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How to do technical analysis in forex trading

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forex trading
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Lesson 4

A technical analysis uses technical indicators or other methods involved in studying price. The basic premise of a technical analysis is studying past price behaviour, which is used to forecast future prices.

Two of the most popular platforms for technical analysis are Meta Trader and Trading View, which are both free and allow you to develop your own analysis.

There are many ways to technically analyse the price of a security. However, the two most common ways involve using technical indicators or studying price action, such as chart patterns, support/resistance levels and trend lines.

No matter the method of technical analysis involved, traders can always develop their own method to analyse prices. In this article, we learn about some of the most common, yet important, technical indicators that can be used in analysing the forex markets.

How we do a technical analysis

A technical analysis could be based on the concept of using indicators to determine trend, volatility and momentum. Depending on the markets in question, some might even add volume as an additional aspect of analysing the markets.

Combining all or some of the elements, traders can effectively build their own method of analysing the currency markets. Based on this, forex traders are then able to effectively trade or speculate.

There are many ways to conduct a technical analysis, and traders are free to use their own interpretations of the markets. This comes with a combination of various indicators.

No matter which technical indicator is used, the indicator often falls into one of the following broadly classified categories:

  • Trend indicators
  • Momentum indicators or oscillators
  • Volume indicators

Trend indicators

As the name suggests, trend indicators are used to determine the security’s trend and to understand whether prices are rising or falling. Based on this, traders can then position themselves accordingly. Some of the most important trend indicators are the following.

Moving Average

The moving averages are the most common, and important, trend indicators. As the name suggests, the moving average indicator plots a continuous line, which is the average price.

There are different types of moving averages, based on the way the average prices are calculated. Examples include simple moving average, exponential moving average and linear weighted moving average. There are also some custom moving average types as well.

Bollinger Bands

Bollinger bands are used both as a trend indicator and as a volatility indicator. The Bollinger bands indicator, developed by John Bollinger, depicts the rising and falling volatility in price. When this information is combined with the trend, traders can look for potential bursts of volatility and trade in the direction of the trend.

Average Directional Index (ADX)

Also known as the ADX indicator, the Average Directional Index is a trend strength indicator. Comprised of three variables, the ADX line can show how strong a trend is by looking at the other variables, such as the +DI and -DI lines. The ADX can be a very powerful trend indicator that can show when the trend is the strongest or the weakest.

Momentum indicators or Oscillators

The class of momentum indicators, also known as oscillators, is primarily used to determine momentum in price. Momentum is often considered an important element regarding price trends.

Higher momentum indicates the price will continue to rise or fall, thus maintaining the trends, while weaker momentum suggests a short-term correction or a change of the trend itself. A common factor to all momentum indicators and oscillators is that they oscillate around fixed values.

Some oscillators move about 0 through 100, while most others tend to oscillate around the zero line. Buy and sell signals are generated according to how the oscillators behave around these levels. The most important momentum indicators are the following.

Stochastic Oscillator

The Stochastic oscillator measures momentum and is based on a math formula. It compares the current price in relation to the previous price range over time. The Stochastic can detect rising and falling momentum, also known as the overbought and oversold levels in technical terminology.

The Stochastic oscillator, as with most other oscillators, can detect overbought and oversold levels in the market. These levels are based on the values of 20 and 80 and simply indicate the peaks and troughs in the momentum of price.

Moving Average Convergence Divergence (MACD)

The MACD or the moving average convergence and divergence indicator is an oscillator based on the moving averages. This indicator is one of the most unique and widely popular. The MACD is based upon the MACD line and the signal line along with the histogram.

Buy and sell signals are generated based on the crossover of the zero line as well as the MACD and the signal line. There are many trading strategies that have evolved with the MACD indicator as the core of the strategy.

Relative Strength Index (RSI)

The RSI, or the Relative Strength Index indicator, is another versatile indicator used to depict the relative strength of price compared to the previous price. The RSI closely mimics the closing line chart of the security.

The RSI is widely used as a divergence indicator in addition to being used as an overbought and oversold oscillator. One can use different types of settings for the RSI, and it has proven to be one of the most versatile indicators, complementing any trading strategy.

This is widely attributed to the RSI’s simplicity, with values of 70 and 30, depicting the overbought and the oversold levels in the security’s price.

Volume Indicators

The volume indicators are another class of indicators based on volume. Volume, as one might know, is depicted at the bottom of the price chart and shows the buying and selling volume in the security.

Volume is one of the most important factors to consider when trading assets, such as futures or stocks. In the forex markets, due to the OTC nature, volume is not an accurate depiction of the real market. Still, some traders prefer to use volumes when trading forex.

A common volume indicator is applying a moving average to the volume bars. This can be shown when volume is rising and can indicate potential levels of volatility in price. There are also other volume indicators, such as the bull and bears, money flow index and the accumulation and distribution volume indicators.

Technical analysis is a wide concept, and there are many different ways to approach it. Traders can either use a combination of indicators or simply use price action techniques to conduct their own technical analysis of the forex markets.