Humor me for a moment and consider this riddle: What is the difference
between a great bass guitarist and a great bass guitarist? It’s an impossible
riddle, right? Although both bass guitarists can play and entertain a crowd,
only one truly understands how music works. The other has simply memorized
notes and mastered a tempo. Without understanding how music is
constructed through scales, chords, and timing, a musician has no idea why
the notes he is playing sound good with other instruments. The same is true
with currency traders who blindly follow technical indicators or oscillators.
Technical indicators might appear to predict the next move price will
make, but in reality they have no influence on price whatsoever. Indicators
are helpful guides, but they are no substitute for learning how to read price
action. Traders who rely on indicators to make all their trading decisions
are playing an instrument without understanding why it sounds good.
Price action is defined by the movement of price on your chart. As
the market moves higher or lower, your chart will depict areas where the
market was unable to continue due to increased demand from buyers or
an oversupply of sellers. You’ll learn how to identify supply and demand
boundaries, known as support and resistance, in Chapter 3. Learning to
read price action is the most important skill a trader can develop, because
it places the trader’s point of view in synch with the supply and demand
forces that drive the market. If you can read a chart without the aid of indicators,
you’ll have an advantage over relying heavily on them. Indicators
and oscillators such as moving averages, Bollinger bands, or stochastics
calculate their indications on past market data. They do not consider supply
and demand and have no influence on what happens to price next.
Using support and resistance, a bargain hunter should identify opportunities
to join price action at a bargain price. Your goal is to enter an existing
trend when the market is offering a very good price, what I call abargain day. Learning to read price action will make it easier to find the
lowest-risk, highest-probability trades when they are offered. When prices
are moving higher in the context of a downtrend, bargain hunters should
be looking for an opportunity to sell. When prices are moving lower in the
context of an uptrend, bargain hunters should be looking to buy. It really is
that simple. Reading price correctly does take some practice, which is why
the methods in this book use some simple indicators to guide you along the
way. They are there to help, but they are no substitute for learning to read
price action.
Indicators Offer a False Sense of Security
I’m picking on indicators a bit here because I want you to forget about
everything you’ve learned from traditional trading books, most of which
promote the use of indicators. Indicators and oscillators are often taught
as if they have predictive powers, and can tell when a market is overbought
or oversold suggesting that is the price where a market will turn. This is
total bunk. Every indicator simply represents a mathematical calculation
on market data that happened in the past. There is no regard for supply
and demand in the calculation of most indicators. Furthermore, indicators
that use volume aren’t helpful in the currency market because there is no
central exchange to provide volume data.
Figure 2.1 demonstrates how an indicator can claim a market is
oversold only to have the market fall further. There is no such thing as
an “oversold” or “overbought” market. The currency market can and will
move until a support or resistance level is reached. Without accounting for
support and resistance, any trading system built on indicators is missing
the point of why price moves to begin with. I believe relying on indicators
to make every trade decision is a crutch that ultimately will hinder your
ability to grow as a trader.
Figure 2.1 illustrates how indicators have no influence on price. In this
example, the GBP/USD continued to fall after the Commodity Channel Index
(CCI) gave an indication that the market was oversold. In fact, the market
didn’t reverse until a demand level was reached, marked by the parallel
lines and the circle.
I’m not suggesting that indicators are the root of all evil, but I am telling
you that price doesn’t move because two moving averages have crossed or
because the CCI leaves oversold territory. There is no such thing as an
oversold or overbought market, as Figure 2.1 clearly demonstrates. Some
people have suggested that indicators help move the market because so
many traders follow them. I believe that notion is complete nonsense. If
you give me 1,000 traders, I’ll show you 1,000 different ways to use the
exact same indicator.
Indicators are like a tape measure used by a carpenter. The measure
guides a carpenter to the right cut, but ultimately it is up to the carpenter’s
skill to cut the wood correctly. Bargain hunters can use indicators to
identify potential support and resistance opportunities, but ultimately it is
up to the trader to make the right trade. In Chapters 6 through 8 we will
look at using indicators to hunt for bargains. Combining indicators with
what you’ll learn about reading price is a solid methodology to find trading
opportunities. Be careful not to let indicators become your core decisionmaking
tool; it is important to learn how to read price action without the
aid of indicators.
Is the Trend Really Your Friend?
Traders talk a lot about trends. Every trading book discusses the virtues
of identifying and trading with the trend. You have probably heard the old
trading adage, “The trend is your friend; trade with the trend until it bends”
a million times, but what is a trend, and is it really your friend? Identifying
trends is an extremely subjective process open to many different interpretations.
One trader’s uptrend may be another trader’s downtrend. Figure
2.2 illustrates this subjective nature of trend analysis. One trader may
believe the EUR/USD is about to continue in a downtrend while another
believes it has established a new uptrend. The advice to identify and stick
with a single trend until it “bends” sounds good but is rather shortsighted.
Within any trend, there are several countertrend moves that occur as
the forces of supply and demand ebb and flow during the course of the major
trend. For example, during an uptrend, eventually the number of buyers
will dry up, allowing sellers to take over for a short period of time until the
buyers emerge again. These cycles happen over and over again and offer
traders who are keen on following price rather than trend an opportunity
to profit, regardless of the predominant trend direction. After all, wouldn’t
it be acceptable to sell during a downtrend within the context of an uptrend?
A trend is a trend, right? Bargain hunting traders should be aware
of major trends, but they shouldn’t allow traditional trend analysis to get
in the way of a good trade. Following price is far more nimble than waiting
for the market to favor a prevailing trend before trading. Figure 2.3 illustrates
how a trader following price action could have taken advantage of
various price action opportunities within the context of a USD/CHF downtrend.
The USD/CHF could have been sold in three areas along resistance
and bought along support as the currency moved sideways
A lot of material in the field is dedicated to discussing whether trading
with the trend is safer than trading against it. Since trend analysis is very
subjective, I believe the argument is a moot point. Understanding the prevailing
trend is useful to determine a general trading bias, but that shouldn’t
stop you from taking a countertrend trade when the opportunity is right. In
Figure 2.3, clearly the bias was to sell USD/CHF in synch with the prevailing
downtrend, but an opportunity to buy the pair emerged as support built in
near $1.06. This is why the second principle of a bargain hunter is to learn
how to read price action. Traders who follow price looking for a good deal
rather than following a trend will be nimbler and able to profit, even when
conditions begin to change against the prevailing trend.
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