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The Use Of Forex Technical Analysis

Having looked at two different types of analysis used, you will be aware of the many advantages and disadvantages of using them. For a deeper insight, this lesson examines the use of technical analysis for trading in more depth.

Being new to Forex trading or are disappointed with your current ability to interpret technical data’s effect on price movements, then this information will be invaluable. It is important to remember that each indicator will generate reliable signals only from a very specific configuration. In a similar way to using the wrong tool to try to complete a complex DIY task at home, it would be incorrect for instance to analyse a trend using RSI, when a combination of moving averages would be much more appropriate.

There are two primary rules for any technical analysis. Keeping it simple is critical, together with remaining utterly disciplined with your risk controls and the management of your money. Technological tools are, as the name suggests, merely a tool. They are not infallible, but they are a great asset when used to identify and act on situations which are offering good potential for risk/reward. However, there is never any certainty, so, you must be fully committed to controlling the allocation of risk. The most experienced technical trader can witness their account emptied if they do not implement these vital risk measures. Once these are in place, you are ready to start your professional journey and hopefully command a profit. So, let’s look at the important tools that will help you to evaluate and understand the price action.

The Precision Of Oscillators

Price action itself has absolutely no limits, meaning that a currency pair can theoretically rise in price from zero to infinity. In practice, there will always be an upper limit on the chart, but it is almost impossible to predict as to where it will be. As an example, let’s say that the price for EUR/USD is 1.50, which means that 1.70 would be a very high price. However, what about 1.75, or 1.85? By definition, all these prices are high, so it is extremely difficult to place a “take profit” or “stop loss” order on the charts. To solve this issue, we must confine the price action and define a practical range, so that we are able to interpret and act on any developments fully.

This is where the use of oscillators come in, by helping to add precision when defining high and low prices for currency pairs, along with the specific time frames. Over the course of the past decades, numerous oscillators have been developed, many of which use different formulas. However, they all have the aim of restructuring price data in a precise mathematical way. They work by facilitating the primary designation of both overbought and oversold levels. As you are aware, an oversold value would indicate a price that is low when compared to its history, and overbought would suggest that excited traders have pushed the price way too high.

Both of these scenarios would also point to a contrarian trade offering a potential profit. All types of oscillators will move between the predefined lower and upper values, which allows for the definition of these overbought and oversold levels. This means that if the price fluctuates towards overbought, the trader can safely think about a “sell order”, or when an oversold price is signalled, they can consider a “buy order”. The different oscillators are defined and utilised depending on their price pattern functions. Some, like the Williams oscillator and the MACD, work to best advantage in a trending market, and some are superior in periodic markets. Others are adaptable to a ranging environment, including the Stochastics and RSSI indicators.

Numerous traders are sceptical about the validity and use of the oversold and overbought levels on oscillators. It is important to see that oscillators are capable of reducing arbitrary levels, but they do not entirely cure the problem. Many oscillators also make use of a divergence/convergence principle between the indicator and the price, although this is an infrequent phenomenon in practice. The ones most commonly used by currency and Forex traders are RSI, Average True Range, Stochastics, Williams Oscillator, Force Index and MACD, although there are many other options available.

Key Trend Indicators And Moving Averages

Oscillators are the perfect tool to use within ranging markets, which can offer traders many profitable opportunities. Many Forex traders concentrate on these ranging markets, but history tells us that the most successful traders were trend followers. These trends can be extremely profitable for traders who manage to identify them and have the necessary tools and experience to exploit them. Anyone who uses fundamental analysis has their own economic theories, analytical skills and statistical tools with which to study these trends. Conversely, the use of technical analysis uses a set of indicators which are tailor-made for this kind of trend analysis.

The moving average is probably the most valuable of the trend-following indicators. It conveniently totals closing prices within any predefined period and then divides them by the moving average. This determines a mean value, which the price action will fluctuate around. Unlike the ordinary numerical average, the benefit of this moving average is its ability to be continuously updated whenever the price varies.

There are two types of moving average that traders need to be aware of. The first is SMA (simple moving average), where prices for each period in the calculation have the same weighting. For instance, the price 10 minutes ago will have the same value as ten days ago, in order to determine the moving average.

The second type, named the exponential moving average, works in a slightly different way. It is much more sensitive to recent price changes and gives the latest period prices a higher weighting. Values from days and weeks ago will receive a lower weighting. This moving average is not always as useful when traders are trying to use it together with the price action, so many traders use a combination. They will use this exponential moving average and a simple moving average for the same timeframe. This then allows them to easily interpret any divergence/convergence across the two trend indicators.

Apart from the use of moving averages, many technical analysts utilise an indicator called the Bollinger Band. This favoured indicator can be combined with others and used for a number of varying predictions. It can help to anticipate any breakdown of range patterns and to forecast entry and exit points in trends. During the lifespan of any trend, there are always long periods where the price settles and consolidates, and the trends calm. Bollinger Bands are the ideal tool to help in predicting when these patterns will end, and to anticipate any opportunities for consolidation.

There are numerous indicators that you can effectively use in combination to generate trade signals in a dynamic market, or you could even write your own! The power of these indicators is always more valuable when they are complemented and paired with strict money management principles.

Understanding Price Patterns

Similar to the composition of a piece of music, prices flow and move in a pattern. During a phase of consolidation tension builds, and when this is resolved, the market is pulled forward breaking down the pattern of consolidation. In both ranging and trending markets, the price action can be divided into smaller patterns, as the market moves into consolidation and prepares for the new phase. These fluctuations create many different types of price patterns. For instance, when any new trend is developing, triangles of all different kinds can be found everywhere. Traders can also learn to recognise numerous short-term patterns which will usually develop during the course of any significant or major trend. Following this, branches of the trend will successively follow the ultimate breakdown of each range pattern.

Traders using technical analysis will primarily divide any price patterns into either reversal patterns or consolidation patterns. As the branches of the main trend start to break down, they will also be able to identify reversal patterns. A consolidation (or continuation) pattern, like triangles, will signal that the trend is still developing and ongoing. During this phase, there will be continual re-arrangement, as all the participants re-adjust positions and re-evaluate strategies. When a reversal pattern is spotted, then this signifies to the analyst that the price action is beginning to lose its speed and power. This is also an indication that the current market dynamics may quickly become invalidated by new market developments. The creative use of these price patterns is a widespread practice in technical analysis, however, always remember these formations are only actionable in hindsight on many occasions.

Our Technical Conclusion

For any Forex trader who wishes to utilise technical analysis fully, there is a wide range of tools available. The techniques can be useful both in identifying new scenarios and evaluating them, but it can be extremely confusing for any level of trader. The ultimate power of this kind of analysis is the precise predictions. However, the process of finding and setting up the configuration of indicators needed to generate these predictions is not a precise science.

Despite these difficulties, the technical analysis remains the most popular method and is utilised by traders worldwide. Its projections hold a mystical and unique power that is validated by the collective behaviour of millions of technical traders.

More From The Free Forex Trading Beginners Course

Part 1: Reading A Currency Quote
Part 2: What Are Forex Pips, Leverage, Lots, And Margin?
Part 3: Explore Currency Pairs And Their Different Aspects
Part 4: Fundamental Analysis And Technical Analysis In Brief
Part 5: The Use Of Forex Technical Analysis
Part 6: The Importance Of Fundamental Analysis For Forex
Part 7: You Need To Apply Some Psychology To Be A Successful Trader
Part 8: Finding The Best Forex Broker Online
Part 9: Disclaimer