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The Ultimate Guide to Technical Analysis in Forex Trading

Technical analysis is one of the main types of analysis used to predict the movement of currencies in the foreign exchange market.

In as much as there is a marked difference between technical analysis and fundamental analysis, both are important in forecasting the behavior of the forex market.

Ultimately, they have the same objective: to assist traders forecast the movement of the market.

Essentially, technical analysis focuses on historical price patterns and trends in the forex market with the aim of predicting the possible direction of currency prices.

While technical analysts may use different tools and concepts in trying to accurately time market moves, the common tool used by all is the chart. This is why at times followers of technical analysis are referred to as “chartists.”

It is important to note that technical analysis is based on the following three major assumptions:

  • Market action is supreme

Technical analysts believe that every fundamental condition, such as state of the economy, social issues and political factors, that could affect the behavior of the market is already illustrated in price movements.

Therefore, technical analysts are only concerned at the kind of movements the charts make, not the reasons behind the movements.

  • The movement of currency prices follow trends

Followers of technical analysis believe that the constant fluctuation of currency prices in the forex market takes place in an orderly manner, which is both systematic and easy to predict.

There are three main trends in the currency market: upwards, downwards, or sideways. After a trend has been established, currency prices often tend to obey that pattern before forming another one.

  • History always repeats itself

The movement of currency prices has been tracked for more than 100 years. And, over time, a number of repetitive patterns have been discovered.

The manner in which these patterns are formed is an indication that human psychology does not experience much change over time.

Thus, technical analysts often study historical price movements because they believe that price will behave the same way it did before.

There are three main schools used in technical analysis in forex trading:

  1. Chartism/ charting
  2. Forex indicators
  3. Theories
  1. Chartism/ charting

Technical analysts often use forex charts to forecast future market movements.

A chartist in essence believes that the movement of the currency prices are not random, but can be forecasted through a study of past trends and other tools in technical analysis.

Here is a description of some of the methods used in charting:

a)      Trends

A forex trend generally refers to the direction in which the market is moving.

As stated previously, the movement of currencies normally occurs in three trends: upwards, downwards, or sideways.

As such, chartists often study the charts to try to identify any of these trends before placing trades on their trading terminals.

In an uptrend, the overall direction of the currency pair is upward i.e. the price is rising.

In a downward trend, the overall direction of the currency pair is downward i.e. the price is falling.

And, in a sideways trend, the overall direction of the currency pair is see-saw i.e. the price is moving up and down without having any definite direction.

A common saying about forex trends counsels, “The trend is your best friend.”

For technical analysts, these wise words teach that placing orders in the direction of the prevailing trend will often lead to more success.

Here is a diagrammatic description of the types of trends:

uptrend, sideways trend, downtrend

b) Support and resistance

Support and resistance are one of the most commonly used concepts in the world of currency exchange.

Generally, support and resistance are terms used by technical analysts to describe price levels on charts that tend to act as hurdles to prevent the price of a currency pair from moving towards a certain direction.

Support refers to a certain price level on charts that tends to hold the price of a currency pair above; that is, it acts as the floor that prevents price from penetrating.

On the other hand, resistance refers to a certain price level on charts that tends to hold the price of a currency pair below; that is, it acts as the ceiling that prevents price from penetrating.

Here is a diagrammatic representation of support and resistance:

The image shows support and resistance levels as used in forex trading.

The above diagram represents an uptrending market, which is moving back and forth as the price of the currency pair is rising.

The highest point it touches before going back is what is called the resistance level. As the price of the currency pair continues to rise, the lowest point it touches before moving up once more is called the support level.

Therefore, this is how resistance and support levels are continually being created as the price of a currency pair rises and falls. If it were a market in a downtrend, the opposite would be true.

c) Trend lines & channels

In forex trading, a trend line is a line that is drawn on a chart to depict the prevailing direction of price. When drawn in the approved manner, they can make out very profitable trade opportunities.

As earlier mentioned, when trend lines are drawn, they help traders know the current trend of the market i.e. whether it is an uptrend, downtrend, or sideways trend.

When parallel trend lines are drawn at the same angle of the prevailing trend of the market, then a channel is created. There are three types of channels:

i)                    Ascending channel

ii)                  Descending channel

iii)                Horizontal channel

As portrayed in this diagram, in an ascending channel, the peaks form higher highs and higher lows:

 ascending channel forex trend lines

As portrayed in this diagram, in a descending channel, the peaks form lower highs and lower lows:

descending channel forex trend lines

 

As portrayed in this diagram, in a horizontal channel, the market is ranging:

 

horizontal channel forex trendlines in a ranging market

 

  1. Forex indicators

In the foreign exchange market, indicators are essential in exhibiting the graphical representation of the rise and fall of currency prices. There are two types of indicators: Leading indicators and lagging indicators.

a) Leading indicators or oscillators

In general, leading indicators or oscillators spot trading opportunities before the market trend is established.

These indicators usually signal “buy” or “sell” when the previous trend has run its course and the market is ready to experience a reversal.

Examples of such indicators include stochastic, parabolic SAR, and Relative Strength Index (RSI).

i) Stochastic

The stochastic is an indicator that enables traders gauge overbought and oversold conditions in the market.

The major concept behind this indicator according to its creator, George Lane, is based on the notion that rising prices are likely to close next to their previous highs, and declining prices are likely to close next to their previous lows.

Here is how stochastic indicator appears on charts:

 stochastic leading indicator forex. It is marked from 0-100

 It is important to note that the stochastic indicator is marked from 0 to 100. And, when the stochastic lines are over the 80 mark, then it signals that the market is overbought.

On the other hand, when the lines are below the 20 mark, then it signals that the market is oversold. The 20 and the 80 levels are also referred to as “trigger levels”.

The basic rule when using stochastic to trade is to enter buy positions when the market is oversold and enter sell positions when the market is overbought.

For example, when the indicator has been showing overbought conditions for some time, then it is likely that a reversal to the downside is bound to happen.

ii)Parabolic SAR

Parabolic SAR (Stop And Reversal) is a simple technical indicator that is used by most traders to identify where a trend might be ending.

The indicator places a series of dots, or points, either above or below a currency price.

Here is how the parabolic SAR indicator appears on charts:

 Parabolic SAR is a simple technical indicator with a series of dots, or points

The positioning of the dots is used by traders as a means of identifying trade opportunities.

When the dots appear below the price of the currency pair, it is interpreted as a bullish signal; that is, traders expect the price of the currency pair to maintain an upward trend.

On the other hand, when the dots appear above the price of the currency pair, it is seen that the bears are in control and the price of the currency pair is likely to maintain a downward trend.

The parabolic SAR is perhaps the easiest indicator to use when trading since it assumes that price is either on an uptrend or on a downtrend.

As such, this indicator identifies the best trading opportunities when the market is trending, and when there are extended uptrends and downtrends.

iii) Relative Strength Index (RSI)

The Relative Strength Index, or RSI, is the same as the stochastic indicator in that it also enables traders measure overbought and oversold conditions in the market. RSI is also scaled from 0 to 100.

The price of a currency pair is deemed to be overbought when the RSI nears the 70 mark, meaning that a reversal to the downside is imminent.

On the other hand, when the RSI nears the 30 mark, it signifies that the price of the currency pair is getting oversold and a reversal to the upside is imminent.

Here is how the RSI indicator appears on charts:

 The Relative Strength Index, or RSI

 

b) Lagging indicators or momentum indicators

On the whole, lagging indicators or momentum indicators spot trading opportunities after the market trend is formed.

These indicators usually identify trade opportunities when the previous trend has been exhausted and the market is ready to experience a reversal.

A major advantage of lagging indicators is that their delay compels traders to wait for sharp and clear signals before pulling the trigger. As such, they are less likely to be wrong.

Examples of such indicators include the Moving Average Convergence-Divergence (MACD) and other moving averages.

i)                    Moving Average Convergence-Divergence (MACD)

The Moving Average Convergence Divergence, commonly referred to as MACD, is a popular and resourceful technical analysis tool mainly used as either a trend or a momentum indicator.

Generally, MACD shows the connection between two moving averages of prices.

This indicator is computed by getting the difference between the 12 and the 26 exponential moving averages (EMAs). It is of essence to note that the 12-period EMA is the faster one while the 26-period EMA is the slower one.

The difference between the faster and the slower moving averages is what is shown as a single line, which is the MACD main line.

Usually, MACD indicators consists of one extra line that is a simple moving average of the main line and it normally has the default setting of 9 in a majority of the trading platforms. This single line is used in identifying turns.

It is of essence to point out that the two lines that are drawn are not moving averages of the price but they are moving averages of the difference between the slower and the faster moving averages.

The MACD histogram stands for the difference between the MACD line and its 9-period simple moving average.

The histogram is usually positive when the MACD line is above the 9-period simple moving average and negative when the MACD line is below the 9-period simple moving average.

The numbers 12, 26 and 9 are the typical settings used with the MACD. Nonetheless, other numbers can be used based on the tastes and preferences of the trader.

Here is how the MACD indicator appears on charts:

macd in forex trading

One of the major ways of trading using MACD is using the cross-over of the moving averages.

Because the two moving averages are not moving at the same pace, it is certain that the fast moving average will respond to price action much faster than the slow moving average.

If a new trend is established, the fast moving average will be the first to respond and eventually cross the slow moving one.

And, if this “cross-over” occurs on charts, the faster moving average begins to diverge or move away from the slow moving one.

For example, when the fast moving average has closed below the slow one, it can signal a start of a downtrend; thus, traders can start looking for short opportunities in the market.

It is important to note that when the moving averages cross one another, the histogram momentarily vanishes because the difference between the moving averages at that time is zero.

In conclusion, traders use MACD cross-over points to identify places of entry and exit in the foreign exchange market.

ii)                  Moving averages

Moving averages are also one of the common tools used by technical analysts in forex trading. Simply, moving averages is a method used in smoothing out the rising and falling of currency prices over a certain time period.

A moving average simply eliminates the noises and chaos and makes the charts easier to spot opportunities for entering buy or sell orders. There are two main types of moving averages:

Simple moving averages

Simple moving averages (SMA) or arithmetic moving averages are the commonest type of moving averages.

A simple moving average is computed by adding up the closing price for a definite number of time periods (for example X) and then dividing this total number by the number of time periods (X).

For instance, if you want to plot a 20 period simple moving average on a 60-minute chart of GBP/USD, you would add up the closing prices of the previous 1200 minutes (60×20) or 20 hours, and then divide that number by 20.

If you do this, you will have the currency pair’s closing price for the preceding 1200 minutes, and, if you continue and connect the closing prices with one another, you will come up with a simple moving average.

Simple moving averages are very important in technical analysis because they assist in gauging the overall sentiment of the market and determining the big picture and therefore ease the process of spotting profitable trade opportunities.

A main weakness of the simple moving averages is that they are susceptible to spikes and this can give false signals when trading.

A simple moving average can indicate that a new trend is about to be formed while in reality nothing serious has happened.

Exponential moving averages (EMA)

Exponential moving averages (EMA) are similar to the simple moving averages; however, the only difference is that the former puts more weight on what has been recently taking place in the market. EMA’s are also referred to as exponentially moving averages.

Since EMA’s put more emphasis on the recent happenings in the marketplace, they get rid of spikes that may give false signals. Also, EMA’s have a lag (delay) because they move faster than SMA’s.

Here is how SMA’s and EMA’s appear on charts:

Simple moving averages (SMA) and Exponential moving averages (EMA)

 

iii) Bollinger bands

Bollinger bands are chart indicators that are majorly used for gauging the volatility of the market.

Bollinger bands comprise of three lines: upper band, lower band and middle band.  It is essential to note that the middle band is just a simple moving average. The upper band and the lower band are important in measuring deviations.

Essentially, Bollinger bands assist traders in knowing whether the market is quiet (low activity) or whether it is loud (high activity).

When the market has low activity, the upper and the lower bands contract; that is, become close together. On the other hand, when there is high activity in the market, the bands expand; that is, spread apart.

It is important to note that one attribute unique about Bollinger bands is that price usually tend to return to the middle of the bands.

As such, price usually touches the upper and the lower band and come to the middle of the band.

It’s also important to note that when the upper and the lower bands squeeze together, it normally signifies that a breakout either to the upside or the downside is imminent.

Here is how Bollinger bands appear when plotted on charts:

 Bollinger bands measure the volatility of the marke with upper band, lower band and middle band

  1. Theories

As stated in the earlier sections of this article and in other articles on this site (www.forextradingbig.com), technical analysts believe that the fluctuation of currency prices take place in a systematic and easy-to-predict manner.

And, this rising and falling of prices has enabled chartists to develop a number of theories to predict the movement of currency prices in the market. Here is a description of some of the major theories used in technical analysis:

i)                    The Elliot wave theory

The Elliot wave theory is based on the concept that the fluctuation of the prices of currencies in the market create “waves” that are easy to spot.

This theory emphasizes that the market movements occur in repetitive patterns that are interpreted to be the emotions of the investors caused by outside influences or the prevailing sentiment of the traders at that time.

According to this theory, the upward and downward swings in price coming from the prevailing sentiment constantly shows up in the same repetitive patterns.

And, these upward and downward swings are referred to as “waves”.  As such, if a trader can accurately predict the repeating patterns in prices, he or she is able to spot profitable trade opportunities in the market.

ii)                  The Dow theory

The Dow theory is regarded as one of the foremost authorities in the field of technical analysis.

Truth be told, technical analysis as we know it today is grounded on this theory, which is currently more than 100 years old.

Basically, this theory asserts that the assets values are already reflecting the underlying fundamental condition of the assets. Thus, by assessing those conditions, it is possible to predict the major trends in the foreign exchange market.

Here is a list of the basic tenets of this theory:

  • The market discounts everything. Dow theory asserts that the actual price of a currency pair is its true price.Therefore, the information about the price of a currency pair has already been taken into account and its reflected in its present price.
  • The three individual types of trends are primary, secondary and minor trends.
  • There are three phases of primary trends. These are accumulation, public participation, and excess.
  • The market indexes usually confirm one another.
  • The volume confirms the trend.
  • The reversal of any trend will take place only with concrete and well-grounded evidence.

iii)                Gap theory

In forex trading, the gap theory holds that gaps are always filled. Gaps are places on charts whereby there is a lack of any trading activity.

        Number theories

Number theories are employed by technical analysts in predicting places of potential price movements. The main number theory is Fibonacci numbers

Fibonacci numbers

Fibonacci numbers are technical analysis tools that are often used in currency trading. Fibonacci retracements are usually used for identifying support and resistance levels. The three most common levels are 38.2%, 50.0% and 61.8%.

And, Fibonacci extension levels are usually used in identifying places for taking profits. The extension levels comprise of all levels of the Fibonacci retracement drawn beyond the standard 100% level. The three most common levels are 161.8%, 261.8%, and 423.6%.

It is important to note that Fibonacci numbers work best in trending markets; that is, in uptrending or downtrending markets.

Here is how the Fibonacci numbers look when applied on charts:

 Fibonacci extension and Fibonacci retracement in forex trading

 Summary

Technical analysis is an influential and profitable strategy to use in trading forex. This type of analysis concentrates on historical price patterns and trends in the forex market with the objective of identifying potential trade opportunities.

As described in this article, there are many tools and concepts used in technical analysis. And, mastering to use them can enable a trader reap massive profits from trading currencies online.

However, it is important for traders to avoid crowding their charts with any kind of indicators, moving averages, or Fibonacci retracement tools.

The trick is to master how to use two or three and use others secondarily to confirm trade entries and exits.

Furthermore, it is important that you keep your approach as simple as possible and trade only what you see, not what you think. You are welcomed to read other articles on this site (www.forextradingbig.com) and discover how to achieve this.

The fault most newbie traders make is to complicate their trading and this makes them lose a lot of money. Technical analysis, when correctly mastered, can make the difference between a losing and a winning trader.

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