What is technical analysis, what are the main tools, and how is it relevant to Forex trading? That’s what I will be covering in this short introduction. Most traders agree that Forex is a market in which technicals are highly influential. We know that fundamentals drive the long-term directions in foreign exchange rates. In the short-term however, especially between key data releases, technicals are king.
Technical analysis is based on price action – the dynamics between buyers and sellers, supply and demand.
Why is forex such a technical market? Unlike bonds and stocks say, there are no valuation models that can accurately predict the value of one currency against another. There are simply too many complexities involved in trying to model macroeconomic and political influences. With floating exchange rates, the fair price is whatever the market says it is.
This is one of the reasons that most short-term traders and day traders in Forex rely almost exclusively on charts. Some claim, because so many are trading on these technical signals, it makes their predictions self-fulfilling – thereby drawing in more and more proponents.
What is Technical Analysis?
Technical analysts look at price charts and other data to try to predict future moves in the market. Technicians don’t consider fair values or economic influences at all, as do fundamentalists. The majority of technical analysis is based on price action. This is the idea that the dynamics between buyers and sellers, supply and demand cause price movements which, to some degree, can be predicted.
As well as historical price data, technical analysts use data from other sources such as trade volumes, open interest (options and futures), and risk metrics to try and gauge market sentiment.
The area of technical analysis that most people are familiar with is called charting. In Forex, traders of all experience levels use charts. One reason for their popularity is that these tools provide an objective viewpoint, rather than a subjective one. Their graphical representation makes them easily understood and accessible. They also supposedly make for a more level playing field in that technical traders believe all relevant information is reflected in the charts.
One thing that makes these kinds of indicators highly useful is that most create objective market entry and exit points. Software systems can analyze price data much more readily than say a news release. This makes them useful as inputs to algorithmic trading systems.
Most trading platforms offer at least the basic chart tools. Metatrader has a good selection of built in chart tools and indicators. It’s also extendable in that you can import new ones and even create your own to extend the basic capabilities.
Technical analysis is a very big topic in its own right. The methods are broadly applicable to all markets. In the rest of this article, I will introduce the main ideas.