Forex Trading: The Importance of Technical Analysis

Forex Trading - like trading in general - is an activity that requires a constant commitment of intellectual and emotional resources. The advertisements that are frequently encountered, suggesting an underlying ease in producing money, are far from reality. Intellectual resources, however, must be channeled into the use of specific tools, typical of the practice of trading. Among the tools, or rather "set of tools," technical analysis certainly stands out. This term refers to the rigorous study of charts and price movements, carried out within a well-codified perspective, which, at least potentially, allows predicting the near future (and why not, even the distant future) of any asset. The main characteristic of technical analysis, which distinguishes it from any other tool used for trading, is its claimed scientific nature. Technical analysis, in fact, claims to be as close as possible to mathematical science available to investors. This "truth" is questioned by detractors, who argue - and not without reason - that the assumptions on which it is based are arbitrary, if not even false. These assumptions, which act as postulates, are well known to investors and analysts.

Technical Analysis: The Postulates

Although detractors contest the contents of the postulates, judging them arbitrary, it should be specified that even in the worst-case scenario, technical analysis is an indispensable resource as it allows understanding the market. For the most pessimistic, it is sufficient to be ready to question the orientations and signals that arise from technical analysis and therefore, if necessary, change tactics on the fly. In any case, the postulates on which this discipline is based are the following. History repeats itself. At the basis of technical analysis is the belief that the market reiterates the same behaviors in a more or less cyclical manner. In a nutshell, equal premises correspond to equal developments. The corollary of this postulate is that it is possible to create models on which to base oneself to understand how an asset will move in the immediate future. In fact, this is precisely what happens in technical analysis, which makes use of the presence of numerous models, some of which are rather refined and based on evidence that is not at all obvious or visible. But... Why does history repeat itself? Simple, because men basically remain the same. Motivations, fears, even approaches do not change. Prices discount everything. It is probably the assumption that generates the most discussion. It is the most contested because it denies, in fact, the need for approaches other than the technical one, essentially graphical. Saying that prices discount everything means denying the need to study the economic, political, and social environment, as well as the dynamics that regulate human behavior which, as we know, exert a certain weight - in terms of confidence, rationality, and irrationality - in the markets. For this reason, proponents of technical analysis tend to "hate," or at least heavily question, fundamental analysis, which indeed studies the environment in which assets are immersed. From a purely technical point of view, saying that prices discount everything means believing that any change in the trend, even exogenous, is abundantly and anticipatorily signaled by the prices themselves. This is true, but only partially, since shocks are not rare and have clearly visible effects. Supporters of technical analysis, however, assert that in these situations, the margin of predictability is null even for fundamental analysis. The market moves in trends. This seemingly enigmatic phrase actually suggests a simple truth: prices do not move randomly but follow trends which, if shocks do not intervene, tend to perpetuate themselves until they encounter exhaustion, a sort of natural death. This postulate, in reality, is also shared by those who support fundamental analysis and is not the exclusive domain of technical analysis. In any case, the conviction or the fact of the "tendency to follow a trend" gives rise to some consequences. Firstly, it confers importance to the study of historical series. Secondly, it suggests the necessity, for traders aiming at reliable profits, not to contradict the trend, thus trading following the direction that the market has undertaken. Hence the famous slogan: "the trend is your friend!"

The Tools of Technical Analysis

How does technical analysis work specifically? In reality, the mechanism is quite simple and is based on the use of indicators. This term refers to those tools that measure the market from a "certain point of view." From these measurements, which are compared with existing and practically immutable price models, signals are derived. In short, the indicators, if read with a certain interpretative capacity, suggest how to place trades. There is a huge number of indicators, although a limited portion tends to be used, including variants. The good news is that all platforms, and therefore brokers, offer a ready-to-use package of indicators. The difference between a well-equipped broker and a less well-equipped one lies in the different quantity of indicators made available. Among the most used indicators are those based on "moving averages." A moving average refers to an average of prices that moves together with the price itself. It is generally represented by a line that crosses or does not cross the actual price line. Depending on the periods, i.e., the frames considered, it is considered slow or fast. For example, the interaction of a fast moving average with its slow analog gives a signal, the progressive distancing another signal. Important indicators are also those that signal the presence of a situation of oversold and overbought. These conditions in turn signal changes in the trend (or why not, even a confirmation of them). The use of indicators is generally completed by the study of specific points, which signal the presence of a watershed. The most evident example is the resistance-support pair. When a price breaks through a resistance, it means that the positive trend is confirmed; when the price goes beyond the support, it means that the negative trend is confirmed. In any case, the approaches to supports and resistances are numerous.

Technical Analysis: The Best Approach

Using technical analysis consistently and correctly is not at all easy. Potentially, it is a very effective resource. If nothing else, in the worst-case scenario, it has the purpose of removing the dominion over the trade from the emotional part, thus replacing programming with approximation, which is among the most dangerous drifts for any trader. However, it would be a serious mistake to assign excessively scientific attributes to technical analysis. Even if done well, technical analysis can very well be contradicted by the market. In this case, the limits of the tool coincide exactly with the limits of those who use it: man is unpredictable, no matter how beautiful the discourses on the cyclicality of the market may be, so the models can also prove to be ineffective. The advice, ultimately, is to rely on the indicators but at the same time be ready to change course. Trust, yes, but not blindly.