The MACD indicator was developed in the 1970s by Gerald Appel. It’s been an extremely popular momentum indicator for many traders and is still used today. In this article, I look at what the MACD indicator does and how effective it is on stocks. Read more »
In this article I look at some moving average crossover strategies and I investigate which moving average crossover lengths are the most effective. Read more »
In this article I explain the RSI technical analysis indicator. I then test the indicator on historical stock market data in order to analyse its effectiveness.
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Trading systems fail all the time
I’d spent hours, days, weeks, months.
Testing, optimising, fine-tuning.
I’d read books, journals, blogs, studied the market, stared at quote screens and charts till my eyes were red and I could see them repeating in my sleep.
I ate, slept and breathed the markets.
I hated the weekends. Whenever Saturday came all I wanted was for Monday to come round again so that the markets would open.
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On the whole, it’s better to avoid trying to pick market tops and bottoms. If you try and pick the tops and bottoms every single day you’re going to get frustrated very quickly and wind up losing a lot of money.
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As I mentioned in a previous post, I do not classify day trading as an easy route to riches. However, if you were to ask me what my favourite approach would be, I would say pivot points. In this post I will illustrate how to use pivot points in trading stocks and forex.
How to use pivot points in trading
Pivot points can be calculated on most charting packages now but it’s still handy to know the exact formula so you can calculate them yourself, so here it is:
Pivot (P) = (High + Low + Close) / 3
R1 = P + (P − Low)
S1 = P − (High − P)
R2 = P + (High − Low)
S2 = P − (High − Low)
R3 = High + 2 × (P − Low)
S3 = Low − 2 × (High − P)
In essence, I think pivot points work quite well because they are always adapting to recent price action. They are also watched by lots of professional traders and because of that I think it gives them more significance.
Traders can use pivot points in different ways. Personally, I find them most useful as profit targets because when a market hits a pivot level it nearly always holds up there for at least a short period of time.
I tend to be bearish on a market so long as the price is below the pivot and bullish so long as the price is above the pivot. I also like to combine pivots with other indicators and to watch the news.
For example, if the market drops through the pivot on some significant piece of news I will often short the market and look to buy it back on one of the support levels. Depending on the momentum of the market, I might take all the position off at the second resistance/support or I might take half the position off. Indeed, I might hold out for the third level if price action is really moving.
Rarely, if volatility is dead, I will take a position off at S1 or R1.
Watching momentum is therefore very important when using pivot points and it’s also a good idea to watch the ATR. That way you can see what is happening to volatility. If volatility and momentum are tapering off it’s a sign to exit your trade more quickly.
In order to illustrate how to use pivot points in trading I thought it would be a good idea to show some examples from last week. These charts are all taken from the same period. You’ll notice from these charts that pivot points do get hit a lot of the time.
As can be seen in the next chart, pivot points often produce uncanny levels in which to enter or exit a market.
On the 29th July, the pivot, or just below it, would have been an excellent place to sell and the third support (S3) would have been a great place to close the trade, making around 30 pips.
On the 30th, the market declined and bounced off the second support and on the 31st the market stayed around the pivot for most of the day.
On the 1st August, the currency pair pushed through the pivot in the morning and moved right up to the third resistance, giving a trader 40-50 pips if long.
During the same period, the pivot also acted as a strong level for GBP USD.
On July 29th, the market dropped 60 pips from the pivot to the third support and on the 30th the currency moved up to the pivot before falling back to the second support.
On the 31st, GBP USD hit the pivot in the morning then moved down to the first support where it consolidated.
And on the 1st August, the currency touched the pivot in the morning then moved lower throughout the session, closing right on the second support. The second support (S2) was a great place to take profits.
As you can see from the next chart, a similar story unfolded for the Kiwi US dollar pair.
On most days, the key pivot levels provided great places to enter buy and sell orders and take profits.
On the 29th, the currency fell through the pivot all the way to the second then third support.
On the 31st, the currency turned back off the first resistance to the pivot and on the 1st August the currency moved between the first support and first resistance.
As can be seen, pivot points can work in volatile as well as trending conditions.
Technical traders have hundreds of different indicators and setups at their disposal. Triangle patterns are just one form of technical analysis that traders rely on but they are probably more accurate than most other indicators.
On the whole, there is much debate around technical analysis. There are many in the academic world who claim technical analysis to be nonsense and trading on the basis of MACDs and resistance lines is a road to nowhere.
On the other hand, there are many profitable traders who swear by technical analysis and there are also many trading systems that are completely technical based. I have also read a number of academic papers that suggest technical analysis does work, particularly in the forex market.
My own opinion is that technical analysis is a tool to be used in conjunction with fundamental analysis. Some traders may be able to profit from technical indicators alone, however, I find fundamentals should also be considered first. In this way, fundamentals provide the main trading idea and technicals provide the timing.
In addition, I believe you need to have a solid understanding of trading psychology in order to utilise technical analysis to it’s full potential. In other words, you need to have enough confidence in your ability to follow your technical signals and hold them into profit.
Here are some of the best triangle patterns used by technical analysis traders:
Best triangle patterns for technical analysis
The ascending triangle pattern typically occurs in bull markets that have stalled and pulled back. As a security moves higher it forms an uptrend with higher lows. (At this point the security is still far away from it’s recent high and is likely also showing a multiple top.)
An upward trend line forms connecting the higher lows and this converges on a horizontal upper resistance, forming a triangle pattern.
The key point about all triangle patterns is that as they converge on the price, they form an apex and the price has nowhere to go. It can either break out to the upside and likely enter a strong upward trend. Or, it can break down through the upward trend line in a strong bearish move.
The ascending triangle pattern can be seen clearly in the chart for $KIE. As the triangle pattern converges, the price finally breaks out to the upside and enters a strong up trend.
Unsurprisingly, descending triangles are the exact opposite to ascending ones.
In $RPRX, the descending triangle pattern converges on the support line that has formed as a result of a number of multiple bottoms. As the price nears the apex, it moves higher than the descending down trend line and breaks out to the upside.
This pattern is usually a good indication that a security is bottoming. A similar pattern is occurring in gold right now (June 2014).
The wedge up is similar to the ascending triangle but instead of a having a horizontal resistance line, the resistance line moves up with the trend. The wedge up therefore always occurs in an up trend and can be used in two ways.
Firstly the wedge up is used as a channel. When the price move to the bottom of the channel it’s a good time to buy and when it moves to the top it’s time to sell.
Secondly, when the price breaks out of a channel it’s a sign that the pattern has changed and time to trade in the new direction.
The wedge down works exactly like the wedge up but in reverse. When the price moves to the top of the channel it’s a time to sell and when it moves to the bottom it’s time to buy. Additionally, if you’re holding a short in the down trend, a break out past the upward trend line signals time to close out the short.
Normal wedges occur during choppy price action where an upward and downward sloping trend line both converge to an apex point. This usually happens when a market is consolidating and is recovering from a volatile phase. Eventually, the two trend lines converge and the market has nowhere to go. It will usually break out to the upside or break down into a new down trend. They can also be used to trade the channel, selling at the top and buying at the bottom.
Want a quick way to find technical triangle patterns?
Simply head over to the Finviz home page and you can screen stocks for a number of different patterns: