In Forex trading, the term technical analysis can be defined as the study of price movements of different currencies. Technical analysis is based on the notion that you can get accurate clues on the current trading conditions as well as the potential/future price movement by looking at past price movements. In theory, all current financial market information is accurately reflected in price movements. Furthermore, price trends tend to repeat themselves over time. This is precisely why technical analysis is one of the most important frameworks for studying financial markets more so the Forex market.
If a certain price level was a key support or resistance level in the past, traders tend to keep an eye on that price level and base their trades on or around that historical price level. Forex traders who use technical analysis also focus on finding similar price patterns in the past that are likely to form in the present and future. Such patterns offer trading ideas with the notion that the price will act in a similar manner like before.
When Forex traders hear the word technical analysis, the first thing that comes to their minds is charts. Technical analysis in Forex trading is all about studying charts. Technical analysts use charts because they offer the easiest and best way to visualize historical prize data. In simple terms, it’s easier to spot trends and patterns when you look at Forex charts as opposed to when you look at raw Forex data. It is however important to note that the most important trends and patterns can’t be spotted by simply looking at a plain chart. This is where indicators come in handy.
Technical analysis and indicators
To be able to understand what technical analysis is in-depth, you have to understand what indicators are and why they are important. Indicators are charting tools that are added to charts to accurately show price, volatility and volume information among other important information depicted by charts. In a Forex trading context, indicators are added to currency charts to offer a more accurate interpretation of price movements, volatility, volume etc.
Major technical analysis indicators used by Forex traders
There are very many types of technical indicators. Below are some of the most important technical analysis indicators to consider as a Forex trader:
1. Bollinger bands
Bollinger bands are used to measure volatility. As the name suggests, they resemble bands that run across charts. Bollinger bands show the support and resistance levels. Without indicators such as Bollinger bands, it would be very difficult for a Forex trader to accurately identify support and resistance levels which offer important clues on when to place, hold or liquidate trades.
Also known as Moving Average Convergence Divergence, this technical indicator is used to identify price trends in advance. When a Forex trader uses the MACD indicator, they can be able to tell when to buy or sell just before a trend reversals happen. The MACD is best used in trending Forex markets characterized by long rallies as well as downturns.
Also known as the relative strength index, this indicator is used to measure the strength of a trend. The RSI highlights overbought and oversold conditions. Such conditions are very important since price reversals happen when a currency pair has been overbought or oversold.
4. Average Directional Index
The Average Directional Index (ADX) is another trend indicator used to measure the momentum behind a trend. Unlike the RSI, the ADX is hardly used to identify the trend direction. The ADX is a very important technical analysis indicator because it tells Forex traders which trends to follow and which ones to ignore. Ideally, traders should follow strong trends and abandon weak ones. The indicators combine the positive and negative directional indicators (price movement measures) to give the strength of the upward and downward trends respectively. The ADX indicator is depicted as a line measured on a 0-100 scale. Readings below 20 are weak while those above 40 are strong.
In a nutshell, technical analysis in forex trading refers to the use of charts alongside indicators to study price movements which offer clues for placing trades. Forex traders who use technical analysis get trading ideas by looking at charts with the help of indicators.