Technical analysis and fundamental analysis differ greatly, but both can be useful forecasting tools for the forex trader. They have the same goal – to predict a price or movement. The technician studies the effects, while the fundamentalist studies the cause of the forex market movements. Successful Forex Traders combine both approaches for the best results.
Note: If both fundamental analysis and technical analysis point to the same direction, your chances for profitable trading are much better.
Technical analysis is built on three essential principles
– Market actions discounts most everything: This means that the actual price is dictated by everything that is known to the market that could affect it. Some of these factors are fundamentals (inflation, interest rates, etc.), supply and demand, political factors (yes even the upcoming elections can be a factor) and market sentiment. But, the pure technical analysis is only concerned with price movements, not with the reasons for any change. – Prices move in trends: Technical analysis is used to identify patterns of market behavior that have long been recognized as significant. For most patterns, and trends there is a high probability that they will produce the results that were expected.
There are also recognized patterns that repeat themselves on a consistent basis. – History repeats itself: Forex chart patterns have been recognized and categorized for over 100 years, and the manner in which many patterns are repeated leads to the conclusion that human psychology changes little over time. Since patterns have worked well in the past, it is assumed that they will continue to work well into the future.
Disadvantages of technical analysis
– Some critic claim that the Dow approach (“prices are not random”) is quite weak, since today’s prices do not necessarily project future prices; – The critics claim that signals about the changing of trends appear too late, often after the change had already taken place.
Therefore, traders who rely on technical analysis react too later, hence losing about 1/3 of the fluctuation; – Analysis made in short time intervals may be exposed to “noise”, and may result in a misreading of market directions; – The use of most patterns has been widely publicized in the last several years.
Most successful traders know these patterns and often act on them slowly in concern. This creates a self-fulfilling prophecy, as waves of buying or selling are created in response to “bullish” or “bearish” patterns.
Advantages of Technical Analysis
– Technical analysis can be used to project movements of any asset available for trade in the capital market; – Technical analysis focuses on what is currently occurring in the forex market, as opposed to what has occurred, and is therefore valid at any price level at any time; – The technical approach concentrates on prices, which neutralizes external factors.
Pure technical analysis is based on objective tools (charts, tables) while disregarding emotions and other factors; – Signaling indicators sometimes point to the imminent end of a trend, maintain profit or minimize losses.
Various techniques and terms you will want to know
Many different techniques and indicators can be used to follow and predict trends in markets. The objective is to predict the major components of the trend: its direction, its level and the timing. Some of the most widely known include:
– Bollinger Bands – a range of price volatility named after John Bollinger, who invented them in the 1980s. They evolved from the concept of trading bands, and can be used to measure the relative height or depth of price.
A band is plotted two standards deviations away from a simple moving average. As standard deviation is measured of volatility, Bollinger Bands adjust themselves to market conditions. When the market becomes more volatile, the bands spread wider (move further away from the average), and during less volatile periods, the bands tighten (move closer to the average).
Bollinger Bands are one of the most popular technical analysis techniques used by traders. The closer the prices move to the upper band, the more overbought is the market, and the closer prices move to the lower band, the more oversold is the market.
Moving Averages – Are used to emphasize the direction of a trend and to even out price and volume fluctuations, or “noise”, that can confuse interpretation. There are seven different types of moving averages:
– Simple (arithmetic)
– Time series
– Volume adjusted
The only significant difference between the various types of moving averages is the weight assigned to the most recent data. For example, a simple (arithmetic) moving average is calculated by adding the closing price of the instrument for a number of periods, then dividing this total by the number of times.
The most popular method of interpreting a moving average is to compare the relationship between a moving average of the instrument’s closing price, and the instrument’s closing price itself.
Sell signal: when the instrument’s price falls below its moving average Buy signal: when the instrument’s price rises above its moving average The other technique is called the double crossover, which uses short-term and long-term averages.
Typically, upward momentum is confirmed when a short-term average (15 ‘day) crosses above a longer-term average (50-day). Downward momentum is confirmed when a short-term average crosses below a long-term average.
MACD – Moving Average Convergence/Divergence – A technical indicator, developed by Gerals Appel, used to detect swings in the price of financial instruments. The MACD is computed using two exponentially smoothed moving averages of the security’s historical price, and is usually shown over a period on charts.
By then comparing the MACD to its own moving average (the signal line), experiensed traders conclude that they can detect when this will affect the RSI by creating false buy or sell signals. The RSI is best used as a valuable complement to other stock-picking tools.
Stochastic Oscillator – A technical momentum indicator that compares an instrument’s closing price to its price range over a given period. The oscillator’s sensitivity to market movements can be reduced by adjusting the time, or by taking a moving average of the result.
This indicator is calculated with the following formula:
%K=100* [(C-L14) / (H14-L14)] – C= the most recent closing price – L14= the low of the 14 previous trading sessions – H14= the highest price traded during the same 14 day period
The theory behind this indicator, based on George Lane’s observations, is that in an upward-trending market, prices tend to close near their high, and during a downward-trending market, prices tend to close near their low.
Transaction signals occur when the %K crosses through a three-period moving average called “%D”.
Trend Line – A sloping line of support or resistance.
– Up trend line – straight line drawn upward to the right along successive reaction lows
– Down trend line – straight line drawn downward to the right along successive rally peaks
Two points are needed to draw the trend line, and a third point to make it valid trend line. Trend lines are used in many ways by traders. One way is that when price returns to an existing principal trend line, it may be an opportunity to open new positions in the direction of the trend in the belief that the trend will hold and the trend will continue further.
A second way is when a price action breaks through (the principal trend line) an existing trend, it is evidence that the trend may be going to fail, and you (the trader) may consider trading in the other direction to the existing trend or exiting in the direction of the trend.
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