Technical Analysis

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Basic Forex forecast methods:

Technical analysis and fundamental analysis

This chapter and the next one provide insight into the two major methods of analysis used to forecast the behavior of the  Forex market.  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 effect, while the fundamentalist studies the causes of market movements.  Many successful traders combine a mixture of both approaches for superior results.

In this chapter...

The categories and approaches in  Forex  Technical  Analysis all aim to support the investor in determining his/her views and forecasts regarding the exchange rates of currency pairs.  This chapter describes the approaches , methods and tools used to this end.   However, this chapter does not intend to provide a comprehensive and/or professional level of knowledge and skill , but rather let the reader become familiar wit the terms and tools used by technical analysts.

As there are many ways to categorize the tools available , the description of tools in this chapter may sometimes sem repetitive.  The sections in this chapter are:

  • Technical Analysis: backround, advantages, disadvantages;
  • Various techniques and terms;
  • Charts and diagrams;
  • Technical Analysis Categories / approaches:
a. Price indicators;
b. Number theory;
c. Waves;
d. Gaps;
e. Trends;

  • Some other popular tools;
  • Another way to categorize Technical Indicators.
Technical analysis

Technical analysis is a method of predicting price movements and future market trends by studying what has occurred in the past using charts.  Technical analysis is concerned with what has actually happened in the market , rather than what should happen, and takes into accound the price of instruments and the volume of trading , and creates charts from that data as a primary tool.  One major advantage of technical analysis is that experienced analysts can follow many markets and market instruments simultaneously.

Technical analysis is built on three essential principles:

  1. Market action discounts everything! This means that the actual price is a reflection of everything that is known to the market that could affect it. Some of these factors are: fundamentals supply and demand, political factors and market sentiment.  However , the pure technical analyst is only concerned with price movements, not with the reasons for any changes.
  2. Prices move in trends.  Technical analysis is used to identify patterns of market behavior that have long been recognized as significant.  For many given patterns there is a high probability that they will produce the expected results.  There are also recognized patterns that repeat themselves on a consistent basis.
  3. 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 critics claim that the Down approach is quite weak , since today's prices do not necessarily project future prices.
  • The critics claim that signals about the changing of a trend appear too late, often after the change had already taken place.  Therefore , traders who rely on technical analysis react too late, hence losing about 1/3 of the fluctuations;
  • 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.  Many traders are quite familiar with these patterns and often act on them in concern.  This cretaes a self-fulfilling probhecy, 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 happened, and is therefore valid at any price level;
  • The technical approach concentrates on prices, which neutralizes external factors. Pure technical analysis is based on objective tools while disregarding emotions and other factors;
  • Signaling indicators sometimes point to the imminent end of a trend, before it shows in the actual market. Accordingly, the trader can mainting profit or minimize losses.
Various techniques and terms

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: İts direction, its level and the timming.  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 standard deviations away from a simple moving average.  As standard deviation is a measure of volatility, Bollinger Bands adjust themselves to market conditions.  When the markets become more volatile, the bands widen , and during less volatile periods, the bands contract.  Bollinger Bands are one of the most popular technical analysis techniques.  The closer 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.
  • Support / Resistance - The support level is the lowest price an instrument trades at over a period of time.  The longer the price stays at a particular level, the stronger the support at that level.  On the chart this is price level under the market where buying interest is sufficiently strong to overcome selling pressure.  Some traders believe that the stronger the support at a given level, the less likely it will break below that level in the future.  The Resistance level is a price at which in instrument or market can trade, but which it cannot exceed, for a certain period of time.  On the chart this is a price level over the market where selling pressure overcomes buying pressure, and a price advence is turned back.
  • Support / Resistance Breakout - when a price passes through and stays beyond an area of supportor resistance.
  • CCI - Commodity Channel Index - an oscillator used to help determine when an investment instrument has been overbought and oversold.  The Commodity  Channel  Index,  first developed by Donald Lambert, quantifies the relationship between the asset's price, a moving average of the asset's price, and normal deviations from that average.  The CCI has seen substantial growth in popularity amongst technical investors; today's traders often use the indicator to determine cyclical trends in equities and currencies as well as commodities.         The CCI,  when used in conjunction with other oscillators, can be a valuable tool to identify potential peaks and valleys in the asset's price, and thus provide investors with reasonable evidence to estimate changes in the direction of price movement of the asset.
  • Hikkake Pattern - a method of identifying reversals and continuation patterns, this was discovered and introduced to the market through a series of published articles written by technical analyst Daniel L.Chesler,  CMT.  Used for determining market turning -points and continuations.  It is simple pattern that can be viewed in market price data, using traditional bar charts, or Japanese candlestick charts.
  • Moving averages - are used to emphasize the direction of a trend and to smooth out price and volume fluctuations, or "noise" that can confuse interpretation. There are seven different types of moving averages;
  1. simple (artichmetic)
  2. exponential
  3. time series
  4. weighed
  5. triangular
  6. variable
  7. 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 calculatd by adding the closing price of the  instrument for a number of time periods, then dividing this total by the number of time periods.
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 used short-term and long-term averages.   Typically ,  upward momentum is confirmed when a short-term average crossed above a longer-term average.  Downward momentum is confirmed when a short-term average crossed below a long-term average.
  • MACD - Moving Average Convergence / Divergance - a technical indicator, developed by Gerald 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 of tşime on a chart.  By then comparing the MACD is frequently used in conjunction with other technical indicators such as the RSI and the stochastic ascillator.
  • Momentum - is an oscillator designed to measure the rate of price change, not the actual price level. This ascillator consists of the net difference between the current closing price and the oldest closing price from a predetermined period.
Where:                   CCP- current closing price
                              OCP- old clossing price
Momentum and rate of change (ROC) are simple indicators showing the difference between today's closing price and the close N days ago. "Momentum" is simply the difference , and the ROC is a ratio expressed in percentage.   They refer in general to prices continuing to trend.  The momentum and ROC indicators show that by remaining positive, while an uptrend is sustained, or negative, while a downtrend is sustained.
A crossing up through zero may be used as a signal to buy, or a crossing down through zero as a signal to sell.  How high the indicators get shows how strong the trend is.
  • RSI - Relative Strenght Index- a technical momentum indicator, devised by Welles Wilder, measures the relative changes between the higher and lower closing prices.  RSI compares the magnitude of recent gains to recent losses in an attempt to determine overbought and oversold conditions of an asset.
The formula for calculating RSI is:

RSI=100 - <100 / (1+RS)>
RS - average of N days up closses, divided by average  of N days down closses
N- predetermined number of days

The RSI ranges from 0 to 100.   An asset is deemed to be overbought once the RSI approaches the 70 level, meaning that it may be getting overvalued and is a good candidate for a pullback.  Likewise, if the RSI approaches 30, it is an indication that the asset may be getting oversold and therefore likely to become undervalued.  A trader using RSI should be aware that large surges and drops in the price of an asset 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.