Chapter 5. Chart Analysis
In this chapter, we will look more closely at the various uses of chart analysis that we have briefly discussed earlier.
When trading binary options, it is important to know what the support and resistance levels of an asset are. These two (2) levels give an indication of the extent of an asset’s price fluctuations. Basically support and resistance levels show the minimum and maximum price level that an asset is suppose to reach respectively. As seen in the diagram above, they are depicted by two (2) horizontal parallel lines. The support level is the lower line while the resistance level is upper line.
The support level is named as such because the asset’s price is presumed to have difficulty in breaching below this line. In other words, prices are “supported” by this level. On the contrary, the resistance level indicates the price level in which an asset’s price will have difficulty in breaking through. In other words, price movements upwards are met with “resistance” at this upper level. These levels are the based on the highest and lowest price that an asset had reached within a certain timeframe. They are considered the “psychological thresholds” that the market must overcome in order for a change in the trend to occur noticeably.
Using Support and Resistance Levels for Trading Binary Options
Analyzing the Support Level
As prices decline toward the support line, one of two things is expected to occur:
- There is an expected rally of prices
- The downward trend is reinforced
If the asset’s price did not breach the support level, this mean the market is optimistic and traders naturally expect the price of the asset to ascend upwards. However if the prices breached the support level, this mean the market feels pessimistic and consequently prices will continue to drop even further.
Analyzing the Resistance Level
If prices are approaching the resistance level, traders can expect one of the following:
- A reinforcement of the upswing in prices
- A fall in prices
If the upswing in prices managed to breach the resistance level, the market will feel optimistic and hence tend to invest more causing a further rally in prices. On the other hand, if prices failed to breach the resistance level, the market will not expect a change in the trend anytime soon and thus express a lack in interest in the asset resulting in prices falling.
In other words, you should try and trade in the following manners:
- For a Support Level breach, go for “Low Options”
- For a holding in the Support Level, go for “High Options”
- In the case of a Resistance Level breakthrough, you should invest in “High Options”
- If the Resistance Level is holding, go for “Low Options”
First introduced by the Japanese in the late 17th century for trading rice futures, the Candlesticks methodology was introduced to the western financial world primarily due to the effort of a financial expert by the name of Steve Nison in his 1991 book titled “Japanese Candlestick Charting Techniques”.
Apart from being a graphic display of prices, Candlesticks charts also provide the following information about an asset:
- The opening and closing prices
- The highs and lows
- Whether the asset closed above or below its opening price
As you can see from the diagram above, candlesticks comprises of:
- A rectangular vertical body
- A wick at both ends of the body
How to Read the Candlestick
- Body’s Top (Red/Black Color)
Indicate the opening price of the asset. If the body is white or blue in color, the top indicate the closing price of the asset.
- Body’s Bottom (Red/Black Color)
Indicate the closing price that the asset. If the body is white or blue, the bottom shows the opening price of the asset.
- Upper Shadow (The length of the top “Wick)
Indicate the highs of the asset price.
- Lower Shadow (The length of the bottom “Wick)
Indicate the lows of the asset price.
- Red/Black Body Color
Asset closed lower than its opening price.
- White/Blue Body Color
Asset closed higher than its opening price.
How to Analyze Candlesticks Charts
Long Vs Short Body
Normally, a long body indicate strong buying or selling pressure. A short body on the other hand indicate a lack of price fluctuations signify market consolidation.
- Long White Candlesticks
Indicate strong buying pressure and a bullish market with aggressive buyers.
- Long Black Candlesticks
Indicate strong selling pressure. Here, the sellers are the aggressive party.
Long Vs Short Shadows
Generally, long shadows shows that the market is active well beyond the opening and closing prices. On the contrary, short shadows represent confined trading actions near the opening and closing prices.
- Long Upper Shadow & Short Lower Shadow
This indicates that the market was dominated by buyers. Prices were bid higher as a result. Because prices were later forced downward by strong selling pressure, the market closed weak with a long upper shadow.
- Short Upper Shadow & Long Lower Shadow
Here the market was dominated by sellers resulting in lower prices. The long lower shadow was the result of buying pressure bouncing prices back to resulting in a strong closing.
Candlesticks are also categorized according to the patterns they form on the charts. Some of the main patterns that you will come across during your trading tenure will most likely include the following below:
- Doji Pattern
- Engulfing Candles
- Evening/Morning Stars
- Hammer/Hanging Man Pattern
- Marubozu Pattern
- Shooting Star/Inverted Hammer
- Spinning Tops
- Three Inside Up and Down
- Three White Soldiers/Black Crows
- Tweezer Bottoms and Tops
Each of the above listed patterns requires a different trading strategy to deal with the market situation. As informative as candlestick can be, it is crucial to remember that they do not provide all the required information that a trader need to formulate his trading strategy with.
The Fibonacci sequence is a peculiar series of numbers that conform to a “golden ratio” that is occurring naturally in the fundamental building blocks of matter. The ratio 1.618 is said to be integral in maintaining balance in nature. Experts have also observed that the movements of prices in the financial markets seem to behave in accordance to this golden ratio. With percentages calculated according to the golden ratio, it is possible to track price movements with the use of:
- Fibonacci Arcs
- Fibonacci Fans
- Fibonacci Retracements
- Fibonacci Time Zones
Moving Averages, specifically MACD, are indicators used for measuring the market trends and their strength essentially what is ideal for trading binary options. The binary option market is a fast moving market. As such, it not uncommon to see many trades being made in the course of one trading day. Because of this, traders tend to stick to trend trading. The key point about MACD is that it can help traders forecast with a fair degree of certainty as to when a trend is on its last legs. When a trend is ending, you will want to switch from trading short term binary options to other types of assets. This is because you cannot be sure if the trend will actually turn or consolidate. Therefore, always watch the MACD indicator closely when you are trading trends.
These two (2) bands normally used to measure the volatility of the market. They can actually be regarded as support and resistance levels on a smaller scale.
- The Bollinger Bounce
This is an assumption that prices always tend to “bounce” back to the center of the Bollinger bands. Hence, buy for “High Options” when the underlying asset price touches the lower band. Go for “Low Options” when prices hit the upper band.
- The Bollinger Squeeze
The Bollinger Squeeze assumes that when the bands are “squeezing”, it is only a matter of time for prices to “breakout” of the squeeze. When a breakout is occurring, you want to be entering a trade on the side of the breakout and not opposite it.
The Parabolic Stop and Reversal (SAR) indicator is used to identify trend reversals and is depicted as a dotted line on the charts. It is one of the easiest indicators to read as it only indicates Bullish or Bearish signals. If the dotted line is above the candlesticks, this indicates a sell signal. Conversely, if the dotted line is below the candlesticks, this indicates a buy signal.
The Stochastic Oscillator is an indicator used for identifying whether a market is overbought or oversold. When the market is overbought, you are looking to sell. For oversold market conditions, you should be looking at buying. Traditionally, the setting for indicating an overbought situation is when the moving average lines are above the setting of 80. Moving averages which move below the setting of 20 signify that the market is oversold.
Relative Strength Index (RSI)
Like the Stochastic Oscillator, the RSI is used for identifying overbought or oversold market conditions. The normal readings used indicating an overbought market condition is above 70. Readings below 30 indicate an oversold market condition. The RSI is also used by some traders to confirm whether a trend is forming or not (wait until the reading reaches above 50 for uptrend and below 50 for downtrend).
Average Directional Index (ADX)
The Average Directional Index indicator is used for determining how strong or weak a market trend is. The indicator operates on a scale from 0 to 100. If the reading is below 20, this mean the trend is weak. Readings that are above 30 indicate that the trend is strong. Once readings have reached 50, this indicates that the trend is starting to end.