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Technical Analysis

What is technical analysis?

In finance, technical analysis is a security analysis methodology for forecasting the direction of prices through the study of past market data, primarily price and volume. Using charts, technical analysts seek to identify price patterns and market trends in financial markets and attempt to exploit those patterns. Technicians using charts search for archetypal price chart patterns, such as the well-known head and shoulders or double top/bottom reversal patterns, and look for forms such as lines of support, resistance, channels, and more obscure formations such as flags, pennants, balance days and cup and handle patterns. Technical analysts also widely use market indicators of many sorts, some of which are mathematical transformations of price, often including up and down volume, advance/decline data and other inputs. These indicators are used to help assess whether an asset is trending, and if it is, the probability of its direction and of continuation.

Science of the market or just folklore?

Technical analysis has been evolving over centuries by merchants and stock and commodity traders. The chart analysis methodologies arose from personal experience, observations of repeating chart patterns and subjective interpretation of specific market moves. As much of the methods and underlying explanations evolved at the times of trading floors, technical analysts tend to use crowd psychology as the theoretical basis for explanations of how specific chart and indicator patterns reflect behavior of market participants and how the present "market sentiment" is going to shape the future price action.
Technical analysis has solely empirical character and has never been established as an apllied science or true "technical" discipline. Folklore is defined as "the traditional beliefs, customs, art, and stories of a community, passed through the generations". Definition of folklore thus perfectly describes the nature of what is somewhat misleadingly called "technical analysis" of markets. Technical analysis is also sometimes described as a sort of art.

What is the predictive power of technical analysis?

Whether technical analysis actually works is a matter of controversy. Methods vary greatly, and different technical analysts can sometimes make contradictory predictions from the same data. Many stock investors claim that they experience positive returns, but academic appraisals often find that it has little predictive power. Specific features of the FOREX market make the chances of making any successful prediction from technical analysis even much lower than in stock and commodity markets.
These features are:

  • Huge numbers of market participants performing trades in different, but mutually correlated instruments, on different time frames, with different profit targets and risk control settings, and very varied position entry strategies (no place for "crowd psychology")
  • Complex relationships between currencies and other assets (stocks, commodities, derivatives, etc.)
  • Numerous economical and political influences
  • Significant proportion of large market participants performing non-speculative trades (the primary purpose of FOREX is exchange of currencies, not speculation)
All these actions, influences, and effects together form a chaotic system, like the Earth's atmosphere, and the chances to succesfully predict next development of the FOREX market are even more limited than those of weather forecasts. One might argue that short term weather forecasts are pretty reliable these days. Well, yeah, but that is due to the satellite snapshots and other data showing what is going on right now and enabling extrapolations of the present processes into the near future (with the help of very advanced mathematical models). There is a nice analogy between the satellite snapshots and central order books of interbank ECNs. These data (volumes of pending limit orders) are like satellite snapshots of the market, hinting bank guys of what is about to happen, particularly what are the true (=believed in) support/resistance levels (many S/R levels are just random patterns). Unfortunatelly, this information is never available to public, imposing a great disadvantage on retail traders.

Support and Resistance

"Support and resistance" is common jargon for areas on the chart where price has a seemingly difficult time breaking through. Support levels tend to stop price from falling below a specific point and resistance levels act like a price ceiling that price cannot break above.



S/R Levels

Support and resistance is one of the most widely used concepts in FOREX trading, but also one of the most flawed. Randomly generated charts display the same high frequency of support and resistance-like formations casting serious doubts on any explanations of these price levels through crowd psychology or specific properties of supply and demand.

Chart patterns

A chart pattern is a distinct formation on a price chart that creates a trading signal, or a sign of future price movements. Chartists use these patterns to identify current trends and trend reversals and to trigger buy and sell signals. The theory behind chart patterns is based on the assumption that "history repeats itself". The idea is that certain patterns are seen many times, and that these patterns signal a certain high probability move in an instrument. There are two types of patterns within this area of technical analysis, reversal and continuation. A reversal pattern signals that a prior trend will reverse upon completion of the pattern. A continuation pattern, on the other hand, signals that a trend will continue once the pattern is complete. These patterns can be found over charts of any timeframe.

The most popular chart patterns are:

  • Double Bottom Reversal
  • Head and Shoulders Top (Reversal)
  • Head and Shoulders Bottom (Reversal)
  • Falling Wedge (Reversal)
  • Rising Wedge (Reversal)
  • Rounding Bottom (Reversal)
  • Triple Top Reversal
  • Triple Bottom Reversal
  • Bump and Run Reversal (Reversal)
  • Flag and Pennant (Continuation)
  • Symmetrical Triangle (Continuation)
  • Ascending Triangle (Continuation)
  • Descending Triangle (Continuation)
  • Rectangle (Continuation)
  • Price Channel (Continuation)
  • Cup with Handle (Continuation)

Technical indicators

Technical indicators are calculations based on the price and the volume of an instrument that measure such things as money flow, trends, volatility and momentum. Indicators are used as a secondary measure to the actual price movements and add additional information. Indicators are used in two main ways: to confirm price movement and the quality of chart patterns, and to form buy and sell signals. There are four groups of technical indicators. The most popular ones are:

  • Trend indicators: moving average (MA), directional moving average (ADX), Ichimoku Kinko Hyo, moving average convergence/divergence (MACD), parabolic SAR
  • Momentum: relative strength index (RSI), stochastic oscillator, Williams % range (%R)
  • Volatility: average true range (ATR), bollinger bands (BB), standard deviation
  • Volume: money flow index, accumulation/distribution line, on-balance volume

The last group should be mentioned specifically, due to trading volume being its primary source of data for analysis. It is undoubtedly true that studies of total traded volume are helpful to financial traders in stock and futures markets. Although the overall theories of these studies can apply to the FOREX spot market as well, there is simply no way to analyze FOREX total traded volume. It's important to note that because the FOREX spot market is traded OTC, no total volume can be calculated. This means that all the indicators of volume a trader sees on his platform only use a sample of total volume for analysis. How much of the data is representative, if at all, is uncertain.




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