Technical Analysis for the Currency Market

RELATED WIKI ARTICLES

Related Articles

 
TOP CONTRIBUTORS

A basic definition of technical analysis is "a study of price action (charts) in order to forecast future price action. Those that apply technical analysis assume a few things: markets trend and history repeats itself. Trend is an important concept because many technical approaches rely on identifying a trend and trading in the direction of that trend. "History repeats itself" is another way of saying that the same patterns occur over time, and that these same patterns indicate either bullishness or bearishness.

The simplest and most common technical tools include basic indicators such as the

  • Simple Moving Average (SMA)
  • RSI (Welles Wilder’s Relative Strength Index), and
  • Chart patterns such as head and shoulders and triangles.

The example below is of a EUR/USD daily bar chart from approximately October 2004 to October 2006. The red line plotted with the bars is a 200-day Simple Moving Average (SMA). A Simple Moving Average is just what it sounds like: the average of a specific body of data.

In this case, each value along the 200-day SMA is the average of the last 200 closing prices. The 200-day SMA is a common tool used to identify the long-term trend. The trend is considered up when price is above the moving average and down when price is below the moving average.

The blue oscillator plotted below the price bars and moving average is a 14-period RSI (14 is the most common input—a smaller input such as 9 will yield a more volatile indicator and a larger input such as 21 will yield a less volatile indicator). Price is considered "overbought" when the indicator is above 70 (upper-dashed line) and "oversold" when price is below 30[1] (lower-dashed line).

Error creating thumbnail
Traditionally, a cross above 30 is a buy signal and a cross below 70 is a sell signal. By combining the 200-day SMA and RSI during the October 2004 – 2006 period, many traders made large chunks of profit during that period.

Chart patterns indicate whether price is likely to continue in the direction (continuation patterns) of the trend or reverse (reversal patterns). A common continuation pattern is the triangle pattern. The triangle shown below is a contracting triangle since the two lines that form the triangle converge. In this specific case, the EUR/USD rallied from 1.1757 to 1.2460[1] (4/26/04 – 7/16/04) before forming the triangle. The triangle gave way to a bullish breakout in late September. A common reversal pattern is a head and shoulders pattern. A well-defined inverse head and shoulders pattern unfolded from early July 2005 to early April 2006. For an inverse head and shoulders, there is:

  • A downtrend into point A;
  • A corrective rally to point B;
  • A drop to a new low in point C;
  • An advance that approaches the B peak, which is point D;
  • A third decline that does not reach the head, which is point E;
  • A close above the "neckline" (A line that connects points B and D), which is point F and the buy point.
Error creating thumbnail
This inverse head and shoulders signaled the 2006 low and the beginning of a major EUR/USD bull run.

Both of these chart patterns led to superb EUR/USD-long trades. Still, trading is all about confidence, and the more signals you have that a market will move in a specific direction, the more confidence you have in trading that market. In other words, combine patterns with indicators, such as moving averages, in order to find the absolute best trades. The breakouts from the aforementioned patterns occurred when the EUR/USD was crossing above its 200-day SMA.

Error creating thumbnail
The Chart pattern indicates the price is likely to continue the direction due to continuation patterns of trend

More on Forex Trading

References

  1. 1.0 1.1 DailyFX - CNBC 12 Lessons
Wikinvest © 2006, 2007, 2008, 2009, 2010, 2011, 2012. Use of this site is subject to express Terms of Service, Privacy Policy, and Disclaimer. By continuing past this page, you agree to abide by these terms. Any information provided by Wikinvest, including but not limited to company data, competitors, business analysis, market share, sales revenues and other operating metrics, earnings call analysis, conference call transcripts, industry information, or price targets should not be construed as research, trading tips or recommendations, or investment advice and is provided with no warrants as to its accuracy. Stock market data, including US and International equity symbols, stock quotes, share prices, earnings ratios, and other fundamental data is provided by data partners. Stock market quotes delayed at least 15 minutes for NASDAQ, 20 mins for NYSE and AMEX. Market data by Xignite. See data providers for more details. Company names, products, services and branding cited herein may be trademarks or registered trademarks of their respective owners. The use of trademarks or service marks of another is not a representation that the other is affiliated with, sponsors, is sponsored by, endorses, or is endorsed by Wikinvest.
Powered by MediaWiki