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Technical Analysis in Forex Trading

Forex trading implies buying and selling currency pairs to make a profit. One cannot trade one single currency: The Forex dashboard is “populated” with currency pairs.

If a trader believes the Euro will rise against the U.S. Dollar, he/she will buy the EURUSD pair. If the analysis points to a rise in the U.S. Dollar, the trader will sell the EURUSD pair.

In other words, an analysis of one currency may push the other currency down. For example, the United States decides to stop buying Canadian oil.

Such news will immediately send the Canadian Dollar (CAD) lower. But the primary pair is USDCAD, and it’ll move higher.

The idea behind the example above was to show how news affects a currency pair. That’s called fundamental analysis.

However, Forex trading has a technical part too. An army of traders backed by super-computers buy and sell currency pairs based on technical analysis every day. But what is technical analysis?

Technical Analysis Explained

In the trading world, the saying goes that a market (currency pair) moves for a reason. Usually, that reason comes from the fundamental side (e.g., economic news). But the direction comes from technical analysis.

Technical analysis has its roots hundreds of years ago. It is believed that the Japanese used so-called candlesticks techniques to forecast future rise prices somewhere around the year 1700.

But this became known only recently, as technical analysis has its roots (where else?) in the United States. No other place on earth embraced speculation and investment with such a frenzy than the United States.

From the famous gold rush to Wall Street investments, the Americans love financial markets. As such, it is no wonder that technical analysis started there, and the most significant technical analysis theories and concepts belong to American traders.

The stock market represented the playground. Traders started to keep track of past prices to see the evolution in time.

And so, charts appeared. Back in those times, with no Personal Computers (PC), charting was done with pen and paper. Imagine that today in 2018, when Forex trading is so popular!

Technical analysis represents the sum of all technical tools used to forecast future prices. Or, put simply, anything related to interpreting a chart, belongs to technical analysis.

Technical traders don’t usually consider fundamentals. However, in today’s markets, when the news is the reason why the prices moves, it is hard to ignore economic data entirely.

Technical Indicators in Forex Trading

The first thing traders do after opening a trading platform is to “play” a bit with the indicators offered. Or, to check which indicators exist.

Some trading platforms, like the MetaTrader4, come with a defined set of indicators. However, it doesn’t imply they are the only one to use.

Traders can build new ones and import them into the platform. Importing new indicators is something that any trading platform allows, not only the MetaTrader4 or 5.

Indicators belong to two main categories: trend indicators and oscillators. Trend indicators are favorite because every trader wants to ride a trend as much as possible.

Trend Indicators in Forex Trading

The problem comes from the fact that trends aren’t that common. While the Forex market is volatile enough, it doesn’t mean a trend is in place.

For example, look at the EURUSD February 2018 price action. The price seemed to break higher, and from 1.22 it moved above 1.25 in a matter of a couple of days.

However, it wasn’t a trend, as the next move was bearish, back to 1.22. Next, it jumped again above 1.25, only to retrace below 1.23. And so on.

While the volatility is there, in the sense that the market moves, no trend is present. Of course, it depends on the time frame used.

Even such small moves may look like trending, if trend indicators appear on five-minute charts, for example. But then, it depends on the trader’s trading style.

Riding a trend isn’t easy, as even the stronger trends have nasty pullbacks. In the end, it depends on the strategy and the trader’s psychology. More on this later in the Trading Academy.

Traders use trend indicators like:

  • Moving Averages
  • Bollinger Bands
  • Parabolic SAR, etc., with the idea of riding a trend until its end. No trend evolves in a vertical line, though, so traders use pullbacks to add onto the initial position.

Together with sound money management, trend indicators proved to be of extreme value in growing a trading account.

Oscillators

Oscillators belong to technical analysis too. They are indicators that appear at the bottom of a chart.

Various mathematical formulas and concepts sit at the core of an oscillator. The idea is to spot divergences between the oscillator’s line and the price line and stick with what the oscillator says.

Or, to use the oscillator’s in-built overbought and oversold levels and trade a currency pair accordingly.

Powerful oscillators are:

  • RSI – Relative Strength Index
  • CCI – Commodity Channel Index
  • DeMark
  • MACD – Moving Average Convergence Divergence
  • Williams Percentage Range, etc.

Forex Trading with Technical Theories

While technical indicators provide the easiest access to technical analysis, trading theories evolved in time. The basis for most of them comes from the stock market in the United States, but traders use them successfully in today’s Forex trading too.

Here’s a list of major trading theories to use in the Forex market:

  • Elliott Waves Theory. Ralph Elliott stated that for every five-wave structure, a three-wave correction comes. That’s a cycle, and the Elliott Waves Theory became famous as it considers human nature when explaining a market’s move.
  • Harmonics. Gartley was the first one to put the basis of harmonic trading. His concepts were extended into today’s harmonics by the works of Pesavento and Carney.
  • Fibonacci Ratios. While not a trading theory, Fibonacci numbers and ratios are an integer part of almost all trading theory that exists. The two mentioned above? They can’t survive without the Fibonacci ratios.
  • Japanese Candlesticks Techniques. Mostly reversal patterns, the Japanese candlesticks became extremely popular in Forex trading. Their more significant advantage is that every pattern considers a relatively small number of candles before pointing to a reversal. Patterns like hammer, morning and evening stars, etc., are part of every Forex trader’s arsenal.
  • Pattern recognition. Belonging to the Western approach to technical analysis, pattern recognition covers concepts like:
    • Head and shoulders
    • Rising and falling wedges
    • Ascending and descending triangles
    • Bullish and bearish flags
    • Double and triple tops and bottoms
    • Rounding tops and bottoms.

They all became famous because, in time, traders documented them and laid a set of rules for how to trade a market where such patterns appear.

Conclusion

This article’s idea was to introduce the concept of technical analysis in Forex trading. However, the notions, indicators and trading theories mentioned, represent only a fraction of what technical analysis really is.

An avid trader always asks many questions and looks for new ways to address a technical concept. For this reason, technical analysis has different interpretations even from traders that use the same ideas.

Does technical analysis work? Like any concept, technical or fundamental, it is not enough to use it for constant profitability.

Trading is a process that involves losses too. It is a game of probabilities, and success in Forex trading needs a bit of everything: technical and fundamental analysis, money management and risk management, deep understanding of markets psychology, and above all, a lot of time, patience, and dedication.