INTRODUCTION TO FOREX TECHNICAL ANALYSIS - LEARN HOW TO TRADE
Forex technical analysis is used by traders to analyse the markets to provide an understanding of historical data to produce entry points in the market.
Technical analysis is a key method of forecasting price movements, especially in the forex market. Whereas in the other markets, such as stock or futures, technical analysis isn’t used as much.
What is Technical Analysis?
The financial market is the place where traders around the world speculate on future price movements. Either using technical analysis or fundamental one, they all aim at identifying the next move in the market. And, with it, to make a profit.
Since the early 1970s, when the United States dropped the gold standard, the currency market emerged as the largest market in the world. Also known as Forex or foreign exchange, its size dwarfs any other market in comparison. Every day over five trillion worth of USD changes hands in the currency market.
Not everyone speculates, though, intending to make a profit. The enormity of the market is given by large international flows pouring out or into national foreign reserves, mergers and acquisitions, loans, to name a few.
But the 1970s brought something else too. The emergence of the Personal Computer (PC) made it simpler for traders to track historical prices.
Therefore, technical analysis (i.e., the art of forecasting future prices based on historical one) evolved from pen and paper charts to complex trend indicators and oscillators.
The Internet made things even more interesting. A simple Internet connection allows retail traders from literally any corner of the world to participate in market speculation.
As it turns out over ninety percent of traders use technical analysis to base their trading decisions. Hence, understanding Forex technical analysis is a must for anyone willing to take his/her chances in the trading arena.
Classic Technical Analysis Patterns
Classic technical analysis patterns, like the ones presented in this article, evolved in the Western world, mainly from stock market trading in the pre-1900’s era. They stood the test of time as traders documented the patterns and used them on any market.
In other parts of the world, like Japan, we can track technical analysis patterns all the way back to the 1700’s. The Japanese used candlesticks patterns to forecast future rice prices.
Besides the two approaches, trading theories do exist too. The Elliott Waves Theory, Gann, Drummond, point and figure, and so on, they all belong to technical analysis.
But no matter the type of the trader, one thing is mandatory: everyone should master the classic technical analysis patterns, especially traders involved in Forex trading. Together with Forex fundamental analysis, they offer an educated guess about where the prices might go next.
The Head and Shoulders Formation
One of the most common reversal patterns seen on daily Forex analysis, the head and shoulders formation has clear and simple trading rules.
- two shoulders (left and right)
- one head
- a neckline
- a measured move
The two shoulders represent consolidation areas, with the left shoulder’s price action misleading traders. The problem is that by the time the price breaks higher after the left shoulder’s consolidation, many traders consider the pattern a continuation one.
However, the break higher is quickly retraced, and another consolidation (on the right shoulder) starts. The quick retracement, or the head of the pattern, is the clue telling us that the market forms a head and shoulders pattern.
The neckline is a support level. Traders wait for the price to break below support, before entering on the short side and targeting the measured move.
Speaking of the measured move, that’s easy to compute: just measure the distance from the highest point in the head’s formation to the neckline and project it from the neckline. That’s the minimum distance the price should travel to confirm the reversal pattern.
As mentioned earlier, the head and shoulders pattern is a reversal one. Our example so far shows a bearish pattern, in the sense that it forms at the end of a bullish trend.
However, a similar pattern appears at the end of a bearish trend, having the same elements and trading rules.
The Trend is Your Friend – Using Channels to Ride Trends
Trends are one of the main reasons why traders use technical analysis. Strong trends are easy to ride and extremely rewarding.
Ascending or descending, bullish or bearish, channels have one thing in common: a series of higher highs and higher lows (bullish, or rising channel) and lower lows and lower highs (bearish or falling channel).
But channels do form on the horizontal too. Long, large consolidations form ahead of important market news, like the NFP (Non-Farm Payrolls) or a central bank interest rate decision.
Also called rectangle channel patterns, they mostly act as continuation patterns, with the breakout in the direction indicated by the price action prior to the channel’s formation.
Double Tops and Bottoms in Technical Analysis
Powerful reversal patterns, double tops, and bottoms reverse strong trends. As the name suggests, they mark a top or a bottom, with huge implications on the future price action.
We should mention here that double tops and bottoms in Forex technical analysis do not refer to an exact level. Because of large market volatility, traders refer to an area as the one that defines double and triple tops.
In any case, the way to interpret the two patterns is the same as in any other market. A double top:
forms at the end of a bullish trend
resembles the letter M
has a neckline and a measured move
For a double top formation, the measured move is the distance from the two tops to the neckline, just as illustrated in the image below.
A double bottom is similar, only that the interpretation differs:
it forms at the end of bearish trends
it has the shape of the letter W
has a neckline and a measured move
While not mandatory, the price tends to retest the neckline after the break. As such, many traders wait for such a retest before trading the measured move.
Triple Tops and Bottoms in Technical Analysis
Just like double tops and bottoms, triple tops and bottoms show reversal conditions. Moreover, the only difference between them and the double tops and bottoms is the fact that the market makes another attempt to the resistance or support area.
Therefore, a triple top pattern tries for three consecutive times to break resistance. Eventually, the price reverses and breaks the neckline.
A measured move exists in this case too. The distance from the pattern’s neckline to the resistance area is the target after the triple top ends.
A triple bottom, like the name suggests, tries for three consecutive times at the support level. By the time the third push lower fails, the price reverses and breaks the neckline’s resistance. Naturally, traders calculate the measured move in a similar way as in the case of a triple top.
As a tip when using triple tops and bottoms in technical analysis, consider that these patterns rarely hold. In fact, towards the end of the pattern, traders don’t know if the triple top or bottom will hold.
Most of the time, the price simply builds energy (consolidates) to break. What results is another classic technical analysis pattern, known by the name of ascending or descending triangle?
Ascending and Descending Triangles – Common Technical Analysis Patterns
A pattern is often seen in Forex technical analysis, an ascending or descending triangle breaks in the direction of the underlying trend. Therefore, such patterns show continuation conditions, not reversal ones.
For various reasons, the market takes its time and consolidates for a while. When this happens, the price simply consumes time, going nowhere, right in the middle of a trend.
It is common for such patterns to form during low-volatility market conditions. For instance, during the Asian session, when subdued price action affects volatility.
An ascending triangle forms around a horizontal level. Effectively, the price tries to push through the resistance area but fails multiple times.
One key element in finding an ascending triangle is the series of higher lows that the price forms. Namely, every pullback from the resistance area fails to break the previous higher low.
Such price action reflects the fact that the market builds energy to break higher. By the time the price overcomes resistance, many traders wait for a retest before trading in the direction of the underlying trend.
In sharp contrast, a descending triangle is bearish. The market finds temporary support before the downtrend resumes.
In this case, the critical element is given by the series of lower highs. The price fails to break the series, and every attempt builds energy for the horizontal support to give way.
Bullish and Bearish Flags – Powerful Forex Technical Analysis Continuation Patterns
Just like ascending and descending triangles, bullish and bearish flag show continuation conditions. However, there’s a difference.
While ascending and descending triangles form against horizontal levels, bullish and bearish flags correct the previous trend. In other words, the price makes a countertrend move, consolidating until the underlying trend resumes.
The two patterns have a price target given by the height of the flag pole. A regular trading plan using bullish and bearish flags has the following steps:
measure the length of the flag pole
project it from the upper/lower side of the flag to find the price target
have a stop-loss order at the lowest/highest point in the bullish/bearish flag formation
A similar pattern, the pennant is either bullish or bearish. However, a difference exists, in the way the price action takes shapes during the consolidation phase.
In this case, the price action takes the shape of a triangular pattern. Effectively, the market fails to break the series of lower highs and higher lows, pointing to an imminent break.
Pennants also have a measured move, given by the height of the pole too. Another distinction that can be made between the pennant and the flag is that the price action is more powerful during the pennant formation.
Put it more simply, the consolidation during the pennant’s formation takes less time than in the case of a bullish or bearish flag.
Symmetrical Triangles as Forex Technical Analysis Patterns
Speaking of triangles as consolidation patterns, they often appear in Forex technical analysis. In fact, it is literally impossible not to see a triangular pattern during the regular daily Forex analysis.
A symmetrical triangle is a pattern most likely to find during pennant formations. As indicated earlier, the inability of price to break the series of lower highs and higher lows leads to the inevitable breakout.
In the case of symmetrical triangles, their base acts as an indication of the derived price target. Therefore, traders measure the length of it (basically measured the length of the first segment in the triangular formation) and project it from the breakout point.
One important point to mention regarding all triangles relates to the Elliott Waves theory. Perhaps one of the most sophisticated trading theories, the Elliott Waves describes concrete steps and rules regarding triangular patterns.
Ralph Elliott noted that triangles are corrective patterns, labeled with letters: a-b-c-d-e. Furthermore, only when the price breaks the b-d trend line, the triangular pattern end. And, most of the time, depending on the type of the triangle, the b-d trendline is retested, making the retest a great place to enter the market.
The Cup and Handle Pattern
A curious pattern, the cup, and handle also show continuation conditions. It is an unusual pattern due to the rounding top or bottom it forms during the cup formation. For it to happen, the market forms tight ranges for quite a long time.
The price action during the handle formation follows the same characteristics as in the case of a bullish flag. Therefore, the focus sits with the breakout point, as traders enter on the long side when the trend line gives way.
Forex technical analysis is a vast subject, increasing in complexity by the day. Certain patterns, like the ones described in this article, stood the test of time as reliable ones to forecast future prices.
An approach using classic technical analysis patterns is called pattern recognition. It involves all the patterns described here.
However, pattern recognition is not the only area part of technical analysis. Trading theories, Japanese candlestick techniques, market geometry, etc., they all come to complete the vast subject of technical analysis.
The classic technical analysis patterns presented here are meant to build a solid base for any technical trader. Armed with this info, anyone can move to other technical analysis areas to complete their trading education.
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