Technical analysis is one of the most popular Forex trading methods and used by the world’s top traders and analysts. Read on to find out what a technical analysis is, why it’s so important, and how it can be used to trade Forex successfully.
What is a Forex Market Technical Analysis?
Technical analysis in Forex is the study of a currency pair or crosses’ past price movements and patterns so that you can make educated predictions about its likely future movements.
Put another way, technical analysis is finding price patterns which you can then use to forecast where the price is going to go next.
For many years, the academic consensus was that liquid markets were “efficient”, which meant there was no method of using historical prices to accurately forecast the probability of future price movements. This “efficient market hypothesis” held that price movement was a “random walk”. However, in recent decades, academics have presented more compelling evidence that some patterns of historical prices are more likely to precede a price movement in one direction than another.
Using the technical analysis method when you trade the Forex market can be helpful in several ways:
It takes a lot of the guesswork out of trading. It’s not uncommon for some traders, at least when they start out, to think that Forex trading is a gamble and that they can guess or “bet” their way to profits based on very limited information (or even no information). This is sometimes justified by the belief that traders can profit even with random trade entries if losses are cut short and winners left to run – but this is unlikely. By conducting a technical analysis, a trader can enter the trading arena armed with factual data and informed predictions about the price, which can give you a real fighting chance to walk away with profits.
It helps you find your trade entries. One of the most valuable things about technical analysis is its incredibly detailed nature. Every nuance is used to paint a picture of a trend or outlook that can help you see where a currency pair is headed. In fact, the measure for a price movement is a pip, which is the fourth decimal place (i.e., 0.0001). With that kind of precision, you have the advantage of being able to pinpoint exactly where you will enter a trade and not have to ballpark it, which would leave your account exposed to risk.
It helps you find your trade exits. Just as important as knowing when to enter a trade is knowing when to exit one, especially if things go south (or north, if you’re bearish). Making great forecasts and accurately predicting price behavior is only half of the equation. The other half is risk management, and knowing when to exit a trade before you incur too much loss is a large part of that.
Understanding Price Charts in Technical Analysis
Technical traders – traders who trade based on their technical analyses – make heavy use of price charts to study prices. Beginner traders tend to be technical traders, as most believe with some justification that it is easier to interpret a price chart than to interpret the economy of even a medium-sized country. A price chart is the canvas on which you’ll draw a price pattern and/or trend, and how you’ll find your trade entry and exit points.
Most technical analysis methods use two main components:
Forex candlesticks. Since their origin in 18th-century Japan’s rice trading commodities, candlesticks are visual tools used to illustrate price action. Each candle has a “body” and two “wicks”, and the length of each is used to communicate important data about the price movements, including the open, high, low, and close prices. Every price chart used in technical analyses is made up of these candlesticks, which are shown in red and green colors.
Forex Candlestick Chart
Support and resistance levels. A support level is a price point at which the price had previously reversed its downward course and started going up. Conversely, a resistance level is a price point at which the price had previously reversed its upward course and started going down. Technical traders “map” out these levels and base their trades on how the price interacts with them. If the price breaks through an established resistance level, for example, a trader might take that as a sign that an upward trend is forming.
Support and Resistance Levels
Charts can also come in various time frames, which are collections of price actions viewed through certain measurements of time. If you look at the daily chart for gold, for example, you’ll see how the price of gold has behaved every day, including its opening price, and closing price, where each candlestick on the chart represents a day. Zooming in to the hourly chart will show you the price action for each hour of the day, where a candlestick represents one hour.
All time frames can come in useful. Higher time frames offer a bird’s eye view of trends and patterns, but the more you zoom in to the lower time frames, the more precise you can be about your trade entries and exits, right down to the pip.
Of course, even a cursory glance at a chart with a high-enough time frame can show you the general direction of a price, which will be in one of two categories:
Trend – when a price is moving in an overall up (bullish) or down (bearish) direction; or
Range – when a price is moving in an overall sideways direction.
A good example of a chart showing range is the USD/NOK price chart image above. During the period covered by the chart, the price moved between 8.2 and 9.1.
A good example of a chart showing a trend is the wheat ETF price chart shown below.
Forex Trending Price Chart
Once you understand the basics of how to read a price chart in technical analysis, it’s time to learn chart patterns, of which there are many. Patterns can really provide you with a picture of the price and where it is likely to go, both in the short term and the long term.
Technical traders will use various kinds of candlestick patterns to analyze the markets, such as:
One of the most famous patterns studied by traders is the wedge pattern. If the price forms a wedge pattern – which usually takes around 3-6 months to form – it signifies that there may be an upcoming trend reversal. So if the price is currently bearish, then it may be about to reverse course into a bullish trend, and vice-versa.
Other examples of patterns include:
There are also quite a few technical tools used for analyzing the markets. Reverse charting, for example, is a favorite among Forex traders in particular because of the structure of currency pairs. Reverse charting is based on the axiom “When in doubt, turn your chart upside down”. While this is not always practical for traders of other assets, Forex traders can easily reverse the currencies within a pair to get a fresh perspective on the market, such as studying the CAD/USD instead of the USD/CAD.
Other technical analysis tools include:
Technical analysis is simply the study of historical prices. While aspects of technical analysis can look very complicated, it is important to remember that all technical analysis methods are just the application of mathematical formulas to the input of past prices. Longer-term, broader technical analysis seems – according to academic studies - to have some ability to predict future price movements, but there is no clear evidence of this being true on smaller time frames. Therefore, traders should treat short-term technical analysis skeptically and instead focus on what the price has been doing over a period of at least three or more months. Short-term analysis can be used to zoom in once you are already confident of your longer-term analysis.
It is important for new traders not to get obsessed with finding the perfect indicator or indicator settings. All you really need to know is whether the price is trending or moving sideways, and if so, how strongly. Almost any technical indicator can answer that for you, but do not focus to heavily on the exact number an indicator is showing you.
What is technical analysis in Forex?
Technical analysis is a way of analyzing the markets by studying the price movements of a given asset.
What are the 3 types of analysis in Forex?
The 3 types of Forex analyses are technical analysis, fundamental analysis and sentiment analysis.
Is Forex better for technical analysis?
Forex and technical analysis go hand-in-hand, with technical analysis being a great way to make sense of the Forex market and predict the price movements of currencies, which can be chaotic.
Does technical analysis work in Forex?
Yes, technical analysis is known to be the primary Forex trading method of the world’s top traders and analysts.