Technical Analysis

"Technical analysis" is an industry term that more often than not sounds much more complicated than the actual process is. Really, it ought to be referred to as "price analysis", as this would be a more accurate description. Through the use of charted data, Forex traders around the world analyze their market of choice. The objective: determine future price movement. The means: understanding price movement patterns of the past.

Forms of technical analysis are far and wide, and all technical analysis is common with one very important fact: it uses the past to try and predict the future. This is similar to using only your car's rear-view mirror to drive forward: looking only in the mirror one can use the lines on the road to make sure the car is driving straight forward, and a corner can be spotted when the lines start to move away from the direction the car driving. Just like technical analysis, driving by only using a rear view mirror can be difficult – if not impossible – to spot upcoming sharp corners, especially when moving at fast speeds.

Before delving into technical indicators and strategies, we think it is important to have a general understanding of the basics to technical analysis.

Trends

When using technical analysis, it is often important to be able to recognize the type of trend the market is in. Generally any market condition can be classified into one of 3 conditions: an uptrend, downtrend, or sideways. For a market to be trending up, new highs need to break previous highs (higher highs) and the lows must be higher than previous lows (higher lows). Once the market fails to break previous highs - or if lows dip below previous lows - an uptrend may be in jeopardy and either a sideways market or a downtrend may follow.

Determining the type of trend a market can sometimes be arbitrary because of trend length. There are 3 different trend lengths: long term, intermediate, and short term. The market will never go straight up – or straight down – without making corrections; therefore, a long term trend may be going up, with a correction leading to an intermediate downtrend within the long term’s uptrend.

Support and Resistance

As the market moves up and down, price levels will form; levels that seemingly provide a level of support, or a ceiling of resistance. These levels are appropriately called support and resistance. In the case of our trend example, each consecutive higher-high will be a resistance level, and each higher-low will, likewise, be a support level. The opposite is true for down trends: subsequent lower-lows will be support levels, and lower-highs will be new resistance levels.

These support and resistance lines can form trend lines, where a trend may seem to be defined by bouncing up off of a rising support level, or bouncing down off of a falling resistance level. In order to draw a trend line at least 2 market points are needed, though ideally a trend line will have 3 or more points which will confirm the trend line drawn. The more points a trend line has, the more confirmed and the more important the trend line becomes.

There are many technical indicators that aid a trader in determining a trend and potential entry and exit points. There are some basic technical indicators that a trader should know which will also help a trader understand more advanced technical indicators.

Moving Averages

Most literature written on technical analysis, more specifically technical indicators, begins with moving averages. The reason for this is simple; they are considered by most analysts the most basic and core trend identifying indicators. As its name would suggest a moving average calculates an average of price range over a specified period. For example, a 10 day moving average gathers the closing prices of each day within the 10 day period, adds the 10 prices together and then of course divides the sum by 10 to determine the average. The term moving implies that as a new day’s closing price is added to the equation, and the day that is now 11 days back is dropped from the equation.

There are many different types of moving averages. To read more about the different types of moving averages – and to learn how to use moving averages to trade – read the Moving Average course from our education center.

Moving Average Convergence / Divergence

The MACD indicator is another indicator that helps provide a fundamental understanding of technical analysis for various different reasons. A typical MACD will consist of 2 lines – the ‘MACD’ line, and the‘signal’ line – and will also have vertical bars that comprise the histogram. The main MACD line is a PIP measurement of the distance between 2 moving averages on the chart. Using default settings, the MACD line will tell the number of PIPs between a 12 and 26 period exponential moving average.

The signal line is then an exponential moving average of the main MACD line – by default, set to a period of 9. The histogram then measures the vertical distance between the main MACD line and the signal line.

There are many ways to decipher what the MACD is trying to tell us. To read more about the MACD, and how to use it to trade, read the MACD section of the Technical Analysis section of our Forex education.

Stochastic Oscillator

The stochastic oscillator is a basic form of oscillator that measures current price in relation to previous prices. Chartists use this indicator – and other similar oscillators – to gauge if the current price is overbought or oversold.

Because a market move typically does not make a move in one fell swoop without any corrections, the stochastic gives an indication if it thinks the market due for a possible downside correction (by being overbought) or due for a possible upside correction (by being oversold). Traders set levels at 80 and 20 and would consider anything above 80 to be overbought, and anything below 20 to be oversold. Generally speaking, a sell signal would be generated once the stochastic drops below 80 and a buy signal once it rises above 20.