Technical Analysis in Forex Trading
Another popular tool in Forex trading is technical analysis. The idea behind technical analysis is the belief that future price movements are based on past price movements. Technical analysts reason that all present market variables are depicted in the price fluctuations on a price chart. Following this line of reasoning, there is no point in analyzing anything but price movements.
Using technical analysis, traders will look for market patterns. Technical analysts try to look for trends and read the flow of the market using a price chart. As scientific as it may sound, technical analysis is actually more of an art than a science. The article on charting will introduce you to the techniques that Forex traders have developed over the years to help them analyze price fluctuations in the market.
Sentiment
Although economists do acknowledge that the fundamental principles of market forces are sound, they are also aware of the fact that human beings have a tendency to act irrationally when in a crowd. We tend to act differently when in a crowd, for it is then that we are susceptible to collective psychology.
The expression of crowd behavior on price fluctuations is known as “market sentiment.” Market sentiment is the reason why the exchange rates in the Forex market diverge so much from the fundamental understanding of how the economy works. As a crowd, market participants do not always make rational and objective trading decisions.
In a dynamic market, buyers and sellers constantly adjust their price expectations based on available information from the market and outside the market. Let us say a potential seller believes that future prices might be higher, so he decides to stay out of the market and wait in the hopes of getting a higher price. Given enough sellers acting in the same manner and choosing to wait it out, the dealing price will rise according to their expectations. In this situation, it is herd mentality, rather than the price, that drives the market.
We now know that market sentiments can be the driving factor behind a price fluctuation. But what actually causes the price fluctuation?
According to the Behavioral Finance theory, price fluctuations are the result of market participants adjusting to what they believe or expect to happen until new information arrives and changes that expectation or belief.
To help Forex traders gain a better understanding of market sentiments before making any trading decisions, certain tools are available. One of these tools is the Commitment of Traders (COT) report.
The COT shows Forex traders long and short contracts in the futures market. Using this information, a trader can roughly gauge if the market is overbought or oversold, which in turn allows the trader to determine if the market favors buying or selling a currency.
Another increasingly popular tool among Forex traders is the Volatility Index (VIX). This index measures the implied volatility of options that are bought and sold on the S&P 500 index. The logic behind the VIX as a market sentiment indicator is the notion that options are considered a hedge or protection against price fluctuations that are going against a major market trend. The implication is that the greater the implied volatility, the greater is the fear factor among the trend followers that the market is peaking or bottoming out. Forex traders pay attention to this index because some currencies react strongly to fluctuations in the equity market.
In addition to the COT and the VIX, there are other tools like the Stochastic indicator and the MACD indicator, both of which are used for discerning trends in the market. We will discuss these two indicators in more detail in the proceeding chapter of our lesson plan. For now, we should remember that when trying to gauge the mood of the market, we should never solely rely on just these technical tools but also remember to look at the other fundamentals of the market.
Technical Analysis vs. Fundamental Analysis: Which is Better?
As we noted earlier, there are basically two schools of thought concerning how Forex should be traded. First we have those who believe that the market operates in an efficient and rational manner according to fixed market theories. They base their trading decisions on fundamentals like economic news stories.
Technical analysts, on the other hand, base their predictions solely on price fluctuations, arguing that all other factors that can affect price movements are already reflected in the price itself. Accordingly, technical analysts rely heavily on historical price data to help them make price forecasts.
The question as to which is the better method of analysis is a matter of contention. With fundamental analysis, virtually every piece of news that can affect the price is considered economic news. A trader who relies solely on fundamental analysis will have to monitor the news 24/7, leaving him no time to analyze the market and trade. The point to remember about fundamental analysis is this: its major disadvantage stems from the fact that countless factors can affect prices in the financial market.
Using technical analysis, traders will have time to properly analyze the market before they make their trading decisions. Many traders, by learning how to properly use the powerful tools of technical analysis, have managed to successfully trade the market.
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