Last update: July 2021
Technical analysis is the study of price action over time. The one thing we know for certain is price action doesn’t lie. However, when new traders first start charting, it can be difficult, if not impossible, to process all the information on the chart. There is a 4-step process to identification.
1. Identify Trend
I want to identify the trend to know which type of trade to look at. This is in reference to either bullish or bearish trades. I also want to identify the strength of the short-term and intermediate trends. This helps me identify how strong my bias is. The trade I select must match the bias in the trend. For example, buying a call option is an extremely bullish trading strategy. The bias in the trend must match the bias in the strategy.
2. Identify Pattern
There are many technical patterns. In broad terms, simply identifying retracement, continuation, or reversal pattern is appropriate. This also helps me identify the bias as well as what type of trading strategy to employ.
3. Identify support and resistance
Identify multiple areas of support and resistance. These areas play a role in every type of trading strategy.
4. Select strategy
The strategy that you select needs to match up with your technical analysis. Too often traders attempt to shove a square peg in a round hole. It’s important to match strategy selection with technical analysis.
Chart Types
There are three chart types that traders primarily use. Candlestick charts are widely used through Legacy Education. We use candlestick charts as they’re visually easier to recognize bullish/bearish singles and patterns. These charts also do a fantastic job at capturing the battle of supply and demand and the indication of momentum within specific candles and patterns.
Western Bar Chart
A style of chart used for technical analysis. It consists of a vertical line at the top, which indicates the high for the period a security traded at during the given time period, and the bottom represents the low. The close/last is displayed on the right side of the bar, and the open is shown on the left side of the bar.
Line Chart
A style of chart that is created by connecting a series of closing prices, from given time frames, together with a line. This is the most basic type of chart used and it is generally created by connecting a series of past prices together with a line.
Candlestick Chart
The method of drawing security charts originated in Japan. Requires the presence of Open, High, Low, and Close price data to be drawn. There are two basic types of candles: the white body and the black body. As with regular bar charts, a vertical line is used to indicate the periods (normally daily) high to low. When prices close higher than they opened a white rectangle is drawn on top of the high-low line. This rectangle originates at the opening price level and extends up towards the closing price. A down day is drawn in black. The combination of several candles results in patterns (with names like two crows or bullish engulfing pattern) which give insight into future price activity. For other Japanese charting approaches, also see Renko and Kagi charts.
Narrow-body candles
Show indecision, loss of momentum, and can be good indicators of support or resistance depending on where they occur on the chart.
Wide-body candles
Show momentum moving into the candle. This is especially nice during breakouts or after retracement occurs.
Candlestick Analysis
Technical analysis is an in-depth subject with discussions on trends, patterns, support/resistance, momentum, probability, indicators, and many more topics. This can lead to a vast degree of confusion with even the most seasoned technicians debating and disagreeing in determining the future movement on a chart. One of the concepts technicians use in projecting immediate movement is candlesticks.
Candlesticks are a helpful tool for quickly identify changes in security price. You want to set your charts as candlestick charts. In the above diagram, you see two candlesticks: white and red. The white candlestick on a chart denotes an upward moving price where the price has closed higher than where it started. A red candlestick denotes a downward moving price where the price has closed lower than where it started. The tail of the candlesticks shows you quickly the highest and lowest point that the currency pair was traded at during the period.
Trend Analysis
In the 1920s and 30s, an accountant named Ralph Elliott formed a trend analysis technique called Elliot Wave Theory. This technique is still in use today by many market technicians. It’s not an exact science, but one that determines probabilities based on past market cycles. According to Elliott, the market moved in a series of waves that were based on natural principles of positive versus negative market movements.
Most people who are familiar with trend analysis learn trends through pattern recognition of higher high / higher low where support and resistance increase over time. Elliott Wave is no different. However, it’s more accurate in determining what level of the trend the security is trading.
Elliott argued that the market moved in a series of waves called motive and corrective waves. These waves added up to five before the ABC pattern corrected the larger trend of the market. See below for illustration.
To determine where the waves started and ended, Fibonacci extensions and retracements were used. To illustrate, let’s look at the USD/JPY pair. This pair was trending neutral between 102 and 104 for four months before it broke out of the 104 level with a wide-body candle. This is what we refer to as a bullish breakout and the beginning of the trend. Once the pair hit resistance at the whole number of 110, the trader draws a Fibonacci retracement tool to draw the retracement zones or catalysts.
As you can see, the USD/JPY pair moved up in wave 1 from 101 to 110. This is a 900 pip movement. According to Elliott Wave theory, the pair will then retrace between 38 and 61% with a standard retracement of 50%; or in this case, 450 pips back down into the 105.50 level. This would be considered motive wave 1 and corrective wave 2. Once support is firmly established with an upward movement in price called confirmation, motive wave 3 begins, which is typically the longest of the wave counts. Motive wave 3 will move into the 100% range at a minimum but if the wave count holds true will move into 161% which the USD/JPY pair did.
Once motive wave 3 hits its target of 161%, the pair will retrace once again into the Fibonacci retracement levels of 38-61%.
Once corrective wave 4 is finished, motive wave 5 forms with a slowing momentum target of 61.8%. After motive wave 5, the ABC pattern forms, which in many instances is a longer-term (larger time frame) corrective wave pattern. The ABC pattern can also be a reversal pattern or a continuation pattern.
As stated earlier, Elliott Wave and Fibonacci retracements and extensions are not exact sciences. Many things can happen to alter the projections. However, it’s a technique that allows the trader to build an expectation based on probabilities.
Now that we have an understanding of the theory behind the analysis, let’s look at the three types of trends.
Bullish uptrend
In a bullish uptrend, the currency pair will form the motive wave up and corrective wave down pattern, otherwise known as the higher high / higher low. It is in this type of trend where the trader wants to buy the base currency.
Neutral sideways
In a neutral trend, there are no higher highs nor lower lows. The trend is basically sideways between two levels of support and resistance. While these trends can be amazing in the stock market due to selling calls or puts in the options market and cash flowing based on theta, they aren’t for the currency trader as most likely the trader will break even or lose time value.
Bearish downtrend
In a bearish downtrend, the currency pair will form motive waves down and corrective waves up or lower highs / lower lows. It is in this type of trend, the traders want to sell the base currency.
This type of trend analysis can be utilized on different time frames for different types of traders. There are four main types of traders. While the analysis is the same for all types of traders, the time frame on the chart will vary.
Day Traders
Day traders are traders that will make a trade that is complete within a 24-hour cycle. They will most likely be trading the forex cycle as discussed in earlier chapters with an emphasis on bank open trades, news-based trades, and standard 1-2-3 pattern trades.
Swing traders
Swing traders are also known as pivot-to-pivot traders, meaning they buy at support on the daily time frame and sell at resistance. The typical length of a swing trade is five to 10 days, but can vary depending on the individual cycle of the pair; known as potential average yield or PAY range. They focus primarily on the day chart but will drop the time frame to the four-hour or one-hour time frame to get exact entry and exit points. They will not hold through corrective retracements.
Position traders
Position traders are similar to day traders in that they do most of their analysis on the daily time frame but will also look at weekly charts to understand the longer time frame. One key difference between the swing and position trader is that the position trader will hold through corrective retracements as long as the pattern within the trend holds true.
Investors
Investors will look at weekly and monthly charts and are typically holding the currency in a form of carry trade or as a protection against fiat macro risk.
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9 Replies to “Forex Trading 101: Technical Analysis”
Thanks for this video Matt! Always good to hear and see the basics again. It’s a good reminder for me that trading does not have to be rocket science. My next goal is to master my emotions during trades. Thanks again for this valuable info!
Awesome video!
Love the Forex 101 series
Thanks Matt
Great video Matt. Very clean presentation visually; it’s easier for noobs to understand the 1-2-3 pattern with this video rather than looking at intimidating real-life charts. Thus, it would be a very good review tool for students to use in between Master Trader online sessions (because the 1-2-3 pattern was emphasized so heavily in that class).
Thanks Matt, very helpful.
Thanks Matt, very succinct.
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