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Technical Analysis in Forex Trading
Written by article default Sunday, 02 August 2009 20:10
What is Technical Analysis?The Relevancy of Technical Analysis in Forex Trading
The main objective behind technical analysis is to identify trends when they initially develop. This will permit the trader to capitalize in on the trend until it switches direction. The reason why technical analysis plays such an important part in the Forex market is because the Forex market comprises mainly of trends. Due to the nature of the Forex market, traders are able to trade on both sides of the market. It is in this situation where Technical analysis is most effective in helping traders predict the movements of the trends.
As opposed to the other financial markets, technical analysis is widely used within the Forex community. In part, the market movement is predicted by technical indicators. However, due to the fact that the majority of the traders are relying on the same technical indicators to predict the price movements, the market movements also become a self fulfilling prophecy. Thus, if technical analysis predicts that the price of a currency pair will decline, because the majority of the traders are acting in response to their analysis, this will result in the price declining further.
Resistance & Support:
One of the fundamental concepts in technical analysis is the concept of support and resistance. Resistance in Forex trading refers to a situation where prices have reached their peak and have difficulty moving further upwards. The level at which price cannot seem to break through is known as the “Resistance Level”. This is actually a subjective level and at times it can be extremely difficult to determine where this level is at precisely.
When you see a resistance level like the one in the figure below you want to sell as close as you can to the resistance line.
Support on the other hand, is the opposite of resistance. It refers to a situation where prices have declined to their bottom and have difficulty moving further down.
Even though technical analysis is more of a scientific and mathematical concept, there is no precise way at arriving at where the support and resistance levels for a particular currency pair will be at. These levels are more or less determined through intuition gleamed from trading experiences. When you have a support line you want to buy as close as possible to that line, take a look at the picture below.
Prices around these two levels normally have difficulty breaching their support or resistance levels due to the lack of opposing market orders. These are the areas which the market outlook is that the market is going to turn soon and hence the lack of participation during these situations.
Range Trading:
Although it is difficult to pinpoint where these levels are at precisely, traders are still able to utilize these concepts because they can trade within these ranges. Thus, within the support level regions, traders just adopt a “Long” market position while at the resistance region; they just adopt a “Short” market position.
Drawbacks of Range Trading:
One of the major drawbacks of range trading is that there are little chances for extraordinary profits within the ranges. The market generally spikes or crashes suddenly when it breaks the threshold of these levels. And when that happens, traders adopting range trading strategies will find themselves incurring huge losses when the prices jump or drop suddenly.
Below is a chart illustrating the concept of range trading:
Momentum Markets:
An alternative trading strategy to range trading is by utilizing the concept of support and resistance to trade beyond the range. When one adopts this trading strategy, one is anticipating the market to break the threshold of these levels. Thus, a trader will place an “Ask” market order above the resistance level and a “Bid” market order below the support level. The underlying principle is that the market will gain impetus once these thresholds are breached. This will allow traders to profit from this situation once the prices breach these levels.
The diagram below shows an uptrend pattern meaning when the momentum is positive you can draw the trend line and join the trend.
This diagram shows a downtrend line meaning when the momentum is negative you want to sell the currency pair.
Oscillators:
Oscillators are a set of technical indicators that will help a trader determine whether a market is overbought or oversold. One such oscillator that is commonly used by Forex traders is the Relative Strength Index (RSI).
Technical Analysis is an effort to forecast price movements by analyzing market data such as historical price trends, volumes, open interest, etc. Technical analysis is conducted based on the principal of 'history repeats itself', it does not result in absolute predictions about the future.
Instead, indicators generated by technical analysis will help investors anticipate what is "likely" to happen to prices over time.
Ever heard of Japanese candle stick? Fibonacci numbers? Relative Strength Index? Moving averages? Pivot points? Elliot Wave? These are some of the charting method that FX traders like to use during trades.
Technical Indicators in Forex
Unlike fundamentals, technical trading relies heavily on graphs and charts. Practically, a technical trader will need at least one charting software to read and plot the related charts for his own references.
As in our case, we will include some common technical indicators in Forex trading as well as its brief explanations. Charts and graph examples will be provided from time to time for the usage of learning.
Limitations on Technical Tradings
Technical analysis looks secure with proven tracks in the past times, however, trading Forex purely based on Technical Indicators would be extremely unsafe as we all knew thatt 'future does not equal to the past'.
A lot of unexpected variables are not considered in Technical Analysis: change of country leaders, change of government, natural disasters, change of bank policies, investor’s mood, war, or even terrorism attacks migh affect the currency value dramatically. These incidents are most likely not happening in the past thus Technical Analysis is not effective enough to predict the price movement.
Trading Forex Purely Based on Technical Analysis
A combined of two approaches (Fundamental and Technical) is always encourage to get the optimum plots on your investment plan. Read about Fundamental Analysis in Forex trading here.
Next, we will take a look on how to get started in Forex trading.