Technical analysis helps you identify and capitalize upon the trends in the forex market. As you get gradually involved in forex trading, you will get to hear more and more of technical analysis in forex trading.
The fundamental concept behind technical analysis is really very simple. Firstly, technical analysis uses certain tools, which are called as technical indicators. These technical indicators collect historical prices pertaining to different currency pairs. What does this mean? It just means that data pertaining to different currency pairs that is already available from prior trading information is first collected. This is what saying “technical indicators collect historical prices” meant. Next, this historical price data is fed into various mathematical algorithms, which outputs the most likely current price values. In other words, technical analysis uses mathematical algorithms basing their input of historical price data. So generally speaking, technical analysis uses previous quotes to arrive at a prognosis of coming prices. Got the point?
Going into the technical aspects of various technical indicators would be beyond the scope of this article. Nevertheless it would be important to know something about these indicators, which you are likely to encounter in most technical analysis. At the least you must know how these indicators could be put to use. Here are some examples of technical indicators, in relation to how they could be interpreted in your forex trading strategy.
Moving Averages~ A simple moving average could be interpreted thus. When currency price rises above its moving average, it’s signal to buy. A sell signal is generated when price of the currency falls below its moving average.
Moving Average Convergence/Divergence (MACD)~ It’s buy signal when MACD rises above signal line, and sell signal comes into play when MACD is falling below signal line.
Volume~ High volume is indicative of the beginning of a new trend, and is usually present near the bottom of a market, and low volume shows that forex investors at that moment were not very decisive.
Bollinger Bands~ Generally a move that originates at one band tends to go on to the other band. Currency prices tend to stay mostly within the upper and lower band. If prices move outside the bands, current trend will likely continue.
Volatility~ If the volatility decreases over a long period of time, it just means that the top of the market is being reached. If there is high volatility over a shorter time frame it means that it was nearing the bottom of the market.
Momentum~ When momentum bottoms down and then turns up, it is time for buy signal. When momentum peaks up and then turns down it is time for sell signal. If there were extremely high values for this indicator, it simply means that that the trend would probably go further.
Stochastic Oscillator~ The following formula is used to calculate this indicator.
%K = 100[(C - L14)/(H14 - L14)]
C = the most recent closing price of the currency.
L14 = low of the 14 previous trading sessions.
H14 = highest price traded during the same 14-day period.
%D = 3-period moving average of %K
When the values are calculated and set out on a graph it appears as two distinct lines. it is then called the “Stochastic Oscillator”. The main line is called “%K.” and is usually displayed as a solid line (black in color) and the second line called %D is displayed as dotted line (sometimes displayed red in color).
Buy when %K (black line) or %D (red line) is below 20. Sell when %K or % D rises above 80 levels. Also buy when %K is crossing %D in an upward direction and sell when %K crosses %D in a downward direction.
Relative Strength Index (RSI)~ Currency overbought situation is indicated by RSI value above 70, so the price is likely to fall down. Currency oversold situation is indicated by RSI value below 30,so trend could reverse and price could pick up.
Technical analysis suits almost all small and medium players in forex markets. What you have to be careful about is the fact that, technical analysis presupposes that all possible fluctuations in the market are included in the price chain. This can often turn out to be a fallacious argument if for example some economic or political event occurs that shakes up the market. So you have to be cautious on this point.
The point is if you use technical analysis or fundamental analysis in isolation to one another, you get to see only one half of the big picture. That could lead you to a crisis situation. For example, imagine for a moment that as per your technical analysis the dollar was to likely to surge and you surely want to get in early. All your technical indicators were pointing in that direction, and so you straightaway go in and place a trade. Then you wait for the dollar surge to happen, but to your dismay the dollar price falls. What could have gone wrong? Soon enough you discover that just released Non-farm payroll data was lower than expected. That was the cause of the dollar not surging upwards in accordance with the technical analysis prognosis. So never look at either technical or fundamental analysis in isolation. On the contrary, combine the two and you could be a winner.