Technical Analysis in Forex Trading
Introduction
Technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume. Unlike fundamental analysts, who attempt to evaluate a security's intrinsic value, technical analysts focus on patterns of price movements, trading signals and various other analytical charting tools to evaluate a security's strength or weakness.
History of Technical Analysis
The principles of technical analysis are derived from hundreds of years of financial market data. Some aspects of technical analysis began to appear in Amsterdam-based merchant Joseph de la Vega's accounts of the Dutch financial markets in the 17th century. However, modern technical analysis as we know it today was developed in the late 19th century by Charles Dow, co-founder of Dow Jones & Company, when he created the Dow Theory.
Principles of Technical Analysis
Technical analysis operates on the theory that market prices at any given point in time reflect all known information, and therefore always assign a fair market value to securities. This principle is based on the Efficient Market Hypothesis (EMH), which states that the market price reflects the sum total of all information available at the moment.
Another principle of technical analysis is that price changes are not random, but rather a result of market psychology. Market psychology refers to the overall sentiment or feeling that the market experiences at any particular time. Traders respond to this psychology, which results in patterns and trends that technical analysts try to detect and analyze.
Tools and Techniques of Technical Analysis
Technical analysis uses a wide variety of charts that show price over time. The most common types of charts used in technical analysis are line charts, bar charts, and candlestick charts. These charts are used in combination with various technical analysis tools like moving averages, trendlines, support and resistance levels, and various types of technical indicators.
Moving Averages
A moving average is a calculation to analyze data points by creating a series of averages of different subsets of the full data set. In financial applications, a simple moving average (SMA) is the unweighted mean of the previous n data points.
Trendlines
A trendline is a bounding line for the price movement of a security. It is formed when a diagonal line can be drawn between a minimum of three or more price pivot points. A line can be drawn between any two points, but it does not qualify as a trendline until tested.
Support and Resistance Levels
Support and resistance is a concept in technical analysis that the movement of the price of a security will tend to stop and reverse at certain predetermined price levels.
Technical Indicators
Technical indicators are heuristic or mathematical calculations based on the price, volume, or open interest of a security or contract used by traders who follow technical analysis.
Technical Analysis in Forex Trading
In forex trading, technical analysis is widely used because of the highly leveraged nature of the market. Forex traders use technical analysis to help them identify the best times to enter or exit trades, determine the strength and direction of price trends, and to identify trading signals.
Technical analysis in forex trading involves looking at patterns in price history to determine the higher probability time and place to enter and exit a trade. As a result, forex traders use technical analysis to help them understand the market and make educated trading decisions.
Criticisms of Technical Analysis
Despite its wide usage, technical analysis has also faced criticism. Critics argue that the evidence suggests that technical analysis has little predictive power and that the patterns technical analysts believe are there are often no more than illusions.
However, many traders and investors continue to believe in and use technical analysis, arguing that even if it can't predict future price movements, it can help identify trading opportunities and manage risk.
Conclusion
While technical analysis has its critics, it remains a popular tool among traders, particularly those in the forex market. By studying price patterns and indicators, traders can gain insight into the market's psychology and make more informed trading decisions. However, like any tool, it should be used in conjunction with other forms of analysis and tools to increase the chances of trading success.