Technical analysis remains principally the same irrespective of the markets you apply to. Before going ahead with the use of charts and technicals in forex trading, let us understand the basic tenets or assumptions underlying technical analysis.
- Due to the constant flow of information and the actions of traders and arbitrageurs, the forex prices are constantly reacting to such news flows. Thus prices are in a constant state of evolution and discovery.
- Past patterns tend to repeat themselves and hence the best way to predict future patterns in price is to study the past price patterns, understand the underlying trend and extrapolate to the future.
- Markets as a summation are smarter and better informed than any individual trader. Hence the best way to trade is to understand these patterns, apply the right pattern and extrapolate the same.
- Price movements are random hence it is tough for one person to identify outliers. It is best to trade within the ambit of such trends and that is where technical analysis really comes in handy.
Since forex trading adheres to most of these principles, you can safely apply technicals to forex trading. It begins with deconstructing the pattern underlying the trend.
How to deconstruct the chart pattern in forex?
Deconstructing the pattern that you are looking for will be available in the form of signals given by the highs, lows, and sentiment surrounding news releases and announcements. These include macro and micro announcements. The best tool to trade forex; be it on the long side or the short side is the utilization of price action to understand the emotions of the market. To that you add the volumes and the accumulation of OI to gauge the conviction in the direction indicated by the charts. Identifying such key price action levels on your charts is the key to usage of technical charts in forex trading.
Let us first understand what is price action; because price action is at the core of applying technical charts to forex trading. Price action is the study of price alone without the use of technical indicators. In other words, price action allows you to just sift through the price data of the market without any additional commentary provided by a moving average, oscillator, stochastic etc. Forex traders will tell you that the price action by itself indicates a lot and you can read a lot into the market by just looking at the price action in vivid detail. Specific indicators are only the next step.
Market has a memory and that applies to forex trading too
Men women who trade markets are the same and the emotions driving them are also the same. That is why markets have a memory because it reflects the conditioning and learning of traders along the way. At the core of technical analysis for forex trading is the idea that price or the market has a memory. How do supports and resistances get built; it is out of force of habit. Consider a small child who touches a hot urn by mistake. That is a rude learning and the child will never touch an urn again. Similarly, the forex market is defined by price and the levels that we grow to believe are either friendly or punishable. That is how supports and resistances for forex levels get built up. Traders are by default cautious and therefore they will take trades in the path of least resistance or near prior reversal levels. The reason for recognizing these levels and potentially trading near these levels is that it would take a considerable extra amount of conviction to break and that is why price memories have a key role to play in supports and resistances. That is how core price action is to technical formations in forex.
Charts also help you identify directional swings in forex rates
You will find that forex trading is less volatile than commodities or equities and hence technical charts become all the more important. Higher lows indicate a bullish environment or uptrend whereas lower highs indicate a downtrend that would encourage you to look for selling opportunities against swing highs or prior support. When you have identified a directional bias based on multiple swings, whether it is a chart of 15-minute candles, four-hour candles, or daily candles, you can utilize that directional bias to create a swing trading strategy in currencies.
Charts help you to narrow your focus on trading specific currencies. After all, you are talking about scores of currencies, multiple permutations and a plethora of strike prices. How do you decide? It is actually quite simple. Your chief concern will always be risk-reward and the fundamental belief that a trend is more likely to continue than to reverse. Therefore, when the price gets close to a trend reversal point but fails because the conviction is not there; you enter the trade with a stop below the reversal point in an uptrend or above the reversal point in a downtrend. In fact, most of the standard technical rules that are applicable to equities, futures and commodities are applicable to chart forex also.
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