Technical analysis is how a trader times their entry into the market. Technical analysis provides a way for traders to define what their risk will be on any given trade, as well as enabling them to limit that risk. Defining and limiting risk is a key component of risk management, and proper risk management is the top priority of all professional and consistently successful traders. The good news about technical analysis is that there are several widely followed tools that allow traders to place their trading strategies in the market. A good grasp of technical analysis helps traders identify the best places to enter the market, take profit, and place their stop losses.
The first step in using technical analysis
Before considering the use of technical analysis a trader will want to first establish the current sentiment and fundamental conditions of the market. Sentiment analysis is simply understanding the current mood of the market while fundamental analysis is understanding why the market is moving in a certain direction. Armed with that knowledge a trader can pick the best currency pair/pairs for their trading strategies, using technical analysis as their means of entry, exit, and stop loss. This article will consider four common aspects of technical analysis: Japanese candlestick patterns, moving averages, support and resistant levels, and the Fibonacci retracement tool.
Emerging in the 18th Century from Japan they are thought to have been developed by a legendary Japanese rice trader, called Munehisa Homma, in order to trade the futures markets. There are a variety of candlestick names and patterns that show the movement of price within various time periods. Has the price accelerated through a key level? Was the price heavily sold off from a certain level? Is the price consolidating within a tight range? Japanese candlesticks provide information about the price at these key levels. When combined with sentimental and fundamental analysis they provide clear clues to the direction of future prices. In the US Oil chart below the weekly bullish engulfing bar provided clear clues that higher prices were ahead.
Some of the most popular moving averages are the 50, 100, and 200 moving averages. These moving averages show what the average price has been over the last 50, 100, or 200 periods. These can be very useful in providing good places to enter the market. Say, for example, that we know the Swiss National Bank has stated that it will support the EUR/CHF pair by buying it up to avoid the CHF becoming too strong. Then, as in the chart below, the 200 moving weekly average provided a natural place for traders to enter long EUR/CHF positions. It also provided an excellent place for traders to place their stop beneath to limit their market risk. Moving averages are most widely followed on the higher timeframes, like the daily and weekly charts, and they become less reliable on the lower timeframes.
Support and Resistance
Arguably the most widely followed aspects of technical analysis is support and resistant levels. Support and resistance levels are key market levels where the price has shown a reaction in the past. As the price moves towards these levels, they become significant as points in the market dividing buyers and sellers. Here is an example in the weekly EUR/USD chart below. If you wanted to place a longer-term swing trade around April 2017 to go long on the EUR/USD chart here, you would place your entry on a pullback towards the Support level in the 1.0300 regions. You would then place your stop on the other side of that level. Your target could be the key overhead resistance at the 1.1500 level. This example is for a weekly chart trade, but support and resistance levels are also widely followed on smaller timeframes, and the same principles apply to using them to identify entry and exit prices.
The Fibonacci tool was named after a 13th-century Italian mathematician, Leonardo of Pisa, known as Fibonacci. He was the son of a Pisan merchant and he traveled widely and traded frequently. Fibonacci numbers are found extensively throughout the natural world, and they are also used in trading as one of the most common trading tools. The best way to use them is when news is released that is very bearish for the EUR/USD. Traders who missed the original move will wait for the price to retrace to a key Fibonacci level in order to rejoin the move. Below is a recent example of just such a situation when the European Central Bank surprised the markets by stating that it would not be increasing rates until September 2019. The EUR/USD sold off quickly. Patient sellers waited for the price to retrace to the 61.8% level in order to place sell orders. Stops could be safely placed above the highs before the ECB broke their news.
By using these common technical analysis tools, traders are well-equipped to identify places to enter, exit, and place their stops. Technical analysis should not be used in isolation from sentimental and fundamental analysis, but when used in combination with them it becomes a powerful component in successful trading.