Thursday, September 01, 2011
In Forex trading, the term “Technical Analysis” or simply TA, refers to visual tools that help traders to determine whether to buy or sell a particular currency pairing.
There are two types of TA tools. The first is using what’s known as pure “price action”. It refers to seeing how price has behaved recently, and how this can be used to estimate future price.
The second is what’s known as “indicators”. These indicators/tools are based on mathematics and complex algorithms. In the past, before the advent of the personal computer, traders had to manually calculate and work out different formulae to apply to currencies/shares/stocks/etc… This as you can imagine was a lot of hard work and very time consuming. Fortunately, the tools we have today can be applied with a click of button, (on the brokers’ software platform) and instantly we have detailed information in a visual format, indicating to us, and allowing us to deduce and decide.
You can see four different charts below containing extra visuals. Besides the actual candlesticks, there are other lines and bars. These are a few examples of indicators. More on indicators in a bit.
TECHNICAL ANALYSIS TOOLS – PRICE ACTIONIn this section, we will just highlight some of the different price action tools utilized by Forex traders. Whilst there are numerous price-action methods, we’re just going to focus on the main three.
We briefly mentioned Candlesticks earlier above. Basically, candlesticks give us four main pieces of information. 1) The price at which the candle opened, 2) the price at which the candle closed, 3) the highest price the candle reached, and 4) the lowest price the candle reached. Potentially, candlesticks on their own have the ability to inform us, whether the market is bullish (moving in an upwards direction), or bearish (moving in a downwards direction).
Knowing how to read the different types candlestick takes time to learn, but can be very useful in gauging the market. In the figure below, the green candle is a bullish candle (i.e. going up), and the red candle is a bearish candle (i.e. going down).
Support and Resistance
Often, you will get a few candles that hit a certain price point or price area, and this creates a potential barrier. This barrier (shown as the white line in the example below), is known as either Support or Resistance. The more candles that fail to break this barrier, the stronger the Support or Resistance could be. Depending on whether the barrier is above or below price determines on whether this barrier is called Support or Resistance. So if the barrier is above the price, the barrier is called Resistance, and if the barrier is below price, it’s called Support.
This example below is of Resistance:
As you can see, some resistance was formed at point 2, after price “tested” the initial area created by point 1. So price came back up a third time (at point 3), to test this resistance, but it failed to break past it. Sometimes, based on this alone, it’s actually possible to predict where price may be headed. So in this case, you might have predicted that the resistance would hold (signified by the white line that I’ve drawn), and you might have decided to “Sell EUR/USD” at point 3, which would potentially have made a lot of money, depending on your initial investment.
Fibonacci trading is named after the Italian mathematician, Leonardo Fibonacci, who lived during the 13th Century. He used a series of special numbers in his calculations. These same special numbers, or ratios, are used today in Forex trading. They allude to the fact that price reacts to certain numbers/ratios, and this reaction can be used to help traders to buy or sell a currency, and therefore profit from it. Hence, just as we’ve seen above where price reacted to the resistance; price can also react to Fibonacci ratios, as shown in the example below:
First, we have to establish that there is a definite trend. And in the example above, we can see there is a downwards (bearish) trend. So then, all we do is, using the Fibonacci tool (available in the forex platform), we draw a line from the high point (point 1) to the low point (point 2). If the trend was upwards (bullish), then we’d draw the line from low to high (instead of high to low). Finally, the Fibonacci tool will then automatically draw the special ratios, (i.e. those yellow horizontal lines) also known as “Fibonacci retracement levels”. So, after point 2, when price was starting to climb up, we already had an indication that price may react to the 23.6 Fibonacci level (point 3). And indeed it did, whereby price raced back down, potentially landing us a handsome profit, if we had anticipated this reaction and sold at point 3. Now, price doesn’t always react to the 23.6 level, it may react at the 38.2 level or the 50.0 level or the 61.8 level. Or it may not even react to either of those levels.
Fibonacci is one of the hardest aspect of Forex trading, and it would be impossible to do it justice unless a whole book (if not volumes of books) were to be written about it. However, suffice it to say, many traders use it, yet many traders don’t use it. Both sets of traders are successful.
TECHNICAL ANALYSIS TOOLS – INDICATORSWe are now going to take a more in-depth look at the different indicators which can help us in our trading. The main reason why people use indicators is to remove any “noise” from the market, i.e. to obtain a smooth visual representation of price, without us having to monitor, assess and analyze every single candlestick.
Now, there are literally hundreds of different indicators that can be applied, however, we will simply be focusing on a few default indicators and how to use them.
The Moving Average
In its simplest form, the Moving Average is a squiggly line that runs across the chart. It’s actually probably the most frequently used indicator in technical analysis, and it shows the average value of a currency’s price over a set time period. It is often used to measure momentum and the general trend/direction of the market. In the example below, the blue line is the moving average.
As you can see, the blue MA gives us a smooth representation of price, i.e. without all the choppiness. What the blue MA line is basically telling us is: The steeper the line is heading down, the more bearish the market is, and the steeper the line is heading up, the more bullish the market is. Although it seems very basic, a lot of traders use the MA to help them in being able to gauge the market. (Some even use a varying form of MA to identify Support and Resistance levels.)
MACD is a special type of Moving Average, which stands for “Moving Average Convergence Divergence”. This indicator can be used as an entry trigger, since there are actually two moving averages which are used.
As can be seen above, when a “cross-over” occurs, a trader may enter on this crossing over. So, at point 1, if using this MACD indicator exclusively, then one could “go long” here, i.e. buy. At point 2, one could “go short”, i.e. sell. And so on and so forth.
There are other ways in which MACD can be used, but we won’t be discussing those here, although the above method is probably the most widely used.
Awesome Oscillator (AO)
The Awesome Oscillator (AO) technical indicator was invented by a man named Bill Williams, who is the author of the “Chaos Trading System”. The Awesome Oscillator is in the form of a histogram and is essentially a visual representation of the market’s driving force at the present moment, using a combination of color (red or green), length (of the actual red/green line), and level (above or below the zero line).
As you can see, in general, the AO turns green when price is moving up, and turns red when price is moving down. There is also a “zero line”, if the AO crosses this line, it can imply there is strength in the trend.
Sometimes the AO may display a series of green-red-green-red bars. This usually means there is no clear market direction.
Parabolic Stop and Reverse (PSAR)
The PSAR indicator is used to determine good exit and entry points; and whether to stay in a trade or not. It may be the case that we’re already in a trade, (before applying the PSAR to our chart), and so once we apply it, it may give us a better idea of whether to exit or stay in.
PSAR is displayed as a series of dots, either above or beneath the candlesticks. So for every candlestick, there is a dot, (whether it’s above or below).
If the candlestick is above the blue dots, it can indicate to us that the trend is heading up (bullish trend), and if the candlestick is below the blue dots, it’s an indication that price may be heading down (bearish trend). PSAR dots also “accelerate” or “decelerate”, meaning the spacing between dots may increase or decrease. This increase or decrease of space is also another method in using the PSAR.
This now sums up the section on Technical Analysis. As you have seen, there are two main types of TA: “Price Action” and “Indicators”. This is by no means comprehensive, but rather a simply a gist of a few of the TA methods that can be used. As you start trading, you will slowly start to implement some of the techniques outlined above, and get a feel for the movement of the market.