Forex technical analysis has certain characteristics and benefits that make it as important as other types of analysis in forex trading. If you are a beginner, here is the complete guide of technical analysis.
Technical analysis is a way to analyze the market fluctuations of investment prices using statistical tools such as graphs and mathematics formulas. The aim is for letting the trader get a description of the market condition at the moment based on the price history in the past. It is also for giving the picture or prediction about the market fluctuation in the future.
Previously, a trader did the calculation by combining the graphs and mathematics formula manually, but nowadays the technical analysis can be done much easier. In general, the trading online platform has been completed with the feature for showing the price fluctuation in various graphs, as well as the technical indicators for analyzing tool assistance.
Table of Contents
- The Basic Principle
- The Components
- The Differences with Fundamental Analysis
- The Comparison with Fundamental Analysis
- Understanding Technical Indicators
- Choosing the Best Technical Indicators
- Building a Trading System
The Technical Analysis Basic Principle
The technical analysis is one of the two types of Forex analysis which is used generally by the trader. The other analysis is a fundamental analysis that analyzes a value of a certain currency based on the economic condition of the native country, the financial market situation, or the news and rumors that have been spread. Different from fundamental analysis, technical analysis is based on these three principles:
1. Market Price Discounts Everything
The price shown on the graph or chart has described the factors that influence the market.
2. Price Moves in Trend
The price doesn't fluctuate randomly. It always forms a certain pattern or trend which will continue changing until the signs to stop the pattern coming. That's the time when the existing trend is replaced by the new one.
3. History Repeats Itself
There is a strong tendency that the market trader behavior today has the same reaction as the market trader in the past. They have the same idea to overcome the various information which influences the market, so the fluctuation motive that has ever happened will happen over and over again.
Technical Analysis Components
Technical analysis consists of some important components. These components must be known by all Forex traders.
1. Price Chart
The price chart shows the value of two currencies conversion and keeps fluctuating from time to time. There are three models of price charts which are generally used in technical analysis, they are the Line Chart, Bar Chart, and Candlestick Chart. Among the three, the most popular one in Indonesia is a candlestick chart as seen below.
2. Technical Indicators
In order to show the price fluctuation which is shown by the charts, we need technical indicators. There are many kinds of technical indicators. However, they all have the same objective to help traders get some perspectives on the price fluctuation at the moment. Therefore, they can get a picture or prediction about the price fluctuation in the future.
Due to the various types of technical indicators in the world, even until hundreds, it makes every trader can use the different indicators. However, there are some indicators of which are generally used such as Moving Average (MA) and Relative Strength Index (RSI). The example is on the chart below, the chart of GBP-USD that uses the technical indicator of MA and RSI.
From the technical indicator condition above, we can understand that the price for GBP-USD is experiencing bearish or the price trend is declining. It means the trader has an opportunity to 'sell'. It is because the price movement is under the MA line. Meanwhile, the RSI declines, too, but not yet reaching 30.0. Next time, if the RSI reaches 30.0, it means the opportunity for traders to 'buy’.
3. Technical Analysis Methods or Techniques
The combination of MA and RSI is for determining the trades. It becomes a part of analysis techniques or methods, based on one indicator, various indicators, or combining several special techniques such as Fibonacci, Retracement and Reversal, Elliott Wave, and others.
The Differences Between Technical Analysis and Fundamental Analysis
As the foundations of Forex analysis, technical and fundamental methods have different characteristics as follows:
- It needs a lot of data to support prediction accuracy.
- Its advantages depend on the trader's skill in reading graphs, applying indicators, and practicing the analysis technique.
- It can be applied to short and long term trading.
- It needs some time to get information from the updated economic data or rumor. An individual trader will find it difficult to get those kinds of information.
- It is subjective because it involves many people's opinions. One trader might consider the economic data is good, but the others might think it's not good.
- It is good to be applied in the middle and long term teaching.
After knowing the characteristics, it is better for beginners to know the comparison of these two techniques in real life.
The Comparison Between Technical and Fundamental Analysis
In analyzing the price fluctuation, Forex traders usually apply two kinds of analysis. The traders who concentrate on the price fluctuation line on the chart and ignore the other factors are the people working on the technical analysis. They are called a 'chartist' or a 'technician'. On the other side, the people who prioritize more on the news and important events that can affect price fluctuation are the ones working on fundamental analysis. They are called a 'fundamentalist'. To get a better knowledge of these two techniques, let's check the comparison and benefits as follows.
See also: Fundamentalist and Technicalist
Technical Analysis and the Benefits
This technique is a new knowledge in the trading world which depends on the chart trading reading. It has three basic principles:
- A trading chart is a picture of all of the aspects causing the price fluctuation. All of the effects causing the fluctuation, including the fundamental factor, are shown on the trading chart.
- The price fluctuation is not random, but it is organized depending on a certain pattern or formula which can be counted and predicted.
- The trend of price fluctuation direction will always be repeated by itself. In other words, the price fluctuation now can be used to predict the next fluctuation.
The technical analysis is simple, direct, and clear. Therefore, it is very popular and is used by almost the whole Forex traders, ranging from the top hedge fund manager until the retail trader. Besides, the technical analysis indicator is relatively easier and can be understood faster than the fundamental indicator.
A true chartist or technician will only refer to the price fluctuation on the chart and ignore the fundamental factors. In its development, many new technical indicators are developed. Although some conflicts might happen on the indicators, the technical analysis can be still very effectively used by the technician expert.
In real trading nowadays, many traders combine technical and fundamental analysis at once. To know the possibilities of the price fluctuation, they refer to the fundamental factors (especially for middle and long term). Meanwhile, for determining the entry and exit momentum, they refer to the signals shown on the technical indicators.
Fundamental Analysis and the Benefits
Fundamental analysis is a knowledge which studies the market price fluctuation relation with the economic fundamental condition changes in a country. For the wider scope, the fundamental analysis does not only focus on the fundamental data release or the important events at some moment, but it also focuses on the various aspects influencing the regional economy. They include political issues, financial system regulation, social effects, and other aspects of society. In reality, the fundamental analysis comes with many indicators compared to the technical analysis indicator.
For the fundamentalist trader, the ability for identifying the unbalanced supply and demand in the Forex market due to the economic data changes might produce sufficient profit, especially in the long term trading. Nevertheless, traders will find difficulties to correct the price fluctuation at some moment and trend reversal. Due to the less attention to the trading chart, the price level limits (support or resistance) usually will be determined only based on the estimation or psychological number only.
The benefits of fundamental analysis are our knowledge as a trader is much deeper relating to the market price fluctuation. This knowledge is important especially for the long term traders who tend to maintain their position in a long period. By understanding the market dynamics, a long-term trader will be more confident to maintain his position despite the changing market volatility.
Since the technical analysis is now mostly used, it is better to know further about the technical analysis indicators. It is because it has various types and their own purpose in mapping the market condition today. It also predicts the price fluctuations in the future based on the charts. The indicators can be used by the traders for analyzing the market.
What is a Technical Indicator?
A technical indicator is a tool made based on the mathematical calculation of price, volume, or market passion towards an investment instrument or financial contract. By applying the technical indicator on the price history data, the traders can use them to map today's market condition. They also can use the indicators for predicting the next fluctuation in technical analysis. The indicator examples are Stochastics, Relative Strength Index (RSI), Bollinger Bands, and so forth.
Forex analysis uses the technical indicator which focuses on the price history data, by ignoring the fundamental factors which influence the price. The technical indicators are usually used by the daily trader for trading stocks, Forex, and commodities. It is because the indicators are designed to analyze the short term price fluctuation. Nevertheless, the middle and long term trader who focuses on the fundamental analysis can also use the technical indicators for identifying the best moments for doing transaction 'buy' or 'sell'.
The Technical Indicators Types
Actually there are tens of technical indicators all over the world. Every mathematician, statistic expert, and other experts who understand the financial market can create their own indicators. So, if the technical indicator shows pretty high accuracy and is favorited by other traders, it will be used widely by other traders in the world. However, generally, viewed from the layout, the technical indicators can be divided in two types: Overlay and Oscillator.
The Overlay technical indicator is usually in the form of charts or graphs which are applied by putting them over the price chart. The most popular indicators are:
- Moving Averages (MA)
- Parabolic SAR
- Bollinger Bands (BB)
- Ichimoku Kinko Hyo
The Overlay indicator can be seen on the EUR/USD chart with Bollinger Bands below. The candlestick chart represents the price fluctuation, while the line chart represents the Bollinger Bands layout.
The Oscillator technical indicator usually shows a certain minimum and maximum values which appear under the price chart. Besides, compared to the Overlay indicator which calculates more on the price data, the indicators in the Oscillator type also calculate the trading volume fluctuations on an instrument. The most popular indicators are:
- Relative Strength Index (RS))
- Moving Average Convergence Divergence (MACD)
- Money Flow Index
- Stochastic Oscillator
The example of the Oscillator indicator on RSI can be seen below under the chart of EUR/USD.
3 Tips on Deciding the Best Technical Indicators
A Forex beginning trader usually learns each indicator one by one, then deciding which one is the most convenient and beneficial for daily usage. However, a trader often uses more than one technical indicator for analyzing the price fluctuations on an instrument. The important thing is to pay attention to the following three tips in deciding the technical indicators.
1. Adjust the Parameter Setting of the Technical Indicator
If we set the technical indicator which is built-in on the trading platform, such as Metatrader, it must have the default setting. However, a trader still can change the parameter in the setting.
For instance, the use of Moving Average which is applied by a trader based on the Close price, High price, or others. The Moving Average itself is calculated based on the price average, so the period can also be adjusted by himself, for example, MA-50 Day (the average is the last 50), MA-100, MA-200, and others.
2. Combining the Technical Indicators Based on Each Function
The combination of the two technical indicators or more for analyzing the prices of an instrument must be based on each indicator function. However, make sure not to attach to many indicators on the chart until it's hard to read clearly.
3. Never Try on a Real Account
The last tip is not to use a real account if you still learn and try some indicators. Use a demo account which enables us to practice in the real market condition without any risks. In the demo account, you will only use virtual funds provided by the broker. Therefore, you are free to do try out as many indicators as you want, with whatever setting or combination that you are curious to explore.
Building Your Own Trading System
For building a good trading system, we need some patience. But if it's built well, it will run very well, too. Building a trading system actually it's not really hard and long. The longer process is trial and error to find better treatment until finding the best and suitable trading system for you. Building a good trading system needs around a month or two. However, if the system has been built well, your patience will be worthwhile.
There are many articles selling a system, but it's better to create your own. Here are the steps which need to be followed for v developing a good system.
1. Create a Time Frame
Some things that you need to decide very first is what type of trading you want to have. Do you want to have a day-trader or a swing-trader account? By knowing the trading for you b want, it will be easier for you to design the time frame which will be used in the reading system.
2. Find an Indicator to Identify a Trend
The purpose is to identify a trend as early as possible. Therefore, we must use indicators that can research the purpose. One of the suitable indicators is Moving Averages, which is commonly used for identifying a trend.
3. Find an Indicator to Confirm a Trend
There are many indicators that can be used today, such as RSI, MACD (Moving Average Convergence Divergence), or Stochastic. Try some indicators and choose the best one which fits your characteristics.
4. Determine the Risk that You're Ready to Take
In building the trading system, you need to determine how big is the loss risk that you can handle for every transaction. Also, you need to calculate the maximum of loss risk that you may experience in one day.
5. Decide When You Enter and Exit a Trade
There is a trader who likes to do a transaction as early as possible, for example, a transaction when the trend signals have been confirmed. On the other hand, there is a trader who likes to wait some time for ensuring the trend manually. In other words, there is an aggressive trader and a play-safe trader.
See also: All About Forex Entry and Exit Strategy
6. Try to Apply the System
The last thing to do is applying. It needs discipline and patience. You will need time to adapt and master a certain trading system, especially in doing real trading. Finally, being a Forex beginner indeed needs special knowledge and skills. But once you master it, you will be the expert of your own trading system and gain a lot of profit and bonus.