When it comes to active forex trading, there are three basic types of analysis: fundamental, technical and hybrid. Each features a collection of unique advantages and may be integrated within the context of a comprehensive trading plan. However, for legions of traders around the globe, technical analysis is the go-to methodology for crafting astute market-oriented decisions.
What Is Forex Technical Analysis?
Technical analysis is the exclusive study of past and present price action. At its core, the discipline aims to place periodic volatilities and asset pricing fluctuations into manageable contexts. To do so, technicians scrutinise price action with the goal of successfully forecasting future market behaviour.
In forex, price action is a function of exchange rate fluctuations. Due to the fact that currencies are traded in pairings, exchange rate values are a representation of one currency's value to another. Thus, forex price action is the movement of a currency's value relative to another; this is a key distinction from other assets that are priced in isolation.
To conduct technical analysis, traders rely on a multitude of devices. At the top of the list are pricing charts and indicators.
The Forex Pricing Chart
For market technicians, the pricing chart is the window to the marketplace. Charts are used to place past and present pricing data into a user-friendly, visual format. After they're created, pricing charts serve as the backdrop for the application of various studies, indicators and tools. When building a robust forex price chart, the technical analyst must address two key characteristics: type and periodicity.
A chart's type refers to the style and fashion in which pricing data is expressed. Common chart types are point-and-figure, open high low close (OHLC), Japanese candlestick and line. Each variety of pricing chart has a distinct presentation, positive attributes and subsequent shortcomings.
Periodicity refers to the duration or increment of the pricing chart. It is a key component of any chart's makeup as it divides pricing data into either short, intermediate or long-term increments. Forex charts may be designed with any periodicity in mind, from minute-by-minute to yearly durations.
When constructing a forex pricing chart, it's important to select a chart type and periodicity that is appropriate for the trading strategy being implemented. For instance, a high-frequency scalper may reference short-term charts with periodicities measured in ticks, minutes or hours. In addition, the chart type must convey information that is useful to crafting trading decisions. To the forex scalper, a candlestick or OHLC chart is likely much more useful than a basic line chart.
Ultimately, the responsibility for designing an ideal chart falls upon the technical trader.
Basic Chart Types
Functionally, conducting technical analysis relies heavily upon the pricing chart. There are many different chart types, each designed with specific functionalities in mind. Three of the most commonly implemented by technical forex traders are Japanese candlestick, OHLC and line charts.
The line chart is the most simple of all forex pricing charts. As in name, the chart consists of a single, continuous line that connects a series of price points. The result is a basic look at price action over a given period—one that visually represents a collection of peaks and troughs.
Line charts are best viewed as being a broad study of price action. While they are useful in identifying trends without any extraneous "market noise," the provided information is vague. When building a line chart, forex traders typically choose to have the chart focus on and connect periodic closing prices. This provides a basic picture of a currency pair's volatility and direction, but the data set is limited and ignores several pieces of potentially relevant details.
Open High Low Close (OHLC)
An open high low close (OHLC) chart is a popular device among technical analysts. In contrast to the line chart, the OHLC provides the technical trader with added information—namely, the periodic opening, high, low and closing values of a currency pair. In doing so, the user is able to quickly ascertain the periodic trading range of the forex pair, as well as the relationship between the opening and closing values.
The OHLC chart divides price into intervals known as "bars." Each bar represents a specific duration and conveys four essential pieces of information. The open is indicated by a dash on the left side of the bar; the close is a dash on the right. Additionally, the periodic high is the upper extreme of the bar and the periodic low is the lower extreme.
OHLC charts work well for identifying market state and the direction of price. As a general rule, an OHLC bar that is vertically elongated signifies enhanced periodic volatility. Also, a close above the open represents bullish pricing momentum; a close beneath the open suggests bearish pricing momentum. OHLC bars may be colour-coded, with green assigned to bullish bars and red to bearish.
Introduced to the western world in the late-20th century by market technician Steve Nison, Japanese candlesticks are an exceedingly popular forex chart type. Through his books Japanese Candlestick Charting Techniques and Beyond Candlesticks, Nison's expertise caught on in trading circles worldwide. Forex trading is no different, as countless technical traders have made Japanese candlestick charts the backbone of their methodologies.
Like OHLC bar charts, candlesticks convey a multitude of information to the reader. The key anatomical components of the candlestick are as follows:
- Body: The "body" of the candle is the distance from the periodic open to the close. Large bodies signify enhanced volatility, while small bodies suggest quieter trading conditions.
- Shadows: A vast majority of candles have an upper shadow (also known as the wick) and a lower shadow (also known as the tail). The upper shadow extends above the body and represents the top of the periodic trading range. Conversely, the lower shadow extends beneath the body and signifies the bearish extreme of the periodic trading range. Elongated shadows suggest enhanced volatility and whipsaw price action.
Perhaps the most useful aspect of candlestick charts is their visual presentation. Each candle represents periodic bullish or bearish price action while defining a concrete trading range. Like OHLC charts, a close beneath the open is considered bearish; a close above an open is classified as bullish.
To simplify analysis, candles may be customised to instantly reflect bullish or bearish price action. Colours such as green (bullish) and red (bearish) are commonly used, as are shaded (bullish) and empty (bearish).
Japanese candlestick charts offer several benefits to the user.
- They are visually easy to read. Bearish or bullish price action is instantly discernable, as is periodic volatility.
- Patterns in price action may also be routinely recognised. Due to their ease of interpretation, active forex traders often prefer candlesticks to OHLC or line charts.
In addition to the pricing chart, indicators are a key facet of technical analysis. A technical indicator is a mathematical device that is applied to price action designed to project future market behaviour. Also, indicators may be visual in nature, such as a moving average crossover or chart pattern.
Forex technical indicators, or "technicals" for short, come in two types: proprietary and public domain. Below is a brief look at each:
- Proprietary: A proprietary indicator is one developed by a person, company or other entity. It is private in nature and not readily available to the public. However, in many cases, interested parties may subscribe to or purchase proprietary indicators for active trade.
- Public Domain: Public domain indicators are considered to be common knowledge. This group of indicators is free for public use and available on most software trading platforms.
It's important to realise that forex technicals come in a vast array of shapes and sizes. Three of the most popular types are oscillators, support & resistance levels and chart patterns.
Momentum oscillators are indicators that measure the strength of a periodic movement in price. Oscillators are popular among trend and reversal traders as they identify when a forex pair is becoming overbought or oversold. Accordingly, an overbought market is primed for a bearish reversal and an oversold market is positioned for a bullish reversal.
Below are three public domain momentum oscillators:
The indicators above may be used in isolation or in concert with one another. Due to the fact that they are public domain indicators, each may be found in the analytical suite of most software trading platforms. Momentum oscillators are most frequently expressed in a separate window adjacent to the primary pricing chart.
Support & Resistance Levels
Support & resistance levels (SRs) are specific price points that may encumber future price action. Accordingly, a support level is a technical indicator that has the potential to cease or prompt reversal of a bearish price movement. Conversely, a resistance level is a technical indicator that has the potential to cease or prompt reversal of a bullish price movement.
SRs are quantitative and derived from past and current pricing data. They are powerful analytical tools that are used to identify market entry and exit points, to spot trends/reversals, or to project future trading ranges. Here are a few renowned devices used to develop SRs:
SRs are typically applied as chart overlays. As a chart overlay, calculated levels are placed directly on top of price. In this way, the SRs can be viewed in concert with live price action. Similar to most indicators, support & resistance levels function well when combined with other forex technicals.
Chart patterns are unique formations that illustrate the tendencies of past and present price action. Patterns come in a variety of unique types and are commonly found on line, OHLC and candlestick pricing charts. Classifications include reversal, breakout, trend continuation and consolidation patterns. For active forex traders, candlestick chart patterns are among the most frequently referenced technical indicators.
A viable forex chart pattern may consist of a single price bar, multiple price bars or a collection of distinct peaks and valleys. The following are prominent examples of such formations:
Perhaps the greatest advantage to conducting technical analysis with chart patterns is that they are user-friendly. Strong patterns are readily discernible and offer concrete guidance for market entry or exit. In addition, they work well when applied with other technicals such as oscillators and SRs.
In modern forex trading, technical analysis is an exceedingly popular way of viewing the market. The study of price action, both past and present, offers participants a means of approaching active trading in a disciplined, consistent manner. Through the construction of pricing charts and application of indicators, technical forex traders are able to develop powerful strategies designed to achieve long-run profitability.