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Technical Analysis is the forecasting of future financial price movements based on an examination of past price movements. Like weather forecasting, technical analysis does not result in absolute predictions about the future. Instead, technical analysis can help investors anticipate what is "likely" to happen to prices over time. Technical analysis uses a wide variety of charts that show price over time.
There are three types of Analysis.
1.Technical Analysis
2.Fundamental Analysis
3.Sentimental Analysis
Which Type of Analysis is Best?
Ahhhh, the million dollar question....
Throughout your journey as an aspiring forex trader you will find strong advocates for each type of analysis. Do not be fooled by these one-sided extremists! One is not better than the other...they are all just different ways to look at the market.
At the end of the day, you should trade based on the type of analysis you are most comfortable and profitable with.
To recap, technical analysis is the study of price movement on the charts while fundamental analysis takes a look at how the country's economy is doing.
Market sentiment analysis determines whether the market is bullish or bearish on the current or future fundamental outlook.
Fundamental factors shape sentiment, while technical analysis helps us visualize that sentiment and apply a framework for our trades.
Those three work hand-in-hand-in-hand to help you come up with good trade ideas. All the historical price action and economic figures are there - all you have to do is put on your thinking cap and put those analytical skills to the test!
Let me pull out that three-legged stool again just to emphasize the importance of all three types of analysis.
Take out one or two legs of the stool and it's going to be shaky!
In order to become a true forex master you will need to know how to effectively use these three types of analysis.
Don't believe us?
Let us give you an example of how focusing on only one type of analysis can turn into a disaster.
* Let's say that you're looking at your charts and you find a good trading opportunity.
You get all excited thinking about the money that's going to be raining down from the sky.
You say to yourself, "Man, I've never seen a more perfect trading opportunity in GBP/USD. I love my charts. Mwah. Now show me the money!"
* You then proceed to buy GBP/USD with a big fat smile on your face (the kind where all your teeth are showing).
* But wait! All of a sudden the trade makes a 100 pip move in the OTHER DIRECTION! Little did you know, one of the major banks in London filed for bankruptcy! Suddenly, everyone's sentiment towards Britain's market turns sour and everyone trades in the opposite direction!
* Your big fat smile turns into mush and you start getting angry at your charts. You throw your computer on the ground and begin to pulverize it. You just lost a bunch of money, and now your computer is broken into a billion pieces.
And it's all because you completely ignored fundamental analysis and sentimental analysis.
(Note: This was not based on a real story. This did not happen to us. We were never this naive. We were always smart traders.... From the overused sarcasm, we think you get the picture.)
Ok, ok, so the story was a little over-dramatized, but you get the point.
Remember how your mother used to tell you as a kid that too much of anything is never good?
Well you might've thought that was just hogwash back then but in forex, the same applies when deciding which type of analysis to use.
Don't rely on just one.
Instead, you must learn to balance the use of all of them. It is only then that you can really get the most out of your trading.
Where do we go from here?
Now that you're done with Kindergarten and learned a little bit about each type of analysis, it's time to delve much deeper! Here's what's in store for the next few years of your life...
We're kidding, we're kidding! We're talking about the next few school years in the School of Pipsology.
Grade school will be all about basic technical analysis tools.
You'll learn all about the dynamics behind price action, such as support and resistance levels, candlestick formations, and common chart patterns. You'll experiment with leading and lagging indicators and discover how to use them in coming up with trade ideas. Sounds pretty exciting, doesn't it?
The remaining years of middle school and high school are devoted to studying more technical analysis tools.
We'll take a look at the more advanced tools also such as pivot points, divergences, Elliott Wave Theory, and Gartley patterns. Sounds fancy? It's because they are! Bet you can't wait to get started on those!
College will be a bit more complicated since you'll be tackling both fundamental and market sentiment analysis at the same time. Talk about hitting two stones with one bird! You're the bird and the stones are... well, you get the point.
A couple of reasons why we're putting fundamental and market sentiment analysis together:
* By the time you reach college, you'll be so hooked on learning more about forex that one lesson simply won't be enough.
* It is hard to draw the line between fundamental analysis and market sentiment analysis.
As we mentioned earlier, fundamental factors are mostly responsible for shaping market sentiment. Those two types of analysis would take up both freshman and sophomore year of college.
In this Blog we will discuss Technical and Fundamental analysis.
sentimental analysis will discuss only if we find requests of our readers.
Technical Analysis
Technical analysis is the framework in which traders study price movement.
The theory is that a person can look at historical price movements and determine the current trading conditions and potential price movement.
The main evidence for using technical analysis is that, theoretically, all current market information is reflected in price. If price reflects all the information that is out there, then price action is all one would really need to make a trade.
Now, have you ever heard the old adage, "History tends to repeat itself"?
Well, that's basically what technical analysis is all about! If a price level held as a key support or resistance in the past, traders will keep an eye out for it and base their trades around that historical price level.
Technical analysts look for similar patterns that have formed in the past, and will form trade ideas believing that price will act the same way that it did before.
In the world of trading, when someone says technical analysis, the first thing that comes to mind is a chart. Technical analysts use charts because they are the easiest way to visualize historical data!
You can look at past data to help you spot trends and patterns which could help you find some great trading opportunities.
What's more is that with all the traders who rely on technical analysis out there, these price patterns and indicator signals tend to become self-fulfilling.
As more and more traders look for certain price levels and chart patterns, the more likely that these patterns will manifest themselves in the markets.
You should know though that technical analysis is VERY subjective.
Just because Ralph and Joseph are looking at the exact same chart setup or indicators doesn't mean that they will come up with the same idea of where price may be headed.
The important thing is that you understand the concepts under technical analysis so you won't get nosebleeds whenever somebody starts talking about Fibonacci, Bollinger bands, or pivot points.
Now we know you're thinking to yourself, "Geez, these guys are smart. They use crazy words like 'Fibonacci' and 'Bollinger'. I can never learn this stuff!"
Don't worry yourself too much. After you're done with the School of Pipsology, you too will be just as... uhmmm... "smart" as us.
Remember one thing always In Technical Analysis Charts is everything.
Types of Charts.
Now, we'll explain each of the charts, and let you know what you should know about each of them.
Let's take a look at the three most popular types of charts:
LESSON 1.
1. Line chart
2. Bar chart
3. Candlestick chart
Line Charts
A simple line chart draws a line from one closing price to the next closing price. When strung together with a line, we can see the general price movement of a currency pair over a period of time.
Here is an example of a line chart for EUR/USD:
Bar Charts
A bar chart is a little more complex. It shows the opening and closing prices, as well as the highs and lows. The bottom of the vertical bar indicates the lowest traded price for that time period, while the top of the bar indicates the highest price paid.
The vertical bar itself indicates the currency pair's trading range as a whole.
The horizontal hash on the left side of the bar is the opening price, and the right-side horizontal hash is the closing price.
Here is an example of a bar chart for EUR/USD:
Take note, throughout our lessons, you will see the word "bar" in reference to a single piece of data on a chart.
A bar is simply one segment of time, whether it is one day, one week, or one hour. When you see the word 'bar' going forward, be sure to understand what time frame it is referencing.
Bar charts are also called "OHLC" charts, because they indicate the Open, the High, the Low, and the Close for that particular currency. Here's an example of a price bar:
Open: The little horizontal line on the left is the opening price
High: The top of the vertical line defines the highest price of the time period
Low: The bottom of the vertical line defines the lowest price of the time period
Close: The little horizontal line on the right is the closing price
Candlesticks Charts
Candlestick chart show the same information as a bar chart, but in a prettier, graphic format.
Candlestick bars still indicate the high-to-low range with a vertical line.
However, in candlestick charting, the larger block (or body) in the middle indicates the range between the opening and closing prices. Traditionally, if the block in the middle is filled or colored in, then the currency closed lower than it opened.
In the following example, the 'filled color' is black. For our 'filled' blocks, the top of the block is the opening price, and the bottom of the block is the closing price. If the closing price is higher than the opening price, then the block in the middle will be "white" or hollow or unfilled.
Here at BabyPips.com, we don't like to use the traditional black and white candlesticks. They just look so unappealing. And since we spend so much time looking at charts, we feel it's easier to look at a chart that's colored.
A color television is much better than a black and white television, so why not splash some color in those candlestick charts?
We simply substituted green instead of white, and red instead of black. This means that if the price closed higher than it opened, the candlestick would be green.
If the price closed lower than it opened, the candlestick would be red.
In our later lessons, you will see how using green and red candles will allow you to "see" things on the charts much faster, such as uptrend/downtrends and possible reversal points.
For now, just remember that we use red and green candlesticks instead of black and white and we will be using these colors from now on.
Check out these candlesticks...BabyPips.com style! Awww yeeaaah! You know you like that!
Here is an example of a candlestick chart for EUR/USD. Isn't it pretty?
The purpose of candlestick charting is strictly to serve as a visual aid, since the exact same information appears on an OHLC bar chart. The advantages of candlestick charting are:
* Candlesticks are easy to interpret, and are a good place for beginners to start figuring out chart analysis.
* Candlesticks are easy to use! Your eyes adapt almost immediately to the information in the bar notation. Plus, research shows that visuals help in studying, it might help with trading as well!
* Candlesticks and candlestick patterns have cool names such as the shooting star, which helps you to remember what the pattern means.
* Candlesticks are good at identifying marketing turning points - reversals from an uptrend to a downtrend or a downtrend to an uptrend. You will learn more about this later.
Now that you know why candlesticks are so cool, it's time to let you know that we will be using candlestick charts for most, if not all of chart examples on this site.
LESSON 2.
Support and Resistance
Support and resistance is one of the most widely used concepts in trading. Strangely enough, everyone seems to have their own idea on how you should measure support and resistance.
Let's take a look at the basics first.
Look at the diagram above. As you can see, this zigzag pattern is making its way up (bull market). When the market moves up and then pulls back, the highest point reached before it pulled back is now resistance.
As the market continues up again, the lowest point reached before it started back is now support. In this way resistance and support are continually formed as the market oscillates over time. The reverse is true for the downtrend.
Plotting Support and Resistance
One thing to remember is that support and resistance levels are not exact numbers.
Often times you will see a support or resistance level that appears broken, but soon after find out that the market was just testing it. With candlestick charts, these "tests" of support and resistance are usually represented by the candlestick shadows.
Notice how the shadows of the candles tested the 1.4700 support level. At those times it seemed like the market was "breaking" support. In hindsight we can see that the market was merely testing that level.
So how do we truly know if support and resistance was broken?
There is no definite answer to this question. Some argue that a support or resistance level is broken if the market can actually close past that level. However, you will find that this is not always the case.
Let's take our same example from above and see what happened when the price actually closed past the 1.4700 support level.
In this case, price had closed below the 1.4700 support level but ended up rising back up above it.
If you had believed that this was a real breakout and sold this pair, you would've been seriously hurtin'!
Looking at the chart now, you can visually see and come to the conclusion that the support was not actually broken; it is still very much intact and now even stronger.
To help you filter out these false breakouts, you should think of support and resistance more of as "zones" rather than concrete numbers.
One way to help you find these zones is to plot support and resistance on a line chart rather than a candlestick chart. The reason is that line charts only show you the closing price while candlesticks add the extreme highs and lows to the picture.
These highs and lows can be misleading because often times they are just the "knee-jerk" reactions of the market. It's like when someone is doing something really strange, but when asked about it, he or she simply replies, "Sorry, it's just a reflex."
When plotting support and resistance, you don't want the reflexes of the market. You only want to plot its intentional movements.
Looking at the line chart, you want to plot your support and resistance lines around areas where you can see the price forming several peaks or valleys.
Other interesting tidbits about support and resistance:
* When the price passes through resistance, that resistance could potentially become support.
* The more often price tests a level of resistance or support without breaking it, the stronger the area of resistance or support is.
* When a support or resistance level breaks, the strength of the follow-through move depends on how strongly the broken support or resistance had been holding.
With a little practice, you'll be able to spot potential support and resistance areas easily. In the next lesson, we'll teach you how to trade diagonal support and resistance lines, otherwise known as trend lines.
LESSON 3.
Trend Lines
Trend lines are probably the most common form of technical analysis. They are probably one of the most underutilized ones as well.
If drawn correctly, they can be as accurate as any other method. Unfortunately, most traders don't draw them correctly or try to make the line fit the market instead of the other way around.
In their most basic form, an uptrend line is drawn along the bottom of easily identifiable support areas (valleys). In a downtrend, the trend line is drawn along the top of easily identifiable resistance areas (peaks).
How do you draw trend lines?
To draw trend lines properly, all you have to do is locate two major tops or bottoms and connect them.
What's next?
Nothing.
Uhh, is that it?
Yep, it's that simple.
Here are trend lines in action! Look at those waves!
Types of Trends
There are three types of trends:
1. Uptrend (higher lows)
2. Downtrend (lower highs)
3. Sideways trends (ranging)
Here are some important things to remember about trend lines:
* It takes at least two tops or bottoms to draw a valid trend line but it takes THREE to confirm a trend line.
* The STEEPER the trend line you draw, the less reliable it is going to be and the more likely it will break.
* Like horizontal support and resistance levels, trend lines become stronger the more times they are tested.
* And most importantly, DO NOT EVER draw trend lines by forcing them to fit the market. If they do not fit right, then that trend line isn't a valid one!
Channels
If we take this trend line theory one step further and draw a parallel line at the same angle of the uptrend or downtrend, we will have created a channel. No, we're not talking about ESPN, ABC, or Cartoon Network.
Still, this doesn't mean that you should walk away like it's a commercial break- channels can be just as exciting to watch as America's Next Top Model or Entourage!
Channels are just another tool in technical analysis which can be used to determine good places to buy or sell. Both the tops and bottoms of channels represent potential areas of support or resistance.
To create an up (ascending) channel, simply draw a parallel line at the same angle as an uptrend line and then move that line to position where it touches the most recent peak. This should be done at the same time you create the trend line.
To create a down (descending) channel, simple draw a parallel line at the same angle as the downtrend line and then move that line to a position where it touches the most recent valley. This should be done at the same time you create the trend line.
When prices hit the bottom trend line, this may be used as a buying area. When prices hit the upper trend line, this may be used as a selling area.
Types of channels
There are three types of channels:
1. Ascending channel (higher highs and higher lows)
2. Descending channel (lower highers and lower lows)
3. Horizontal channel (ranging)
Important things to remember about trend lines:
* When constructing a channel, both trend lines must be parallel to each other.
* Generally, the bottom of channel is considered a buy zone while the top of channel is considered a sell zone.
* Like in drawing trend lines, DO NOT EVER force the price to the channels that you draw! A channel boundary that is sloping at one angle while the corresponding channel boundary is sloping at another is not correct and could lead to bad trades.
Trading the Lines
Now that you know the basics, it's time to apply these basic but extremely useful technical tools in your trading. Because here at BabyPips.com we want to make things easy to understand, we have divided trading support and resistance levels into two simple ideas: the Bounce and the Break.
The Bounce
Man bouncing off trampoline
As the name suggests, one method of trading support and resistance levels is right after the bounce.
Many retail traders make the error of setting their orders directly on support and resistance levels and then just waiting to for their trade to materialize. Sure, this may work at times but this kind of trading method assumes that a support or resistance level will hold without price actually getting there yet.
You might be thinking, "Why don't I just set an entry order right on the line? That way, I am assured the best possible price."
When playing the bounce we want to tilt the odds in our favor and find some sort of confirmation that the support or resistance will hold. Instead of simply buying or selling right off the bat, wait for it to bounce first before entering. By doing this, you avoid those moments where price moves fast and break through support and resistance levels. From experience, catching a falling knife can get really bloody...
Bounce of supportBounce of trend line
The Break
In a perfect world, support and resistance levels would hold forever, McDonalds would be healthy, and we'd all have jetpacks. In a perfect trading world, we could just jump in and out whenever price hits those major support and resistance levels and earn loads of money. The fact of the matter is that these levels break... often.
So, it's not enough to just play bounces. You should also know what to do whenever support and resistance levels give way! There are two ways to play breaks: the aggressive way or the conservative way.
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The Aggressive Way
The simplest way to play breakouts is to buy or sell whenever price passes convincingly through a support or resistance zone. The key word here is convincingly because we only want to enter when price passes through a significant support or resistance level with ease.
We want the support or resistance area to act as if it
just received a Chuck Norris karate chop: We want it to wilt over in pain as price breaks right through it.
Aggressive way of trading a break of support or resistance
The Conservative Way
Imagine this hypothetical situation: you decided to go long EUR/USD hoping it would rise after bouncing from a support level. Soon after, support breaks and you are now holding on to a losing position, with your account balance slowly falling.
Do you...
1. Accept defeat, get the heck out, and liquidate your position?
2. OR Hold on to your trade and hope price rises up again?
If your choice is the second one, then you will easily understand this type of trading method. Remember, whenever you close out a position, you take the opposite side of the trade. Closing your EUR/USD long trade at or near breakeven means you will have to short the EUR/USD by the same amount. Now, if enough selling and liquidiation of losing postions happen at the broken support level, price will reverse and start falling again. This phenomenon is the main reason why broken support levels become resistance whenever they break.
As you would've guessed, taking advantage of this phenomenon is all about being patient. Instead of entering right on the break, you wait for price to make a "pullback" to the broken support or resistance level and enter after the price bounces.
The conservative way of trading breaks of support and resistance: Wait for the pullback
A few words of caution... THIS DOES NOT HAPPEN ALL THE TIME. "RETESTS" OF BROKEN SUPPORT AND RESISTANCE LEVELS DO NOT HAPPEN ALL THE TIME. THERE WILL BE TIMES THAT PRICE WILL JUST MOVE IN ONE DIRECTION AND LEAVE YOU BEHIND. BECAUSE OF THIS, ALWAYS USE STOP LOSS ORDERS AND NEVER EVER HOLD ON TO A TRADE JUST BECAUSE OF HOPE.
Summary: Support and Resistance
Summary of support and resistance
When the market moves up and then pulls back, the highest point reached before it pulls back is now resistance.
As the market continues up again, the lowest point reached before it climbs back is now support.
One thing to remember is that horizontal support and resistance levels are not exact numbers.
To help you filter out these false breakouts, you should think of support and resistance more of as "zones" rather than concrete numbers.
One way to help you find these zones is to plot support and resistance on a line chart rather than a candlestick chart.
Another thing to remember is that when price passes through a resistance level, that resistance could potentially become support. The same could also happen with a support level. If a support level is broken, it could potentially become a resistance level.
Trend Lines
In their most basic form, an uptrend line is drawn along the bottom of easily identifiable support areas (valleys). In a downtrend, the trend line is drawn along the top of easily identifiable resistance areas (peaks).
There are three types of trends:
1. Uptrend (higher lows)
2. Downtrend (lower highs)
3. Sideways trends (ranging)
Channels
To create an up (ascending) channel, simply draw a parallel line at the same angle as an uptrend line and then move that line to position where it touches the most recent peak.
To create a down (descending) channel, simple draw a parallel line at the same angle as the downtrend line and then move that line to a position where it touches the most recent valley.
1. Ascending channel (higher highs and higher lows)
2. Descending channel (lower highers and lower lows)
3. Horizontal channel (ranging)
Trading support and resistance levels can be divided into two methods: the bounce and the break.
When trading the bounce we want to tilt the odds in our favor and find some sort of confirmation that the support or resistance will hold. Instead of simply buying or selling right off the bat, wait for it to bounce first before entering. By doing this, you avoid those moments where price moves so fast that it slices through support and resistance levels like a knife slicing through warm butter.
As for trading the break, there is the aggressive way and there is the conservative way. In the aggressive way, you simply buy or sell whenever the price passes through a support or resistance zone with ease. In the conservative way, you wait for price to make a "pullback" to the broken support or resistance level and enter after price bounces.
LESSON 3.
Moving Averages
Smooth Moving Averages
A moving average is simply a way to smooth out price action over time. By "moving average", we mean that you are taking the average closing price of a currency pair for the last 'X' number of periods. On a chart, it would look like this:
Like every indicator, a moving average indicator is used to help us forecast future prices. By looking at the slope of the moving average, you can better determine the potential direction of market prices.
As we said, moving averages smooth out price action.
There are different types of moving averages and each of them has their own level of "smoothness".
Generally, the smoother the moving average, the slower it is to react to the price movement.
The choppier the moving average, the quicker it is to react to the price movement. To make a moving average smoother, you should get the average closing prices over a longer time period.
Now, you're probably thinking, "C'mon, let's get to the good stuff. How can I use this to trade?"
In this section, we first need to explain to you the two major types of moving averages:
1. Simple
2. Exponential
We'll also teach you how to calculate them and give the pros and cons of each. Just like in every other lesson in the BabyPips.com School of Pipsology, you need to know the basics first!
After you've got that on lockdown like Argentinian soccer player Lionel Messi's ball-handling skills, we'll teach you the different ways to use moving averages and how to incorporate them into your trading strategy.
By the end of this lesson, you'll be just as smooth as Messi's!
Are you ready?
If you are, give us a "Heck yeah!"
If not, go back and reread the intro.
Simple Moving Averages
A simple moving average is the simplest type of moving average (DUH!). Basically, a simple moving average is calculated by adding up the last "X" period's closing prices and then dividing that number by X.
Confused???
Don't worry, we'll make it crystal clear.
If you plotted a 5 period simple moving average on a 1-hour chart, you would add up the closing prices for the last 5 hours, and then divide that number by 5. Voila! You have the average closing price over the last five hours! String those average prices together and you get a moving average!
If you were to plot a 5-period simple moving average on a 10-minute chart, you would add up the closing prices of the last 50 minutes and then divide that number by 5.
If you were to plot a 5 period simple moving average on a 30 minute chart, you would add up the closing prices of the last 150 minutes and then divide that number by 5.
If you were to plot the 5 period simple moving average on the 4 hr. chart... Okay, okay, we know, we know. You get the picture!
Most charting packages will do all the calculations for you. The reason we just bored you (yawn!) with a "how to" on calculating simple moving averages is because it's important to understand so that you know how to edit and tweak the indicator.
Understanding how an indicator works means you can adjust and create different strategies as the market environment changes.
Now, just like almost any other indicator out there, moving averages operate with a delay. Because you are taking the averages of past price history, you are really only seeing the general path of the recent past and the general direction of "future" short term price action.
Disclaimer: Moving averages will not turn you into Ms. Cleo the psychic!
Here is an example of how moving averages smooth out the price action.
On chart above, we've plotted three different SMAs on the 1-hour chart of USD/CHF. As you can see, the longer the SMA period is, the more it lags behind the price.
Notice how the 62 SMA is farther away from the current price than the 30 and 5 SMAs.
This is because the 62 SMA adds up the closing prices of the last 62 periods and divides it by 62. The longer period you use for the SMA, the slower it is to react to the price movement.
The SMAs in this chart show you the overall sentiment of the market at this point in time. Here, we can see that the pair is trending.
Instead of just looking at the current price of the market, the moving averages give us a broader view, and we can now gauge the general direction of its future price. With the use of SMAs, we can tell whether a pair is trending up, trending down, or just ranging.
There is one problem with the simple moving average and it's that they are susceptible to spikes. When this happens, this can give us false signals. We might think that a new trend may be developing but in reality, nothing changed.
In the next lesson, we will show you what we mean, and also introduce you to another type of moving average to avoid this problem.
