While fundamental analysis helps illustrate the larger forces affecting the currency market, and
long-term prospects for economic health, it has some critical failings. First, the almost limitless
amount of factors that can be plugged into a forecast model might force a trader into a perpetual
state of analysis, unable to pull the trigger on potential deals. More importantly, however, is
fundamental analysis' uselessness in predicting entry and exit points. Technical analysis, on the
other hand, ignores fundamental forces, focusing on short-term currency movements to identify
trends and determine exactly when and what to buy and sell.
A trend is basically a prolonged price movement in a one direction. An upward trend can be
identified by sketching a line beneath a series of lows; a downward trend by tracing a line above a
series of highs. Over time, recurring price trends form support and resistance levels, or barriers at
the top and bottom of the trading level. It is difficult for currencies to penetrate these levels because,
over time, supply/demand has been built up in adequate abundance at both levels—demand at the
floor, supply at the ceiling. These levels are obvious positions for buy/sell orders. Once these levels
are definitively broken, however, they tend to form the opposite barrier.
Dow Theory
Technical analysis is based on the Dow Theory, which rests on a number of fundamental
assumptions:
1. Price is a comprehensive reflection of all market forces. All the fundamental indicators
described above almost immediately find expression in market pricing.
2. Price movements are trend followers. There are three types of trends: primary, secondary
and daily fluctuations.
Primary trend: A primary trend remains in effect until definitive signals prove otherwise.
Secondary trend: A secondary trend reacts against the primary trend, and is a temporary
phenomenon. In a bull market, a secondary trend is called a correction; in a bear market
secondary trends are sometimes called reaction rallies. A secondary trend can retrace up to
2/3 (usually 50%) towards the starting point of the trend before resuming its primary course.
Daily fluctuations: There is very little opportunity for forecasting daily fluctuations.
Overemphasis on daily fluctuations can easily lead to loss.
3. Primary trends are composed of three stages: accumulation/distribution, run-up/run-down
and irrational pessimism/optimism.
Accumulation/distribution: During the first stage, knowledgeable traders buy/sell stocks
against consensus.
Run-up/run-down: This is the longest stage of the cycle. The market begins to move, the
trend is identified and trend followers jump aboard/bail out.
Irrational pessimism/optimism: Run-up/run-down is the longest stage of the cycle. At some
point, investors experience irrational exuberance/despair, and the knowledgeable investor
will distribute/buy holdings in anticipation of the start of a new cycle.
4. The volume of trades must confirm the trend. Movement on low volume trades can be
attributed to many different ephemeral factors; high volume movements are indicative of the
true direction of the market.
Elliott Wave Theory
According to the Elliott Wave Theory, a complete market cycle is composed of eight waves,
including five waves in the direction of the trend and three waves against. The upward waves within
a bull move are called impulse waves, and the three countertrend waves are called corrective
waves.
Corrective waves follow certain rules: the second wave can never retrace more than 100% of the
first wave; the third wave is never the shortest in an impulse sequence, and often the longest; and
the fourth wave can never enter into the price range of the first wave.
Extensions: In any five-wave sequence, a tendency exists for one of the three impulse subwaves to
extend in an elongated movement, usually with internal subdivisions, which can sometimes have
nearly the same amplitude and duration as the larger waves. Extensions can provide a useful guide
to the length of future waves.
Failures: Failures occur when the extreme in the fifth wave fails to exceed the extreme in the third.
This signals a weakness in the underlying trend, and a sharp reversal usually follows.
Charts
Price fields: Technical traders base actions on price and volume analysis. The fields, which define a
security's price and volume, are explained below.
Open: The price of the first trade during the period.
Close: The last price that the security traded during the period.
High: The highest price that the security traded during the period.
Low: The lowest price a security traded during the period.
Volume: The number of shares (or contracts) traded during the period.
Line chart: A line chart plots single prices for a select period. The daily chart, for instance, generally
illustrates the daily closing prices. The obvious problem with the daily chart is its inability to show
intra-daily price activity.
Bar chart: The bar chart is the most widely used Forex chart. Each bar represents a certain time
period, with the timeframe's high and low represented by the upper and lower boundary of the bar.
A small line extends to the left and right of the bar, representing the opening and closing prices of
the period, respectively. The closing horizontal line of one period will always be at the same level as
the open of the next, forming a price continuum.
Candlestick chart: The candlestick chart is closely related to the bar chart. It also illustrates the
high, low, open and close of each period. The opening and closing prices form the rectangular
'body' of the candlestick. Extending from the upper and lower sides of the body are two legs, the
boundaries of each representing the high and low of the period. If the close is lower than the open,
the body will be shaded; if the close is higher than the open, the body is left blank.
Chart Patterns
Currency valuation moves in trends, and these trends do not last forever. When a particular
commodity experiences a countertrend, it usually is not an instantaneous phenomenon. Instead,
prices decelerate, pause and reverse. These phases occur as investors form new expectations and,
in doing so, shift supply/demand lines. The psychology underlining the changing of expectations
often causes price patterns to emerge that are remarkably similar to one another.
Head and shoulders: The head-and-shoulders price pattern is the most reliable and well known
chart pattern. It gets its name from its resemblance to a head in the middle of two shoulders. A first
upward surge is followed by a secondary trend, after which a larger upward trend propels prices up
past the first shoulder. After this new high, or the head, the decline begins. A second shoulder is
created as bulls try to push prices higher, ultimately failing. Confirmation of a downtrend (upturn in a
reverse head and shoulders) is confirmed when the neckline is penetrated.
Rounding tops and bottoms: Rounding tops/bottoms occur as expectations gradually shift between
bullish and bearish.
Triangles: As the range between high and low narrows a triangle is created by drawing trend-lines
above the highs and below the lows. A symmetrical triangle occurs when prices are making lower
highs and higher lows. An ascending triangle occurs when there are higher lows and consistent
highs, usually due to a resistance level. A descending triangle occurs when there are lower highs
and consistent lows, usually due to a support level. Ascending and descending triangles often lead
to breakouts, in the direction of the trend.
Double tops and bottoms: The double tops is a pattern formed when prices rise to a resistance
level, falls, and then returns to the line at a lower volume level. A double top usually marks the
beginning of a downtrend. The phenomenon is the same for double tops, in reverse.
Statistic Tools
Simple moving average: The simple moving average (SMA) calculates the average currency value
over a select period of time (The previous 14-21 days are most common). The SMA eliminates the
noise of daily fluctuations, which makes price trends and reversals easier to identify.
Moving average convergence divergence (MACD): Is the average of two cycles, a short exponential
moving average and a long exponential moving average. The signal line represents the MACD over
Bollinger bands: Bollinger bands are two lines a standard deviation above and below the moving
average. The Bollinger bands adjust automatically to changes in volatility, moving closer to the
average during less volatile periods, further away during times of increased volatility. A tightening of
the bands indicates that volatility will probably begin to increase. If the moving average moves close
to the bottom Bollinger band it means the currency is being oversold, and overbought if it moves
close to the top band.
Fibonacci retracement: Traders who use the Fibonacci retracement method believe that support
and resistance levels can be found at key Fibonacci points. These points are located by sketching
trendlines at the two extreme levels, high and low, and then dividing the vertical difference by key
Fibonacci ratios—50%, 61.8% and 38.2%.
Gann fan: The Gann fan is a set of angles which define potential support and resistance point. The
ideal relationship between time and price would follow the 45% line from the center of the Gann fan.
In total there are eight lines extending from the base of the fan; after one line is broken, the next
becomes a new support/resistance barrier.
Momentum: momentum measures the rate at which prices are falling or rising. Speculators will take
a long/short position on a position exhibiting accelerated momentum, in the hope that it will continue
on its path. This is a short-term method of trading, and is quite risky.
Relative Strength Index (RSI): The RSI is calculated by averaging the highs of a certain time period,
averaging the lows, and then dividing the average high number by the average low number. This
relative strength is put into the RSI, producing an oscillator that measures price movements on a
scale between 0-100. When a price reaches the level of 30 or 70, it means it is being oversold or
overbought, respectively.
Stochastic oscillator: The Stochastic oscillator illustrates the current close relative to the high-low
range over a set period. The figures are plotted on a graph, with y axis values 0-100. If the
Stochastic meter dips beneath 20, the commodity is considered to be oversold, overbought if it
surges above 80.
