FX TECHNICAL ANALYSIS
at the Slow Stochastic in particular. The calculation looks at the relationship between the close and its vicinity to the high and low. In any trend, by default closes will tend to err towards the high or low depending on what the trend is. Therefore once the indicator gets into its overbought or oversold zone, it often takes just one or two bars of price movement in the opposite direction to make the indicator cross over. This is highlighted in the recent Eurodollar fall as shown in Figure 1. Note how a two day correction makes the indicator cross up before the market slumps once more and then on the next subsequent up bar, the indicator posts divergence. This divergence then continues on 4 more occasions in quick succession before finally the market does post some modest gains. This highlights how a trader can feel that the market remains irrational longer than they can remain solvent. The RSI presents a somewhat different dilemma as typically there is no crossover feature meaning the trader is simply left with 3 alternatives. Track divergence, track any move out of the extreme, or simply a change of direction when in that extreme.
Figure 2
Again looking at the Eurodollar in Figure 2 none of these scenarios would have been satisfactory as price moves out of the extreme and changes direction on the same bar just before the downtrend resumes, and then in a similar vein to the Stochastic, posts multiple divergences that eventually come good. In fact on the day new lows are posted for the trend, the Rsi is very close to 50 in value. In my testing experience the lesser of the evils is to reference a simple change in direction when the indicator has been beyond 85 or 15.
Figure 1 8 FX TRADER MAGAZINE July - September 2010
So what are other solutions? One obvious alternative is place a non linear calculation on non linear data. The preferred method of choice for many traders is the Macd. Whilst this is an improvement on the others there are still problems associated with how extremes are qualified. Normally it is necessary to create a point of reference from previous trends and the extremes that they created. However, this is a somewhat haphazard approach and on historical data can provide relatively few sample sets. However, the concept of divergence normally produces a lower number of false signals, and if the trader is prepared to be patient and have higher risk, waiting for the
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