What is Technical Analysis?

Technical analysis attempts to forecast future price movements by examining past market data.

Most traders use technical analysis to get a "big picture" on an investment's price history. Even fundamental traders will glance at a chart to see if they're buying at a fair price, selling at a cyclical top or entering a choppy, sideways market.

Most technical analysts make a few key assumptions:

All market fundamentals are reflected in price data. Moods, differing opinions, and other market fundamentals need not be studied.

History can repeat itself, often in regular, fairly predictable patterns. These patterns, generated by price movements, are called signals. A technical analyst's goal is to uncover a current market's signals by examining past market signals.

Prices move in trends. Technical analysts believe price fluctuations are not random and unpredictable. Once an up, down or sideways trend has been established, it usually will continue for a period.

Get in and get out - at the right time

Traders rely on price charts, volume charts and other mathematical representations of market data (called studies) to find the ideal entry and exit points for a trade. Some studies help identify a trend, while others help determine the strength and sustainability of that trend over time.

Technical analysis can add discipline and minimize emotion in your trading plan. It can be hard to screen out fundamental impressions and stick with your entry and exit points as planned. While no system is perfect, technical analysis helps you see your trading plan more objectively and dispassionately.

Price chart types

Bar charts

The most common type of chart showing price action. Each bar represents a period of time - a "period" as short as 1 minute or as long as several years. Over time, bar charts can show distinct price patterns.

Candlestick Charts

Instead of a simple bar, each candlestick shows the high, low, opening and closing price for that period of time it represents. Candlestick patterns provide greater visual detail as they develop.

Point & Figure Charts

Point & figure patterns resemble bar chart patterns, except Xs and Os are used to mark changes in price direction. Point & figure charts make no use of time scale to associate a certain day with a certain price action.

Technical Indicator Types

Trend

Trend indicators smooth price data out, so that a persistent up, down or sideways trend can be easily seen. (Examples: moving averages, trend lines)

Strength

Strength indicators describe the intensity of market opinion on a certain price by examining the market positions taken by various market participants. Volume or open interest are the basic ingredients of strength indicators.

Volatility

"Volatility" refers to the magnitude of day-to-day price fluctuations, whatever their directional trend. Changes in volatility tend to anticipate changes in prices. (Example: Bollinger Bands)

Cycle

Cycle indicators indicate repeating market patterns from recurrent events such as seasons or elections. Cycle indicators determine the timing of a particular market pattern. (Example: Elliott Wave)

Support/Resistance

Support and resistance describe the price levels where markets repeatedly rise or fall and then reverse. This phenomenon is attributed to basic supply and demand. (Example: Trend Lines)

Momentum

Momentum indicators determine the strength or weakness of a trend as it progresses over time. Momentum is highest when a trend starts and lowest when the trend changes.

When price and momentum diverge, it suggests weakness. If price extremes occur with weak momentum, it signals an end of movement in that direction. If momentum is trending strongly and prices are flat, it signals a potential change in price direction. (Example: Stochastic, MACD, RSI)

Using Indicators

Using Indicators to Identify Trends

You've probably heard the expression "the trend is your friend" - but what does it mean? If your trend takes a sudden counter-move and your trailing stop activates at a loss, it's natural to ask yourself: how can you be sure the next trend will be more friendly?

Confirm the trend is real

Using technical indicators in combination can help ensure a potential trend has staying power - a good habit for all kinds of technical trading, but especially in forex. Currencies tend to move in trends naturally due to long-term macroeconomic factors and short-term international capital flows. All of this makes it that much harder to see a trade-able trend that will last.

Trendlines

From a trader's perspective, a trend is a predictable price response at levels of support or resistance that change over time. Trendlines mark these levels, with support acting as the "floor" and resistance as the "ceiling". When prices break through either of these levels, that signals a trend for that movement to continue.

It's easy to draw perfect trendlines on historical charts - but harder to be right when the trend is still developing. Still trendlines help focus your attention on finding support and resistance levels, the first step to identifying a new trend.

Start by drawing trendlines over longer timeframes (daily or weekly charts) and then carry them forward into shorter timeframes (hourly or 4-hourly). That way you'll highlight the most important support and resistance levels first and not lose the major trend development by chasing a short-term, minor one.

Directional Movement Indicator (DMI)

Developed by J. Welles Wilder, the DMI minimizes the guesswork in spotting trends and helps confirm trendline analysis.

The DMI system has two parts:

  • ADX (average directional movement index). If the ADX reading is above 20, that indicates a "real" or sustainable trend. The ADX also measures the trend's strength: the higher the ADX, the stronger the trend.
  • The ADX also provides an early indicator of a trend's end. When it drops from its highest level, it may be time to exit the position and wait for a fresh signal from the the DI+/DI-.
  • DI+ and DI- lines. When DI+ crosses up through DI-, that's considered a buy sign. When the opposite happens, that's usually a sell sign.

Wilder recommends following the "extreme point rule" to confirm the signals. Note the extreme point for that period in the direction of the crossover (the high if DI+ crosses up over DI-; the low if DI- crosses up over DI+). Only if that extreme point is breached in the subsequent period is a trade signal confirmed.

Many traders use the parabolic indicator along with the ADX to identify a trend's end. The parabolic indicator follows the price action but accelerates its own rate of increase over time and in response to the trend. The parabolic continually closes in on the price, and only a steadily accelerating price rise (the essence of a trend) will prevent the price from falling below the parabolic, signaling an end to the trend.

Trading short-term

The methods above can be used for short-term decision making, even in markets that are trading sideways - a "trendless" market.

However, if you're trading short-term, don't ignore the big picture entirely. There's no point in trying to ride a short-term trend that is counter to the larger trend.