Technical analysis does not take into account any of the aforementioned fundamental factors, but instead relies solely on technical data obtained and computed from market observables like price, volume and open interest.
The basic premise of technical analysis assumes that all available fundamental information is already reflected in the exchange rate for a currency pair. As a result, technical analysts focus on the levels of supply and demand of one currency versus another currency, which ultimately determines the equilibrium rate of exchange seen in the forex market.
A large part of technical analysis consists of interpreting price charts, although forex traders also use other technical indicators such as momentum oscillators, moving averages and volume figures in order to determine a forecast for future exchange rates that they feel comfortable trading on.
Most individual forex traders use technical analysis extensively in their trading plans, primarily because using technical analysis gives a trader considerable objectivity that makes trading currencies so much easier.
As it relates to the forex market, technical trading involves the process of analyzing past levels of market observables like exchange rates, trading volume or open interest in order to forecast and profit from future price action.
Technical forex traders focus primarily on the behavior of exchange rates itself, rather than on what the underlying fundamental causes of that behavior might be.
Many of the techniques used in technical analysis are based on ideas originally laid out in the early 1900’s by Charles Dow, a famous stock trader who lent his name to the Dow Jones Industrial Average or DJIA stock index.
Mr Dow’s theory regarding stock market prices also pertains to exchange rates and so is widely followed by forex traders. His Dow Theory can be expressed rather succinctly as follows:
(1) The market develops in three movements. These occur simultaneously — but not randomly — and are known as primary, secondary and intra-day movements. They can be used to define and trade along with the market trend as it develops.
(2) Price discounts all. The equilibrium price prevailing in the market is the net effect of all relevant information available to market participants. This information includes fundamental data like news, economic and political factors, and anything else that might affect the price.
(3) History repeats itself. Techniques that worked in the past to forecast prices should also work in the future.
The following course sections will cover in greater detail some of the various types of technical analysis methods used by forex traders to forecast future exchange rate levels.
Key Technical Factors
Technical analysts forecast future exchange rates by focusing largely on the past and present levels of exchange rates which they believe discount all of the available information at the time they were observed.
Nevertheless, some technical analysts also take into account other forex market observable like trading volume and open interest. These quantities are often easiest to monitor in the exchange traded currency futures market for major currency pairs.
Armed with such historical data, one of the first things that a technical analyst will tend to do is to plot the exchange rate versus time. They do this in order to obtain a so-called “chart” or visual representation of the path that the exchange rate has followed as it evolved to its present level.
Charts can be of several different types which will each be discussed further in the following section. A technical analyst will often use one or more of them to look for important reversal points that indicate levels where a rallying market met selling pressure — known as resistance — or where a falling market saw buying activity — known as support.
Traders also look for trends on charts, as well as reliable chart patterns that can help them forecast exchange rates.
Technical indicators are computed based upon one or more market observables. They help technical traders quantify important things like directional price behavior, volatility or the average closing price observed over a certain period of time.
Analysts will generally either superimpose indicators over the price action or place them in a special indicator box underneath the price action. In either case, they also evolve over time and so will be plotted over the same time frame as the price.