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Education / Technical Analysis

Technical Analysis

An investigation of the role of technical analysis in Forex

Technical analysis is one of the most powerful instruments of forecasting financial markets. It is a method of predicting movements for various financial instruments such as stocks, bonds, currencies, indexes, futures and precious metals. This analysis is based on studying the graphs of previous price movements, in order to predict possible movements in the future by looking at different trading variables. Understanding the advantages and limitations of a technical analysis gives you a set of skills and tools which enables you to become a better trader.

One of the oldest and most famous methods of technical analysis is the Dow Theory which describes stock prices behaviour through time. The theory is based on a series of editorials by Charles Henry Dow who was an American journalist, the first editor of the “Wall Street Journal” and a co-founder of the “Dow Jones and Co” company. Following Charles Dow’s death, the theory was summarized by William P. Hamilton, Charles Rhea and George Schaefer, and was named the “Dow Theory”.

Six Dow Theory postulates:

According to the Dow Theory, there are three trend types: primary (or long-term), secondary (or intermediate) and minor (or short-term)

In the case of an ascending primary trend the market is called “bullish”, and in the case of a descending one – “bearish”. A primary trend is divided into three stages (phases): an accumulation phase, a public participation phase, and a distribution phase. The most speculative traders open new positions at the accumulation stage. At the public participation phase, the most market participants “see” the current movement and rush to use it. Finally, at the distribution phase the most perceptive traders take profit and close their positions, while the trading activity generally reduces and the market falls. The secondary trend is a correction to the primary one, and it can reduce the price change achieved during the primary trend by one third, a half or two thirds.

The graph illustrates an example of a trend reversal in a bearish currency market. The signals to buy appear in points A and B, where the price is above the previous high.

Each primary trend has three phases 

The Dow Theory affirms that each primary trend consists of three phases: an accumulation phase, a public participation phase, and a distribution phase. During the first phase the most perceptive investors start buying (selling) stocks against the general opinion of the market. This phase is not accompanied by sharp price changes since the amount of such investors is quite low. At some point, a part of the market catches the new trend, and the perceptive investors are followed by active traders using technical analysis. This phase is accompanied by sharp price movements. During the third phase the whole market detects the new trend, and volatility starts. At this moment the perceptive investors start to take profit and close positions. 

The market takes all news into account 

Stock prices react quickly to any new information. This reflects not only to financial and economic indicators, but also to any news in general. This affirmation of the Dow Theory correlates well with the efficient market hypothesis.  

Stock indexes should confirm each other 

This affirmation relates to the Dow Jones' Industrial Index and the Dow Jones Rail Index (now Transportation Index). According to the Dow Theory, the current trend and the signals of a trend change must be confirmed by both indexes. However, some discrepancy in the time of signals is acceptable; for example one of the indexes may give a signal of a trend change earlier than the other.  

Trends are supported by trade volume 

Dow believed that trade volume should be considered in a trend detection. Change of stock prices at a low trade volume can be explained by different reasons and does not characterize the current trend. However, if the price changed in the midst of high trade volume, this reflects the “real” opinion of the market and characterizes the current trend development or a new trend.

A trend remains in force until a clear signal of its end 

This affirmation should be perceived in the following way: a trend tends to continue, and price changes against the trend in case of uncertainty should be interpreted as a temporary correction, but not a trend reversal. 

The cyclical changing of currency prices denotes the tendency of events in the market to be periodically repeated approximately at the same time, and this is an important substantiation of the Dow Theory.

Resistance and support lines

The price of a financial instrument (currency pair, stock index or security) can be pictured as the result of a battle between the bulls (buyers) and bears (sellers). The bulls push the prices upwards, buying, in hope of the price growth in the nearest future or in a long term perspective; the bears act vice versa – they sell, considering that the price is going to fall. The real price direction shows whose side wins.

Support levels show the price at which most investors expect it to fall; resistance levels show the price at which most investors consider that it is going to rise to. However, in the course of time investors’ expectations change!

Plotting resistance and support lines

Plotting resistance and support lines on graphs are considered to be the main elements of technical analysis.

In order to plot a support line (support level) you should join the essential common lows on the graph. Based on the definition of the trend line, you can assume that during price falls, the demand in the market starts growing at some point, and the price reaches the support line and starts growing (reverses).

Accordingly, for plotting a resistance line (resistance level) you need to join the essential common highs on the graph with a tentative line. During the price growth in a bullish trend a reduction of demand occurs at some moment, and this is reflected in the price reaching the resistance line and starting to fall or stopping its growth.

Thus, plotting tentative support and resistance lines often helps answer the question: what are the characteristics of the current trend and what is the direction of its primary movement.

If the resistance level gets broken through, it becomes the support level. With the same logic, a broken through support level becomes the resistance level.

Technical analysis specialists believe that when the price reaches the support or resistance levels, a strengthening of the relevant trend follows inevitably: the prices either continue increasing or decreasing until they come across new support and resistance levels accordingly. A breakthrough of these levels usually has high psychological impact on the market participants, and stocks (orders) sell-off or buying begins. Round prices are often more important psychologically, and they are oriented in technical forecasts.

Supply and demand

There is nothing mysterious in the support and resistance phenomena: this is a classical reflection of supply and demand. These lines show what the supply and demand will be at a given price.

The supply line shows the volume of a financial instrument that the sellers are ready to supply at this price. At growing prices the amount of sellers grows, as there are more people wishing to sell at a higher price. The demand line shows the volume of a financial instrument that the buyers are ready to acquire at this price. At growing prices the amount of buyers reduces, as there are fewer people wishing to buy at higher prices.

At any price the supply/demand graph shows how many sellers and buyers there are in place in the market. In the free market these lines, are constantly shifting. When investors’ expectations change, the prices that buyers and sellers demand also change. A breakthrough of the resistance level indicates the demand line shifting upwards which reflects the growth of the amount of those who wish to buy at higher prices. With the same logic, a breakthrough of the support line means the supply line is shifting downwards.

Supply and demand concept forms the basis of the most technical analysis instruments. Financial instruments rates charts will demonstrate the effect of these factors.

Traders’ remorse

After a breakthrough of the support/resistance level traders frequently start wondering if the new prices correspond to reality. Thus, if after a breakthrough of the resistance level buyers and sellers question the justification of the new price, they will start selling. As a result, so-called “traders’ remorse” will occur and therefore, after the break through the prices will return to the support/resistance level.

The price dynamics after the “remorse” period is of crucial importance. One of the two is possible: either the traders will agree in their expectations that the new price is unjustified, and then it will return to the previous level; or the traders will accept the new price — then it will continue its movement towards break through.

In the first case, for example when after the “remorse” traders arrive at the opinion about the inconsistency of the higher price, a typical “bull trap” (or false break) occurs. For instance, the prices broke through the resistance at a certain level (tempting a herd of bulls hoping for the growth to continue), and then again fell below the resistance line, leaving the bulls with overpriced financial instruments. A trap for bears appears according to a similar psychological scheme. The prices stay below the broken through support for quite a long time in order to convince the bears in the possibility of selling. However, they rise again above the support level, and the bears stay out of bounds.

In the second case, the mentality of the “remorse” traders can change, and the new price will be accepted. Then, the prices will continue moving in the break through direction.

The traders’ expectations after breakthrough are subject to quantitative evaluation through the trade volume that was accompanying it. If the prices broke through the support/resistance level at a significant growth of trade volume (as it is comparatively low in the "remorse" period), this means that the new expectations were shared by the majority (and the remorse are in the minority). And vice versa: a breakthrough at moderate volume and “remorse” at growing volume means that the changes in expectations were insignificant and the return to the initial expectations, for example the initial prices, is inevitable.

Resistance becomes support

If the resistance level gets broken through, it becomes the support level. With the same logic, a broken through support level becomes the resistance level.

The reason for this is the appearance of a new “generation” of bulls who refused to buy when the prices were low. Now, they start to buy actively in any return of the prices to the previous level. With the same logic, when prices fall below the support level, it often becomes the resistance which is difficult to break . As the prices approach the previous support line, investors start selling by trying to limit their losses.

Japanese candlesticks

Japanese candlesticks is a type of graph used to reflect the price changes of stocks, currencies, commodities, etc. It was firstly used by the Japanese to reflect the rice price movements. Japanese traders considered that four price levels were the most important during the day: the open and close price – this change reflects the intraday upward or downward trend and also the highest and the lowest price during the day.

A “candlestick” consists of a black (red) or white (green) body and an upper/lower shadow (wick). The upper and lower levels of the shadow reflect the price high and low during the underlying period. The boundaries of the body reflect the open and close prices.

Generally, If there is an increase in the price, the body is painted in green; the lower boundary level of the body reflects the open price, and the upper one – the close price; such a candlestick is called a “bullish candlestick”. If there is a decrease in the price, then the body is painted in red; the upper boundary level of the body reflects the open price, and the lower one - the close price. Such a candlestick is called a “bearish candlestick”.

It is considered that this type of charting has been developed by the legendary Japanese rice trader Homma Munehisa in the 18th century.

«Japanese candlesticks» are very popular due to the simplicity of the information representation and the easiness of reading. Starting in the 17th century, a lot of people were trying to develop various schemes and graphs to help predict the market behaviour in the future. This method proved to be the most interesting, as in one element which managed to reflect four figures at once (open price, close price, high price, low price) instead of one. The Japanese rice traders quickly realized that the graphs plotted with use of Homma’s “candlesticks” could help predict the future demand and price movements with quite a high degree of probability. Various combinations of Japanese candlesticks have been distinguished, that help to draw a conclusion whether a trend reversal is going to happen in the market, or the trend continues, and to forecast the price movements. The market analysis and forecasting the price movements with use of candlesticks combinations are called candlestick analysis. Amazing but true fact, over 300 years have passed, and these models work even in the modern financial markets.

The candlestick analysis gives the most accurate results in one hour to one month timeframes.

Trend indicators and oscillators

The technical analysis instruments called trend indicators and oscillators are a result of mathematical treatment of time-averaged prices.

Oscillators (Lat. oscillo – I swing) are a group of technical analysis indicators that characterize the market overbought or oversold conditions.

These indicators are efficient in a side trend when prices move within the bounds of a relatively narrow market corridor.

RSI (Relative Strength Index) correlates the relative strength of directional price movements within a certain timeframe.

RSI is mostly used as an indicator of an overbought/oversold market, and as an instrument of detecting divergence/convergence.

Divergence/convergence at which the price reaches a new high (low), but the RSI does not overcome the previous high (low), shows possible price trend reversal. If RSI then turns down (up) and falls lower (rises higher) its previous low (high), then it finishes the so-called “failure swing”. This signal is a confirmation of an approaching trend reversal.

When RSI approaches the upper boundary of its range (for example rises above 70) or the lower boundary (for example falls below 30), either a reversal or a temporary consolidation is possible in the market.

Stochastic oscillator describes the position of the current price of a financial instrument with regards to the price range in a certain time period.

The application of stochastic oscillator is similar to the application of RSI.

If oversold (below 20), especially with convergence, the faster line %К crosses the slower %D from the bottom upwards, this is a signal to buy.

If overbought (above 80), especially with divergence, the faster line %К crosses the slower %D from the top downwards, this is a signal to sell.

Moving Average (MA) is a simple and reliable indicator, helping to define short-, mid- and long-term trends.

Moving average belongs to the trend indicators class which helps to define the start of a new trend and its end. The power (velocity) can be estimated by the angle of the line slope; МА is used in many other technical indicators as a basis or a smoothing factor.

There are several types of МА such as Simple, Exponential, Smoothed, Linear Weighted.

Simple moving average, SMA

Simple moving average is the average performance (mean value) in the last ‘n’ prices and it is also a common arithmetic mean of prices in a certain time period.

Simple moving average of a period n at the moment k is the average arithmetic mean of n values from k-n+1 till k.

(P1 + P2 + P3 + P4 + ... + Pn) / n

n – the main parameter – smooth length or period of moving average (the amount of prices comprising the moving average calculation).

SMA averages prices, following the main market trend, while low fluctuations are smoothed on the graph. Moving average with a short parameter detects a new trend earlier, while a lot of false fluctuations occur. МА with long parameters filters low fluctuations, but a new trend is detected later.

Exponential moving average, EMA

EMA is a weighted average of the last n prices, where the weighting reduces exponentially at each previous price.

EMAn-1 + ((2 / (n + 1)) * (Pn - EMAn-1))

Smoothed moving average SMMA

One more moving average, called smoothed, is calculated based on SMA.

The first value of this smoothed moving average is calculated in the same way as the simple moving average (SMA).

SUM1 = SUM (CLOSE (i), N)

SMMA1 = SUM1 / N

The second and following moving averages are calculated by the following equation:

SMMA (i) = (SUM1 - SMMA (i - 1) + CLOSE (i)) / N

Most common trading strategies based on moving average

Upwards or downward trend is defined by the direction of the МА.

  • Buying points at growing MA and closing prices higher than MA
  • Selling points at falling MA and closing prices lower than MA
  • Buying points at the price crossing the MA upwards
  • Selling points at the price crossing the MA downwards

Several MA’s with different parameters are often used in trading. Crossing of a long moving average by a shorter one from the bottom upwards is a signal to buy, and vice versa. A divergence of two averages with different parameters is a signal of possible trend reversal.

Moreover, there are other instruments used in technical analysis, such as graphic models of reversal. Some examples are Elliott Waves, Fibonacci levels, Gann Theory and Andrews Pitchfork. It is recommended that you become acquainted with these as they will help you become familiar with the world of trading.

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