Technical Analysis is the study of the Price and Volume of any currency, stock, or commodity over a certain period. In Technical Analysis different tools are used to evaluate the shift of demand and supply and its effect on the price and volume of a security. Technical Analysis is also used to gauge the volatility of the price movements. Technical Analysis is used to generate signals for buying and selling. The biggest advantage of Technical Analysis is that it can be used on any security which has historical trading data. By Technical Analysis we try to predict the future behavior based on the past data of price action and volume. In Technical Analysis we are least concerned about the overall performance of the company, security’s intrinsic value, or fundamental analysis instead the main focus of the Technical Analyst is to identify chart patterns and the trend of security in near future.
Technical Analysis Vs Fundamental Analysis
Technical Analysis and Fundamental Analysis are the most widely used techniques applied by modern traders for Forex Trading and trading in other financial markets. Technical Analysis focuses on the price action, volume, and volatility of any security. Technical Analysts believe price moves in trends and charts patterns occasionally repeat. Fundamental Analysis is a technique to find the intrinsic value of any security. One big advantage of Technical Analysis is that it can be applied to different Financial Markets and different securities with just a few variations. The Fundamental Analysis in Forex Trading is different from the Fundamental Analysis of any other security. The Fundamental Analysis of every financial market is different from the other. Fundamental Analysis of Forex involves analyzing the Economic, social, and political situation which can affect any currency pair. Fundamental Analysis involves the evaluation of the overall economy of any country by going into details of imports, exports, GDP, Gross Income, Tax to GDP ratio, and many other economic indicators.
The drawbacks of Technical Analysis
Technical Analysis gives certain signals to buy or sell the currency pair. The technical chart can give false signals and often a trader can misinterpret the technical charts. More and more technical indicators are being developed now by traders and firms in thousands to increase the accuracy of trading signals but it is difficult to get to the lucky 2 or 3 technical indicators which would work for you. Sometimes trade signals from different technical indicators can contradict each other and can cause misperception for the trader for example a moving average can give a buy signal and a MACD can give a sell signal at the same time. Technical Analysis does not take into account the fundamental analysis for example changes in the economy or GDP or Political Situation of any country which can affect the price of the currency pair drastically. There are many situations where price falls drastically downwards due to any political situation where technical analysis is unable to predict it or price can shoot up within seconds on any fundamental news. So while using technical indicators, there is always a risk.
Type of Technical Analysis:
Technical Analysis can be categorized into two main types. Chart Patterns and Statistical approach of technical analysis (Technical Indicator based).
Technical Indicators (Statistical Approach)
A technical indicator is a tool used by Traders and Investors to make a trading decision, confirm the trend, or predict the future price of any security. Technical indicators are based on mathematical models and patterns and are calculated by using the historical data of any security such as past price and past volume.
Technical Indicators are often presented in Graphical Form compared with the price movement of the currency pair or any security. Technical indicators demonstrate the behavior of the traders and investors by mathematical tools which in turn generate a buy or sell signal. Traders use technical indicators in different ways, sometimes a single technical indicator is used to generate a trade signal, and generally, a combination of technical indicators is used to develop a trading strategy. Technical Indicators can be categorized into two main types.
a) Leading Technical Indicators
A Leading Indicator is a tool used to generate a signal before the actual change in the price has happened. Traders and Investors use the Leading Technical Indicators to predict the future price behavior, forecast reversals (shift in trend), and use to gauge the momentum overall trend of a currency pair or any other financial security. The Leading Technical Indicators are a good tool to predict the trend reversal points. A Leading Indicator can be used by economists and policymakers to forecast future economic events and predict the direction of the economy. Businessmen, traders, investors, government policymakers, and economists all use different Leading Indicators to make critical decisions about their investments and policies. The most common problem with the Leading Indicators is that they generate false signals and are not always accurate. Stochastic Oscillator, Relative Strength Index (RSI), On Balance Volume (OBV), Fibonacci Retracements, and Fisher Transform are few examples of a Leading Technical Indicator.
b) Lagging Technical Indicators
A Lagging Indicator is used to spot the shifts or reverses after the actual change has occurred in the financial or economic variables on which the indicator is based. There is a delay between the actual reversal and the signal generated by the indicator that is why the lagging indicators are called confirmation indicators. Lagging Indicators are best to gauge the trend of a Forex Currency Pair or any other financial security. The Lagging Indicators are not useful to predict the exact reversal points rather these types of indicators are best to confirm the trend reversals. The Lagging Indicators can be used as a tool to double-check the trading signals generated by the leading indicators as Leading Indicators generate false trading signals quite often. A Trader following a Lagging Indicator for making Trading Decisions may enter a trade too late after the actual reversal or trend shift has happened that results in low profit. Moving Averages, MACD, Bollinger Bands, Average True Range (ATR), and Donchian Channels are few examples of a Lagging Indicator.
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Technical Indicators can be further differentiated on how they are calculated and what type of data is used for the mathematical calculation of that indicator.
1) Trend Indicators:
“Trend is your best friend” is a famous phrase quoted by Traders who follow Trend Trading. Technical Indicators based on trend following are used by traders to evaluate and measure the strength of a trend of any financial security. Financial Markets, Currency Pairs, and other financial securities move in an Up Trend, Down Trend, or Sideways directions. Trend Traders try to identify the ongoing trend, measure the strength, and ride on the wave of Up Trend or Down Trend to ripe the profits. Generally, Trend Traders use a set of indicators to develop a Trading Strategy. The most common Technical Indicator for Trend Trading is Moving Average and Moving Average Crossovers. A trader can use a Moving Average of 20 days, 50 days, 100 days, or any other Moving Average Lenght depending on the time frame a trader is working on. Moreover, 9 days / 26 days Moving Average Crossovers are very common among trend traders to get into a trade assuming the trend would continue after the crossover in a particular direction. The baseline Method of Trend trading is also very popular where a Trend Trader applies a baseline on the price graph if the price is moving above the baseline the currency pair or security is in an uptrend and if the price is moving below the baseline, then the major trend is downwards. Super Trend Indicator, Ichimoku baseline indicator, Volatility Index, and different types of Moving Averages can be used as a baseline for Trend Trading.
2) Momentum Indicators:
Momentum Indicators are a type of Technical Indicators used to measure the strength of price movement in a particular direction. The current price is compared with the previous price to identify how fast the price of the security is moving in an upward direction or downward direction. History has proved that prices of financial securities tend to move up and rise often. The bull markets last longer than bear markets and it is easy to identify the momentum of a rising market over a long-time frame as compared to a shorter time frame. Therefore, the Momentum Indicators are very effective on the longer time frames when the market is a rising bull market. Momentum Indicators are also used by Traders to spot a shift of a trend or reversals. The reversal points are identified by using crossover or divergence on different Momentum Indicators. Moving Average Convergence Divergence (MACD) and Relative Strength Indicator (RSI) are the most commonly used Momentum Indicators. Momentum-based Indicators are widely used by Traders generally in combination with other types of indicators to form a Trading Strategy where a Trader measures the strength of the move by using a Momentum Indicator.
3) Volatility Indicators:
Volatility Indicators are a type of Technical Indicators used to measure the rate of change of price reference to the mean price. It is the calculation of the price fluctuations and how much the price of the currency pair or security is moving up and down from a mean price level. If the price goes up and then comes down and then again closes at the opening price or near the opening price it means the volatility is high. One way to evaluate the volatility is by using a candle stick chart pattern. If a candle has a big shadow as compared to the body of the candle that means there is a high fluctuation in the price of the currency pair or security resulting in high volatility. In high volatility markets, the demand and supply are shifting fast which results in sideways or range bounds sessions. It becomes difficult for the Forex Trader to identify the trend of the market. The sideways and range bound market sessions are quite dangerous for the traders as the stop loss is hit. Due to high volatile markets, the profits of Forex Traders are badly affected who are in a habit of placing strict stop losses. Traders need to identify the level of volatility and change the trading strategy as per the market conditions. Professional Traders apply wide stop losses in a situation of high volatility in the prices and try to reduce their exposure in the market. Average True Range (ATR), Bollinger Bands, Candle Stick Patterns, and Volatility Index VIX are the most commonly used Volatility Indicators.
4) Volume Indicators:
Volume Indicators are based on the traded volume of a currency pair, a stock, or any other financial security. In Forex Trading the number of lots of a currency pair traded in a specific time is regarded as the volume, for stocks the volume is the number of shares traded in a specific time. Volume indicators are used by the traders to measure the strength of the move or the strength of the trend based on the volume. If the volume is increasing with respect to time, the trend is considered strong. If the volume is decreasing as the prices are approaching new highs, then the traders become cautious that the trend is losing the fuel that is keeping the prices high. This declining volume is a signal of loss of interest from the traders and investors. Volume is considered as a fuel, as soon as traders push the paddle on the gasoline the prices go up or down strongly depending on the major trend. Traders also use volume to gauge the weakness of a move. If the price starts to move up on low volume, the security movement is considered to be weak mainly due to the low interest of investors and traders. The traders who have volume-based indicators as a part of their trading strategy stay away from the moves that have low volumes and they generally wait for reversals to trade in the opposite direction.
Volume in the Forex Market:
Forex is a decentralized marketplace, a marketplace where buyers and sellers indulge in trading activity with each other directly without any involvement from market exchange. Therefore the concepts and calculations of volume in the Forex Market are different from the stock market or other Financial Markets. In Forex Market the volume is calculated by counting the tick movements that is how much the price has moved with respect to time. No matter the calculation of volume is different in the Forex Market but the effect of the volume on the trading is similar as with the other markets. Same volume-based indicators can also be used in Forex Market for confirmation of Trend Strength, identification of trends, and identifying the breakouts. On Balance Volume (OBV), Money Flow Index (MFI), Chaikin Money Flow, and Accumulation / Distribution are the most commonly used Volume Indicators.