Technical Analysis in Forex Trading

Technical Analysis in Forex Trading

3.1. What is Technical Analysis?

Technical analysis is the study of past price patterns to forecast future price action. The price of a currency pair is the only input studied by technical analysists because they believe it to be the ultimate representation of market sentiment at any given moment. Technical analysis uses price charts to organize price movement into recognizable patterns. The basic price pattern used by technical analysts is the candlestick. Any single candlestick summarizes the effect of trading decisions made by all of the active forex traders in the world during the time the candlestick was forming. These decision are made for a variety of reasons (either technical or fundamental in nature), but what ultimately matters is their net outcome which is recorded in the open, high, low and close of a candlestick. The relationship between these levels demonstrates the relative strength of bearish (inclined to sell) or bullish (inclined to buy) sentiment among the market participants who traded during the candlestick's time period.

A series of candlesticks combine into more complex price patterns which reflect how the market as a whole swings between different degrees of bullish and bearish sentiment. By examining these price patterns a technical analyst tries to understand the collective emotional state of market participants (prevailing market sentiment) and to profit from their emotional extremes. It is possible to profit from such analysis because mass trader psychology has been found to be governed by specific rules of development which can be objectively measured. Technical analysis, in essence, provides a collection of tools, derived from these rules, which allow currency traders to objectively measure various aspects of mass investor psychology - without being affected by the crowd's changing emotional states. Because the forex market is the largest market in the world and therefore very accurately reflects the rules of mass investor behaviour, systematic application of these rules in your forex trading can lead to substantial profits.

Quote: "Price extremes coincide with extremes of sentiment, which can vary from euphoria to revulsion.", John Percival in his book "The Way of the Dollar".

3.2. Using Technical Analysis in Forex trading

You can use technical analysis to profit from emotional extremes of the other forex market participants. Technical analysis uses tools like trendlines and moving averages to measure the prevailing market sentiment, which is called the trend. Trends are made up from alternating periods of increasing bullish and bearish sentiment. In uptrends bullish sentiment rises more powerfully than bearish sentiment - leading to stronger price advances (called price thrusts) and weaker counter-trend price declines (called price reactions). In a downtrends bearish sentiment rises more powerfully than bullish sentiment - leading to stronger price declines (price thrusts) and weaker counter-trend price advances (price reactions).

Technical analyst employs various techniques (like indicators, Fibonacci retracements, pullbacks to trendlines, Bollinger bands and continuation price patterns) to determine the completion or exhaustion of a price reaction and enters the market when the following price thrust has started. The exit is made when the price thrust gets overextended (i.e. when the prevailing sentiment reaches it highest and therefore unsustainable level). Some of the tools which you can use to identify these conditions are price channel projections, indicator divergencies, trendline breakdowns and reversal price patterns. By entering the market at the start and exiting the market at the end of price thrusts, a technical analyst is able to profit from the strongest price moves produced by the prevailing market sentiment. By capturing the price thrusts the traders is able to profit from the impulsiveness (from the impulse waves) of the market participants.

By using different tools simultaneously to analyze the forex market sentiment the technical analyst is able to find currency price levels where the probability of the sentiment shift is high. The probability for a sentiment shift increases when unrelated technical tools - each in its own unique way reflecting the dynamics of underlying mass investor psychology - give the same signal that the current emotional state of the market is unsustainable.

Quote: "Emotions drive the markets to extremes, and these extremes are the ideal spot to exit our trades.", by Linda Bradford Raschke in "Street Smarts: High Probability Short-Term Trading Strategies".

Note: Elliott wave analysis categorizes all currency price moves into two types of waves depending on if they are made in accordance with the prevailing market sentiment (called impulse waves) or contrary to it (called corrective waves). To account for the emotional component of each market movement Elliot Wave principle includes the concept of wave personality, which reflects the nature of mass investor psychology behind the formation of each wave type.

Unlike fundamental analysis, technical analysis makes it possible to make precise timing decisions for your trade entries and exits - so that you can minimize your risk and maximize your reward. Moreover, by categorizing the trends into separate groups, technical analysis allows to accurately define your preferred holding period. Knowing which degree of trend you are trading forces you to focus on specific types of support and resistance at which you should enter and exit your positions.

Technical analysis allows to capitalize on the excessive emotions of the other forex market participants. Therefore, to consistently profit from this study you should prevent yourself from getting emotionally involved in any kind of market development. The only way you can achieve this is to design your own forex trading plan before you start to trade on the currency market and to strictly follow this plan after you begin trading. By having a trading plan against which you can judge any price move you will be able to objectively pick out high-probability trading setups without being controlled by the feelings of greed or fear which rule the markets. If you do not have a trading plan you will most certainly become affected by the crowd's emotions and will lose your ability to make objective trading decisions.

Quote: "Sirens were sea creatures of Greek myths who sang so beautifully that sailors jumped overboard and drowned. When Odysseus wanted to hear the Sirens' songs, he ordered his men to tie him to the mast and to put wax in their own ears. Odysseus heard the Sirens' song but survived because he could not jump. You ensure your survival as a trader when on a clear day you tie yourself to the mast of a trading plan and money management rules.", Alexander Elder in his book "Trading for a Living: Psychology, Trading Tactics, Money Management".

Technical analysis of the foreign exchange market can be compared to the work of a therapist trying to understand the pattern of his patient's mood swings (the market being the patient and the technical analyst being the therapist). While real-life experience of his patient (fundamental developments) do serve as the original cause of the patient's general emotional state, most of the patient's psychological dynamics are governed by what he, in his own mind, is making of these experiences and of his own reactions to them (as studied by the technical analysis). When a person encounters a particular circumstance in his life he tends to behave consistently with his earlier reactions to similar events in his past, thereby strengthening his interpretational model of such experiences.

Meta4: If the patient's interpretational model of a series of similar circumstances has been forming long enough (trendline can be drawn) a therapist can anticipate with a fair degree of accuracy how the patient will respond to similar circumstances in the future (prices will bounce off the trendline). The more intense the patient's feelings (the steeper the trendline) the more likely he is to shrug off real-life events (i.e. news) which do not support his interpretational model. If external circumstances (other people's interpretation of reality (e.g. longer-term trendline) or the reality itself (e.g. unexpected fundamental development)) do provide sufficiently strong reasons to rethink the existing model, it will be discarded (trendline gets broken). The longer the person develops his approach to reality (long-term trendline) the stronger the reasons (e.g. unexpected change in interest rate policy) are required to force him to reconsider his beliefs.

Continuing with the above metaphor, proper technical analysis should be based on letting the currency markets tell you how they "feel" while remaining emotionally detached from their "story", thereby preserving objectivity of your analysis. It boils down to reading the signals given by the forex market about the prevailing sentiment and acting only when the signal is strong enough for you (i.e. when the probability of the sentiment shift is acceptable to you, as written in your forex trading system).

3.3. Mastering Technical Analysis

When you trade on forex it is easy to get caught up in the emotions of greed or fear and by doing so decrease your chances of success. To avoid this, your approach to using technical analysis on the currency market should be strictly organized. First, you should select technical analysis tools that you are comfortable with. You can select these tools based on what professional forex trading community is actually using - as revealed by books on currency trading or technical analysis reports distributed by forex newswires and investment banks. As a second step, you should use your chosen technical analysis tools as building blocks to create your own forex trading system which will guide you in your currency trading. Finally, you need to learn to control your emotions and develop discipline to take ALL the trading signals that your trading system generates.

If you wish to develop a deeper understanding of the psychological forces behind the formation of various currency price patterns and technical signals, I highly recommend the book written by Alexander Elder, "Trading for a Living: Psychology, Trading Tactics, Money Management", which provides detailed information on this topic.

One of the best books on the dynamics of investor sentiment on the forex market is "The Way of the Dollar" , written by John Percival. You can download this book for free from the author's site.