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XM Forex Penguin

What is Technical Analysis?

Last Updated: Mar 3, 2022 @ 6:18 pm

Trading forex successfully requires the 3 “Ms”: mental, money management, and method. For method, you can choose between a system that uses fundamental analysis, technical analysis, or price action. In some cases, you might combine aspects of more than one of these types of analysis.

For our introduction to fundamental analysis, please see our post, “What is Fundamental Analysis?” In this article, we are going to introduce you to technical analysis.

What Technical Analysis Is

Technical analysis is a type of analysis where you look at trends in past data on your charts for a currency pair, and use that information to predict what might happen next.

You can conduct technical analysis by plotting indicators on your chart that help you visualize what has been happening with the price.

Note that for technical analysis to be effective, you must have a reliable, consistent method.

You cannot simply add indicators to your charts at random and make a wild guess based on what it looks like they are telling you what is going on.

Types of Indicators

There are hundreds of different types of indicators in existence. Many of these will come loaded right into your charting platform. But if you are using MetaTrader 4, you also can add custom indicators to your charts.

This is not a comprehensive post specifically on indicator types, so we will not go over an exhaustive list of examples. But here are a few, just to give you a general idea:

  • Bollinger Bands: Use this indicator to plot a pair of bands that show changes in volatility.
  • Moving Average: One of the most useful indicators all-around is the moving average. You can calculate these differently by changing the period and the type (simple, exponential, smoothed, or linear weighted). In fact, many technical analysis systems involve signals based on one moving average crossing over another.
  • Moving Average Convergence/Divergence (MACD): This is a combination of two moving averages and a histogram. It can help you look for trends and reversals.
  • Relative Strength Index (RSI): This is an oscillator that can give bullish and bearish signals.
  • Stochastic Oscillator: This is another type of oscillator that helps you know if the market may be overbought or oversold.

Read about these and other popular technical indicators in our article, “Popular Tools to Help with Forex Trading.”

Other Tools You Can Use

Along with technical indicators, you will find a range of drawing tools available on your charting platform.

These are different than indicators. Most of them do not involve any sort of mathematical formula. They are simply tools you can use to manually draw on your chart.

For example, you can draw horizontal lines or sloped trendlines. This is a good way to manually mark support and resistance.

This is also where you will generally find Fibonacci retracement levels and related tools, though some people do refer to them as indicators. Placing these on your charts can also help you spot support and resistance.

While you can use drawing tools directly in your trading, you also can use them to take notes on charts to save for your own reference or share with others

In fact, there may be a text tool in your platform that allows you to write directly on your charts.

Do not underestimate the usefulness of these tools, since being able to study and share your charts can be essential to mastering a technical analysis system and using it successfully.

How Do You Use Technical Analysis to Trade Forex?

Now you know the basic ingredients of technical analysis. But how do you actually put it to work to place profitable forex trades?

Well, the answer can vary quite a bit depending on the exact approach you are using. But we can still go over some basic steps.

1. Build or find a technical analysis system.

The first thing you are going to need to do is to get a trading system or method. This simply refers to a set of rules that tells you when and how to enter and exit trades based on your technical analysis.

Here is a simple example of a trading method using technical analysis:

  • Open the 15-minute chart.
  • Plot a 5-period EMA, a 20-period EMA, and a 50-minute EMA.
  • Wait for the 5-period EMA to cross the 20-period EMA.
  • Wait for the price, the 20-period EMA, and the 5-period EMA to cross the 50-EMA in the same direction.
  • Buy or sell as appropriate (you want to buy when the 5-period EMA crosses up, and sell when it crosses down).
  • Put your stop loss 10 pips out.
  • Take profit at 20 pips.
  • If the 5-period EMA re-crosses the 20-period EMA, consider exiting.

That is just one example. There are numerous variations on this type of moving average system, and plenty of other types of trading methods that are entirely different.

You can also combine technical analysis with a price analysis. For instance, you could use price patterns to tell you when to enter your trades, but use technical indicators to provide you with confluence.

Where can you get a trading system? If you search around, you will find there are many resources you can use. Here are some ideas of where to look:

  • Trading websites and blogs
  • Trading forums and communities
  • Trading training programs
  • Trading eBooks
  • Physical books about trading (check your library or Amazon)

Moreover, you can also try to build your own system from the ground up once you get a feel for the basics.

2. Set up your charts and plot your indicators.

After you choose a trading system, how do you put it to practical use? The next step is to open your charts and get them set up.

You are going to want your charts to be as clear and easy for you to understand as possible. So, take some time to customize the appearance of your charts. Make adjustments to grids, colors, and so forth. Decide on whether you find bars or candles easier to read.

Once you have taken care of that step, save a template of your chart so that it is easy for you to set up other charts in the future with a single click.

Next, you just need to add your indicators to your charts. Usually, that entails searching for them on a list of indicators in your platform and adding them one by one. When you select an indicator to add to your chart, you will have a chance to modify its settings.

You then need to watch your charts or set alerts that help you spot potential setups based on your system rules.

3. Enter and exit based on your trading rules.

When your technical analysis system shows a promising setup based on your rules, you can enter a trade.

Exiting the trade is also as simple as following your rules.

I recommend that you stick with the rules you set as closely as you can. There may be situations that call for you to make complex decisions.

If so, I suggest that you try and think of all possible ways a trade could go in advance as you are working on your system. Create rules for each contingency.

That way, when it comes time to make those decisions, you will have tested rules that can help you produce reliable outcomes.

Note: There Are No Guarantees

The value of a trading system of any type (technical or otherwise) is that it can help you to produce winning results time and again.

But it is important to know that there are no guarantees.

Just because the trading system produced a win last time, that does not mean that it necessarily will this time even if the setup looks very similar.

That is why you can never get a win percentage of 100%.

Nevertheless, trading systems are designed to help you find order amid chaos. But that means that you also need to apply them in an orderly way for them to work at their best.

Best Practices for Technical Analysis

You now have a basic idea of how to apply a trading system. Below, we go over a few pointers that can help you get the most out of the technical analysis.

1. Backtest and demo test first.

Just as you would if you were trading using fundamental analysis or price action, you should test your technical analysis system thoroughly on paper before trading with real money.

That process starts with backtesting. This is testing that does not take place in real-time. Instead, you go through the historical charts available for your platform, moving them forward bar by bar, and trading on paper as if events were unfolding in real-time.

The benefit of doing this is that it is a relatively rapid process. You can quickly find out whether this strategy would have produced results over hundreds of trades.

After that, you can progress to demo testing, which is the kind of testing you do live in real-time using virtual money in your trading platform.

Once you are profitable with demo testing your technical analysis system, you can try trading with real money.

2. Do not clutter your charts!

One common mistake that beginners make when they trade using technical analysis is to try and use as many indicators as they can all at once.

This instinct is understandable. The thinking goes that if one indicator can provide you with useful information, surely ten indicators can provide you with ten times as much useful information.

More likely, however, you will come up with a bunch of conflicting signals that will leave you suffering from analysis paralysis.

Even worse, you may have a difficult time even reading your charts with so much visual distraction in the form of so many indicators.

A far better practice is to stick with just several technical indicators. Your charts will be easier to read and they will produce less confusing trading signals.

3. Pay attention to context.

In a way, technical analysis is about understanding the context of what is happening around a price bar. But it is still easy to miss some things related to context.

For example, some technical analysis systems may produce entry signals in both smooth and choppy markets—but only the signals in smooth conditions tend to be profitable.

If you forget to check for chop and just dive right into a trade, you will probably find yourself stopped out on a whipsaw.

Make a checklist of things to be on the lookout for so this sort of thing does not happen to you.

4. Only take top setups.

Many systems produce a range of entry signals. Some are fantastic. Others are pretty good, but not amazing. Still, others are mediocre. And some entry signals are so weak that you might find yourself arguing about whether they really are signals or not.

When you are new to trading, you are probably excited to trade as much as possible. So, you might try to take as many of those setups as possible.

But if you do that, you probably will not achieve the best results that the system is capable of producing.

Instead, we recommend taking a “less is more” approach. Try and take only the setups that are actually fantastic. You should see an improvement in your win/loss ratio.

Even though you are taking fewer trades overall, you probably will end up making more money this way.

5. Be ready to adapt.

Finally, market conditions can change as time goes by. A year from now, your trading system may not perform how it does today. So, be ready to test adjustments when necessary. This can be one of the most frustrating and challenging aspects of any type of forex analysis, but it is one you cannot avoid.

Summary

Now you know how to use technical analysis to trade forex, and you have some recommendations to help you do so profitably.

Designing or discovering the system that fits your trading personality will take time, as will testing and refining it.

But once you do, you will have a powerful tool that can help you pursue a long-term profitable career as a forex trader.


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