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Forex technical analysis

FOREX analysis is divided into two types: Fundamental and Technical. Fundamental analysis attempts to predict movements in currencies by examining current political and economic events. Technical analysis uses historical economic data to predict movements in the FOREX. These two articles will examine the principles of technical analysis and the tools involved.

These main categories of technical analysis will be described in this site:

 

Technical analysis is based on three assumptions:

1. Price movements are a result of all market forces combined. Things that can affect currency prices include political events, economic conditions, supply and demand, seasonal variations and weather conditions. The technical analyst, however, is not concerned with the reasons for market movement, but rather, the movements themselves.

2. Currency prices follow trends. Many market patterns have been recognized as having predictable consequences.

3. Price movements follow historical trends. FOREX data has been collected for over 100 years and patterns have emerged over time. These patterns are based on human psychology and the way people react to certain sets of circumstances.

There are five categories in Forex technical analysis theory:

  • Indicators (oscillators, e.g.: Relative Strength Index (RSI)
  • Number theory (Fibonacci numbers, Gann numbers)
  • Waves (Elliott wave theory)
  • Gaps (high-low, open-closing)
  • Trends (following moving average).

Some major technical analysis tools are described below:

- Relative Strength Index (RSI)

The RSI measures the ratio of up-moves to down-moves and normalizes the calculation so that the index is expressed in a range of 0-100. If the RSI is 70 or greater, then the instrument is assumed to be overbought (a situation in which prices have risen more than market expectations). An RSI of 30 or less is taken as a signal that the instrument may be oversold (a situation in which prices have fallen more than the market expectations).

- Stochastic oscillator

This is used to indicate overbought/oversold conditions on a scale of 0-100%. The indicator is based on the observation that in a strong up trend, period closing prices tend to concentrate in the higher part of the period's range. Conversely, as prices fall in a strong down trend, closing prices tend to be near to the extreme low of the period range. Stochastic calculations produce two lines, %K and %D that are used to indicate overbought/oversold areas of a chart. Divergence between the stochastic lines and the price action of the underlying instrument gives a powerful trading signal.

- Moving Average Convergence Divergence (MACD)

This indicator involves plotting two momentum lines. The MACD line is the difference between two exponential moving averages and the signal or trigger line, which is an exponential moving average of the difference. If the MACD and trigger lines cross, then this is taken as a signal that a change in the trend is likely.

- Number theory

Fibonacci numbers: The Fibonacci number sequence (1,1,2,3,5,8,13,21,34...) is constructed by adding the first two numbers to arrive at the third. The ratio of any number to the next larger number is 62%, which is a popular Fibonacci retracement number. The inverse of 62%, which is 38%, is also used as a Fibonacci retracement number.

- Gann numbers

W.D. Gann was a stock and a commodity trader working in the '50s who reputedly made over $50 million in the markets. He made his fortune using methods that he developed for trading instruments based on relationships between price movement and time, known as time/price equivalents. There is no easy explanation for Gann's methods, but in essence he used angles in charts to determine support and resistance areas and predict the times of future trend changes. He also used lines in charts to predict support and resistance areas.

- Waves

Elliott wave theory: The Elliott wave theory is an approach to market analysis that is based on repetitive wave patterns and the Fibonacci number sequence. An ideal Elliott wave patterns shows a five-wave advance followed by a three-wave decline.

- Gaps

Gaps are spaces left on the bar chart where no trading has taken place. An up gap is formed when the lowest price on a trading day is higher than the highest high of the previous day. A down gap is formed when the highest price of the day is lower than the lowest price of the prior day. An up gap is usually a sign of market strength, while a down gap is a sign of market weakness. A breakaway gap is a price gap that forms on the completion of an important price pattern. It usually signals the beginning of an important price move. A runaway gap is a price gap that usually occurs around the mid-point of an important market trend. For that reason, it is also called a measuring gap. An exhaustion gap is a price gap that occurs at the end of an important trend and signals that the trend is ending.

- Trends

A trend refers to the direction of prices. Rising peaks and troughs constitute an up trend; falling peaks and troughs constitute a downtrend that determines the steepness of the current trend. The breaking of a trend line usually signals a trend reversal. Horizontal peaks and troughs characterize a trading range.

Technical analysis advantages

1.Forex dwarfs all other markets in trading volume. Forex trading has grown some 2,000% over the last three decades, rising from barely $1 billion per day in 1974 to an estimated $2 trillion by 2005, so there is plenty of turnover to produce liquidity.

2.Forex markets never close during the trading week so there is no build-up or backlog of client orders overnight or pent-up reaction to news stories hitting the market at the open. This means no gaps that can create instant losses (or gains) for those holding positions overnight. The trading week begins in Sydney, Australia, on Monday while it is still Sunday in North America and Europe and ends in New York on Friday afternoon so you can trade in the middle of the night or whenever you want.

3.There are two basic types of markets: trending and trading-range markets. It is far easier to make money in trending markets. Currencies tend to experience longer-lasting trends that can continue for months or even years. This makes them ideal vehicles for trend-trading and breakout systems and explains why chart pattern analysis works so well in forex trading. With such widespread groups playing the game around the world, crowd behavior plays a large part in currency moves, and it is this crowd behavior that is the foundation for technical analysis tools and techniques.

4.Due in part to its size, forex is less volatile than other markets. Lower volatility equals lower risk. For example, the S&P 500 Index trading range is between 4% and 5% daily, while the daily volatility range in the Euro is around 1%.

5.Forex is an ideal market for the "intermarket" method of market analysis developed many years ago by respected industry professional Louis B. Mendelsohn. Trading veterans know that markets are interdependent, with some markets more heavily influenced by certain markets than others. Mendelsohn's VantagePoint analytical software detects hidden, yet repeating, patterns that occur between related markets. By using neural networks to analyze data from a number of related markets (see Figure 2), the software projects moving averages that lead the turns in actual moving averages with a success rate of about 80%.

In summary, technical analysis is a key to success for a Forex Trader. Basically technical analysis should be viewed as the study of historical prices at the market in order to forecast or even know with greater probability in what direction the future prices will move. Mathematical equations applied to Forex prices and many other techniques used make up the concept of Forex Technical Analysis.

There is no doubt that profound knowledge and understanding of the Forex Technical Analysis mechanism is very essential for successful trade at the Online Forex Market. Those traders who apply technical analysis, read daily fluctuations with much greater precision and invest adequately gaining profit.

Remember that theory combined with practical thinking leads to positive results and efficient market trade. Never use those analytical devices you dont understand. There is a great variety of them, so feel free to choose those you are comfortable with. Make informed investments and succeed trading Forex.