In this section, you will get know technical analysis of Forex trading. We always give our best to provide you with the most accurate and updated knowledge of Forex trading and more materials will be added as the time goes. Please enjoy your learning.
Technical analysis is a mathematical analysis method for forecasting the direction of prices by analyzing statistics generated by market activity, such as past prices and volume. Technical analysis employs models and trading rules based on price and volume transformations. Technical analysts use charts and other tools to identify patterns that can suggest future activity instead of attempting to measure the intrinsic value of a security.
The difference between technical and fundamental analysis is that technical analysis analyses price, volume and other market information whereas fundamental analysis evaluates the actual facts of the market, currency or commodity. Most of the brokerage or financial institution will have both a technical analysis and fundamental analysis team.
There are 3 basic assumptions to follow in technical analysis:
- Everything should be considered at the market movement
Technical analysis only considers price movement and ignores the fundamental factors of the company. Market price reveals everything that could affect the company – including fundamental factors. It is believed that the company’s fundamentals, economic factors and market psychology, are all priced; eliminate the need to consider these factors separately.
- Price Moves in Trends
Price movements are believed to follow trends. After a trend has been established, the future price movement tends to be in the same direction as the trend than to be against it and it will usually continue for a period of time. Most technical trading strategies are based on this assumption.
- History Tends To Repeat Itself
History repeats itself in regular, fairly predictable patterns. These patterns, generated by price movement are called signals. A technical analyst’s objective is to find out the current market’s signals. Due to the repetitive nature of price movements, market participants tend to provide a consistent reaction to similar market stimuli over time.
Traders, usually for their short-term trading decisions, use Technical Analysis very often. This short-term trading may be further divided into day trading and short-term investment. A day trader is one who opens and closes off his/her position both on the same day. In the foreign exchange markets, the use of technical analysis may be more widespread than fundamental analysis. However, this does not mean technical analysis is more applicable to foreign markets.
Technical analysis is widely used by traders because of a simple reason – its works. By using technical analysis as the prime trading tools, there are thousands of traders who make profits in the markets over and over again. Technical analysis is not the “Holy Grail”, it is math and statistical based. It looks at the historic performance of currencies and uses modern technology to analyze the future behaviour of prices. Traders who use technical analysis input past price information into a computer program which then supplies a series of data on the patterns. These patterns are evaluated with real time price movements and forecasts are made. Thus, this is why technical analysis can be very accurate in predicting the future prices.
Besides, technical analysis is easy to follow compared to fundamental analysis due to its use of facts and statistic instead of data information that needed to be interpreted. Therefore, technical analysis is simpler to master than fundamental analysis which requires years of practice to learn.
The main strength of technical analysis is its flexibility. It is flexible and can be easily applied to any market, either spot or future, any currency as well as any timeframe. The same technical principles can be used to trade another currency when the currency traded currently has less movement.
Functions of Technical Indicator and Trading Plan:
- Focus and use the most common indicators that is used by most successful traders. Most of the common indicators that traders use are Fibonacci retracement, Moving Average, MACD, and RSI. Some of the technical indicators can identify excellent entry and exit points in the market. Some recognize a trend, while others determine the strength and sustainability of that trend over time. In addition, it is very important to choose the trading tools that are suitable to a person’s trading style and always sticking with them.
- Next, traders must develop their own trading plan which include risk management in order to control the risk and have an idea of total pips, profit that they are going to earn on the trade. Technical analysis works well together with trading plan for traders to be more discipline and minimize their emotion. Emotion is the number one killer in foreign exchange market. Once a trading plan is developed through technical analysis and charting skills, trader should then trade and follow the plan.
In technical analysis, the first thing is a chart. Charts are used because they are the easiest method to visualize historical data. In foreign exchange market, there are typically 3 types of chart; line chart, bar chart and candlestick chart. Among these, candlestick chart is the most favorite chart because it provides much more information with a single price structure compared to others and is easy to visualize.
- LINE CHART
It is the most basic type of chart. It is a single line plotted by connecting all the closing prices for selected period. Thus, it does not give much of other information except the closing prices.
- BAR CHART
Bar chart is an improved chart which provides more information likes open, close, high, and low price in a single bar. Each bar represents a period of time. Therefore, bar charts show distinct price patterns over time.
- CANDLESTICK CHART
Candlestick chart is similar to bar chart, providing the exact same information with the only difference being candlestick chart has a colorful body structure. Having the colorful body structure appearance, it looks like a candle. Hence, it is called candlestick chart. Candlestick chart is easier to visualize with its color graphic and thus, it become the most favorite chart to be used. Below are the views of the three charts; line, bar and candlestick (from left to right).
Sometimes, trend reversal can be spotted by identifying some basic chart patterns as well as line studies. Here are some of the easily seen chart patterns:
Support and Resistance
Support and resistance is one of the most widely used and effective concept in Forex trading. The resistance is the price levels whereby the selling pressure exceeds the buying pressure. Meanwhile, the support is the price levels whereby buying pressure exceeds the selling pressure. Every trader will have their own way of measuring their support and resistance level. These resistance and support level describe the current buying or selling power in the market. At resistance level, the buying power has been lessening and more power needed in order to breakout the level and the inverse will occur for support level. The more often the price had been tested with a level of resistance or support without breaking it, the stronger the area of resistance or support is. When a support or resistance level breaks, a large trend is taking place and held overtime depending on how strong the broken support or resistance had been holding. If the price failed to break through the strong support or resistance level, a trend reversal will happen soon. A strong resistance level will then turns into a strong support level if it is penetrated and vice versa.
- Double top and double bottom
Double top is a popular formation, appears as a shape of “M” on a technical analysis chart. A double top occurs when prices form two distinct peaks on a chart. Double top reflects a reversal pattern of an upward trend in price. In other words, it marks an uptrend is in the process of becoming a downtrend. Double bottom is the inverse of double top.
- Head and Shoulders and Inverse Head and Shoulders
The Head and Shoulders formation is one of the most reliable and well known of all the major reversal patterns. It is also one of the most popular formations that has been studied thousands of times by analysts. Head and Shoulders formation consists of a left shoulder, a head, and a right shoulder and a line drawn as the neckline. The drawn neckline of the pattern represents a support level, and assumption cannot be made that the Head and Shoulder formation is completed unless it is broken. In this chart pattern, the price rises to a peak and subsequently declines. Then, the price rises above the former peak and again declines. Finally, it rises again, but not to the second peak, and declines once more. The situation is opposite for inverse Head and Shoulders.
- Triangles (symmetrical, ascending, descending)
In chart patterns, there are three different types of triangles (symmetrical, ascending and descending). Triangles are formed by drawing two trend lines alongside the fluctuations of price and the two lines will intersect at a certain point. Then, the shape of triangle is formed. The triangles chart pattern is a very indicative method of placing an entry point for trade. The triangles can be a continuation or a reversal pattern depending on the direction in which the market price breaks out of the triangle. Once price breaks out, it is the right time to enter as it has much potency to go on in the direction it breaks.
Fibonacci Retracements Fibonacci Retracements are an integral of support and resistance. They are named after their use of the Fibonacci sequence. Fibonacci retracement is the potential retracement apportion of a price movement after which they will continue to move in the original direction. Fibonacci retracements are created by drawing a trend line connecting two Swing High and Swing Low points and then dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%. Then, several horizontal lines are formed to indicate areas of support or resistance at the key Fibonacci levels before it continues in the original direction. The levels which hold the most weight are usually the middle levels (38.2%, 50.0%, and 61.8%). However, chances of success can be increase by using Fibonacci tools together with other support and resistance levels, trend lines, and chart patterns for the purpose of spotting an ideal entry and stop loss points.
Technical indicators are the tool of the quantitative trading formulas and the result of mathematical calculations based on indications of price and/or volume with the present or past data. Technical indicators are developed by technical analyst a long time ago. Currently, there are hundreds of common technical indicators available in the market. Technical indicators look to predict the future price levels, or simply the general price direction. Basically, technical indicators can be divided into two main categories: trending indicators or momentum indicators. Examples of trending indicators are the famous moving averages, parabolic SAR and etc while momentum indicators are MACD, RSI, Stochastic and etc. Momentum indicators determine the strength or weakness of a trend as it progress over time.
- Moving Average
The moving average is a moving mean of price or in another words an average price of a financial instrument over a given time period. The line is smoother if longer time period is used. This smoothing of data makes Moving Averages a popular tool to identify price trends and trend reversals.
There are three types of moving averages:
- Simple moving average (SMA)
SMA is calculated by summing up the prices over a certain number of periods and then divided by the number of such periods.
- Linearly weighted moving average (LWMA)
LWMA assign more weights to the most recent price data in calculation rather than equal emphasis for SMA.
- Exponential moving average (EMA)
EMA is similar to LWMA which both assign greater weight to the most recent data. However, EMA maintain all the data instead of dropping off the oldest data in the selected period as LWMA does.
The differences between the three types of moving averages are only at the way that they are calculated and whether they include all the data available or only the data within a selected period in calculation. Therefore, each moving average has its own characteristics. Eventually, they will response to the changes in the underlying price in different speed. Opportunities to buy or sell may occurs at the crossover point of combinations for different periods moving averages.
- Simple moving average (SMA)
- Moving Average Convergence-Divergence (MACD)
Moving Average Convergence-Divergence (MACD) is one of the simplest and most effective trend following momentum indicators available. The MACD is a computation of the difference between two moving averages of closing prices (subtracting the longer moving average from the shorter moving average). This difference is charted over time, alongside a moving average of the difference. The divergence between the two is shown as a histogram or bar graph. MACD fluctuates above and below the zero line which is also known as the centerline.There are three common methods to interpret the MACD.
- SIGNAL LINE CROSSOVER
Signal line crossovers are the most common MACD signals. In default setting, signal line is a 9-day EMA. The standard interpretation here is to buy when the MACD line crosses up through the signal line, or sell when it crosses down through the signal line. The upwards move is called a bullish crossover while the downwards move a bearish crossover. Correspondingly, they indicate that the trend is about to boost in the direction of the crossover.
- ZERO LINE CROSSOVERS
Centerline crossovers are the next most common MACD signals. A crossing of the MACD line through zero line occurs when there is no difference between the fast and slow moving averages. Above zero line is positive while below zero line is negative. A move from positive to negative is bearish and from negative to positive, bullish. Zero line crossover somehow has less confirmation of its momentum than a signal line crossover.
Divergence is referred to a discrepancy between the MACD line and the price. Positive divergence between the MACD and price takes place when price reaches a new low, but the MACD does not. This provides a bullish signal, signifying the downtrend momentum has ended. For negative divergence, the condition is inversed.
- MACD LIMITATIONS
Nevertheless, MACD has its limitation. It failed to respond in a very low or alternately very high volatility market conditions due to it is inherently a lagging indicator since the MACD is based on moving averages. MACD is also not so useful for identifying overbought and oversold levels because it does not have any upper or lower limits to bind its movement. MACD can continue to exceed beyond historical extremes (overbought or oversold) during sharp moves. Yet, a skilled trader may overcome these limitations by combining application of several technical indicators.
- SIGNAL LINE CROSSOVER