Do not ever trade at such high

leverages to allow such a thing to happen to you.

As we can see, leverage is clearly a double-edged sword. It

allows you to multiply your profits by 100 times, though it can just

as easily multiply your losses by 100 times, too. When leverage is

employed by reckless traders who ignore basic trading foundations

and discipline, it can quickly lead them to over-extend, and their

entire capital can be eaten up within a short period of time. In fact

with leverage employed, it is possible to lose more than the capital

that you have put up, at which point the broker may pursue legal

measures to reclaim the losses incurred. However, when leverage

is used correctly and prudently, it can be a powerful tool. It allows

the trader to pursue higher gains without requiring or locking up a

substantial amount of their capital.

As a FX trader, remember that just because a broker offers us

100:1 leverage, does not mean that we should use 100:1 leverage.

Employing a lower leverage would allow us to withstand volatile

market movements and sustain losses better, and is often thesmarter choice.


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scenario, if market participants know there is a major news announcement coming

up immediately, they may choose to stay out of the market to digest the news first.

In such cases, the spreads will also be momentarily higher.

The spread can be seen as a form of trading cost, and many brokers earn the

difference between the Bid and the Ask. But the spread’s purpose is not just to cover

the cost of operations of the broker and to allow it to earn a small profit. The spread

is absolutely essential, as it compensates the broker for the risk it takes on in

providing the liquidity. Take the case of the money changer. Let’s say he bought

€100,000 from customers at the Bid price of US$1.3000. If in that very afternoon, a

major earthquake happens in Europe that makes the EUR/USD drop by 200 pips,

then the money changer would be stuck with €100,000 that it now has to sell at a

loss. Thus we can see how the spread is necessary to compensate the broker for the

risk it has to take on. The greater the potential risk exposure, the bigger the spreadrequired.

With increasing competition among the various online brokerages, spreads can

be quite tight, and they tend to move in intervals of 0.1 pips (also known as a

pipette). This has greatly reduced the costs of trading for retails FX traders.

Common Trade Orders

Now that we have understood currency prices in the form of the Bid, Ask and thespread, let’s take a look at how we can execute trades to buy or sell these currencies.

We execute trades by submitting trade orders to our brokers, and there are different

ways of classifying and categorizing orders.

Entry Orders

The first kind of order that we should familiarize ourselves with is the

entry order. As the name suggest, an entry order allows us to enter an

open position. An entry order can be a buy order to go long or a sell orderto go short.

Take-Profit Orders (TP)

Once we have an open position however, we need to think of a way to exit

and close the position. A Take-Profit (TP) order is an order that is tagged to

our Entry order. It will be executed to reverse the Entry order and close

the open position, once certain preset profit conditions are met. This locks

in and realizes the profits.


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we originally desired, and this difference between the expected

price of a trade and the actual filled price is known as the slippage.

Slippage tends to be higher during periods of higher volatility.

Higher slippage during entry would eat into your profits, and can

thus be an issue. Some broker platforms allow you to set the

maximum slippage that you will allow for each trade. If the slippage

is more than the preset maximum, then the trade will not go

through.

Conditional Orders

Instead of using market orders, another way to execute trades is to submit

conditional orders beforehand. Unlike market orders, conditional ordersare already residing in the broker’s servers pending execution once the

preset conditions are met. As the delay is greatly minimized, conditional

orders suffer less from the issue of slippage. Entry, Take-Profit, and Stop-

Loss orders can all be executed using conditional orders.

Stop Orders. The first kind of conditional order is known as the

stop order. A stop order is an order to buy or sell once prices

surpass a preset point. Once the condition is met, a stop order is

converted into a market order for immediate execution.

Stop orders to buy have to be placed above the current

market price, so that we would only buy once prices go up to our

preset level. Similarly, stop orders to sell have to be placed below

the current market price, so that we sell when prices drop to the

level we have set beforehand. For example, if the current market

price of EUR/USD is 1.3050, then I can only place a stop order to

buy EUR/USD above 1.3050. Say if I place a stop order to buy at1.3060, then the stop order will be executed once prices advance

and rise to 1.3060.

Note that the executed price of the stop order need not be

exactly 1.3060. There will usually be some slippage, with the

position being entered slightly above 1.3060. In very rare cases,

there can also be negative slippage, with the position being

entered slightly below 1.3060.


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Also, limit orders provides greater price certainty in that they

can only be executed at the preset prices or better. In contrast,

stop orders will be executed once the preset conditions are met.

The actual executed price may end up higher or lower than the

preset level. Limit orders are thus useful for entering Take-Profitorders, as unlike Stop orders, they ensure the price of execution

and thus the minimum profits that we will receive.

Other Common Orders

Other common order terminologies you may encounter are OCO orders,

OTO orders, GTC orders and trailing stops.

OCO Orders. OCO orders stand for “one-cancels-the-other” orders.

For example, Take-Profit and Stop-Loss orders are often OCO

orders, as only one of them needs to be executed. For example if

the Take-Profit has been executed, then the Stop-Loss order is no

longer meaningful or necessary, and would be cancelled

automatically.

OTO Orders. OTO orders stand for “one-triggers-the-other” orders,

also known as contingent orders. For example, Take-Profit and

Stop-Loss orders are often tagged to the corresponding Entry order.

Once the Entry order is triggered, they will also be entered into the

system pending execution. If the Entry order is not triggered, the

two orders will not be entered into the system.

GTC Orders. GTC orders stand for “good-till-cancelled” orders. They

will remain active until you decide to cancel them. This is incontrast to time-based orders, which are valid only for a preset

amount of time, after which they will be automatically cancelled.


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Chapter Review

Let us recap what we have learnt in this chapter. We have learnt to:

1. Describe the characteristics of the various trading sessions.

2. Differentiate between major pairs, cross pairs and exotic pairs.

3. Differentiate between a base currency and a counter currency.

4. Differentiate between a direct quote and an indirect quote.

5. Understand the meaning of going long, going short and being square.

6. Understand the meaning of position size, leverage, margin, mark-to-

market, and pips.

7. Interpret a Bid-Ask spread.

8. Understand how to use various common orders (entry, take profit, stop

loss, market orders, conditional orders, stop orders, limit orders, etc.).


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What is Technical Analysis?

As mentioned earlier, technical analysis is the study of prices as well as otherstatistics generated by market activity, for the purpose of making profitable trading

or investment decisions. Before going further into this study, let’s first look at some

of the basic key assumptions of technical analysis.

Key Assumptions

Price is Determined by Supply and Demand

Similar to fundamental analysis, technical analysis believes in theeconomic theories of supply and demand. Supply and demand is

significantly influenced by buyer and seller expectations, thus market

psychology and sentiment plays a key role.

As we have learnt earlier, expectations can be different between

different parties, because they receive new information at different

speeds, or perceive the same information differently. Expectations can

also be shaped by human emotions like greed and fear, as well as be

affected by cognitive limitations like behavioural biases and faulty thinking.

All these will influence the supply and demand, and thus, prices.

The Market Discounts Everything

Technical analysts believe that the market is always correct. Instead of

trying to consider all the fundamental factors that may influence the

supply and demand of currencies, they believe that all the dynamics are

already factored into the currency prices themselves. Thus the focus and

emphasis is on what happens within the markets, instead of what happensoutside.

Price Moves in Trends

A trend is a directional movement of prices that remain in effect long

enough for it to be identified, and profited from. Trends result from supply

and demand. For example, if a bullish piece of news emerges, it will filter

to the market participants at different speeds. As more and more people


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from each jagged edge. Go progressively

deeper and the complexity of the jags shows

itself more.

Similarly, market prices follow a fractal

nature. For example, if you look at a long-

term price chart over 10 years, and compare

it to a short-term price chart over 10 weeks,

you will not be able to differentiate them. In

fact, you can zoom in further to shorter and

shorter time frames, and the patterns will all

look similar. Thus when analysing trends, the

length of the trend is irrelevant. The basic

technical principles can be applied to all timeframes.

Price Action

After understanding the key assumptions of technical analysis, let us now cover one

of the most important topics in technical analysis: price action. Price action is

basically how prices move, and price action analysis works best in markets where

liquidity and volatility are highest, like the FX market. At Six Capital, price action

trading is the method that we focus on, so it is important that you understand thistopic well. We shall begin our discussion on price action with an introduction to price

charts.

Price charts are graphical displays of the underlying reality of actual price

movements. Price charts are very useful, because they aid us in recognizing patterns

and trends. Of course, the recognition can be quite subjective at times, so it is

important for the trader to accumulate experience and hone up his skills.

Line Charts

The most basic form of price chart is the line chart. The simply chart

provides information about two variables, price and time, with price

usually referring to the closing price of each period. In a daily chart for

instance, the price points will be plotted based on the daily closing price.

The closing price is preferred by some traders, as they do not care

about the price fluctuation during a time frame and only the closing price

is important for them. This is especially so for higher timeframes of at leasta day, on markets which do physically open and close (e.g. the stock

Figure 3.2: Both coastlines

and price movements

display a fractal nature


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A ranging market describes a market with no clear direction.

There is no indication of an uptrend or downtrend. It is

characterized by the lack of any significant highs or lows. In this

example, we can see that there are no significant highs and lows.

This forms a market where there is no clear direction of price

upwards or downwards. This is called a ranging market.

Trendlines. When describing trends, it is possible to draw

trendlines to box in the price action. Trendlines are like support

and resistance levels, just that they are sloping instead of

horizontal lines.

Now let’s learn what constitutes a trendline. In our trading

methodology, we always adopt a three point trendline. The

trendline must constitute the incident, coincident and trend in

order to confirm a trendline.

The incident of a trendline is the first occurrence point formed

at the bottom of a potential up channel, or the top of a down

channel. It is simply a price level where a new trend starts to form.

The coincident of a trendline is the first higher low in an

uptrend, or the first lower high in a downtrend. The incident and

coincident forms a tentative trendline, and they are connected

using a dotted line. We use a blue dotted line for a tentative

uptrend, and a red dotted line for a tentative downtrend.

The trend is formed as the next higher low in an uptrend, or

the next lower high in a downtrend. When the trend is confirmed,

all 3 points are connected using a solid line.

Figure 3.17: A range-bound market has no significant highs and lows


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and even in our fingers when curled. Fibonacci ratios are also frequently

used in architecture, and have been used since ancient times in the

building of the pyramids.

Traders believe that the market also tends to follow the Fibonacci

numbers. Recall from the Elliot Wave Theory that prices move in waves,

and every trend will usually contain retracements. It is believed that when

the market retraces, the retracements will usually hold at the key

Fibonacci levels of 0.382, 0.500 or 0.618, before resuming the main trend.

Let’s elaborate using the example of an uptrend. To obtain the

Fibonacci levels, we need to identify the start of the uptrend, as well as

the highest point reached in the trend. To identify the start of the trend,we choose the lowest candlestick at the start of the trend of interest. This

is known as the swing low. To identify the highest point, we will need to

wait for the market to be obviously retracing from a highest point, and

then we take the highest candlestick. That is known as the swing high.

Most charting tools on trading platform will then automatically plot out

the Fibonacci levels for you. If prices retrace to the 0.382 level, it means

the market has retraced 38.2%. While if prices retrace to the 0.500 level, it

means prices have retraced 50% since the beginning of the uptrend.

As market participants anticipate the Fibonacci levels, the levels will

tend to act as support or resistance levels. We can thus get a clue to the

strength of the bullish sentiment of the main uptrend, by seeing where the

retracements hold. For example, if prices retrace to 38.2% and then

resume the main uptrend, then the market has to be quite bullish. Even if

prices retrace to 50% or 61.8%, they are still bullish indicators, as they are

within the normal range of retracement.

Figure 3.25: Fibonacci patterns are found commonly in nature, for example in this flower above


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However, if prices fail to hold at 61.8% and go down further, this may

signal two possibilities:

a) Firstly, it may mean that the market is no longer bullish. We may

see a 100% retracement of the main uptrend.

b) Secondly, we may be seeing a trend reversal. If price retraces more

than 61.8% in the main uptrend, many buyers may turn into sellers,

and turn the main trend from an uptrend into a downtrend.

One key thing to remember though is that Fibonacci levels do not

always hold true. They are a useful tool for the trader, but they must serve

as only one out of the many tools that the trader uses.

Fractal Nature of Price Action

Due to the fractal nature of trends, all the lessons that we have learnt so

far can be applied to any time frame. Depending on the timeframe we are

looking at, we will see different things. For example, on the 1-minute chart,

it may be an uptrend for the past three hours; while on the 10-minute

chart, we may be stuck in a ranging market for the past day. If we zoom

out further to the hourly chart, we may actually be on a downtrend for the

past week.

Which timeframes of the market we look at is determined by the

kinds of trades that we are intending to do. For example, if we are

intending to enter and exit our trades within minutes, then it may not

make sense to focus on the hourly chart, where trends can take days to

materialize.

Figure 3.26: Prices retrace to the 38.2% Fibonacci level before resuming the upward trend


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The preceding trend is bullish, as higher highs and higher lows are

formed until here, where the high reaches almost the same level as the

previous high.

Neckline. At this point, the low formed by the pullback is a

significant support level, as any significant break below that level

will breach the trend and result in the formation of a lower low.

This significant support level is commonly known as the neckline,

and the double top is materialized once this support is broken

convincingly.

The neckline is also used to determine the minimum objective

of the move, which is measured from the tops to the neckline and

then projected down from the neckline. Usually, after a break, the

market will pull back and find resistance at the neckline, before it

continues its move down to the objective.

Double BottomsDouble bottoms are exactly like double tops, except that they form at the

end of a downtrend, after an extensive decline. The breakout happens in

the direction of an uptrend. A double bottom is formed when price first

forms a low, pulls back from it and retests the low. The high formed by the

pullback marks the neckline of the double bottom.

For the double bottom, the measuring objective is measured from the

bottom to the neckline. The minimum objective is found by projecting the

measuring objective up from the neckline. The double bottom is said to

Figure 3.33: Double Top


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The preceding trend is bearish, as lower lows and lower highs are

formed. At the support level, there is significant buying interest that

pushes price up to the resistance level at the previous high. Now, we can

see the left shoulder and inverted head forming. At the resistance level,

there is some selling interest. However, the buyers cannot wait to buy,hence a higher low is formed.

Neckline. At this point, the highs formed by the pullbacks rests on a

significant resistance level, as any significant break above that level

will breach the trend and result in the formation of a higher high.

This resistance level is known as the neckline, and the inverted

head and shoulders is materialised once this resistance level is

broken convincingly.

The neckline is also used to determine the minimum objective

of the move, which is measured from the Head to the neckline.

Usually, after a break, the market will pull back and find support at

the neckline, before it continues its move to the objective.

Key Reversal Variant: Triple Tops and Triple Bottoms

Triple tops are reversal patterns that form at the end of an uptrend. Price

tests a resistance level 3 times, before going into an extended decline.

Triple bottoms are simply the opposite. When compared to a double top

formation, a triple top is formed when the highs are tested thrice instead

of twice. When compared to a head and shoulders formation, the 3 tops

are at equal levels instead of the head being the extreme. The minimum

objective and breakout is similar to a double top formation. Let’s look at

an example.

Figure 3.37: Triple top


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