Technical Analysis – What to Consider
If the fundamental analysis is giving traders the reason why a market is moving, technical analysis is giving the direction, or the target for any given trade. It is being said that fundamental and technical analysis should be both considered before opening a trade, as they are equally important for a trading decision. Technical analysis deals with interpreting patterns on the left side of the chart, or patterns that formed back in time (using historical prices), with the purpose of identifying future price levels that can be derived from those patterns. This kind of analysis might look as being unreliable, but works very well when it comes to finding support and resistance levels that matter for a currency pair. There are so many different approaches when it comes to technical analysis that at one moment of time one would have to choose what suits best as it is not possible to use all of them when trading. There are the Western and the Japanese approaches to consider, trend indicators and oscillators to interpret, and different trading theories to use and master. One thing must be understood from the very beginning: there’s no holy grail in using technical analysis and any kind of setup works only in a specific situation. Any technical analysis setup should consider fundamental factors as well, as any analysis that is not using both approaches will be doomed to failure.
What Makes Technical Analysis
In plain English, technical analysis represents the ability to chart a currency pair using different technical tools in order to have an idea about future market direction. The beauty of doing that is that the outcome should have a direction, a take profit, and a stop loss, and this makes trading well anchored in money management rules, making it very difficult for a trading account to be wiped out. There are many things to consider when looking at the overall technical analysis, and they are being classified based on the inputs traders are using for charting a currency pair.
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Western Approach vs. Japanese Approach
Technical analysis has its roots in the Western hemisphere as the United States of America was the first part of the world to use charting techniques in order to forecast future prices a financial product may make. For that, various concepts like reversal and continuation patterns have been introduced, with them representing the very basic of technical analysis these days. In this category, we can talk about rising or falling wedges, head and shoulders patterns, double and triple tops, and all of them represent reversal patterns. There is virtually no trader out there (or at least it should not be one) that doesn’t know these patterns and how to interpret them Channeling techniques and continuation patterns like pennants and bullish or bearish flags are also part of the same basic technical analysis concepts. The only thing that is different is that some traders are mistaken a bullish flag with a pennant, but in the end, the price should break in the same direction so the actual technical analysis has the same outcome. Recently (in the last couple of decades), the whole technical analysis concept as it was known so far was influenced by the Japanese approach to this subject. Japanese were using different charting tools to anticipate price reversals or continuations and these tools were based on a new type of chart: candlesticks chart. The price of a financial product is being divided in different time frames, like the monthly, weekly, daily, four hours, hourly, and even lower, and a candle represents the time unit that corresponds to that chart. For example, a candle on the monthly chart represents one month, while a candle on the hourly chart represents one hour. Moving forward, the Japanese applied so-called Japanese Candlestick Techniques mostly to find out reversal patterns based on these candles and to spot tops or bottoms. In a way, it is the same thing the Western approach tried to do: to use patterns to find out reversal or continuation patterns, only that for the Japanese these patterns were actually candles or group of candles.
These techniques were so effective as they were embraced with much enthusiasm by the Western world and to this day they are being widely used. One can talk about reversal patterns like bullish or bearish engulfing, dark-cloud cover or piercing, morning and evening stars, hammer or hanging man, or about continuation patterns like a simple Doji candle.
Trend Indicators and Oscillators
On top of that part of technical analysis mentioned above, there are a lot of trading indicators that can be used in order to forecast future prices a currency pair is about to make. These indicators are either trend indicators or oscillators.
Trend indicators are applied on the actual chart and they represent exactly what the name suggests: indicators that are used for the purpose of riding a trend until its exhaustion. It is being said that a trend is a trader’s friend, and this is true to the extent that the trader knows when a trend started and what to do to ride this trend. There are so many trend indicators that it makes no sense to mentioned them all here. Just keep in mind that the most popular ones are moving averages (simple and exponential ones), Bollinger Bands or the SAR Parabolic indicator. All of them are showing basically the same thing: how to ride a trend. When using them, traders are looking to buy dips in a bullish trend or to sell spikes in a bearish one.
The other category of trading indicators is being formed out of oscillators. These indicators are being applied on the lower side of the screen, below the actual chart, and represent a value plotted based on different inputs the oscillator takes into account (number of candles considered, averages, etc.). Successful approaches when trading with oscillators relate to traders looking for divergences between the moves price and oscillator are making. There are bullish and bearish divergences, so long or short trades can be taken.
Last but not least, the technical analysis comprises many trading theories one can use in order to forecast future prices. From Elliott Waves to Gann, there are many trading theories worth mentioning, and here on Forex Trading Academy, we’re going to cover the most important ones. All in all, technical analysis is a must for any trader involved in the Forex market. No matter the tool used (indicator, pattern, or trading theory), technical analysis, if used correctly, gives the direction where the market is supposed to move.
Other educational materials
- Moving Averages – Find Support and Resistance Areas
- How to Use Parabolic SAR to Buy Dips or Sell Spikes
- Bollinger Bands – Profit from One of the Best Trend Indicators
- What is Forex Trading?
- What is a Currency Pair?
- Majors and Crosses – How to Trade Them?
Recommended further readings
- “The use of technical analysis in the foreign exchange market.” Taylor, M. P., & Allen, H. (1992) Journal of international Money and Finance, 11(3), 304-314.
- Market statistics and technical analysis: The role of volume. Blume, L., Easley, D. and O’hara, M., 1994. The Journal of Finance, 49(1), pp.153-181.