Beside fundamental and sentiment analysis, technical analysis is one of the most popular types of analysis in any financial market. This is especially true for the foreign exchange market, where many traders rely exclusively on technical analysis to draw conclusions about future price movements of a currency pair.
What is Technical Analysis
Technical analysis is based on the assumption that historic price levels can be used to predict future price movement. It is a form of pattern recognition dependent on the idea that humans work in a relatively consistent manner.
One of the most important things required for the successful operation of technical analysis is a lot of historic data, which is why the forex market is a prime opportunity for those who would like to use technical analysis in their trading.
Since the forex market is open 24 hours a day, and has the highest daily turnover of any financial market, it’s perfect for traders who use technical analysis as their primary type of analysis.
Technical analysis helps traders look for trends rather than arbitrage opportunities. It’s not about what can be gained right now, but knowing where a currency is going to move in the future and reacting with prescience.
The flow of capital based on economic, political, and psychological factors is what will determine the future rate of a currency. Technical analysis assumes that all fundamental information is already discounted in the current exchange rate, which makes the chart the best friend of a trader.
Using Technical Analysis to Spot Trends
While fundamental analysis tends to focus on whether a currency is overvalued or undervalued relative to its equilibrium value, technical analysis is interested on whether the currency moves upwards, downwards, or sideways. If a currency pair breaks above or below an important historic price level, technical-based models will issue a recommendation to go long or short on that pair, regardless of the fundamental “fair” value of a currency.
There are three major trends that can form in the forex market: upward trends, downward trends, or sideway trends.
The sideways range indicates that a currency is range-bound and is going to maintain said rate for a period of time. To identify these trends, traders often draw lines connected by the highs and lows of the price, which then form support and resistance levels. Other popular tools include drawing trendlines and channels to project the current trend into the future.
There is usually a lot of hidden information in this data, and a technical trader believes it can be used to conclude future price movement that will allow him to make some profit.
Upward and Downward Trends
Upward and downward trends can be visualized as a series of primary and secondary waves, where the primary waves move the currency pair in the direction of the broader trend, and secondary waves act as corrective phases of the primary waves. The following chart shows a typical upward and downward trend in the forex market.
As a general rule, the major currency pairs (anything including the USD, such as GBP/USD, EUR/USD, USD/JPY) tend to form trends, whereas currency crosses (pairs involving major currencies but excluding the USD) remain range-bound. This can be attributed to the way people classify these countries.
For a long time, some of the major currencies such as USD, JPY and CHF have been seen as safe-havens and when there is trouble in the world, money usually flows into these currencies, forming trends. The interesting part about this is that different currencies have their own personalities and patterns, which creates trading opportunities as traders analyze the movement of different currencies in different ways.
Technical Analysis in Short-Term and Long-Term Trading
When performed on shorter time-frames, technical analysis usually gives better results than any other type of analysis. Short-term trading is in the most part influenced by technical levels, and this is especially true if a currency trades around its long-term fair value.
The reason for this is that fundamental traders will most likely stand beside the market and will not open new positions if a currency is close to its equilibrium level, which gives place for technical traders to fully employ all tools of technical analysis. In the long run, however, currencies tend to move in the direction of their fundamental equilibrium level.
According to a survey of FX dealers published in “How Do UK-Based Foreign Exchange Dealers Think Their Market Operates?”, a whopping 97% of FX dealers believed that fundamental factors played no important role in short-term price movements, while 87% felt that fundamental factors are the main driving force on a long-run basis beyond 6 months.
According to the survey, technical factors are the crucial force behind price movements on an intraday and short-term basis.
This is the reason why technical analysis is so popular with shorter-term traders, such as day traders and swing traders. They use technical models in their daily trading which can be a combination of trend-following rules, counter-trend trading, breakout trading and swing trading.
Using Technical Indicators
Although trends are the most basic aspect of technical analysis; there are also many indicators that are employed for the purpose of predicting where a price is going to move in the future. These include moving averages, stochastics, MACD, RSI, Bollinger Bands and other.
Some of these indicators are used to identify potential oversold and overbought levels, such as stochastics and RSI, while others are used to measure price volatility, such as Bollinger Bands. Although technical indicators can be used in a variety of ways, they all have in common that they use data of previous price levels for their calculation.
Before You Trade
Overall, technical analysis is a way of examining the wisdom of the crowds and using it to your advantage. As a forex trading strategy, it is viable and has a lot of solid data to back it up. Technical analysis is especially popular in short-term trading, where it returns the best results. In the longer-run, fundamental analysis tends to have an edge over technical analysis.
Technical traders can use a variety of tools, such as trendlines, channels, support and resistance levels and technical indicators, to perform their analysis regardless of where the currency stands in relation to its “fair” value.