About Technical Analysis

Technical analysis (TA) or “Chartism” is the study of patterns found in price and trading volume movements. Technical analysts use charts created using historical price data, known as “price action”, to extrapolate future price movements. Followers tend to focus solely on the lines on their charts, disregarding fundamental data, in order to trade successfully.

There are three key assumptions that are commonly used by technical analysts. The first is that the market discounts everything (i.e. that everything that could affect an asset’s price is known to the market and is represented in the price at all times). The second is that prices move in a trend, and that once an identifiable trend is established then the asset is more likely to move in that direction than against it. This has spawned the popular phrase “the trend is your friend” (i.e. go with the trend and you’ll be ok). The third assumption is that past movements are repeated in current and future price action as investors tend to react in the same way to a set of circumstances, whether they occurred 20 years or 20 days ago.

In this section we will review the concepts and charts, explain how they’re created, and provide insights in how to use them for foreign exchange trading.

Before we delve deeper into the charts and how to analyse them, let’s start with the basic component of a foreign exchange chart: the candlestick. Candlesticks are the building blocks of a chartist’s toolkit because we do not depict charts as a classic line graph. We use candlesticks or bar charts.

Candlesticks are the key formations as far as technical analysts and traders are concerned. For any timeframe concerned they depict more information about the price action of currencies in one composite image than the line equivalent. While a line gives one price point per period, a candlestick shows the opening and closing price of that period, be it 5 minutes or a month, and also shows the top and bottom values of the price range during the period concerned. Typical candlesticks look like the picture below.

The rectangular form or “body” of the candlestick shows the difference between the opening and closing price over the time period. Traditionally the lighter body shows that the price has increased over the course of the period (i.e. the closing price is higher than the opening price) and this is often called a “rising candlestick”. While a dark body (could be depicted in other colours, e.g. red) shows that the price has decreased over the period (i.e. the closing price is lower than the opening price) and this is called a “falling candlestick”. The lines intersecting the body of the candlestick, called the “shadows”, represent the high and low price limits (or range) reached during the time period. The upper shadow will show the high price of the period while the lower shadow will indicate the low price. A larger candlestick indicates that the price movement was more drastic over the time period; a small candlestick reveals a relatively smaller price change in the period.

But how do we interpret them?

Candlestick Patterns

Individual candlesticks, as well as particular combinations of candlesticks, provide one of the key tools of technical analysis. Let’s look at some of them:

1. A Marabozu pattern suggests that one side, either seller or buyer, has been in control of the price action over the entire time period the candlestick represents. The key feature of a Marabozu candlestick is that there are no shadows. Again, in the case of the lighter Marabozu it shows that the lowest price seen was at the open while it finished at the high. The dark Marabozu indicates the opposite; the highest price was at the open and it declined to the low by the close.

   

2. Long upper shadows represent that buyers drove prices up to begin with however prices closed down below the opening price by the close. Long lower shadows show that initially sellers were driving prices down over the course of the period but eventually prices rose higher than the opening price due to buying pressure.

   

3. The “spinning top” formation shows traders that the market is indecisive about which way to push a price. As you can see from the picture, both shadows are of equal size and the body is not particularly large. When a spinning top appears after a period of rising prices we might conclude that buyers are unwilling to continue buying as prices move higher and that a price reversal (lower) may be forthcoming. Likewise a “spinning top” after a downward price action may show that momentum is turning and a reversal (bounce-back higher) in the prices may occur.

   

   “Spinning Tops” are very similar to “Doji” candlesticks, shown below.

   

4. Dojis show that buying and selling interest is evenly matched at a certain price level and this makes them a neutral pattern for chartists. They are extremely useful when used in conjunction with other candlesticks as an indicator of a trend change.

   Such trend changes or reversal patterns as they are otherwise known are a key area of technical analysis and it is worth looking at a few reversals in detail.

5. Dojis following a series of rising (or falling) candlesticks may indicate an end or even reversal of the preceding price trend. The white example below shows that current prices have risen too high to attract more buyers and therefore with the fall in demand, prices will fall. Whereas in the black example the doji may hint to traders that a reversal higher after a period of selling is likely (i.e. prices may bounce back as there may be a renewed demand due to low price levels). The longer the trend, the more significant the doji.

   

6. Hammers, hanging men and shooting stars are the other key reversal patterns. Without getting too confused about the various names, hammers and inverted hammers refer to trend reversal signals in a falling market/ declining trend and always have light (rising) bodies. On the other hand, Shooting Stars and Hanging Men are reversal candlesticks in rising markets and have dark (falling) bodies.

   Hammers and Shooting stars have tails pointing in the direction of the existing trend; however indicate a possible reversal of the trend. Inverted hammers and Hanging men have tails already pointing to the reversal of the trend. The main point to keep in mind is that all reversal candlesticks have quite long tails and shallow bodies in the reverse colour of the trend before them.

   

Trends

As we said above, the focus of a trader using TA is to watch for, and act on, trends. This area is easily the “bread and butter” of the world’s professional and aspiring amateur technicians. Looking at the charts below, we can see a fairly clear price trend on the left hand side chart, but the real skill is finding the trend when no clear one presents itself such as in the right hand chart. In this case we’ve got “up legs” (a rise in the price above the previous high price point in the chart), “down legs” (a fall in the price below the previous low price point in the chart) and “sideways consolidation” (steady prices over a period of time). In many cases like this, the key is in the selection of an appropriate timeframe for trend identification and analysis.

Use of trend lines and channels like in the chart below are the most common forms of technical analysis. As with all things, they must be applied correctly to give an accurate picture of the price action. Breaking the rules turns charting into guesswork and the risk of making mistakes. The most common way of drawing trend lines is by joining at least 2 tips of the candlesticks’ shadows that can be grouped in an upward pattern, downward pattern or sideways pattern, while keeping in mind that there must be a sufficient number to create a trend (i.e. a trend does not happen over 2 or 3 candlesticks).

A trend is established based upon a significant pattern in the historical price action, and are then extended to predict future price action and its boundaries.

Support and Resistance

Trend lines give an indication to traders of where ‘support’ or ‘resistance’ may lie. ‘Support’ is determined by connecting multiple price points at the bottom of the price range, and drawing them along a straight line, hence finding the support for any fall in price to this level. ‘Resistance’ is determined by connecting multiple price points at the top of the price range, and drawing them along a straight line, hence showing resistance to future price increases above the line.

Support and resistance lines can also be horizontal to represent recent highs and lows in the price range. Find the highest price point in the range and draw a horizontal line at this price, and do the same with the lowest price point in the range. These are the significant resistance and support points for the period.

As you can see from the above graph some levels are further characterised as being ‘major’ or ‘minor’ resistance or support. The more often price reaches (“tests”) a level of resistance or support without breaking it the stronger the area of resistance or support becomes. Breaks of major levels can occur suddenly and lead to the establishing of another range; it is also very common for an old resistance level to become a support level for the new price range or vice versa.

It is a safe assumption to think of these “levels” not as individual numbers but as zones. False breaks are common and traders will look for a clean break before they jump into a new trend. False breaks can be seen when, despite a temporary break in the support or resistance line, the prices fall back within the limits set by the support and resistance lines.

Fibonacci levels

Another indicator that markets watch faithfully is Fibonacci levels. Leonard Fibonacci was a famous Italian mathematician, who discovered a simple series of numbers that created ratios describing the natural proportion of things in the universe. The ratios arise from the following number series: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144... where each successive number arises from the sum of the two previous ones.

As the sequence progresses, the ratio of any number to its neighbour approaches and, finally, reaches 0.618. The ratio between alternate numbers follows the same pattern but approaches 0.382. These ratios are referred to as the ‘golden mean’, or ‘golden ratios’.

In a markets/charts context, the Fibonacci series provides key levels that are good indicators for natural price retracements (or extensions) especially after extended periods of continuous trends. These levels are found at 76.4%, 61.8%, 50%, 38.2% and 23.4% of the original high or low of the move.

In the example above you can see the original trend low and high (circled in green) and a standard Fibonacci retracement grid drawn on those levels. The Fibonacci retracement levels that are meant to act as supports are circled in red.

Along with major support and resistance levels, be they horizontal or channels, Fibonacci levels are likely the single most important tool in the process of defining future targets of the price movement or reversal levels, especially when considered within a medium term trending environment.

Moreover, like with any technical tools, the more market participants that use the various levels identified as targets or retracements, the more these levels fulfill their expectation. For example the more traders feel that a strong support point has been identified, the more orders these traders will place at or near that price, thus supporting the market (and creating a self-fulfilling prophecy).

Moving Averages

Put simply, moving averages give a trader a smoothed price trend over a time period. Typically it would show the closing price for an asset over ‘X’ number of periods and from that we can see whether the asset’s live price is above or below the average, which in turn helps decide whether an asset is overpriced or not.

In the graph above, the coloured lines (pink, green and yellow) are known as simple moving averages (SMAs) in that they are a simple average of all prices in a given period. In this case the pink represents the simple moving average of prices in the past 21 periods, the green represents the simple moving average of the past 55 periods and the yellow represents the simple moving average of the past 200 periods. Those time periods are the most commonly used and stem from the original use of daily charts where 21 periods represented 1 month worth of prices (i.e. 21 business days in a month), 55 periods represented one quarter’s worth of price data and 200 represented a year’s worth of price data. Market traders now use the same conventions (21, 55 and 200), but adjust them for other timeframes (from 21 x 5 minutes to 21months).

Some traders tend to use another moving averaging calculation that gives more weight to recent price action than it does to values taken from the beginning of the period. These are known as Exponential Moving Averages or EMAs (as seen in the graph below).

The difference between these two types of moving averages is not very significant as one can see from the similarity of the lines. However, they can each be useful in different scenario analyses. Given that exponentials give more weight to recent prices they tend to change direction quicker to signify a trend change, whereas simple moving averages are used more predominantly to indicate levels of support and resistance.

The use of MAs

We can use moving averages (simple or exponential) to define trends in price and help us identify where levels may be heading in the future. Typically when a short dated moving average (in the example below the 21-day in purple) crosses higher through a longer dated one (a 200-day moving average in yellow) traders will be looking for prices to rise. These instances have been shown in the graph below by the green circle and arrow. Likewise if we see a shorter dated moving average cross below a longer dated one (circled in red in the chart below) then prices tend to fall (as seen by the red arrow).

Having shown the use of MA intersections between one another, it is also worth talking about what happens when prices themselves cross moving averages. These instances, especially when they occur close to MA intersection, can point towards continuation of an existing price trend. This is especially true when prices cross the longer dated moving average lines, as there tends to be a continuation of this price action which can be sustained over a significant amount of time. For example, in the chart above the 200EMA line is crossed by the price line (purple circle), and subsequently we see a period of decline in the price, which matched our expectations. Conversely, the blue circles show the opposite. It is worth noting that the closer the distance between the price intersection and the MA intersections; the stronger the expected price trend continuations will be, as you can see above.

Moving averages can also act as support or resistance to price levels in a trend against rising or falling prices. In the example below we can see from the blue circles that traders have relied on the 21 day moving average, in purple, to find the support level for the price action. However it is important to note that moving averages in price support or resistance roles are less accurate and, as a rule of thumb, it is the shorter term indicators that exhibit support and resistance characteristics better.

Leading Indicators

Everybody in financial markets is looking for a clue as to where prices are likely to move in the future. One of the most common ways of deciphering these signals is to use a leading indicator. Most leading indicators measure the momentum of the change in price; the faster the price rises, the larger the increase in momentum, the higher the leading indicator. When a currency pair trades in a flat manner one would expect to see the momentum start to slow (and hence a lower indicator value). One of the most popular leading indicators is RSI or Relative Strength Index.

Traditionally an RSI reading above 70.0 indicates that the currency is overbought (i.e. prices have risen too quickly / too high over the period and this price rise is not sustainable - hence a very high momentum). This is seen on the chart above where the RSI hits the red upper limit (at 70) and immediately we see a downturn in momentum and prices (note the price level changes after the red lines). An RSI reading below 30 shows that the currency may be oversold (prices are at a low point) and future prices will tend to rise, as shown by the green lines in the example above.

One way that traders use RSI is to see if there is a “divergence” between the price and the momentum as this commonly means a trend change may be imminent.

MACD

Moving Average Convergence/Divergence or MACD for short is a very important indicator that is also quite unique in that it has elements of being a leading and lagging indicator. The MACD tends to be most effective in wide swinging markets where momentum and price action regularly reverse.

The typical set up is (12,26,9) which means that the indicator plots (bottom of the chart) the difference between the 12-day moving average and the 26-day moving average on one line (grey in our example)and compares/superimposes it with the 9-day moving average used as a baseline called the ‘signal’ or ‘trigger’ line (red).

If the MACD (the grey line) is above 0, or the centre point as it is sometimes known, then it is indicative that the 12-day moving average is above the 26-day, and below 0 indicates the opposite. There is also a histogram depicted by blue bars in our example that shows the difference of the MACD line (grey) to the signal line (red).

The most common trade signal we get from the MACD indicator is that of a “Signal Line Crossover”; when the MACD crosses above the signal line then it is seen as bullish (i.e. prices are likely to increase) while a cross lower is a bearish signal (i.e. prices are likely to decrease).

In the above graph there were 7 significant crossovers in GBPUSD between November 2010 and June 2011, three positive (green circles) and four negative (purple circles). In all except one instance the signal has predicted the price action.

The lagging element of the MACD occurs when the MACD crosses the centre, either upwards or downwards. This means that while the trend already exists, it is likely to continue for a while longer, until we see the next signal crossover. In the above graph we highlight 5 centre point crossovers (shown by yellow lines) in the past year (2 positive, 3 negative) and the respective price action. They have all worked well so far to prove the continuation of the existing trends which lasted anywhere from 3 weeks to 3 months.

Divergence example

As with RSI, we can measure the divergence between the price and the MACD to draw conclusions of further price action. Below we show an example of a bearish (or negative) divergence between price and MACD. This happens when the price reaches a new high (green arrow) but the MACD only achieves a high that is lower than the previous (red arrow). In this case, we expect to see the price decline imminently. A bullish (or positive) divergence occurs when the price hits a new low but this is not matched by the MACD’s level. In this case we expect to see the price increase imminently.

An important point to stress here is that positive and negative divergence events need to be observed for ideally three crossover instances for confirmation of a change of direction in the price action. These are called triple positive or negative divergences.

In the graph below we can see an example of a triple negative divergence in EURGBP in March/April of 2011 (as shown by the red arrow), which indeed confirms a change in the medium term trend. EURGBP has risen to a new high while the MACD has not confirmed this move and has instead drifted lower. The price action is confirmed by a falling triple signal line crossover and the price declines shortly thereafter. It is worth bearing in mind, that whilst this example illustrates the point perfectly, no indicators work every time all the time.

Conclusion/Summary

We have used this space to give our clients and audience a basic and practical introduction on technical analysis. This is more of an extraction and selective presentation of a handful of workable and, we feel, really useful TA tools, rather than a complete executive summary of the A to Z of technical analysis.

Technical Analysis works really well for Foreign Exchange trading. Our piece on TA targets the aspiring FX trader who hasn’t used TA to trade before or someone who hasn’t used TA in an FX environment.

We have covered candlesticks, the one key ingredient of TA. We have then looked at some key candlestick patterns that are easy to identify and analysed their significance in terms of trend reversals. We have looked at trends themselves, how one draws trend lines and what those imply in terms of future support and resistance levels. We have then added the importance of moving averages, simple or exponential and Fibonacci’s all in the context of identifying and trading off technical levels. We finally have taken a good look at two key leading indicators, the RSI and MACD, providing illustrated examples of their practical uses in terms of momentum and divergence interpretations.

This is by no means an exhaustive TA script. It is not even a summary of what is out there, as a quick browse on Amazon will convey. If you found what you read here useful, then it would certainly benefit you to read a couple of books on the topic.

A final key item to remember is that while the practice (i.e. how you apply the tools) of Technical Analysis is an exact science, its main application is targeted at financial markets, which are... anything but an exact science. Market sentiment will always be the unknown, magical component. Therefore, TA has been called a scientific art form for a reason.

Our very best wishes for successful trading,

The World Markets team