The value of technical analysis is a source of great debate in economic circles; nonetheless, the majority of FX traders swear by it. Wherever you stand, FXTM’s Ben Lovell-Viggers takes you through the five technical analysis tools that every trader should have in their locker.
Ben Lovell-Viggers, FXTM
Despite what Hollywood might have you believe, investment decisions are rarely governed by instinct or impulse. In reality, successful traders employ a variety of analytical methods to inform their trades. These methods can be roughly divided into two disciplines: fundamental analysis and technical analysis. Fundamental analysis involves looking through the various economic, political and social factors that can affect a currency’s value, while technical analysis focuses entirely on statistics to determine price movements. Technical analysis is an integral part of trading Forex, as it gives clearer indication of short-term price movements than fundamental analysis generally can.
The value of technical analysis is a source of great debate in economic circles; nonetheless, the majority of FX traders swear by it. Wherever you stand, FXTM’s Ben Lovell-Viggers takes you through the five technical analysis tools that every trader should have in their locker.
Japanese Candlesticks
Candlestick charting was invented in 18th century Japan by a rice trader called Munehisa Homma. Aware that the price of securities was influenced by more than just supply and demand, Homma developed a pictorial way of representing market sentiment. Using a simple, hollow candlestick shape, information such as market direction, sentiment and pricing extremes can be easily read and interpreted. Trading’s first technical analysis tool reportedly allowed Homma to conduct one hundred profitable trades in a row, although Western traders had to wait until the late 1980s (when the method was popularised by Steve Nison) to try and match this record. Surely the biggest testament to the effectiveness of Japanese Candlesticks is their continued use over more than 300 years.
Relative Strength Index (RSI)
Next up is Relative Strength Index, or RSI. One of the most venerable and trusted indicators in a trader’s toolkit, RSI was developed in 1978 by J. Welles Wilder Jr. – the godfather of technical analysis. It determines whether a security is experiencing more buying or selling pressure by measuring its momentum (the rate at which a price rises or falls). In turn, this indicates whether the asset is ‘overbought’ or ‘oversold’.
RSI is usually measured over a fortnight on a scale of 0-100. Any reading above 70 is considered overbought – a signal for traders to start offloading the asset. Measurements under 30 are oversold, indicating that the security is ripe for the taking. Traders value RSI for its unparalleled ability to measure price movement through changes in momentum – take a leaf out of their book and add it to your arsenal.
Moving Average (MA)
Moving Averages are a range of useful tools commonly employed by traders. They are used to filter out the volatility, or noise, of random fluctuations in a price chart. This makes it considerably easier for traders to identify a security’s price trend, as well as any potential changes to that trend. MAs are pretty straightforward – simply add an asset’s closing price for a number of time periods, then divide by the number of time periods to calculate the moving average.
An advantage of MAs is their ability to identify uptrends and downtrends. This is done by comparing MAs that cover different time frames – if the short-term MA is higher than the long-term average, an uptrend is indicated, and vice versa. Examples of Moving Averages include Simple Moving Averages (SMAs), Exponential Moving Averages (EMAs) and Weighted Moving Averages (WMAs).
Fibonacci Retracement
Fibonacci Retracement is a popular, if controversial, method of technical analysis that has its roots in the genesis of western mathematics. It’s based on the so-called ‘Golden Ratio’ of 0.618 (also known as Phi), a number derived from the differences between integers in a Fibonacci Sequence. Fibonacci Retracement involves tracing the distance between an asset’s high and low. This vertical distance between the two is then divided using the key Fibonacci ratios of 23.6%, 38.2%, 61.8% and 100%, allowing traders to determine the asset’s support and resistance levels. Unlike Moving Averages or Oscillators, Fibonacci Retracement levels are entirely static and therefore quick and easy to interpret. This makes them popular in markets that require traders to react and make decisions extremely swiftly, such as Foreign Exchange.
Bollinger Bands
Named for their inventor John Bollinger, Bollinger Bands are an indicator of volatility that takes the form of a Simple Moving Average flanked on either side by price bands. Bollinger Bands are prized for the way in which they represent different levels of volatility, helping traders identify potential trading opportunities. Periods of low volatility are signaled when the central SMA is ‘squeezed’ by the adjacent trading bands; distant bands indicate high volatility. Many traders believe that low volatility conditions precede periods of high volatility; however, it’s important to understand that Bollinger Bands do not predict the direction or extent of price changes and should therefore not be used as trading signals.
These five examples represent some of the most popular and widely used technical analysis tools; however, there are hundreds more, each with their own applications, benefits and drawbacks. For a more detailed exploration of the complex world of technical analysis, visit FXTM’s education hub. You’ll find a comprehensive depository of articles, videos and online tutorials that cover everything from analytical tools to the strategies that use them, developed and curated by FXTM’s Head of Education, Certified Technical Analyst Andreas Thalassinos.
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