Technical analysis is a graphical strategic tool that helps forex traders identify price trends and patterns by examining the past price movements of the currency pairs and market statistics. Forex traders largely rely on technical analysis tools as they help them make quick trading decisions in the market.
There is a popular saying “History repeats itself”. Technical analysis works on the same theory that markets move in repeatable and quantifiable patterns and it is necessary to identify those to predict the future price movements of the financial assets.
Quick insights
Top 10 forex technical analysis tools
Technical analysis is commonly used in forex markets because they have trading platforms with advanced graphical tools. Hence, forex markets are said to be well suited to using technical analysis.
The base of technical analysis is the graphical chart where the historical prices of the currency pairs are plotted along with other factors in detail. You can choose a time frame for trading based on your strategy and the currency pair’s trend. The time frames can be long-term, short-term, or intermediate-term. For example, if a trader wants to take an intra-day position, he prefers to check the hourly and minute charts.
Technical indicators are categorized broadly into two parts. Leading indicators and lagging indicators. As the name implies, leading indicators tend to look forward to support future predictions whereas lagging indicators rely largely on the past price actions of the currency prices.
Moving averages
The moving average represents the average of all closing prices of a currency pair for a specific period of time. A moving average curve is made by averaging closing prices on a price chart. This helps to determine if the current currency price is trading above or below the curve.
When the price trades above the moving average curve, it denotes an accumulation of the currency. When the price trades below the moving average curve, it denotes short positions dominating in the currency pair. Traders make use of buying and selling indications using the moving average curve to make trading decisions.
Simply put, moving averages help traders to identify the direction of the trend. Traders use moving averages for multiple time-frames to get a clear picture of the currency price trends.
For example, short and long-term moving averages can be plotted in a single price chart for comparison. If the short-term MA curve crosses above the long-term MA curve the trend is said to be bullish and signals a buying opportunity.
The types of moving averages are:
- Simple moving averages
- Exponential moving averages
- Moving Average Convergence & Divergence (MACD)
Relative strength index – RSI
RSI is a very common technical analysis indicator among forex traders as it is used for more than one purpose. RSI is plotted with recent price gains vs recent price losses below the currency price chart and it moves between 0 and 100. RSI generally helps in gauging the momentum and strength of the underlying trend.
RSI is also largely used by forex traders to identify overbought and oversold levels of the currency prices. When RSI crosses above 70, it indicates the currency pair is overbought and potential trend correction is impending. Traders may exit their long positions or open a near-term short position at this level.
Similarly, when RSI falls below 30, it indicates the currency pair is oversold and an upward correction is likely. Traders may exit their short positions or open a near-term long position at this level. RSIs are generally used for short-term views only and do not support long-term trading decisions.
Stochastic oscillator
The stochastic oscillator compares the current trading price of the currency pair to the price range of the number of periods. The stochastic oscillator is plotted between 0 and 100. The background theory of this indicator is, that when the trend is upward the price makes new highs and when the trend is downward the price makes new lows.
Stochastic tends to move up and down quickly from 0 to 100 by showing the overbought and oversold levels. Stochastic indication levels above 80 represent overbought and below 20 represent oversold.
When a currency pair is in an uptrend and the stochastic indicator crosses below 20 levels, it clearly denotes that the correction in the uptrend has ended and the price is about to resume its uptrend from the current level. Traders initiate fresh long positions at this level or add more to their long position in expectation of a continuation of the uptrend.
Bollinger bands
Bollinger bands are one of the most frequently used indicators in forex trading. By showing how volatile the market is Bollinger bands help the forex traders to determine the entry and exit points of their trade.
There are 3 parts in Bollinger bands namely upper bands, middle bands, and lower bands. These bands enable the forex investors to find the overbought and oversold price levels. The best part of Bollinger bands is they help in characterizing both price and volatility over time.
The upper and lower bands of the Bollinger bands act as a resistance and support level of the currency pair price. The band acts as a channel along the price movement so that when the currency price hits the upper band it denotes the overbought and when the currency price hits the lower band it denotes the oversold condition.
Pivot points
Pivot points help the forex traders to find the upcoming support and resistance levels of the currency prices. The average of the previous session’s highest, lowest, and closing prices are plotted in the price chart with a label P. The resistance levels R1, R2, R3, and R4 are marked above the P and the support levels S1, S2, S3, and S4 are marked below the P.
The market is said to be bullish when the currency price trades above P and it is said to be bearish when the currency price trades below P. S and R levels indicate the future support and resistance levels respectively.
When the currency price level crosses above the pivot points, it indicates higher demand for the currency pair and when the price falls below the pivot points, it indicates lower demand for the currency pair.
Fibonacci retracements
Fibonacci is also a very common and popular tool that allows forex traders to determine the direction of the market and trend reversals. This tool works in the back of the theory when a currency pair reverses its trend, it retraces at least a certain percentage of the previous trend.
A trendline is drawn connecting the recent high and the recent low of the trend. There are numerous trading software that come with an automatic Fibonacci tool to identify the points. When the currency price touches the fibonacci ratio, traders can go long or short. The support and resistance levels help the traders decide where to apply stop and limit orders.
Average true range – ATR
The average true range tells us how long the current trend can sustain. A rising ATR indicates high volatility in the market and a falling ATR indicates consolidation in the market. Currency pairs usually don’t move much during consolidation and hence forex traders can modify their trading strategy accordingly.
Using ATRs, forex traders easily find the key exit and entry points for their trade.
Parabolic SAR
Parabolic SAR intends to give forex traders clarity on the direction of the forex market and also give entry and exit points for their trades. It is very essential to look for the signal of trend reversals to exit at the right time and the parabolic indicator sheds light on that aspect.
SAR stands for Stop And Reverse, which indicates entry and exit points. Using this indicator, forex traders can determine the short-term momentum of the trend and decide where to place stop and limit orders at the SAR value. When the currency price crosses above the SAR value, it indicates a trend reversal and traders exit their long positions.
Ichimoku
Ichimoku indicator highlights and provides higher probability trades in the forex market. Ichimoku interpretation involves more data points than the others and it represents both current and past price actions. This indicator always emphasizes trading in line with the underlying trend thereby helping traders to avoid trading in the opposite direction.
Ichimoku helps forex traders to limit the losses of trading, however, forex still involves potential loss. It gives the traders reliable support and resistance levels and determines the strength of the current trend.
Donchian Channel
Donchain channel indicator enables forex traders to measure the relative volatility of the currency prices and potential breakout points.
Conclusion
There are risks associated with forex trading and hence strategic planning is essential before initiating a position on either side.Foreign exchange is a high-risk trading platform due to its volatile nature and the numerous macroeconomic factors influencing the market movement.
Having said that, forex traders and investors need more than fundamental analysis and that is how technical analysis enters.
Being an endowment for forex traders, technical analysis provides numerous charting tools and indicators to help traders minimize their losses in forex trading, and yet it still works successfully.
Pro Tip
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