Understanding Technical Analysis
Technical analysis is a method traders used to study price movement in the Forex market. In theory, the trader looks at historical charts. He or she is observing price movements and price patterns of the past. By studying price history, a trader can assess current trading conditions. This can measure chart probabilities for future price movement. All activity in the market reflects in the current price.
Traders who use technical analysis believe that price action is king.
Traders who use technical analysis look at the flow of the market. They check for trends and the rhythm of a currency. Some traders ONLY use technical analysis.
History does repeat itself. If you scroll back through a chart over the years, you will find defining areas where the price reversed. There are strong areas of support and resistance. In these areas, you will see the price has touched many times.
Why do These Areas Exist?
It’s simple. Sentiment drives the Forex market. Imagine hundreds of thousands of traders looking at the charts. Yes, every trader sees a chart in a different way. But all technical traders will see support and resistance zones. Traders set alerts for these areas and look for a trade when the price touches the zone. So, if there is a strong support area, traders will be looking to get in for a buy. This creates further market sentiment which then drives price.
Price movement creates patterns on a chart. These patterns tend to repeat. So, the belief is there’s a good chance of that pattern playing out again in the current market.
There are no guarantees of course. Technical analysis focuses on probability. Sometimes, price breaks through support and resistance zones. It may bounce out and pull back. Or it may go flying through and carry on its path.
How do I Study Technical Analysis?
Well, first you need to get familiar with the charts.
Technical analysis is very subjective. Two Forex traders can look at the same chart and have different opinions. And that’s OK. It’s important to trust your analysis. Never allow the opinions of other traders to sway your instincts. For one, you learn better making your own mistakes.
Forex charts make it easier to map out historical data. Technical analysts devote their time to reading their charts. Traders are looking for areas of potential probability. They are waiting for an opportunity to enter a trade.
It’s important to understand the key concepts of technical analysis.
A technical trader may use indicators or other tools for analysis. They are looking to -
- Identify trend
- Identifying support and resistance zones through the charts and via various timeframes
The market can go up, down or sideways. If you look at a chart, you will see it doesn’t move in straight lines. It zigs and zags. If the market is going sideways, this is a range. Depending on the scope of the range, most traders leave it alone. If the price is trending up, it tends to zig-zags upwards. It forms higher lows and higher highs. If the trend is down, price zig-zags down, forming lower highs and lower lows.
Technical analysis can help a trader decide where to:
- Enter the market
- Exit the market
- Set stop losses
How Can I Use Technical Analysis?
No one knows for sure what will happen next in the Forex market. It appears chaotic for the most part. But price action is not 100% random. Mathematical Chaos Theory proves that identifiable patterns arise out of chaos. And these patterns tend to repeat.
Most traders know there is no certainty in Forex trading. It isn’t possible to predict exact price movements. So, here’s the thing. Forex trading is NOT about being right or wrong. This is where novice traders fall short. They fail to understand this core principle of successful trading. Professional traders live and breathe the conceptual understanding of probabilities. So, part of determining probabilities involves assessing possible market direction. You then determine entry and exit points.
What is as important is to work out your risk-to-reward ratio (RTR).
Here’s a quick example of that. Let's imagine you have a 65% win rate. Hey, that’s good! You set every trade to 1:1 ratio. You risk £1 to win £1. With a 65% win rate, are you in profit?
What? I’ve achieved 65% and I’ve made no money?
YES. That is correct.
OK, so you decide to set your RTR at 1:2. For every £1 you risk, you win £2. Are you in profit now?
Now you’re flying. You decide to default your RTR to 1:3. For every £1 you risk, you win £3.
You’re cruising now!
The higher your risk-to-reward ratio, the more chance you have of coming out ahead. This is a fact many new traders overlook. With this snippet of knowledge, you now have an advantage.
Indicators aren’t magic. They won’t give you conclusive evidence that a trade will go the way you wish. Successful traders use indicators as conformation. Some traders use a combination of indicators. Others may use one or two. Some traders don’t use indicators at all. They prefer to focus on price action on the chart. Indicators can help to measure long or short-term forecasts
Forex indicators are useful in a variety of ways. They work as handy tools in most trading platforms. They can give a trader perspective on the market. Indicators can show a different viewpoint for a trader to consider. There are many indicators available to use, most are free.
There is more to trading than relying on tools. Risk management is fundamental to success. As is emotional regulation, patience and discipline. But, for some traders, indicators can be helpful.
Which Indicators Are Best?
This is a subjective area. Traders often have their favourite indicators and swear by them. They form part of their strategy, which for many professional traders is rule-based. But, no matter what other traders tell you, there is no one BEST indicator. Every trader’s style is different. No one trader has the same personality or trading psychology. Some traders are impatient and trade on lower timeframes. Other traders are steady and patient. They wait for the perfect sniper moment to get into the market.
Moving averages are technical indicators on the chart. They give a picture of the direction of the market and potential breaks in the market. They take the form of a line on the chart and they gauge the average value of a Forex pair over a timeframe. You can set this time yourself. Typical examples are 14 and a lot of traders use a 50 moving average.
For example, you are trading the daily chart. You see the price breaks from above the moving average. Now it is below the moving average. This could be a sign that price is falling and a trader needs to look out for an opportunity to enter the market.
Look at the picture below. The blue line is a 50 EMA (Exponential moving average) on the 4-hour chart.
As you can see, the AUS/USD has been in an uptrend for a while. For a long time, the price has stayed above the 50EMA. It tested it several times and now seems unsure whether it wants to stay above or below. There are certain points on this chart where price touched the EMA which could have been a good buy. If you see the areas where the price tapped the line and then moved on. These are good buy areas.
Currently, price is struggling to stay above the 50EMA and has not formed a higher high for a while.
You can add an SMA (Simple moving average) or an EMA (Exponential moving average). They are a stable indicator, although can be lagging. So, they don’t always respond to fast-moving markets. The EMA is more dynamic than the SMA.
Forex oscillators are usually separate to the chart. They show levels when the price may be overbought or oversold. At this point, the price stabilises or may reverse. An oscillator can help to identify or confirm trends.
Oscillators can help to forecast a breaking point in the price movement of the market. On a graph, it will seem like the lines are moving in the same direction as the price. But when the lines begin to move apart, analysts will consider the trend to be losing momentum.
An oscillator can show a divergence in a market which can be useful information to a trader. They are not 100% reliable and can often show false signals. If you are using an oscillator, it is a good plan to have another indicator for confirmation.
Typical oscillators used by traders are –
- ATR ~ Average True Range
- MACD ~ Moving Average Convergence/Divergence
- RSI – Relative Strength indicator
These indicators are external, at the bottom of the chart.
Average True Range (ATR)
The ATR is a volatility indicator. It will show you how many pips price is moving across the average during a given timeframe. This can help a trader to plan target profit levels. For instance, it would be no good if you set a 100 pip target if the price is currently averaging 50 pips range. It can also help to determine where to place your stop loss.
Moving Average Convergence/Divergence (MACD)
The MACD is a moving average indicator that follows the trend. It shows the relationship between two moving averages. Traders watch for when the price is trending bullish or bearish. This can help highlight the possible entry and exit points for a trade.
The Stochastics show overbought or oversold areas. It is a momentum indicator which can also help to highlight reversal areas. There are various versions of stochastics. It shows two moving average lines which, when they intersect it may be a shift in the trend. Much like all indicators, there can be a lot of false signals.
Relative Strength Index (RSI)
The RSI is like the stochastic indicator. The purpose is to find areas of price being overbought or oversold. The usual settings are 70 and 30. If the line crosses over 70, it may be overbought. If it crosses below 30, it may be oversold. In reality, the price can keep going so there can be many false signals.
If you are working with an oscillator indicator, always look for other conformation. It is better not to rely 100% on the signals produced by these indicators.
Fibonacci Retracement Lines
Traders often get confused by Fibonacci. They are unsure which point to start from on the chart. Fibonacci is simple. This indicator is measuring support and resistance. The levels highlight areas where price may pull back. Fibonacci ratios are 23.6%, 38.2%, 50% and 61.8%. These areas, identified on the chart, can assist in planning exit and entry points. It is also good to know where to set your stop loss. Like all indicators, it is subjective. Traders will place it at different points on the chart, so get different results. You could say the popularity of Fibonacci makes the results self-fulfilling. It is an indicator used by many traders. Fibonacci is not based on mathematical logic or economic theory.
Technical analysis is popular with traders. There's a good reason for that. With practice, technical analysis can STOP you getting into trades that aren’t going to work. In Forex, it is often said, ‘It isn’t the trades you take that make you successful. It is trades you don’t take that make you profitable’’
It can give you a level of accuracy as you learn to wait for certain indications on the chart. Despite that it seems complicated, it isn't. A little knowledge and practice and you'll be doing technical analysis like a pro.
No one indicator is a magic formula. The best way to use any indicator is as a guide, allowing it to highlight areas to check for potential trades. We have mentioned the most often used indicators. In reality, there are hundreds of indicators available. But there are similarities with most of them.
In the next chapter, we are going to discuss risk management and how you can apply it to your trading.