Introduction to Technical Analysis

The technical analysis is the study of price movement. You can look at historical prices and determine the current trading conditions and potential changes in the market. The main concept for using technical analysis in forex is that all current market information is reflected in the market price.

Chart

A price chart is a sequence of prices which are plotted over a specific time frame. The vertical axis on the chart, represents the price scale and the horizontal axis represents the time. The three most popular chart types are the line chart, the bar chart and the candlestick chart.

The line chart draws a line from one closing to the next closing price. When you combine them together with a line, you can see the general price movement over a certain period of time. For technical analysis, the line chat gives a fairly good idea of where the price of a currency pair has travelled over a given time frame.

The bar chart shows the opening and closing prices, as well as highs and lows. The bottom of the vertical bar indicates the lowest traded price for that time period whereas the top bar indicates the highest price within that same period. For technical analysis, the vertical bar itself, indicates the currency pair’s trading range. By including open, high, low and close information, bar charts allow you to have a more detailed analysis rather than the standard line chart.

The candlestick chart is the most commonly chart used by Forex traders. It still indicates the high to low range with a vertical line. The larger block of the candlestick in the middle indicates the range between the opening and closing prices of a currency pair. Traditionally, If the block in the middle is filled or colored, then the currency closed lower than it opened. On the other hand, If the block is white or unfilled, then the closing price is higher than the opening price.

Support and Resistance

One of the most commonly used lines is the support and resistance lines. The support levels indicate the price where the majority of traders believe that prices are oversold and that they will move higher. At the resistance levels the price indicates that the majority of investors believe that the price will move lower. As long as the currency pair’s price moves between a support and resistance level, the trend is likely to continue. However, a break of a support level can be a sign of a reversal of the trend and a break of a resistance line can be a sign of an acceleration of a trend.

When prices pass through resistance, that resistance line could potentially become a support line. Similarly, when a support level is broken and prices fall below that support line, that support level becomes a resistance level. The more often a currency rate tests a level of support or resistance without breaking it, the stronger the area of resistance or support is. Lastly, when support or resistance levels break, the strength of the follow through move depends on how strongly the broken support or resistance had been holding.

Trend Lines

The trend lines can be very accurate if they are drawn correctly. In a basic form, an uptrend line is drawn along the bottom of easily identifiable support areas. On the other hand, when there is a downtrend, the trend line is drawn along the top of easily identifiable resistance areas.

To draw a trend, you only need to locate two major tops or bottoms and connect them. If you draw a stiff trend line, then is less reliable and it will most likely break. Similar to support and resistance lines, trend lines tend to become stronger the more times they are tested. It is highly advisable not to draw trend lines to fit in the charts. If the trend line does not fit , then that trend is not considered valid.

Price Channels

Price channel is a continuation pattern bound by a trend line and a return line. They can be used to determine good places to buy or sell. Both the tops and bottoms of channels represent areas of support or resistance. To create an ascending channel you need to draw a parallel line at the same angle as an uptrend line and then move the line to position then it touches the most recent peak.

An ascending price channel is considered a bullish signal. Forex traders tend to go long when prices reach the trend line (support) and are more likely to go short the market when it reaches the return line (resistance). On the other hand, a descending channel is considered bearish. Traders will look to go short when the market reaches the trend line (resistance) and will look to go long the market when it reaches the return line (support).

Fibonacci

The Fibonacci number is a sequence that is made by simply starting at 1 and adding the previous number to arrive at the new number.

0+1=1, 1+1=2, 2+1=3, 3+2=5, 5+3=8, 8+5=13, 13+8=21, 21+13=34, 34+21=55,…

The ratio of any number to the text number in the series approaches 0.618 after the first 4 numbers. For example 34/55=0.618. In addition, the ratio of any number that is found in two places to the right approaches 0.382. For example 34/89=0.382. The ratio of any number to the number that is found three places to the right approaches 0.236. For example 21/89=0.236. These relations in the numbers of the series are the basis of the ratios that are used to determine price retracements and price extensions during a trend.

Traders use Fibonacci retracement levels to find potential support and resistance levels. To apply Fibonacci levels to your charts you will need to identify Swing High and Swing Low points. A Swing High, is a candlestick with at least two lower highs on both the left and right of itself. A Swing Low is a candlestick with at least two higher lows on both left and right of itself. For example, if a price retraces from a Swing Low, it will encounter resistance at one of the Fibonacci levels. If a price retraces from a Swing High, it will encounter support at one of Fibonacci levels.

Moving Averages

Moving Average is an average of a shifting body of prices calculated for a given number of days. It makes it easier to visualize market trends. The Simple Moving Average (SMA) is calculated by summing up each interval’s price and dividing the sum by the number of intervals covered by the moving average. The SMA shows the overall sentiment of the market at a certain time. It gives a broader view and gauge the general direction of a currency pair’s rate.

Exponential Moving Average (EMA) is a weighted average of a price which puts a higher weight on recent data point. Because it gives more weight to the most recent data, EMA enables traders to react faster to recent currency pair rate changes.

Moving Average Convergence-Divergence (MACD) is used to determine trends in momentum whether it is bullish or bearish. The MACD is calculated by subtracting a longer EMA from a shorter EMA. The most common values are the 12-day and 26-day EMA. Based on the differential, there is a 9-period moving average that is calculated that is usually named as signal line. Due to the exponential smoothing, the MACD is quicker and tracks recent price changes faster than a signal line. When MACD crosses the signal line meaning that 12-day moving average is higher than the rate of change of the 26-day moving average this is considered a bullish signal.

Bollinger Bands

Bollinger Bands is a chart indicator developed by John Bollinger. The indicator is used to measure market’s volatility. Bollinger Bands widen during periods of high volatility and they narrow during periods of low volatility. In general lines, the price tends to return to the middle of the bands. When the prices continually touch the upper Bollinger Band, the prices are thought to be overbought and this triggers a selling signal. On the other hand, when they touch the lower Bollinger Band prices is reconsidered to be oversold triggering a buy signal. This means that Bollinger Bands act like dynamic support and resistance levels. In a longer time frame Bollinger Bands tend to be stronger.

The Parabolic System, Stop and Reverse (SAR)

The aforementioned indicator helps you determine where a trend might be ending. A Parabolic SAR places dots or points or a parabola line on a chart aims to indicate potential market reversals. When the dots or points or parabola line are below the candles this is considered as a buy signal and when the dots or points or parabola are above the candles then this is considered as a sell signal. So for traders who hold open positions may consider Parabolic SAR as a good indicator whether and when they should exit the market.

Relative Strength Index (RSI)

This indicator identifies overbought and oversold conditions in the market. The RSI is based on the difference between the average of the closing price on up days vs. the average closing price on the down days, observed over a 14-period. It is scaled from 0 to 100 and in general lines readings below 30 indicates oversold while readings over 70 indicate overbought. RSI is well known because you can use it to confirm trend formations. If you are looking at a possible uptrend, then make sure the RSI is above 50. If you are looking at a possible downtrend, then make sure that the RSI is below 50.

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