Basics of Technical Analysis
There are two reasons why traders take a position on the currency market: fundamental and technical ones. Both are equally important in the decision-making process, and it is common among traders to consider both analyses before engaging in a trade, especially if the time horizon for that trade is consistent. There are advantages and disadvantages to using these two analysis types separately, but to better manage them, they need to be considered together. A currency pair is formed of two currencies that are paired against each other. If one looks at the differences between the two economies that represent these two currencies and compares them, then one economy will turn out to be performing better than the other one. This should reflect in its currency being stronger than the currency it is paired against in a currency pair. The process of comparing economic data to gather information about how a currency or a currency pair is moving is called fundamental analysis. Traders using fundamental analysis as the basis for their decisions being called fundamental traders. The ones that fit in this category usually have a longer time perspective for a trade to reach a target than technical traders do.
What is Technical Analysis?
Technical traders are chart people. These people look at chart set-ups on different timeframes and from different angles, and compare historical data to work out future price levels. Patterns have the tendency to repeat themselves in time, just as history repeats itself. This, and much more, is technical analysis .
Technical Analysis Based on Indicators
Technical traders come in different types as well, and most of them use indicators to get in and out of a trade. The idea behind this type of trading is to look at overbought and oversold levels in an oscillator, or to use a trend indicator to ride a trend. The technical analysis field is so vast because there are so many indicators that it is impossible to consider them all. As a result, everyone uses what fits with their personality and trading style. Much of trading is about market psychology and people’s view of the market. Not everyone can be a trader, and not everyone trades with the same time horizon in mind. A good example would be that traders find it equally difficult to hold a winning position for a long time or to hold a losing one for the same period. In the first instance, the fear of the market returning and wiping out profits dominates, and in the second, the fear of taking the loss only to watch the market returning to its initial direction will punish traders. To avoid emotions, traders that fit into this category use technical indicators, trend or oscillators, and rely on the signals provided. This works to some extent, but even in this case, human nature plays tricks on us, and rules are not followed 100% of the time.
Technical Analysis Based on Technical Trading Strategies
The technical analysis field is an old one, and the whole thing started in the United States. This is also known as the Western approach to technical analysis, and in the beginning, it dealt with basic patterns that are popular even today. Such patterns are head and shoulders, wedges, pennants, flags, triangles, etc.; things that are mandatory even today for all traders involved in speculation to know. However, things evolved, and technical analysis grew, with more and more concepts being added.
Elliott Waves Theory
This is one of the most popular theories, and all traders in the world know at least some basic stuff regarding it. The reason why it is so popular comes from the fact that the concept is an easy one to understand. However, as it is with all things that are simple or perceived to be simple, there is a catch. Elliott Waves theory is one of the most complicated and diversified trading theories in the world, and the only one that allows for putting a time perspective to a trade.
Japanese Candlestick Techniques
In contrast with the Western approach, the Japanese dealt with candlesticks throughout their history, as this was a new method to forecast fish prices. Candlesticks were embraced with enthusiasm in the Western world, as they are powerful patterns. The beauty of candlesticks comes from the fact that they are reversal patterns, and the longer the timeframe is, the stronger and more powerful the reversal to follow will be. They give clear entry and exit levels, and allow for proper risk/reward ratios to be defined.
Other Trading Theories
The above-mentioned trading theories are not the only ones that exist. There are traders who look at Gann, Pitchfork, DeMark, or Gartley approaches, or use Point and Figure and Renko charts to forecast a trend. All of these theories come with their specific rules and interpretations, but in the end, the aim is the same: to forecast future prices based on something that happened in the past. There is not a clear recipe or a holy grail for which theory is the best. If there was, then trading or speculation would not be so challenging. There are people who made it, in the sense that they found something that works for their trading style and lifestyle; and together with a sound money management system and trading discipline, they can monetise the whole system. There are simply people who are not suited to trading, as emotions and the day-to-day roller-coaster in the currency markets are too much for them to handle. In any case, one thing is sure: technical analysis is here to stay, but it won’t work as a stand-alone way of looking at things. It is no wonder that retail traders are fond of technical analysis such as trading with indicators, and rely on these indicators for their trading decisions. In doing that, they’re using short time horizons for their trades, and they are mostly scalpers (traders who keep a position open for a short period, and have multiple entries and exits during a trading day). Scalping is a great way of profiting from the swings in the Forex market, but unfortunately it is not for anyone. The high-frequency trading industry has its footprint on it, and the swings caused by trading robots are enough to wipe out even the most experienced swing traders. Experience is key here, but to gain experience one needs to first survive in this ever-changing environment. To gain experience it means that other factors rather than only technical ones need to be considered. Fundamental factors are the ones that complement the overall picture, and by the time experience is gained, traders are hooked on the fundamental side as well; then just like that, both fundamental and technical analysis end up as equally being the basis of taking a trade in the Forex market. This is the right approach, and anyone failing to understand this will suffer when it comes to the profitability of their trading account.
Recommended Further Readings
- Forex Brokers Types – ECN or STP?
– What ECN and STP are; how brokers deal with clients’ orders; and advantages and disadvantages of the two types.
- What Makes a Good Forex Broker?
– Things to consider when deciding what broker to trade with. What are the factors that weigh the most in the decision-making process?
- Why Trade with a Regulated Forex Broker?
– What regulation is for brokerage houses; why it is important; and things to look for, such as how to check whether the broker is telling the truth, etc.
- Benefits of Mobile Forex Trading
– Pros and cons of mobile trading, highlighting the net benefits of it.
- Explaining Commissions in Forex Trading
– What type of Forex trading accounts are subject to paying commissions, what it means and whether it is a good or a bad thing.
- Forex Brokers Types – ECN or STP?
Other Educational Materials
- Designing a neural network for forecasting financial and economic time series. Kaastra, I., & Boyd, M. (1996). Neurocomputing, 10(3), 215-236.
- Beyond technical analysis: How to develop and implement a winning trading system. Chande TS. John Wiley & Sons; 2001 May 24.