Forex Technical Analysis

It is believed that technical analysis is the most popular type of analysis nowadays. In one form or another it is used by approximately half of all the traders on the planet.

Technical analysis (TA) is a method of prediction of rates on the basis of their previous values and on the volume of trade in the Forex market. In other words, we turn a blind eye to all the ‘real’ reasons for the fluctuation of quotations and study price alone! It is worth mentioning that most brokers provide their clients with quotation history for several previous years and not only the last few days and hours.

It may sound strange but TA is a very powerful tool to a trader. In contrast to fundamental analysis, technical analysis uses mathematic and statistical methods instead of intuition and intelligence. Generally, it is a pure science. At the same time there are no strict systems and orders in it. Quite the contrary – it contains many different methods the majority of which have been kept a secret until recently. For example, there is a simple graphical analysis and there is an analysis based on neuronal networks and algorithms corresponding to it. It may happen that one method contradicts others, but that is not necessarily of great significance. When you start trading, you will probably use a combination of more than one method, and maybe
even invent your own. To begin with, let us remember some general principals and axioms. The whole of technical analysis is based on three postulates.

First postulate: the current rate already accounts all major factors

Fundamental analysis considers action to be the first event to happen which then causes a change in the exchange rate. Let us imagine that the talented CEO of a big company announced that he had got tired of working and wanted to retire and leave with his young wife for warmer climes. Within one hour, shares of that company dramatically collapse. TThe reason for the collapse in share price was the event of the CEO leaving. The action of the collapse was the result. That’s how fundamentalists use economic indicators and news in order to predict market action. As another example, a rise in demand, according to fundamental analysis, generally leads to the rise of a currency’s exchange rate.

Technical analysis observes the market from the opposite direction: the change itself becomes the ‘reason’ for a market action. All the factors that influence the market are already represented in current prices, so there’s no use in stuffing one’s head full of them. It is enough to look back over the history of prices to forecast their future behavior. This postulate is argued by the fact that fundamental factors influence market prices not in a direct way but through the heads of traders. The news that a principal leader has quit isn’t the cause of a fluctuation in rates but that negative expectations of traders connected with this event not only can – but definitely will – affect the currency rate. At the same time, people have billions of opinions and expectations which means that the most objective measures remain the trade values (amounts of a currency bought and sold), thus the price becomes the global opinion of all the traders and the market in general. From the point of view of technical analysis the growth of a currency
rate leads to the growth of demand for this currency and as a result increases the value of the currency.

TA became popular by its connection with the Efficient-Market Hypothesis. This hypothesis declares that it is impossible to trade with the help of Fundamental analysis more profitably than a typical trader. If your profit was bigger or smaller than average it was just because of some excessive risks you took. However, TA also has some weak points.

All first-postulate criticism can be reduced to two statements:

• Shocking news may provoke unexpected market fluctuations which couldn’t be reflected in the current rate value, thereby it can’t be predicted.
• Different traders receive news at different times: some sit all day long at the computer and trade by following every move of a rate, whilst others fulfill medium and long-term operations over the phone, earning rates from newspapers.

However, in the case of the Forex market, both these considerations can be rejected. The first one can be rejected because it is true for any logical analysis (fundamental, technical or other), as the word “unexpected” means that nobody expected this event to happen anyway. The second consideration can be ignored because receiving or not receiving information is a voluntary thing and it has nothing to do with the described method of analysis.

Second postulate:price developments have a tendency

That prices follow trends or tendencies is the concept underpinning the theoretical basis for TA. It states that markets follow trends and fluctuations of rates in trends more often than they change trends. So we can say that the essence of TA is reduced to the determination of the current trend and discovery of signs of completion of old trends and development of new ones.

There are three types of tendencies distinguished:

• Up trend. This is when a price grows. Sometimes this trend is called “the bullish trend” as “bulls” mostly try to profit from up trends.
• Down trend. This is when a price falls. Sometimes it is called “the bearish trend” as usually “bears” try to profit from down trends.
• Sideways or Trading range. This is stagnation or the absence of any noticeable changes in price.

There are many different methods for determining the market trend. Dow Theory is an example of a system based on something more than intuition alone. According to Dow Theory the trend is up if every next local maximum and every next local minimum is higher than the previous one. And vice versa: we deal with a down trend if every next fall point and every next peak is lower than previous ones. At the same time the trend is described as sideways if none of the above apply.

The most common criticism for this postulate is “this postulate is too trivial”. Indeed, if the price changes at all it is in a trend even if a very short one so it is only not in a trend when prices move nowhere. Thereby the postulate affirms that salt is salty. This criticism can also be refuted; just because a postulate is trivial, doesn’t mean that it is wrong!

Third postulate:history repeats itself

This is probably the main postulate of technical analysis. TA wouldn’t exist without it. Its essence is that the psychology of the crowd or even a single person hardly ever changes. You can be among talented investors, find yourself in the crowd of loud soccer fans or stand in line for a subway ticket – all these situations have short-term aims and interests that arise just because you became part of that mass. Roughly speaking, it doesn’t matter how many years have passed and how many generations of traders have changed, their behavior will remain the same with some insignificant differences. So, the key to understanding current and future price action is price history.

Being guided by this postulate we may conclude that TA is a set of mathematical methods of analysis of human behavior expressed in price (affected by this behavior).

Usually this postulate is criticized with following:

• There never can be two identical situations
• The market is a reflexive system. If traders have started using technical analysis it must have reduced its effectiveness as its usage has been discounted in the price that has been analyzed by this method. In other words this use of TA by traders becomes a separate market factor that makes them causes them to make decisions differently than they would have made without TA.

It is worth mentioning that these two critical arguments might also be rejected as they have nothing to do with our case study and are of a cavil nature as a result of excessive theorizing. First of all, nobody needs two identical situations – because if they had existed no one would have to make predictions (and analysis accordingly). Secondly, there’s no problem at all with the use of TA becoming a market factor, since we are not trying to predict the whole future of the market. We choose a reasonable time-span, let’s say one business day or a week, and forecast that! This will be enough to gain significant profits. The next currency rate will include all the factors including our trade, and therefore we can make another iteration of technical analysis.

As we can see TA itself is quite a simple thing but it requires and encourages inventiveness. It has almost no weak points except one: the trader’s level of faculty for analysis. Some more advantages of technical analysis include its applicability to any type of market, whether it be orange juice concentrate or the wine-market – their trends can be studied the same way as those of the Forex market. There is no need to buy data or information (insider’s info or fresh market reports) and analyze huge amounts of indicators, every one of which has its own unit of measurement, behavior and degree of influence on the market. All that TA needs is the price history of a traded instrument (in the case of Forex – a currency) for a long enough period of time. This history is usually accessible to the public and free.