Technical Analysis and the Forex Market: A beginner’s guide

The fact is that you do not need to pay the big bucks to learn how to trade. Technical analysis is not hard or scary. Once you understand the basics, you will realize that there is a lot of information to be learned from your charts and it is all free for the taking. Most of us have done a little technical analysis whether we know it or not. Just looking at a price chart is a rudimentary form of technical analysis.

Before we get started however I want to remind you that trading well is a skill that takes years of practice, a little training, and a lot of learning from mistakes. I am not going to offer you a posy-lined path to market wisdom and success. To use an over-used analogy, there are many ways to build a house. You need to decide what kind of house suits you.

Technical Analysis

The official definition is that technical analysis is the analysis of past price data to determine future price movement. It is the study of prices in order to make better trades. The basis of modern-day technical analysis can be traced to the Dow Theory, developed around 1900 by Charles Dow. It includes principles such as the trending nature of prices, confirmation and divergence, and support / resistance. Technical analysts, or chartists, use a number of tools to help them identify potential trades, some of which I will attempt to cover here.

Why does Technical Analysis work (or not)

Technical analysis uses past and current behavior to predict future behavior. Think of it like weather forecasting. The weatherman (alright, weatherperson) will look at the weather patterns that are currently emerging and compare them to similar weather patterns that have happened in the past. If the last 10 instances of this particular weather patterns, 8 instances has resulted in rain, the weatherperson can confidently predict rain.

Technical analysis works because humans are predictable. People often behave in predictable ways. They will consistently repeat their behavior under similar circumstances.

Technical analysis is the art/science of identifying crowd behavior in order to join the crowd and take advantage of its momentum. This is where the oft over used phrase, “control your emotions” comes into play. You will want to be sensitive to what the market is doing without succumbing to crowd mentality. Technical traders work hard to avoid political and analyst chatter because they believe that all the information they need to know is already embedded in the price.

Remember not to over analyze however, every action causes a reaction (though not necessarily equal or opposite, that is physics not trading). There are millions of traders analyzing the same charts as you are and that leads to a cat-and-mouse sort of game playing that can be incredibly complex, riddled with bluffing, cheating feints and double-crosses. Traders can be a crafty bunch.

Charts

Most technical analysts use charts as their primary tool. Charts are the heart and soul of the technical analyst’s tools and they come in all shapes and sizes. The most commonly used types of charts are line, bar, candlestick, point and figure, and renko. Each price style has different interpretations and uses and everyone has their favorites. Pick your favorite for now and we’ll get into price style analysis at another stage.

Trends

If I hear one more person say, “The trend is your friend” I will probably vomit. Unfortunately, it is pretty apt and you would be wise to remember that the trend rules (as a general rule). The problem is how do you define trend.

I did a google search and found the following definitions for trend:

- The general drift or tendency in a set of data.

- The general direction, either upward or downward, in which prices have been moving.

- The direction in which price and trading volume are moving over a short term or long term basis. The movement may be either up, down or sideways.

- The change in a series of data over a period of years that remains after the data has been adjusted to remove seasonal and cyclical fluctuations.

It seems to me that the definition of trend is a little blurry. And even once you define trend.. what type of trend are you talking about? Is it a major trend, a secular trend, a trend micro? For the sake of this article we will define a trend as a series of higher highs or lower lows over a period of time.

Trend Lines

Trend lines are pretty easy to see on a chart especially when someone has taken the care to draw them on the chart for you. The big question is, do you know how to draw your own trend lines? A trend line is defined as a straight line that starts at the beginning of the trend and stops at the end of the trend. Clear as mud right?? Pick the lowest lows in a move and draw a straight line connecting both of the bottoms. Congratulations! There’s your first trend line.

Be realistic about whether a trend line is drawable, please. Often trend lines aren’t drawable on your chart and I don’t want letters telling me off. Remember, a valid trend line is a line that helps you to identify the direction of a price move. Once you start drawing trend lines on your chart you will be unable to stop. It is fascinating to watch a price move up and along a trend line, bouncing along it like a rubber ball.

Once you get comfortable with your trend lines, start looking for break outs.

A break out is any part of the price bar penetrating a line that you drew on the chart. You will want to beware of false breakouts though. False break outs can be especially damaging because you may automatically want to assume that a breakout means a reversal. This is not necessarily true. But it is very tempting to jump into a breakout because the first few periods after a break out are often the best time to get in on the market move. Now don’t quote me but a breakout that occurs in the course of a low volatility trend is more likely to be meaningful than a breakout that occurs in a highly volatile trend.

Support & Resistance

Support and resistance lines are another valid concept that all technical traders respect. Think of prices as a head to head battle between the currency pairs you are trading. For instance, in the case of the Euro/USD, imagine the Euro traders pulling one way and the US Dollar trader pulling the other. The direction the price actually moves reveals who is winning the battle. Each time the price reaches a certain level (let’s say 1.270) the Euro traders will pull the Euro’s value back up and prevent it from falling further. This type of price action is called support, because the Euro traders are supporting the price. Similar to support, a resistance level is the point at which the sellers take control of prices and prevent them for rising higher. Support levels indicate the price where the majority of the investors believe prices will move higher, and resistance levels indicate the price at which a majority of investors feel prices will move lower.

You can identify support and resistance lines by drawing straight lines on your charts. It is always a good idea to know the support level of the currency pair you are trading. The development of support and resistance levels is probably the most noticeable and recurring event on a price chart. Penetration of these support and resistance levels leads to the formation of new support and resistance levels.

Traders Remorse

After the penetration of a support or resistance level it is common for traders to question the new price levels. This is termed traders remorse and signals a temporary return to a support/resistance level following a price breakout. The price action directly following this remorse period is critical. Either the consensus will be that the new price level is not warranted and the prices will move back to their previous levels, or investors will accept the new price and the price will continue to move in the direction of the penetration.

Resistance Becomes Support and Vice Versa

When a resistance level is successfully penetrated, that level usually becomes a new support level. Similarly, when a support level fails, that level usually becomes a new resistance level.

Indicators

An indicator is a mathematical calculation that is applied to a security’s price. The result is a value that is plotted on a chart and used to anticipate price changes. There are literally thousands of indicators and many a book has been published about different indicators. I am not going to go into all the different indicators here but I would advise you to keep it simple. There are four basic types of indicators, those that measure; velocity, momentum, volatility, and volume. Volume doesn’t hold in forex but choosing one indicator from the remaining three categories and it should give you a balanced view of what is going on with your chart.

Convergence and Divergence

You will hear these two terms often when you listen to the market analysts. Convergence refers to two indicator lines coming closer to one another and divergence refers to two indicator lines moving farther apart. Convergence is most often seen in indicators on the price chart, and generally means that the price action is starting to go sideways or has a narrower high-low range.

Benchmark Levels

Benchmark levels refer to the historic highs and lows on a price chart. These aren’t indicators that can be applied to a chart but may serve to indicate future price action. When a price makes a new historic high or low and then retreats it can be quite some time before the benchmark is surpassed. Historic levels can cause some strange indicator behavior. If an uptrending indicator flattens out mysteriously, widen the timeframe on your chart to see whether the price is near a historical level. The market will test historical levels. If the test fails then you might expect a retracement and perhaps a reversal.

Retracements

Admitting that no one can forecast a retracement hasn’t stopped many people from trying. The following guidelines are helpful but they aren’t statistically sound so caveat emptor.

The noted technician W.D. Gann used to say that the best retracement was a 50 percent retracement. It is the best place to re-enter an existing trend. If the trend resumes, it will then exceed the previous high, which identifies an immediate minimum profit target.

Fibonacci

Fibonacci numbers were named after Leonardo of Pisa, also known as Fibonacci (though these numbers had already been described earlier in India). Fibonacci is perhaps best known for a simple series of numbers, introduced in Liber abaci and later named the Fibonacci numbers in his honor. The Fibonacci numbers are studied as part of number theory and have applications in the counting of mathematical objects such as sets, permutations and sequences. Fibonacci numbers essentially form a sequence. After two starting values, each number is the sum of the two preceding numbers. Fibonacci levels are commonly placed on charts to predict potential retracements levels.

Ralph Nelson Elliot was a true scholar of the markets. He believed that those Fibonacci numbers could also be found in man’s behavior and could therefore be charted to predict future behavior. Elliott observed that securities prices appear in a wavelike form on charts, hence the name Elliott Waves. Elliott Wave adherents often use Fibonacci levels, with special attention to 38 percent and 62 percent, to predict the extent of retracements.

Now you have the basic technical analysis tools you need to take a look at your charts with fresh eyes. The study of prices is educational and fun and with a little work and a little luck you should see your trades improve.

My final caveat is to remember, investors expectations change over time. That means you will have to be on your toes, watching for changes and emerging trends.

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Marilyn McDonald is an author and foreign exchange trader. She can be reached via her website at www.marilynmcdonald.com

This article is intended solely for information purposes. The opinions are those of the author only. Please conduct further research and consult your financial advisor before making any investment/trading decision. No responsibility can be accepted for losses that may result as a consequence of trading on the basis of this analysis.

Information, charts or examples contained in this lesson are for illustration and educational purposes only. It should not be considered as advice or a recommendation to buy or sell any security or financial instrument. We do not and cannot offer investment advice. For further information please read our disclaimer.