Technical analysis is concerned with what has actually happened in the (forex) market, rather than what should happen. A technical analyst will study the price and volume movements and from that data create charts (derived from the actions of the market players) to use as his primary tool. The technical analyst is not much concerned with any of the “bigger picture” factors affecting the market, as is the fundamental analyst, but concentrates on the activity of that instrument’s market.
Technical analysis is based on three underlying 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, for example, supply and demand, political factors and market sentiment. 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 behaviour which have long been recognised as significant. For many given patterns there is a high probability that they will produce the expected results. Also there are recognised patterns which repeat themselves on a consistent basis.
3. History repeats itself
Chart patterns have been recognised and categorised for over 100 years and the manner in which many patterns are repeated leads to the conclusion that human psychology changes little with time.
List of categories of the technical analysis theory:
Indicators (Oscillators, eg: Relative Strength Index RSI)
Number theory (Fibonacci numbers, Gann numbers)
Waves (Elliott wave theory)
Gaps (HighLow, OpenClosing)
Trends (Following Moving Average)
Chart formations (Triangles, Head & Shoulders, Channels)
Relative Strength Index (RSI):
This index is a popular indicator of the Forex (FX) market. The RSI measures the ratio of upmoves to downmoves and normalises the calculation so that the index is expressed in a range of 0100. If the RSI is 70 or greater then the instrument is seen as overbought (a situation whereby prices have risen more than market expectations). An RSI of 30 or less is taken as a signal that the instrument may be oversold (a situation whereby prices have fallen more than the market expectations).
Stochastic Oscillator:
This is used to indicate overbought/oversold conditions on a scale 0100%. The indicator is based on the observation that in a strong up trend, closing prices for periods tend to concentrate in the higher part of the period’s range. Conversely, as prices fall in a strong down trend, closing prices tend to be near to the extreme low of the period range.
Stochastic calculations produce two lines, %K and %D which are used to indicate overbought/oversold areas of a chart. Divergence between the stochastic lines and the price action of the underlying instrument gives a powerful trading signal.
Moving Average Convergence Divergence (MACD):
This indicator involves plotting two momentum lines. The MACD line is the difference between two exponential moving averages and the signal or trigger line which is an exponential moving average of the difference. If the MACD and trigger lines cross, then this is taken as a signal that a change in trend is likely.
Technical indicators
Relative Strength Index (RSI)
Stochastic Oscillator
Moving Average Convergence Divergence (MACD)
Number theory
Waves
Gaps
Trends
Chart formations
Relative Strength Index (RSI):
This index is a popular indicator of the Forex (FX) market. The RSI measures the ratio of upmoves to downmoves and normalises the calculation so that the index is expressed in a range of 0100. If the RSI is 70 or greater then the instrument is seen as overbought (a situation whereby prices have risen more than market expectations). An RSI of 30 or less is taken as a signal that the instrument may be oversold (a situation whereby prices have fallen more than the market expectations).
Stochastic Oscillator:
This is used to indicate overbought/oversold conditions on a scale 0100%. The indicator is based on the observation that in a strong up trend, closing prices for periods tend to concentrate in the higher part of the period’s range. Conversely, as prices fall in a strong down trend, closing prices tend to be near to the extreme low of the period range.
Stochastic calculations produce two lines, %K and %D which are used to indicate overbought/oversold areas of a chart. Divergence between the stochastic lines and the price action of the underlying instrument gives a powerful trading signal.
Moving Average Convergence Divergence (MACD):
This indicator involves plotting two momentum lines. The MACD line is the difference between two exponential moving averages and the signal or trigger line which is an exponential moving average of the difference. If the MACD and trigger lines cross, then this is taken as a signal that a change in trend is likely
Number theory
Fibonacci numbers:
The Fibinacci number sequence (1,1,2,3,5,8,13,21,34…..) is constructed by adding the first two numbers to arrive at the third. The ratio of any number to the next larger number is 62%, which is a popular Fibonacci retracement number. The inverse of 62%, which is 38%, is also used as a Fibonacci retracement number.
Gann numbers:
W.D. Gann was a stock and a commodity trader working in the 50’s who reputedly made over $50Mio in the markets. He made his fortune using methods which he developed for trading instruments based on relationships between price movement and time, known as time/price equivalents. There is no easy explanation for Gann’s methods, but in essence he used angles in charts to determine support and resistance areas and predict the times of future trend changes. He also used lines in charts to predict support and resistance areas.
Waves
Elliott wave theory:
The Elliott wave theory is an approach to market analysis that is based on repetitive wave patterns and the Fibonacci number sequence. An ideal Elliott wave patterns shows a five wave advance followed by a three wave decline.
Gaps
Gaps are spaces left on the bar chart where no trading has taken place.
An up gap is formed when the lowest price on a trading day is higher than the highest high of the previous day.
A down gap is formed when the highest price of the day is lower than the lowest price of the prior day. An up gap is usually a sign of market strength, while a down gap is a sign of market weakness.
A breakaway gap is a price gap that forms on the completion of an important price pattern. It signals usually the beginning of an important price move.
A runaway gap is a price gap that usually occurs around the midpoint of an important market trend. For that reason, it is also called a measuring gap.
A exhaustion gap is a price gap that occurs at the end of an important trend and signals that the trend is ending.
Trends
A trend refers to the direction of prices. Rising peaks and troughs constitute an uptrend; falling peaks and troughs constitute a downtrend, that determine the steepness of the current trend. The breaking of a trendline usually signals a trend reversal. A trading range is characterized by horizontal peaks and troughs.
Moving averages are used to smooth price information in order to confirm trends and support and resistance levels. They are also useful in deciding on a trading strategy particularly in futures trading or a market with a strong up or down trend.
For simple moving averages, the price is averaged over a number of days. On each successive day, the oldest price drops out of the average and is replaced by the current price hence the average moves daily. Exponential and weighted moving averages use the same technique but weight the figuresleast weight to the oldest price, most to the current.
