Technical Analysis is a term that refers to the process of analyzing the price movements, or market activity, of a currency pair or other financial asset.
The key principle behind Technical Analysis is that the price of a financial asset reflects all the available information about the particular asset. This means that, in most cases, technical analysts do not consider any of the fundamental factors that could affect the price of a currency pair. Instead, they believe that everything a trader or investor would like to know about a currency pair is reflected in its price.
The first step to performing Technical Analysis is to understand the three main assumptions on which it is built:
This assumption is also referred to as the efficient market hypothesis, which allows traders to ignore all fundamental factors that could affect a currency pair. Therefore, technical analysts and traders typically focus solely on analyzing the currency pair’s price movements.
This assumption states that despite the millions of individual price movements recorded in a day, price movements are not random as they do follow specific trends. The main objective of Technical Analysis is to identify the current trend and use it to predict future trends.
This assumption is based on the belief that prices in the Forex markets are driven by the human emotions of fear and greed. Therefore, price patterns that occurred in the past tend to be repeated if the same conditions that drive traders’ emotions exist today.
The above principles explain why some Technical Analysis patterns and tools have been in existence for over 100 years, yet they are still effective in today’s markets.
Traders use Technical Analysis for the following purposes:
i. Identifying a current trend
ii. Identifying areas of value such as support and resistance levels
iii. Determining the best entry and exit points for their trades
iv. Managing their risk exposure and for position sizing
The following steps may help guide you when using Technical Analysis as part of your trading strategy.
This is the first step in Technical Analysis for Forex traders because trading strategies can either follow the trend or go against the trend. However, for each of these systems you have to identify whether the current trend is an upward trend, downward trend, or a sideways trend. Each of these three trends requires a different trading approach, depending on your trading strategy. In this case we’ll demonstrate using a trend following trading system.
For such a system, traders generally buy or take long positions in currency pairs that are in an uptrend. Currency pairs in a downtrend are typically sold short, while currency pairs in a trading range are commonly entered into at established support or resistance levels where a trader believes there is a high likelihood of a trend reversal.
Support and resistance levels are areas where the price of a currency pair is likely to reverse or to stage a breakout.
A support level is a level where the downward price trend of a currency pair pauses as buying demand increases, so the trend reverses and turns upward. The same reasoning applies to resistance levels where the upward price momentum of a currency pair weakens and the price is likely to reverse and head downward. Support and resistance levels can provide excellent opportunities for traders to open new trades.
While identifying areas of support and resistance can present excellent entry positions, there are other factors technical traders can consider when determining their entry positions. These include the values of technical indicators such as the Average True Range (ATR) and relative strength indicator. These are volatility indicators, which can help a trader establish whether there’s adequate momentum behind a price move.
Technical momentum and volatility indicators such as the Average True Range are commonly used by professional traders to help with position sizing and risk management. Depending on your chosen risk:reward ratio, you can use the ATR to determine where to place your Stop Loss once you’ve identified an entry position. For example, some long-term traders prefer to set their stop loss order 1ATR away from their entry position with a profit target 3ATRs away for a 1:3 risk:reward ratio.
While not meant as an exhaustive guide, the information outlined above summarizes important aspects of Technical Analysis that can be useful to traders at all levels and help build your technical trading skills.
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