Technical Analysis of the Forex Market – Beginner’s Guide

Technical Analysis of the Forex Market

The section seeks to teach you how to apply and decipher the various technical indicators to identify trending and ranging phases, spot predictable chart patterns, and use certain rules to enter and exit a high-probability trade. All successful Forex traders use some technical analysis in their trading. There is no Holy Grail mix of technical indicators that is "the best" because technical indicators should be just components of your own personalized trading system and not systems in and of themselves.

Introduction to Technical Analysis of The Forex Market

What is Technical Analysis?

Technical analysis is a method of predicting future price movements by looking at market-generated data, which in the Forex market, is the price data.

Technical analysis assumes that:

• All market fundamentals and market psychology are already reflected in the actual prices, therefore, actual market fundamentals and various emotions like fear, greed, hope, and differing opinions of market participants need not be studied separately.
• History tends to repeat itself because the market participants tend to give a consistent reaction to similar market stimuli over time. Hence, markets move in fairly predictable, or at least quantifiable, patterns. These patterns, generated by price movement, are called signals. The goal of technical analysis is to try to identify trend signals given off in a current market by examining past market signals.
• Prices move in trends and do not fluctuate randomly. They can move in one of three directions: up, down, or sideways. Once a trend in any of these directions is established, it will usually continue for some period.

The primary tool of technical analysis is price charts. Price patterns and trends can be identified by looking at the price charts, and traders use them to determine entry and exit levels. There are also many technical analysis tools available as well which can provide traders with more information on market psychology, and they fall under two main categories: trend-following and momentum indicators. Trend-following indicators are said to be lagging, whereas momentum indicators are said to be leading. You will learn more about these later on.

 Technical Analysis and the Forex Market

Technical analysis can be applied to any security with historical price data. It works particularly well in the Forex market because short-term currency price fluctuations are mainly driven by human emotions or market perceptions and because the majority of the market participants are traders.

Technical Forex traders are not concerned with comments made by government officials and politicians regarding currencies or interest rates. They believe that the message of the statements will be contained in the currency prices that they are monitoring. Technical traders, in essence, follow the lead of traders who track fundamental news. They do not initiate market movements.

Trading Forex solely based on technical analysis may not be a good idea because fundamentals can trigger technical movements that are not expected on the currency charts. For example, a price breakout may turn out to be false before or after the release of certain economic data or currency-related comments from government officials. Thus, it is recommended to take both technical and fundamental factors into consideration when planning your trades.

The Dow Theory

The Dow Theory was developed in the late 1890s by Charles Dow, one of the founders of The Wall Street Journal, and is the oldest theory in technical analysis. It states that prices fully reflect all existing information. The theory was developed primarily around stock market averages and postulates that there are three movements in the market: primary, secondary, and minor.

The goal of the theory is to determine changes in the primary movement of the market. Once a trend has been established, it is assumed to continue until a reversal signal is given. The limitation of the Dow Theory is that it has no forecasting value as to the duration of size of the trend. The basic principles of the theory are applied in other branches of technical analysis.