Forex Trading Technical Analysis: What to Know Before Using It
August 6, 2019
Technical analysis is a complicated yet essential activity. It's one of the few tools to bring clarity to the market, to estimate the behavior of assets, and to draw useful and reliable insights.
Improvising is risky when it comes to technical analysis. The danger is to derive false signals and practice simply wrong trading. Therefore, it's a subject that needs to be studied thoroughly. Before doing so, however, it's necessary to know some characteristics and gain a basic knowledge of this tool.
A definition of technical analysis
What is technical analysis? Obviously, all traders know how to answer this question. Absolute beginners, or those approaching trading for the first time, may only have a vague idea of analysis. So, it's good to provide a definition.
Technical analysis is the study of the chart with more or less complex tools, according to precise principles, aimed at receiving signals that suggest not only the direction of the price, but also the best entry and exit points of a position.
In reality, it's a very complex activity that involves well-structured subjects such as statistics. Fortunately, the calculation part is generally not delegated to the trader but is carried out by software. However, the work of interpretation, but also of organizing the necessary tools for technical analysis, is the exclusive task of the trader (or almost, as some exceptions are noted).
Technical analysis claims to act as if it were a scientific artifact. In reality, some of its components could be defined as arbitrary, or not one hundred percent corroborated by facts, at least if the scientific method is not used. The reference is to the three cardinal principles of technical analysis, which according to some detractors can be considered as dogmas.
The principles of technical analysis
The principles of technical analysis are actually easy to understand. However, the implications from an analytical and organizational point of view are complicated. Taking these principles for granted means changing one's view of trading. In any case, they are universally considered by the trading community as true, or at least very plausible.
The market discounts everything. This is probably the most difficult principle to assimilate, also because it's quite counterintuitive. According to this principle, everything you need for trading can be found in trading. It's sufficient to study it - with technical analysis, in fact - to get an idea of the near future of prices and generate profits. Nothing else is needed. The reference, in this case, is to extra-market study, such as those achievable through fundamental analysis. This principle gives reduced weight to external agents. When this weight is actually exerted, still according to this first principle, it's still possible to derive the addresses from within, that is, by studying the market.
Assets arrange themselves in trends. An old adage dear to traders suggests that "The trend is your friend". This is just a corollary of the second principle, which assigns assets a certain tendency to.... develop in trend. Prices, therefore, do not move in a causal and arbitrary way, also because investors themselves generally act with a certain reasoning. According to this second principle, the trend is the norm, while breakouts and related trend reversals are a rarity, which can still be intercepted by studying the chart. Therefore, it's senseless to look for the breakout at all costs, while a trend following approach is recommended, at least until a very high level of competence is reached.
History repeats itself. The market tends to reiterate some assets. The reason is simple: it's the investor who behaves in a repetitive way. And there wouldn't even be anything to be surprised about: after all, the goal is always the same: to earn. This principle significantly affects the analytical phase and also the operational one. In fact, it assigns the market a certain predictability. Behind the veil of complex elements, of contrasting dynamics, the market hides an overwhelming tendency to repetitiveness, in which the reaction to a given stimulus is always the same. In fact, it justifies the existence of indicators from an ontological point of view. As we'll see later, the indicators are based on statistical models, and the models make sense only if the market is intrinsically endowed with a certain predictability.
Elements of technical analysis
As already explained, technical analysis is a complex subject. Like all complex subjects, it is "formed" by complex elements, or tiles that must be put in their place and given a definition. Below is a list of elements - among tools and facts - that you always come across when practicing technical analysis.
The price. Obviously, to practice a technical analysis worthy of this name it is necessary to analyze the price. This analysis is particular, as it develops according to a diachronic dimension. That is, the current price is studied on the basis of past performance. This is a necessary action, first of all to contextualize present and future movements; and secondly to produce the subsequent phases of the analysis, those that also involve other tools. Among other things, the analysis of the "naked and raw" price also serves to get a first idea of the (possible) volatility that the asset is facing at that precise moment.
The chart. There are various types of charts. The most widespread, also because it is denser in information, is the candlestick chart. It, in fact, allows you to also check the closing and opening prices. Furthermore, thanks to the coloring system (green or white for price increases, red or black for decreases), it allows you to understand with a single glance what sign the asset's performance has been, session by session. The candles themselves form particular figures, that is, they arrange themselves in such a way as to launch trading signals, always according to the principles according to which history repeats itself in the market, giving rise to the formation of patterns.
Volume. The concept of volume is simple. This term means the number of open positions about a specific asset, in an equally precise time frame. It may seem like information that leaves the weather that finds, yet it is of fundamental importance for the trader, and can reveal a lot. For example, when the trend appears strong but volumes are decreasing, it means that the trend is actually running out (obviously this is a probabilistic estimate). The examples that can be made are numerous. In any case, volume is a parameter that must be studied, if only to be used as a countercheck (if not as a real signal source).
The trend. The trend is simply the direction in which prices are inserted. We speak of an upward trend when prices are rising, while we speak of a downward trend when prices are falling. Obviously, this is a general indication, since even within the strongest trends there are contrasting movements. The trend is never one hundred percent regular. Basically, at least according to technical analysis, prices tend to set themselves in trends. However, it is obvious that the direction can be reversed. In reality, it happens more often than usual. It is precisely in that case that the most important game is played for a trader. He can be taken by surprise by the reversal, or he can ride it and exploit it at will.
The indicators. They are the most used tools when doing technical analysis. They are extensions that appear on the chart, upon setting, and have a main purpose: to analyze the chart in depth and produce evidence that can be used as signals. They are the result of modeling and calculation. The calculations can also be very complex, but luckily they are not delegated to the trader. In any case, the indicators are very useful, but they also represent a double-edged weapon. They can in fact generate false signals. For this reason it is good to use more than one at the same time, so that one acts as a countercheck for the other.
Supports and resistances. Both are price levels. The supports indicate the level below which the asset struggles to go down. The resistances indicate the level above which the asset struggles to rise. There are several supports and resistances, which differ in strength and in the method by which they are traced. When the price interacts with supports and resistances, signals are generated. How reliable? Generally the degree of reliability is high. However, it is good to provide the counterproof with an indicator. In fact, indicators often produce supports and resistances as a "side effect" (see Bollinger Bands and MACD). In general, the signals can be both for trend continuation and reversal.
