Forex traders who employ technical analysis techniques often just use past exchange rate movements seen in the market to forecast the future exchange rate behavior. Technical analysis takes many forms, and might including looking over forex charts for well-known and reliable chart patterns, drawing trend lines and calculating several technical indicators. Some technical analysts even consider the overall pattern of forex rate movements using more advanced techniques such as Elliot Wave Theory.
Price Discounts All
In general, technical analysts base their techniques on the principle of “Price discounts all.” This means that all of the current known fundamental information involved is thought to be already priced into the exchange rate for a particular currency pair by professional market-makers. This principle allows technical traders to focus on how past exchange rate levels can indicate the direction of future exchange rates.
Types of discounted information might include such things as economic data, the level of short-term interest rates and the credit quality of the countries concerned. While this usually represents quite a good assumption, it can nevertheless break down in the short period during which new information is being assimilated into the price, such as the time of a key economic data release, like the U.S. Non-Farm Payrolls report.
Some Advantages of Technical Analysis
One of the primary advantages of using technical analysis is that it reduces distractions which can really help when trying to sort through all of the economic information pertaining to the EURUSD exchange rate, for example. Technical analysis also increases objectivity which can help to manage emotions encountered when trading and its techniques also lend themselves well to being incorporated into forex trading plans.
Price Chart Analysis
Price chart analysis is one of the key elements of technical analysis. In general, it involves looking for patterns occurring in a bar chart that plots the high, low, open and close of the currency pair’s exchange rate for a particular chosen time period as it evolves over time. In addition to bar charts, other popular forms of price charts used for this purpose include Point and Figure charts and Candlestick charts.
When analyzing a price chart, technicians will look for such things as:
- Trends – directional price action indicated by higher highs and higher lows for an uptrend or lower highs and lower lows for a down trend through which a line can be drawn. If the line through the lows is roughly parallel to the line drawn through the highs, then that forms a Channel.
- Reversals – key points where the market shifts direction from down to up or up to down. These can indicate the presence of buying activity that supports the market, and selling pressure that resists the market from moving higher. This forms the basis for the popular support and resistance levels used by technical analysts to help determine their trade entry and exit points.
- Classic Patterns – over the years, technical traders have identified a number of classic or well-established chart patterns that tend to have predictable outcomes. These include Head and Shoulders Tops and Bottoms, Double Bottoms and Tops, Triangles, Channels, Flags, Pennants, Rectangles and Wedges.
Technical Indicators
Another very popular technique used by technical analysts involves computing some of the good selection of technical indicators that can be used to quantify characteristics of exchange rate activity or trading volume. Examples of popular technical indicators might include Moving Averages, the Relative Strength Index or RSI, Momentum, Historical Volatility, Stochastics, the Average Directional Index or ADX, Parabolics and On Balance Volume.