"Technical analysis" is an industry term that more often than not sounds much more complicated than the actual process is. Really, it ought to be referred to as "price analysis", as this would be a more accurate description. Through the use of charted data, Forex traders around the world analyze their market of choice. The objective: determine future price movement. The means: understanding price movement patterns of the past.

Forms of technical analysis are far and wide, and all technical analysis is common with one very important fact: it uses the past to try and predict the future. This is similar to using only your car's rear-view mirror to drive forward: looking only in the mirror one can use the lines on the road to make sure the car is driving straight forward, and a corner can be spotted when the lines start to move away from the direction the car driving. Just like technical analysis, driving by only using a rear view mirror can be difficult – if not impossible – to spot upcoming sharp corners, especially when moving at fast speeds.

Before delving into technical indicators and strategies, we think it is important to have a general understanding of the basics to technical analysis.

Trends

When using technical analysis, it is often important to be able to recognize the type of trend the market is in. Generally any market condition can be classified into one of 3 conditions: an uptrend, downtrend, or sideways. For a market to be trending up, new highs need to break previous highs (higher highs) and the lows must be higher than previous lows (higher lows). Once the market fails to break previous highs - or if lows dip below previous lows - an uptrend may be in jeopardy and either a sideways market or a downtrend may follow.

Determining the type of trend a market can sometimes be arbitrary because of trend length. There are 3 different trend lengths: long term, intermediate, and short term. The market will never go straight up – or straight down – without making corrections; therefore, a long term trend may be going up, with a correction leading to an intermediate downtrend within the long term's uptrend.

Support and Resistance

As the market moves up and down, price levels will form; levels that seemingly provide a level of support, or a ceiling of resistance. These levels are appropriately called support and resistance. In the case of our trend example, each consecutive higher-high will be a resistance level, and each higher-low will, likewise, be a support level. The opposite is true for down trends: subsequent lower-lows will be support levels, and lower-highs will be new resistance levels.

These support and resistance lines can form trend lines, where a trend may seem to be defined by bouncing up off of a rising support level, or bouncing down off of a falling resistance level. In order to draw a trend line at least 2 market points are needed, though ideally a trend line will have 3 or more points which will confirm the trend line drawn. The more points a trend line has, the more confirmed and the more important the trend line becomes.

There are many technical indicators that aid a trader in determining a trend and potential entry and exit points. There are some basic technical indicators that a trader should know which will also help a trader understand more advanced technical indicators.

Moving Averages

Most literature written on technical analysis, more specifically technical indicators, begins with moving averages. The reason for this is simple; they are considered by most analysts the most basic and core trend identifying indicators. As its name would suggest a moving average calculates an average of price range over a specified period. For example, a 10 day moving average gathers the closing prices of each day within the 10 day period, adds the 10 prices together and then of course divides the sum by 10 to determine the average. The term moving implies that as a new day’s closing price is added to the equation, and the day that is now 11 days back is dropped from the equation.

There are many different types of moving averages. To read more about the different types of moving averages – and to learn how to use moving averages to trade – read the Moving Average course from our education center.

Moving Average Convergence / Divergence

The MACD indicator is another indicator that helps provide a fundamental understanding of technical analysis for various different reasons. A typical MACD will consist of 2 lines – the ‘MACD’ line, and the‘signal’ line – and will also have vertical bars that comprise the histogram. The main MACD line is a PIP measurement of the distance between 2 moving averages on the chart. Using default settings, the MACD line will tell the number of PIPs between a 12 and 26 period exponential moving average.

The signal line is then an exponential moving average of the main MACD line – by default, set to a period of 9. The histogram then measures the vertical distance between the main MACD line and the signal line.

There are many ways to decipher what the MACD is trying to tell us. To read more about the MACD, and how to use it to trade, read the MACD course from our education center.

Stochastic Oscillator

The stochastic oscillator is a basic form of oscillator that measures current price in relation to previous prices. Chartists use this indicator – and other similar oscillators – to gauge if the current price is overbought or oversold.

Because a market move typically does not make a move in one fell swoop without any corrections, the stochastic gives an indication if it thinks the market due for a possible downside correction (by being overbought) or due for a possible upside correction (by being oversold). Traders set levels at 80 and 20 and would consider anything above 80 to be overbought, and anything below 20 to be oversold. Generally speaking, a sell signal would be generated once the stochastic drops below 80 and a buy signal once it rises above 20.

Basic Technical Analysis Concepts

Charting & Charting Styles

'Charting' is essentially the most basic expression of technical analysis. There are many different charting styles and methods. We will cover three of the basics: line charts, bar charts, and candlestick charts.

Line Charts

A line chart is a simple visual representation of data. It generally plots the closing price of a given period and over the course of time connects the dots. The following image shows an example of a basic Forex line chart:

Bar Charts

Bar charts are one of the most popular types of trading charts. A Bar Chart displays a price's open, high, low and closing prices. As shown in the following image the top of the bar chart represents the highest price of the period, and the bottom of the bar represents the lowest price of the period. The opening price of the bar is shown by a short horizontal line on the left hand side of the bar. The closing price is shown by the same short horizontal line on the right hand side of the bar.

Candlestick Charts

Candlestick charting is widely believed to have first appeared sometime after 1850. Much of the credit for candlestick development and charting goes to a legendary rice trader named Homma from the town of Sakata.

The candlestick is comprised of a "body" and an upper and lower "wick". The body of the candle is typically a dark color when the close is at a lower price than was the open (a bearish candle). Conversely, if the close is at a higher price than was the open the candle will be hollow or a light color (a bullish candle). The wick of the candle represents the entire range of price for that period. The top of wick of course represents the price at its highest point, while the bottom of the wick represents the price at its lowest point.

Looking for Trends

There are certainly a few things that you are going to want to consider when looking at a chart. Ask yourself what the Forex chart on your screen is telling you, and which of the following questions are worth considering:

• Is there an obvious trend or direction of the market within the time frame that you are viewing?
• Are there any basic chart patterns formations such as triangles, wedges, pennants, double tops or bottoms or otherwise that might suggest a pending breakout or trend reversal?
• Is the market trading within the walls of any obvious support and resistance levels, or is the market trading within a channel?
• Have you considered any technical indicators?

Trends

The following chart shows an example of an upwards trend.

It takes two or more points to draw a trend line. The trend line in our example was drawn by identifying the lowest low of the trend and connecting the line to the following low preceding a new high. A solid trend line should continue in this manner until several lows followed by new highs are plotted.

Support and Resistance

Support and resistance represent key junctures where the forces of supply and demand meet.

Support is the price level at which demand is thought to be strong enough to prevent prices from declining further. Support levels are usually below the current price, though it is not uncommon for prices to dip below support briefly. Support does not always hold and a break below support levels signals that the bears (sellers) have won out over the bulls (buyers). A decline below a support level indicates a new willingness to sell and/or a lack of incentive to buy. Once a support level has been broken, another support level will be established at a lower level.

Resistance is the price level at which demand is thought to be strong enough to prevent prices from rising further. Resistance levels are usually above the current price, though it is not uncommon for prices to rise above resistance briefly. Resistance does not always hold and a break above resistance levels signals that the bulls (buyers) have won out over the bears (sellers). A raise above resistance levels indicates a new willingness to buy and/or a lack of incentive to sell. Once a new resistance level has been broken, another resistance level will be established at a higher level.

Moving Averages

Most literature written on technical analysis, more specifically technical indicators, begins with Moving Averages. As its name would suggest a moving average calculates an average of price range over a specified period. For example, a 10 day moving average gathers the closing price (or the open, high or low) of each day within the 10 day period, adds the 10 prices together and then of course divides by 10. The term moving implies that as a new day's closing price is added to the equation, the day that is now 11 days back is dropped from the equation. Figure 1 shows an example of a simple moving average line placed on a candlestick chart.

The example in figure 1 outlines what would be considered a Simple Moving Average. There are at least 7 varieties of moving averages, we will focus on the following three:

• Simple Moving Averages
• Exponential Moving Averages
• Weighted Moving Averages

What are moving averages trying to tell us?

It is essential that you understand what a moving average is trying to tell you. A moving average calculating the last 30 days of prices in the market essentially represents a consensus of price expectations over that 30 day period.

Understanding a moving average is at times as simple as comparing the market's current price expectations to that of the market's average price expectations over the time frame that you are viewing. The average gives us a range that traders are comfortable trading within.

When prices stray from this zone, or from the moving average line, a trader should begin to look for potential entry points into the market. For example, a price that has risen above the moving average line typically implies a market that is becoming more bullish. ( view figure 2 ) Just the opposite, when prices begin to fall below moving average lines the market is becoming visibly bearish.

Notice the angle of the moving average shown above at various points across the chart. Moving averages not only give traders a much smoother look at the true trend of the market, they also offer keen directional insight found in the angle of the moving average line. Erratic sideways markets tend to be represented by moving average lines that are flat or sideways, whereas markets that are beginning to trend strongly in one direction or another will begin that trend with a strongly angled moving average line.

Simple Moving Averages

Calculating simple moving averages is really quite simple (no pun intended). As was outlined in the beginning of this section the sum of all closing prices is divided by the number of days in the equation. With each new day the now oldest day that is no longer a part of the time frame is subsequently dropped from the equation. A simple moving average is considered a lagging indicator. In fact, the simple moving average perhaps epitomizes the meaning of lagging indicator in that its visual data often comes a bit after the fact. Nevertheless, simple moving averages are an indication of where the price range should be trading at. When prices begin to break away from the moving average line in conjunction with a sharply angled moving average line – basic mathematics is indicating a move up or down in the market. The down side when observing lagging indicators is that the prediction often comes too late; thus the reasons for other types of moving averages, averages that more heavily weigh recent data and can offer more rapid predictions.

Exponential Moving Averages

Exponential and weighted moving averages attempt to resolve the issue of lagging directional forecasts. This is done by placing greater emphasis on more recent price data. Instead of evenly distributing plotted points of a moving average across all candles in the period, a weighted or exponential moving average puts more emphasis on the most recent data; allowing the angle of the moving average to react more quickly.

Reading moving averages is about comparing an average view of the market's recent trends to an actual view of recent price data. Notice in figure 4 that the exponential average reacts more quickly to price chance than does this simple moving average.

The Moving Average Cross

The moving average cross is a tool that many traders use. As can be seen in figure 5 ( view figure 5 ) there are two moving average lines plotted on this chart. The idea is to combine a short term moving average with a long term moving average. For example, a 10 day moving average on top of a 20 day moving average. Of course the shorter moving average period will react more quickly to price direction, whereas the longer moving average period will be represented by a smoother less volatile line. When the two lines cross this is considered an indication of a quickly approaching trend reversal or change in price direction. As always, watch for the angle of the moving average line, particularly the shorter time frame (in this case the 10 day moving average). When lines cross with a sharp angle and an obvious separation from one another this may be an indication of a change in price direction.

MACD

The Moving Average Convergence / Divergence is a technical indicator that illustrates the difference between a fast and a slow exponential moving average (EMA), usually 12 day EMA and a 26 day EMA with a 9 day EMA used as a trigger line. The 12 day EMA will react to the market more quickly than will the 26 day EMA. Visually this results in a MACD that is slanted upwards. Conversely when prices fall or trend downwards the opposite will occur and the 12 day EMA will decrease faster than will the 26 day, creating an obvious visual slant downwards. The MACD does oscillate at what would be considered a zero line.

As is the case with trading moving average crosses, buy and sell signals derived from a MACD will come from the crossing of two lines. However, these two lines are not your two EMA lines, rather one is the combined level of the two EMA lines and the second is the signal, or trigger line (the 9 day exponential moving average of the actual MACD itself). The MACD crossing signal line from above would indicate a sell order and conversely the MACD crossing the signal line from below would indicate a buy order.

MACD as a Histogram

The histogram is a visual indication of convergence (moving average lines of MACD moving towards one another) and divergence (moving average lines of MACD moving away from one another).

As the moving average lines cross the histogram will show no lines whatsoever, indicating to traders that lines (prices) may now start in a new direction.

Pattern Recognition

Chart Patterns - Double Tops & Double Bottoms

Double Tops & Double Bottoms Double Tops provide technical traders with an indication of a beginning downward trend. Double Tops occur when a new high is plotted, raising the resistance level. The price then retraces and declines, only to rise again and reach the same high or resistance level.

The psychology behind a double top is thought to work like this:

• Traders around the globe push the price to a new high; because the new high is a tad extreme the price retraces.
• Again traders push up to the same level, testing it just one more time; again the price feels too extreme.
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• The market has decided that an upwards trend is just not in the cards, twice a new high was tested and twice the market sold to push it back down.

After observing a Double Top, many traders assume that for the time being the market will move in a downwards trend, thus affording an opportunity to sell, or exit a soon to be falling long position.

Double Bottoms are just the opposite of Double Tops. Twice the market will test a new low, and twice the market will refuse the idea of pushing beyond that point. The buyers will rally and an uptrend will follow.

Pattern Recognition Systems can automatically identify and alert Forex traders of double tops and double bottoms patterns.

Chart Pattern - Triangles

There are three types of triangles that technical traders focus on:

1. Ascending Triangle
2. Descending Triangle
3. Symmetrical Triangle

Ascending Triangles

Ascending triangles are considered bullish Forex chart pattern formations, though depending on whether they are formed during an up-trend or a down-trend they may have different implications regarding future price movement. Spotted within an up-trend an ascending triangle is typically considered an indication that the upwards trend will continue. Just the opposite, if an ascending triangle forms during a downwards trend it is considered an indication of a trend reversal. Essentially, ascending triangles are comprised of a series of candles that form the shape of a triangle. The term ascending triangle refers to the fact that the triangle's two trend lines are not created equally; the top line of the triangle will represent a fairly even level of high prices, while the lower level of the triangle will represent a continued series of higher lows.

The consolidation between buyers and sellers at an upward slant suggests pressure from the buyers. The resistance line can typically only hold for so long before the buyers get the best of the sellers and the price breaks out in an upwards trend, at which point the resistance level often becomes the new support level. Figure 3 shows an example of an ascending triangle chart pattern.

Descending Triangles

Descending triangles are just the opposite of ascending triangles. In a downwards trend the triangle forms as an indication that the trend will continue downwards. In an upwards trend the triangle forms as an indication of a trend reversal. Descending triangles are formed when there is a series of progressively lower highs and relatively even lows. As can be seen in the image below the top line or resistance line of the triangle will be angled down, while the lower line or support level will appear as a level horizontal line.

Symmetrical Triangles

Symmetrical triangles are most often considered a continuation chart pattern. Symmetrical triangles can be seen as a series of lower highs and higher lows develop forming the shape of a triangle. This pattern represents a struggle between buyers and sellers, as is usually the case with price consolidation; more often than not symmetrical triangles precede a price breakout. Though it is generally safe to assume that symmetrical triangles will only present themselves as an indication that the current trend either upwards or downwards will continue, this may not always be the case.

Triangle patterns can automatically be identified by Pattern Recognition Systems and alert Forex traders as they emerge.

Chart Pattern - Wedges

Wedges are often considered a difficult Forex chart pattern to recognize, and or are often confused with triangles. The key to spotting the difference is found in the slant or the angle of the support or resistance line. When observing triangles notice that ascending triangles show a flat or even resistance line, conversely descending triangles show a flat or even support line. Symmetrical triangles, as their name suggests, are neither slanted downwards or upwards. Wedges on the other hand, are represented by support and resistance lines that both slant in the same direction, be it up or down.

There are two types of wedges: rising wedges and falling wedges.

Falling Wedges

Falling wedges are considered bullish Forex chart pattern formations. When found in a downwards trend the falling wedge suggests a reversal of the trend. When found in an upwards trend the falling wedge suggests a continuation of the upwards trend. The falling wedge is formed by a series of lower highs and lower lows. Notice that both the support and resistance levels of the wedge are slanted downwards, this is what sets this pattern apart from a triangle chart pattern. Prices within the falling wedge will continue to tighten until the resistance line is finally penetrated and the breakout upwards begins.

Rising Wedges

Rising wedges, the opposite of falling wedges, are considered bearish patterns and are represented by a series of continued higher highs and higher lows which are narrowing or consolidating. The rising wedge suggests that though the buyers are reaching new highs, these highs a progressively tighter and tighter. These progressively tighter highs indicate that the upwards trend is losing steam. A rising wedge found in an upwards trend would suggest a trend reversal and a rising wedge found in a downwards trend would suggest a short rally from the buyers, but ultimately a continuation of the downwards trend.

Pattern Recognition Systems can correctly identify and alert Forex traders of wedge patterns.

Chart Pattern - Flags & Pennants

Flags and pennants are perhaps the most common of continuation chart patterns. Spotting a flag or a pennant usually begins with noticing the flag pole, or the trend line. Flags and pennants typically form after a substantial trend up or down as an indication that the price is consolidating or being tested before continuing in the initial direction of the trend. Often the consolidation period (the flag or pennant) is slanted in a direction opposite of the initial trend, this demonstrates the Forex market's hesitation to continue upwards or downwards, but ultimately it is nothing more than a hesitation and an indication that the initial trend is continuing.

Though both flags and pennants indicate a continuation of the current trend, there is a distinct visual difference between the two. The flag is usually represented by a more rectangular consolidation period, ( view figure 7 ) meaning both support and resistance levels will be about an equal distance from one another. A pennant on the other hand will be represented by support and resistance levels that are moving towards one another in the shape of an asymmetrical triangle. Both the flag and the pennant are always spotted at the end of the flag pole, or at the end of a sharp directional trend.

A good Pattern Recognition System can automatically identify and alert Forex traders of flag and pennant patterns.

Chart Pattern - Head & Shoulders / Reverse Head & Shoulders

Head and shoulders are usually found after a long trend either up or down. . Consisting of three peaks, one of which (the head) is centered and higher than the two lower and relatively equal peaks (the shoulders). Head and Shoulders is perhaps the most well known reversal patterns. Formed after a long upwards trend the left shoulder begins to form while still in the upwards trend. Essentially the left shoulder forms as prices rally up and quickly thereafter retrace, typically the upwards trend line, or resistance level will not be broken as this happens. Notice that when the left shoulder is seen alone, it can also be viewed as a forming flag. As the left shoulder completes, prices again rally, this time to a new high which will become the head of the chart pattern. After the high peak or head of the pattern is formed and prices have retraced back down, again prices will rally to near the same level as the left shoulder to form the right shoulder.

Essentially, within an upwards trend prices have attempted to rally three times and each rally has seen limited success, or in other words has been rejected by the sellers. Once the right shoulder breaks through the support line equal with the right shoulder (the neck line), the reversal of the trend has officially begun. Buyers have tried to continue the upwards trend, and three times have lost their battle to the sellers.

Reverse Head and Shoulders

Reverse head and shoulders represent essentially the same situation as normal head and shoulders, but of course are found in long term downwards trends as opposed to long term upwards trends. Instead of the head and shoulders represented by new peak highs they are represented by new peak lows. The reverse head and shoulders tips the trader that the downwards trend is losing steam as three new lows have been tested and each time bested by the buyers in the market.

Use our Pattern Recognition System from our Forex trading tools section to automatically detect and alert you to emerging head & shoulder patterns.