For example, if you are a short-term trader, it is not useful to look

for overbought and oversold signals on a weekly chart.

To match my time horizon, I look at a simple but effective
overbought and oversold measure: How far away is spot from the
100-hour moving average? I call this ��deviation from the 100-hour��
or just the Deviation and use it as a nice back-of-the-envelope
overshoot warning system.
When trading overbought and oversold you must understand that
you are, by definition, going against a strong trend. Things that are
overbought can get more overbought. Things that are oversold can
get more oversold. So no matter how crazy the move is so far, things
can always get crazier.
As a matter of fact, if things rip way outside of the normal range
you are used to for overbought and oversold, the first thing you
should ask yourself before reflexively wanting to go the other way
is: Why? Sometimes there is a clear reason for the extreme trending
behavior and that reason is perfectly valid and should not be
ignored. You generally want to fade overbought and oversold markets
when there is no strong fundamental reason for the move. Let�s
look at an example of this using the Deviation as a tool:
USDCAD is a currency pair known for mean reversion. Therefore,
it is well-suited to strategies that hunt for conditions of overbought
and oversold.When trading USDCAD, I constantly monitor how far
it is trading from the 100-hour MA. Take a look at Figure 7.5.
The black bars show USDCAD hourly, the line on the main chart
is the 100-hour MA, and the line underneath the main chart shows
the difference between the two. The farther spot moves away from
the 100-hour, the more stretched it is, like a rubber band. The elastic
is eventually more likely to snap back than it is to keep stretching.
You can see in this example that the line below the chart oscillates
roughly between �100 pips and +100 pips. The extreme points will
depend on overall volatility but I have generally found over the years
that anything more than 1% away from the 100-hour means USDCAD
is overdone. So with USDCAD at 1.10 that means 110 pips.
You can see in the chart that USDCAD generally runs out of steam
whenever the deviation touches 100/110 pips on either side.
As with any technical indicator, I will never use the deviation on
its own to initiate a trade. However, if I am already looking to get
into a short USDCAD trade, I will be on high alert for moments
when spot gets more than 100 pips above the 100-hour MA, or I will
leave a resting order 100 pips above the 100-hour when I�m out of
the office.2
2The 100-hour moves, obviously, so you need to recalibrate your order at times
to keep it accurate. I don�t change it every hour. That is not necessary because
the
MA does not move all that fast�once or twice a day is fine.
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164
Figure 7.5 Hourly USDCAD with 100-hour MA and deviation from the 100-hour moving
average, July 31, 2014 to October 30, 2014.
UNDERSTAND TECHNICAL ANALYSIS II (THE SEVEN DEADLY SETUPS)
165
The chart shows a great example where USDCAD spiked to
1.1400 and took the deviation up to 140 pips before crashing back
down to 1.1220 just a few hours later. Understand that when you
trade the deviation, you are going against the prevailing short-term
trend and so you need to be careful and disciplined. I usually set
my position when the deviation touches 1% and then put my stop
loss another 0.7% away to give it plenty of extra room to further
overshoot.
While my experience is that the deviation tends to close as spot
reverts to the mean, there are also instances where the deviation
closes as spot goes nowhere and the moving average catches up over
time. This relieves the overbought or oversold condition without
generating a profitable trade. Note that the deviation is also a good
indicator for take profits on winning trades. If you are long USDCAD
and it rallies more than 100 points away from the 100-hour
MA, sell some out and buy it back lower.
The deviation from a moving average can be useful on any time
frame. A chart that shows how far spot is trading from the 100-day
or 200-day moving average, for example, would give a useful reading
of bigger picture overbought or oversold conditions. Just make
sure you know your time horizon.
� 4. Volume Spike at a Price Extreme
Not many traders use volume when analyzing FX markets. This is
because most FX trading takes place in the interbank or over-thecounter
(OTC) market where volume data are not always readily
available. FX volume data can be found, however, using futures markets
or other sources. While I have always traded in the interbank
market, I find futures volumes are an acceptable proxy for overall
volume. This is because actual volume is not important; what matters
is relative volume.
Some questions I ask when looking at volume: Are volumes high
today? Is volume in the latest hour much higher than usual? How
does volume in the past 10 minutes compare with volume in other
10-minute periods? Are we seeing a big price move on extreme
volume?
There is a large body of theory about how volume and price interact
in financial markets and I encourage you to study it and come
up with your own strategies on how to combine price and volume
in FX. This is a potential source of edge for you because most FX
practitioners barely factor in volume.
My favorite volume plus price setup is when you get a large volume
spike at a price extreme. This is indicative of capitulation as
UNDERSTAND TECHNICAL ANALYSIS II (THE SEVEN DEADLY SETUPS)
166
the market transacts high volumes in a short span. Many positions
are transferred very quickly, usually moving risk from weak hands
to strong hands.
The next chart is an excellent example. On October 15, 2014,
the market was hit by some bad news about Ebola and a weak US
Retail Sales report. The market was wearing a large structural short
position in fixed income (i.e., themarketwas short bonds, positioned
for higher rates) and there was a massive unwind in the fixed income
markets. USDJPY tends to be correlated with US interest rates so
when US yields started collapsing,3 USDJPY started to fall.
As the fall gained momentum, volume started to pick up and the
move climaxed with a complete crapout on massive volume. You
can see the low in price (black bars) coincides with the volume spike
(bars below). As volume fell off, USDJPY regained its footing and
slowly rallied back.
The way I trade these volume spikes is to stay out of the way
until the dust settles. Figure 7.6 shows 30-minute USDJPY bars in
black and volume as bars below. When I see a huge volume spike
like the one in this chart, I wait until I see two or three bars (60 to
90 minutes) of falling volume. After, say, 90 minutes, you can see
that things are settling down so you go long with a stop below
the lows.
In this case you go long at 105.70 with a stop at 105.14 looking for
a rally back toward the top of the waterfall move (107.40). As I have
stated and restated, I would never buy USDJPY just because there
was a volume/price spike�I always want to have other reasons for
the trade besides a lone technical signal. That said, the volume/price
spike is one of the most powerful signals out there and can lead to
some spectacular trades.
� 5. Broken Triangles
Triangles tend to attract attention because they are visually compelling