Technical Analysis
Technical Trading
For new traders, jumping into technical trading may bring to mind a whole host of financial terms like Moving, Average, Relative Strength Index, Fibonacci Retracements and Bollinger Bands, all of which seem designed to confuse and intimidate. Thankfully, you have nothing to be afraid of as a trader—despite their seemingly complex names, most components technical trading can be rather easy to wrap your head around. No matter your level of experience as a trader, you will be able to make use of these indicators in your day-to-day trade decisions and market predictions. The purpose of this section on technical trading is to break the whole process down for you and help use these popular technical indicators to your benefit.
The Flipside of News Trading
We have learnt in the previous section of the Trader’s Academy that news trading utilizes real-world information such as geopolitical events, economic indicators and market sentiment to determine the “true” value of an asset within a market. Technical trading, also referred to as technical analysis, offers a different approach—it is concerned only with the information presented within a given market itself, and nothing else. In order to understand technical trading, we have to pay attention to its assumptions:
Assumption 1: Price Tells You Everything
Technical trading hinges on the belief that everything that has affected or can affect an asset is reflected in its price. All the factors that come to play in news trading such as economic indicators and market psychology can be read entirely by looking at an asset’s price. With this logic, all that we need to study is price movement itself—that is the core of this assumption.
Assumption 2: Price Movements Tend to Trend
Technical trading leans heavily towards the notion that price movements follow trends. In other words, once a price trend has been established (whether it is moving upwards or downwards), the future price movement is likely to continue in the same direction rather than against it. A great number of technical trading strategies take into account this assumption.
Assumption 3: The Future is Reflected in History
The last assumption of technical trading is the idea that history is likely to repeat itself when it comes to price movements. Traders tend to react in similar ways when confronted by similar market events. This is often attributed to market sentiment, which leads to the repetitive nature of price movements. Many of the chart patterns analyzed in technical trading today have been in use for over a century, and they are still believed by many to be highly relevant. This tells us how much of the future is informed by the past.
With these core assumptions of technical trading in mind, we can begin to delve into some of the technical indicators we have mentioned earlier. By definition, technical indicators are metrics that use past and present information to forecast future price levels or the rough direction of tradable assets. Typically, they are used to forecast both immediate and long-term movements in the markets. Because of their ability to predict short-term price movements, technical indicators are especially helpful forFX Derivatives trading. Before we get into the different examples of technical indicators, it will be useful for us to understand the concepts of resistance and support levels and moving averages, for they make up an integral part of all technical indicators.
Resistance and Support Levels
When it comes to price graphs, resistance and support levels are lines at which technical traders expect the price of an asset to shift towards during different market circumstances. The resistance level signals a reversal that comes after an increase, and the support level signals a return after a decline. In the financial markets, it is common to hear analysts talking about particular securities approaching levels of resistance or support. These lines, on a basic level, indicate a range of prices which a given security or currency does not frequently go under (support level) or over (resistance level). Here is a visual representation of these two lines (Figure 1):
Figure 1: Resistance and Support Levels
Moving Averages
Throughout the history of technical analysis, moving averages have been used as a means of assessing trend direction, and this long-standing indicator is still highly relevant and used by many today. The principle advantage provided by a moving average is to minimize rate fluctuations (or, as termed within the industry, “noise”) which make it difficult to deduce real-time exchange rate information accurately. By making these fluctuations more “quiet” or “flat,” moving averages allow traders to monitor and authenticate possible market rate trends with greater ease, thus allowing them to find these trends amidst the typical up-and-down movements that are typically of all currency pairs.
Figure 2 below shows a short-term moving average crossing over a long-term moving average. This signifies an upward trend for that given asset.
Figure 2: Upward Momentum
Figure 3: Downward Momentum
What is most important to understand when it comes to moving averages is the fact that all successful traders are constantly looking for trends when monitoring price graphs and the information they present. Successful traders also make the effort to identify a rate reversal point so that they may time market purchases and sells at the most profitable levels at the best points in time. Understand moving averages will be extremely helpful in this regard.
Now that we understand the basic concepts of resistance and support levels and moving averages, we can take a look at a few examples of technical indicators which we can use to inform our trading decisions.
Relative Strength Index
The concept of the Relative Strength Index was introduced by Wells Wilder in his 1978 publication New Concepts in Technical Trading Systems. At its core, the relative strength index is a measure of gains and losses that tells traders whether an asset has been over-sold or over-bought. It is an oscillator type indicator, which means it shifts up and down in response to fluctuations of market rates. The relative strength index is measured on a scale from 0 to 100. When the relative strength index of an asset surpasses the 70 mark, it is typically indicative of the given asset being over-bought, which tells us that it is moving towards a price reversal. When the relative strength index of an asset dips below 30, it tells us that an asset has recently been undervalued. This is visually represented in Figure 4.
The relative strength index is most often used in combination with trend lines, as support and resistance levels in trend lines will typically coincide with support and resistance levels in the relative strength index. To sum it up, the relative strength index is principally used to identify over-bought or over-sold conditions in the trading of any given asset.
Figure 4: Relative Strength Index
Bollinger Bands
Bollinger bands were conceptualized in the 1980s by technical analyst John Bollinger. They were used to identify the magnitude of real-time volatility for any particular currency pair. In essence, Bollinger Bands are lines plotted two standard deviations above and below a straightforward moving average. Bollinger Bands are situated over a price chart and consist of a moving average together with upper and lower lines that denote pricing “channels.”
Bollinger Bands have two primary uses. Firstly, they help traders become aware of volatile market conditions (the further apart the bands, the more volatile the price). Secondly, they provide non-linear support and resistance levels, as we can see in the figure above.
It is interesting to note that Bollinger was not the first to monitor and plot moving averages. In fact, moderating the effect of rate changes through a moving average has long been in the toolbox of technical traders. What Bollinger did, however, was push the concept of the dynamic moving average further by applying the notion standard deviations to include bands above and below the moving average line, in doing so defining the upper and lower boundaries.
Figure 5: Bollinger bands
Fibonacci Retracement
Fibonacci retracement lines are derived from the Fibonacci sequence and can be regarded as a forecasting technical indicator which offers feedback on potential exchange rate levels in the future. On a basic level, Fibonacci retracement lines are levels of support and resistance drawn between the price highs and lows that indicate the Fibonacci ratios of 23.6%, 38.2%, 61.8% and 100%. Figure 6 below illustrates these lines.
The lines illustrated in Figure 6 allow traders to isolate possible entry points. These are especially helpful when used in combination with the relative strength index. To sum it up, Fibonacci retracement lines can be used as triggers on pullbacks during an uptrend. In situations of downtrend, the levels can be used to short sell when bounces reverse off a Fibonacci retracement level. In circumstances when a price level overlaps with other indicator price levels (for example, a 100-day moving average), it becomes a fortified price level, making it an even more significant support or resistance level.
Figure 6: Fibonacci Retracement