Technical Analysis: Core Discipline in Forex Trading

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Technical analysis is a core discipline in Forex trading. It is a security analysis discipline used for forecasting the direction of currencies through the study of past Forex market data. Technical analysis is the use of past price behavior to guide trading decisions in asset markets.

 

Investors and economists are interested in technical analysis for different reasons. Investors are concerned with “beating the market,” earning the best return on their money. Economists study technical analysis in foreign exchange markets because its success casts doubt on the efficient markets hypothesis, which holds that publicly available information, like past prices, should not help traders earn unusually high returns.

Instead, the success of technical analysis suggests that exchange rates are not always determined by economic fundamentals like prices and interest rates, but rather are driven away from their fundamental values for long periods by traders’ irrational expectations of future exchange rate changes.

Technical traders will not hold positions for months or years, waiting for exchange rates to return to where fundamentals are pushing them. In contrast, fundamental investors study the economic determinants of exchange rates as a basis for positions that typically last much longer, for months or years. Some Forex traders, however, make use of technical analysis in conjunction with fundamental analysis. This doubles their positions when technical and fundamental indicators agree on the direction of exchange rate movements.

 

A technical analyst's behavior is guided by three important principles:

 

 Market action (prices and transaction volume) discounts everything. In other words, all relevant information about the asset is incorporated into price history, so there is no need to forecast the fundamental determinants of an asset’s value. As a matter of fact, Murphy (1986) claimed that asset price changes often precede observed changes in fundamentals.

 Asset prices move in trends. Predictable trends are essential to the success of technical analysis because they enable traders to profit by buying (selling) assets when the price is rising (falling). The analysts appeal to the Newton's law of motion to explain the existence of trends: Trends in motion tend to remain in motion unless acted upon by another force.

 History repeats itself. Asset traders will tend to react the same way when confronted by the same conditions. Technical analysts do not claim their methods are magical; rather, they take advantage of market psychology.

 

Technical analysts used two methods in analysis: charting and mechanical rules.

 

Charting involves graphing the history of prices against a specific period, determined by the technical analyst, to predict future patterns in the data from existence of past patterns. This subjective system requires the analyst to use his judgment and skills in finding and interpreting the patterns.

 

To identify trends through the use of charts, practitioners must first find peaks and troughs in the price series. A peak is the highest value of the exchange rate within a specified period of time (a local maximum), while a trough is the lowest value the price has taken on within the same period (a local minimum). A series of peaks and troughs establishes downtrends as well as uptrends respectively.

Mechanical rules, on the other hand, imposes consistency and discipline on the analyst by requiring him or her to use rules based on mathematical functions of present and past exchange rates. Charting is very dependent on the interpretation of the technician who is drawing the charts and interpreting the patterns.

Mechanical rule avoids this subjectivity and so is more consistent and disciplined, but, according to some analysts, it sacrifices some information that a skilled chartists might discern from the data. Mechanical trading rules are even more explicitly extrapolation than charting; they look for trends and follow those trends. A well- known type of mechanical trading rule is the "filter rule,” or “trading range break” rule.

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