Understanding Technical Analysis in Forex

Technical analysis attempts to evaluate and identify trading opportunities by analyzing data from trading activity, such as price movement and volume. Unlike fundamental analysis, which attempts to evaluate a security's intrinsic value, technical analysis focuses on patterns of price movements, trading signals, and various other analytical charting tools to evaluate a security's strength or weakness.

Through evolution, pattern recognition allowed us to read words, understand language, and recognize our tribe. It occurs when information from the environment enters short-term memory, causing an automatic activation of a specific content of long-term memory. This foundational cognitive process is what allows traders to use technical analysis.

Pillars Of Technical Analysis

Technical analysis relies on three primary concepts: price action, chart patterns, and indicators.

• Price action: the movement of a security's price plotted over time
• Chart patterns: formations created by the price movements on a chart and can signal future price movements. 
• Indicators: statistical calculations based on the price, volume, or open interest of security, used to predict future price movements.

3 Types Of Charts

The most common types of charts used in technical analysis are line charts, bar charts and candlestick charts.

• Line Charts: The simplest form, connecting the closing prices of a security over a period, providing a clear view of the overall trend.
• Bar Charts: Provide more information than line charts, showing the opening, closing, high, and low prices for each period.
• Candlestick Charts: Similar to bar charts but more visually informative, showing the same price information but in a format that emphasizes the relationship between the opening and closing prices.

Example of a Line Chart

Example of a Bar Chart

Example of a Candlesticks Chart

Importance of Time Frames

Technical analysis can be applied to different time frames, making it versatile for various trading strategies. In fact, various technical trading approaches are fractal – they look equally on different time frames. Time frames are categorized as short-term (minutes to days), medium-term (weeks to months), and long-term (months to years). Day traders might use short-term analysis, while long-term analysis suits investors looking at broader market trends.

Role of Support and Resistance Levels

Support and resistance are critical concepts in technical analysis. Support is a price level at which a downtrend can be expected to pause due to a concentration of demand. Resistance is a price level at which a trend can pause or reverse due to a concentration of selling interest. Identifying these levels helps traders determine entry and exit points and set stop-loss orders to manage risk.

Most Popular Technical Indicators

The following are the most popular technical indicators that traders use to interpret price data at a glance. These include:

Moving averages

A derivative of price movement, moving averages smooth out price data to identify trends by averaging the price over a specific period. Two main types are:

• Simple Moving Average (SMA): The arithmetic mean of a given set of prices over a specific number of days in the past.
• Exponential Moving Average (EMA): Gives more weight to recent prices, making it more responsive to new information.

Relative Strength Index (RSI)

RSI is a momentum oscillator that measures the speed and change of price movements. It oscillates between 0 and 100, typically using 70 as an overbought level and 30 as an oversold level. Traders typically use oscillators to look for reversals in a ranging price environment.

Moving Average Convergence Divergence (MACD)

MACD is a trend-following momentum indicator that shows the relationship between two moving averages of a security’s price. It is calculated by subtracting the 26-period EMA from the 12-period EMA, while the signal line is a 9-period EMA. Traders look for buys when the MACD crosses above the signal line and sell when it crosses below it.

Bollinger Bands

Invented by John Bollinger, Bollinger bands envelop the price, showing deviation from the average movement of price. They consist of a middle band (SMA) and two outer bands set at a specific number of standard deviations from the SMA. They help determine overbought and oversold conditions and provide signals for price breakouts.

Technical Analysis Strategies

Three of the most common technical analysis strategies include trend following, breakouts and reversals.

Trend Following

This strategy involves identifying and following the direction of the market trend. Traders use moving averages and trendlines to recognize upward or downward trends and make trades in the direction of the trend. Trend following is a powerful approach because it stacks the odds in traders' favor, given the ability to correctly identify the underlying trend and use sensible points to enter the market.

Breakout

Breakout strategies focus on entering a trade as the price breaks through a significant support or resistance level. This approach aims to capitalize on the volatility that typically follows these breakouts. A key factor to watch in the breakout is trading volume, as higher-than-average volume confirms the breakout.

Reversal

Reversal strategies aim to identify when a current trend is about to reverse. Arguably, it is the hardest strategy, usually looking to capitalize on spotting a high time frame support or resistance level. Indicators like RSI and MACD commonly detect overbought or oversold conditions that may precede a reversal. Market trends tend to range most of the time, so reversal strategies tend to do well. However, risk management is a crucial factor in managing the occasional losses.

Risk Management Techniques

An old Wall Street saying states that the difference between a short-term trade and a long-term trade is that the long-term trade is currently underwater. Effective risk management is crucial when trading, regardless of the approach.

Traders relying on technical analysis typically use stop-loss orders to limit potential losses and take-profit orders to secure profits. Placing these orders requires a keen eye of the market to spot crucial price levels. Often it comes to experience of thousands of hours of watching the market to really fine-tune this approach and stick to the trading plan, resisting the temptation of fear and greed.

Technical Analysis Implications for Singapore Forex Traders

Due to its favorable taxation policy, Singapore is an important financial center that attracts forex traders. However, intraday traders have to adjust to the market, as the Asian session tends to trade differently than the London and New York sessions, which are the prime times for the forex markets.

This is particularly important for breakout traders who look for higher volatility and need volume to confirm and fuel those larger moves. These traders will find more success late in the day when London and New York overlap. Meanwhile, traders looking for reversals might find more opportunities earlier in the day through the Asian session. For more information, check out our guide on the best times to trade forex in Singapore.

Frequently Asked Questions

Is technical analysis enough for trading?

Technical analysis can be enough, especially for short-term trading. It can be used on any financial instrument as long as enough historical trading data is available.

Why do traders use technical analysis?

Traders use technical analysis to predict price movements. This approach is particularly suitable for the short term, as fundamentals become more important in the longer time frame.