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Lesson 8: Basics of Technical Analysis

Basics of Technical AnalysisWe have seen in the previous article the chart, how the price of a currency pair is represented, and the time-frame. Now we will focus on the basic aspects of technical analysis so that we can read what the chart tells us.

What is technical analysis? Technical analysis is a term used for predicting the direction of prices of a market (e.g. a stock, a currency pair or a commodity) through the study of past market data, primarily price and volume.

Below the Candlestick chart of Eur-Usd that you have seen in the previous article.

EUR-USD Candlestick Chart

As you can see the candles go first up, then down and at the end of the chart go up again. That movement is called the trend.

There are three possible situations in which a currency pair can find at any given time. It can go up (uptrend), it can come down (downtrend) or it can move sideways (congestion).

The trend, therefore, represents the direction in which moves the price of a market. It is said that a market is in an uptrend when we have higher highs and higher lows as shown below.

Uptrend

Similarly, we have a bearish trend when we have lower highs and lower lows as you can see below.

Downtrend

Let's see the chart of Eur-Usd again (below), with highlighted two uptrends (in black) and a downtrend (in blue).

EUR-USD Candlestick Chart

A retracement is a temporary reversal in the direction of a currency pair's price that goes against the previous trend. A retracement does not signify a change in the larger trend. In practice, after a certain movement, it begins the profit taking. Who gains decides to take home the money and this determines, for a period of time, a movement against the trend of the market.

You can see them in the Eur-Usd chart every time that in an uptrend the price falls at a higher low and in a downtrend when the price rises at a new lower high. Retracements represent a good opportunity to buy or sell at prices more convenient and to get into a market less tired.

During periods of congestion, a currency pair moves sideways, oscillating between lows and highs. I introduce another concept: the highs of a congestion form a resistance, the lows a support.

More generally:

  • The support reflects the inability of a currency pair to drop below a certain price level.
  • The resistance reflects the inability of a currency pair to climb above a certain price level.

More than of level, we should talk about support/resistance area. This is because more and more often we see extreme attempts to raise a price for selling a currency pair at a more favourable level or bring it down in for buying the currency pair at a lower price before it changes its trend (false breakout).

In addition, let's see an example to better understand this concept with the chart of Usd-Cad below.

Usd-Cad congestion, support, resistance

The last aspect. Although in Forex they are very rare and can only occur between the closing of Friday and the subsequent opening on Sunday, let's see what the gaps are.

A Gap Up, a Rising Window in Candlestick analysis, occurs when there is a space between the previous candle's high and the current candle's low. The key support area is the bottom of the Window.

Rising Window or Gap up

A Gap Down, a Falling Window in Candlestick analysis, occurs when there is a space between the previous candle's low and the current candle's high. The key resistance area is the top of the Window.

Falling Window or Gap down

In Forex, the only way for getting a Window is on Sunday when markets open and it is unlikely (but not impossible) that a Window remains open. Most of the times, Windows hides the will of strong hands to rise or to fall a currency pair before it changes trend.

Only very positive/negative news or events, the effect of which is destined to last for a long time, have the power to let opened a Window on a currency pair.

We classify three types of gaps:

1. Breakaway Gap: they occur when the price action is breaking out of their trading range or congestion area. To break out of these congested areas requires market enthusiasm and, either, many more buyers than sellers for upside breakouts or more sellers than buyers for downside breakouts.

The volume will pick up significantly, due not only to the increased enthusiasm but because many are holding positions on the wrong side of the breakout and need to cover or sell them.

2. Continuation Gap: sometimes called Runaway Gap or Measuring Gaps, they are gaps that are caused by increased interest in the stock. For runaway gaps to the upside, it usually represents traders who did not get in during the initial move of the uptrend and while waiting for a retracement in price, decided it was not going to happen.

Runaway gaps can also happen in downtrends. This usually represents the increased liquidation of that stock by traders and buyers who are standing on the sidelines.

3. Exhaustion Gap: they are those that happen near the end of an uptrend or a downtrend. They are many times the first signal of the end of that move. They are identified by high volume.

They can easily be mistaken for runaway gaps if one does not notice the exceptionally high volume.

These are just the basic concepts to read a chart, what you need to know for going on with reading this e-Book. Technical analysis is much more extensive and complex, impossible to explain in a single article. And, however, technical analysis is not the subject of course.

 

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