Technical Analysis

In my last two posts I have touched on Fundamental Analysis so it is now time to talk on Technical Analysis, the other major branch of analysis that most traders carry out.

Technical Analysis (TA) can be defined as the study of historical price movements to predict future price movements or looking at the market past behaviour to see what is most likely to happen in the future. There is this standard disclaimer that "past performance is no guarantee of future results" and also the equally common "history repeats itself" so which one do the Forex market follow? Well, it is a bit of each and a combination of both and that makes the market both predictable and unpredictable the same time. So nothing is 100% certain in the market and we can only talk of high probability and TA provides the tools to help traders make decisions with a high probability of success, hopefully.

Two factors make TA a viable tool for traders - the market is made up of human and thus follow human crowd behaviour and TA is used by the majority of traders and thus it has a self-fulfilling prophesy aspect. This is more so in the Forex market than the other trading markets and it makes TA an important tool for Forex traders.

There are hundreds (if not thousands) of books written on Technical Analysis and you can get loads of information on the Internet so I'll just give a brief summary here and mention only the common items. Broadly, TA can be broken into the following main areas but these are not clear divisions and there are overlaps.

1. Chart Analysis
2. Pattern Analysis
3. Trend Analysis
4. Momentum Analysis
5. Predictive Analysis.

Chart Analysis
Briefly, this is looking at the charts and price to see the movement in the market and this forms the basis of all the other analysis. The two main types of charts are the Bar Chart and Candlesticks and the latter is gaining popularity since it gives a record of the price movement that is slightly easier to interpret visually that the traditional Bar Charts.


Pattern Analysis
Over a period of time, the Bars or the Candlesticks will form certain patterns and from pass experience, certain patterns will behave in a certain way. Past gurus have given names to these patterns such as Double Tops, Head and Shoulder, Flags, etc. In the case of Candlesticks, a particular candle or a certain combination of candles will occur before subsequent behaviour in a certain way and they also have names such as Doji, Morning Star, Harami, etc.

Trend Analysis
The price will sometimes make higher highs or lower lows and by joining some of these points, you will will be able to form a trend line. Sometimes the price will stop repeatedly at certain points and by joining these stops, you will have the support and resistance lines, akin to the ceilings and the floors of a room. To smooth out the choppy price movements, Moving Averages are normally used and they can also come under trend analysis since after being smoothed out, the MA will show some kind of trend, especially over longer periods. There are two main types of MA, the Simple (SMA) and the Exponential (EMA).

Momentum Analysis
Apart from moving sideways, prices will move up or down and the momentum will show how fast or slow it is moving and there are technical indicators that show this momentum and they tend to oscillate between 0 and 100%. Such oscillators include Relative Strength Index (RSI) and Stochastic. You will meet Overbought and Oversold areas in these oscillators and also the somewhat predictive Divergence.


Predictive Analysis
Under this would be the Fibonacci Retracement, Fibonacci Extension, and Elliot Waves since traders use them to predict what the future price will likely to be or where it will likely to change directions.

There are some common indicators that do not fall clearly into any of the above analysis. One is MACD (or Mac-D) that is a combination of moving averages and oscillators that do not oscillate between 0 and 100% but around the zero point. Another one is the Bollinger Band, a combination of moving average and the standard deviation. When the bands contract, a breakout is imminent.

A successful trader will use a combination of all or some of the above analysis before making a trade. Some are used to trigger a trade, some used for confirmation and some used to set stops or profit targets. If you enter with too little analysis, it will be like gambling; if you make too much analysis, you may never enter at all or miss the opportunity. As they say this is "Paralysis by Analysis"

So it has to be a practical compromise between the two extremes and this will come with experience and it depends on the individual as a certain combination of indicators are best suited for a certain trading style. In summary, all these tools are used in combination to time when to enter the market and when to exit for high probability trades with the best results.

Ronald Kwok
http://cbpirate.com/s/cbp/ronaldkwok