What to look for in a chart?
An important starting point in a chart is to look for underlying trends. Lines can be drawn to visualise the trend, although this is somewhat subjective as prices rarely fit a precise pattern.
It is important to assess whether a long-term trend still prevails. Equally importantly, trend lines can be used to assess whether a trend has started to reverse. This is an extremely important aspect for investors as identifying potential turning points are pivotal in making successful decisions and avoiding substantial losses.
Prices will often move in channel, bouncing between the floor and ceiling. While these trend lines are respected, there will be expectations that the underlying trend is still intact.
If the trend lines are broken, however, this is an important warning that the underlying trend might be changing.
If, for example, a currency is at historically strong levels and showing signs of turning down, then any investor needing to sell that currency should see this as an opportunity to sell. Similarly, there is a case for buying a currency which is at very weak levels and showing signs of recovering.
Example of trend line – AUD/USD
From a peak above 0.8000 in September 2017, AUD/USD declined to lows around 0.7500. The break of the downward trend line around 0.7600 warned over a trend change and there was a sustained move higher.
Chart from TradingView
A related and extremely important chart tool is support and resistance. Market prices are the result of a constant tussle between buyers and sellers. The relative strength of these forces will determine prices. As prices decline, buyers will eventually step-in to the market which will tend to push the price higher once again.
Similarly, strong gains in prices will eventually be met by sellers. The relative strength of buyers/sellers will determine the next move in prices. If sellers tend to gain control then previous buyers will look to take profits and this selling tends to accelerate the process of decline.
If sellers cannot push prices below an important support level, there is the strong potential for a rebound. If, however, a support level breaks, there is the risk that prices will drop further.
Similarly, a successful test of resistance would increase the risk of falling prices while a break higher suggests the potential for further moves higher.
The signal is more important if the technical levels are tested successfully two or three times. If a price rebounds twice from a support level this is known as a double bottom while three successful defences would be a triple bottom. Similarly, two failures to break above a resistance level would indicate a double top.
It is also important to note that traders will look to place stop-loss levels just below a key support level. If a price level breaks, these stops will be triggered which increases the risk of a sharp downward move.
Following a break below support, the level tends to become resistance or block to any renewed attempt to move higher.
Charts give easy and clear insight into support and resistance levels.
Example of support/resistance – EUR/GBP
EUR/GBP continued to hit resistance around 0.9000 late in 2017 with this level rejected consistently and the pair then moving lower.
Chart from TradingView
Round numbers are important
Psychologically, important round numbers have an important impact and it is notably more difficult to break round numbers. In this context, these numbers can act as key reversal points for underlying trends.
Important examples of big psychological levels are; 1.00 in EUR/USD, 100 in USD/JPY and 2.00 in GBP/USD.
Moving averages smooth out price fluctuations and take an average of previous prices. The most important moving average is the 200-day moving average (200 DMA). This is the average of the past 200 readings and is either a simple or average or can be weighted to give greater emphasis on recent prices.
If a price moves lower, but holds above the moving average this suggests that the underlying trend is intact. If, however, a price dips below the 200 DMA it suggests that the underlying trend is weakening.
Similarly, a price break above the 200 DMA suggests that the underlying trend is becoming more favourable.
A substantial move away from the moving average is also a warning that price trends are likely to prove unsustainable.
Example: USD/CAD daily price and moving average
USD/CAD dipped below the 200-day moving average in June and failed to regain this level. USD/CAD subsequently moved substantially lower. Since then, USD/CAD has traded below the 200-day moving average.
Chart from DailyFX
Technical analysis is also useful in assessing the speed of market gains and the risks of at least a temporary reversal.
Even if a price is on a sustained uptrend, there is a risk that the price will move higher too fast. In this case, there will be pressure for at least a limited correction weaker before the advance can continue.
Relative Strength Indicator (RSI)
One of the major momentum indicators is RSI. The index oscillates between 0 and 100 depending on the rate of change in prices. If prices are moving sharply higher, the RSI index will move higher towards 100 while the index will decline towards 0 if prices are moving lower at a fast pace.
In general terms, a reading below 30 indicates that an asset is over-sold and due for a correction higher. A reading above 70 suggests that the price is overbought and vulnerable to a corrective decline.