Forex Technical Analysis

Traders use technical analysis in Forex trading because they believe that exchange rates aren't always determined by economic fundamentals - central bank activity, prices and interest rates. Though long-term trends in the Forex markets are likely caused by these fundamental events, it seems that Forex traders are driven to use technical analysis because of the volatility and leverage offered by the various Forex markets.

KEY TAKEAWAYS

• Technical analysis is the best tool to understand Forex market.
• Many fundamental traders use fundamental analysis to determine whether to buy in the market, but once they have made that decision, they then use technical analysis to pinpoint good low-risk entry price levels.
• Trend detection is the first step in technical analysis for traders, because Forex trading strategies can either follow the trend or go against it.

What is Forex Technical Analysis

Technical analysis is the best tool to understand Forex market and trade it.

As you know technical analysis is a set of techniques used to attempt to predict future price movements of financial products based on historical movements and price patterns.

Technical analysis boils down to two things:

• Identifying the trend
• And identifying support and resistance lines, through the use of price charts or time tables.

Technical analysis is based on the theory that markets are chaotic and no one knows exactly what will happen next, but at the same time, price movements are not completely random. The mathematical theory of chaos proves that in a state of chaos there are certain patterns that tend to repeat themselves.

Technical analysis of a market can help you determine when and where to enter and exit the market.

It is important to understand trendlines and know how to draw them, since they are instrumental in spotting areas of support and resistance on a price chart. Trendlines are straight lines drawn on a chart by connecting a series of descending highs or lows.

Types of Technical Analysis

Traders who prefer to base their trading on technical analysis find that current or past price action in the market is the most reliable indicator of future price movement. Many fundamental traders use fundamental analysis to determine whether to buy in the market, but once they have made that decision, they then use technical analysis to pinpoint good low-risk entry price levels.

As we mentioned in our article there are two major types of technical analysis are:

• Forex chart patterns are a subjective form of technical analysis in which traders attempt to identify areas of support and resistance on a chart by looking at certain patterns. These patterns are designed to predict the price direction after a breakout or breakdown from a specific price point and time. For example, an ascending triangle pattern is a bullish pattern that shows a key resistance area. A break of this resistance can lead to a significant move up with high volume.

• Technical indicators are a statistical form of technical analysis in which various mathematical formulas are applied to prices and volumes. The most common technical indicators are moving averages, which smooth out price data, making it easier to spot trends.

  More sophisticated technical indicators include Moving Average Convergence Divergence (MACD), which looks at the interaction between multiple moving averages. Many trading systems are based on technical indicators because they can be quantified.

  • Trend Indicators
  • Volume
  • Volatility
  • Momentum indicators

Unfortunately there are limitations to technical analysis that can affect traders profitability.

Technical analysis has the same limitations as any strategy based on certain trading triggers. The graph may be misinterpreted. Formation can be based on low volume. The periods used for moving averages may be too long or too short for the type of trade the trader wants to take.

As more and more strategies, tools and methods of technical analysis become widespread, they have a significant impact on price behavior.

For example, do head and shoulders form because price information justifies a bearish reversal, or because traders universally agree that they should be followed by a bearish reversal and trigger it by going short?

History of Technical Analysis

The prerequisites for the emergence of technical analysis were the observation of price changes in financial markets over the centuries. The oldest tool in the arsenal of technical analysis is the KEISEN method (けい線), developed by Japanese rice traders in the 18th and 19th centuries. In the world it is known as "Japanese candles".

At the end of the 19th century, the American journalist Charles Dow published a series of articles on the securities markets that formed the basis of the Dow theory and served as the beginning of the rapid development of technical analysis methods at the beginning of the 20th century.

How to Use Technical Analysis

Learning how to use technical analysis can be difficult at first for those thinking about diving into the financial markets.

Studying chart patterns, candlesticks, indicators and market trends understandably becomes overwhelming for many novice traders.

While it is not easy to learn how to perform technical analysis, it is far from impossible. Every day, traders enter their brokerage houses and successfully apply their technical analysis skills to profitably navigate the financial markets.

First, traders need to understand their strategy and have a trading plan in place. This is important to find out if the market environment is right for the strategy. Based on this, then comes choosing suitable trading instruments.

For example, if strategy is based on range trading, it's better to choose a low volatility currency pair such as EUR/CHF.

Before moving on to the analytical part, traders only need to have technical indicators on the chart that are part of their strategy. It is important not to overdo it with the number of indicators, as they can give conflicting signals.

After the analysis, it is important to track the selected indicators.
The following steps will use technical analysis as part of a trading strategy.

1. Trend Detection

This is the first step in technical analysis for traders, because trading strategies can either follow the trend or go against it. However, for each of these systems, traders must determine whether the current trend is up, down, or sideways. Each of these three price trends requires a different approach to trading, depending on trading strategy.

Traders usually buy or take long positions in assets that are in an uptrend. Assets in a downtrend usually sell short while instruments in a trading range usually open at established support or resistance levels when the trader believes there is a high chance of a trend reversal.

2. Drawing Support and Resistance Levels

Support and resistance levels are areas where the price of an asset can reverse or break out.

A support level is the level at which an asset's downtrend in price is suspended as buying demand increases, so the trend reverses and turns up. The same reasoning applies to resistance levels where the asset's upward price momentum wanes and the price is likely to reverse and head lower. Support and resistance levels can provide excellent opportunities for traders to open new trades.

3. Establish Entry and Exit Points

While identifying areas of support and resistance can provide excellent entry positions, there are other factors that technical traders can consider when determining their entry positions. These include the values of technical indicators such as ATR and RSI. These are volatility indicators that can help a trader determine if there is adequate momentum behind a price move.

4. Position Sizing and Risk Management

Technical indicators of momentum and volatility, such as the average true range, are commonly used by professional traders for position sizing and risk management. Depending on the chosen risk/reward ratio, traders can use the ATR to determine where to place a stop loss once an entry position has been determined.

Bottom Line on Forex Technical Analysis

No technical indicator is perfect. None of them gives signals that are always 100% accurate.

Therefore, traders are always on the lookout for warning signs that the signals of their chosen indicators can be misleading. A well-executed technical analysis can certainly increase your profitability as a trader. However, what can do more to improve your trading condition is to spend more time and effort thinking about the best thing to do if the market turns against you (i.e., using risk management), rather than just fantasizing about how you are going to spend your profits.

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