Technical analysis in forex trading is the basis that most traders employ to study price movement in the market.
This type of analysis recognizes price patterns and trends in the foreign exchange market with the aim of forecasting price movements in the future.
Essentially, technical analysis helps traders to know the big picture of historical price movement to correctly time market moves.
Whereas followers of technical analysis may use various tools and concepts in trying to find the best trading opportunities, the common tool used by all is the chart.
That is why sometimes technical analysts are called “chartists”.
Technical analysis is grounded on the following three main assumptions:
- Every fundamental condition is depicted in price movements
Technical analysts believe that the fundamental factors, such as state of the economy, social issues, and political forces, that affect the value of currencies are already reflected in price movements.
Thus, their analysis of the market is directed exclusively at the type of movements charts make.
- The movement of currencies takes place in trends
Traders using technical analysis in navigating the forex waters hold that the constant rise and fall of prices occur in an orderly fashion, which is both systematic and easy to forecast.
Prices of currencies generally move in three trends: upwards, downwards, or sideways. After a pattern has been formed, price movements will tend to move within that pattern before another one is developed.
- History tends to repeat itself
Forex traders who rely on technical analysis study historical price movements since they hold that price will behave in the same way it did before.
For example, if a strong support area has formed on a currency pair in the past, technical analysts will seek to find out if either price bounces off the area or price breaks it before calling a shot on the pair.
It is of essence to note that the term technical analysis is basically an umbrella term that is used to illustrate any type of price analysis that depends principally on the studying of charts.
Beneath this umbrella, various schools of technical analysis are present and different kinds of concepts have been used in identifying profitable trade opportunities.
Here are the five main schools of technical analysis:
- Trends
As earlier mentioned, the movement of currencies generally take place in three trends: upwards, downwards, or sideways.
Therefore, traders using technical analysis usually study the charts to identify any of these trends before executing orders on their trading platforms.
- Indicators
In the world of trading currencies, indicators are important in portraying the graphical representation of the fluctuation of prices.
Examples of leading indicators (identify possible trading opportunities before trend is formed) include Stochastic, Parabolic SAR, and Relative Strength Index (RSI).
And, examples of lagging indicators (identify possible trading opportunities after trend is formed) include Moving Average Convergence-Divergence (MACD) and other moving averages.
- Waves
As earlier mentioned, technical analysts hold that the rise and fall of currency prices occur in orderly and predictable patterns.
These fluctuations form “waves” that are easy to spot. The common technique used by most traders here is the Elliot Wave theory
- Gaps
Gaps are places on charts in which there is no trading activity. Technical analysts usually trade them by looking at high-low and open-closing prices.
When there is a gap on a chart, traders usually expect it to be filled. This is called the gap theory.
- Number theories
Number theories are used for forecasting areas of potential price movements. Examples include the Fibonacci numbers and the Gann numbers.
Summary
When used as a basis for trading currencies, technical analysis can be as difficult or as easy as the trader wants it to be.
The fault most novice forex traders make is to crowd their charts with indicators, moving averages or Fibonacci numbers and attempt to trade based on a multitude of approaches.
The truth is that maintaining a simple approach and comprehending the basics will usually lead to better results.
As the old adage goes, “if you are a jack of all trades, you will be a master of none”.
It is essential you keep your approach as simple as possible and you will overflow your account with pips faster than you expected.
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