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Introduction to Forex Technical Analysis

Reading time: 10 minutes

Technical analysis is statistical in nature, because the data it analyses can be easily quantified and further visually demonstrated through charts and chart overlays. In this article we're going to explain how to learn Forex technical analysis and where to start with it in regards to technical trading.

Forex technical analysis introduction

In Forex, as well as in many other financial markets, technical analysis is a method of price forecasting for financial assets. In Forex we look at currency pairs using five basic units of historical data: the opening price, the highest price, the lowest price and the closing price. The fifth dimension is represented by the volume, but this can be problematic in the Forex spot market, since it can't quite be measured in the same way as it is with stocks, commodities, and even Forex futures.

Technical origins

FX technical analysis has existed for as long as there have been markets driven by supply and demand. The first known historical records are dated around the 17th century for Dutch merchants, and the 18th century for Japanese rice traders. At the end of the 19th century technical analysis began to take off, as it was propelled into the trading masses by the founder and editor of The Wall Street Journal, Charles Dow.

Among his contemporary compatriots were other technical pioneers; Ralph Nelson Elliott - the founder of the famous Elliott wave theory, William Delbert Gann - the founder of the Gann angles theory and Richard Demille Wyckoff. Wyckoff was possibly the first market psychologist who theorised that the market with all the historical data recorded is best considered as a single mind. His teachings are still taught at some of the top universities in the US. For most of the 20th century and throughout history, technical analysis was limited to charting, as statistical computation of vast amounts of data was unavailable. That means no indicators. It also means that now - the digital era - can probably be considered as the Golden Age of technical analysis.

General Elements

Although Forex technical analysis typically employs numerous tools, techniques and methods, it is generally chart bound. Traders use charts, which are nothing more than price history depicted graphically, which ease the search for price patterns. Price patterns, whether they are trend patterns, reversal patterns or ranging patterns, are market formations - commonly referred to as market moods - that increase the probability of winning trades.

For many technical traders, the trick is in figuring out what the current mood of the market is, and how long is it going to latest, in order to figure out how to plan their technical trades. To help identify these major patterns, traders have developed and perfected a series of charting tools. They start with support and resistance lines and price channels, and then end with a multitude of technical indicators which are applied directly to their charts in real time.

Does Technical Analysis Help?

Some people believe that looking at historical price data will not provide any value for current decisions. They may believe that the random walk theory (or efficient-market hypothesis) is true, which states that financial market prices move and behave according to a random walk (whereby price changes are random) and thus cannot be predicted.

Many investors, however, heavily dispute this theory, including famous investor Warren Buffet, who commented that he is "convinced that there is much inefficiency in the market". Inefficiencies, in turn, create potential opportunities for traders to capitalise on price movements. They believe that analysing price action, in fact, enables traders to make better, more informed trading decisions.

Here is an example of a technical analysis chart for the EURUSD currency pair:

EURUSD 4 Hour Chart

Source: EUR/USD 4-hour chart - currency trading analysis - Data Range: 27 December, 2017 to 18 January, 2018 - (showing trend lines, 1 moving average (green), Admiral Keltner channel (light purple), Admiral Pivot Points (S1, PP, R1), and AO)

How and Why Does Technical Analysis Help?

The financial markets are not simple to analyse. They are impacted and influenced by a wide range of factors including, for instance, monetary policies administered by central banks, fiscal policies delivered by governments, and many internal economic factors that are determined by companies and consumers alike. Studying all those factors, realising how they impact all of the assets and markets, and knowing which factors have the most impact is an incredibly difficult task. Equally important, is that when analysing these factors, it is easy to see that traders can make errors in cause and effect. This is particularly true for individual traders who have limited time and focus. However, the good news is that there is a reliable short-cut whereby analysts can focus a lot of their attention on just one piece of data – price movement. Technical analysis (TA) is also known as chart analysis. TA allows traders to analyse historical price movement.

This analysis can then offer traders:

  • A way how to judge whether the chart is interesting to trade on or not
  • How traders can look for potential trade setup
  • Where traders can find potential trade setups
  • How to manage those potential trade setups

Indicators

Technical indicators are statistically programmed add-ons for the body of trading platforms that mathematically analyse relations between various elements, in an attempt to assist with price prediction. Broadly speaking, there are four groups of technical indicators.

The most popular ones are:

The last group should be mentioned specifically, due to trading volume being its primary source of data for analysis. It is undoubtedly true that studies of total traded volume are at least helpful to financial traders in the stock market, the futures market and the commodity market amongst others. Although the overall theories of these studies can apply to the Forex spot market as well, there is simply no way to analyse Forex spot total traded volume. It's important to note that because the Forex spot market is traded OTC (Over-The-Counter), no total volume can be calculated. This means that all the indicators of volume a trader sees on their platform only use a sample of the total volume available for analysis. How much of the data is representative is up for debate.

Technical analysis is widely used by financial traders around the world, however, it is a method that is mostly favoured by Forex traders due to the possibility of their application on time-frames that are lower than one day. That being said, many scholars disregard the concept of technical analysis in Forex or any other market, claiming that it is not effective for price prediction. Users of the FX trading technical analysis believe that even though it's incapable of predicting the future, technical analysis is still a powerful tool for analysing the present, which is all they really need to be consistently profitable.

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Basic Principles

Price action discounts everything

The logical framework and justification of technical analysis derives from one of the Dow theory postulates, which claims that the price accurately reflects all relevant information. Thus, whatever factor has an impact on supply and demand (the primary price moving forces) will inevitably end up on the chart. As for researching, or even being aware of the events outside price action, they are mostly rendered useless, as they are unquantifiable and may provide unreliable data.

Price moves in trends

Technicalists tend to favour the trend-like nature of the market - another echo of the Dow theory. Markets can move in uptrends - a bullish market that continuously creates higher highs and higher lows, while in the big picture the price seems to be jumping up and down within an upward corridor. A similar market behaviour, only characterised by lower lows and lower highs, constitutes a downtrend - a bearish market.

A horizontal trend is called a ranging market and is not a particularly desirable place for a trader to be. This is because during the ranging periods, there is hardly any way to be certain about what will happen next. A ranging market means that the bulls and the bears are more or less equal in power, and neither side is strong enough to dominate another long enough to form a trend. Markets range on average about 60% of the time, which makes identifying trends extremely important. It's worth remembering that Forex statistical analysis doesn't concern itself much with the 'whys' of why things happen. For example, 'why do trends occur?' would be a reasonable question, but to a technical trader it's completely irrelevant. They just wouldn't know how to quantify the answer. To them, the existence of trends is simply an empirically proven fact.

History repeats itself

Technicalists agree that investors, as a whole, operate in patterns. Because of this behaviour, technicalists believe that they are able to accurately identify patterns and make trades with a higher probability. All they need is a small statistical advantage, multiplied by repetitions and leverage. Pure technical Forex analysis isn't the best idea. It is often used in some sort of combination, along with a fundamental analysis or a sentiment analysis. Truly, while technicalists may excel at identifying and confirming trends, it is the fundamental shifts that organise conditions for those trends to develop. One last thing to consider is the method of Forex backtesting.

Also known as historical backtesting, this is a method employed by traders that use historical data to test a trading strategy. It can only work with technical FX analysis. As with all statistical findings in any area of human activity, past data does not guarantee that the pattern or the probability will last. It is only a tool. Additionally, backtesting requires traders to know the exact market conditions for entry and exit.

Conclusion

Forex market technical analysis is a method of evaluating trading instruments by analysing the statistical record of their price history. Technical analysis is not concerned with the factors that influence bulls and bears, supply and demand, or any other factors that may affect prices. By analysing only what has already happened can technical traders gain their competitive edge. Most often the price history is committed to charts by the means of various charting methods, with Japanese candlesticks being one such method. Various tools such as support and resistance lines, trend lines, and technical indicators, are used to analyse charts in an attempt to identify patterns.

Patterns are the key concept in technical Forex analysis that everything revolves around. The existence of market trends is an empirically proven fact, and is of utmost importance to every technical trader. Despite daily Forex technical analysis being criticised in some academic circles for its insolvency, most practical traders from various financial markets apply at least some form of it, usually in combination with other methods.

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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.

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