Forex technical analysis is the method of studying historical price action by the use of charts, to forecast the future prices. A technical analyst studies the chart, identifies the trend which in turn identifies the demand and supply for an asset.
If the demand is high for an asset, a technical analyst assumes the price will go up. Likewise, if the supply is more, the technician assumes the price will go down.
Basic Assumptions of Technical Analysis
Market discounts Everything
Technical Analysis assumes that ‘the market discounts everything’- the market discounts all the factors, whether it be fundamental or psychological, affecting the market. It simply means that the factor should change the dynamics of demand and supply of the market.
Prices move in Trends
The basic purpose of studying charts is to identify the trends at the earliest. Always remember the mantra ’Trend is your Friend’. It is wise to assume that the trend is likely to continue rather than reverse.
History tends to Repeat Itself
What has worked in the past, will work in the future also. People tend to buy at support levels and sell at resistance levels. The chart pattern indicates the psychology of the human brain which is pretty hard to change.
Technical Analysis is based on the premise that price move in trends. The trend is the general direction of the market. It indicates whether the demand is increasing or supply is decreasing, sequentially. The market does not move in a straight line; it is characterized by a series of highs(peaks) and lows(troughs). Here we have discussed trend based on price action but the trend can also be defined with the help of moving average and indicators like RSI, MACD and ADX.
In an uptrend, the price action makes a sequence of higher highs and higher lows. The demand will be high and supply will be low in an uptrend. Traders tend to take a long trade on the higher lows.
When the price action makes a sequence of lower lows and lower highs, it is said to be in a downtrend. The supply will be high and demand will be low in a downtrend. Hence, it is wise to initiate short trades on the lower high points in a downtrend.
The price action is between a tight range in a sideways trend. The demand and supply will be equal in a sideways trend. The price action after making a trend move forms a sideways trend in order to consolidate. The sideways trend can be a reversal pattern or a continuation pattern. The sideways trend is a tricky market for newbies but experienced traders identify the range quickly and trade the range.
The higher lows of an uptrend or the lower highs of a downtrend can be connected through a line referred as the trendline. A minimum of 3 points needs to be connected to form a trendline. The slope of the trendline should be between 15 degrees to 30 degrees, for it to sustain for a longer period of time. If the slope is more than 30 degree, the momentum can’t be sustained by price action.
Trendline serves a dual purpose – continuation and reversal. A trader initiates a long trade whenever the currency pair touches the trendline. Likewise, when the trendline breaks, it indicates a trend reversal which certainly leads to a major sell-off.