Forex Technical Analysis
By FELIX OLUOCH
Chief technical analyst-Earn As You Learn Program
It refers to the analysis of the price action of a currency pair without considering the economic trends and facts.
We need to analyze the price action before taking a position about the entry and then about the exit. Technical analysis is not only about the indicators, but chart patterns also play a very important role. It is always better to keep an eye on the commonly occurring Forex chart patterns while analyzing the price movement based on your chosen analysis indicators. The reason is simple—that you would find these chart patterns working miraculously most of the time. If your indicators are suggesting one trading move but the chart pattern is suggesting otherwise, then you may prefer to follow the advice of the chart patterns or the combination of indicators and moves suggested by the chart patterns.
FOREX TECHNICAL INDICATORS
Moving averages are trend following and hence lagging indicators. Lagging indicators confirm the trend once the trend has already begun. These indicators do not predict the future market direction in advance.
Technical analysts use moving averages very commonly for price action forecasting. The explanation here is focused around Forex trading but the same concepts are applicable for other trading markets:
- Identification or confirmation of the trend.
We can use Moving Averages for the identification or confirmation of a trend. Bullish sentiments or uptrend is indicated when the moving average line is slopping upwards and the price action is continuously above it. Similarly bearish sentiments or uptrend is indicated when the moving average line is slopping downwards and the price action stays below it.
Please note that the above statements are just for initial guidelines because there are other factors and consideration which are important for the determination of a trend situation. The factors are as follows:
- Time frame of the chart: There may be a short-term uptrend on an hourly chart while there is a longer-term downtrend on the daily or weekly chart. Hence the time-frame of the chart we are analyzing is important.
- Period setting of the moving average: The price action may be showing bullish or bearish sentiments with reference to a shorter-time period moving average, say 5 periods, but may be indicating a different picture with reference to a moving average of a longer period setting, say 55-day moving average.
- Identification of possible reversal points of the trends.
When the moving average suddenly goes lower than the previous period, it may be a signal that the ongoing uptrend may be ending or a consolidation may be on the way. Similarly when the moving average suddenly goes higher than the previous period, it may mean that the downtrend is ending or a consolidation may be on the way.
- Gauging the momentum of the trend.
- Identification of possible support and resistance levels.
Types Of Moving Averages
i) Simple Moving Average (SMA)
ii) Linearly Weighted Moving Average (WMA)
iii) Exponential Moving Average (EMA)
Stochastic Oscillator was developed by George C. Lane in the late 1950s. This is a momentum indicator and used quite commonly for technical analysis. It is called an oscillator because it oscillates in a range of 0 to 100. It compares the current price with the highest and lowest prices during the selected time period and tells us where does the current price lies with reference to the lowest and highest prices. Stochastic indicator does not track the price action in the absolute terms but follows the rate of change in the prices. The Stochastic oscillator has two lines. The main line (called %K) and the trigger line (called %D). The main trading signals are generated when the main line crosses the trigger line upwards or downwards. Trading signals are also generated by over bought & over sold situations and divergences which are explained later.
Stochastic signals can be interpreted in the following ways:
- i) Over bought / over sold situation
Readings below 20 are considered oversold situation and indicate that it may be the time to buy as the currency pair might have already been oversold. Readings above 80 are considered to be overbought and indicate that it may be the time to short-sell as the currency pair might have already been overbought.
However, level above 80 does not necessarily mean that people will not buy further and a reading below 20 cannot conclude that people will not sell further. The market may continue to rise after the Stochastic Oscillator has reached 80 or crossed over 80 and continue to fall after the Stochastic main line has reached 20 or gone below 20. The overbought and oversold situation are just indications that sooner or later a reversal may come. Taking positions only on the basis that Stochastic has moved over 80 and hence prices would come down or because Stochastic has gone below 20 and hence market would start going up is never a good idea as trends may continue for a long time. Avoid taking actions only based on such observations.
ii)Crossover (the Stochastic line crossing the Trigger line)
Bullish and bearish signals are generated when %K moves over or below %D, respectively.
When %K line moves over the %D line, it signals that the upward momentum is increasing and the prices may move up further. Such a crossover gives us a “Buy” signal. Please note that the “Buy” signal by the crossover is more authentic when the Stochastic is near or below 20 (oversold region). Avoid using this “Buy” signal when it is near 80 or above 80 (overbought zone).
When %K line moves below the %D line, it signals that the downward momentum is catching up and prices may move down further. Such a crossover gives us a “Sell” signal. Please note that that the “Sell” signal by the crossover is more authentic when the Stochastic is near or above 80 (overbought zone). Avoid using this “Sell” signal when it is near 20 or below 20 (oversold region).
For the most reliable trading signals, wait for a divergence to develop from overbought or oversold levels.
Once the oscillator reaches overbought levels, wait for a negative divergence to develop and also wait for a move below the 80 level. It’s better not to sell at the first dip below 80 but wait to see sustains below 80 for some time. Most of the time it would bounce back over 80 after the first dip. The second dip results in the sell signal.
For a buy signal, wait for a positive divergence to develop after the indicator moves above 20. It is better to disregard the first break above 20. After a positive divergence forms, the second break above 20 confirms the divergence and this is a better time to enter a long position.
Bollinger bands gauges the volatility of the market and compare those with the average prices. It consists of 3 lines or bands.
- The center band represents the moving average of the price action.
The other two bands are on the either side i.e. above the center band and below it.
- The upper band represents the volatility towards the highs of the price action and
- The lower band represents the volatility on the lows.
Trading with Bollinger Bands
Bollinger Bands can be used for trading in following way:
1) Sideways price action
When the price action is in range then the price generally moves between the upper and the lower bands. Once the price action hits the upper band, it is an indication that it may move down towards the lower band and vice versa. Please not that this cannot be classified as a signal but just as an indication. During the trends the price may keep hitting the bands and bands would keep slopping upwards or downwards with the uptrend and downtrend respectively.
What goes up comes down and what goes down comes up. Even during very strong trends prices take temporary reversal and consolidate quite frequently. It’s like taking the breathing time before moving ahead. The retracement levels derived from Fibonacci ratios indicate the levels to which the price action may consolidate before continuing in the direction of the ongoing trend.
Fibonacci ratios and retracements
The Fibonacci ratios as percentage are what Fibonacci retracements in technical analysis are all about. The 0.236 is 23.6% retracement, 0.382 is 38.2% retracement and 0.618 is 61.8% retracement. The most common retracement levels are as follows:
In technical analysis, Fibonacci retracement Levels are used as support and resistance levels. During an uptrend when the price consolidates downwards then these retracement levels become support levels. Similarly during a downtrend when the price retraces for correction or consolidation then these levels become resistance levels.
When to use?
The first indication of a consolidation towards the Fibonacci retracement levels is when during a trend there is a slow-down in the momentum and the price-action starts going in the sideways. This situation may be an opportunity to enter the market to target the retracement levels.
When you come across such situation then you may like to check for a trading signal generated by some other indicator e.g. MACD or moving average crossover as a confirmation for the entry.
RELATIVE STRENGTH INDEX (RSI)
Relative Strength Index (RSI) oscillator was developed by J. Welles Wilder
RSI is one of the commonly used momentum indicator (oscillator) for technical analysis. Please note that the following explanation for the usage of Relative Strength Index is focused for Forex trading but the same is equally valid for stocks or any commodity trading.
How to Trade with RSI?
The signals RSI or Relative Strength Index generates are for overbought and oversold positions. Please note that overbought and oversold situations should only be analyzed when market is running into range and there is no clear trend.
- RSI Indicator – Overbought situation: RSI suggesting that it’s time to short sell.
- RSI – For oversold situation: RSI suggesting that it’s time to buy.
As mentioned above, please note that RSI (relative strength index) works well when the market moves in range but gives false signals when the market is in trend i.e. Bullish (uptrend) or Bearish (downtrend). You may use ADX for analyzing if the market is in range or has a trend.
RSI readings range from 0 to 100.
- When the RSI nears 30 or goes below 30, the signal is that the currency pair is oversold and it may be the time to buy the pair.
- When RSI nears or crosses 70 and goes below, the signal is that the market is overbought and it may be the time to short sell.
When to Use?
RSI should be used when there is a sideways movement without a trend.
You may use Average Directional Index (ADX) to see if market is moving sideways (ADX below 25) and then use. ADX is an indicator used in technical analysis as an objective value for the strength of trend. ADX is non-directional so it will quantify a trend’s strength regardless of whether it is up or down. ADX is usually plotted in a chart window along with two lines known as the DMI (Directional Movement Indicators). ADX is derived from the relationship of the DMI lines.
The lowest price at which a financial instrument is offered for sale.
1) The currency in which an investor or issuer maintains his/her book of accounts; the currency against which other currencies are quoted. In the Forex market, the US Dollar is normally considered the “base” currency for quotes, meaning that quotes are expressed as a unit of one USD per the other currency quoted in the pair. 2) The first currency quoted in a pair.
An investor who believes that market prices will decline.
A trend distinguished by a prolonged period of declining prices accompanied with widespread pessimism.
The price at which a buyer is prepared to purchase; the price offered for a currency.
Tradable instruments (debt securities) issued by a borrower to raise capital. They pay either fixed or floating interest, known as the coupon. As interest rates fall, bond prices rise and vice versa.
An individual or firm that acts as an intermediary between buyers and sellers, usually for a fee or commission. A dealer, by contrast, performs the same service but commits capital and takes one side of a position, hoping to earn a spread (profit) by closing out the position in a subsequent trade with another party.
An investor who believes that market prices will rise.
A trend distinguished by a prolonged period of rising prices; the opposite of bear market.
Trader jargon referring to the Sterling/US Dollar exchange rate. The term originated in the mid 1800â??s, when the rate was transmitted via a transatlantic cable.
A chart that indicates the trading ranges for the day as well as the opening and closing price. If the close price is lower than the open price, the rectangle is shaded or filled. If the open price is higher than the close price, the rectangle is not filled.
Markets intended for medium- to long-term investment, such as US government bonds and Eurobonds
A government or organization that manages a country’s monetary policy. For example, the US central bank is the Federal Reserve, while others include the ECB, BOE and BOJ.
An individual who interprets historical data to find trends, predict future movements and aid in technical analysis.
Close a Position (Position Squaring)
To eliminate an investment from one’s portfolio by either buying back a short position or selling a long position.
An exchange rate between two currencies. The cross rate is said to be non-standard in the country where the currency pair is quoted. For example, in the US, a GBP/CHF quote would be considered a non-standard rate; whereas in the UK or Switzerland, GBP/CHF would be one of the primary currency pairs traded.
The opening and closing of a position within the same trading session.
An Exchange Traded Fund
A statement related to monetary policy which implies looser policy (lower rates).
A council consisting of the economy and finance ministers of the European Union. They meet once a month.
Refers to monetary policy tending towards lower interest rates. Monetary authorities (a central bank) will want easy monetary policies (lower interest rates and even perhaps a program like quantitative easing, in order to encourage economic growth)
A statistic that measures economic growth and stability; e.g., Gross Domestic Product (GDP), employment rates, trade deficits, industrial production and business inventories.
Federal Open Market Committee, the monetary policy-setting group within the Federal Reserve Bank of the USA. It consists of 12 members, the seven members of the Federal Reserve Board and five of the twelve Federal Reserve Bank presidents 9selected on a rotating basis for one-year terms).
Foreign Exchange (or Forex or FX)
The simultaneous buying of one currency type and selling of another in an over-the-counter market.
A method of trading financial instruments, currencies or commodities for a specific price at a specific date in the future. Unlike options, futures entail the obligation (not the option) to buy or sell instruments at a later date. They can be used to both protect and speculate against the future value of the underlying product.
A statement regarding monetary policy which implies tighter policy (higher rates)
An investment position or combination of positions that reduces the volatility of ones?? Portfolio value.
An increase in the price of consumer goods that erodes purchasing power.
The required initial deposit to enter into a trade position.
The Foreign Exchange rates at which large international banks quote other large international banks.
Interest Rate Swaps (IRS)
An exchange of two debt obligations that have different payment streams. The transaction usually exchanges two parallel loans; one fixed the other floating.
Economic variables that are considered to predict future economic activity; e.g., unemployment, Consumer Price Index, Producer Price Index, retail sales, personal income, Prime Rate, Discount Rate and Federal Funds Rate.
An order to buy at or below a specified price, or to sell at or above a specified price.
Liquid and Illiquid Markets
Investors’ ability to buy and sell at ease with minimal impact on price stability. A market is described as “liquid” if the spread between the bid and the offer is small. Another measure of liquidity is the volume of buyers and sellers, with more players creating tighter spreads.
Assets that can be easily converted into cash. Examples: money market fund shares, US Treasury Bills, bank deposits, etc.
To close an open position by executing an offsetting transaction.
A position characterized by purchasing more of an instrument than is sold in hopes that the value will appreciate.
Funds deposited as collateral to cover any potential losses from adverse movements in prices.
A request by a broker or dealer for additional funds or other collateral in order to guarantee performance on a position that has moved against the trader.
An order to buy/sell at the best price available when the order reaches the market.
Risk relating to the market in general that cannot be extinguished by hedging or holding a variety of securities.
Short-term investment opportunities (e.g. under one year.) Participants include banks and other financial institutions. Examples include Deposits, Certificates of Deposit, Repurchase Agreements, Overnight Index Swaps and Commercial Paper.
Amount of assets that exceed liabilities. For an individual, this refers to the total value of all possessions such as houses, stocks, bonds and other securities; minus all outstanding debts, such as mortgage and loans. May also be known as “stockholders’ equity” or “net assets.”
Pip (or Point)
The smallest incremental move an exchange rate can make. Depending on context, this is normally one basis point (0.0001 in the case of EUR/USD, GBD/USD and USD/CHF; and .01 in the case of USD/JPY).
A strategy used by central banks once targeting short-term interest rates becomes ineffective because rates have reached zero (or close to it). The central bank buys assets, typically government bonds, in an effort to inject money into the economy.
Exposure to uncertain change.
The amount of money that an individual can afford to invest that, if lost, would not affect his/her lifestyle.
To hedge one’s risk by employing financial analysis and trading techniques.
The interest rate variation between the two currencies when the settlement of a deal is rolled forward to a different date.
An investment position that results from short selling.
To sell an instrument without actually owning it in hopes that the price will decline so it can be bought back in the future at a profit.
A transaction that occurs immediately. The funds will usually change hands within two days after deal is struck.
The difference between the bid and offer (ask) prices, which is used to measure market liquidity. Narrower spreads usually signify high liquidity.
An order to buy/sell at an agreed-upon price.
A term used in technical analysis indicating a specific price level below which a currency is unable to cross. Recurring failure for the price to move below that point produces a pattern that can be displayed using an approximate straight line.
The temporary holding of a security that is then exchanged after a fixed period of time. To calculate the swap, find the interest rate differential between the two currencies. The value may be used for speculative purposes to exploit anticipated movement in the interest rates.
An order which closes out a market position once a certain price level trades in the market. For example, a sell order placed below the market price to protect against accelerating losses.
An effort to forecast future market activity by analyzing market data such as charts, price trends, and volume.
The volume traded over a specified period.
Taper / tapering:
It is thought that the Federal Reserve will begin to slow down its asset purchasing in response to an improving US economy not requiring so much monetary accommodation. This slowing down (not stopping) of purchases is referred to as tapering
A statistical measure of a market or a security’s price movements over time, calculated by using standard deviation. Associated with high volatility is a high degree of risk.
The value of securities traded during a specific period.
A condition in a highly volatile market characterized by a sharp price movement quickly followed by a sharp reversal.