When speculating on the Forex and CFD markets, traders can sometimes use historical data in order to try and predict what will happen to a particular asset in the future. To do this, they use technical analysis to identify previous trends and gauge where they think the product’s value will move.
Although it can be a powerful tool, it is important to remember that technical analysis does have its limitations. Past performance is not always a reliable indicator of future performance, so traders should always use other forms of research when formulating their strategies.
Here are the basics of technical analysis:
What type of trader are you?
The first thing you should consider is what your trading style will be. Are you more likely to open and close your positions in a short period of time, or will you tend to hold on to your assets to see how the market holds out?
Your response to this question will determine the types of trend you will use to carry out your analysis. There are usually three for you to choose from – short term, intermediate term and long term.
For those who like to conduct their trades at a fast pace, they can use daily or intraday charts (such as hourly). If you are a trader who likes to take their time, you will be more likely to use weekly or monthly charts.
Support and resistance
One way Forex traders can use technical analysis to determine their strategy is the use of support and resistance levels. These are metaphorical points on a chart at which investors expect the current trend of an asset to reverse.
In upward trends, investors will look to a resistance level to anticipate when an asset will start to decline. For downward trends, they will expect the product to ascend in value once a support level has been reached.
Such is the popularity of support and resistance levels, they can sometimes turn out to be self-fulfilling prophecies. This is due to the fact that a high volume of investors will place ‘take profit’ orders around these levels in anticipation of a reversal. When this happens, a large scale buying or selling period alone will be enough to send the market in the opposite direction.
Traders will usually plot levels across a number of different time periods – such as weekly or daily charts. If these anticipated support or resistance points are close together, the asset is said to be more likely to react off them.
As with most things in Forex and CFD trading, nothing is absolutely certain. Sometimes a trend can manage to break through support or resistance levels, and carry on the same trajectory. If this happens, investors will typically look for the next level and expect the asset to react off that.
In the event a resistance level is broken, it will then act as a support level if the downward trend starts to reverse. The same is true for a support level, in that it becomes a new resistance level if the prevailing trend begins to move downwards.
Upward and downward trends do not continuously move in the same direction. If you look closely at a chart, you will see a number of peaks and troughs throughout the trend line. These minor corrections are called retracements.
Retracements are expressed as a percentage, with the most common values being 50% and 100% - though there are various other levels in between. Traders can use several different techniques, such as Fibonacci, to plot where they think a retracement will happen, and how far it will go. They can then use this information to create more opportunities to take profits or prevent losses.
Another method traders use to predict the trajectory of an asset is by plotting trend lines. This is done by drawing two diagonal lines that connect consecutive peaks and troughs.
The price of your chosen financial product will likely move between these lines for as long as the trend continues. If the instrument manages to break through, the prevailing trend is said to be over.
Investors will pay particular attention to a trend line that has been tested numerous times, as this indicates that a trajectory will continue for longer. It is also important to note that not all market movements can be identified as trends. Markets must touch a trend line at least three times before they are valid.
These useful tools can inform traders if a particular asset has been overbought or oversold. If this happens, the market price will usually be unable to sustain its current trend, as there will be a lack of available buyers or sellers left to propel the trajectory further. At this point, investors can be more confident that a reversal is imminent.