The purpose of technically analyzing a price-chart is to possibly forecast the direction and the movement of price. There are hundreds if not thousands of technical indicators freely available for the purpose of technical analysis. This makes it difficult to chose the right method or tool for trading, specially for beginners.
Even worse, I’ve seen traders using as much as 10 indicators within a single trading strategy; without even knowing the purpose of using them. Fortunately all these indicators can be categorized under few approaches to technical analysis.
In this post, I reveal the 5 essential technical analysis methods, with each method covering a unique attribute of the market.
Table of content
| 1. Price action |
| 2. Support & resistance and trendlines |
| 3. Price trends |
| 4. Patterns and structure |
| 5. Momentum, order flow and tick volume |
1. Price action
What is price action?
Price action simply means the movement of price. But technical analysis of price action is based on candle formations on the chart. Direction of the price is determined according to the identified candlestick formation. There are at least 35 known candle patterns. The concept of price action trading is that price repetitively form uniquely identifiable candlestick patterns near reversal zones.
Pros
- Objective approach
- Specific rules to define candle patterns
- Accuracy up to the pip or point
- Provides definitive price levels
- Can be used as an entry / exit strategy within a trading system
Cons
- Disregards context of trends and corrections
e.g. provides signals for both directions within a sideways market - H4 and higher candlestick charts of the same instrument from different brokers can have different candle formations. Because the server times differ between brokerages.
- False signals happens more often
- Forecasts only the price direction
2. Support and resistance + trendlines
What is support and resistance?
This technical analysis method is based on straight lines drawn on the chart. Horizontal support and resistance lines focus on price levels where historical price action has had difficulty to move across. Trendlines are drawn by connecting higher-highs or lower-lows of a seemingly trending market.
The theory is that if price breaks out of these price levels or trend lines, previous support becomes resistance and vice versa. But there is no explanation as to why price should respect or otherwise penetrate through such support/resistance and trendlines.
Support and resistance is never a be-all and end-all strategy.
Pros
- Simple analysis technique
- Minimal rules and quick implementation
- Possibility to analyze multiple timeframes at once
- Can be used as an entry / exit levels within a trading system
Cons
- Ambiguity of price behavior at these lines
- Skewed or distorted charts may lead to wrong trading decisions
- False breakouts and mixed signals happen often
- Both price directions are equally valid, thus trading has to be after the reversal or breakout
3. Price trend
What is a trend in forex?
A trend is a continuous and consistent movement of price in one direction, with little to no pullbacks or retracements in between. A trend in a weekly chart can last for years, because a whole single year consists of just 52 or 53 weekly candles.
The cliché “trend is your friend” combined with the other famous cliché “buy low and sell high”, literally summarizes the technical analysis method of price trends. Analyzing trends could be elusive, because no indicator can consistently signal the start or the end of trends. But it’s not required to catch the very beginning or exit at the very end of a trend to make a good profit. In fact, a strategy that can catch 20%-30% of total trend-movement, could yield exponentially high ROI.
Time-tested “Turtle trading system” has proven that catching a better part of long-term trends is a slow, yet highly rewarding, trading strategy.
Pros
- Plenty of technical analysis indicators that focus on price trend
- Can coexist with other analysis methods comprising a trading strategy
- Straightforward visual analysis
- Strong trends can produce huge movements in a short period of time
Cons
- Inability to define or predict that beginning and the end of a trend
- Trends can abruptly end, reverse and gather momentum in the reverse direction
- Trends occur only in a small percentage of the market because most of the time the price is in a correction (sideways market)
- Does not forecast price, but mainly the direction only
- News flashes can produce backlashes to opposite direction, before continue the trend in the original direction. This can lead to premature exit from trades and even losses
4. Patterns and structure
What is a chart pattern?
A chart pattern is a repetitive and recognizable design created by the movement of price. History repeats! In technical analysis it means the same chart patterns and structures keep repeating in similar market conditions.
Price moves due to 2 factors – supply and demand. Supply and demand is governed by greed and fear of the market-participants.
This simple equilibrium creates recognizable price patterns in the market.
The simplest form of a price pattern has 2 waves – an impulse wave and a corrective wave. All chart patterns include various combinations of this same basic impulse-correction component.
Stand-alone classic price patterns include head and shoulders, double top, double bottom. On the other hand Elliott waves has a vast array of classic chart patterns defined within it’s theory. More recently “Harmonic trading” was introduced, which is also a technical analysis method based on chart patterns.
Pros
- Rule based
- Realistically Anticipates the next wave to the opposite direction
- Appreciates the fractal nature of the financial markets and allows for multi-timeframe analysis
- Helps to wrinkle out the unnecessary noise in the chart
Cons
- Does not provide the precise time or price for the next move
- Comparatively, chart analysis is more time-consuming
- Takes a lot of practice, chart-time and a trained eye to spot the patterns consistently
5. Price momentum, order flow and tick volume
What is price momentum?
Momentum of price is the approximate indication of how much the price accelerates in a direction. In simple terms, momentum means the strength of price towards a given direction. Analysis of order flow and tick volume also can help determine the price momentum.
If you study the above image closely, on average tick volume keeps increasing. But right before a correction occurs, there is a visible decline in tick volume, that means the momentum of price is slowing down. In addition to this, MACD histogram too starts declining or levels out, right at the start (or slightly beforehand) of a correction.
This essentially makes the MACD histogram and tick volume – “leading indicators”, if you use it for the correct purpose!
Not many indicators serve this purpose. However, the MACD (Moving average convergence divergence) is a very good example. MACD technical indicator visually interprets the momentum of the price with its histogram.
Order flow and volume too correlate to the momentum of price. But unlike the stock market, in forex neither order flow nor trade volume is explicitly available to traders. No broker would ever expose this data. Even if they do, the data would be limited to their brokerage only, and does not in any way reflect the whole global market.
Next closest thing we have for trade volume is the tick volume. But tick volume is entirely a different type of data.
Tick volume is the activity in the market. Every trade causes the market to move thus generating a new price – a tick. Because large brokerages are generally a good sample size of the market, tick volume data from such a large brokerage, presumably reflects the overall global market activity.
Pros
- Enables to trade along with the momentum
- Price momentum can help to catch big movements in a short period of time
Cons
- Lack of indicators
- Lack of real definitive data for trade volume and orderflow
Ideally a trading strategy should use multiple, carefully selected indicators and tools from different technical analysis methods explained in this post. Signals from such a trading system are based on confluence of technical analysis indicators and tools. Analyzing various aspects of the chart will help to make well-informed trading-decisions and in turn increase your ROI.
