This guide was composed by Mr. Tim Clayton, a market analysis specialist with more than 20 years of experience under his belt. He specialises at global economic trends, macro economical policy and central bank policies. His writing style involves taking complex topics and simplifying, using layman terms.
If you understand the fundamentals of foreign exchange rates like economic indicators, and wish to be able to do comprehensive to conduct currency forecasts, then this article may be for for you.
Technical analysis is often portrayed as a method to predict futures changes in asset prices including currencies. Although this is an important element, technical analysis is a more subtle and complex tool. It had a crucial role in risk management, especially as analysis of price movements can give important warnings over likely changes in trend and unsustainable levels.
What is technical analysis?
At a simple level, technical analysis is the process of using the pattern of prices moves to gain perspective on underlying trends in supply and demand. These patterns, in turn, give insight into likely price moves in the future.
Technical analysis essentially assumes that behaviour is repetitive and predictable. If an asset price has behaved in a certain way previously, there is a strong chance that emotions and the interplay of both human and trading factors such as fear and greed will lead to these patterns repeating in the future.
Supply and demand determine prices
Market prices are determined by the interplay of supply and demand and these forces are constantly in flux. It is extremely important to realise that global traders at the professional level are constantly engaged in a battle to trade profitably. The outcome of this battle will have an important impact on price direction, at least in the short term.
It is also crucial to understand that technical analysis does not specifically predict what will happen to prices. Using technical analysis and studying potential patterns do give important clues as to what is happening in the battle between supply and demand and these developments will have an important impact on price moves.
Taking out the emotion
An important element of technical analysis is that it should help to take some of the emotion out of assessing underlying trends and likely developments. The use of charts is important in giving a more objective stance which lessens the risk of investment decisions based on subjective factors and gives greater objectivity surrounding investment decisions.
Charts give perspective
An extremely important element in technical analysis is that the use of charts gives investors an important sense of perspective.
The main market and media focus is on short-term moves for all asset classes including currencies. The concentration on short-term moves, however, risks losing the longer-term perspective, especially where currencies are close to turning points or have reached unsustainable levels.
This is particularly important when looking at longer-term currency valuations. It is, for example, extremely important to assess where currencies stand in relation to historic valuations.
Professionals use technical analysis
Most individual traders tend to use technical analysis and it is important to note that institutions will use it as well. There is, therefore, an element of analysis being self-fulfilling. Nevertheless it is only one element of the market and by no means the only factor which determines prices.
First Step: Looking at a chart
The first element in technical analysis is to be comfortable with looking at the chart. At the most basis level, line charts join the daily closing points. A more advanced process is to use bar charts which show the open, close, high and low points for the time period.
The most common use is of a particular form of bar chart called candlesticks. These charts have a candle shape between the open and closing levels. If the price moves higher, the candle will usually be shaded green or white while it will be red or black if there is a daily decline in prices.
Candlestick charts originated in Japan and were used by traders in an attempt to determine future price moves for rice and now tend to dominate technical charts.
Time frame is important
As well as the type of chart, the time frame is also a key variable. Charts are available for short-term time frames as little as a minute or less. Longer-term charts will focus on time frames up to monthly with any time frame of 4 hours of more considered longer-term timeframes.
For investors looking to take investment decisions, longer-term charts tend to be more valuable while day traders will be focussed more on shorter-term charts.
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.
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.
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.
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.
Technical analysis price patterns
Head and shoulders
This is one of the classic price patterns and can important implications. There are a series of three price peaks with prices dipping lower in the interim. The middle peak in price, or head is the highest while the peaks to the right and left (shoulders) are lower. This pattern suggests that there is a major downside risk in the price.
Example of head and shoulders
USD/JPY showed a head and shoulders pattern in July 2017 with a peak near 114.50 and two shoulders around 113.50. after the right-hand shoulder and failure to move higher, USD/JPY fell sharply.
This is the reverse of a head and shoulders with three price troughs with the lowest price in the middle. This pattern suggests that a major price bottom is forming.
Example of inverse head and shoulders
GBP/USD formed an inverse head and shoulders around the turn of 2017. There were dips to around 1.2200 in October 2016 and March 2017 with a 30-year trough of 1.2000 in January 2017 which represented the low point. Thereafter, the currency rallied.
Most participants tend to use candlestick charts as it gives the most information. The combination of open and closing levels, together with highs and lows give important insights into underlying conditions and the on-going battle between buyers and sellers.
For example, if a price moves sharply higher during the day and then retreats, this is a warning that buyers are unable to make further progress, increasing the risk of a sharp downward correction.
Potential bullish candlesticks patterns
In a hammer pattern, the price moves sharply lower during the day before reversing course and closing near the opening level. This suggests that sellers have lost control during the session. If prices have been in a bear market, this suggests that there may be a reversal in progress.
This involves 2 candles with the first daily candle showing a downward move. Prices initially move lower on the second day, but then reverse course to trade higher than the first candle. This pattern is a strong warning that the underlying trend has changed.
Potential bearish patterns
This is effectively the reverse of a hammer. The price initially moves sharply higher during the day but then reverse course and trade close to opening levels. This is an important warning that buyers have lost control.
This is the opposite of a bullish engulfing.
Prices move higher in the first candle and initially move to fresh highs in the second candle. Prices then fall sharply and close below the first-day opening level.
This is an important warning that sellers have started to gain control.
Bullish and bearish engulfing candles
There are many more candlestick patterns, some more useful than others.
Limitations of using technical analysis
Keep it simple
One important risk of using charts is making it too complicated. There are a very high number of indicators which can be added to a chart in an attempt to improve the predictive power. There is, however, an important risk that the position will become over-complicated and analysis will effectively become meaningless.
Technical analysis is not magic
An important error is to consider technical analysis infallible and the overriding determinant of prices. For example, any sharp change in fundamentals will be more important for underlying trends. It is vital to see technical analysis as one tool in assessing likely trends and not the sole determinant. A major fundamental event will have a much greater impact on prices and completely override technical factors.
Another danger of technical analysis is the attempt to force a pattern when the evidence is not clear. There is always some leeway in analysis, but there is no value in trying to find a pattern where none exists. Technical analysis is also subjective with situations open to a number of interpretations.
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