Part 12 Technical Analysis – Confirming price action reversals

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Part 12: Technical Analysis – Confirming price action reversals

In the previous episode we’ve talked about how to confirm a reversal from the important support or resistance lines using basic or advanced indicators. In case you haven’t read it, I should probably introduce you to the basics.

What is a reversal

In the world of binary options and trading as such, we consider a breakout when the price stops at the given line (for example a trend line or support and resistance lines) and after a bit, the price continues to move in the other direction than before. It’s important to state that these lines are never an exact value (i.e.: 1.20322), but it’s always a value around let’s say 10 pips each way. We’ve talked about similar things in our Part 8: Technical analysis show.

The breakouts can be divided into three basic types:

  • The breakout with the trend
  • The breakout against the trend
  • And the breakout with the stagnation trend, recommended to be traded with short-term options

3 basic types of bounces

How to recognize and confirm a breakout

Realizing that the breakout could happen is really easy. All you need to do is to draw, in a right way, the important price lines and at the moment the price comes close to approx. 10 pips it could turn whenever, in this case the breakouts could happen. That’s why I was talking about an imaginary circle before.

To do so in the right way, I mean to find out whether the bounce was real is not an easy thing. That’s why we need to learn to recognize the false breakouts, so we don’t have unnecessary loses and the sooner we do, the better. We can recognize the breakouts by two basic methods – using indicators or price action and using both methods together is the best.

False breakouts could go in the same direction, it means that if we assume the downward direction of the bounce then the price will really turn and red candles will start to form. The problem though starts, when the trader enters a trade and the candle changes its mind, starts to increase and never goes back down.

Price action method

Using price action makes the confirmation of the bounces as easy as a pie.

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  • Simple method using PIN BARs
    • If the price reaches the resistance line, we’ll wait until the next bar goes upwards, breaks the line and then starts to go back down. When a pin bar is formed and the next candle is bearish, we can talk about a confirmed reversal.

Simple pinbar preview

  • Easy method using so-called pullback (more on pullbacks in one of our future episodes)
    • The price breaks a given line (the figure shows a 61.8% Fibonacci line) and after couple of candles, comes back to the same line. Then, all you need is one candle going in the supposed turn and the confirmation is successful.

I think that these two methods should be enough for now, because these methods are the most used ones. I’m sure you’ll drop me a comment in the section below, if you have any questions. ��

Author

More about the author Step

I’ve wanted to build a business of some kind and earn money since I was in middle school. I wasn’t very successful though until my senior year in highschool, when I finally started to think about doing online business. Nowadays I profitably trade binary options full-time and thus gladly share my experiences with you. More posts by this author

Part 11: Technical Analysis – Confirming reversal using indicators

Now that you’ve come all the way to the part 11 of our technical analysis series, I assume that you’ve studied all the previous ones. If not, I recommend you to have a look – it’s all very important and every intraday trader should know about them.

We’ve already talked about support, resistance, trend line and fibonacci lines. That’s already a whole bunch of tools that you could use for trading, isn’t it? However, what you don’t know yet is that you’re still missing the most important thing – how to know whether the price will bounce off the line instead of breaking through it? In Part 8: Technical analysis show – The breakouts, we have talked about the complete opposite and that is how to confirm that the price has broken out.

There are 3 basic types of reversals:

  • The reversal with the trend where you can go along with it
  • The reversal against the trend that is recommended only for the advanced traders
  • The reversal with the stagnating trend that could be used with the short-term options

3 basic types of reversals

How to recognize and confirm a reversal

To realize that the reversal could happen is really easy. All you need to do is to draw in a right way the important price lines and the moment the price will come close to approx. 10 pips it could go right back whenever, in this case the reversal could happen.

To do so in the right way, to find out whether the reversal was real and not only a false alarm is not an easy thing. That’s why we need to learn to recognize the false reversals, so we don’t have unnecessary losses and the sooner we do, the better. We can recognize the reversals by two basic methods – using indicators or price action and using both methods together is the best.

Indicators method

The bounces can be seen very nicely using oscillators, such as stochastic oscillator or DSS Bressert, but also indicators such as ADX or by simply showing Volume.

  • Simple method using STOCHASTIC
  • the oscivator breaks 80 or 20 lines inwards

A simple use of stochastic oscillator

  • Simple method using VOLUME IN THE GRAPH

– Volume is decreasing – > we could assume a real reversal

A simple use of volume

  • Simple use of ADX Indicators
    • If the main ADX curve is coming towards the line 50 we could soon await a reversal against the trend (it’s usually a short term reversal before continuing in the previous direction)

A simple use of ADX indicator

Price action method

You’ll find out how to confirm reversals using price action soon, in one of the following technical analysis series (Here: Part 12: Technical Analysis – Confirming price action reversals) Are you looking forward to it? Show it to your friends and share this article on Facebook!

Author

More about the author Step

I’ve wanted to build a business of some kind and earn money since I was in middle school. I wasn’t very successful though until my senior year in highschool, when I finally started to think about doing online business. Nowadays I profitably trade binary options full-time and thus gladly share my experiences with you. More posts by this author

4 Responses to “Part 11: Technical Analysis – Confirming reversal using indicators”

This is really helpful thanks but i have a question.How can you avoid fake reversals? i find myself putting or calling a trade that looks like its going to reverse and then it keeps rallying in its original direction.how can I avoid this?

Hi Tanaka, I recommend not to trade before the reversal happens. The price should go back for at least 10 pips before opening a trade in reverse direction.

I enjoyed the article so much. Wouldd you happen to mentor people?

Dear Mamidza, yes, if I have time, I gladly respond to any questions either in my mail or beneath every article �� Just ask away!

Technical Analysis (Part 12): Direct Price Analysis (DPA): Trending or Ranging?

In the last article, we looked at indicators on price. This week we try to answer one of the hardest questions in technical analysis. When is a market trending or ranging? Understanding what camp you are currently in will be crucial for your trading success. Many of the technical tools you will come across work better in the different periods of price action. We look in particular at one indicator; the Directional Movement Indicator (DMI), which tries to answer this question.

There are many ways to ascertain whether you think a market is trending or ranging. To start with you have to remember one very important statistic: Markets trend approximately only one third of the time

With this key bit of information locked away in the background of your analysis, you will get to appreciate that tools such as moving averages (a trend following approach) are going to be pretty useless two thirds of the time and it is therefore crucially important to recognise if the market is trending or ranging!

The most simple approach is by very quickly visually analysing your charts – often it is very obvious if a market is moving up, down or sideways. After building up experience, this approach can be very effective. But, being analysts we want to quantify our subjectivity somehow. A lot of this objective quantification will come down to a rules based filtering system of analysis.

Rules based filtering analysis

You could use higher charting time frames to confirm whether the price is trending or ranging. If for example you are trading in the 30 minute charts, use the 4hr and 1 day charts to confirm the trend direction. If the trend / range is obvious in the higher time periods use that analysis in your trading window.

You can use other charting methods to determine the trend – for example, the Japanese charts: Kagi, Renko and 3 Line are all very helpful in determining if an asset is trending or ranging. Ichimoku as well – if the price is below the cloud price is bearish, above bullish and in the cloud neutral.

Posts Tagged: price action

Part 12: Technical Analysis – Confirming price action reversals

In the previous episode we’ve talked about how to confirm a reversal from the important support or resistance lines using basic or advanced indicators. In case you haven’t read it,…

Part 11: Technical Analysis – Confirming reversal using indicators

Now that you’ve come all the way to the part 11 of our technical analysis series, I assume that you’ve studied all the previous ones. If not, I recommend you…

Technical Analysis (Part 12) – Direct Price Analysis (DPA): Trending or Ranging?

In the last article, we looked at indicators on price. This week we try to answer one of the hardest questions in technical analysis. When is a market trending or ranging? Understanding what camp you are currently in will be crucial for your trading success. Many of the technical tools you will come across work better in the different periods of price action. We look in particular at one indicator; the Directional Moving Indicator (DMI), which tries to answer this question.

There are many ways to ascertain whether you think a market is trending or ranging. To start with you have to remember one very important statistic:

Markets trend approximately only one third of the time

With this key bit of information locked away in the background of your analysis, you will get to appreciate that tools such as moving averages (a trend following approach) are going to be pretty useless two thirds of the time and it is therefore crucially important to recognise if the market is trending or ranging!

The most simple approach is by very quickly visually analysing your charts – often it is very obvious if a market is moving up, down or sideways. After building up experience, this approach can be very effective. But, being analysts we want to quantify our subjectivity somehow. A lot of this objective quantification will come down to a rules based filtering system of analysis.

Rules based filtering analysis:

You could use higher charting time frames to confirm whether the price is trending or ranging. If for example you are trading in the 30 minute charts, use the 4hr and 1 day charts to confirm the trend direction. If the trend / range is obvious in the higher time periods use that analysis in your trading window.

You can use other charting methods to determine the trend – for example, the Japanese charts: Kagi, Renko and 3 Line are all very helpful in determining if an asset is trending or ranging. Ichimoku as well – if the price is below the cloud price is bearish, above bullish and in the cloud neutral.

Moving Averages can also be used e.g. if the 20 moving average is above the 50 moving average is above the 200 moving average then this can determine a bullish trending environment. The angle of the trend in the average can also be important. Flat moving averages, or averages crossing each other in a tight group can indicate a ranging market.

Indicators:

The Parabolic SAR is a very useful indicator in a trending market but can catch you out when things go sideways.

Example: Parabolic SAR on the Nikkei 225 Index (Charts: TradingView) The system is denoted by the crosses above or below the price – above = bearish, below = bullish:

Trending or Ranging? Hard to tell in some instances.

Directional Movement Indicator:

For me, there is only one indicator that stands out in the mainstream which very quickly gives you an impression as to whether a market is trending or ranging and that is the Directional Movement Indicator (DMI). This indicator was created in the ’70’s by one of the great technical analysts, J.Welles Wilder Jr. He set out to try to measure the directional movement in a mathematical equation of any commodity or stock and to scale it between upper and lower bands.

Example: Vodafone PLC (VOD:LN) (Charts: Stockopedia) incorporating the full DMI system:

Constructing the DMI:

Wilder used a default of 14-days in his calculations. 14 is not a number set in stone but is most commonly used. Today’s charting software allows you to change these inputs very easily – lengthening or shortening the inputs can slow down or speed up the signals the DMI will give.

Directional Movement is made up of three parts; Average Directional Index (ADX), +Directional Indicator (+DI), – Directional Indicator (-DI).

What do these three parts signify:

  • + Direction Indicator (+DI) = upward trend movement
  • – Direction Indicator (-DI) = downward trend movement
  • Average Directional Movement Index (ADX) = if the market is trending or ranging.

Method to calculate the DMI:

Uses an Average True Range (ATR) approach so factors in the volatility of the instrument.

1. Calculate : True Range (TR), +DM and -DM) for each period and smooth values.

2. 14-day smoothed +DM / 14-day smoothed TR = +DI14 * 100. (+DI14 = green line)

3. 14-day smoothed -DM / 14-day smoothed TR= -DI14 * 100. (-DI14 = red line)

Then need to calculate the ADX:

1. DX = absolute value of +DI14 minus – DI14 / sum of +DI14 and – DI14 *100.

2. ADX = 14-day average of DX, then smoothed.

Using the DMI:

The indicator is very simplistic in its application. The rules I am going to lay out here to get you started, are based on Wilders initial model. As the decades have rolled on, other technicians have adapted and tweaked the set up.

  • When the +DI crosses above the -DI a long position is taken
  • When the -DI crosses above the +DI a short position is taken
  • ADX >25 = trending
  • ADX 20 or less = ranging
  • On the day that +DI and -DI cross, the reverse point is the extreme price made that day.
    • If you are long: the reverse point is the low made on day of crossing
    • If you are short: the reverse point is the high made on day of crossing
  • When the ADX is > the -DI or +DI indicates a turning point
  • When ADX -DI = long, if -DI > +DI = short

Example: Nikkei 225 daily chart (Charts: TradingView):

Which indicators work better in trending or ranging markets?

Once you have finalised the tool or method you are going to use to determine whether a market is trending or ranging you need to be aware that certain technical tools work better in the different situations. From my own experience, I find moving averages, Parabolic SAR, MACD work better in a trending environment and stochastics work better in a ranging environment.

Further reading and learning:

If you are interested in learning more about trending or ranging indicators, then the following reading may help:

  • New Concepts in Technical trading Systems, J.Welles Wilder Jr, Hunter Publishing Company, 1978.
  • Technical Analysis of the Financial Markets, John J Murphy, New York Institute of Finance, 1985.
  • Technical Analysis, The Complete Resource for Financial Market Technicians, Charles D Kirkpatrick, FT Press, 2006.

Conclusion:

Factoring in to your trading and investing whether a market is trending or ranging will be imperative to your success. There is no point coming up with a great strategy that only works in a trending market and loses you your shirt if you continue to trade it through a ranging market. Why also enter a long or short position if the market is dead and flat? As we have seen, the DMI can quantify and simplify your analysis further. Hopefully this article has given you an insight as to why trying to answer the question of ‘is a market trending or ranging’ is important.

Next time: Technical Analysis (Part 13): Direct Price Analysis (DPA) – Fibonacci

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