There are about as many ways to trade the forex market as there are traders in this world, so how do we make sense of which methods we should use and which ones we should stay away from? It can be quite confusing for beginners to even know where to start, so let’s start out by giving you the big picture.
Generally, analysis of the forex market, and any other financial market for that matter, can be divided into these three broad categories:
- Quantitative analysis: Predict future price movements by using mathematical and statistical modeling of past price movements to find repetitive patterns.
- Fundamental analysis: The study of what an asset should be worth based on underlying economic or financial conditions.
- Technical analysis: The study of price itself and how the market is responding to the underlying economic or financial conditions.
Each of these has its unique characteristics and avid followers. Some traders are experts in one area, and barely pay any attention to the others. Most professionals, however, have an understanding of all three: Quantitative, fundamental and technical analysis. It’s also important to note that although each of these has their own hardcore proponents, in reality they are just different ways of interpreting the same underlying market.
In this article, we will talk about the method most commonly used by retail forex traders: technical analysis.
In its essence, forex technical analysis is all about studying price itself, rather than what is driving the change in price. If, for example, the EUR/USD currency pair is trending up, you, as a technical trader will not start looking for reasons why it is doing so, such as interest rates in the countries or statements from the central bank. Instead, you will simply acknowledge that the market is trending up and if the chart otherwise meets your requirements for a trade, you will enter a position in the EUR/USD market.
Charts – visual representation of price action
As a technical analyst, you depend on charts showing past price action to make your trading decisions. There are many different things to look for in the charts before making your trades, with the most important being:
- Chart patterns – for example head & shoulder, cup with handle, etc. According to the theory, these patterns are supposed to give you an indication of where the price is headed next. However, keep in mind that they are not always easy to spot. When one trader sees a head & shoulder, another may see something completely different… Learning how to spot these takes practice and a good technical analysis education.
- Trend analysis – is the price showing signs of being in a steady uptrend or downtrend? Most traders prefer to take trades in the same direction as the underlying trend, but there are exceptions to this.
- Indicators – Ever heard of MACD, RSI or SMA? If not, maybe it’s time to study up! Most technical traders use at least a couple of technical indicators on their charts to help them make decisions. For example, the MACD and SMA could be combined to create a trading strategy to follow.
- Candlestick formations – Candlestick!? It may sound weird, but the most common way to represent price on charts is actually something called “Japanese candlesticks.” Some traders simply love candlesticks and will not even pay attention to anything else. But hey, if it works then there’s nothing wrong with that!
Although some traders stick to just one of these disciplines, most successful traders have learned to use them all in combination with each other. Combining them and relying on input from more than one before making a trade, dramatically increases your chance of being right. In trading it is called confluence when two or more of these are indicating that you should take your position, and it is one of the most reliable indications we can get. You can also combine several of them to create your own forex technical analysis strategies.
Benefits of using Technical Analysis
- Less input data is required. Price is the only data required to make trading decisions.
- You don’t need to worry about not getting the news fast enough, or not knowing “everything” there is to know about why an asset is moving.
- Timing your trades is easier than with fundamental analysis because you rely on quantifiable data and objective price action to make decisions.
- Many traders find it easier to master than traditional fundamental analysis. The way to measure if you master it is if you are profitable or not. After all, it doesn’t matter how much you know about interest rates or central bank policies if you can’t make money from it in the markets.
Technical traders and the forex market
Purely technical traders do not take into account any fundamentals or news that might impact the price of the asset they are trading. If in any way they are following the news, it is usually so they can be sure to stay away from the market during the time when important news is released.