When you trade Forex, you should carefully implement
an analytical approach as part of your trading strategy. If you have
been around the markets for any length of time, you will have heard of
technical analysis. This is one of the two primary forms of currency
analysis. And, I believe, the more essential part of the trader’s
arsenal. So in this article, we are going to discuss what technical
analysis is and how you can incorporate it into your trade analysis for
better market timing.
There are three basic types of forex market analysis:
Three Types of Forex Market Analysis
To begin, let’s look at three ways on how you would analyze and develop ideas to trade the market.There are three basic types of forex market analysis:
- Technical Analysis
- Fundamental Analysis
- Sentiment Analysis
What is Technical Chart Analysis?
Technical analysis, as it relates to forex, is an
on-chart examination of the respective currency pair in an effort to
find price patterns that can provide clues into future price movement.
Fx technical analysis relies on past Forex data, which is taken into
consideration when determining potential support and resistance levels.
It is commonly accepted that if a Forex pair bounces from a specific
level or pivot point, the pair is likely to conform to this level in
future.
As such technical trading at its most basic level involves using
horizontal and diagonal lines in an attempt to find and trade support
and resistance zones . This type of trading is often referred to as pure
price action trading. Other assistant tools, which technical traders
sometimes use, are technical analysis indicators.
By combining different technical tools, Forex traders
are able to perform a detailed chart analysis of Forex pairs to
ultimately hone in on the best trading opportunities on their chosen
timeframe.
Support and Resistance as a Primary Technical Analysis Tool
If you want to learn technical analysis, you should
start with understanding what support and resistance is. Support and resistance are psychological levels on the chart. These are levels which the price action tends to conform to. If the price creates a top at a certain exchange rate, an eventual return to this level often causes the price action to hesitate. Sometimes the price breaks the level and continues its progress. However, in many cases reaching an already created level might cause the price to bounce. For this reason traders use support and resistance levels for entry and exit points of their trades. But what is the difference between support and resistance?
start with understanding what support and resistance is. Support and resistance are psychological levels on the chart. These are levels which the price action tends to conform to. If the price creates a top at a certain exchange rate, an eventual return to this level often causes the price action to hesitate. Sometimes the price breaks the level and continues its progress. However, in many cases reaching an already created level might cause the price to bounce. For this reason traders use support and resistance levels for entry and exit points of their trades. But what is the difference between support and resistance?
Support Levels
A price support level is a specific level on the chart, which the
price tests while it is decreasing. In this manner, supports are located
below the price action. If the price meets a support on its way down,
there is a good chance that the price will bounce off in a bullish
direction. On the other hand, if the price breaks a crucial support area
on the chart, then we expect the decrease to continue to the next lower
level of price support.
Imagine you are in a short trade in the EUR/USD and the pair is
decreasing in your favor. Suddenly, the price meets an old support
level, which has been tested and has held on prior attempts. In this
case, the respective support level would be a good exit point. You would
close your trade in anticipation of a minor or major reversal off the
support zone.
Now imagine instead, the price breaks that support. In this case,
assuming that your bias is still to the downside, You can reopen your
trade in order to catch an eventual further price decrease.
Resistance Levels
Resistances on the chart act absolutely the same way as
supports, but in the opposite direction. When the price is increasing
and starts hesitating at a certain level, we say that the price has
found resistance. In the case of another price interaction with this
same resistance area, we might expect another bounce from this level.
Same as with support levels, if the price breaks a resistance level, we
expect a continuation of the rally. As such, resistance areas are used
to set entry and exit points when trading – similar to supports.
Let’s assume you are in a long trade in the GBP/USD, and the price is
steadily increasing. The price action then meets a resistance level on
the chart. In this case, this resistance is a good exit point from the
trade. You can exit the trade in anticipation of a minor or major
reversal off the resistance zone.
However, the price might go through this level, right? If this happens, you can then reopen your trade after the breakout for an attempt to catch a further price increase.
Let’s look at this price chart below, which illustrates support and resistance levels in action:
Above you see the H4 chart of the Swissy (USD/CHF) for Feb – Mar,
2016. Note how the price action is squeezed between two well defined
levels on the chart. We have the resistance at the level of 1.0000 and
the support at 0.9890.
Notice that both levels are many times tested and they both contain
the price action for a relatively long time. At the same time, there are
a few cases where the price manages to go below the two psychological
levels, but proved to be false breakouts. So the bottom line is that the
majority of the price action managed to stay within
the corridor formed between 1.0000 and 0.9890. The resistance gets
tested approximately 7 times and the support about 6 times. The 7th time
the price tests the support leads to a real breakout through that
level. After breaking the support, the USD/CHF begins a sideways
movement and eventually tests the already broken support as a
resistance. The price then bounces downwards, creating new lows.
Every price bounce from the support at 0.9890 could be used to open
long trades, which could be closed when the price interacts with the
1.0000 resistance. In addition, every price interaction with the 1.0000
resistance could be used to open short trades. When the price meets the
0.9890 support you would look to close these trades. Then when you spot
the breakout on the support side, you would prepare to go short on an
assumption for a further decrease. More aggressive traders would enter
on be breakout candle and less aggressive traders would wait for the
retest before entering into the short position.
Forex Technical Analysis Using Trend Lines
Another important building block when trading with technical analysis
in currency pairs are the use of trend lines. The trend line acts as a
diagonal support and resistance which measures the scope of a price
tendency (trend). A Trend line is an on-chart straight diagonal line,
which connects the tops and/or the bottoms of the price action,
depending on the direction of the overall trend. Let’s now dive into the
different trend lines you can use on the chart.
Bullish Trend Line
The bullish trend line is a straight line, which connects the sloping
candle lows on the chart during an uptrend. In this manner, the bullish trend line is
always located below the price action. Since the bullish trendline is
located beneath, on its way up the price is frequently bouncing from it.
Therefore, the bullish trend line acts as a support for the price
movements.
If there is a bullish tendency on the chart, and the price returns to
the bullish trend line and bounces upwards, then we have a nice
opportunity for a long trade. In this case you can buy the currency pair
on an assumption that the price is likely to increase for a new leg up.
However, if the price goes through the bullish trendline, then we say
we have a bearish breakout in the trend. When a bullish trend gets
broken, we expect the price to change direction and begin to move to the
downside.
Bearish Trend Line
The bearish trend line acts the same way as the bullish trend line,
but in the opposite direction. Bearish trendlines are used to visualize
and measure the price action during bearish tendencies on the chart. In
this manner, bearish trend lines are located above the price action and
they connect the tops of the candles during downward moves. When the
price is in a down run, it frequently bounces in a bearish direction
from its bearish trendline.
When the price returns to its bearish trend line and bounces from it,
we expect a further price decrease. However, if the price goes through the bearish trend in a bullish direction, we say the trend is broken upwards. In this manner, we expect the price to interrupt the bearish tendency and to reverse to the upside.
we expect a further price decrease. However, if the price goes through the bearish trend in a bullish direction, we say the trend is broken upwards. In this manner, we expect the price to interrupt the bearish tendency and to reverse to the upside.
Let me now show you how a trend line acts on a chart:
Above you see the weekly chart of the Cable (GBP/USD). The period it
covers is Mar 2014 – Jun 2015. The image illustrates a bearish trend on a
chart. The blue bearish line is the respective trend line of the
downward price tendency. The black arrows on the chart point to the
moments when the trend is being tested. The red circle on the chart
shows the moment when the price creates a bullish breakout through the
trend. The last two arrows at the end of the trend show the moment when
the bearish trend turns from a resistance into a support. The green
arrow indicates the reversal in the price direction after the breakout
in the trend.
Forex Technical Analysis Indicators
Many technical traders use indicators in addition to horizontal and
trend line support and resistance lines. There are two types of technical analysis indicators
based on the timing of the signals they give. These are the lagging and
the leading indicators. Let’s now discuss each of these types.
Lagging Indicators
Lagging indicators are also known as trend confirming indicators. The
reason for this is that the signals of the lagging indicators come
after the event has occurred on the chart. In this manner, the signal
has a confirmation character.
The biggest benefit of Lagging indicators is that they provide
relatively high success rate of signals. The negative though is that the
lagging indicators put you in the trade fairly late. Because of this
you will typically miss a relatively big part of the price move.
Some of the most popular lagging indicators are the Moving Averages
(simple, exponential, volume weighted, displaced, etc.), Parabolic SAR
and the Moving Average Convergence Divergence (MACD).
Leading Indicators
Leading indicators are typically the oscillator type. They are
considered leading because these indicators give you a signal before the
potential reversal has actually occurred on the chart. As such their
signals tend to lead the events on the chart. The biggest benefits of
leading indicators are that they can put you into a potential reversal
early.
However, the biggest negative of oscillators is that they can provide
many false signals leading to a relatively lower success rate. This is why leading indicators are not good single standalone analysis tools for executing trades. Traders that utilize leading indicators should combine their analysis with other tools such as candlesticks and support and resistance when implementing their daily technical analysis in FX.
many false signals leading to a relatively lower success rate. This is why leading indicators are not good single standalone analysis tools for executing trades. Traders that utilize leading indicators should combine their analysis with other tools such as candlesticks and support and resistance when implementing their daily technical analysis in FX.
Some of the most widely used leading indicators are the Stochastic
Oscillator, the Relative Strength Index, and the Momentum Indicator.
Now let me show you one of these indicators in action – the
Stochastic Oscillator. The Stochastic gives two signals – overbought and
oversold. In this manner, the indicator has three areas – an overbought
area, an oversold area, and a middle area. When the indicator enters
the oversold area we get a long signal. When the price enters the
overbought area, we get a short signal. When the price is in the middle
area, we get no signals.
Take a look at some of the signals that are provided by the Stochastic Oscillator:
This is the hourly chart of the USD/CAD Forex pair for Nov 18 – Nov
25, 2015. At the bottom of the chart we have attached the Stochastic
Oscillator.
The red circles on the indicator show three overbought signals that
led to price reversals. The green circles point out the valid oversold
signals. Each signal has its adjoining arrow, which shows the move as a
result of the signal. As you see there is a relation between the
indicator signals and the price behavior. When the Stochastic enters the
overbought area, a price decrease comes afterwards. When we see an
oversold signal, we then see the price increasing.
Forex Price Action Trading
Pure Price Action trading is a subset of technical trading, which
relies more on price and chart analysis than the use of trading
indicators. Price action technical analysis in Forex is
based on support, resistance, trend lines, chart patterns and candle
patterns. Since we have already discussed supports, resistances and
trend lines, lets now turn our attention to chart patterns and
candlestick patterns.
Candlestick Patterns
Candle patterns are specific formations, which are created by
individual or multiple candlesticks on the price chart. There are two
main classifications of candle patterns – reversal candlestick
formations, and continuation candlestick formations.
Reversal candle patterns are candlesticks, which
tend to reverse the direction of the current price. Some of the more
reliable reversal candlestick patterns are: hammer, shooting star,
hanging man, engulfing, morning star, and evening star.
Continuation candle patterns are candlesticks, which tend to continue
the price movement in the same direction. Some of more reliable
continuation candle patterns are: mat hold, deliberation, method, and
concealing baby swallow.
What is important to note is not the actual names of the candle
patterns themselves, but the price action that they create. Once you are
able to recognize the price movements that comprise the formations, you
will be able to take advantage of trading them in an informed manner.
Classical Chart Patterns
Chart patterns are specific formations, which are created by the
general price action on the chart. Same as the candle patterns, chart
patterns are also classified in two types – reversal, and continuation.
Reversal chart patterns are likely to be followed by reversal price
movement on the chart. The most reliable reversal chart patterns in
trading are: double top,double bottom, triple top, triple bottom, and
head and shoulders.
Continuation chart patterns are used to predict the continuation of
the general trend. The most popular among the continuation chart
patterns are flags, triangles and rectangles.
The image below shows how price action based technical analysis works:
This is the H4 chart of the USD/CHF for Dec 30, 2015 – Jan 15, 2016. The image shows a few interesting on-chart events, which lead to potential trading opportunities.
The image starts with the price moving after a bullish trend line
(red). Suddenly, the trend gets broken in a bearish direction, which
creates a short breakout signal. The price starts to decrease
afterwards. Two bottoms are created on the chart. The second one ends
with a Hammer Reversal candlestick. As you see the price starts
reversing to the upside shortly afterwards. On the way up the blue
bearish trendline gets broken.
The two bottoms on the chart create the well known Double Bottom
reversal chart pattern. The yellow resistance on the chart indicates the
top between the two bottoms of the chart pattern. Therefore, the yellow
resistance is the trigger line of the pattern. After the price action
closes a candle above the yellow resistance, we expect a price increase
equal to the size of the formation. So, the trend was bearish (blue
line) and a Hammer candlestick, trendline breakout, and a Double Bottom
chart pattern forecasted the reversal of the bearish movement.
Conclusion
Technical Analysis in Forex relies on analyzing previous price behavior of currency pairs to determine potential price moves in the future.
The most important tools in technical analysis are:
- Support Lines
- Resistance Lines
- Trend Lines: bullish and bearish
Other trading tools that currency technical analysts use are trading indicators. They are two types of trading indicators:
- Leading Indicators: give the signal before the event has actually occurs on the chart
- Lagging Indicators: gives the signals after the event has actually occurred
Pure Price Action analysts rely on technical analysis using price and
chart analysis exclusively. Some of the common things that technical Price action traders utilize include:
chart analysis exclusively. Some of the common things that technical Price action traders utilize include:
- Chart Patterns: reversal, and continuation
- Candle Patterns: reversal, and continuation
- Support and Resistance Lines
- Trend Lines
