Technical analysis is one of the three pillars in Forex Trading which traders base their decisions on. Without any doubts, the technical analysis is the most popular way of analysis among retail traders and the most efficient one when a trader wants to analyse a chart of any instrument.
If you are interested in knowing more about the fundamental analysis and sentiment analysis, we cover these also.
What is technical analysis?
Technical analysts believe that history repeats itself and patterns that emerged in the past tend to repeat themselves in the future.
One of the reasons for this is the belief that we can see the crowds behaviour on the chart and spot the places of its optimism and panic at certain periods. The assumption is that this behaviour often remains unchanged the patterns on the charts will repeat themselves.
As a technical analyst, you will be reading the charts, gathering all the available information and trying to identify those patterns, and predict the future move of the price.
The meaning of price action is the movement of any market plotted over a given time. Price action traders love to trade with what is known as “naked charts”.
To read such price action or “naked charts”, traders use different methods. Live charts, bar charts, candlesticks or other tools. A bar or a candlestick is formed by 4 components: Open Price, Close Price, High Price and Low Price.
The easiest example would be to look at the chart and try to identify whether price is moving up (creating higher highs and higher lows), down (lower lows and lower highs) or sideways.
In this specific example, we can clearly see swings that create lower highs and lower lows; hence the price is in a bearish trend.
In this specific example, we can clearly see swings that create higher highs and higher lows; hence the price is in a bullish trend.
Another very valuable piece of information we can gather from such “naked charts” or pure price action charts, is demand\supply zones, also known as Support-Resistance zones.
Those are levels where the price reacted (whether this reaction is a complete reversal of the trend or short-term bounces\retraces). Technical analysts will identify such levels and follow them closely, developing strategies and looking for potential entries around them.
On the image above we can clearly see that the zone marked with the rectangle is a resistance zone \ supply zone, which the price doesn’t manage to go above.
On the image above we can clearly see that the zone marked with the rectangle is a support zone \ demand zone, which the price never manages to go below.
There are hundreds of books and online resources on price action alone and patterns that are structured by price only, and even though we can’t cover in-depth, here are a few names to get you started:
Triangles (ascending, descending, symmetrical), Flag, Wedge, Head and Shoulders (Inverted Head and Shoulders), Double Bottom, Double Top.
Traders that master the price action analysis and know-how to spot such patterns and trade them by the rules have a significant edge in their hands over the other traders.
Technical indicators are another major component in technical analysis. Here is a very basic and simple explanation of how they work:
Indicator X would look at (N) number of bars, crunch some numbers, apply formulas and deliver output. You will find a great variety of indicators, covering anything that comes to mind. Even though there are multiple categories here as well, the most popular ones are divided into two categories:
- Lagging Indicators
- Leading Indicators
An example of a lagging indicator would be a Simple Moving Average. The indicator would look back N bars (or periods), do some calculations, crunch some numbers and deliver the outcome on the chart for you.
What’s crucial here is that the information used by the indicators will use only 1, in some cases 2 of the 4 components mentioned above.
That means when we use indicators, we are not working with all the available information, hence the result we get from the indicator is indeed simply a suggestion. The majority of the indicators should be used as an extra confirmation, and not as a main decision factor.
A leading indicator as opposed to the lagging indicator tries to forecast or predict where the price is headed. Fibonacci Retracement and Expansion tools are the perfect examples of this kind of indicators! RSI and MACD indicators are also among the most popular ones in this category.
Another subcategory of the technical analysis is candlestick patterns. All trading platforms nowadays offer candlesticks as one of the options on how to see price on the chart. This is the most used type of charts when analyzing the price.
What are Japanese Candlesticks?
Each Japanese candlestick shows the Open, Close, High and Low price. However, the big secret here is the relationship between these 4 components. Based on how the candle closes at the end of the period, a different formation occurs.
Here is a very easy to recognize a pattern, favourite of many traders.
We see that even though the candle close was above the open (forming a bullish candle), bulls couldn’t maintain the bullish pressure. This is usually a sign of weakness. If a few other conditions are in place, we can expect the price to go lower, after such candles.
Here is what happened on the very next candle.
Some of the most reliable candlestick patterns include; Bullish and Bearish Engulfing, Hammer and Hanging Man, Doji, Shooting Star, Harami, Piercing and more.
There are traders who rely solely on candlestick patterns as they believe they offer all the information a trader needs. Without any doubt, knowing to read the candlestick patterns correctly will increase the value of the analysis of any trader.
Why Technical Analysis is preferred among retail traders?
The main advantage of technical analysis is the timing. That means that if you can analyze your charts correctly, you can enter any trade with much better timing than with any other technical analysis methods.
Due to multiple reasons (size of capital for one), the majority of the retail traders will stick to the short-mid-term trading opportunities, making technical analysis the perfect weapon.
Any type of analysis has its pros and cons, this is why becoming an expert in one, and knowing enough in any of the other two will give you a much greater edge.
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