Technical Analysis categories / approaches

Patterns and forecast methods used today

Basic Forex forecast methods:

Technical analysis and fundamental analysis

This chapter and the next one provide insight into the two major methods of

analysis used to forecast the behavior of the Forex market. Technical analysis

and fundamental analysis differ greatly, but both can be useful forecasting

tools for the Forex trader. They have the same goal - to predict a price or

movement. The technician studies the effects, while the fundamentalist

studies the causes of market movements. Many successful traders combine a

mixture of both approaches for superior results.

If both Fundamental analysis and Technical analysis point to the same

direction, your chances for profitable trading are better.

In this chapter…

The categories and approaches in Forex Technical Analysis all aim to support

the investor in determining his/her views and forecasts regarding the

exchange rates of currency pairs. This chapter describes the approaches,

methods and tools used to this end.  However, this chapter does not intend to

provide a comprehensive and/or professional level of knowledge and skill, but

rather let the reader become familiar with the terms and tools used by

technical analysts.

As there are many ways to categorize the tools available, the description of

tools in this chapter may sometimes seem repetitive. The sections in this

Technical Analysis can be divided into five major categories:

Price indicators

(oscillators, e.g.: Relative Strength Index (RSI))

•

Number theory

(Fibonacci numbers, Gann numbers)

•

Waves

(Elliott's wave theory)

•

Gaps

(high-low, open-closing)

•

Trends

(following moving average).

•

[a] Price indicators

Relative Strength Index (RSI):

The RSI measures the ratio of up-moves to

down-moves and normalizes the calculation, so that the index is expressed in

a range of 0-100. If the RSI is 70 or greater, then the instrument is assumed to

be overbought (a situation in which prices have risen more than market

expectations). An RSI of 30 or less is taken as a signal that the instrument may

be oversold (a situation in which prices have fallen more than the market

expectations).

Stochastic oscillator:

This is used to indicate overbought/oversold conditions

on a scale of 0-100%. The indicator is based on the observation that in a

strong up-trend, period closing prices tend to concentrate in the higher part

of the period's range. Conversely, as prices fall in a strong down-trend, closing

prices tend to be near the extreme low of the period range. Stochastic

calculations produce two lines, %K and %D, that are used to indicate

overbought/oversold areas of a chart. Divergence between the stochastic

lines and the price action of the underlying instrument gives a powerful

trading signal.

Moving Average Convergence/Divergence (MACD):

This indicator involves

plotting two momentum lines. The MACD line is the difference between two

exponential moving averages and the signal or trigger line, which is an

exponential moving average of the difference. If the MACD and trigger lines

cross, then this is taken as a signal that a change in the trend is likely.

[b]  Number theory:

Fibonacci numbers:

The Fibonacci number sequence (1, 1, 2, 3, 5, 8, 13, 21,

34 ...) is constructed by adding the first two num bers to arrive at the third.

The ratio of any number to the next larger number is 61.8%, which is a

popular Fibonacci retracement number. The inverse of 61.8%, which is 38.2%,

 

is also used as a Fibonacci retracement number (as well as extensions of that

ratio, 161.8%, 261.8%). Wave patterns and behavior, identified in Forex

trading, correlate (to some extent) with relations within the Fibonacci series.

The tool is used in technical analysis that combines various numbers of

Fibonacci retracements, all of which are drawn from different highs and lows.

Fibonacci clusters are indicators which are usually found on the side of a price

chart and look like a series of horizontal bars with various degrees of shading.

Each retracement level that overlaps with another, makes the horizontal bar

on the side darker at that price level. The most significant levels of support

and resistance are found where the Fibonacci cluster is the darkest. This tool

helps gauging the relative strength of the support or resistance of various

price levels in one quick glance. Traders often pay close attention to the

volume around the identified levels to confirm the strength of the

support/resistance.

Gann numbers:

W.D. Gann was a stock and a commodity trader working in

the '50s, who reputedly made over $50 million in the markets. He made his

fortune using methods that he developed for trading instruments based on

relationships between price movement and time, known as time/price

equivalents. There is no easy explanation for Gann's methods, but in essence

he used angles in charts to determine support and resistance areas, and to

predict the times of future trend changes. He also used lines in charts to

predict support and resistance areas.

[c] Waves

Elliott's wave theory:

The Elliott Wave Theory is an approach to market

analysis that is based on repetitive wave patterns and the Fibonacci number

sequence. An ideal Elliott wave pattern shows a five-wave advance followed

by a three-wave decline.

[d] Gaps

Gaps are spaces left on the bar chart where no trading has taken place.

Gaps can be created by factors such as regular buying or selling pressure,

earnings announcements, a change in an analyst's outlook or any other type of

news release.

An up gap is formed when the lowest price on a trading day is higher than the

highest high of the previous day. A down gap is formed when the highest price

of the day is lower than the lowest price of the prior day. An up gap is usually

a sign of market strength, while a down gap is a sign of market weakness. A

breakaway gap is a price gap that forms on the completion of an important

price pattern. It usually signals the beginning of an important price move. A

runaway gap is a price gap that usually occurs around the mid-point of an

important market trend. For that reason, it is also called a measuring gap. An

exhaustion gap is a price gap that occurs at the end of an important trend and

signals that the trend is ending.

[e] Trends

A trend refers to the direction of prices. Rising peaks and troughs constitute

an up trend; falling peaks and troughs constitute a downtrend that determines

the steepness of the current trend. The breaking of a trend line usually signals

a trend reversal. Horizontal peaks and troughs characterize a trading range.

In general, Charles Dow categorized trends into 3 categories: (a) Bull trend

(up-trend: a series of highs and lows, where each high is higher than the

previous one); (b) Bear trend (down-trend: a series of highs and lows, where

each low is lower than the previous one); (c) Treading trend (horizontal-

trend: a series of highs and lows, where peaks and lows are around the same

as the previous peaks and lows).

Moving averages are used to smooth price information in order to confirm

trends and support-and-resistance levels. They are also useful in deciding on a

trading strategy, particularly in futures trading or a market with a strong up

or down trend. Recognizing a trend may be done using standard deviation,

which is a measure of volatility. Bollinger Bands, for example, illustrate

trends with this approach. When the markets become more volatile, the

bands widen (move further away from the average), while during less volatile

periods, the bands contract (move closer to the average).

Various Trend lines

Pattern recognition in Trend lines, which detect and draw the following

patterns:  ascending; descending; symmetrically & extended triangles;

wedges; trend channels.