Technical analysis is the study of past price movements to determine the future direction of assets. Similar to other forecasting methods, technical analysis is not foolproof. The goal of a chartist who uses technical analysis is to anticipate what is likely to occur with prices over time. Technical analysis uses a wide variety of charts, and studies to show how the price of an asset might react in the future. The most efficient way to evaluate price movements is through software that provides graphs. Rakuten Securities Australia uses the powerful Meta Trader 4 (MT4) platform that provides users with a plethora of different built-in technical analysis tools. The most popular types of technical analysis include:
- Support and Resistance
- Trend Following
- Mean Reversion
What are Support and Resistance?
The change in the price of an exchange rate or index generally follows a predictable flow. Either prices trade-in well-defined ranges or prices trend in a specific direction. Usually, an exchange rate will move from one range to another. During a trend, the time that an exchange rate is spent in each range is fleeting. One of the best ways to determine a trading range is to use support and resistance tools. Support is a price level that experiences demand where prices have a difficult time moving lower. Resistance on the other hand acts as a cap, where prices have a difficult time moving higher. There are several ways to measure support and resistance. Some of the more popular tools include trend lines, Fibonacci levels, and moving averages.
A trend line connects two or more daily (or any period) highs or lows, that can be drawn using a bar chart or a candlestick chart. You can use a trend line on a line chart, but it is less efficient. A resistance trend line connects the last two highest points and is generally downward-sloping, or horizontal. Support trend lines connect the last two lowest lows and are generally upward-sloping or horizontal. When the exchange rate closes above a resistance trend line a breakout has likely occurred, which could be the beginning of a new short-term trend. Similarly, when an exchange rate closes below a support trend line a breakdown has occurred which could designate a new short-term trend. You can create a trend line using any period. It can be daily, weekly, monthly or intra-day periods. The longer the period the more forceful the breakout or breakdown when prices breach support or resistance levels.
Another tool that can be useful to measure support and resistance are moving averages. A moving average is the average of a specific number of periods. For example, the 20-day moving average is the average of the last 20-days. On the 21st day, the first day is dropped from the average calculation. A moving average has a smoothing effect on prices, removing some of the volatility an exchange rate might experience.
Additional good way to find support and resistance levels are Fibonacci retracements. You can find this tool in your MT4 software that is provided by Rakuten Securities Australia. The Fibonacci retracement levels are calculated using the Fibonacci sequence. The most common Fibonacci ratios are 61.8% and 38.2% ratios.
The EUR/USD exchange rate tends to trade in ranges and then either breaks out or breaks down into a new range. One way to determine if an exchange rate is trending is to use moving averages. Since the moving average smooths the volatility of price movements it can provide you with an idea of when the average is moving in a specific direction. Another idea to measure this is to use a moving average crossover strategy. For example, when the 20-day moving average crosses above the 50-day moving average an uptrend is in place. When the 20-day moving average crosses below the 50-day moving average a downtrend is in place.
As a trend unfolds, it usually starts with a breakout or breakdown that reflects accelerating positive or negative momentum. Momentum is the rate of change in an exchange rate. As the rate of change accelerates, prices tend to move faster. One way to measure momentum is the Moving Average Convergence Divergence Index (MACD). This indicator uses the change in 2-different moving averages. The default setting on your MT4 will likely be the 12-period moving average and the 26-period moving average. As the 12-period moving average accelerates away from the 26-period moving average, momentum is either rising or falling. The MACD compares the difference in the moving average to the 9-period moving average of the difference called the MACD signal line. The MACD indicator produces crossover buy and sell signals which allow you to determine when positive momentum is accelerating or negative momentum is accelerating.
While momentum and trend following are geared towards identifying a trend and potential breakouts, the Bollinger band can help you define ranges that are likely to hold. The Bollinger bands, created by John Bollinger, provide a potential range for prices in the future. This is based on the variance in the price over a specific period. The default period is generally 20-days (weeks, months, etc.) The variance is generally 2-standard deviations. The Bollinger high is 2-standard deviations above the 20-period moving average. The Bollinger low is 2-standard deviations below the 20-period moving average. Bollinger bands can be used as a mean reversion tool. When the exchange rate reaches the Bollinger band high, it has moved too far too fast and is likely to revert to the 20-period moving average. When the exchange rate hits the Bollinger band low, it’s likely to revert to the 20-period moving average. The Bottom Line When you use technical analysis tools you should consider using several in conjunction with one another. Support and resistance can be used with trend following and momentum to determine if a breakout has momentum or in the middle of an uptrend or downtrend. You can also use Bollinger bands in junction with support and resistance to define a range. By combining technical analysis tools to help you determine the future price of an asset, you give yourself the best opportunity to make money.