Risk Management – Technical Analysis
What is Technical Analysis?
The second method used to forecast Forex price movements is called technical analysis. This framework is built around the ability of a trader to study price movement, allowing them to look at historical changes and therefore determine potential future price movements. We have all heard the phrase 'history tends to repeat itself', well this is the basic principle behind technical analysis. Traders who apply technical analysis will look for similar patterns that occurred in the past, they will then initiate trades based on these ideas, believing that the price will follow the same pattern as it did before. Some of the more commonly known technical analysis methods include the Fibonacci numbers, relative strength index, moving averages, pivot point and the Elliot wave. All of these forms of technical analysis are studied by traders using what are called charts. Charts are used because it makes it much easier to visualize historical data. By looking at the past, you can identify patterns and trends in certain trades, thus allowing you to find some great trading opportunities.
Technical Analysis Limitations
If it were true that everything that happened in the past will happen again on the Forex market, well everyone would be rich! Unfortunately this is not always the case, no matter how much you study or plough through chart after chart, sometime it just doesn't happen again. The future does not always equal the past. There are a number of unexpected variables that are not considered what so ever in Technical analysis. For example: change of country leaders, government changes, natural disasters, war, bank policy alterations and even terrorist attacks. All these could have a devastating affect on a currencies supply and demand, therefore throwing all your hard work (and money) out the window. This is not to say that utilising technical analysis cannot be extremely lucrative. The best option is to use a combined approach of both technical and fundamental analysis, allowing you to optimise plots on your investments and minimise your risk.
Within the Forex market, traders usually take advantage one of three popular charts, depending on their skill level and the information they are seeking. These charts are: the line chart, the bar chart and the candlestick chart.
To explain a line chart simply; one line is drawn from one closing price to the next. When you view a series of these together, you can get a general idea of the price movement of a certain currency pair over a set period of time. Here is an example for a EUR/USD line chart.
A bar charts differs slightly from a line chart. It shows traders both the opening and closing prices, as well as the highs and the lows of that currency pair. The very bottom of the bar represents the currencies low for that day, whilst the top indicates the highest price point. The complete vertical bar gives us an indication of the overall trading range for that particular currency pair. There is a horizontal hash on the left hand side of the bar, this represents the opening price. Located on the right hand side is another horizontal hash, this tells traders the closing price.
It is important to know that bar charts are also known as 'OHLC' charts, because they tell traders the open, the high, the low and the close for that particular currency. You may see them referenced to as this throughout your Forex journey. Here is an example of a bar chart for the EUR/USD.
A Candlestick chart is similar to a bar chart, however it shows us the same data in a much more graphic format. They are the most commonly used chart by Forex traders. Here are a few reasons why: -Candlesticks are great for beginners, easy to interpret and allow straightforward chart analysis. -Candlesticks are very easy to use. -Candlesticks are great at helping traders identify market turning points. Here is an example of a Candlestick chart for the EUR/USD:
Different colours in a Candlestick chart tell us if a price closed higher or lower than it opened. A green candlestick indicates that a currency price closed high than it opened. Whereas a red candlestick tell us the a currency closed at a lower price than it opened. The vertical line above or below the bar tells us the high or low point of the price during trading.