It would not be an exaggeration to say that technical analysis is the most popular analytical method in the financial market. Many new Forex traders follow strategies based on the results of this analysis. However, not everyone truly understands what technical analysis is, what it’s based on, or why this trading strategy is sometimes successful and sometimes not. You will learn about the different types of technical expertise, advantages, and disadvantages while reading this article. It will also help you decide whether or not you are going to use this method in your trading strategy, and if so – how to use it correctly.
Definition of Technical Analysis
Technical analysis is a prediction of future price changes based on the analysis of price changes in the past. Technical analysis consists of the study of charts and the identification of patterns. Mathematics and statistics calculations are often used to convert models and patterns that are formed in the chart into the forecasts, which determine the one that can be opened for trading.
History of Technical Analysis
It is believed that technical analysis was first implemented in Japan during the 18th and 19th centuries. During those times, Japanese rice merchants started using charts to track and analyze product prices.
Later, Western countries called these charts “Japanese candle”.
At the end of the 19th and beginning of the 20th century, an American journalist and researcher named Charles Dow started the classic technical analysis. His published series of articles about prices on the securities market later became a fundamental component of the Dow theory.
In the middle of the 20th century, the development of computer technologies allowed the first indicators to appear. The indicators calculations were created automatically, which made it possible to apply the results of complex formulas to the graph. From that point onwards, computer analysis developed very fast, indicators began improving, and new tools were found. “Candle” and graphic analyses have kept their initial design, but they are still quite popular among traders.
Postulates of Technical Analysis
There are several main postulates of the technical analysis made by Charles Dow (or by his followers on the basis of his articles). They represent the very essence of technical expertise and explain why it should even work in the first place.
Price considers everything
This postulate rejects the significance of the fundamental analysis. Price considers everything means that there is no point in tracking down all economic and political news, pay attention to the “loud” events. Everything that could affect the price is already taken into account. That is why the priority is to study charts and indicators.
Price movement delivers the trend
Random price fluctuations form the sequences – trends. Each timeline represents the directional price movement (ascending and descending trends), or flat – fluctuations in the horizontal diapason. Even though the tendencies break and change sooner or later, it is believed that the possibility of the continuation of the current trend is higher than the probability of its change.
History repeats itself
This postulate explains how technical analysis works in general. It is based on the following idea: let’s say, that you formatted a certain pattern on the graph, which resulted in the price moving in a particular way. The next time the same pattern occurs, it is likely the price will behave similarly. At the very least, its probability will be much higher than the probability of a different scenario.
People change the market and their actions can be explained by psychology. Technical analysis allows market trends to be seen in graphic form.
The main problem is that the probability of an absolutely identical situation occurring is extremely rare. That is why analyzing the patterns is a priority. Often, a trader has to decide whether the situation on the graph fits the pattern or not, and question whether he should open a deal.
Technical Analysis tools
Let’s take a look at comprehensive technical analysis tools which are used in contemporary Internet trading.
Candlestick analysis is believed to be the very first sub-type of technical analysis, its predecessor. In contemporary candlestick analysis, trade is conducted on the patterns formed by one or several candles.
The main patterns of candlestick analysis are:
- External bar
- Internal bar
- Morning/evening star
- Gap, etc
Each pattern informs a trader that the price will likely move in a particular direction. For example, the “hangman” pattern on the graph indicates that the price is more likely to turn downwards (the pattern forms at the top of the ascending trend). The pattern thus gives the trader a signal to sell.
The trend line is the basic instrument of graphic analysis, which helps to reveal the current direction of the trend. It is first defined in a visual manner, then the relevant line is added.
- If the trend is ascending, the line is held under it, being attached to the local minimums.
- If the trend is descending, the line is held above, attached to the local maximums.
The most effective way to trade using trend lines is to trade breakouts.
- If the price penetrates the descending trend’s line, bottom-up, then one should open a deal to buy.
- If the price is penetrating the ascending trend’s line, top to bottom, one should open a deal to sell.
Support and resistance levels
Support and resistance levels are quite similar to trend lines. The only difference is that the S&R levels are horizontal. The support is built on the local minimums and the resistance is built on the local maximums. Support breakout gives the signal to open a deal to sell, while resistance breakout signals that it is the right time to buy.
Figures of Graphic Analysis
Graphic analysis is one of the largest components of technical analysis. It is based on studying the figures created by fluctuations in the price chart.
There are three types of figures:
- Turnaround figure (head and shoulders, double top/double bottom). If you see these figures, then the trend is very likely about to change, and you should open deals in the opposite direction.
- Figures of the trends’ continuation (flag, pennant). Formation of these figures signals that there is a high possibility that the trend will continue, and you should open deals in its’ direction.
- Uncertainty figures (triangles and others). Such figures mean that the market could move in any direction and one should abstain from the trade for a while.
In accordance with the type of figure formed on the chart, the trader will open a deal in one direction or another, or will even stop trading for the moment.
Technical analysis indicators are automatic tools which spare the trader the necessity to analyze the graph himself and make a decision about opening the deal.
The indicator gives you a clear sign and the trader opens the deal when he sees the signal.
Each indicator is automatically plotted according to a certain formula. For example, the most popular and basic indicator, moving average, is just the average value of the price indicators during a certain period. A moving average, with a period of 10, is the arithmetic mean of the price for the last 10 time marks.
Indicators can be the following:
- Volume indicators
Usually, the signal for opening a deal is formed by the interaction between indicators and the price, or with other indicators.
Fundamental vs. Technical Analysis
It is hard to tell what type of analysis – technical or fundamental – is more effective or popular. Each of them has its own advantages and followers.
Fundamental analysis is based on studying the news, reports and other external factors that can affect the price.
Followers of this method certainly do not agree with the postulate “price considers everything”. They believe that technical analysis is looking at the past (and history doesn’t always repeat itself), while fundamental analysis is looking to the future.
Though they may have one thing in common: even the most thorough analysis of the fundamental data does not guarantee you a prediction of the price changes that is 100% correct. For example, a positive quarterly company report, with the revenues significantly exceeding expectations, may not raise the price of the company’s shares if the market participants think that it is already high.
Novice traders may find it challenging to choose the type of analysis they should use for themselves. On the one hand, technical analysis systems are often totally automated and the trader just has to notice the signal in time and open a deal in the proper direction. On the other hand, newbies also look for strategies that do not have indicators (they think indicators are too complicated for them), and fundamental analysis does not use these tools except for several information panels.
Technical Analysis in Forex
In Forex trading, technical analysis has an even better position than fundamental analysis. This is due to certain fundamental analysis facts that are relevant for the stock market (like quarterly reporting of a company or dividend info), but are not suitable for the Forex market. Still, the techniques used in technical analysis can be applied to both the stock and Forex market.
The classic strategy of technical Forex trading consists of several indicators, which give signals and function as filters for each other.
For example, let’s have a look at the Forex trading strategy using the MACD indicator and two MA.
You can open a strategy transaction when you meet the following requirements:
- If the fast-moving average (5-period) crosses the slow (10-period) from top to bottom and the MACD histogram crosses the MACD line in the same direction, a sales transaction is opened.
- If the fast-moving average crosses the slow one from the bottom up and the MACD histogram crosses the line from the bottom up, a buy transaction is opened.
This is an example of a simple Forex strategy. Some trading strategies are based on the readings of five or more indicators and include tools for the automatic recognition of the figures of graphical analysis. Complex systems are not always better than simple ones, although well-known strategies are rarely profitable. To be able to make a fortune using Forex trading, you have to develop your own unique strategy.
Every trader should know the basics of technical analysis, even if he doesn’t plan on building his own trading strategy using technical expertise. This method allows for a better understanding of the market and its participants.
To practice technical analysis, a trader needs a trading system. One of the best options is to use the Libertex system provided by the Forex Club. It is completely free, and novice traders may train there using a demo account until they are ready to start trading for real. Besides, the platform has all of the necessary instruments and indicators to complete a high-quality technical analysis of the charts.