Learn how to use technical analysis to trade the market
Technical analysis relies on the analysis of historical price data using custom indicators and other charting tools to predict movements in the exchange rates of currency pairs or other financial markets. It is arguably the most popular method of market analysis in the currency markets as it favors short-term trading strategies, which are becoming increasingly prevalent among traders.
You can use technical analysis to:
- Identify interesting opportunities to trade
- Provide further confirmation signals regarding a trade setup
- Compare price movements over time and gauge market volatility
- Measure the momentum of a trend and its direction
How to use technical analysis to spot market opportunities
Whereas fundamental traders try to make sense of the reasons behind market movements, a major aspect of technical analysis lies in identifying various levels through objective means and tools that only take into consideration the data offered by the price chart itself.
Some of the most popular technical analysis tools available in all trading platforms are the simple drawing tools, such as horizontal or vertical lines which can be drawn directly on the chart and technical indicators, which are automated instructions that can reveal trends, market momentum as well as any upcoming price reversals.
For example, a basic trading strategy, which involves trading when the price nears major support and resistance levels, can make use of the horizontal lines to identify these levels and plan entry and exit points accordingly.
Support and resistance levels/zones are important areas wherein earlier sessions, the exchange rates had difficulty declining below or rising above.
A support area is an approximate price point where buyers are more than likely to try to open buy positions thereby pushing the prices up, while a resistance area is a price point the sellers believe is unsustainable and therefore open sell positions to profit from the upcoming drop.
So, when the price of an asset – and this is relevant with all financial markets – nears a key support or resistance zone, it is likely that the price will either bounce back from that level. However, if the momentum is powerful enough and there is a strong fundamental factor behind the movement, it is also likely that a reversal will take place and the market will break through a resistance level which will then become the support or vice versa.
Traders who utilize technical analysis have also noted that there are certain price formations on the chart that tend to provide clues into the market’s future direction. Some notable examples of these patterns include the Head and Shoulders, the Double and Triple Top and Bottom.
These patterns can provide favorable entry signals to the market and skilled technical traders can pinpoint these patterns and immediately know whether they should buy or sell.
The popular Head and Shoulders pattern involves a series of three peaks with the middle one being the highest as it’s considered the Head, while the other two are approximately at the same price point. The price decline between these peaks is what forms the Head and Shoulders shape.
The Head and Shoulders usually indicates that the market is undergoing a reversal and the uptrend is about to end. However, there is also the inverse Head and Shoulders pattern, which consists of three bottoms instead and provides a buy signal as the downward trend is ending.
It’s important to note that while technical analysis is a highly effective tool in a trading strategy, these signals offered by chart patterns may not always be accurate. However, due to the popularity of technical analysis, the large number of traders who follow these patterns and utilize them as a basis for their market entries, can sometimes cause the market to move accordingly.
For example, if the market is certain that the exchange rate of a currency pair will rise and traders rush to open buy orders, then the increased demand will more than likely drive the rates upwards. This is why technical analysis is sometimes referred to as a self-fulfilling prophecy.
Indicators are highly popular in forex trading and many have ventured to create their own custom indicators to serve different functions.
In short, technical indicators take into account the historical price data and can provide insights into trend formation and momentum, market volatility and trading volume. Some popular indicators include the Moving Average (MA), Ichimoku Kinko Hyo, the Relative Strength Index (RSI) and Bollinger Bands (BB).
These indicators are overlaid on top of the price chart of your asset of choice, however, due to a large amount of indicators available by default in the platform, sometimes it’s best to try and keep things simple and remove those that you don’t find useful.
You can find thousands of free and paid technical indicators available in the MetaTrader 4 platform and you can test them out through CM Trading’s demo account completely risk-free.
You can open a trading account with CM Trading to get access to the most effective technical indicators and trade the markets with unmatched trading conditions.
Register here to get started!