Foundations of Forex Technical Analysis

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.

Some people with a certain amount of expertise in financial analysis might disagree with this assessment. Nevertheless, they are usually those who hold advanced degrees in economics and do not wish to feel that they are wasting their time by watching economic fundamentals instead of just focusing on price action like pure technical analysts do.

Anyway, putting that debate aside for the moment, the following sections of this article will provide some background as to what the foundational assumptions of technical analysis. This can help traders understand why these methods can apply so well to trading the forex market.

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.

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.

Some chart pattern analysts use a more sophisticated technique known as Elliott Wave Theory to predict future price action. This increasingly popular technical analysis approach was initially developed by R.N. Elliott who postulated that markets tend to trend in five wave movements and then subsequently correct that trend in three waves.