Basic forecast methods:
Technical analysis and fundamental analysis
This chapter and the next one provide insight into the two major methods of analysis used to forecast the behavior of markets. Technical analysis and fundamental analysis differ greatly, but both can be useful forecasting tools for the trader. They have the same goal – to predict a price or movement. The technician studies the effects, while the fundamentalist studies the causes of market movements. Many successful traders combine a mixture of both approaches for superior results
Categories and aim of this chapter
The categories and approaches in technical analysis all aim to support the investor in determining his/her views and forecast price movement of the products traded. Here we will describes the approaches, methods and tools used to this end. However, this chapter does not intend to provide a comprehensive and/or professional level of knowledge and skill, but rather let the reader become familiar with the terms and tools used by technical analysts.
Technical analysis by currency traders
Technical analysis is a method used by traders to predict price movements and future market trends by studying what has occurred in the past using charts. Technical analysis is concerned with what has actually happened in the market, rather than what should happen, and takes into account the price of instruments and the volume of trading, and creates charts from that data as a primary tool. One major advantage of technical analysis is that experienced analysts can follow many markets simultaneously.
Technical analysis is built on three essential principles:
1. Market action discounts everything! This means that the actual price is a reflection of everything that is known to the market that could affect it. Some of these factors are: fundamentals (inflation, interest rates, etc.), supply and demand, political factors and market sentiment. However, the pure technical analyst is only concerned with price movements, not with the reasons for any changes.
2. Prices move in trends. Technical analysis is used to identify patterns of market behavior that have long been recognized as significant. For many given patterns there is a high probability that they will produce the expected results. There are also recognized patterns that repeat themselves on a consistent basis.
3. History repeats itself. Chart patterns have been recognized and categorized for over 100 years, and the manner in which many patterns are repeated leads to the conclusion that human psychology changes little over time. Since patterns have worked well in the past, it is assumed that they will continue to work well into the future.
Charts are based on market action involving price. There are five categories in technical analysis theory:
- Indicators (oscillators, e.g.: Relative Strength Index (RSI)
- Number theory (Fibonacci numbers, Gann numbers)
- Waves and Gaps (Elliott wave theory)
- Trends (following moving average).
The most common technical analysis tools:
Coppock Curve is an investment tool used in technical analysis for predicting bear market lows.
DMI (Directional Movement Indicator) is a popular technical indicator used to determine whether or not a currency pair is trending.
Bollinger Bands – a range of price volatility named after John Bollinger, who invented them in the 1980s. They evolved from the concept of trading bands, and
can be used to measure the relative height or depth of price. A band is plotted two standard deviations away from a simple moving average. As standard deviation is a measure of volatility, Bollinger Bands adjust themselves to market conditions. When the markets become more volatile, the bands widen (move further away from the average), and during less volatile periods, the bands contract (move closer to the average).
Bollinger Bands are one of the most popular technical analysis techniques. The closer prices move to the upper band, the more overbought is the market, and the closer prices move to the lower band, the more oversold is the market.
Support / Resistance The Support level is the lowest price an instrument trades at over a period of time. The longer the price stays at a particular
level, the stronger the support at that level. On the chart this is price level under the market where buying interest is sufficiently strong to overcome selling pressure. Some traders believe that the stronger the support at a given level, the less likely it will break below that level in the future. The Resistance level is a price at which an instrument or market can trade, but which it cannot exceed, for a certain period of time. On the chart this is a price level over the market where selling pressure overcomes buying pressure, and a price advance is turned back.
Currency Charts and Diagrams
Charts are based on market action involving price. Charts are major tools in trading. There are many kinds of charts, each of which helps to visually analyze market conditions, assess and create forecasts, and identify behavior patterns.
Most charts present the behavior of prices over time. Rates (prices) are measured on the vertical axis and time is shown of the horizontal axis.
Charts are used by both technical and fundamental analysts. The technical analyst analyzes the micro movements, trying to match the actual occurrence with known patterns. The fundamental analyst tries to find correlation between the trend seen on the chart and macro events occurring parallel to that (political and others).
What is an appropriate time scale to use on a chart?
It depends on the traders strategy. The short-range investor would probably select a day chart (units of hours, minutes), where the medium and long-range investor would use the weekly or monthly charts. High resolution charts (e.g. minutes and seconds) may show noise, meaning that with fine details in view, it is sometimes harder to see the overall trend.
The major types of charts
The most basic chart is a line chart. A line chart reflects one point during a specific period. The most common line chart shows the closing price of a financial security.
Drawbacks: Unfortunately, a line chart will only relay one point, which makes it difficult to determine support and resistance. During the course of a day, week or month, the highs and lows during those period could be substantially different from the closing price, making it difficult to see levels that show strong supply or robust demand for a security.
“Bar chart convey a plethora of information – is one of the most widely used charts.”
Benefits: A line chart is clean, and helps an investors eliminate the noise that is associated with charts that contain 2 or more points. Line charts are excellent for spreads between 2 instruments, such as the difference between gold and silver prices.
Another type of chart is a bar chart. A bar chart, shows multiple points. The most common are the open, high, low, close / last. The opening price on a bar chart is generally designated by a small tab on the left side of the bar. The closing or last price is designated by a small tab on the right side of the bar. The high and the low points are self-explanatory.
A bar chart conveys a plethora of information, and is one of the most widely used charts. Many traders will eliminate either the open or the close or both, as the securities they trade are transacted around the clock and therefore the open and close are less important.
Drawbacks: The bar chart has a great deal of information and therefore can be very busy and generate unwanted noise.
Benefits: The bar chart reflects every point that occurs during the course of a trading period. It is very helpful in determining support and resistance levels. Many times traders will use bar chart highs points or bar chart low points to generate trend lines that reflects resistance and support levels.
One of the most popular charts is the Candlestick chart. Candle stick charts allow investors to view the relationship between prices which describe current market conditions.
A Candlestick bar is derived from prices during the course of a day, which include a high, low, open and close. Candlesticks can be used on any time period, including monthly, weekly, daily and intra-day horizons. The body of the candlestick is the middle portion of the candle which the thin lines at the top and bottom are the tails.
Using a chart is an important tool to help an investor view the historical movements of a security which can only assist in helping predict future price movements.
Candlesticks bars will create an impression of market conditions which can be viewed by the color or pattern created by one or more bars. When a security closes higher than the opening price, the body of the candle is blue or (uncolored). The top of the body is the closing price and the bottom of the body represents the opening price. When a security closes below the opening price the body of the candle is red or (coloured).
Drawback: There is a lot of information on a candlestick chart which creates noise.
Benefits: Candlesticks reflect a more complete picture of price action compared to a standard bar chart or a line chart. The relationship between the open and close as well as the high and low, allows an investors to envision where prices moved through a day (or week/month).
For more information please read our e-book on Fundamental and Technical Analysis. You can get it here.