Technical analysis provides currency traders with an excellent method of finding potentially profitable trades and generating objective trading signals. With technical analysis, forex traders can use forex charts to easily gauge levels of supply and demand in the market to initiate trading positions at more optimal levels.
If you currently trade or wish to trade forex, the good news is that you can substantially improve your chances of making profitable trades by analyzing forex charts and computing technical indicators, which is the basis of technical analysis.
In this article, Benzinga explains the advantages and disadvantages of using forex technical analysis to trade currency pairs and what you need to learn to get started.
How Does Technical Analysis in Forex Work?
Technical analysis is one of the two principal types of market analysis used by traders operating in financial markets. The other complementary method of analysis commonly used by traders is known as fundamental analysis.
When using technical analysis, a forex trader typically examines exchange rate charts to look for classic patterns forming on them. They might also compute technical indicators from market observables like exchange rates and trading volumes that tell them something useful about the market.
In contrast, fundamental analysis involves analyzing the underlying economic and geopolitical conditions that influence exchange rates. These fundamental factors include the state of the economy, politics, monetary policy and trade balance for the currency’s issuing country. Since currencies trade in pairs and their valuation is thus relative, this detailed analysis must be done for both currencies in a currency pair.
Forex technical analysts instead base their trading decisions on the premise that all pertinent fundamental information for both sides of a currency pair is already fully reflected or “discounted” in the prevailing market exchange rate for that pair.
This is the basis of the technical traders' key assertion that “price discounts all” because they make the simplifying assumption that all relevant information on pair of currencies is already factored into its exchange rate that is shown on the charts they review.
Technical forex traders do not only base their decisions on historical data but also on the premise that “history tends to repeat itself” in the market. The classic chart patterns they look for are thought to reflect basic elements of human mass psychology.
By observing such readily identifiable chart patterns forming on an exchange rate chart, the trader can then initiate or liquidate positions in a currency pair based on the expectation that its exchange rate may behave in a similar fashion in the future as it has in the past.
Key Concepts to Understand
Forex technical traders base their decisions on several key concepts that determine levels of supply and demand. The most important of these concepts are identifying support and resistance levels, major and minor trends and the range of the exchange rate over a certain period of time.
Support and Resistance
Support and resistance levels consist of areas on an exchange rate chart where the exchange rate has difficulty moving beyond, either on the upside (resistance) or on the downside (support). When the exchange rate penetrates a known support or resistance level, this move could signal a reversal of an ongoing trend.
While penetration of support and resistance levels could signal a trend reversal, the move could also imply the exchange rate was moving its support or resistance level to a lower or higher level but still continuing in a major trend. Many traders use support and resistance levels to establish short-term positions and trade off the reaction to the level of penetration.
Having a sound sense of support and resistance levels can help you identify profitable trade set-ups regardless of the time frame you’re using. Discerning these levels will also give you signals on exiting trades.
Trends and Ranges
“The trend is your friend” is an old financial market adage that is especially true in the forex market. It describes the importance of identifying trends when trading.
A trend can be either upward or downward in direction and typically describes the situation when a market moves in one general direction overall. All markets tend to move in an uptrend or a downtrend unless they are instead trading sideways in a trading range or a consolidation pattern like a triangle, which tends to arise between trending phases.
One classic chart pattern that often shows up in a trend is known as a channel. This pattern has parallel upper and lower lines that encapsulate the exchange rate action and move in the same direction.
The three main types of trends seen in financial markets are distinguished largely by their duration:
- Major trend: A major trend describes the market’s direction over an extended period of time, usually stretching from a few months to a few years.
- Intermediate trend: An intermediate trend occurs within the major trend and describes when the market moves in a certain direction over a shorter time span.
- Minor trend: A minor trend can appear over a short period of time, sometimes lasting less than a day.
Trends
Trading trends in the forex market can involve using different strategies. For example, if you’re a long-term position trader, then you would look to identify the major trends in forex pairs. Once identified, you can then position your trades to capture the large moves you’re anticipating to enhance your profits.
In contrast, medium-term traders like swing traders who focus on following the market’s momentum may hold their position for several days or weeks. They would typically look to identify an intermediate trend to follow while also profiting from any counter-trend corrections they see coming.
Day traders do not hold positions overnight, so they can only take advantage of short-term minor trends to make their profits, while scalpers tend to trade the noise in the market rather than focusing on trends.
Ranges
Ranges occur within or between trends, and they have variable durations. When an exchange rate has rallied or declined consistently for several weeks, the rate typically pauses and trades within a range to consolidate its gains or losses.
The classic chart pattern that often shows up in a ranging market is known as a rectangle. This pattern has parallel and horizontal upper and lower lines that encapsulate the exchange rate action.
When the exchange rate then breaks out of the range the rectangle encompasses, this could signal either a continuation of the previous trend or a reversal depending on which direction the breakout occurs in.
Technical traders usually expect the market will continue to move an amount equal to the full width of the rectangle in the direction of the breakout once it occurs. They can use this measurement to set a trading objective and enter a take-profit order.
Range trading is often performed by intermediate and short-term forex traders. Range traders typically seek to buy at the low end of the range and sell at the high end.
The main risk with range trading is that the market will eventually break out of its range, so the range trader needs a backup plan to protect themselves against losses in case the market then goes substantially against their position.
They thus typically use a stop-and-reverse order placed safely outside the trading range to protect their account against losses and to benefit from the breakout continuing even further toward the breakout objective as the trend either resumes or reverses itself.
Advantages of Using Technical Analysis
One of the most beneficial aspects of learning how to use technical analysis is that it can be used in any market and applied to any financial instrument or commodity. No matter whether you want to trade stocks, forex, bonds, real estate or soybeans, you can use technical analysis to analyze any market where human mass psychology plays an important part in determining market levels.
Another benefit of using technical analysis is that its many indicators that have been developed over the years by experts can give you objective signals that tell you when to get into and out of the market. Indicators can also help you time and position your trades more effectively.
Technical analysis can help you identify when an exchange rate’s momentum is slowing as an existing trend becomes exhausted so that you can position for a trend reversal ahead of time.
Chart pattern analysis can also give traders an insight into planning and positioning their trades by looking for and interpreting reversal and continuation chart patterns as they develop.
Another advantage of using technical analysis is that you don’t have to follow fundamental events to trade currencies, which can greatly simplify your trading decisions. Fundamental forex traders often need to watch the news and monitor economic conditions closely to position and exit their currency trades appropriately.
Disadvantages of Using Technical Analysis
Since a fundamental premise of technical analysis is that “price discounts all,” the biggest drawback of only using technical analysis to trade forex is highlighted when the market shifts rapidly to discount new information. Such fast valuation adjustments can leave unwary technical traders showing considerable losses.
For example, sometimes an event occurs that substantially affects the forex market and overrides all data relating to the supply and demand of a currency pair that show up on the charts technical analysts use.
A classic example of this sort of rapid market reevaluation was the “Swiss Shock.” This traumatic event occurred in 2015 when the Swiss National Bank suddenly dropped its 3-year-old closely pegged exchange rate of 1.2000 Swiss francs per EU euro.
As a result, the Swiss franc fell sharply in value from 1.2000 to 0.8600 per euro. This wiped out many unsuspecting forex traders’ margin accounts and caused financial difficulties at some major online forex brokers like FXCM.
While this type of dramatic market event cannot be anticipated by technical analysis methods that break down during the resulting discounting process, they do tend to occur quite infrequently. Still, it only takes one Swiss shock to put a lot of traders out of business, so remember to keep that risk firmly in mind when using technical analysis.
To get around this drawback, many prudent technical traders discipline themselves to square their trading positions just before the release of major relevant fundamental data or when elections are being held or natural disasters occur.
Technical Analysis vs. Fundamental Analysis
You can analyze the forex market using just fundamental or technical analysis methods exclusively. Still, both methods have their advantages and disadvantages, so combining the two market analysis methods can give you a more balanced view of future exchange rate action.
For example, many traders use fundamental analysis to get a sense for and forecast the general direction that the trend in a currency pair should progress in over the long term. They might also use technical analysis to select better times to initiate and exit their trading positions.
When deciding on whether to use technical analysis vs. fundamental analysis, a trader’s choice will often be impacted by their psychological trading profile. Traders who prefer to analyze markets objectively tend to gravitate toward technical analysis, while traders who are comfortable taking a more subjective viewpoint on the market might prefer to analyze a currency’s fundamentals.
Should You Use Technical Analysis for Forex Trading?
Many of the top forex traders routinely use technical analysis to take positions that let them profit from operating in the forex market. Some might use chart patterns and some employ market cycle methods like Elliott Wave Theory. Others compute technical indicators or use a combination of technical methods.
Nevertheless, to stand the best chances of analyzing the forex market successfully using technical tools, you should first do your homework by learning as much as possible about the rather complex subject of technical analysis trading a technical strategy you have devised in a live forex account.
Keep in mind that because of inexperience, market volatility and the ill-advised use of excessive leverage, among other factors, the majority of retail forex traders lose money. They eventually quit trading currencies out of disappointment or economic necessity.
Using technical analysis will not guarantee that you’ll always trade forex profitably, but it will likely give you greater objectivity about making trading decisions. This benefit can significantly increase your chances of success compared to those who just try to trade forex by the seat of their pants without using some form of rational market analysis, which amounts to little more than just gambling.
Frequently Asked Questions
Does technical analysis work on forex?
While success is certainly not guaranteed, currency traders who use technical analysis properly to guide their operations in the forex market tend to be more profitable than those who do not.
Which analysis is best for forex?
Both technical and fundamental analysis can produce profits depending on the trader, and many successful traders use a combination of both market analysis methods. Technical analysis tends to suit traders who like to have objective reasons to trade, while fundamental analysis can suit those who are more comfortable basing their trading decisions on subjective factors.
How do I learn technical analysis?
A number of online resources can help you learn how to use technical analysis including YouTube videos, online webinars by expert traders and books like Technical Analysis for Financial Markets Traders.
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About Jay and Julie Hawk
Jay and Julie Hawk are the married co-founders of TheFXperts, a provider of financial writing services particularly renowned for its coverage of forex-related topics. With over 40 years of collective trading expertise and more than 15 years of collaborative writing experience, the Hawks specialize in crafting insightful financial content on trading strategies, market analysis and online trading for a broad audience. While their prolific writing career includes seven books and contributions to numerous financial websites and newswires, much of their recent work was published at Benzinga.