The basic goal of technical analysis is to determine the direction and strength of the current trend in the market, and then identify when that trend is about to change. If the technician identifies the trend as bullish, the forecast is to remain long and keep buying until the trend is deemed to be over.
Technical analysis focuses almost exclusively on past and current prices. The technician believes that all the economic supply/demand news and forecasts are built into the current prices. Compared to fundamentalists, technicians, in a sense, take a shortcut. While fundamentalists study external factors, technicians study the effect of those factors as shown in actual price trends and patterns.
Spotting trends is essential, because neither bullish nor bearish markets ever go straight up or straight down. They fall during the course of an upward trend, and go up in the midst of a downward trend. Suppose a chartist sees that on one day the market finishes on an upward note with high volume and open interest, but the next day it finishes down on low volume and similar or decreased open interest. The chartist would note that the market might be turning bullish, because sellers in the marketplace were not as keen to sell as buyers had been keen to buy on the previous day.
Advantages of Technical Analysis
- It requires much less data than fundamental analysis. From price and volume, a technical trader can obtain all the information he needed.
- As it is focused on identifying trend reversal, the question of timing to enter a trade is easier to address with technical analysis.
Drawbacks of Technical Analysis
Technical analysis can become a self-fulfilling prophecy. When many investors, using similar tools and following the same concepts, shift together the supply and demand, this can lead to the prices moving in the predicted direction
Now that you know most of the fundamentals and basic aspects of forex, in this section we'll introduce you to some charting patterns and a method of analysis within a field called technical analysis. Technical analysis is a method for evaluating currency movements by analyzing the data generated by market activity; this data is often historical data such as past prices and volume. Technical analysts will attempt to analyze this data in order to identify patterns that can help them predict future (short-term or long-term) price movements in the currency.
There are several different techniques technical traders use to analyze data. In this section of the tutorial, we'll introduce you to moving averages, trends, resistance and supports, double tops and double bottoms, Bollinger Band and the popular MACD.
But first, let's look at three reasons why many traders believe technical analysis can be a good way to analyze currency movements. Technical analysis is based on three underlying assumptions about the market and prices.
- Technical analysis is based on the assumption that the market discounts everything.
This means the price of the currency reflects all available information, including fundamental factors (i.e. economic news) and thus doing fundamental analysis, some argue, would add no value. Instead, technical analysts believe the analysis of price movement or the supply and demand of currencies is the best way to identify trends in the currency.
- Technical analysis is based on the notion that price movements tend to follow a trend.
This means past price behavior is likely to be repeated, and if a trend has been established the currency will most likely continue in that same direction.
- In connection with the belief that prices move in trends, technical analysis assumes that history tends to repeat itself.
The assumed repetitive nature of price movements is attributed to the psychology of the market participants. Generally, this is based on the idea that market participants have, historically speaking, often reacted in a similar fashion to reoccurring market events. Many well-known chart patterns are based on the assumption that history tends to repeat itself.
With that said, there are also many traders who believe fundamental analysis - looking at macroeconomic factors that affect the economy and thus the currency - is a good way to analyze currencies. There has always been the debate between which is the better method, but it would likely be best for you as a trader to be well-versed in both methods of analysis. Both have their strengths and weaknesses. (For a primer on fundamental analysis' role in forex trading, refer to our article Fundamental Analysis for Traders.)
Not Just for Currencies
Technical analysis can be used on any security with historical trading data. This includes stocks, futures and commodities, fixed-income securities, etc. In this tutorial, we'll use technical analysis examples to analyze currencies, but keep in mind that these concepts can be applied to a variety of securities.
Now that you understand the philosophy behind technical analysis, we'll get into the more common tools of technical analysis and build towards more advanced analysis techniques in the next few sections.
Whilst trading, you will be seeing some times where the market is not trending, but is in a range bound situation. In other words the market has no direction. Profits can be still made in this scenario but we have to be careful with the technical analysis in order to identify the support and resistance levels. The example below is with the use with Bollinger bands indicator.
So, we can trade range markets by buying at support and selling at resistance many times until the pair breaks out of the channel. The upper boundary of the channel is shown by a trend line that connects the points representing a pair’s highs over a given time period. The lower boundary of the channel is identified by connecting the points representing a pair’s lows. The downside of this strategy is that when a pair breaks out of the channel, it usually experiences a large price movement in the direction of the breakout. If the breakout direction is not favorable for the trader's position, he or she could lose badly.
BOC Interest Rate Decision: This is the rate set by the Bank of Canada, based on which other financial institutions (commercial banks) set their interest rates on loans and deposits. A decision to lower interest rates can spur economic growth while increasing the inflationary pressure, whereas the increase in rates leads to lower inflation but also slows down the economy growth. The Bank of Canada's rate decision has significant influence on financial markets. Changes in rates have a direct impact on interest rates for consumer loans, mortgages, and bond rates.
Building Permits: The indicator reflects the number of new building projects authorized for construction. The indicator is widely used to assess real estate market, since receiving a building permit is the first step in the building process. Thus, the growth of the indicator reflects the growth in the construction sector. Also, due to the high outlays needed for construction projects, the indicator reflects the corporate and consumer optimism. Additionally it can act as a leading indicator for the economy as a whole.
Consumer Price Index (CPI): The indicator measures changes in retail prices of goods and services purchased by householders. The Index includes the price level of food, clothing, education expenses, health, transportation, utilities and leisure. The indicator is calculated monthly and is the main indicator of inflation in the country. It is considered the most important indicator of inflation.
Gross Domestic Product (GDP): It is the sum of domestically produced goods and services expressed in prices. It is a major indicator reflecting the state of the national economy. GDP is the main characteristic of the economic success of countries that measures its economic growth or recovery. GDP growth is an important indicator for the Canadian dollar.
Housing Starts: Indicator showing the number of buildings that appear each month. The start of construction is considered to be laying the foundation for future building. The index is a leading indicator of economic activity in the construction sector.
Ivey Purchasing Managers Index: The indicator reflects the level of business activity of the industrial sector. More than one and a half hundred managers from different regions and sectors are asked to assess the level of their purchases as compared to the previous month (higher, lower or the same). The value above 50 indicates an increase in purchases, a value below 50 indicates a decrease. This indicator can be used to measure business optimism and forecast economic growth. Companies increase purchases and spending in response to growing demand for their goods and services.
New Housing Price Index: The index reflects changes in prices for new housing and is part of CPI. Increase in housing prices suggests an increase in consumer demand and growth of the real estate market. At the same time, high real estate prices that accompany economic expansion often lead to inflationary pressures.
Retail Sales: This is the index of change in retail sales. This is an important indicator of consumer spending, and is used for calculating the consumer price index. An increasing number of sales can signal consumer confidence and growth to come, but higher consumption can also lead to inflationary pressures.
Retail Sales Excluding Motor Vehicles: The indicator shows the volume of retail sales excluding car sales, which amounts to about 25% of the total retail sales in the country. This is an important indicator of consumer spending, and is used for calculating the consumer price index.
Unemployment Rate: The percentage of people in the total - labor force without jobs but willing to work and are actively seeking employment. Low unemployment rate indicates good economic state, leading to greater personal income and greater consumption. However, such increased expenditure with economic growth may increase inflationary pressures. On the other hand, higher unemployment leads to lower consumption and lower economic growth. The unemployment rate is one of the most watched indicators in the Canada's labor market.
Being able to identify trends is one of the most fundamental skills a forex trader should acquire. The main method of identifying trends is by using moving averages. Moving averages are lagging indicators, which mean that they do not predict new trends but confirm trends once they have been established. In general, a currency pair is deemed to be in an uptrend when the price is above a moving average and the average is sloping upward. Conversely, a trader will use a price below a downward sloping average to confirm a downtrend. Many traders will only consider holding a long position in an asset when the price is trading above a moving average.
The forex market generally tends to moves in trends more than the overall stock market. Why? The stock market is made up of a collection of individual stocks that are generally affected by the micro-dynamics of the particular individual companies. The forex market, on the other hand, is driven by macroeconomic trends that can sometimes take years to play out. These trends usually best manifest themselves through the major pairs such as the EUR/USD, USD/JPY, GBP/USD, and USD/CHF. Here we take a look at these trends and a common moving average technique to detect these trends.
In the chart above we have chosen a 20 period moving average (red), a 50 period moving average (blue) and a 100 period moving average (yellow) in order to indentify the shorter term, medium and long term of the pair move respectively.
You can also find the trend with a simple trend line like in the chart below. Then you know that if you are in an uptrend, you can just wait for a reversal to buy again. On the other hand in a down trund you must wait for an upward movement to find a nice area of offers to sell again.
Support and Resistance
Support and Resistance is the most basic type of technical analysis.
Support occurs at a price low or price trough in the market. When a market is falling in value it will usually encounter support at some point. It is the point at which the buyers come in and overpower the sellers that have forced the market down to the point of support. The price should bounce back up from a support point.
Resistance is the opposite. It occurs at a price high or price peak. When a market is rising, it will be the point where sellers enter the market and overpower the buyers. The price should bounce back down from a resistance point.
The next time the market then goes towards this point of support or resistance you would expect a bounce again as there will now be more traders believing in the level due to the previous bounce from it.
After a certain amount of bounces, it is a good idea to expect a break through this level. When a break occurs, an area of resistance will then turn into support, and vice versa. This is because the level will still remain a level, but any level below the market is considered support and any level above as resistance. On short-term timeframes (5min, 15min) generally expect a good level to hold 3- 4 times. On longer-term timeframe levels (60min, daily, weekly) expect a level to hold 4-5 times. An example of resistance becoming support can be seen below in the 1.1300 technical and psychological levels. Also, if a level was a very strong level, when it breaks, expect a big break, as stops get hit and more traders enter the market like the resistance in 1.1355 where we saw the range breaking with a big volume.
Trend-lines as Support and Resistance
Support and Resistance levels can also come in the form of trend lines and trend channels. In these instances, the line will act as support or resistance. The main difference with these types of support and resistance levels compared to what we previously discussed is that these levels change as the line changes in time. The line is constantly moving as it is trending upwards or downwards. A trend line can be drawn from as little as two points, and then expecting there to be a level when the market touches the line again. Trend lines should always be drawn from left to right. The longer a trend goes on, the stronger it becomes, but as we discussed before levels are there to be broken and will eventually break. The same rule applies as discussed earlier.
When trend lines do break it can give a good indication of the future direction of the market. They can mean that a trend is broken and the market may change the characteristics it has been displaying whilst in the trend. When looking for a trend line break, an important indicator to monitor is volume. High volume on the break would normally mean that the market is determined to break out strongly.
When you spot a trend line, it is a good idea to see if there is a parallel line running to it. This is often the case. If there is, it is a good idea to draw it in and this then becomes known as a channel or a trend channel. It will normally show that the market has been trading between these two lines in the past.
If you feel a channel is going to hold then the idea is to buy at the bottom of the channel or sell at the top of the channel. Then you would like to hold it to the other side of the channel where you would look to exit the position for a winner. Sometimes the other line will be very far away and it may not be possible to hold the trade all the way, but it is a good idea to trail stops as the trade moves on side to bank some profit in case the market turns before it reaches the other side of the channel. These trailing stops can be moved as discussed in the trailing stop section earlier. When a channel breaks, it is normally a stronger break than that of just a trend line.
Trend continuation patterns are patterns that will usually show the market direction slowing down and tailing off, before the trend continues in the original direction. In these circumstances, the trader is waiting for a breakout of the pattern to go inside the main direction of the trend. For example, if we have a 80 pips daily uptrend for EUR/USD and we see some correction we may wait on a good support to buy more. Let’s see the main patterns that could be considered as trend continuation.
Flags are marked by an almost horizontal entry into the market pattern. They are bound by parallel lines of support and resistance. When a flag breaks it is often a very big fast break. They tend to form at a slant opposite to the direction of the market trend at the time. The break we spoke about is in the same direction as the market trend. Below you can see an example of how a bullish and bearish flag look like.
When trading a rectangle, you can trade the horizontal lines as support and resistance (as discussed previously), but when it does break expect the break to be around the same as the height of the rectangle.
Triangles are another form of a continuation patter and there are 3 types of recognized triangles. The first is a symmetrical triangle or pennants. It is a period of consolidation during a trending market. There is a line of support slanting upwards, and a line of resistance slanting downwards. When these lines converge, there is a breakout in the direction of the original trend. The breakout can normally be expected to be at least the height of the triangle.
Then there is a descending triangle, the opposite of an ascending triangle. There is a slanting down line of resistance and a flat line of support. The same principles apply here as an ascending triangle, just the opposite direction.
Finally we have a wedge. It forms very similarly to a symmetrical triangle and if it breaks out, you can expect a sharp break in the direction of the original trend. Like a flag though, the wedge will normally form in the opposite direction of the trend.
Do trends last forever?
Trends will not continue to go in one direction forever. Often times, a trend will reach what is known as a resistance or support, which are price levels that the currency can't seem to push past. We'll introduce you to the concept of resistance and supports in the next section.
The most important thing when trading is to build a view, then to trade it using technical analysis. In essence, if you think that EUR/USD will continue downwards on the long term but you have lost the initial move, just search for resistance areas to go in the market again. Here is an example of how to use technical analysis to trade the view:
A strategy here will be to sell the rally. So, when the market hits a good resistance you can wait for a confirmation to sell.
Head and Shoulders
The head-and-shoulders pattern is one of the more popular and reliable chart reversal patterns. And from the name, the pattern somewhat looks like a head with two shoulders.
There are two shoulders (Left/Right Shoulder) which are at close levels and a head (H) which is above these levels and is the centre peak. There is a neckline which is the common line of support for all three peaks. When the neckline breaks it usually confirms the start of a new downward trend. This is not always the case, although if the neckline then holds as resistance after the break it is usually a good sign that there is a new trend. Another factor to take into account is the momentum. If the momentum during the formation of the left shoulder was higher than the right shoulder, then it would indicate that buying pressure is decreasing and a reversal is, indeed, taking place. The downward move will usually be at least the distance between the head and the neckline.
The inverse head-and-shoulders pattern is the exact opposite of the head-and-shoulders top, because it indicates that the currency pair is set to make a move upwards.
Formation of the left shoulder occurs when the price initially falls to a new low and then subsequently rallies to a high. The formation of the head occurs when the price moves to a low that is below the previously mentioned shoulder's low, followed by a return to the previous high. This move back to the previous high creates the neckline for this chart pattern. The formation of the right shoulder is typically a sell-off that is less severe than the one from the previous head. This is followed by a return to the neckline. When the currency pair breaks above the neckline the pattern is complete.
Double Top and Double Bottom
A double top is when a market rises and hits resistance and bounces down towards a support level. The market will then come back up towards this level and again the level will hold and therefore it becomes a double top. When the market then goes down again, if it breaks the support level where it bounced from just earlier, then it starts a new downward trend. A double bottom is the opposite, when a support forms rather than a resistance.
Triple Top and Triple Bottom
Same principle as double top, double bottom, just with an extra top or bottom. A Triple top is stronger than a double top or bottom and almost a certain sign for a big reversal. If the market does break through it then expect a big move the other way.
Rounded Top and Rounded Bottom
This kind of top/bottom forms when the market slowly shifts from bearish to bullish. It is a steady gradual shift. Once the shift has been made the trend has changed.
All candlesticks and patterns indicate where price should move in the future. This is not an exact science, however these patterns play out more often than not and that’s why they are very powerful tools to use with your trading. The key is to recognize these patterns and know when to trade them and when “not” to trade them.
When the candle body engulfs the previous candles body, this is called an “engulfing” pattern. Green engulfing candles are considered bullish engulfing patterns and red engulfing candles are considered bearish engulfing patterns. Bullish engulfing patterns are usually found at price bottoms and bearish engulfing patterns are found at price tops. Candlesticks such as dojis, hammers, hanging mans need trend confirmation before engulfing patterns should be used.
Evening Star Patterns
In an uptrend, the market builds strength on a long green candle and the next candle the market trades within a very small range and closes at or near its opening price. This can be a doji, spinning top or hammer candle. This usually means the existing trend is coming to an end. The 3rd candle in this pattern is used for confirmation of the trend reversal. If this is a red candle closing down in price, then this completes the pattern.
Note: The star candle can have a very small body but the “wicks” should be more noticeable than the actual body of the candle.
There are also “Evening Star Doji Patterns” and the only difference is the moring star candle is a doji instead of a small body candle:
Morning Star Patterns
In a downtrend, the market loses strength on a long red candle and the next candle the market trades within a very small range and closes at or near its opening price. This can be a doji, spinning top or hammer candle. This usually means the existing trend is coming to an end. The 3rd candle in this pattern is used for confirmation of the trend reversal. If this is a green candle closing up in price, then this completes this pattern.
Note: The star candle can have a very small body but the “wicks” should be more noticeable than the actual body of the candle.
There are also “Morning Star Doji Patterns” and the only difference is the morning star candle is a doji instead of a small body candle:
Single Candle Patterns
A single candle pattern can be Doji's, such as Dragonfly Dojis, Gravestones, etc, Hammers/Hanging Man, Shooting Stars and others.
Dojis are primarily reversal candlesticks. They usually means indecision in the market and in most cases indicate a reversal, but remember a doji by itself doesn’t mean anything. It’s the surrounding candles (e.g evening stars, morning stars, etc) that determine what the doji means. There are a few different Doji types:
These patterns have longer shadows than the real bodies. The colors of the real bodies are not important. The patterns indicate the indecision between the bulls and the bears:
Hammers and Hanging Man Patterns
Hammers and Haning Man candles are short body candles with little or no upper shadow, and a lower shadow at lease twice as long as the candle body. Hammers are formed after price declines, and hanging man's after price advances. When confirmed they become powerful reversal signals. The color of the hanging man/hammer is not important but some consider green hammers and red hanging man's stronger reversal signals.
A shooting star has long upper shadow (wick) and a small real body at the lower end of the price range.
Confirmation of the trend reversal would by an opening below the body of the Shooting Star on the next candle. If the open and the close are identical, the indicator is considered a Gravestone Doji. Many traders consider the Gravestone Doji of having a higher reliability than a Shooting Star.
The Forex Candles and Candlestick patterns on this page are considered to be the most dependable patterns for finding high probability trade setups. There are more patterns such as The Three Black Crows, The Three White Soldiers, Rain Drops and many others. As long as you familiarize yourself with the candlesticks and patterns above, and use them when they present themselves, you will do very well technical trading the forex market.
Among the most widely used technical indicators, a moving average is simply a tool traders use to smooth out the price movement in a given currency. Price movements can be volatile in the short term, so many traders will use a moving average in order to identify or gauge the direction of a trend.
Mathematically, moving averages are calculated by taking the average price of the currency over a certain number of days or periods. For example, a 50-day moving average would be calculated by adding up all the prices the currency closed at over the previous 50 days and then dividing by 50. All modern day charts will usually automatically do this for you. Once determined, the resulting moving average is then overlaid onto the price chart in order to allow traders to look at smoothed data rather than focusing on the day-to-day price fluctuations. An example of a 50-day moving average in GBP/USD is shown in the chart below.
Because of the way moving averages are calculated, you can customize your moving average to literally any time period you think is relevant, which means that the user can freely choose whatever time frame they want when creating the average. The most common increments used in moving averages are 15, 20, 30, 50, 100 and 200 periods. Shorter moving averages such as the 15 period, or even the 50 period, will more closely mirror the price action of the actual chart than a longer time period moving average. The longer the time period, the less sensitive, or more smoothed out, the average will be. There is no "right" time frame to use when setting up your moving averages.
Often in Forex, traders will look at intraday moving averages. For example, if you're looking at a 10 minute chart and wanted a five-period moving average you could take the prices in the previous 50 minutes and divide by five to get the five-period moving average for a 10 minute chart. Many traders have their own personal preference, but usually the best way to figure out which one works best for you is to experiment with a number of different time periods until you find one that fits your strategy.
SMA vs. EMA
There are actually two general types of moving averages: the simple moving average (SMA) and the exponential moving average (EMA). The moving average we were discussing previously is a simple moving average because it simply takes a certain number of periods and averages it for the desired time frame - each period is equally weighted. One of the main complaints with a simple moving average (especially short-term ones) is that they are too susceptible to large price movements up or down. For example, suppose you were plotting a five-day moving average of the USD/CAD and the price was steadily and consistently going up. And then one day there was a large down spike anomaly causing the moving average to go much lower and the trend to go down when perhaps that one day could have been caused by something not likely to occur again.
To mitigate this problem you may want to use a different moving average - an exponential moving average (EMA). An EMA gives more weight to the more recent prices in its calculation of a moving average. So if you were using a five-day moving average, an EMA would give a higher weight to prices occurring at the end of the five day period, and lower weight on prices occurring five days ago. So if a large spike occurred on days one or two, the moving average wouldn't be affected as much as a simple moving average. Again, traders should experiment with both types of moving averages to find their preference. In fact, many traders will plot both types of moving averages with various time periods at the same time. In the chart below, we have printed a 50 sma (yellow) and a 50 ema (red) and you can understand the differences.
One of the primary uses of a moving average is to identify a trend. In general, moving averages tend to be lagging indicators meaning they can only confirm that a trend has been established rather than identifying new trends. In the next section we'll take a closer look at how moving averages are used to gauge the overall trend of a currency.
Pivot points are used to identify critical support and/or resistance levels. Pivots are also frequently used in the forex market and can be an extremely useful tool for range-bound traders to identify points of entry and for trend traders and breakout traders to spot the key levels that need to be broken for a move to qualify as a breakout.
Calculating Pivot Points
By definition, a pivot point is a point of rotation and can be used in any chart (many traders use daily pivot levels in all charts). The input prices used to calculate the pivot point are the previous period's high, low and closing prices for an asset. The calculation for a pivot point is as follows:
Central Pivot Point (P) = (High + Low + Close) / 3
First Resistance (R1) = (2*P) - Low
First Support (S1) = (2*P) – High
Second Resistance (R2) = P + (R1-S1)
Second Support (S2) = P - (R1- S1)
Applying Pivot Points to the FX Market
Generally speaking, the pivot point is seen as the primary support or resistance level. The following chart is a 1-Hour chart of the currency pair EUR/JPY with xStation pivot levels calculated using the hourly high, low and close prices.
- The yellow line is the pivot point (P).
- The green lines are the first resistance/support levels (R1/S1)
- The red lines are the second resistance/support levels (R2/S2)
We can see that the pair started trading below the daily pivot level and when it came back, it found a strong resistance giving the traders a second opportunity to go in the down trend.
Uses of Pivot Points in Trading
1) As an Entry levels: Since these points are strong level of support and resistance, we can use them to predict future movement.
This is how you can use these levels for Entry
If you are in an uptrend and you see the price breaking above a pivot level, you can enter a LONG position and then place your stop loss below the pivot level.
If you are in an uptrend and you see the price repelled by the pivot level, you can enter a SHORT position and then place your stop loss above the pivot level.
For this method to work better, you can add some indicators like the MACD or RSI to help you with your entry decision.
2) As an Exit levels: Similarly you can also use these levels for planning your exit.
Now that you know how to enter a trade with the pivot points, we will see you how we can use these levels to exit a trade.
If we enter a LONG trade after the price break above a pivot level, we will usually place a target profit 10 pips below the next higher pivot level.
However if we enter a SHORT position after seeing the price being repelled by the pivot, we will exit the trade once the price move down to half the pivot length.