8.

Forex Trading – Technical Indicators Forex Trading

In this chapter, we will learn about charts that act as technical indicators in forex trading.

What is a chart?
Charts are the main tools of technical analysis. In technical analysis, we use charts to plot
a sequence of prices (price movements) of an asset over a certain duration. It is a graphical
way of showing how the stock prices have performed in the past.

The period to represent the price movement of an asset (ex. currency) vary from minutes
(30 min), hour, day, week, month or many years. It has an x-axis (horizontal axis) and a
y-axis (vertical axis). On the chart, the vertical axis (y-axis) represents price and the
horizontal axis (x-axis) represents the time. Thus, by plotting a currency pair price over a
period of time (time frame), we end up with a pictorial representation of any asset (stock,
commodity or FX) trading history.

A chart can also represent the history of the volume of trading in an asset. It can illustrate
the number of shares (in case of equity) that change hands over a certain period.

Types of Charts
The asset price (stock, currency pair, commodity, etc.) charts come in many varieties. It
is the choice of the individual traders or investors to choose one type over another. This
decision may be based on:

 Familiarity and comfort

 Ease of use
 Underlying purpose

The line chart

Line charts are formed by connecting the closing price of a specific stock or market over a
given period. It means, if we want to draw a line chart of a particular currency pair
(USD/INR) in a 30 min time frame, we can draw the line chart by putting a straight line
between prices before 30 min and current price after 30 min. The charts provide a clear
visual illustration of the trend of a particular currency (or stock price) or a market’s (index)
movement. It is an extremely valuable analytical tool for technical analysts, traders and
also investors.

Line charts are mostly used when two or more trends have to be compared. For example,
comparing closing prices of two more companies (same exchange listed and from same
domain) or for a currency pair (USD/INR) compared to all the other listed currency pair in
the region (ex. Asia).

The line chart exhibits price information with a straight line (or lines) connecting data
(price or volume) values.

Below is the line chart of USDINR of 1-year time frame.

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Bar Chart
Bar chart is a commonly used type of chart by technical analysts. It is called bar chart
because each day’s range is represented by a vertical bar.

Although daily bar charts are best known, bar charts can be created for any period –
weekly, monthly and yearly for example. A bar shows the high price for the period at the
top and the lowest price at the bottom of the bar. Lines on either side of the vertical bar
serve to mark the opening and closing prices of an asset (stock, currency pair). A small
tick on the left side of the bar shows the opening price and a tick to the right of the bar
shows closing price.

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Many traders work with bar charts created over a matter of minutes during a day’s trading.

Following is a 5-Day Bar chart of USDINR in 5 minutes interval.

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With 1-Day interval, 1-month chart of USDINR will be shown like this:

Candlesticks Chart
The candlesticks chart is very popular among the traders community. This chart provides
visual insight to current market psychology. A candlestick displays the open, high, low and
closing price of a security very similar to a modern-day bar chart, but in a manner that
mitigates the relationship between the opening and closing prices. Each candlestick
represents one time frame (e.g., day) of data. The figure given below displays various
elements of a candle.

Elements of a Candle
A candlestick chart can be created using the data of High, Open, Low and Closing prices
for each time period that you want to display. The middle portion (filled portion) of the
candlestick is called “the body (“the real body”). The long thin lines above and below the
body represent the high/low range and are called “shadows” (sometimes called “wicks”
and “tails”).

The body of the candlestick represents a stock’s opening and closing price of the security
(stock or currency pair).

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 Forex Trading

The following image shows Candlestick chart of USDINR (3 month) on 1-Day interval. The
color of the candlestick denotes a higher close in green whereas lower close in red, for the
day.

The red candles in the above figure show days when the USDINR closed than the previous
day. In contrast, green candles denotes days when the USDINR closed higher than the
previous day.

Professional traders and investors sometimes prefer using candlestick chart because there
are patterns in the candlesticks that can be actionable. However, candlestick charts
consume time and skills to identify the patterns.

What is the chart pattern to use when trading?

The professional traders try to check the same security across different chart types. You
may find one type of chart that works for you. Once we decided on what type of chart to
follow, next step is to look for historical patterns like trends, support and resistance and
other actionable patterns.

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Following are some of the major trend indicators:

 Moving averages
 MACD
 Average directional index
 Linear regression
 Forecast oscillator
 Parabolic SAR

Example
We can buy a security (USD) if its closing price is higher than the 30 days simple moving
average -

 BUY (when) close > sma(30)

Volume Indicators
The volume of trades of a security is a very important component of trading. Every trader
takes notice of the volume of trades in determining the signal (buy, sell or hold) strength.

Following are some important volume indicators:

 Money Flow Index

 Ease Of movement
 Chaikin money flow
 On balance volume
 Demand index
 Force index

Example
Many tradersr sell the security when Money Flow Index enters an oversold area:
 sell (when) mfi(30) < 30

Momentum Indicators
The momentum (how fast or slow) is a measure of the speed at which the security value
moves in a given period.

Most traders follow momentum indicators where security price is moving in one direction
with huge volumes.

Commonly used momentum indicators are as follows:

 RSI
 Stochastics
 CCI
 Commodity Channel Index

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 Forex Trading

 Williams %R

Chande’s momentum oscillator

Traders used momentum indicators to determine overbought and oversold positions.

Example
One widely used indicators among traders is the RSI, where once the security enters into
an oversold area they buy it and once it enters into the overbought area they sell. It is
determined by the Relative Strength Index indicator (RSI).

Volatility Indicators
Most traders use volatility indicators to get the buy or sell signals .

The volatility is the rate of change or relative rate at which the security prices move (up
or down). A high volatile security means prices can suddenly move very high or very low
over a short period of time. Inversely, if the security is less volatile, it means its prices
move gradually.

Following are a few commonly used volatility indicators:

 Bollinger bands
 Envelopes
 Average true range
 Volatility channels indicators
 Chaikin volatility indicator
 Projection oscillator

Though volatility is usually measured in standard deviation, there are many other
measures to check the volatility of assets:

 Close-to-Close ( C )
 Exponentially weighted ( C)
 Parkinson (HL)
 Garman-Klass (OHLC)
 Rogers-Satchell (OHLC)
 Yang-Zhang (OHLC)

Here,

 O = Open price
 C = Close price
 L = Low price
 H = High price of the security

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Example
Let us take the Bollinger band indicator for example. A trader may sell a security when the
prices go below the lower Bollinger band.

 sell (when) prices cross(BbandsLower (30, 2, _MaSma), close)

Relative Strength Index (RSI)

The RSI is part of a class of indicators called the momentum oscillators.

An oscillator is an indicator that moves back and forth across a reference line or between
prescribed upper and lower limits. When an oscillator reaches new high, it shows that an
uptrend is gaining speed and will continue to do so. Inversely, when an oscillator traces a
lower peak, it means the trend has stopped accelerating and a reversal can be expected
from there.

The momentum oscillator like the RSI is referred to as a trend-leading indicator. The
momentum is calculated as the ratio of positive price changes to negative price changes.
The RSI analysis compares the current RSI against neutral (50%), oversold (30%) and
overbought (70%) conditions.

The following figure shows the RSI analysis of USDINR where RSI shows a value of 57.14
% value, which is between neutral and oversold.

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Application of RSI
RSI is a momentum oscillator used in sideways or ranging markets where the security
(equity or currency) or market moves between support and resistance levels. Many traders
to measure the velocity of directional price movement use it.

Overbought and Oversold

The RSI is a price-following oscillator that ranges between 0 and 100. Mostly, traders use
30% as oversold region and 70% as overbought region to generate buy and sell signals.
Traders or TA generally abide by the following -

 Go long when the indicator moves from below to above the oversold line.
 Go short when the indicator moves from above to below the overbought line.

Following is a silver chart showing buy and sell point, and failure in trending market.

Divergence
The way to look at RSI is through divergences between price peaks/troughs and indicator
peaks/ troughs.

A positive divergence occurs when the RSI makes a higher bottom despite lower trending
by share price. This indicates the downward movement is running out of strength and an
upward reversal can soon be expected.

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Similarly, a negative divergence occurs when the RSI starts failing and makes a lower top
despite share prices moving higher. Since there is less power or support for the new higher
price a reversal could be expected.

A bullish divergence represents upward price pressure and a bearish divergence represents
downward price pressure.

The following diagrams show strong divergence:

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The following diagram shows moderate divergence:

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Estimating Price Targets

Traders and investors benefit by trading in the direction of the trend. The RSI is also used
for determining and confirming the trend.

A security (stock or currency) which is in strong uptrend will rarely fall below 40 and
usually moves between 40 and 80 levels. In such a case, when the RSI approaches 40, a
trader can use this opportunity to buy, and when it comes close to 80, it can be a square-
off signal. Therefore, traders should not go short on a counter that is in a strong uptrend.
Similarly, if the security is in a strong downtrend, its RSI usually moves between 60 and
20; and if it comes close to 60, it can be used for selling short.

Failure swings are considered as strong signals of an impending reversal.

Bullish Failure Swing (for buying)

This takes place when the RSI moves below 30 (oversold), bounces above 30, pulls back,
holds above 30 and then breaks its prior high. It moves to oversold levels and then a
higher low above oversold levels.

Bearish Failure Swing (for selling)

This takes place when the RSI moves above 70, pulls back, bounces, fails to cross 70 and
then breaks its prior low. It is a move to overbought levels and then a lower high below
overbought levels.

The following diagrams show the Bullish and Bearish Swing Failure:

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12. Forex Trading – The Role of Inflation Forex Trading

Inflation gives very good indication of the current account balance of a country. Inflation
measures the rate of change in prices of goods and services over a given period. An
increase in inflation indicates prices are quickly rising and if the rate of inflation decreases,
the prices of goods and services are increasing at a slower rate.

The rise and fall of inflation within a country also provides information about the medium
term direction in foreign exchange and the current account balance of a country is also
used to determine the long term movements of foreign exchange.

Higher and Lower Inflation

It is a general belief (among economic theories) that low inflation is good for the economic
growth of a country while high inflation points to poor economic growth. High inflation in
a country means the cost of consumer goods is high; this points to less foreign customers
(less foreign currency) and the country’s trade balance is disturbed. Lesser demand of the
currency will ultimately lead to a fall in currency value.

Foreign exchange is very much affected by inflation which directly affects your trades.
Declining exchange rate decreases your purchasing power. This in turn will influence the
interest rates.

Following diagrams show the relation between inflation, interest rates and the economic
growth of a country:

A detailed knowledge on inflation helps you to make your forex market trades profitable.

Let us now see the major indicators of inflation that the market tends to watch at all times
especially in forex market trades.

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Gross National Product (GNP)

It is the output of the citizens of the country (like India or US) and the income from assets
owned by the country entities, regardless of the location; whereas, the Gross Domestic
Product (GDP) represents the total monetary value of all goods and services produced
over a specific time period – the size of the economy.

GDP is usually expressed in comparison to previous year or previous quarter (3 month).

For example, if the year-to-year GDP is 4%, this means the economy has grown by 4%
over the last year.

GNP defines its scope according to ownership (irrespective of location); whereas, GDP
defines its scope according to location.

In 1991, the US switched from using GNP to using GDP as its primary measure of
production.

GDP has a direct impact on nearly every individual of the country. A higher GDP indicates
there is low unemployment rate, higher wages as businesses demands labor to meet the
growing economy.

How GDP affects Forex market?

Every economic data release is essential for a forex trader; the GDP data holds a lot of
importance as it directly indicates the overall state of a country. As GDP data may create
lots of volatility in the currency market, traders try to create a new position or may hedge
their existing position (long or short position).

If the country economy is growing (GDP), the benefit will eventually affect the consumer;
this leads to an increase in spending and expansion. Higher spending leads to increase in
prices of consumer goods which country central bank will try to tame if they begin to
outpace the rate of economic growth (high inflation).

Producer Price Index

The producer price index or PPI in short, is a monthly report detailing the purchasing price
of various consumer goods. It measures the change in prices charged by wholesalers to
their clients like the retailers who then add their own profit margin to the producer’s price
and sell it to consumer.

It is important because traders mainly use the PPI as an indicator of price inflation over
time. One major drawback especially for forex market traders is that PPI excludes all data
on imported goods, making it difficult for traders or investor to detect the influence of one
country’s market on another with respect to currency prices.

In general, the PPI is more volatile with larger fluctuations than the CPI (Consumer Price
Index), is giving a macro sense of the underlying price developments that are not
necessarily reflected on consumer’s bills.

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Consumer Price Index (CPI)

The Consumer Price Index (CPI) proves effective on central banks (like RBI, US Federal
Reserve), and market participants. It holds more significance when compared with the
PPI.

CPI indicates the cost of living in a country, has a direct effect on interest rates.

It CPI index measures the prices changes at the retail level. It stores the price fluctuations
only to extent that a retailer is able to pass them on to the consumer.

Higher CPI gives central banks (RBI, FED) the necessary supportive data to rate hikes
(though it’s not the only factor which central bank looks for). Higher interest rates are
bullish for the country’s currency.

The CPI includes sales taxes number but excludes income taxes, prices of investments like
bonds or prices of homes.

The CPI report is generated monthly and covers data of the preceding month.

The core CPI is the most noticeable figures among market participants. This does not
include food and energy prices and central bank (to adjust its monetary policy).

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13. Forex Trading – The Commodity Connection Forex Trading

The movement of foreign exchange prices is based on multiple factors including demand
& supply, economic factors (GDP, CPI, PPI), interest rates, inflation, politics. Since the
economic growth and exports of a country are directly related, it is very natural for some
currencies to heavily depend on commodity prices.

The economic growth of countries like Saudi Arabia, Russia, Iran (largest oil producing
countries) is heavily dependent on the prices of crude oil (commodity). A couple of years
back, when crude oil prices exceeded $100 per barrel, stock market and currency market
responded very positively (strong currency) and then in 2016-17 when crude oil prices
went down below $30 per barrel, financial market responded very negatively. The prices
went down by 7% in a single day (stock market, extreme volatility), currency prices goes
down. Since specifically few countries which are commodity exporting countries, economic
growth is directly related to commodity prices. As we know, strong economic growth in a
country means stronger its currency.

Specifically in case of dollar, there is an inverse relationship between the dollar prices and
commodity prices. When the dollar strengthens against other major currencies, the
commodity prices drops and when dollar weaken against other major currencies, the prices
of commodities generally moves higher.

But why so??

The main reason is that the dollar is the underlying (benchmark) pricing mechanism for
most commodities. The US dollar ($) is considered as the reserve currency of the world.
As it is considered as the safe-haven currency ($), most countries hold dollars as reserve
assets. In case of raw material trade (export/import), the dollar is the exchange
mechanism for many countries if not all. When the dollar is weak, it costs more dollars to
buy commodities. At the same time, it costs lesser amount to other country currency (JPY,
EURO, INR) when dollar prices are down.

Generally Higher Interest rates lead to lower commodity prices. For example, if the RBI
(India central bank) raises interest rates, that may reduce the level of economic activity
and thereby lower commodity demand.

For countries like India, which is very large oil importer. Low oil prices is good for oil
importing countries because when oil prices come down, inflation will cool down and with
that interest rates will come down and that will increase economic growth.

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Unit 3: Putting It Together

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14. Forex Trading – Position Sizing & Money Forex Trading

Management

An important aspect of forex trading success is taking the correct position size on each
trade. A trader position size or trade size is considered more important than your entry or
exit point especially in forex day trading. You might have the best trading strategy but if
you do not have proper trade size, you will end up facing risks. Finding the proper position
size will keep you within your risk comfort level is relatively safe.

In forex trading, your position size is how many lots (mini, micro or standard) you take on
your trade.

We can divide the risk into two parts:

 trade risk
 account risk

Determining your Position Size

Follow these steps to get the ideal position size, irrespective of the market conditions:

Step 1: Fix your account risk limit per trade

Set aside the percentage amount of your account you are willing to risk on each trade.
Many professionals and big traders choose to risk 1% or less of their total account on each
trade. This is as per their risk taking capacity (here they can deal with 1% loss & the other
99% amount still remains).

Risking 1% or less is ideal but if your risk capacity is higher and you have a proven track
record, risking 2% is also manageable. Higher than that of 2% is not recommended.

For example, on a 1,00,000 INR trading account, risk no more than 1000 INR (1% of
account) on single trade. This is your trade risk and is controlled by the use of a stop loss.

Step 2: Determine pip risk on each trade

Once your trade risk is set, establishing a stop loss is your next step for this particular
trade. It is the distance in pips between your stop loss order and your entry price. This is
how many pips you have at risk. Based on volatility or strategy, each trade is different.
Sometimes we set 5 pips of risk on our trade and sometimes we set 15 pips of risk.

Let us assume you have 1,00,000 INR account and a risk limit of 1,000 INR on each trade
(1% of account). You buy the USD/INR at 66.5000 and place a stop loss at 66.2500. The
risk on this trade is 50 pips.

Step 3: Determining your forex position size

You can determine your ideal position size with this formula:

Pips at Risk * Pip Value * Lots traded = INR at Risk

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It is possible to trade in different lot sizes in forex trading. A 1000 lot (called micro) is
worth $0.1 per pip movement, 10,000 lot (mini) is worth $1, and a 100, 000 lot (standard)
is worth $10 per pip movement. This applies to all pairs where the USD is listed second
(base currency).

Consider you have $10,000 account; trade risk is 1% ($100 per trade).

 Ideal position size = [$100 / (61 * $1)] = 1.6 mini lots or 16 micro lots

Creating a Forex trading spreadsheet to track your performance

Creating and maintaining a forex trading spreadsheet or journal is considered a best
practice, which not only helps an amateur forex trader but also a professional trader.

Why do we need it?

We need a trading spreadsheet to track our trading performance over time. It is important
to have a way to track your results so that you can see how you are doing over a couple
of trades. This also allows us to not get caught up on any particular trade. We can think
of a trading spreadsheet as a constant and real reminder that our trading performance is
measured over a series of trades not only based on one particular forex trade.

Not only we keep track of our trades with the help of spreadsheet, we keep track of trends
with different currency pairs, day after day, without layers of technical indicators.

Consider this sample of a forex trading spreadsheet:

Documenting your forex trading activity is necessary and serves as a helpful component
to becoming a professional forex trader.

Foreign Exchange Risks

Every country has its own currency just as India has the INR and the USA has USD. The
price of one currency in terms of another is known as exchange rate.

The assets and liabilities or cash-flow of a company (like Infosys), that are denominated
in foreign currency like the USD (US dollar) undergo a change in their value, as measured
in domestic currency like the INR (Indian rupees), over a period of time (quarterly ,half-
yearly etc.), because of variation in exchange rate. This change in the value of assets and
liabilities or cash flows is called the exchange rate risk.

So, foreign exchange risk (also called “currency risk”, “FX risk” or “exchange risk”) is a
financial risk that exists when the company financial transaction is done in currency other
than that of the base currency of the company.

This uncertainty about the rate that would prevail on a future date is known as exchange
risk.

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15. Forex Trading – Foreign Exchange Risks Forex Trading

Banks have to face exchange risks because of their activities relating to currency trading,
control management of risk on behalf of their clients and risks of their own balance sheet
and operations. We can classify these risks into four different categories:

 Exchange rate risk

 Credit risk
 Liquidity risk
 Operational risk

Exchange Rate Risk

This relates to the appreciation or depreciation of one currency (for example, the USD) to
another currency (base currency like INR). Every bank has a long or short position in a
currency, depreciation (in case of long position) or appreciation (in case of short position),
runs the risk of loss to the bank.

This risk mainly affects the businesses but it can also affect individual traders or investors
who make investment exposure.

For example, if an Indian has a CD in the United States of America worth 1 million US
Dollar and the exchange rate is 65 INR: 1 USD, then the Indian effectively has 6,50,00,000
INR in the CD. However, if the exchange rate changes significantly to 50 INR: 1 USD, then
the Indian only has 5,00,00,000 INR in the CD, even though he still has 1 million dollars.

Credit Risk
Credit risk or default risk is associated with an investment where the borrower is not able
to pay back the amount to the bank or lender. This may be because of poor financial
condition of the borrower and this kind of risk is always there with the borrower.

This risk may appear either during the period of contract or at the maturity date.

Credit risk management is the practice of avoiding losses by understanding the sufficiency
of a bank’s capital and loan loss reserves at any given time. Credit risk can be reduced by
fixing the limits of operations per client, based on the client’s creditworthiness, by
incorporating the clauses for overturning the contract if the rating of a counterparty goes
down.

The Basel committee recommends the following recommendations for containment of risk:

 Constant follow up on risk, their supervision, measurement and control

 Effective information system
 Procedures of audit and control

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Liquidity Risk
Liquidity refers to how active (buyers and sellers) a market is. Liquidity risk refers to risk
of refinancing.

Liquidity risk is the probability of loss arising from a situation where -

 there is not enough cash to meet the needs of depositors and borrowers.
 the sale of illiquid assets will yield less than their fair value.
 the sale of illiquid asset is not possible at the desired time due to lack of buyers.

Operational Risk
The operational risk is related to the operations of the bank.

It is the probability of loss occurring due to internal inadequacies of a bank or a breakdown

in its control, operations or procedures.

Interest Rate Risk

The interest rate risk is the possibility that the value of an investment (for example, of a
bank) will decline as a result of an unexpected change in interest rate.

Generally, this risk arises on investment in a fixed-rate bond. When the interest rate rises,
the market value of the bond declines, since the rate being paid on the bond is now lower
than the current market rate. Therefore, the investor will be less inclined to buy the bond
as the market price of the bond goes down with a demand decline in the market. The loss
is only realized once the bond is sold or reaches its maturity date.

Higher interest rate risk is associated with long-term bonds, as there may be many years
within which an adverse interest rate fluctuation can occur.

Interest rate risk can be minimized either by diversifying the investment across a broad
mix of security types or by hedging. In case of hedging, an investor can enter into an
interest rate swap.

Country Risk
Country risk refers to the risk of investing or lending possibly due to economic and/or
political environment in the buyer’s country, which may result in an inability to pay for
imports.

Following table lists down the countries, which have lower risks when it comes to
investment:

Rank Rank Change (from previous year) Country Overall Score

(out of 100)

1 - Singapore 88.6

2 - Norway 87.66

3 - Switzerland 87.64

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4 - Denmark 85.67

5. 2 Sweden 85.59

6. 1 Luxembourg 83.85

7. 1 Netherlands 83.76

8. 4 Finland 83.1

9. - Canada 82.98

10. 1 Australia 82.18

Source: Euromoney Country risk – published January 2018

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Trading Rules To Live By

Money Management and Psychology

Money management is an integral part of risk management.

Understanding and implementation of proper risk management is as much more significant

than understanding of what moves the market and how to analyse the markets.

If you as a trader making huge profits in the market on a very small trading account
because your forex broker is providing you 1:50 leverage, it is most likely that you are not
implementing sound money management. May be you are lucky for one or two days but
you have exposed yourself to obscene risk because of an abnormally high “trade size”.
Without proper risk management and if you continue trading in this fashion, there is a
high probability that very soon you would land with series of losses and your loose you
entire money.

Against the popular belief, more traders fail in their trade not because they lack the
knowledge of latest technical indicator or do not understand fundamental parameters, but
rather because traders do not follow most basic fundamental money management
principals. Money management is the most overlooked, yet also the most important part
of financial market trading.

Money management refers to how you handle all aspects of your finances involving
budgeting, savings, investing, spending or otherwise in overseeing the cash usage of an
individual or a group.

Money management, risk to rewards works in all markets, be it equity market, commodity
or currency market.

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16. Forex Trading – Trading Rules to Live By Forex Trading

What most professional traders have in common is the discipline to follow some of the
basic forex trading rules.

Let us now see what these rules are. The rules are listed as follows:

Start slow
For an amateur trader, it is always better to start slow and with less money. Do not expect
or think that your first trade will be a jackpot. It is common that your first trade will not
work as planned. If you lose too much money, you will be out of the game soon and if you
make too much (then you anticipated) money, then because of your over-confidence, you
will do over-trading and loose most of what you gain.

Limit your losses

You should have an exit plan before you enter any trade. You should have strict stop loss
in case trade is not going in your favour. If your trade is with the trend, you should readjust
your stop losses and hold onto your profit. In order to keep these nightmares (your losses)
from occurring, a trader should follow strict stop loss and exit the trade in case of losing
trades before they turn into disasters.

Hold on to your profits

Many traders have no problem cutting losses but they also insist on exiting trades at the
first sign of profits. However, they eventually see that their small profits could turn huge
if they hold onto their position for little longer. The strategy here should be – “cut your
losses and hold onto your gains”.

Trading strategy

A good trading strategy is required. However, money management is also very important.
Your trade risk should not be more than 2% of your account in each trade.

Listen to the charts (technical indicators)

Everything is reflected in the price and volume when it comes to technical analysis. Master
the skill of understanding different indicators and use it.

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