Basic Technical Analysis in Trading – Forex & Other Instruments

The Japanese began using technical analysis to trade rice in the 17th century. While this early version of technical analysis was different from the US version initiated by Charles Dow around 1900, many of the guiding principles were very similar:

  • The “what” (price action) is more important than the “why” (news, earnings, and so on).
  • All known information is reflected in the price.
  • Buyers and sellers move markets based on expectations and emotions (fear and greed).
  • Markets fluctuate.
  • The actual price may not reflect the underlying value.

Basic technical analysis (BTA) is a very important analysis method that has been used increasingly in the markets over the past decades. In essence BTA is simply a study of supply and demand and comprises of a set of tools that attempt to determine which direction markets are most likely to follow.

Trading is based on human psychology and BTA uses well-tested and proven patterns that try to maximise potential trade success. It’s important to note that the presence of a particular BTA pattern doesn’t guarantee a successful outcome; rather it skews the probability of success slightly in its favour. A trader who uses BTA as an analysis tool should always be aware of the potential risk/reward associated with a particular pattern. Trading is a game of probabilities and risk management, and traders can use BTA as an excellent tool that helps them gain an edge.

Fundamentals of Technical Analysis

Trending Market

A trending market is one that generally moves in one direction for a prolonged amount of time. The movement (filtering out spikes either way) is consistent and it’s characterized by a distinct pattern in highs & lows. In an upward trending market, we tend to see higher highs and higher lows; conversely in a downward trending market it’s lower highs and lower lows.

Uptrend

An instrument is said to be in an uptrend simply if its overall direction is upward. This is visually demonstrated in a chart by a succession of higher peaks and troughs.

Downtrend

An instrument is said to be in a downtrend if its overall direction is downward. This is visually demonstrated in a chart by a succession of lower peaks and troughs.

Ranging Market

In contrast to a trending market, a ranging market is described by broadly sideways action. Such markets usually make the same highs and lows several times. In a ranging market support and resistance levels tend to have a high probability of holding, and traders often try to take advantage of this.

Market Support

Market support is an area where you expect an instrument to find increased difficulty to penetrate through (essentially where you expect selling interest to emerge). That can be a T/L (trend line), a Fibonacci retracement or a horizontal zone. If volume increases, then the chances of successful support also increase and hence the instrument will find support higher within the zone.

Market Resistance

Market resistance is an area where you expect an instrument to find increased difficulty to penetrate through (essentially where you expect selling interest to emerge). That can be a T/L (trend line), a Fibonacci retracement or a horizontal zone. If volume increases, then the chances of successful resistance also increase and hence the instrument will find resistance higher within the zone.

Confluence Zone

Confluence is when several key levels (resistance, support, fibonacci retracement etc) are in close vicinity. This makes the probability of resistance or support much greater than normal. Traders usually look for areas of confluence where price action usually becomes more predictable.

Fibonacci Retracement-Extension

Fibonacci retracements and extensions are mathematical ratios used to derive resistance and support levels. They are very popular with traders and are also used to predict the extent of corrections or pullbacks in technical analysis. As a side note, harmonic trading patterns are almost exclusively based on them.

The basic Fibonacci retracement ratios are: 0%, 23.5%, 38.2%, 50%, 61.8%, 100% and the most popular ratio is the 61.8%.

Fibonacci extensions are used to project an existing move to another point on a chart and hence connect 2 separate moves with each other. Traders frequently use them in most forms of technical analysis and especially those using harmonic patterns and Elliot Wave theory. Classic examples are measuring the equality of 2 legs of a move AB = CD for harmonics or the projection of a Wave 1 to Wave 5 expecting wave 5 to be a ratio of Wave 1 (usually 61.8% or 100%) for Elliott Wave theory.

Channel

A channel is a chart structure that is bound by two parallel trend lines (the lower trend line and the upper trend line).

Gaps

A gap is a part of the chart where there are no trades at all. This usually occurs when new market-moving information becomes available when a market is closed; the price gaps up or down when the market subsequently reopens. Another cause of gaps is when some major news/data/event comes out and causes a violent repricing of an instrument (e.g. 9-11, the removal of the EURCHF SNB floor etc).

Price action often returns to revisit the initial point of the gap break (called “fill the gap”) and for this reason gaps are usually used as reference points or targets by traders.

Two specific types of gaps are of particular interest:

  1. “Runaway gaps” – these are gaps that exhibit a significant price continuation following the gap and are sometimes characterized by higher volume. These gaps usually follow a substantial and real change in fundamentals of an instrument.
  2. “Exhaustion gaps” – these are gaps that usually occur near the end of a prolonged price move and signal the start of a reversal. This phenomenon is deeply linked with human psychology, as it is the manifestation of deep euphoria or pessimism near tops & bottoms.

Basic Chart Patterns

Flag

A flag pattern is a continuation pattern which is described as a short sloping rectangle bounded by two parallel trend lines. This is a typical consolidation after a strong move, which has to be less than 50% of the initial impulsive move (the “pole”). If it exceeds that it’s more likely to be a channel forming, rather than a flag.

Pennant

A pennant pattern is a continuation pattern which is described as an initial large movement followed by a consolidation period with converging trendlines. It tends to be followed by a breakout in the direction of the strong (current) trend and is usually a consolidation where the price action takes the form of a symmetrical triangle. If it’s consolidating after a strong move higher/lower, it is likely a pennant pattern.

Bullish/Bearish Wedge

A wedge pattern is described as a pattern whose trend lines above and below converge into a triangular shape. A bullish wedge is usually defined by “consistent highs and higher lows”. A bearish wedge is usually defined by “consistent lows with lower highs”.

Ascending/Descending Wedge

Also known as a rising or falling wedge, these are patterns where price loses momentum in the current trend. They are reversal patterns that tend to have an explosive move once the trend line is broken and subsequently provoke a counter trend move. A minimum target is usually the 38.2% retracement of the previous trend.

Channel

A channel is a chart structure that is bound by two parallel trend lines (the lower trend line and the upper trend line). A channel is defined by at least 4 points of contact (support and resistance). Channels can be rising, falling or horizontal. Occasionally channels evolve over time to triangles as traders attempt to undercut each other within the channel range.

Bullish Channels pattern Forex
Bearish Channels pattern Forex

Double Top/Bottom

A double top is a chart pattern described by two distinct, well-defined peaks which occur at around the same price level. Conversely, a double bottom is described by two distinct, well-defined troughs which occur at around the same level.

Double Tops pattern Forex
Double Bottoms pattern Forex

Triple Top/Bottom

A triple top is a chart pattern described by three distinct, well-defined peaks which occur at around the same price level. Conversely, a triple bottom is described by three distinct, well-defined troughs which occur at around the same level.

Triple Tops pattern forex market analysis
Triple Bottoms pattern Forex
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Heads and Shoulders

A head and shoulders pattern is described by three peaks that comprise of a middle peak (the “head”) and two peaks on either side (the “shoulders”). The “head” is always higher than the shoulders in a regular H&S pattern, and lower in an inverse H&S pattern.

A head and shoulders pattern is a reversal pattern, not a continuation pattern. In other words, when trending higher, traders look for a regular H&S pattern and when in a downtrend, for an inverse one.
In a regular H&S pattern, the entry is typically just below the neckline, and the stop is above the right shoulder. For an inverse H&S pattern, the entry is typically just above the neckline and the stop is below the right shoulder. The measured target from the entry point is equal to the distance from the top of the head to the neckline.

head and shoulder's pattern
Inverted head and shoulder's pattern

Cup and Handle

A Cup and Handle pattern has the shape of a cup profile, with the handle always on the right side (regardless whether it’s a regular or inverse C&H pattern). It is formed by: (a) a gradual counter-trend move (the beginning of which is the first point of a neckline), (b) a return to the neckline, (c) another counter-trend move which is always smaller in magnitude, and finally (d) another retest & break of the neckline.

The breakout past the neckline usually is powerful as it triggers stops of traders who had built counter-trend positions anticipating a possible reversal. When trading a C&H pattern the entry is just beyond the neckline and the measured target is equal to the distance from the extreme of the cup (note: not the handle) counter-trend move to the neckline.

Cup and Handle Pattern
Inverted Cup and Handle Pattern

Common Technical Indicators

RSI

The Relative Strength Index (RSI) is an indicator that shows momentum. It measures the magnitude and timing of up or down moves of an instrument. The definition is the following:
RSI = 100 – 100 / (1+RS)
(Where RS is equal to the average gains divided by the average losses for that specific period)

The RSI is a relatively simple indicator, but a very powerful one. RSI values below 30 are considered to be oversold (i.e. the instrument may be undervalued) and conversely RSI values above 70 are considered to be overbought (i.e. the instrument may be overvalued).

The RSI can often “lead” the price action of the underlying instrument, in which case it’s said to have RSI divergence. For example, if an instrument’s price is going higher but the RSI is dropping, that often indicates that the instrument’s price will soon follow lower.

Moving Averages

Moving Averages (MA) are widely used indicators for an important reason: by filtering out short-term price fluctuations, they smooth out the price sequence and hence make it much clearer to see the bigger picture.

The calculation of MAs is very simple – every data point is the average of the specified number of previous data points (for example, a 100-day MA averages the latest 100 days of daily data points in order to produce the next one). There are two popular types of MAs:

  • Simple Moving Average (SMA) – the simple average of the data points.
  • Exponential Moving Average (EMA) – an average of the data points that gives more weight to the most recent points.

At ForexAnalytix we usually track the 50-day and 200-day SMAs, which are the most commonly used MAs in the market. These particular MAs are very useful indicators when looking at the medium term view of an instrument.

An important event that many analysts look for is when two MAs cross. This can often indicate a substantial change in the general trend of an instrument. The most popular of these is the “Golden Cross”, which occurs when a short-term MA breaks above a long-term MA (for example the 50-day MA crosses above the 200-day MA).

Volume

Volume is an often overlooked but important indicator. It shows the associated volume for every price change, and this can be used to interpret the relative strength of the move.

For example, a rising market should in theory be accompanied by rising volume and vice versa. Low-volume moves tend to have a higher probability of being reversed at a later stage. This is because a legitimate move higher (or lower) should be accompanied by an increased level of interest by market participants, indicating that something has changed in the fundamentals of the particular instrument.

An interesting phenomenon near market extremes is that of market exhaustion. This is where price moves are usually very sharp in magnitude, with increased volume and short duration. This reflects human psychology where investors either try to get into a market uptrend in fear of missing out, or getting forced out in a downtrend.