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Introduction to Forex technical analysis

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 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. Fundamental 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 begin.

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 the discipline of 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 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 the Golden Age of technical analysis.

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General elements

Although Forex technical analysis employs numerous tools, techniques and methods, it is generally chart bound. Traders use charts, which are nothing more than a 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 last.

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 end with a multitude of technical indicators which are applied directly to their charts in real time.

Indicators

Technical indicators are statistically programmed add-ons to 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:

Trend indicators: moving average (MA), directional moving average (ADX), Ichimoku Kinko Hyo, moving average convergence/divergence (MACD), Parabolic SAR Indicator

Momentum: relative strength index (RSI), stochastic oscillator, Williams % range (%R)

Volatility: average true range (ATR), bollinger bands (BB), standard deviation

Volume: money flow index, accumulation/distribution line, on-balance volume

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, no total volume can be calculated. This means that all the indicators of volume a trader sees on his platform only use a sample of total volume for analysis. How much of the data is representative, if at all, is a question for another article.

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 utterly incapable of any 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.

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) it will inevitably end up on the chart. As for researching or even being aware of the events outside the price action, they are mostly rendered useless as unquantifiable and unreliable data.

Price moves in trends

Technicalists advocate in favour of 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 bother much about the 'whys'. For example, 'why do trends occur?' would be a reasonable question, but to a technical trader it's completely irrelevant. He just wouldn't know how to quantify the answer. To him the existence of trends is an empirically proven fact which he would be more than happy to demonstrate to you as many times as you please.

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History repeats itself

In order to discuss the third basic premise of Forex technical trading, we're going to refrain from getting too philosophical or psychological, or attempting to prove or disprove that humans operate in patterns.

Technicalists agree that that investors, as a whole, operate in patterns. Because of this behaviour, technicalists believe that they are able to 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 or sentiment analysis. Truly, while technicalists 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 backtesting. Also known as historical backtesting, this is a method employed by traders that uses 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 knowing 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 couldn't care less about 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 very dear to the heart of 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 a combination with other methods.