Technical Analysis Explained

book-threedimensionalapproachSaying that there is a huge amount of information to absorb in the forex market is an under statement of monumental proportions! First and by no means least, we have the daily stream of economic data from around the world, all of which have an impact, both on the home currency, as well as those it trades against in the currency pair – and make no mistake, a release from a powerhouse industrial nation such as China, the US or Japan will send shock waves through the market. Add to this, the regular announcements and comments from central bankers and government finance officials, along with geopolitical events, the information we need to absorb can become overwhelming.

To help make sense of all this information, much of which is often simply additional noise which we can safely ignore, professional forex traders focus on the one piece of information that is not subject to dispute or opinion, and that’s the price, which is displayed second by second on the price chart.

In many ways the price chart can be likened to a giant food mixer, where all the raw ingredients are thrown in, the mixer switched on, with the ingredients then blended into one uniform mixture. This is the essence of a price chart. All the news, views, opinions and market sentiment from every trader, investor or speculator anywhere in the world is captured in that one spilt second on the price chart. If prices are moving higher, then ingredients have combined to produce a positive view, and if prices are moving lower, then the ingredients have combined to produce a negative view.

What is technical analysis

What does the term technical analysis mean, and what are we trying to achieve in studying a price chart and its associated movements as the markets ebb and flow?

Well, in a nutshell, technical analysis, or technical trading, is the study of historical price movements to predict future price movements, and in many ways could be considered to be a philosophy, based on a subjective approach, designed to bring a sense of order to what might otherwise appear to be seemingly random price movements. It is an art, not a science, and is anchored on three over riding principles.

First, that markets are made up of humans and human decision making, and that the human psychology of trading and investing haven’t changed much over the years, whether it was the Dutch tulip frenzy of the 1600’s or the dot com bubble of the late 1990’s, human emotions remain the same. Now, it could be argued, and indeed I would suggest this myself, that this notion is gradually changing, as increasingly price action in the forex markets is increasingly being influenced by automated ultra fast trading executions, with many of the major banks now entering and exiting huge trades in nano seconds, taking huge positions and fractions of a pip. These positions equate to large financial gains or losses. This is likely to become an increasingly prominent feature of the forex markets over the next few years, which could dramatically change the way technical analysis is viewed and approached for ever.

For the time being however, we can assume that the balance of the price action on a chart is triggered by humans and it is the emotional forces of humans buying and selling that is reflected in the historical price patterns that appear over and over again each and every day. So as long as humans are still making decisions, then you will be able to look at the past behavior as a guide to what is likely to happen in the future. And herein lies the problem with the technical approach, in that all our analysis is based on what has happened in the past, and all the tools and indicators that we use are referred to as lagging, in other words, they base their calculations on historical data.

Only ONE leading indicator

book-volumepriceanalysisBut there is one which is a true leading indicator, which leads the market and it’s called volume. Volume leads the way and when combined with the price action on the chart, tells us instantly what is likely to happen next. Volume is the only indicator that we have in our toolkit of technical analysis that has this unique ability.

However, there’s a problem, in that the forex market is one with no central exchange, and with no central exchange we have no access as forex traders to the ultimate leading indicator volume, which is present in every other market. Trade in equities and we have volume on our price chart, which tells us whether a move is genuine, or false, and when compared to the price action, gives us clear signals as to whether the volume is buying or selling volume. Trade in forex, and we have no volume – until NOW.

Volume is the king of indicators, the holy grail, the ultimate indicator that all forex traders desire. Finally we have it on our price charts. No longer is there a blank space at the bottom of the screen, but one filled with volume price bars, to tell us whether the market is buying, selling or moving sideways. What more could we possibly want! And even better, with the MT4 trading platform, the volume indicator is free. All you need to do is to study volume price analysis, and the you’re done!

But to move on – the second underlying philosophy of technical analysis is that in many ways the price action on the chart is a self fulfilling prophecy. After all the greater the number of forex traders who focus on technical analysis, then the more likely it is that their actions will be reflect the interpretations of the charts, and so reinforcing the impact of the analysis. If we are all looking at the same chart and see an area of support or resistance which is then breached, then all those technical traders around the world will be making the same decision, based on the same conclusions and all going long or short at the same time. This of course makes it extremely easy for both brokers and market makers alike to judge where the bulk of these traders have entered, along with likely positions of any stop loss orders, which can then be taken out in due course.

Technical analysis is a subjective assessment of market price action, where individual interpretations can and do vary significantly. Indeed, tow traders looking at the same currency chart may arrive at very different conclusions regarding the future direction of the market. They could both be right, but it depends on the time frame and their respective strategies. After all, as someone once said, you’re always right in the forex market, it’s just your timing that’s wrong!

Applies to all charts in all timeframes

Technical analysis requires patience, discipline and practice, but the beauty of this approach is that is can be applied to every currency pair in every time frame, providing a consolidated and simple view of market sentiment and market mood. So short term traders focus on the intra day charts of minutes or ticks, using certain tools and indicators, whilst longer term traders focus on the hourly, daily or weekly charts. Certain technical approaches work better in some currency pairs than in others, whilst overall market conditions of volatility and liquidity also influence which technical approach works best. The key is to develop your own approach based on your attitudes to risk, which in turn may guide you to trade in certain timeframes and with particular and well defined strategies. Which approach you choose will be a personal choice, but in simple terms technical analysis breaks down into three main approaches.

First, of course, technical analysis is all about the price action on the chart, from which we derive a view of the future market direction. Second, this approach allows us to identify patterns or chart formations, which in turn can give us clear signals of reversals or breakouts. Finally, technical analysis gives us a view of both the momentum and trend of the market with the rate of price change clearly signaling both the speed of any move in price, along with the strength of the associated trend.

In summary, understanding technical analysis and incorporating it into your own trading approach is the first step to becoming a consistently successful forex trader. There are many ways to use this unique form of price action analysis, and ultimately which approach you use will depend on your attitude to risk, your trading capital, and finally the amount of time that you have to devote to your forex trading. There is no right or wrong way to trade the forex markets, but technical analysis sits at the heart for all professional forex traders.