Now that you know most of the fundamentals and basic aspects of forex, in this section we'll introduce you to some charting patterns and a method of analysis within a field called technical analysis. Technical analysis is a method for evaluating currency movements by analyzing the data generated by market activity; this data is often historical data such as past prices and volume. Technical analysts will attempt to analyze this data in order to identify patterns that can help them predict future (short-term or long-term) price movements in the currency.
There are several different techniques technical traders use to analyze data. In this section of the tutorial, we'll introduce you to moving averages, trends, resistance and supports, double tops and double bottoms, Bollinger Bands® and the popular MACD.
But first, let's look at three reasons why many traders believe technical analysis can be a good way to analyze currency movements. Technical analysis is based on three underlying assumptions about the market and prices.
1. Technical analysis is based on the assumption that the market discounts everything.
This means the price of the currency reflects all available information, including fundamental factors (i.e. economic news) and thus doing fundamental analysis, some argue, would add no value. Instead, technical analysts believe the analysis of price movement or the supply and demand of currencies is the best way to identify trends in the currency.
2. Technical analysis is based on the notion that price movements tend to follow a trend.
This means past price behavior is likely to be repeated, and if a trend has been established the currency will most likely continue in that same direction.
3. In connection with the belief that prices move in trends, technical analysis assumes that history tends to repeat itself.
The assumed repetitive nature of price movements is attributed to the psychology of the market participants. Generally, this is based on the idea that market participants have, historically speaking, often reacted in a similar fashion to reoccurring market events. Many well-known chart patterns are based on the assumption that history tends to repeat itself.
With that said, there are also many traders who believe fundamental analysis - looking at macroeconomic factors that affect the economy and thus the currency - is a good way to analyze currencies. There has always been the debate between which is the better method, but it would likely be best for you as a trader to be well-versed in both methods of analysis. Both have their strengths and weaknesses. (For a primer on fundamental analysis' role in forex trading, refer to our article Fundamental Analysis for Traders.)
Not Just for Currencies
Technical analysis can be used on any security with historical trading data. This includes stocks, futures and commodities, fixed-income securities, etc. In this tutorial, we'll use technical analysis examples to analyze currencies, but keep in mind that these concepts can be applied to a variety of securities.
Now that you understand the philosophy behind technical analysis, we'll get into the more common tools of technical analysis and build towards more advanced analysis techniques in the next few sections.