Education to help you become a more confident trader
Technical Analysis
Guide to Forex Trading
What's so great about technical analysis?
Once a trader masters technical analysis, it is easy to apply it to any currency and time frame, thus allowing a relatively short amount of time to figure out where trends are going. Because of the short time, technicians can follow numerous currencies at the same time, whereas fundamentalists usually focus on one or two pairs of currencies, because there is so much information in the market to analyze.
Traders using fundamental analysis can run into trouble because there are so many different ways to analyze market information. This causes controversy and can lead to misdirection, misunderstanding, and, ultimately, loss of money. On the other hand, technical analysis can be much more straightforward. Many traders even consider it to be a self-fulfilling prophecy, meaning that it works well because so many traders use it. This is an important aspect of technical analysis because if many traders are basing their decisions on technical indicators, then the indicators must be watched because they reflect the sentiment of the market and the majority of the traders.
Why is the foreign exchange market an ideal market to use technical analysis?
The foundation behind using technical analysis is to find trends when they first develop, which allows the trader to ride the trend until it ends. The foreign exchange market is typically composed of trends and is, therefore, a place where technical analysis can be effective. Traders are able to speculate on both up and down trends in the foreign exchange market because it is possible to buy a currency and sell against another currency. This aspect of currency trading works well with technical analysis, because technical analysis helps determine where the trends are and which way they are going, thus giving the trader a chance of trading in the market, regardless of its direction.
In comparison to the equities and futures markets, technical analysis is much more common and popular within the foreign exchange markets, which causes the traders to pay attention to them. The market partially moves because of all the technical analysis performed. For example, according to technical analysis, if a currency pair decreases, then the majority of traders will sell the pair, causing it to drop further.
Support & Resistance
At the core of all technical analysis theory are two very simple concepts: support and resistance. Support can be defined as a "floor" through which the currency pair has trouble falling below. There is no scientific formula for calculating support; it is something that is typically "eyeballed" by traders, and hence involves somewhat of a subjective element.
Resistance, on the other hand, is simply the opposite: it is the upper boundary through which a currency pair has trouble breaking. Similar to support, resistance levels are somewhat subjective. Generally, if the market reaches a certain number, a number of times and cannot sustain a break above that level; it can be identified as resistance.
The reason why price has trouble breaking these levels is the presence of actual orders around these levels. A support level is simply a price area where buy orders tend to be, and so it takes more than normal selling pressure to break that level. Similarly, a resistance level is a price area where sell orders tend to be, and so it takes more than normal buying pressure to break that level.
Support and Resistance in Range-bound Markets
One simple way to use support and resistance in trading is to simply trade the range: in other words, traders can simply buy at support level, and sell at resistance level. A key advantage of this is that the FX market is range-bound a majority of the time, making it an attractive strategy for many market conditions.
The downside of range-bound trading, though, is twofold:
Range-bound trading generally does not yield substantial gains on a per-trade basis.
When the market breaks out of the range, it often will make big moves. As a result, traders using range-bound strategies can suffer large losses when the market breaks out of the range.
The chart above illustrates the concept of range-bound trading.
Support and Resistance in Momentum Markets
Another way to use support and resistance is to trade outside of the range; in other words, to anticipate a breakout. This involves placing orders to buy above resistance and to sell below support. The rationale is that the market will gain momentum once it breaks out of the range, and thus by placing orders just below or above of support or resistance, traders may be able to profit if the market continues to move out of the range and they are on the right side of the market. Momentum trading is a bit counter-intuitive, as it involves buying at a higher price and selling at a lower price.
The chart above illustrates the concept of momentum trading.
Oscillators
Oscillators are a class of mechanical trading tools that offer indications of when a currency pair is overbought or oversold. A popular oscillator is the Relative Strength Index.
Relative Strength Index
The relative strength index (RSI) is a momentum indicator that measures a currency pair's strength relative to its own recent past performance. As the indicator is front-weighted (more importance is given to the most recent data), it typically provides a better velocity reading than other oscillators. RSI is less affected by sharp movements, and filters out a lot of "noise" in the Forex market. Many traders also use this indicator as a substitute for volume confirmation, since the over-the-counter structure of the FX market does not allow for real-time volume reporting.
The basic formula for calculating RSI is as follows:
100-[100/ (1+U/D)]
U = average of upward price change
D = average of downward price change
To obtain U (or D), add closing values for the up (down) days and divide this total by the time period under study.
RSI's levels are between 0 and 100. Most traders use 30 as an oversold condition and 70 and as overbought condition, although some traders may use 20 and 80. When choosing the settings for RSI, traders should typically use the default time period of 14, since that is what the market as a whole tends to look at.
There are five different uses for RSI:
- Top and Bottoms – Overbought and Oversold conditions are usually signaled at 30 and 70.
- Divergences – When a pair makes new highs (lows) but RSI does not, this usually indicates that a reversal in price is coming.
- Support and Resistance – RSI may show levels of support and resistance, sometimes more clearly than the price chart itself.
- Chart Formations – Patterns such as double tops and head and shoulder may be more visible on RSI rather than on the price charts.
- Failure Swings – When RSI breaks out (surpasses previous high or low), this may indicate that a breakout in price is coming.
An Example:
RSI was useful in detecting this USD/JPY short after a crossover of the 70 "overbought" level materialized on the daily. Following the clear sell signals, the pair moved down 450 pips over the next 30 days.