Technical Analysis
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Chart Types
Charts represent the price data fluctuations caused by varying market forces. The information found in these charts enables a chartist skilled in the science of technical analysis to draw trading signals for future price activity. The primary chart types used for the analysis of the Forex market are:
Line Chart
Bar Chart
Candlestick Chart
The most popular type of chart in use today is the candlestick chart. Originally developed in Japan, it did not come into popular use until the 1980s. The line chart is the original type of chart and is still in wide use today, primarily due to its convenience and effectiveness in plotting price data over extremely long and short periods of time. The bar chart is also used by many traders. Although any one of these chart types can be used equally well for most analytical techniques, most traders develop certain preferences for use in their analysis.
Line Chart
In order to plot a line chart, single prices for a selected time period are connected by a line. The most popular variation of the line chart is the daily line chart, which plots each day's closing price. The basic problem with the daily line chart is its lack of data on intraday market activity. This issue has been amended in recent years with the use of computer power to plot line charts with smaller increments. Whereas other chart forms may fall behind in the accurate reporting of price data over very small intervals, the line chart can be used to plot data for intervals as short as 5 seconds or even a single tick. Line charts are also extremely useful for obtaining a “big picture” view of market trends over several years. The only remaining flaw with the line chart is its lack of ability in reporting price gaps, as these cannot be represented on a continuous chart.
Bar Chart
Any given line in the bar chart consists of four important points.
High - The top point of the vertical bar
Low - The bottom point of the vertical bar
Opening Price - A small horizontal line to the left of the vertical bar
Closing Price - A small horizontal line to the right of the vertical bar
The bar chart’s advantages are its ability to display the price range over the selected period as well as its capacity to plot price gaps. One of the bar charts major disadvantages however is its inability to plot the whole price fluctuation, even when plotted for extremely small periods of time.
Candlestick Chart
The candlestick chart is quite similar to the bar chart as it also consists of the same four primary price points: the high, the low, the open and the close. The candlestick is often considered easier to view and thus analyze than its bar and line chart contemporaries.
The body of the candlestick bar is comprised of the difference between the open and close price. If the opening price was lower then the closing price or the given commodity gained value, then the body of the bar is colored blue. To contrast, if the opening price was higher then the closing price or the given commodity lost value, then the body of the bar is red. If the high and low prices are located outside of the open-close range they are marked off by two lines known as the upper and lower shadows. The upper shadow protrudes from the top of the candlestick's body and marks the high price for the given time period represented by the bar. Conversely, the lower shadow protrudes from the bottom and marks the low price.
Trends
The trend is the fundamental cornerstone of technical analysis. The trend denotes the overall direction of the market at a given time over a given scope, showing the trader the tendency of change in market prices. More simply put, the trend shows the direction of the market. Thus it follows that all trends fall under one of the following three categories: upward, downward, and sideways. Trends may also be classified by their timeframes as long-term, medium-term and short-term trends. However, any number of smaller trends can occur within larger trends.
Upward Trend
Downward Trend
Sideways Trend
Upward Trend
An upward trend is denoted by the systematic and extended rise in the price of the given currency pair over some prolonged period of time. This does not mean that the price of the given currency pair never recedes, but merely that in the overall picture the price rises more than it falls in the given timeframe. A theoretical sketch of an uptrend is presented on the right.
A real life example lasting several months, taken from a VT Trader screenshot, is shown below.
Downward Trend
A downward trend shares all the characteristics of the upward trend but in the reverse direction, thus denoting the fall in the price of a given currency pair.
On the right we show a theoretical image of a downward trend, and a real life counterpart below.
Sideways Trend
The sideways trend is also known as a trendless, ranging or flat market. Though similar to the other two types, the sideways trend shows no major difference in the price values between the beginning and the end of a specific time period. The sideways trend denotes market conditions in which prices may be moving back and forth between levels of support and resistance (covered next).
Concept of Support and Resistance
In order to clearly see trends a technical analyst must draw trendlines and identify levels of support and resistance. This page will teach you about these crucial aspects of technical analysis.
Support and Resistance
Trendline
Trendline Penetrations
Support Turns into Resistance or Resistance Turns into Support
Channel Line
Support and Resistance
Trends do not move in straight lines; they zigzag in a general direction forming progressively higher (or lower) peaks and lows.
At a price peak, or high, buyers that are pushing up the price of a currency pair hit resistance. There are many sellers at that particular price, and they overpower the buyers (who may turn into sellers themselves). Price will dip as long as this selling pressure is present. If the uptrend is significant however, as price dips buyers that missed the opportunity to buy (or have sold at the peak), will now buy the pair and price will recover until there is a next peak. These peaks within a trend are known as the trend’s resistance levels.
At a price trough, or low, the opposite is happening. A currency pair that is falling in value will meet some support. It is the price at which sellers are overpowered by an influx of buyers. These lows within a trend are known as support levels.
Here is an example of support and resistance levels in a sideways moving trend:
Trendlines
A trendline is a straight line connecting significant support or resistance levels. In the above figure they are the green and brown lines. Generally, a trendline can be drawn from as few as two support/resistance levels. However, the more support/resistance levels that are touching the trendline, the more stable the trend is.
Just as the trends themselves, trendlines can be upward, downward or sideways.
A trendline connecting a set of support levels is referred to as the line of support.
A trendline connecting resistance levels is referred to as a line of resistance.
Trendlines are always drawn from left to right.
Higher volume at a given support/resistance level, extensive repetition of support/resistance levels on the trendline and prolonged duration of trendline adherence all signify the markets determination to obey the trend and thus strengthen it.
Research has also shown that the more significant trends form at 45-degree angles. A sharper angle suggests an unsustainable rally and a shallower angle suggests that a trend may be close to reversal.
Trendline Penetrations
Trendline penetrations, also known as violations or breaks, are key technical signals in determining the market’s future direction. They can mean that an existing trend is ready to reverse or change its characteristics. You can see examples of trendlines being violated in the above figure (in September 2004 and in May 2006).
It is important to monitor market volume during a trendline penetration.
High volume on a trendline penetration or the failure of consecutive support/resistance levels to exceed each other would be characteristic of the market’s determination to break out of or even reverse a trend.
Support Turns into Resistance or Resistance Turns into Support
Upon penetrating a firm line of resistance, the market often chooses to take up that very line of resistance as its new line of support. In the figure below, there is a trendline break in November. When price recedes from its new high near 1.3400 it bounces off support at the line that had previously been resistance.
The reverse is also true, as lines of resistance often replace previous lines of support in cases of downward penetration. In this example the trendline is upward sloping, not sideways. There is a downward trendline break in October. The old trendline, which had acted as support now turns into resistance, first right away and then again three months later.
Channel Line
The channel line runs parallel to the basic trendline, joining the support levels in an upward trend and the resistance levels in a downward trend. If the price of the currency pair continuously oscillates between the trendline and the channel line then one can assume that a valid channel exists.
The channel is one of the most useful analytical patterns. Unlike the breaking of a trendline, which signifies a possible reversal in the trend, the penetration of the channel line is a common indicator of expected acceleration of the already prevalent trend. A failure to reach the channel line on the other hand is an indication that the trend is failing and that price may break through the trend line on its next turn.
Trend Reversal Patterns
The sideways price action of a reversal pattern signifies that upon breaking out of the pattern there will be a turnaround in the current trend.
We will be investigating the Head and Shoulders and Inverse Head and Shoulders on this page. Double Tops and Bottoms and Triple Tops and Bottoms will be discussed on the next page.
Other reversal patterns such as Rounded Tops and Bottoms, V-Formations, and Diamond Formations are not as common and harder to see. Rounded Tops and Bottoms will be discussed briefly on the next page while you can check our glossary for some information on V-Formations and Diamond Formations.
Head and Shoulders
The Head and Shoulders pattern is one of the most classic patterns in a technical analyst’s toolkit.
This three-peak formation is named for its resemblance to a head and two shoulders. The center peak (head) protrudes above the remaining two peaks (shoulders), which are set at or close to identical levels. The common line of support for all three peaks, which does not have to be a horizontal line, is known as the Neckline. The final downward penetration of the neckline confirms the start of a new downward trend.
There is a chance that even after there is a break of the neckline that the trend may not reverse. A good validation of a reversal would be if the break is significant or if the neckline is tested and it turns from support to resistance. Also, a trader should look and see if momentum was higher during the formation of the left shoulder compared to the right shoulder as this would indicate that buying pressure is decreasing and a true reversal pattern is taking place. During a true head and shoulders reversal, the downward move can be expected to be equal to the distance from neckline to head.
Inverse Head and Shoulders
The inverse Head and Shoulder pattern follows the same model.
In the 4-hour chart below you can see that at first price is heading downwards. After the pattern forms, price reverses and there is a substantial move in an upward direction. Soon though price retracts and tests the neckline. The neckline holds as support, and the uptrend continues, completing the reversal. You can also see, from the momentum indicator, that selling pressure eases by the time the right shoulder is forming
More Reversal Patterns - Various Tops and Bottoms
Some other chart patterns that signal reversals are double tops, double bottoms, triple tops and bottoms, and rounded bottoms and tops.
Double Top
A double top is formed when the price of a pair in an uptrend rises and encounters resistance. Following this, price retreats to a support level which will become the neckline and subsequently returns to the resistance level. After failing to break the resistance level a second time the pair falls back down. At the neckline price breaks down into a new downward trend.
Double Bottom
The same but opposite scenario occurs in the case of a double bottom. A downtrend reverses after testing a certain support level twice. Failing to breakthrough, price reverses into a new uptrend. Sometimes, the pair will retest the neckline, which should switch its role from support to resistance.
Triple Tops / Triple Bottoms
In the typical triple top formation each one of the heads is about the same size. A line of resistance can be drawn connecting the three tops. A neckline should be drawn connecting the support levels. After the third head, price falls below the neckline. The market may rebound for a short attempt at breaking back past the neckline only to be followed by the start of a new downward trend.
To the right is an example of a triple top. Notice that the neckline is slanted upwards instead of perfectly horizontal, which is normal. For all of these patterns, a trader will be hard pressed to find them exactly as they are shown in their theoretical forms.
Rounded Tops/ Rounded Bottoms
Another variation of the shape a top and bottom can take is one in which the reversal is "rounded". The rounded top formation forms when the market gradually yet steadily shifts from a bullish to bearish outlook while in the case of a rounded bottom, from bearish to bullish. The prices take on a bowl shaped pattern as the market slowly and casually changes from an upward to a downward trend.
Continuation Patterns
Continuation patterns indicate that the price action described by the pattern is merely a pause in the prevailing trend and that upon breaking out of the pattern the price trend will continue in the same direction. We will look at the following patterns that imply trend reversals: Flags, Rectangles, Triangles, and Wedges. The latter two are presented on the next page.
Of course, patterns do not result in a continuation of the prevailing trend all the time and analytical skill is needed to gauge whether they will come to fruition.
Flags
Flags are a type of short-term pause in the dynamic and progressive movement of a market trend. Flags are usually marked by a sharp, almost horizontal entry into the pattern. Flags are bound by parallel lines of support and resistance. The pattern is commonly followed by a sharp break back into the prevailing trend. Flags have a tendency to form slanted in the direction opposite to the major market trend they inhabit.
Below is a flag that interrupts an uptrend. It is short lived, and there is a substantial breakout when price moves
above the line of resistance.
The flag pattern during a downtrend, that plays out in a long timeframe. The consolidation phase lasts two months but
does not turn into a new trend. The line of support is broken, ending the flag pattern and continuing the downtrend.
Rectangles
A Rectangle is a period of consolidation within an existing trend where the price moves sideways, fluctuating between two horizontal lines before finally resuming its previous trended course. Such a pattern is not very significant to the trend’s future course - a rectangle seldom accelerates the prevailing trend beyond its previous slope. Though not characteristic in determining any anomalous effects in the presiding trend, a rectangle pattern presents an opportunity to trade within, as one can open alternating positions as the price repeatedly bounces from support to resistance and back.
A theoretical sketch of a rectangle in a downtrend and an uptrend is shown below.
A real world example is presented below. An uptrend that was started in September enters a period of consolidation in October. Price forms a rectangle pattern before the uptrend continues. You can see a flag pattern emerge a couple of months later as well.
More Continuation Patterns
Triangle patterns are usually characteristic of a trend consolidation followed by an accelerated break out of the pattern in the direction of the continuing trend. Triangles form in three basic categories: symmetrical, ascending and descending. A variant of the triangle pattern is the wedge.
Symmetrical Triangle
A symmetrical triangle is indicative of a period of consolidation during an uptrend or a downtrend. The symmetrical triangle has a line of support that slopes upwards and a line of resistance that slopes downward. The triangle pattern yields to a breakout in the direction that corresponds with the trend beforehand, though not always.
Ascending Triangle
An ascending triangle is indicative of a period of consolidation during an uptrend. It is formed when price action moves between a line of resistance that is relatively flat or horizontal and a line of support that is sloping upwards.
As the two lines converge the chance of a break out increases. When price moves strongly above the line of resistance the pattern ends.
On the right is a daily chart showing an uptrend that consolidates for almost a month in an ascending triangle pattern.
Descending Triangle
A descending triangle is indicative of a period of consolidation during a down trend. It is formed when price action moves between a line of resistance that is sloping downwards and a line of support that is relatively flat or horizontal. As the two lines converge the chance of a break out increases. When price moves strongly below the line of support the pattern ends and the downtrend continues. A real life example is shown to the right.
Wedges
The wedge pattern shares most of its characteristics with the symmetrical triangle and the flag. The wedge forms much like the triangle and signifies a sharp expected breakout in the direction of the prevailing trend. Much like the flag, however, the wedge itself forms at an inclination opposite to the direction of the trend before breaking out in the direction of the prevailing trend.
Supply and Demand
Prices of goods, commodities and exchange rates are determined on open markets under the control of two forces, supply and demand.
The laws of supply and demand show that:
High supply causes low prices, and high demand causes high prices.
When there is an abundant supply of a given commodity then the price should fall.
When there is a scarce supply of a given commodity then the price should increase.
Therefore, an increase in the demand for a commodity would cause it to appreciate in value, whereas an increase in supply would cause it to depreciate.
The value of a nation’s currency, under a floating exchange rate, is determined by the interaction of supply and demand. We will work through some charts and an example to show how these forces work, from a theoretical point of view.
Demand Curve
Figure 1 shows the demand for British pounds in the United States. The curve is a normal downward sloping demand curve, indicating that as the pound depreciates relative to the dollar, the quantity of pounds demanded by Americans increases. Note that we are measuring the price of the pound-the exchange rate-on the vertical axis. Since it is dollars per pound ($/£), it is the price of a pound in terms of dollars and an increase in the exchange rate, R, is a decline in the value of the dollar. In other words, movements up the vertical axis represent an increase in price of the pound, which is equivalent to a fall in the price of the dollar. Similarly, movements down the vertical axis represent a decrease in the price of the pound.
For Americans, British goods are less expensive when the pound is cheaper and the dollar is stronger. At depreciated values for the pound, Americans will switch from American-made or third-party suppliers of goods and services to British suppliers. Before they can purchase goods made in Britain, they must exchange dollars for British pounds. Consequently, the increased demand for British goods is simultaneously an increase in the quantity of British pounds demanded.
Supply Curve
Figure 2 shows the supply side of the picture. The supply curve slopes up because British firms and consumers are willing to buy a greater quantity of American goods as the dollar becomes cheaper (i.e. they receive more dollars per pound). Before British customers can buy American goods, however, they must first convert pounds into dollars, so the increase in the quantity of American goods demanded is simultaneously an increase in the quantity of foreign currency supplied to the United States.
Equilibrium Price
Suppliers and consumers meet at a particular quantity and price at which they are both satisfied. Figure 3 combines the supply and demand curves. The intersection determines the market exchange rate and the quantity of dollars supplied to United States. At the exchange rate R, the demand and supply of British pounds to the United States is Q.
This is known as the equilibrium or the market’s clearing point
Changes in Demand and Supply
In figure 4, an increase in the US demand for the pound (rightward shift of the demand curve) causes a rise in the exchange rate, an appreciation in the pound, and a depreciation in the dollar. Conversely, a fall in demand would shift the demand curve left and lead to a falling pound and rising dollar. On the supply side, an increase in the supply of pounds to the US market (supply curve shifts right) is illustrated in Figure 5, where a new intersection for supply and demand occurs at a lower exchange rate and an appreciated dollar. A decrease in the supply of pounds shifts the curve leftward, causing the exchange rate to rise and the dollar to depreciate.
Increase in Demand Increase in Supply
When the forces between supply and demand change, the market moves in ways to clear itself through a change in price.
In international finance markets, if many investors are selling a particular currency, they are making it more readily available and increasing its supply. If there is not an equal amount of buyers, or demand, for that currency, its price will go down in order to strike a new balance between supply and demand.
The direction in which the value of a currency is heading can cause cash to flow into or out of that currency. A currency that is appreciating can cause money to flow into its country’s assets as investors and Forex traders want to benefit from buying or taking “long” positions on the currency as the currency’s price rises.
There are many players that affect supply and demand for foreign currency exchange. Lets meet them.
Exchange Rates & Supply and Demand
Factors that Affect Supply and Demand
A variety of actors cause currencies to experience changes in supply and demand:
companies that export and import,
foreign investors and banks,
speculators who wish to engage in market activity,
and central banks that control the movement of interest rates.
Who Comprises the Forex market?
Due to its vast volume and large number of participants, no individual or single company has complete control over which way the market will sway. Historically, Forex has been dominated by commercial banks, money portfolio managers, money brokers, large corporations, and very few private traders.
Lately this trend has changed. While there are many reasons for participating in foreign exchange including facilitating commercial transactions, corporations converting its profits, or hedging against future price drops, more and more people are getting involved in the market for the purposes of speculation.
Exporting and Importing Companies
Large multinational corporations influence the foreign exchange market as they purchase and sell goods and materials between different countries.
The first group that has influence in the foreign exchange markets is typified by large, multinational corporations. Imagine a New York City firm exports its products to a German company. The business transaction will be settled in dollars so the American firm obtains revenue in its own currency and can pay its employees’ salaries in dollars.
To facilitate the transaction, the German firm needs to convert some of its capital from euros to dollars on the foreign exchange market. The supply of euros increases leading to an appreciation of the dollar and depreciation of the euro. It can also be said that the German firm increases the demand for dollars, again causing the dollar to appreciate in comparison to the euro. This transaction would have to be for a very large contract in order for the exchange rate to actually move a pip up or down.
If the payment by the German company is coming 6 months later, it introduces the risk that the amount of dollars they would receive for a certain amount of euros today will not be the same in 6 months time. A company may want to limit, or hedge, this exchange rate risk by immediately converting their euro into dollars, or by purchasing forward contracts in the foreign exchange market. A forward contract is a contract to convert euros into dollars at a future date at a set price.
Importing companies affect the demand of a currency as well. For example, an American retailer features Japanese furnishings and pays its suppliers in Japanese yen. If consumers like these products then they will indirectly contribute to an increase in demand for the yen as the American retailer will have to buy more merchandise from Japan. As the retailer purchases the yen and sells the dollar on the exchange market, the yen appreciates.
Foreign Investment Flows
Foreign investment has many aspects, having to do with goods, services, stocks, bonds, or property. Suppose a Canadian company wants to open a factory in America. In order to cover the costs of the land, labor and capital the firm will need dollars. Suppose the company holds most of its reserves in Canadian dollars. It must sell some of its Canadian dollars to buy US dollars.
The supply of Canadian dollars on the foreign exchange market will increase and the supply of US dollars will decrease, which causes the US dollar to appreciate against the Canadian dollar. On the flip side, foreign investors are also increasing or decreasing the demand for the currency of the country in which they are interested in investing.
Banks
The Federal Reserve For a long time the foreign exchange market has been associated with the term “interbank” market. This term was employed to capture the nature of the foreign exchange market when it predominantly dealt with banks. Banks included central banks, investment banks and commercial banks.
Examples of central banks include the Federal Reserve Bank of the United States or the European Central Bank.
Investment banks include those of Goldman Sachs, JP Morgan, and Bank of America.
Today, banks are not the only participants within the foreign exchange market. With the onset of technology and the growing ease of accessibility to market activity, there has been an increase in many non bank participants such as individuals.
Speculators - Investment Management Firms, Hedge funds, and Retail Traders
Many financial institutions use currency exchange as a method to generate income. There are also many individuals who try to do the same thing. The currency markets move in one direction only when many investors act together. An individual investor cannot move the exchange rate of a currency but many traders, investment funds, and banks may collectively move it.
If speculating traders think the Japanese Yen is going to weaken in the near future due to poor economic data or a change in interest rate policy, then they sell the yen on the foreign exchange market relative to another stronger currency. The supply of yen will increase and cause the currency to depreciate. If many investors feel that a particular currency will depreciate in the near future, their collective selling of that currency will move its price down. Similarly, if speculators feel that a currency is going to appreciate in the near future then they will buy that currency today and cause it to experience a higher demand which causes its price to go up. Investors help materialize their predictions by acting in a herd mentality, and in some peoples eyes bring about a self fulfilling prophecy.
On the next page we expand our discussion of central banks and their role in the financial markets.
Exchange Rates & Supply and Demand
Central Banks
Floating vs. Fixed Exchange Rates
There are two types of exchange rate systems: floating or fixed. A floating exchange rate is one in which a currency’s value is determined by market forces. A fixed exchange rate matches, “pegs”, the value of the currency to: one currency, several currencies or even to a fixed amount of a commodity.
Floating Exchange Rates Prior to 1971’s breakdown of the Bretton Woods Agreement (a fixed exchange rate system revolving around the US Dollar and gold), most currencies were pegged. Today, the current international financial system squares most of the currencies of the world against one another in a free market. Floating exchange rates are preferable to fixed ones since floating rates are reflective of market movement and the principles of supply and demand and limit imbalances in the international financial system. Fixed exchange rates grant more control to central banks (who may or may not be independent of the government) to set a currency’s value, and during times of volatility are preferred for their greater stability. Many developing countries use fixed exchange rates in order to evade market abuse.
In extreme situations such as political unrest, terrorist attacks or natural disasters a country’s currency may experience a period of heavy selling that causes it to depreciate in value. The country’s central bank may intervene in order to restore the value of the currency. A central bank regime that routinely intervenes would use the term "managed float". Sometimes, the central bank may set upper and lower bounds known as price ceilings and floors, respectively, and intervene whenever those bounds are reached.
Central Banks, Interventions, and Interest Rates
Central banks influence the supply and demand of their country’s currency through control of interest rates or though intervention actions.
For many large economies, central banks can influence their currency’s value by changing interest rates. The US central bank, the Federal Reserve, is not necessarily trying to achieve a weak or strong dollar policy, but acts in a manner that curbs inflationary pressure while maintaining steady growth within the economy. It uses interest rates as a mechanism to achieve this type of economic state. Our next lesson explains more about interest rates and central banks.
