Technical Analysis and its use in Forex Trading

We had earlier seen why it is necessary to analyze forex market movements and to use this information to predict future price trends.

We have also looked at the first major tool of market analysis known as fundamental analysis. Now we will consider the second major tool which is technical analysis.

Technical analysis is the process of forecasting the future trend of prices through the study of past market data principally volumes and prices. The oldest use of technical analysis is thought to be in the early 18th century by the Japanese rice trader Homma Munehisa and has today evolved into the charting technique known as candlesticks or Japanese candlesticks. Modern technical analysis is based on the Dow Theory formulated in the late 19th century by the co-founder of Dow Jones, Charles Dow.

Technical analysts concerned themselves with the use of charts and other tools to analyze the data on forex trading activity such as volumes and prices which can suggest how the market will move in the future. Unlike fundamental analysts, technicians or chartists concerned themselves exclusively with prices and volume data and make no attempt to ascertain whether an asset is over or undervalued. There are several schools of technical analysis some of which concern themselves solely with charts, others with indicators such as oscillators and still others that use a combination.

The three basic assumptions that underlie technical analysis are as follows:

#1) The market discounts everything. Some people puzzle why technical analysis ignores all the fundamental factors such as economic financial unions and focuses entirely on price. The explanation is that the price itself reflects every single important fundamental including market sentiment and by considering price they have automatically considering every single factor that moves the market. They therefore need to concentrate only on the analysis of price movements which is in effect a study of supply and demand.

#2) prices move only in patterns or trends. This means that once a trend pattern has been established, the market is more likely to move with the trend than against it. The trading strategies that many technical analysts use are based on identifying these trends and projecting the market movement accordingly.

#3) history repeats itself. Because traders in the market react in a similar fashion to market developments, their behavior can be consistently predicted and trends and patterns will repeat themselves time after time. In fact, some charts contain data that goes more than a hundred years back because they are believed to contain repetitive patterns that are still useful.

Technical analysis versus fundamental analysis: broadly speaking, fundamental analysis concerns itself with economic and financial fundamentals and attempts to establish whether the currency is overvalued or undervalued.  Believing that the situation will correct itself in due course, positions are established accordingly. This is why fundamental analysis is sometimes regarded as a value investment approach. On the other hand, technical analysis concerns itself with price movement only. To put it another way, fundamental analysis concerns itself with long-term data over the past few years while technical analysis is generally used for short-term trading and concerns itself with more short-term data.

Quite simply, as forex brokers will tell you, there is no such thing as a right or a wrong technique. Canny traders will use whatever information is to their advantage and not worry about being either fundamental or technical purists. For instance, many fundamental traders will use technical analysis to determine the timing of their entry into and exit from the forex market. Equally, many technicians will use fundamental factors to evaluate the accuracy of the predictions from the charts and indicators. What you should bear in mind is that there is no need to be dogmatic and you can mix and match the data to suit your personal investment style.