So you know the basics of forex trading, and you know all about managing risk with sound money management, but should you buy or sell? Which currency pair? And just as importantly, when should you buy or sell?
In order to answer those questions, traders have developed a set of analytical tools which can be grouped under the term Technical Analysis.
These technical tools focus on analyzing past (and current) price behavior by using charts and indicators that signal the ideal entry and exit points for a trade.
Let’s start at the beginning.
Assume for a moment, that you want to make money trading currencies.
You don’t know with 100% certainty what the price of a currency pair will be by the end of the day. Thus, you have to come up with a good guess of what the price will do.
One approach is to see where the price is now. Like my regressions professor used to say:
“If I ask you what will be tomorrow’s temperature, today’s temperature isn’t a stupid guess”.
But we don’t want a single price point, we are more interested in the price direction, and whether we are entering the trade at a profitable time (as in, at the beginning of the price movement vs the end).
Enter charts. In a chart, you can graph all the prices of a currency pair for a period of time.
The cool thing about charts is you can see price behavior in an easy to understand way.
For example, in the following charts, it’s clear that price has been trending upwards in left and bottom while declining in the chart to the right.
In the upward cases, buying might not be a “stupid guess”.
But even if we decide to buy, when and at what price should we buy?
Traders use many different technical analysis tools to try to pin these points down. But this is more an art than a science.
I will introduce you to some of the most important concepts and tools:
Probably the most important concept in technical analysis is that of support and resistance levels.
If you draw a line that touches the lowest price points in a chart, you have what is called a support level.
Support is the level price doesn’t fall below of (or hasn’t in the period you are examining).
The intuition is that most traders are also analyzing these support levels, and therefore, when the price falls close to the support line, traders believe it is a good time to buy the pair. So they buy.
Why is it a good time to buy the pair? Because price seems to stay above that level, therefore, it is likely that price will not keep falling, and instead, it will rebound.
Even if you don’t fully believe this explanation, take into consideration that whatever the reason, price hasn’t gone below the support level. If the market hasn’t changed, then it’s not a “stupid guess” to think price will rebound once again.
What about resistance levels? Resistance is the opposite of support. It is the level price doesn’t rise above.
If you draw a line at the highest price points in your chart, you would get a resistance level.
The intuition behind resistance levels is similar to that of support: when price increases and is close to resistance levels, traders believe price has come too high and it’s a good time to sell the pair.
It sounds relatively simple. Just add a few lines to your chart and voila!
Well, I really wish it were that simple. You see, sometimes you will have multiple support and resistance levels in your chart.
Other times, what was once a resistance level becomes a support level (or vice versa).
Finding appropriate support and resistance levels is an art each technical trader has to master in the quest for pips.
There is much we have not seen yet. So don’t
forget to check part 2 of technical analysis.
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