Forecasting Forex -The Technical Approach
Forecasting Forex currency movement may be assessed using two general methods: Fundamental Analysis and Technical analysis. Fundamental Analysis studies the long-term cause of currency movement while technical analysis studies the short-term effect.
Technical Analysis Preface and Three Basic Principles
Theoretically speaking there is no way you can forecast future currency movement as everything is incorporated in the prices of financial assets before the blink of an eye. Practically speaking, the incorporation of news and events can not happen always so fast. Just think that there are multiple time zones around the globe and when something is happening in New York most probably traders in Asia are inactive. Furthermore, some events are so complex by nature that need several days in order to be analyzed reliably and get incorporated in the price of financial assets. Technical Analysis relies on three basic principles:
(i) Price Action Discounts Everything
This means that all known news and updates that could affect the prices of financial assets are eventually incorporated in the prices of financial assets.
(ii) Price Moves in Trends
That means that prices of financial assets tend to move in the same direction (upwards or downwards) for long periods of time. The explanation of this condition is based on the fact that the raw of news and events in real economy tends to move also in a particular direction for long periods
(iii) History Repeats Itself
Forex currencies tend to react exactly the same way to their past reactions if the market conditions are identical. That can be explained as the human behavior tends to repeat itself. If human behavior is repeating itself then the price of financial assets is repeating itself as markets are traded by humans.
These are some popular technical analysis tools and practices presented in this article:
■ Pivot Points
■ Indicators and Oscillators
■ Price Patterns
■ Elliott Wave Theory
■ Number Theories
All Forex technicians study the historic course of exchange rates using charts. Charts are used for multiple purposes including trend identification, price pattern recognition, plotting trendlines and major support & resistance levels identification. In addition, several indicators can be visualized by using price charts such is Moving Averages, Bollinger Bands, Parabolic SAR etc.
Three Categories of Forex Charts
There are three main categories of Forex charts: line charts, bar charts, and candlesticks.
(i) Line Chart
A line chart offers the simplest way for monitoring historic prices. Line charts do not provide a lot of information.
(ii) Bar Charts
Bar charts plot currency movement using bars. Each bar represents the price behavior over a single time period. That means that in 1-minute charts, each bar represents 1 minute, in 1-hour charts, each bar represents 1-hour and so long. Each single bar contains 4 prices:
□ Open Price (price as the period is starting)
□ High Price (the highest price of the period)
□ Low Price (the lowest price of the period)
□ Close Price (the last price as the period ends)
(iii) Candlestick Charts
Candlestick charts contain the exact number of information as in the case of bar charts (Open, High, Low and Close), the difference comes on the way this information is presented.
The top and the bottom points of the candlestick body represent the opening and closing prices during a certain period (for example 1-hour). The color of each candlestick signifies if the closing price was higher or lower than the opening price.
□ Higher closing price than opening price is usually plotted by using white or green main body
□ Lower closing price than opening price is usually plotted by using black or red colored b main body
This is one of the key tools used daily by Forex Professionals. Each pivot is simply the average of the high, the low and the closing price of the previous trading period. Usually, this time period involves the past 24 hours.
■ Pivot Point = ( High + Low + Close ) / 3
Stock traders usually add also the opening price and divide the sum by 4.
If the price of a financial asset trades above the main pivot point is thought as an ongoing bullish sentiment, if it trades below the main pivot point it is thought as an ongoing bearish sentiment. When the price reaches one of the key pivots price reversals are very common. You can use Daily Pivots, Weekly Pivots or even Monthly Pivots.
Indicators and Oscillators
Indicators and Oscillators are used by Forex Traders for multiple purposes including Forecasting Trends and Reversals, Identifying Overbought / Oversold markets, Trading Signals Generation etc. The indicators are plotted within the price chart while oscillators are plotted below the price chart. Oscillators are usually used for markets that are moving in ranges, and that means that they don’t move in trends.
Some PopularPrice-Based Indicators /Oscillators
There are hundreds of indicators / oscillators used by Forex Traders, here is a list including the most popular:
MACD (The best Indicator for Trading Forex)
Relative Strength Index (RSI)
Average Directional Index (ADX)
Average True Range (ATR)
Commodity Channel Index (CCI)
Rate of Change (ROC)
Moving averages are indicators used for smoothing the price action over time. There are many different types of moving averages the most popular are the SMA and the EMA:
■ Simple Moving Average (SMA)
A simple moving average is calculated by summing the closing prices of N periods and by dividing the result by N.
■ Exponential Moving Average (EMA)
Exponential moving averages work like the SMAs but give extra weight to recent periods.
Price Chart Patterns
Been able of identifying price patterns is very important for all Forex Traders. There are many different price patterns while Head & Shoulders is the most popular:
Head and Shoulders Price Pattern
This pattern signifies a trend reversal formation. The components include a price peak (shoulder), followed by a higher price peak (head), and finally a lower price peak (shoulder). Note that during a strong downtrend this pattern can generate much more reliable signals.
■ Other popular price patterns include Ascending Triangles, Descending Triangles, Railways Tracks, Pins etc.
The Elliott Wave Theory
The Elliott Wave Theory was originally developed for trading the stock market but it is used also by Foreign Exchange traders. According to Mr. Ralph Nelson Elliott, markets tend to trade in a similar repetitive cycle that contains 8 waves (5 bullish and 3 bearish).
5 – 3 Elliott Wave Pattern
□ The bullish 5-waves are called impulsive waves
□ The bearish 3-waves are called corrective waves
First investors entering the market by buying an asset that they consider as an undervalued asset. The Price starts to rise.
As more and more investors have entered the market, the financial asset’s price becomes overheated and therefore some investors capitalize a part of their profits. As supply exceeds demand the price of the asset finally corrects.
As the price has corrected enough new investors are entering the market. The end of wave-2 and the start of wave-3 it is usually characterized by a decreasing trading volume. Wave-3 is confirmed when the price exceeds the highest point of wave-1. The wave-3 is the longest in time and the strongest in profits wave.
As the price becomes overbought again, investors capitalize again some of their profits. Wave-4 is usually weak as most investors are still bullish about the future price of the financial asset.
After the price correction, new investors are entering the market. In most of the times, important news and updates are released during wave-5. The wave-5 is confirmed when the price exceeds the highest price of wave-3. Usually, wave-5 is characterized by purchasing hysteria.
Wave-6 (or wave a)
The end of wave-5 and the start of wave-6, it is usually signified by a tremendous increase of trading volume. Institutional investors sell heavily and the price tanks. The wave-6 usually ends close to the price area of prior Wave-4 low.
Wave-7 (or wave b)
After a strong selling during wave-6, wave-7 involves a short-term upwards movement or else a Bear-Market Rally. This is an upward correction of the downtrend as some investors are expecting the formation of a new uptrend.
Wave-8 (or wave c)
After the bear-market rally during wave-7, the wave-8 confirms the new downtrend. The downtrend is confirmed when the price drops below the lowest level of wave-6. At this point, the price really tanks as investors are panicked.
Elliott Theory 3 Conditions:
-Wave-2 can never retrace more than 100% of Wave-1
-Wave-3 can not be the shortest of the three bullish waves
-Wave-4 can not overlap Wave 1
Number Theories (Fibonacci numbers and Gann numbers)
■ The Fibonacci Sequence of Numbers
Every number in the Fibonacci sequence is calculated by adding the previous two numbers.
-Fibonacci numbers are very popular among stock traders. The Fibonacci Retracement is widely used by all kind of traders.
More at TradingFibonacci.com: » http://TradingFibonacci.com
■ Gann Numbers
Gann was a famous Wall Street trader. The key number of the Gann Theory is 144, so when the price of a financial asset reaches 144, 288 or 432 and so on then traders should be very careful as concerns reversals etc.
■ George Protonotarios, financial analyst, Forecasting Forex using Technical Analysis