Although forex charts seem especially popular at present, traders in all financial markets use charts. In fact, many of the techniques used by forex traders in charting exchange rates were originally developed by technical analysts operating in the stock and commodity markets.
Furthermore, since the analysis of price data does not depend on a specific product, traders record and interpret price charts in a similar manner for all markets in which human psychology plays a part.
The sections below cover some of the reasons why charting techniques have such a general level of applicability.
The Repeatability of Human Behavior
Many believe that the primary reason why charting techniques seem so general arises from the predictable repeatability of human behavior when acting in large numbers.
This characteristic of mass psychology was both noted and exploited by advanced technical analysts of the past who used the idea to develop their own technical analysis methods.
These include the likes of R.N. Elliott, who developed Elliott Wave Theory, and W. D. Gann, who originally proposed the Gann lines that traders now use to project possible trend slopes.
The Past as the Best Predictor of the Future
Another principle that may be at work behind making charts generally useful to those trading financial markets involves the repeatability of history. The phrase “History repeats itself” comes to mind in this context.
Many traders routinely use this principle to test the performance of their trading systems. This so-called back testing process involves taking the trading system’s rules and seeing how the system would have performed had it actually been traded precisely over the price action observed in the past.
Back-testing, especially when taken over a significant time period of five to ten years, can give you a good sense of what you might be in for when actually engaged in live trading the proposed system. Read more on back testing here.
Price Discounts All
One of the key assumptions underlying charting techniques in general is the principle that the prevailing market price incorporates all available information known about the traded item.
This concept often gets summarized as “Price discounts all”, and while it can break down briefly in the short period when a new piece of information is being assimilated into the traded market price, this actually tends to be quite a reasonable assumption in practice.
Perhaps the most significant advantage of making this assumption is that you can then safely ignore all old news when making forecasts about the future of the market, since such information is generally already reflected in the traded price.
It may initially come as a surprise to those new to forex trading to find that the same charting techniques that were initially applied to trading rice in Japan in the 1700’s, may be a very good predictor of where USD/JPY may currently be headed.
Of course, this is a reference to candlestick charts which have seen a popular resurgence in use in the currency markets due to the additional information they provide. Read more on candlestick charts here.
The fact remains that markets are markets, no matter what products are traded, and since it is humans who are still doing most of the trading, their psychology when acting in groups will ultimately be reflected in the observed price action.