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Evaluating Probabilities Using Technical Analysis
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Besides technical analysis, I also use simplified statistical analysis made on the basis of long observation of the market behavior and study of its common laws. Many laws can be quite well explained from the common sense point of view, as well.

Such preliminary probability evaluation allows me to avoid the most common mistakes at opening and liquidating of my positions. The criteria follow.

• Usually, the probability that the market will continue its current movement in the present direction is higher than the probability that the market will soon change direction to the opposite.

Because the market has a high degree of momentum, the logical con­clusion would be that opening a position in a current prevailing direction already gives a trader some statistical advantage of making a profit, rather than having a loss in such a case. However, even though it directly follows from one of the basic postulates of the technical analysis (the market moves in trends), many traders prefer to search for the opportu­nity to catch the moment of the market transition from one direction to another, instead of going with the trend. My own observation shows that many novices intuitively feel this law and open the majority of their positions (in the very beginning of their trading careers) in a direction of a current market move. In fact, the less theoretical knowledge and practical experience a beginner has, the more expressed such a tendency is. Although they don't yet feel capable of predicting future changes in the market behavior and don't try to do so, they base their trading on what they see on the screen.

Because the FOREX market has a very high volatility, often such a tactic is justified and brings novice traders success during the initial period of their trading careers. This is why the overwhelming majority of the novices succeed while practicing dummy trading or even trading with real capital in the beginning. Unfortunately, this ability to go with the market soon disappears. Then it becomes substituted with analysis, mostly in accordance with knowledge received from books. Instead of simply following market fluctuations, traders begin to predict its future behavior and try to act in advance. From that point on, the majority of new positions are based on analysis and forecasts, and very often against the current market movement. From the moment strategy is shifted to mostly picking tops and bottoms, the chances to survive in business are sharply lowered.

From my point of view, the formula "sell on weakness, buy on strength" has an obvious advantage over another popular formula "buy low, sell high." The latter better fits a longer-term trader or investor rather than a short-term speculative trader, whose basic purpose is to enter and exit the market fast enough to get a relatively modest profit and then to secure it. In real trading conditions and especially in a day trade, it is much more difficult to define a point or even an approximate zone of a market turn, than to receive fast profit, catching the market on the run and opening a position in a direction of its current movement. Therefore, any trade tactics providing a position opening in a direction of movement (that already has begun) can be considered preferable in comparison with tactics focused on picking extreme market levels (tops or bottoms) to open a position against the prevailing direction at the moment.

• If the market had committed a significant move in some direction during the day, there would be a high probability of some extension in the same direction during the next day. The same assumption can also be used for analysis of weekly and monthly charts. See Figures 8.5 and 8.6.

The trend is one of the main market's features and occurs frequently. There is nothing unusual in this fact, and the FOREX market is famous for

FIGURE 8.5 This is a very impressive sample of my statement: A strong and volatile move in one direction, with the closing price of the day almost at the very bottom of its range, continued during the next day. Despite the fact that the volatility of the third day was big, the closing price was closer to the top of the day than to the bottom, and therefore, no further extension is seen.

its trends. Simply looking at the charts you can relatively easily identify the day, week, or month when a movement has begun. Such a period is characterized by the prevalent tendency in one or another direction and by an essential difference between the opening and closing prices of each bar on the charts. See Figure 8.7.

While conducting simple statistical analysis of daily and weekly charts at the end of each trading day and week, pay attention to the closing price of this day or week. If the market closed near the high of the last bar, there is a great probability, that the high of the following bar will be even higher. See Figure 8.8.

If the market closing price was almost on the low of the bar, then most likely that low of the following bar will be even lower. See Figure 8.9. Because gaps on the FOREX market's daily and weekly charts are very rare, the open price almost never coincides with the future high or low of the bar.

For example, if the day's closing price was near the high, on the next day the probability of a repeated attempt to reach and exceed the previous day's high would be much greater than the downward market movement. In other words, the market usually trades in both directions from

FIGURE 8.9 In the case of a downtrend or fast and deep correction, each closing near the bottom of the weekly bar with an above-average range leads to a continuation of the move in the same direction.

the day's open price, but the main direction of the day is mostly the same as during the previous day.

It is also important to keep in mind that if a trend is present, the aver­age number of consecutive days on which the closing price of the day is lower or higher than the opening price is four. In my memory, the highest number of consecutive positive or negative day closings was nine.

• The purpose of technical analysis is not to predict where and when the market will go, as many traders think. The main goal of analysis is to define in advance the critical points or levels. Then, based on this research, you can build a trading strategy for the next trade.

Creating and improving my trade method, I have developed a routine pro­cedure of market analysis. The research is made regularly and always precedes any real actions on the market. This procedure provides me with the preliminary analysis of a current market condition at the end of each trading day. It begins with definition of key points, critical zones, supports and resistances, and also includes preliminary and rather rough probability evaluation of the main market direction during the next day. At the end of each week, I do such analysis for the whole next week, too. Despite the fact that this part of the chapter is large in volume and contains many steps that a trader needs to take before he completes his daily routine analysis, the actual time you will spend on the daily procedure is unlikely to exceed 15 to 20 minutes.

The Weekly Chart Analysis

Preliminary analysis on weekly charts is conducted at the end of the week, and is supposed to be updated at the end of each trading day.

(The fact that you prefer a short-term trade is not so important. Longer-term market analysis should be done even if you consider yourself as a day trader and the majority of your positions are taken and liquidated within the same trading day. To make a right decision on an intraday trade, you also have to see the bigger picture, to identify key levels and current longer-term trends. As a matter of fact, dividing the FOREX market participants among short-term, intermediate-term and long-term traders seems a bit artificial to me. For example, I personally never refuse to keep my position open for a longer period of time if there is a strong reason to believe that the current trend will continue. Transforming an intraday trade into a positional trade, revising my initial plan and changing the time frame can do the necessary adjustment.)

The purpose of this analysis is to define the prevalent intermediate- to longer-term trends and identify on the chart critical points, zones, and lev­els. Those levels should be located relatively close to the previous week's closing price and within the reach of a potential next week's range. All technical formations and patterns have to be taken into consideration and identified as well. The trendlines should be drawn and the measured ob­jective targets (if any) calculated. The charts, along with the lines drawn on them, should be saved in your computer and updated every day.

(The Omega SuperCharts (end-of-day) software, which I use for intermediate and long-term analysis, is the best software I know. This computer program allows you to save in the memory a large number of graphic windows with lines drawn on them and, if it is necessary, any number of indicators.)

Every day, in accordance with the market's changes, you should plot a new day bar and revise the lines that have been drawn on the weekly chart the week before. If necessary, remove the old lines and add new ones. For example, even for a day trader all the trendlines, support, and resistance lines lying within 2 to 3 days of an average trading range could be important. Those critical points that are on a distance up to 300 to 500 pips in both directions from the closing price of the day have to be noted and placed on the chart. The levels nearest to a closing price are the most important and require more attention. You have to precisely calculate the critical point where this level might be penetrated by the market in the nearest future.

The most basic task, but at the same time the simplest, is to define a direction of a current intermediate-term trend. I don't think anybody has a problem with this definition, because presence or absence of a trend is usually visible from the first look at the chart. Therefore, I want only to remind you that analysis should be conducted on both bar charts and line- on-close charts.

• You should begin with the search of already formed technical forma
tions (head and shoulders, double (triple) tops/bottoms, triangles,
wedges, flags, channels, etc.). They should be identified in the follow
ing order:

a. complete formations, with already broken trend/or necklines (crit
ical lines)

b. complete formations, but the critical levels have not been broken yet

c. formations, coming nearer to completion

d. formations that are just starting their development

(In the case of d, we are making some projections for the future. This is the most complicated task, and requires certain practical experience and some imagination from a trader.) After identification of a technical formation, you should draw and save all necessary lines forming this pattern, including the possible measured objective target, if this given formation allows defining it. See Figure 8.10.

•  Drawing trend lines and horizontal supports and resistances will be
the next step. Identification and allocation on the chart of possible
horizontal and inclined channels limited by two trend lines is also
very important. Such lines should be drawn only according to certain
strict rules. According to the laws of geometry, it's possible to draw a
direct line through any two points in space. Therefore, trend lines,
only if they are not necklines of one of the technical formations, will
make sense only when they are drawn through a minimum of three
important points on the analyzed chart.

•  The trend lines should be drawn through three consecutive tops, or
three consecutive bottoms, or highs and lows of daily and weekly
bars. Preferably, the bars should not intersect the trend line along the
way. The line, which has many casual and unconfirmed intersections,
is less reliable for a trader. A perfect trend line should be placed on a

Analysis of daily charts is similar to analysis of weekly charts. The difference between them is basically that a smaller time interval allows you to define critical levels and zones more precisely and accurately, to plan a future trade. Furthermore, some formations that cannot be identified on the more large-scale charts, can be visible on the charts with the shorter time frame. In addition to the points just listed, you should conduct the search of gaps on daily and weekly charts.

The FOREX market is densely filled with technical traders and, for this reason, the formations frequently do not fulfill their destination to give traders reliable signals to enter a market and make some projection for the future.

Gaps on Daily Charts

Because the FOREX market works five days a week around the clock (in contrast to other financial markets), we don't see classical gaps the way they appear on future and stock markets. As is generally known, a gap is a break between two consecutive bars on the chart, when the low of the previous bar is above the high of the previous one or the high of the previ­ous bar does not reach the low of the bar directly following it. Such gaps, in their classic description, are very rare on the spot currency market. Nevertheless, breaks on exchange rates charts exist, though they look a little different than they are described in technical analysis books.

Gaps (or formations I define as gaps) with reference to the FOREX market are formed more often between Friday and the following Monday, and are very rare in the middle of a week. They look like breaks between the closing price of the previous day (and accordingly the previous week, if this day is Friday) and the low or the high of the following trading day (occasionally also all of the following week). The examples of such gaps are shown on a formation like the one in Figure 8.15.

Most of the time, the market comes back to the gaps a bit later and completely covers the price break formed on the chart. The gap identification is very important but usually I don't trade on return and closing of such a gap. Formed some time back, a gap gives me additional confidence if my position is open toward a gap, and provides a warning signal if the position has been opened in the opposite direction.

Combs on Daily Charts

A formation such as a comb doesn't exist in technical analysis. This is my own definition of the specific formation, which sometimes appears on daily bar charts. (It is also common on intraday charts.) A comb repre­sents a specific kind of trend. The specific feature of a comb is that you can draw a trendline on a certain part through highs or lows of any three of five consecutive daily bars. The trendline will make sense if it's directed

under some angle upward, drawing through lows, and angled down, drawing through highs. The examples of such formations are shown on the formations in Figures 8.16 and 8.17. A comb is one of my favorite patterns, which gives a reliable signal to enter the market with the appropriate position in the moment of a trendline intersection.

OTHER FORMATIONS ON DAILY AMD WEEKLY CHARTS

Identification of various formations on the intermediate and long-term charts should be conducted in accordance with technical analysis rules. Identification includes head and shoulders, double (triple) top (bottom), rectangle, triangles, wedge, flag, diamond, and so on. Usually, if you have basic knowledge and some experience, it shouldn't be a problem to identify them. However, I repeatedly found myself in situations in which even relatively experienced traders were unable to identify formations that were quite obvious from my point of view. Sometimes they saw such pat­terns in places where I, having sufficient imagination and significant practical experience, was unable to identify them as such—with all my diligence and even with the help of another trader.

Different interpretations of technical patterns and formations are frequent among traders. Their interpretations of possible market behavior based on such identification also differ. As I already mentioned, the FOREX market is densely filled with technical traders, and for this reason formations frequently do not fulfill their destination to give a trader a reli­able signal to enter a market and make some projection for the future. According to this fact, a trade on a projected target frequently can be unsuccessful. However, we shouldn't ignore these formations also. We will discuss how to use these formations and how to ensure that we are safe in the chapter devoted to trading signals.

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