How Does Technical Analysis Work in Forex?

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Technical analysis is a specific way of analyzing financial markets, such as forex markets, where the analysis only considers historical price action in order to form market forecasts. This is done by observing chart patterns as well as utilizing various types of computerized indicators. Forex traders find technical analysis useful for forecasting short-terms price fluctuations as well as for entry and exit points in the market.

Chart Patterns

Forex traders look at patterns seen in charts of historical price action for particular currency pairs that give clues as to possible direction or turning points for price movements. One of the most commonly utilized chart strategies is support and resistance which looks at historical highs and lows shown in price charts in an attempt to pinpoint potential reversals in trends. Other types of chart patterns used by technical analysts include double tops and double bottoms, descending and ascending flag shapes, head and shoulders as well as numerous other patterns that indicate future price action in one direction or another.

Technical Analysis Includes All Possible Factors

Forex traders use technical analysis because it includes all possible economic, political, psychological and social factors. The theory behind technical analysis assumes that all of these factors that influence market movements have already been priced into the currency market rates. Since interpreting these factors individually requires significant subjectivity, technical analysis enables traders to better quantify their forecasts in a more objective manner.

Disadvantages of Technical Analysis

On the other hand, technical analysis has disadvantages as well. The growing widespread use of technical analysis by traders creates a herd-like effect many times. Large numbers of forex traders may tend to position their stop losses at the same price levels. This can result in exaggerated declines or rallies. Many larger players in the market, such as financial institutions, may recognize technical patterns or technical indicator readings and use the herd-like mentality of smaller retail traders to intentionally trigger their stops. This results in profits for the larger market players and losses for the smaller retail traders.

Given this disadvantage it would make sense for forex traders to incorporate other methods of market analysis in order to provide a more accurate view of the market. Usually fundamental analysis of macroeconomic factors become more significant in longer-term trading strategies. However, fundamental factors and market sentiment can also cause market fluctuations on shorter time frames as well. Ultimately, the significance given to technical factors, fundamental factors and market sentiment will vary with each individual trader.

 
Writer Bio

LeBach Pham Le Bach Pham has been writing professionally after receiving his Bachelor’s of Art in English Literature from the University of California, San Diego in 2002. He now specializes in writing about legal, business and financial topics. Pham also earned a Paralegal Certificate from the University of San Diego and has experience working in the legal field. He also has experience in writing business plans for clients from various fields, including banking, finance, retail, education, beauty and various other sectors.

Sources:

  • http://www.investopedia.com/university/forexmarket/forex7.asp
  • http://www.forextraders.com/forex-analysis/forex-technical-analysis/technical-versus-fundamental-analysis.html
  • http://www.investopedia.com/walkthrough/forex/intermediate/level4/resistance-support.aspx
  • http://www.investopedia.com/university/charts/

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