Technical Analysis
What is it?
Technical
analysis is another method of forecasting prices. It studies past price
action in an attempt to predict the future. The technical analyst
focuses exclusively on market information and works on the assumption
that all fundamental information is already reflected in the price.
Unlike the fundamentalist, the technician attempts to predict future
price directions by searching for established patterns of price
behavior that have signaled major movements in the past.
Charts are the major tool in technical analysis.
The following is an introduction to the most common technical
analytical tools used to identify trends and recurring patterns in a
volatile market. Most automatic trading systems rely on technical analysis.
There are three main types of charts used in technical analysis:
Line Chart: The line chart is a
graphical depiction of the exchange rate history of a currency pair
over time. The line is constructed by connecting daily closing prices.
Bar Chart: The bar chart is a
depiction of the price performance of a currency pair, made up of
vertical bars at set intraday time intervals (e.g. every 30 minutes).
Each bar has 4 'hooks', representing the opening, closing, high and low
(OCHL) exchange rates for the time interval.
Candlestick Chart: The candlestick
chart is a variant of the bar chart, except that the candlestick chart
depicts OCHL prices as 'candlesticks' with a wick at each end. When the
opening rate is higher than the closing rate the candlestick is
'solid'. When the closing rate exceeds the opening rate, the
candlestick is 'hollow'.
One
use of technical analysis is to derive "support" and "resistance"
levels. The underlying idea is that the market will tend to trade above
its support levels and below its resistance levels. A support level
indicates a specific price level that the currency will have
difficulties crossing below. If the price repeatedly fails to move
below this particular point, a straight line pattern will appear.
Resistance levels on the other hand, indicates a
specific price level that the currency will have difficulties crossing
above. Recurring failure for the price to move above this point will
produce a straight line pattern.
If a support or resistance level is broken, the
market is expected to follow through in that direction. These levels
are determined through analysis of the chart and by assessment of where
the market has encountered unbroken support or resistance in the past.
Moving
averages provide another tool for tracking price trends. A moving
average is in its simplest form an average of prices that rolls over
time. A 10-day moving average is calculated by adding the last 10 days’
closing prices and then dividing them by 10. On the following day, the
oldest price is dropped, and the new day’s closing price is added
instead; now these 10 prices are divided by 10. In this way, the
average "moves" each day.
Moving averages provide a more mechanical approach
to entering or exiting the market. To help identify entry and exit
points, moving averages are frequently superimposed onto bar charts.
When the market closes above the moving average, it is generally
interpreted as a buy signal. It is in the same way considered a sell
signal when the market closes below the moving average. Some traders
prefer to see the moving average line actually change direction before
accepting it as a buy or sell signal.
The sensitivity of a moving average line and the
number of buy and sell signals it produces is directly correlated with
the chosen time period for the moving average. A 5-day moving average
will be more sensitive and will prompt more buy and sell signals than a
20-day moving average. If the average is too sensitive, traders may
find themselves jumping in and out of the market too often. On the
other hand, if the moving average is not sensitive enough, traders risk
missing opportunities by identifying buy and sell signals too late.
Moving averages can be extremely useful tools for the technical trader.
A trend line helps identify the trend as well as potential areas of
support and resistance. A trend line is a straight line that connects
at least two important peaks or troughs in the price action of an
underlying tradable. No other price action must break the trend line
between the two points. In this way a trend line marks a support or a
resistance area where the price has turned (peaks and valleys) and has
not been violated. The longer a trend line the more valid it is,
especially if price has touched the line several times without
penetration.
The penetration of a long term trend line may be
an indication that a reversal of the trend is about to occur. However,
there is no guarantee that this will happen. As with all indicators of
a price trend reversal, there is no proof method that predetermines
where future prices will go.
When
a market is moving swiftly in a given direction, it may sometimes pull
back as market participants take their profits. This phenomenon is
known as a retracement often it presents a good opportunity to re-enter
the market at more attractive levels before the underlying trend
resumes.
Using Fibonacci ratios is a common way of measuring retracements.