FOREX EDUCATION: Everything You Need To Know About Forex Trading
Technical Analysis is the study of price that reflects the supply and demand factors of a currency. Technical analysis uses charts to determine the psychology and behavior of the market as well as predicting future price movements. While fundamental analysis focuses on economic data, technical analysis concentrates on mathematical calculations to forecast the price movement.
Prices discounts everything
The market reflects all news whether economical, political and psychological. Market prices quickly absorb new information once they are released that is why the new market prices will be reflected as soon as possible. Every price change in the market represents the hopes, the fears and the expectations of all participants. In other words, everything there is to know is already reflected in the markets through the price.
Price move in trends
Price movement follows a certain direction. There are three types of trends: bullish or uptrend, bearish or downtrend and consolidation or sideways trend wherein price remains practically unchanged. However, each of the three trends rarely encountered in its pure form as straight price actions seldom occurs in the market. Furthermore, Dow says that during bullish or bearish momentum, each consequent peak and fall is higher than the previous one. This suggestion is the main principle behind technical analysis which is very applicable in forecasting the price movement of the currency when it comes to trading.
Signs of a turnaround may either be a temporary reversal or a start of a new trend. In reality it is very hard to pinpoint which is which that is why other technical tools are being used to help traders make a correct prediction. But it is also depends on the traders as they may interpret signals differently.
History repeats itself
Experts believe that history repeats itself. Once a certain rule has worked in the past, there is a big possibility that this rule will also work in the future given that price is formed based on human psychology. If you want to be a successful trader, you must know how to recognize a trend and continuously study it under different scenarios or situations. Once you have mastered it, just remember that the rule which worked in the past may be applicable in the future as well with the same success rate.
Types of Charts
The line chart or line graph is the simplest form of chart. It displays price charted against time with the changes usually by a straight line. The line chart is plotted by connecting a series of points which represents individual measurements. Any point can be plotted but traders tend to focus on the closing price because it is deemed to be the most important. The line chart is used to visualize a trend for a selected time period.
OHCL Bar Chart
The OHCL or Open High Low Close bar chart is a kind of chart which shows the opening price, the day high, the day low and the closing price. Every line represent a time frame, it may be per hour, per day, per month, depending on the choice of the user. The highest point in the line represents the high price the currency was able to reach while the bottom tip of the line indicates the lowest price. Furthermore, the left hand node on the line indicates the day open while the right hand node the day close.
The candlestick chart is mostly used by technical analysts. It is closely related to the bar chart because it also captures the four major prices which are the high, low, open and close. The body of the candlestick represents the opening and closing prices while the thin lines on the top and bottom of the candlestick's body, known as shadows, indicates the day's high and low prices. If the close is higher than the open, then a hollow candlestick is drawn. If the opening value is higher than the close value, then a filled candlestick is drawn.
The trend line is a primary element in the analysis of price movements. Because the market normally moves in a zigzag pattern rather than a straight line, trend lines are very useful in recognizing trends and identifying significant highs or peaks and significant lows or troughs. Trend line is also a form of technical analysis formation created by drawing a line that connects a series of descending tops, descending bottoms, ascending tops or ascending bottoms.
Support and Resistance
Support is the price level at which the buying is expected to take place. It may also be defined as the price level in which a currency pair has difficulty falling below. At support, price action tends to stall before breaking below, or reverse in the opposite direction.
Resistance is the price level at which the selling is expected to take place. It is also the price level in which a currency pair has difficulty trading above. At resistance, price action tends to stall before breaking above, or reverse in the opposite direction.
The upper and bottom borders of trade channels are referred to as support and resistance lines. The peaks represent the price level at which the selling pressure exceeds the buying pressure. These are known as resistance levels. The troughs on the other hand represent the price level at which the buying pressure exceeds the selling pressure. These are called support levels. In an uptrend, the consecutive support and resistance levels mush surpass each other respectively. This is also true in a downtrend.
In technical analysis especially when the market is ranging, key support and resistance levels are used as buy and sell signals. The general rule is that the strength of support and resistance levels are measured by how many times the price reaches a specific level, but fails to break through. Also should a level have been tested a number of times previously, traders will often watch for a breakout to come.
Head and Shoulders (Top)
The head-and-shoulders (top) pattern is one of the most popular and reliable chart pattern in technical analysis. And as the name suggests, the pattern looks like a head with two shoulders.
Head and shoulders is a reversal pattern that, when formed, signals the currency is likely to move against the previous trend. There are two versions of the head-and-shoulders pattern. The head-and-shoulders top serves as a reversal signal that a currency's price is set to fall, once the pattern is complete, and is usually formed at the peak of an upward trend.
The first step in this patter is the formation of the left shoulder, which is formed when the currencies reaches a new high and retraces to a new low. The second step is the formation of the head, which occurs when the currencies reaches a higher high, then retraces back near the low formed in the left shoulder. The third step is the formation of the right shoulder, which is formed with a high that is lower than the high formed in the head but is again followed by a retracement back to the low of the left shoulder. The pattern is complete once the price falls below the neckline, which is a support line formed at the level of the lows reached at each of the three retracements mentioned above.
Inverted Head and Shoulder
The inverted head-and-shoulders pattern is the exact opposite of the head-and-shoulders (top) pattern, as it signals that the security is set to make an upward move. It often comes at the end of a downtrend, the inverted head and shoulders is considered to be a reversal pattern, as the security typically heads higher after the completion of the pattern.
The formation starts with the formation of the left shoulder, which occurs when the price falls to a new low and rallies to a high. The formation of the head, which is the second step, occurs when the price moves to a low that is below the prior low, trailed by a return to the previous high. This move back to the prior high creates the neckline for this chart pattern. The third step is the formation of the right shoulder, which shows a sell-off, but to a low that is higher than the previous one, followed by a return to the neckline. The pattern is complete when the price breaks above the neckline.
The double top pattern, also referred to as "M" formation because of the pattern it creates on the chart, is one of the most frequently seen and common of the patterns. A double top pattern occurs when prices form two diverse peaks on a chart. A double top is only complete, however, when prices decline below the lowest low or the neckline of the pattern.
The double top is also considered as a reversal pattern of an upward trend in a currency pair's price for the pattern marks an uptrend in the process of becoming a downtrend.
Many investors assume that, because the double top is such a common pattern, it is consistently reliable. This is not the case, however. Richard W. Schabacker estimates that probably not more than a third of them signal reversals and that most patterns which an investor might call a double top are not in fact that formation, while Thomas Bulkowski estimates the double top has a failure rate of 65%. If an investor waits for the breakout, however, the failure rate declines to 17%.
Consequently, the double top pattern requires close study for correct identification.
Double bottoms are often seen and are considered to be among the most common of the patterns. A double bottom pattern occurs when prices form two diverse lows on a chart. A double bottom is only complete, however, when prices rise above the high end of the point that formed the second low. It is a reversal pattern of a downward trend in a currency pair's price for the double bottom marks a downtrend in the process of becoming an uptrend.
Thomas Bulkowski estimates the double bottom has a failure rate of 64%, which he termed surprisingly high. If an investor waits for a valid breakout, however, the failure rate declines to 3%.
Consequently, the double bottom pattern requires close study for correct identification.
The triple top is a reversal pattern made up of three equal highs followed by a break below the support. Triple tops usually form over a shorter time frame and typically range from 3 to 6 months.
Throughout the development of the triple top, it can start to resemble a number of patterns. Before the third high forms, the pattern may look like a double top. Three equal highs can also be found in an ascending triangle or rectangle. Of these patterns mentioned, only the ascending triangle has bullish insinuations, the others are neutral until a break occurs. In this same streak, the triple top should also be treated as a neutral pattern until a breakout occurs. The inability to break above resistance is bearish, but the bears have not won the battle until the support is broken. Volume on the last decline off resistance can sometimes yield a clue. If there is a sharp increase in volume and momentum, then the chances of a support break increases.
When looking for patterns, interpretations should be moderately specific, but not overly exacting as to obstruct the strength of the pattern. A pattern may not fit the description to the letter, but that should not detract from its sturdiness.
For example: It can be difficult to find a triple top with three highs that are exactly equal. However, if the highs are within reasonable proximity and other aspects of the technical analysis picture blend, it would embody the spirit of a triple top. The spirit is three attempts at resistance, followed by a breakdown below the support, with volume confirmation.
The triple bottom is a reversal pattern made up of three equal lows followed by a breakout above the resistance. While this pattern can form over just a few months, it is usually a long-term pattern. Because of its long-term nature, weekly charts are preferred for analysis.
The triple bottom can start to resemble a number of patterns as it develops. Before the third low forms, the pattern may look like a double bottom. Three equal lows can also be found in a descending triangle or rectangle. Of these patterns mentioned, only the descending triangle has bearish insinuations, the others are neutral until a breakout occurs. Similarly, the triple bottom should also be treated as a neutral pattern until a breakout occurs. The ability to hold support is bullish, but demand has not won the battle until the resistance is broken. Volume on the last advance can sometimes yield a clue. If there is a sharp increase in volume and momentum, then the chances of a breakout increases.
Rounded top, also known as inverted bowl or saucer top pattern, is a bearish trend reversal chart pattern indicating the end of an existing uptrend and start of a new downtrend. It is a dome shaped formation with a fairly smooth and rounded top without any noticeable spikes. Rounded top chart pattern is a gradual market shift from bullish sentiment to bearish sentiment; thus favoring usually long-term traders. In rounded top formation, usually the volume shows just the opposite pattern to the price; that is, when the price is rising volume tends to decrease, and when price is declining volume tends to increase. The duration of the pattern can range from some weeks to many months. Generally, the pattern is more reliable when it takes more than two months to form.
Traders can sell when the pattern is confirmed. Different traders use different methods to confirm the trend reversal. Generally, the start of a downtrend is confirmed when the price breaks below its moving average or when it breaks below the starting price of the pattern. But the reliability of the bearish signals is greatly challenged when the price breaks above its moving average instead of breaking below. The rounded top can tell a trader that there is trouble ahead for the currency pair. It is characterized by a gradual deceleration of price increase followed by a gradual acceleration in price downward, demonstrating to the observer that money is moving out of the issue. The rounded top warns the observer that distribution is taking place and provides sufficient opportunity to exit before the horizontal support or a rising trend line is violated. Of course it is always possible that the formation can turn into a consolidation pattern from which price breaks out and moves higher, but money is far better off in an issue that has just broken out of a long base, where price appreciation is expected to be greater and come sooner.
A Rounding bottom, also known as the saucer bottom, is a long-term pattern that anticipates a change in trend from downtrend to an uptrend. Due to the long-term look of these patterns and their components, the signal and build of this pattern s more difficult to identify than other reversal patterns.
A Rounded Bottom is elongated and U-shaped. The basic formation of a rounding bottom comes from a downward price movement to a low, followed by a rise from the low back to the start of the downward price movement - forming what looks like a rounded bottom.
The pattern is confirmed when the price breaks out above its moving average. The start of the rounding bottom (its left side) is usually caused by a peak in the downward trend followed by a long price descent to a new long-term low. The time distance from the initial crest to the long-term low is considered to be half the distance of the rounding bottom. This shows how long the chart pattern will last or when the pattern is expected to be complete, with a breakout to the upside.
Volume is one of the most important confirming measures for this pattern, and tends to mirror the price pattern, by which volume should be high at the initial crest and weaken as the price movement heads toward the low. As the price moves away from the low to the price level set by the initial peak, volume should be rising. On the other hand, breakouts in chart patterns should be accompanied by a large increase in volume, which helps to strengthen the signal formed by the breakout. Once the price moves above the peak that was established at the start of the chart pattern, the downward trend is considered to have reversed and a buy signal is formed.
Cup and Handle pattern, also known as the saucer, is a bullish continuation pattern that marks a consolidation period followed by a breakout. This pattern is a long term pattern which sometimes can take 2-4 month to form. However, it may occur during one day period and can be also found on the hourly charts.
The cup forms after an advance and looks like a bowl or a rounding bottom. As the cup is completed, a trading range develops on the right hand side and the handle is formed. A subsequent breakout from the handle's trading range signals a continuation of the prior advance. There are several components of the cup and handle that should be noted in order to evaluate the potential trading signal. First, it's important that there is an upward trend before the formation of the cup and handle. The larger the prior trend is, the lower the potential for a large breakout after the pattern has been completed. The build of the cup itself should be a nicely rounded formation, similar to a semi-circle, for the cup-and-handle pattern is a signal of consolidation within a trend, where the weaker investors leave the market and new buyers and resolute holders stay in the security. If the shape of the cup is too sharp (or quick), it is not considered a true consolidation phase in the upward trend and thus weakens the potential trade signal. The cup's height should also be between one-third and two-thirds the size of the previous upward movement, depending on market volatility. So, if the move of the preceding trend was from $10 to $35, the height of the cup should be at least $8 (roughly $25 x 33%) to $16 (roughly $25 x 66%). The height of the cup can also be used as an initial price target after the pattern completes itself and breaks out of the handle.
An inverse saucer pattern, also known as dome, is a formation indicating the price has reached its high and that the upward trend has come to an end. This pattern is formed when prices rise gradually upward, and then gradually turns lower, forming an inverted cup shape on the price chart. In the inverse saucer pattern, the volume traces out the mirror shape, decreasing as it approaches the top and increasing as the prices dips on the other side, leading to very strong volume as it breaks out downward, when an increasing number of investors recognize the trend reversal. This pattern can last for mere weeks or extend into years. The new trend that develops may last a similar duration to the previous trend it reversed.
Common Continuation Patterns:
The flag formation provides signals for direction and price objective. This formation represents a brief consolidation period within a solid and steep upward or downward trend. The consolidation itself is borders by a support and resistance line which are parallel to each other pr very mildly converging, making it look like a flag or similar to a parallelogram. It also tends to be sloped in the opposite direction from the slope of the original trend or is simply flat. The previous sharp resembles a flagpole.
The pennants are closely related to the flags so more or less the same principles apply. The only difference is that the consolidation area better resembles a pennant, as the support and resistance line converge. If the original trend is bullish, then the chart pattern is a bullish pennant.
Triangles can be considered as pennants with no poles. There are three types of triangles namely symmetrical, ascending and descending:
A symmetrical triangle consists of two symmetrically converging support and resistance line, defined by at least four significant points. The two symmetrically converging lines suggest that there is a balance between supply and demand in the foreign exchange market. Consequently, a break may occur on either side. Therefore, in the case of a bullish symmetrical triangle, the breakout will likely occur in the same direction, qualifying the formation as a continuation pattern.
Ascending triangle consists of a flat resistance lien and an upward sloping support line. This pattern suggests that demand is larger than supply. The currency is expected to break on the upside. The ascending triangle also provides a price objective. Measuring width of the triangle base and then transposing it to the breakpoint calculates this objective.
Descending triangles consists of a flat support line and a downward sloping resistance line. This pattern suggests that supply is larger than demand. The currency is expected to break on the downside. The descending triangle also provides a price objective. Measuring width of the triangle base and then transposing it to the breakpoint calculates this objective.
The wedge formation is a close relative of the triangle and the pennant formations. It resembles both the shape and the development time of the triangles, but it really looks and behaves like a pennant without a pole. The wedge is clearly sloped and the breakout occurs in the direction opposite to its slope, but similar to the direction of the original trend. The signal we receive from the wedge formation is direction only. There is no reliable price objective. Depending on the trend direction, there are falling and rising types of wedges.
Common Technical Indicators:
Technical indicator is a mathematical manipulation of a security price and/or volumes aimed at forecasting of future price changes. Decisions about how and when to open or close positions can be made on basis of signals from technical indicators. According to their functionalities, indicators can be divided into two groups: trend indicators and oscillators. Trend indicators help to assess the price direction and detect the turn moments synchronously or with a delay. Oscillators allow you to find the turning moments ahead or synchronously.
A moving average is an average price of a certain currency over a certain time interval (in days, hours, minutes etc) during an observation period divided by these time intervals. This averaged price is determined consequently for each regular interval beginning from the first.
A moving average has a smoother line than the underlying currency because statistical 'noises' are excluded to provide a more convenient visualization of the currency activity. A moving average may be used as a special indicator or to create an oscillator. The moving average may be based on the midrange level or on a daily average of the high, low, and closing prices. The charts of moving averages are plotted with the same coordinates as the underlying price chart.
There are three types of moving averages in technical analysis:
Simple Moving Average (SMA)
The Simple Moving Average also known as Arithmetic Moving Average is calculated by adding the closing price of the security for a number of time periods and then dividing this total by the number of time periods. Short-term averages respond quickly to changes in the price of the underlying, while long-term averages are slow to react.
Linearly Weighted Moving Average
The Linearly weighted Moving Average (LMA) is a type of moving average that assigns a higher weighting to recent price data than does the common simple moving average. This is achieved by multiplying the last day's price by one, and each closer day by an increasing consecutive number. In our previous example, the fourth day's price is multiplied by 1, the third by 2, the second by 3, and the last one by 4; then the fourth day's price is deducted. The new sum is then divided by 9, which is the sum of its multipliers.
Exponential Moving Average
The Exponentially Smoothed Moving Average (EMA) provides the best smoothing of averaged data by taking into account the previous price information of the underlying currency. This type of moving average reacts faster to recent price changes than a simple moving average. The exponential moving average is also known as "exponentially weighted moving average
Bollinger bands combine a moving average with the instrument's volatility. The bands were designed to gauge whether prices are high or low on a relative basis via volatility and are plotted two standard deviations above and below a 20-day simple moving average. The bands look a lot like an expanding and contracting envelope model. When the band contracts drastically, the signal is that volatility is low and thus likely to expand in the near future. An additional signal is a succession of two top formations, one outside the band followed by one inside. If it occurs above the band, it is a selling signal. When it occurs below the band, it is a buying signal.
Relative Strength Index
The Relative Strength Index ( RSI) measures the relative changes between the highest and lowest close prices.
A popular method of analyzing the RSI is to look for a divergence in which the security is making a new high, but the RSI is failing to surpass its previous high. This divergence is an indication of an impending reversal. When the Relative Strength Index then turns down and falls below its most recent trough, it is said to have completed a "failure swing". The failure swing is considered a confirmation of the impending reversal
Ichimoku Kinko Hyo:
The Ichimoku Kinko Hyo indicator (or simply "Ichimoku") is used to simultaneously determine market trend direction, support and resistance levels and to trigger buy and sell signals. This indicator incorporates a number of other indicators in itself as well as varying approaches concerning the prediction of price movement. To construct an Ichimoku's chart, four differing time intervals are used and each interval is assigned a grounded value. the following lines constituting the Ichimoku, which are the lines of median prices in a corresponding interval.
Tenkan-sen (Reversal Line) shows the average value of a price during the first time interval, which is the sum of the maximum and minimum price divided by two.
Kijun-sen (Main Line) shows the average value of a price of the second time interval.
Senkou Span A
Senkou Span A shows the middle of the distance between the two preceding lines "moved ahead" on the value equal the second time inverval.
Senkou Span B
Senkou Span B shows the average value of the price during the third time interval "moved ahead" on the value equal the second time interval.
Chinkou Span shows the close of a current candlestick "moved back" on the value equal the second time interval.
Candlestick charts are on record as being the oldest type of charts used for price prediction. They date back to the 1700's, when they were used for predicting rice prices. Much of the credit for candlestick development and charting goes to a legendary rice trader named Homma from the town of Sakata.
Many traders consider candlestick charts to be more visually appealing and easier to interpret compared to the traditional bar charts. In addition, each candlestick clearly depicts price action. A trader will immediately see and compare the relationship between the open and close as well as the high and low. The relationship between the open and close is considered vital information and forms the essence of candlesticks.
Candlesticks are formed using the open, high, low and close.
• The hollow or filled portion of the candlestick is called "the body" or "the real body"
• The long thin lines above and below the body represent the high/low range and are called "shadows" or "wicks" "tails"
• The top of the upper shadow is the "high".
• The bottom of the lower shadow is the "low".
• If the stock closes higher than its opening price, a hollow candlestick (usually displayed as white) is drawn with the bottom of the body representing the opening price and the top of the body representing the closing price. Hollow candlesticks indicate buying pressure.
• If the stock closes lower than its opening price, a filled candlestick (usually displayed as black) is drawn with the top of the body representing the opening price and the bottom of the body representing the closing price. Filled candlesticks indicate selling pressure.
Long Versus Short Bodies
The longer the body of the candlestick is, the more intense the buying or selling pressure. On the other hand, shorter the candlesticks is the less the price moves indicating consolidation movement
Long white candlesticks show strong buying pressure. The longer the white candlestick is, the further the close is above the open. This indicates that prices advanced significantly from open to close and buyers were aggressive. Long white candlesticks are generally bullish.
Long black candlesticks show strong selling pressure. The longer the black candlestick is, the further the close is below the open. This indicates that prices declined significantly from the open and sellers were aggressive
Marubozu do not have upper or lower shadows and the high and low are represented by the open or close. A White Marubozu forms when the open equals the low and the close equals the high. This indicates that buyers controlled the price action from the first trade to the last trade. Black Marubozu form when the open equals the high and the close equals the low. This indicates that sellers controlled the price action from the first trade to the last trade.
Long Versus Short Shadows
Upper shadows represent the session high and lower shadows the session low. Candlesticks with short shadows indicate that most of the trading action was confined near the open and close. Candlestick with long shadows show that traded extended well past the open and close. Candlesticks with a long upper shadow and short lower shadow indicate that buyers dominated during the session, and bid prices higher. Candlesticks with long lower shadows and short upper shadows indicate that sellers dominated during the session and drove prices lower.
Doji form when a security's open and close are virtually equal. The length of the upper and lower shadows can vary and the resulting candlestick looks like a cross, inverted cross or plus sign. Alone, doji are neutral patterns. Any bullish or bearish bias is based on preceding price action and future confirmation. Preferably, the open and close should be equal. A doji with an equal open and close would be considered more robust.
Long-legged doji have long upper and lower shadows that are almost equal in length. These doji reflect a great amount of indecision in the market. Long-legged doji indicate that prices traded well above and below the session's opening level, but closed virtually even with the open. Overall, the end result showed little change from the initial open.
Gravestone doji form when the open, low and close are equal and the high creates a long upper shadow. The resulting candlestick looks like an upside down "T" with a long upper shadow and no lower shadow. Gravestone doji indicate that buyers dominated trading and drove prices higher during the session. However, by the end of the session, sellers resurfaced and pushed prices back to the opening level and the session low.
Dragon fly doji form when the open, high and close are equal and the low creates a long lower shadow. The resulting candlestick looks like a "T" with a long lower shadow and no upper shadow. Dragon fly doji indicate that sellers dominated trading and drove prices lower during the session. By the end of the session, buyers resurfaced and pushed prices back to the opening level and the session high.
Hammer/ Hanging Man
Both the Hanging Man formation and Hammer are created when the open, high, and close are roughly the same price. Also, there is a long lower shadow, twice the length as the real body.
The Hammer and Hanging Man look exactly alike, but have different implications based on the preceding price action. Both have small real bodies (black or white), long lower shadows and short or non-existent upper shadows. As with most single and double candlestick formations, the Hammer and Hanging Man require confirmation before action.
The Hammer is a bullish reversal pattern that forms after a decline. After a decline, hammers signal a bullish revival. The low of the long lower shadow implies that sellers drove prices lower during the session. The Hanging Man is a bearish reversal pattern that can also mark a top or resistance level. Forming after an advance, a Hanging Man signals that selling pressure is starting to increase. The low of the long lower shadow confirms that sellers pushed prices lower during the session.
Candlesticks with a long upper shadow, long lower shadow and small real body are called spinning tops. Spinning tops represent indecision. One long shadow represents a reversal of sorts. The small real body which may either be whether hollowed or filled shows little movement from open to close, and the shadows indicate that both bulls and bears were active during the session. Even though the session opened and closed with little change, prices moved significantly higher and lower. The result was a standoff because neither buyers nor sellers could gain the upper hand.
After a long advance or long white candlestick, a spinning top indicates weakness among the bulls and a potential change or interruption in trend. After a long decline or long black candlestick, a spinning top indicates weakness among the bears and a potential change or interruption in trend.
Shooting Star /Inverted Hammer
Both the Shooting Star and Inverted Hammer are created when the open, low, and close are roughly the same price. Also, there is a long upper shadow, which should be at least twice the length of the real body.
The Inverted Hammer and Shooting Star look exactly alike, but have different implications based on previous price action. Both candlesticks have small real bodies (black or white), long upper shadows and small or nonexistent lower shadows. These candlesticks mark potential trend reversals, but require confirmation before action.
The Shooting Star is a bearish reversal pattern that forms after an advance and in the star position. A Shooting Star can mark a potential trend reversal or resistance level. The Inverted Hammer on the other hand forms after a decline or downtrend. Inverted Hammers represent a potential trend reversal or support levels.