Technical analysis is another method of forecasting prices. It studies past price action in an attempt to predict the future. The technical analyst focuses exclusively on market information and works on the assumption that all fundamental information is already reflected in the price. Unlike the fundamentalist, the technician attempts to predict future price directions by searching for established patterns of price behavior that have signaled major movements in the past.
Charts are the major tool in technical analysis. The following is an introduction to the most common technical analytical tools used to identify trends and recurring patterns in a volatile market.
There are three main types of charts used in technical analysis:
Line Chart: The line chart is a graphical depiction of the exchange rate history of a currency pair over time. The line is constructed by connecting daily closing prices.
Bar Chart: The bar chart is a depiction of the price performance of a currency pair, made up of vertical bars at set intraday time intervals (e.g. every 30 minutes). Each bar has 4 ‘hooks’, representing the opening, closing, high and low (OCHL) exchange rates for the time interval.
Candlestick Chart: The candlestick chart is a variant of the bar chart, except that the candlestick chart depicts OCHL prices as ‘candlesticks’ with a wick at each end. When the opening rate is higher than the closing rate the candlestick is ‘solid’. When the closing rate exceeds the opening rate, the candlestick is ‘hollow’.
One use of technical analysis is to derive “support” and “resistance” levels. The underlying idea is that the market will tend to trade above its support levels and below its resistance levels. A support level indicates a specific price level that the currency will have difficulties crossing below. If the price repeatedly fails to move below this particular point, a straight line pattern will appear.
Resistance levels on the other hand, indicates a specific price level that the currency will have difficulties crossing above. Recurring failure for the price to move above this point will produce a straight line pattern.
If a support or resistance level is broken, the market is expected to follow through in that direction. These levels are determined through analysis of the chart and by assessment of where the market has encountered unbroken support or resistance in the past.
Moving averages provide another tool for tracking price trends. A moving average is in its simplest form an average of prices that rolls over time. A 10-day moving average is calculated by adding the last 10 days’ closing prices and then dividing them by 10. On the following day, the oldest price is dropped, and the new day’s closing price is added instead; now these 10 prices are divided by 10. In this way, the average “moves” each day.
Moving averages provide a more mechanical approach to entering or exiting the market. To help identify entry and exit points, moving averages are frequently superimposed onto bar charts. When the market closes above the moving average, it is generally interpreted as a buy signal. It is in the same way considered a sell signal when the market closes below the moving average. Some traders prefer to see the moving average line actually change direction before accepting it as a buy or sell signal.
The sensitivity of a moving average line and the number of buy and sell signals it produces is directly correlated with the chosen time period for the moving average. A 5-day moving average will be more sensitive and will prompt more buy and sell signals than a 20-day moving average. If the average is too sensitive, traders may find themselves jumping in and out of the market too often. On the other hand, if the moving average is not sensitive enough, traders risk missing opportunities by identifying buy and sell signals too late. Moving averages can be extremely useful tools for the technical trader.
A Trend line helps identify the trend as well as potential areas of support and resistance. A trend line is a straight line that connects at least two important peaks or troughs in the price action of an underlying tradable. No other price action must break the trend line between the two points. In this way a trend line marks a support or a resistance area where the price has turned (peaks and valleys) and has not been violated. The longer a trend line the more valid it is, especially if price has touched the line several times without penetration.
The penetration of a long term trend line may be an indication that a reversal of the trend is about to occur. However, there is no guarantee that this will happen. As with all indicators of a price trend reversal, there is no proof method that predetermines where future prices will go.
A Double or a triple bottom formation also provides a good level for a technical sell-stop order. Such a sell-stop order would normally be placed just below the prior lows. Likewise does a double or a triple top formation provide a good level for a technical buy-stop order just above the prior highs?
When a market is moving swiftly in a given direction, it may sometimes pull back as market participants take their profits. This phenomenon is known as a retracement often it presents a good opportunity to re-enter the market at more attractive levels before the underlying trend resumes. Using Fibonacci ratios is a common way of measuring retracements.
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