Why Does Technical Analysis Work?
Technical analysis describes different ways of predicting the future of the underlying market based on its history. Unfortunately, technical analysis is not an exact science. Many prominent scientists label it as “voodoo science”. They claim that due to market efficiency, if you use TA to find your entry positions, you’re no better off than someone who chooses those positions randomly. Market efficiency means that all the available information is already calculated in the market prices, and that you can only guess how wills the price behave in the future.
The “voodoo science” theory would make sense if it wasn’t for a fact that there is a significant number of traders who are able to consistently make profits in currency markets. Those traders use technical analysis as their main tool. Since any trader has or can have access to the same TA tools we have to ask how can a small group of traders consistently win and the other larger group, more or less consistently lose in the currency trading game. What is it that winning traders know about technical analysis that gives them the upper hand?
The answer is simple: Technical Analysis works but not necessarily for the reason most people believe. Many successful traders don’t want to share this secret. TA works because many people use it, and successful traders are able to predict how will other people react on different TA indicators and signals. In other words, while the losing traders are using TA to determine their trades, winning traders are winning because they know how the losers are going to react based on this data. For example, when a price goes below one of the key moving averages, MA, many traders will sell to protect themselves against additional losses.
By doing so, they will drive the price of that instrument/currency lower and that will prompt some traders to start short selling in anticipation of further decline. Prices continue the downward trend, forcing traders who were long on that particular instrument/currency to sell their positions because it is going below their stop limits. This creates a domino effect as the price continues to decline. However, at this point, successful traders realize that most of the current price action was created artificially. They start to enter the positions on the buy side and more often than not price starts to reverse. The losing traders have already sold their positions based on the TA tools. The winning traders buy the instrument/currency because they understand that fluctuation was temporary, and they seize the opportunity based on the losing trader’s reactions.
No TA tool by itself will give you reliable buy or sell signals. There is no Holy Grail or magic black box that will give you the perfect, accurate signal. However, combining of the right group of TA indicators with discipline and adequate trading capital has been the road to fortune for many traders. There is no reason why you cannot emulate their success.
Technical Analysis is similar to studying history. Historians are usually able to make the most accurate predictions of future and outcomes of events. Usually the past repeats itself. History proves that people historically behave in the same manner in the similar situations. Great empires start to fall when everybody starts thinking that they are invincible.
The same thing happens in currency markets. Every time when there has been a long lasting bull market in any major currency, new experts come from the woodwork claiming that this time it is different, that for this currency sky is the limit, fundamentals are strong there are hundred reasons why this currency should continue to appreciate. And now everybody starts to buy this currency more and more. Money is borrowed, leveraged and put into this currency.
However, when no fresh money is coming in to feed this beast, it has to start to feed of itself. There comes the bear. If traders who were among the last to join the party looked at the charts of previous times, they would have noticed that many technical indicators were behaving similarly as they had in the past.
When you’re unprepared and unaware of historical facts, history is doomed to repeat itself. This is the last lesson you want to learn the hard way when entering the currency trading battle. If you learn while in the battle, not beforehand, your chances of success will most likely be lost.
We will now examine the most important TA indicators and how can they be effectively used in predicting future movements in currency prices.
Moving average is one of the most widely used TA indicators. Moving average is calculated by finding the average price of the trading instrument over a set number of periods. It is called a ‘moving” average because as the newest period is added, the oldest period is dropped. MA crossovers are used in many trading systems as buy or sell signals. Usually combinations of two or three MA intervals are used. Another popular way of observing buy and sell signals is by using single, longer term MA such as 20 day MA. Buy signals occur when the current price crosses MA from below to above. The sell signal occurs when current price crosses MA from above to below.
Figure above is a daily candlestick chart for EUR/USD covering a five-month period.
Blue line represents 20 day Moving Average. As we can observe from the chart when the price crosses blue line from the above to below it is usually a negative signal and the trend becomes bearish for a certain period of time. Then, when the price crosses the blue line from below to above, sentiment changes and the trend becomes bullish for a certain period of time.
Figure above is 1-hour candlestick chart for EUR/USD covering a five-day period. Red line represents 4 hour moving average and blue line represents 12 hour moving average. Buy signal occurs when 12 period MA (blue line) crosses 4 period MA (red line) from above to below and sell signal occurs when 12 period MA crosses 4 period MA from below to above.
Relative Strength Index RSI
Relative strength index is a momentum indicator. It usually moves ahead of price. It is an indicator that measures an instruments price relative to itself. The values that it can have are between 0 and 1000. Sudden short-term movements in an instruments price do not affect it. Therefore, it looks at the overall picture and eliminates much of the marketplace noise. RSI is usually used in combination with other indicators. RSI value of 30 or less is generally considered as buy signal and RSI value of 70 or more is considered as sell signal.
Figure above is a daily candlestick chart for EUR/USD. The RSI value is represented by the blue line on the bottom part of the chart. From the chart above we can observe that when the RSI starts reaching upper horizontal line price is often peaking and is starting to reverse its course and when the RSI starts reaching lower horizontal line price is often bottoming and is starting to reverse. Traders also look for the divergence between price movement and RSI (price moving up and RSI moving down and vice versa). If you see such movement, it is very likely that price is about to change direction.
Support and Resistance Levels
Support and resistance is the most basic concept of technical analysis. There is no wonder since support and resistance are based on supply and demand. And as we all know supply and demand determine the price of goods in this case of the currencies traded. To recollect the law of support and demand in forex: as the demand for some currency increases the price of this currency will also increase and v.v. if the supply for some currency increases the price will decrease.
What are then support and resistance?
Support is created at points below current price where there are enough buyers to prevent and eventually reverse decline of the underlying instruments price. Resistance is created at points above the current price where there are enough sellers to stop and eventually reverse advance in the underlying instruments price.
If the price breaks through support then support becomes resistance level and if the price breaks through resistance then resistance becomes support.
And what we are trying to do, is nothing else than forecast the price of currencies at the given time. So if we can find out what are the support and resistance levels, we could with high probability tell in which direction price will move.
Support and resistance are often established around key exponential moving average such as 20 day MA and 50 day MA or around key Fibonacci Retracement levels. Sometimes they simply establish around round numbers such as 1.15, 1.10, 0.75 etc…