Technical analysis (TA) is one of the primary tools of a forex trader. It stands for the analysis of the price action of a financial product. TA is used not just by forex traders but active investors in virtually every asset class in the world. Technical Analysis’ foundation lies in crowd psychology—that similar price action will lead to a similar reaction by traders because of herd mentality.
That means if you find patterns in markets they will help you forecast the future price movements!
The types of indicators I will discuss in this article are:
- Support and Resistance lines
- Moving Averages
- Momentum Indicators
- Fibonacci retracement and extension levels
There are many indicators out there but most of them fall in a category with one of these five groups so you will get a comprehensive guide to the tools of technical analysis.
Probabilities or forecasts?
To be precise, with TA, you are predicting what the most likely route of the price is. This is a crucial notion as you always have to be prepared to the event of the price not going in the predicted direction.
That means you have to manage risks for every trade!
The good news is that technical analysis helps you in that too by identifying levels of significance for the price that can determine if you are right or wrong! How?
Let’s see what resistance and support lines are!
Support and resistance lines (S/RLines)
These lines come from multiple sources but have the same meaning—the price will be supported or held back by them (ormaybe both). Why? These levels can be of psychological or practical significance. A round number, for instance, will usually act as an S/R line as traders flock in the market at those levels. Zones around previous highs and lows also may also be S/R lines since normally a lot of trading is concentrated around them.
The lines described so far are all horizontal lines, but there are not other S/R levels too. These are called trend lines and accompany longer (for the timeframe of the chart) directional movements and describe the ‘angle’ of that move. As a lot of traders concentrate on these levels they also follow the rules of self-fulfilling-prophecies, meaning that sometimes prices follow these lines perfectly.
This is the case with the descending trend line you can see on the attached hourly chart of the EUR/USD. All counter-trend advances stalled exactly at the trend line. That is how powerful these levels can be.
Moving Averages (MAs)
Moving averages are simple representations of the prevailing trends on various time-frames. For example, if you plot the 50-day MA next to the price it will show the average of the market for the last 50 trading days (for every day).
A moving average smoothes the daily fluctuations out, and shows a clear picture of the underlying trend. The more the number of days (or any other time periods that the MA is based on) in the MA the longer term trend the indicator shows.
So if you look at the sample chart the 200-day MA (red line) shows a longer term trend while the 50-day MA (blue line) represents a shorter one.
Another common (and very effective) way of using MAs is to analyze the alignment of a short and a long-term one. If the shorter average is above the longer one that is a bullish sign while the opposite is considered bearish (MA cross strategy).
These indicators are a bit different from moving averages as they are also used to spot extremes in markets. Some of them are based on purely price change (momentum, ROC) but others measure the difference between the price and some moving averages.
One of the most widely used indicators is the MACD (Moving Average Convergence Divergence) as plotted on the bottom of the charts above. It has a broad range of applications like identifying current trends, oversold and overbought conditions, and reversals.
The most reliable way of profiting from MACD is to first identify a prevailing trend with moving averages and trade that trend with MACD crosses; the same way as with MAs.
Fibonacci retracement and extension levels
Great supplementary tools for trend indicators are the Fibonacci-levels. They are based on the theory that prices (price patterns to be precise) follow the Fibonacci numbers and the “Golden Ratio” like a lot of natural patterns including geographical, biological, and physical processes. In practice, this means that a move in a stock price is often followed by a counter-move or correction that reaches the Fibonacci-levels of 38.2%, 50%, and 61.8% (to a lesser extent 23.6%) for the Fibonacci-retracements.
Fibonacci retracement levels in the EUR/USD pair
Conversely Fibonacci-extensions mean that if a price breaks out of a trading range the potential targets of that moves are the range’s size extended by these percentages.
Putting it all together
As you can see these indicators serve different purposes by using different angles of analysis concerning the price. What they all share is the fact that that they are used to tell what the most probable outcome is!
Always remember this basic rule when applying technical analysis—this way it will help you in achieving great results in trading!