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Picking Tops and Bottoms
- How to trade tops and bottoms appropriately.
- Risk:Reward should be intact, and letting profits run is more important here than other strategies such as news trading.
- Spotting a top or bottom can be done through typical patterns, psychological numbers as well as strong support and resistance levels.
In forex trading, price action can be considered as moving in a series of waves and that each one has a crest or top and a trough or bottom. Tops and bottoms are considered to be major reversal patterns that signify a fundamental change in a long term price trend. One of the most popular forex trading strategies is to attempt to detect a top or bottom and then trade to the next opposite one i.e. enter at a top and trade to a bottom or enter at a bottom and trade to a top. The aim is to try and detect tops and bottoms as accurately as possible by using techniques such as the following.
Many resort to using scientific formulas such as the Elliot Wave, W. D. Gann or the Fibonacci theories. Each is based on the theory that market behavior repeats itself. However, basing your strategy on such theories alone is not a wise practice. One of the main reasons for this is that that the forex market is not predictable and the best you can attempt to achieve is to determine the probabilities of its next move. This means that if you just try and predict the market’s next move, you are, in fact, not playing the odds. Thus, you will most likely lose over the long haul. In addition, a currency market advances in such a way that prices cannot be predicted. Scientific theories should be used with caution and only in conjunction with other methods.
Other traders base their strategies on the favorite forex maxim which is: “buy low and sell high” but this concept is not so easy to implement as it sounds. In order to detect the bottom, traders search for support levels that the price has bounced off many times. Once achieved, they then set an entry condition to buy. The flaw with this type of action is that you would be only guessing or even gambling that the support will hold this time. Instead, you should wait and confirm that the support does indeed hold. You need evidence that the support remains intact and that the market has generated enough momentum to drive the price back upwards, before you consider entering a new trade.
If you start to understand that the forex market is about odds and not certainties, you can then begin to position your trades to achieve more wins than losses and will begin to enjoy more success. I personally apply several elements which help me achieve these objectives. One of them is that I examine weekly and monthly charts, searching for tops and bottoms. In particular, I am attempting to locate ones against which the price action has bounced a number of times. Once achieved, I then join the peaks and troughs creating resistance and supports lines for the currency pairs in question. People are often confused about the importance of high or low (of a candle) vs. close. In my opinion you should look for both and not let this be the only aspect which you determine it on. With that being said, the close of a candle is the more important of the two as this is where there is equilibrium, hence this is where the market agrees on a close. In addition to this, you should also look at the “emotion” of a candle; that is, when it reaches a support or resistance level, does it bounce back hard and fast or slow and only a small retrace? This should give you a good idea of a strong pivot point. These lines offer exact chances of entering new trades on the rebound especially if I can detect evidence of momentum buildup in the reverse direction as well.
Another way to spot great levels for reversals is to locate psychological levels for currency pairs e.g. 1.000 or 1.5000 for the EUR/USD. These numbers not only seem to have some kind of effect on the minds of traders but also provide excellent opportunities for entry points. However, if you attempt to do this, always check historical data and confirm that the levels held a number of times previously. Again, you need to confirm signs of reverse momentum which you can do by setting your entry point about 20 pips back in the direction that you expect the price to reverse.
When you are searching for levels as described above, bear in mind that although the price may pierce through them this time, this action could be a fakeout and not a real breakout. To overcome this problem I employ a stop of about 100 pips. I do this not only to protect from fakeouts but also because my potential reward on a true reversal could be a lot larger than the risk. I do not advise that you use a larger stop than 100 pips (in such a situation; more on larger stop losses in chapter 17), because if you do you could suffer a substantial loss should a real breakout occur. In addition, I attempt to move my stop to breakeven as soon as the price has reversed by 50 pips. This action then enables me to enjoy risk free trading as well as still providing my trade room to breathe. If you are fortunate to find yourself in such an envious position, you must adopt a policy of letting your trades run so that you can rake in the big profits, as discussed previously.
Here are some of the most common reversal tops and bottom patterns which should help you detect them and as a result improve your trading results.
DOUBLE TOP AND BOTTOM PATTERNS
Double top patterns, which are also called “M” patterns, are initially formed by a long rise in trading price. The shape then continues with two tops, separated by a valley, before terminating with a significant drop in the trade price. Double bottom patterns are referred to as “W” patterns and commence with a long drop in currency price, followed by two bottoms separated by a hill, and ending with a sharp price rise. The main characteristics of top and bottom patterns are the following:
Tops and bottoms are significant reversal patterns that usually mark the end of a long term price trend.
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Tops are usually more unstable and shorter that bottoms.
The double top and bottom trends are strong verification signs of a change in currency trading direction.
TRIPLE TOP AND BOTTOM PATTERNS
A triple top is a currency trading pattern where the price rebounds of a level three times and is a very strong indication of a powerful resistance level.
Similarly, a triple bottom pattern occurs when the price retracts from its support level three times which again indicates a condition of very strong buying interest.
HEAD AND SHOULDERS PATTERN
The well-known head and shoulders pattern is formed by three peaks. The center peak, or head, is slightly higher than its two lower, and not necessarily symmetrical, shoulders. The line joining the bottoms of the two shoulders is called the neckline. The neckline is rarely symmetrical or perfectly horizontal because of price fluctuations. This pattern is again a strong reversal sign and is not complete until the neckline is broken. A good policy in order to confirm the momentum of the reversal is to wait for two successive closes below the neckline on at least an hourly chart. The real confirmation of a developing head and shoulders pattern comes with the formation of the right shoulder, which is invariably accompanied by distinctly lower volatility. Some traders use the distance between the neckline and the top of the head to project a target level for their trade. They do this by measuring the distance from the neckline to the head in pips and projecting the same distance below their entry point.
The V-pattern is an unusual pattern in that a sharp trend switches from one direction to the other without warning and with high volume at or just after the turn around.
Trend reversals offer some of the most important opportunities for entering a market with a good profit potential. They usually represent fundamental changes in the underlying character of a particular market and often go on to yield big moves.
However, a market top or bottom is often difficult to identify and it is even more difficult to choose appropriate entry and exit points. One problem is distinguishing between an actual change in trend or merely a congestive phase in the middle of a move. It is usually advisable to wait for prices to actually confirm a trend reversal by developing one of these well-tested and reliable reversal patterns. The actual buy or sell signals are based on a breakout in the direction of the new trend.
In summary, developing trading methods to enable you to successfully detect tops and bottoms can be a very profitable activity and as such is well worth your time studying.
How to time market tops and bottoms
Buy low, sell high. It’s probably the most clichéd trading truism ever spoken. Even people who have never seen a chart in their lives have heard it. However, anyone who’s ever traded with real money has found to their frustration that in practice buying low and selling high is much easier said than done.
If there really were a reliable way to identify market tops and bottoms, it would be like a license to print money or like being in possession of a goose that lays golden eggs. It would be like having Michael J Fox’s sports almanack from Back to the Future 2.
- But are there any ways to at least increase your odds of getting it right?
- Are there any sound words of advice to help you with such a difficult task?
Technical indicators are just a guide
It’s important to keep in mind that technical analysis is only really a guide as to what’s going on. You probably shouldn’t use the data from anyone technical indicator in strict isolation as a buy/sell signal. RSI is a perfect example of this.
RSI, or relative strength index is one of the most widely used overbought/oversold technical indicators that traders use to identify market tops and bottoms. The conventional wisdom goes that when RSI hits 70 it’s a sign that the asset in question is overbought and when it hits 30 the asset in question is oversold.
These levels are usually thought of as signalling imminent turning points.
However, in practice, sticking blindly to this logic will cause you to blow up your account in no time. Why? Because markets can carry on being overbought or oversold for ages. RSI levels can surge beyond 70 in the case of a euphoric bull market that breaks its all-time highs.
Similarly, they can plunge below 30 and stay there for a long time, as many bear market veterans will tell you. If you’re relying exclusively on RSI to tell you when to sell the top or buy the bottom, you could be in for a bad time.
The bitcoin price chart at the daily timeframe. In figures 2, 3 and 4 below we’ll zoom in to the hourly timeframe and examine the above buy and sell signals in more detail
Look out for divergences
A good way to still use RSI but not be a slave to the numbers it generates is to look out for divergences between what the RSI indicator is telling you and what the price action is saying. This is a much more reliable way to trade market tops and bottoms without losing your shirt.
In the image above we have identified three tops (selling opportunities) and two bottoms (buying opportunities) at the daily timeframe of the bitcoin price chart. In the following examples, we’re going to zoom in on these opportunities at the hourly timeframe and learn about how divergences can help us identify possible market tops and bottoms.
The reason we’ve chosen bitcoin is that it’s a market where everything occurs in a more condensed period of time, with more pronounced market tops and bottoms. This is partly due to the fact that it trades 24 hours per day, 7 days a week, but also because it’s a much more volatile and fast-moving market.
Of course, to a certain extent, this means that we’re sort of cherry-picking our data here, but this is only for the sake of illustration. RSI divergences are a legitimate trading strategy that can be applied to any and all markets.
Bitcoin’s price chart zoomed in to the hourly timeframe to show the first sell and buy signals highlighted in Figure 1 above.
Notice how the RSI actually tops-out before the price does. If you were trading the above chart using RSI on its own, you would have received a sell signal way in advance of the price topping-out. If you had taken a position when RSI first hit 70, or even when it rose above 80 (the first black arrow) not only would you have gone in too early and missed the top, but if trading on margin you would have been in trouble as the price continued to rise.
However, using RSI divergence as your strategy, the first sell signal actually comes not when RSI breaches 70, but when the price sets a new high and the RSI fails to do so, setting a lower-high instead (the second black arrow). This is a sign that the strength of the price move is starting to lose steam and it’s an indication that a reversal could be imminent.
The same is true of the first buy signal. As you can see above (the third black arrow), the RSI bottoms-out first, it looks like the price is going back up, but then there’s a sharp move down to $9600, a new lower-low while the RSI sets a higher-low at around 40. This signals that the bears could be running out of steam and indicates that a new move up may be in store.
The two signals above, read in this way would have indicated a sell the top and buy the bottom scenario. Of course, hindsight is always 20/20, but let’s move on to the next two signals and see if this RSI divergence methodology held true.
Bitcoin’s price chart zoomed in to the hourly timeframe to show the second sell and buy signals highlighted in Figure 1 above.
Once again, you can see the RSI becoming very overheated before the price tops-out (the first black arrow). If you were employing this strategy, you would have refrained from taking a position until the next move higher and then waited for confirmation from the RSI setting a lower-high while the price was setting a higher-high (the second black arrow).
The same is true of the buy signal (third and fourth black arrows). Although in this case, as you can see above, the divergence is nowhere near as pronounced as in the previous examples. As we saw in Figure 1, the chart shows bitcoin in an ever-tightening range. In such cases, the power of each subsequent move becomes progressively smaller.
When this happens divergences also become less pronounced, so you can only really use this strategy a few times in a tightening range before the signals start becoming less clear.
In any case, as you can see above, the price dips, RSI becomes oversold, then the price dips even lower but the RSI fails to drop lower than on the first dip.
Bitcoin’s price chart zoomed in to the hourly timeframe to show the final sell signal highlighted in Figure 1 above.
Finally, we come to our last sell signal example. Following a pronounced move up, RSI tops-out as the price trades around $11800 (the first black arrow). After a brief period of consolidation, the market rallies onwards to $12,200 but the RSI shows signs of momentum cooling off, again setting a lower-high to the price’s higher-high (the second black arrow).
We’ve seen this pattern repeated for three market tops and two bottoms in a three-month period, demonstrating that RSI divergences do hold true. They may not be a crystal ball, however, they do work enough of the time in order to make a useful addition to your existing RSI strategy.
You don’t have to capture both sides of the price move
My first trading mentor gave me a very valuable piece of advice that still informs how I look at markets today. He was adamant that trying to catch both market tops and bottoms doubles your risk and your chances of failure. According to him, the long and short sides of the trading game are completely different styles of trading that require a different combination of skills and mindset.
His advice was to pick the side that you’re temperamentally best suited to and focus on that. In other words, if you’re a long trader, focus on picking bottoms and leave the market tops to the short-sellers. Similarly, if you’re a short trader, focus on picking tops and leave the oversold conditions to the bottom-fishers.
There are key psychological differences between the long trade and short trade games and it pays to be mindful of this fact.
It’s a very simple, sound and indeed obvious piece of advice that so often gets overlooked. That’s not to say that it’s impossible to trade both sides, as many traders do. But the point is that trading is a game of probabilities, where your main priority should be to focus on maximizing your edge and minimizing all the things that end up costing you money.
It’s a long game, no-one catches all the market tops and bottoms. Narrow in on what you do best, focus in on that and be selective with the trade setups that you choose to play.
Disclaimer: This article is not investment advice or an investment recommendation and should not be considered as such. The information above is not an invitation to trade and it does not guarantee or predict future performance. The investor is solely responsible for the risk of their decisions. The analysis and commentary presented do not include any consideration of your personal investment objectives, financial circumstances or needs.
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method / indicator to spot tops and bottoms
Updated July 14th 2020 by teamtc247
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7 Popular Technical Indicators and How to Use Them to Increase Your Trading Profits
Ever wondered how to use technical indicators in trading? Well wonder no more, this article introduces 7 popular indicators, and the strategies you can use to profit from their signals.
Technical trading involves reviewing charts and making decisions based on patterns and indicators.
These patterns are particular shapes that candlesticks form on a chart, and can give you information about where the price is likely to go next.
Indicators are additions or overlays on the chart that provide extra information through mathematical calculations on price and volume. They also tell you where the price is likely to go next.
There are 4 major types of indicator:
Trend indicators tell you which direction the market is moving in, if there is a trend at all. They’re sometimes called oscillators, because they tend to move between high and low values like a wave. Trend indicators we’ll discuss include Parabolic SAR, parts of the Ichimoku Kinko Hyo, and Moving Average Convergence Divergence (MACD).
Momentum indicators tell you how strong the trend is and can also tell you if a reversal is going to occur. They can be useful for picking out price tops and bottoms. Momentum indicators include Relative Strength Index (RSI), Stochastic, Average Directional Index (ADX), and Ichimoku Kinko Hyo.
Volume indicators tell you how volume is changing over time, how many units of bitcoin are being bought and sold over time. This is useful because when the price changes, the volume gives an indication of how strong the move is. Bullish moves on high volume are more likely to be maintained than those on low volume.
We won’t cover volume indicators here, but this class includes On-Balance Volume, Chaikin Money Flow, and Klinger Volume Oscillator.
Volatility indicators tell you how much the price is changing in a given period. Volatility is a very important part of the market, and without it there’s no way to make money! The price has to move for you to make a profit, right?
The higher the volatility is, the faster a price is changing. It tells you nothing about direction, just the range of prices.
Low volatility indicates small price moves, high volatility indicates big price moves. High volatility also suggests that there are price inefficiencies in the market, and traders spell “inefficiency”, P-R-O-F-I-T. We’ll cover 1 volatility indicator today, Bollinger Bands.
So why are indicators so important? Well, they give you an idea of where the price might go next in a given market. At the end of the day, this is what we want to know as traders. Where is the price going to go? So we can position ourselves to take advantage of the move and make money!
As a trader, it’s your job to understand where the market might go, and be prepared for any eventuality. You don’t need to know exactly where the market is going to go, but understand the different possibilities, and be positioned for whichever one materializes.
Remember, traders make money in bull AND bear markets. We take advantage of long AND short positions. Don’t get too attached to the direction of the market, as long as the price is moving you can profit. Indicators will help you to do this.
Without further ado, here are the stars of the show.
1) Bollinger Bands
Bollinger bands are a volatility indicator. They consist of a simple moving average, and 2 lines plotted at 2 standard deviations on either side of the central moving average line. The outer lines make up the band.
Simply, when the band is narrow the market is quiet. When the band is wide the market is loud.
You can use Bollinger Bands to trade in both ranging and trending markets.
In a ranging market, look out for the Bollinger Bounce. The price tends to bounce from one side of the band to the other, always returning to the moving average. You can think of this like regression to the mean. The price naturally returns to the average as time passes.
In this situation, the bands act as dynamic support and resistance levels. If the price hits the top of the band, then place a sell order with a stop loss just above the band to protect against a break out. The price should revert back down towards the average, and maybe even to the bottom band, where you could take profits. Check out the screenshot below.
When the market is trending, you can use the Bollinger Squeeze to time your trade entry and catch breakouts early on. When the bands get closer together (i.e. they squeeze), it indicates that a breakout is about to happen. It doesn’t tell you anything about direction so be prepared for the price to go either way.
If the candles breakout below the bottom band, the move will generally continue in a downtrend.
If the candles breakout above the top band, the move will generally continue in an uptrend. Take a look at the screenshot below.
In summary, look out for the Bollinger Bounce in ranging markets, the price will tend to return to the mean. In trending markets, use the Bollinger Squeeze. It doesn’t tell you which way the price is going to go, just that it’s going to go.
2) Ichimoku Kinko Hyo (AKA Ichimoku Cloud)
Ichimoku Kinko Hyo (AKA Ichimoku Cloud) is a collection of lines plotted on the chart. It’s an indicator that measures future price momentum, and determines areas of future support and resistance. At first glance this looks like a very complex indicator, so here’s a breakdown of what the different lines mean:
So how can you translate these lines into trading profits? I’m glad you asked.
The Senkou span acts as dynamic support and resistance levels. If the price is above the Senkou span, the top line acts as first support, and the bottom line as second support.
If the prices below the Senkou span, the bottom line acts as the first resistance, and the top line as the second resistance. Simple as that!
The Kijun Sen (blue line) can be used to confirm trends. If the price breakouts above the Kijun Sen, it’s likely to rise further. Conversely, if the price drops below this line, then it’s likely it’ll go lower.
The Tenkan Sen (red line) can also be used to confirm trends. If the line is moving up or down, it indicates the market is trending. And if it’s moving sideways, then the market is ranging.
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