A Few General Principles on Technical Analysis
Updated: April 15, 2013 at 7:59 AM
Traders new to forex might be mystified as to why technical analysis can provide such excellent market calls, perhaps even initially considering it another fortune telling hoax like reading tea leaves.
Nevertheless, as many forex traders who have been around for a while can probably tell you, having a good understanding of technical analysis can be the key to successful trading in the forex market.
Technical analysis studies chart patterns, and it aims to identify trends, decide on entry/exit points and determine the psychological attitude of the market environment.
So why can technical analysis apply so well to forex trading?
Price Discounts All
Perhaps the most basic assumption of technical analysis can be encapsulated in the popular phrase: "Price Discounts All."
The idea behind this statement is that all of the fundamental information relevant to a particular currency pair that is currently known or widely rumored has already been rapidly priced into its exchange rate.
Sometimes known as discounting, this process will typically be performed by professional market markers whose job requires them to keep constant track of market conditions.
Furthermore, this assumption can break down in the short period of time that it takes for new information to be assimilated, like during major economic data releases when the market often moves rapidly to discount the new data.
Nevertheless, with that possible exception, forex traders often find they can rely almost exclusively on technical analysis as their forecasting method, and that it provides sufficiently accurate market calls for their trading purposes.
Human Behavior Tends to be Predictable
Psychologists have observed that mass human behavior, and hence human history, tends to repeat itself. Technical analysts exploit this idea by identifying certain characteristics of the price action observed for a currency pair that tend to have predictive value.
For example, one of the most interesting things that technical analysts look for on the price charts they pour over is the well-known set of classic chart patterns. These might include such firmly-established patterns as the following:
- Head and shoulders tops and bottoms.
- Double and triple bottoms.
- Channels and trends.
- Rectangles and ranges.
- Flags, pennants and wedges.
- Symmetrical, ascending and descending triangles.
Technical analysts look for these specific patterns because they can often provide a predictable outcome with respect to the market's future price action once a certain condition is met. This condition often comes when the market breaks a line on the price chart that the pattern's development has defined. Read more on how to spot a coming breakout here.
After such a break occurs, the pattern will then provide the analyst with a clear trading entry signal and direction. The signal also usually includes a place to put stop-loss orders to manage risk, as well as the so-called measured move objective of the pattern that will help them know where to take profits.
A few principles on technical analysis
In general, there are a number of points to keep in mind about the suitability of an indicator to a chart pattern.
The first step in performing technical analysis should be the determination of the type of price action that the market is experiencing. Since the conclusions drawn by employing technical analysis often depend on the presumptions made about the type of the market action (whether the market is trending, breaking out, consolidating, or ranging), the trader should carefully study the price chart, and the fundamental factors that influence it, before employing the tools provided by technical analysis.
- Oscillators are best suited to analyzing ranging markets where the trend is confined and going nowhere. The basic purpose behind the construction of an oscillator is to artificially limit the price action into a predefined range in order to create buy or sell signals, and it’s only natural that oscillators are most effective when the price action is itself in a range.
- Moving averages are more suitable for the study of trending markets, where the often violent price movements invalidate the signals generated by the oscillators.
- Support and resistance lines can be very helpful in determining the boundaries of ranging markets, and they can also be helpful in deciding on entry or exit points when the trader desires to join an existing trend. A successful breakout from a well-defined price range can be very powerful and the trader can attempt to reduce the volatility of his portfolio by avoiding trading close to major support or resistance lines when he’s not safe about his analysis or assumptions.
- Simple trend lines, whether drawn manually or created by moving averages, can be exceedingly useful in reducing the role of speculation in analyzing price action. If, for instance, a moving average of a certain period (like the 100- and 50-day moving averages) provides an insurmountable barrier to the price action for a considerable time, the trader can use it as a naturally occurring trend line without worrying about the intricacies of technical analysis. Conversely, when such a barrier line is invalidated by the price action, the trader can regard this as a signal for a countertrend move. But in all cases, the trader must avoid changing his tools constantly or seeking the best indicator, since this will only cause distraction.
- And finally, the golden rule of technical analysis is to keep it simple. Even indicators of the same type are prone to creating conflicting signals, and there’s no reason to expect that false signals generated by a multitude of indicators can be combined to create a correct signal (though this may be possible logically, but in practice it’s extremely unlikely). Since we will not know which indicator tells the truth until the price action confirms it, there’s little to be gained by compounding the uncertainty inherent in our analysis by adding to the noise in our data with more and more indicators.
Good luck with your trading using technical analysis!
Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.