In Chapter 10 of his book, Forex Patterns and Probabilities: Trading Strategies for Trending and Range-bound Markets, forex specialist Ed Ponsi introduces what he calls “The Ultimate Indicator.” Given the hundreds of technical indicators available to traders, which one is the “ultimate”? Ponsi’s answer might surprise you. Ponsi is a professional trader and money manager who is the president of FXeducator.com. He has been the advisor to hedge funds, institutional investors and individual traders alike.
People often ask: what is the best indicator to use in forex trading? Is it the relative strength index (RSI), or exponential moving averages (EMAs), or perhaps Bollinger bands? Or is it something more esoteric? New indicators are being created every day, as market technicians attempt to leave their mark on the trading world. What is the ultimate forex indicator?
Well, there is one indicator that stands above the rest, and that indicator is the price. Most indicators are simply an equation or formula that is applied to the price.
The price is the key
A moving average is a good example, as it consists of the average, or mean, price of a trading vehicle over a designated period of time. Oscillators such as stochastic or RSI (see Figure 10.1) measure the difference between the current price and recent prices, to determine if a currency pair (or stock, or commodity) is overbought or oversold. Eventually, every indicator boils down to the price.
Technically speaking, in the forex market we do not have a price per se. Instead, we have an exchange rate, which allows us to compare two currencies in one equation. Many times throughout the course of this book, you will notice references to the “price.” In currency trading, the word “price” is
simply slang for “exchange rate.” This is especially true for those of us who formerly traded stocks, and are in the habit of referring to the numbers that we see on the chart as the “price.”
When buyers repeatedly step in at a particular price, this is referred to as support. Think of support as the floor beneath you. If you drop a rubber ball to the floor, it bounces back up to you. The price bounces up from support in a similar fashion.
When sellers repeatedly step in at a particular price, this is referred to as “resistance.” Think of resistance as the ceiling above you. If you throw a ball at the ceiling, it then falls back down to you. The price falls from resistance in a similar manner.
Why is this price information valuable? Unlike most indicators, support and resistance levels tell us where the buyers and sellers have set up camp. Remember: many of the large players, the hedge funds and the money-center banks, do not enter trades in the same manner that individual traders do.
While many individual traders enter and exit positions all at once, institutional traders usually enter and exit positions gradually. This is necessary due to the large size of the orders being placed. Big traders are concerned that their orders might move the market, by creating too much buying or selling pressure at one time.
In the case of a large buyer, this can drive the exchange rate higher, making additional purchases more expensive. So, instead of chasing the price higher, the institutional trader waits for the price to come back to the desired entry point, and then increases the size of the position. The result is a currency pair that bounces back up when it falls to a particular price level (see Figure 10.2).
Conversely, a large seller can inadvertently smash the exchange rate lower, creating an inferior price at which to continue selling. For this reason, the institutional traders will sell at a particular level, wait for the price to rise back up to that level, and then resume selling. The result is a currency pair that tends to stop rising when it reaches a particular price level (see Figure 10.3).
As individual traders, we can use this phenomenon to our advantage. We can enter long trades at the levels where the big traders are buying, and we can sell short at levels where the big traders are selling. We can also exit long trades at points where there is evidence of institutional selling, and exit short trades at points where there is evidence of institutional buying.
It’s important that we think of support and resistance as areas. In a perfect world, the exchange rate would always rise and fall to the same exact price points, over and over again. The world of trading is far from perfect, and prices rarely rise and fall to the exact same spot.
In the real world, the exchange rate will often overshoot or undershoot the mark (see Figure 10.4). That’s why traders using support and resistance should use a “soft target.” For example, instead of referring to support as “1.2847,” we would consider this to mean that there is support in the area of 1.2850. This is a much more realistic approach to trading support and resistance levels.
Why support becomes resistance
If support and resistance held forever, then trading would be easy indeed. We could simply enter and exit as the price seesaws up and down between support and resistance levels. Of course, the idea that trading could be so simple is wishful thinking.
Let’s consider the process that occurs when support breaks. Imagine that a support level exists that has withstood numerous tests; in other words, the exchange rate has repeatedly fallen to a price area, only to bounce back up every time. The reason why the price bounces back is that buyers are stepping in at that level on repeated occasions. These buyers could be institutional traders, individual traders, or a combination of the two.
Every time that these traders have entered long positions at the support level, the market has rewarded them; we could say that they’ve been conditioned by the market to enter at the area of support. One day, the level is tested again, and traders either initiate or add to their long positions.
Only this time the price breaks through, and now traders who entered long at support find that their positions are “underwater.” Many of these traders will be taken out of their positions by protective stops, which are generally located beneath support for those who are entering long in the area of support. However, since we know that not all traders use stops, some of these individuals will now begin to experience some serious anxiety.
There is a wonderful thing that we can do as we analyze any trading situation: We can try to understand how the situation feels to those who are directly involved. Perhaps at some point in the past, before learning the importance of risk management, we may have been ensnared in a similar predicament as the current market participants described above.
The pleasure principle and trading
You may be familiar with the pleasure principle, a psychoanalytical term coined by Gustav Theodor Fechner, a predecessor of Sigmund Freud. Quite simply, the pleasure principle drives one to seek pleasure and to avoid pain. If you can understand this simple concept, and apply it to how you think about trading, it will allow you to understand the reactions of other traders in the market-and you thought Psych 101 was a waste of time!
The reason for considering the emotions of those involved in the trade is this: Although time passes and traders may come and go, human nature remains essentially unchanged. Fear and greed have always ruled the markets, and they probably always will.
Now imagine how it must feel for those traders who are holding on to their losing positions after support breaks; what are their predominant emotions? Fear and anxiety immediately come to mind. If these traders are not using good risk management, they are afraid of what might happen next-and they should be! They are afraid that they may have a big losing trade on their hands, and they are hoping and wishing for the exchange rate to rise.
If the price then rises up near to the entry point (the former support level), many of these traders are going to bail out of their losing trades, so that they can experience a different emotion-a feeling of relief. These traders have but one wish-to get out at or near the breakeven point. Always remember, if at any point during a trade you find yourself hoping or wishing instead of following a predetermined course of action, you should close the trade and reevaluate your trading method.
If enough selling occurs as the price nears the former support level, the exchange rate will reverse and begin to fall. Now, the former area of support has become an area of resistance (see Figure 10.5).
The reverse is also true-a former area of resistance, now broken, can become an area of support for the same reasons (see Figure 10.6).
By the way, we can resolve now that we will never be ensnared in a similar situation, by using good risk management rules such as using a stop on every trade, and by never averaging down on a losing trade. Traders who do not use stops and average down on losing trades are not really traders at all-at least, they won’t be for long.
Traders are concerned not only with the ability (or lack thereof) of the price to break through support or resistance, but also with the behavior of the price when it reaches these key levels. They want to know not only if support or resistance is holding, but also how it is holding.
For example, did the price make a halfhearted attempt at breaching support, and then drift away, or did it fail repeatedly in its persistent attempts to break out to the other side?
How is the price moving? Is it rushing headlong toward support or resistance, indicating a strong commitment on the part of traders? Or is it meandering aimlessly, as if traders were afraid of encountering a key level?
The “attitude” of the price at key support and resistance levels can betray the next directional move. I never want to enter a trade based on support or resistance unless I can first observe the price action.
For example, if a pair repeatedly fails after numerous attempts to breach resistance, it reveals the presence of a large seller in the vicinity.
I can “lean” on this seller, meaning that I will join him in selling this pair at resistance (see Figure 10.7).
The point is that this seller may be building or exiting a large position; either way, he might continue selling for some time. If the price finally breaks resistance, I would interpret this to mean that the seller is finished, and the order is filled. There would no longer be any reason to place trades based on that resistance level. Remember: if the reason for entering the trade is no longer valid, then the trade itself is no longer valid.
Don’t stand in front of a freight train
Many traders make the mistake of placing an order directly on a support or resistance level, and then waiting. This removes any chance for the trader to use the chart’s price action to his or her advantage.
Placing an order in this manner is similar to making a prediction that the level will hold, but this is not advisable. No matter how dependable that support or resistance level has been in the past, it can and often will break. If the price is rushing headlong toward your support or resistance level, get out of the way.
We want some measure of assurance that support will hold. Instead of trying to catch a long entry as the price is falling, try this: Allow the price to fall to support, and then set up an entry order to go long, above support. Wait until the price is beneath you, testing support, and only then place the entry order (see Figure 10.8). Your stop will be located beneath support (see Figure 10.9).
When the price reaches support, one of two things will happen: Either the price will keep falling, or it will turn and begin to rise. If the price keeps falling, we haven’t lost a thing, because our entry order has not been reached. But if the price bounces up, we now have evidence of buying at the support level.
The idea is to catch the entry for the long trade as the price is rising from support. Sure, we will not be able to enter the trade at the bottom of support, but that’s OK. We want to increase our chances of success by waiting until the evidence is on our side.
In the case of resistance, we can simply do the opposite: allow the exchange rate to rise up to resistance, and then place your entry order beneath resistance (see Figure 10.10). Your stop will be located above resistance. This way, if the resistance level holds, we can catch the currency pair as the price is falling. If the level fails and the price breaks higher, our order will remain unexecuted (see Figure 10.11).
Ed Ponsi is the President of FXEducator.com and is the former chief trading instructor for Forex Capital Markets, LLC. He is an experienced professional trader and money manager who has advised hedge funds, institutional traders, and individuals of all levels of skill and experience. Ponsi is featured on the FXEducator.com DVD series, “Forex Trading with Ed Ponsi.” He is a dynamic public speaker who has appeared on numerous television and radio programs, and is a frequent guest lecturer at trading conventions and seminars around the world. For more information, please visit www.edponsi.com and www.fxeducator.com.
Excerpted with permission of the publisher John Wiley & Sons, Inc. from Forex Patterns and Probabilities: Trading Strategies for Trending and Range-bound Markets. Copyright (c) year by Ed Ponsi. This book is available at all bookstores, online booksellers and from the Wiley web site at www.wiley.com, or call 1-800-225-5945.