How to Use Forex Technical Analysis Properly
A general discussion of the limitations of forex technical analysis and how to properly apply this element into your forex trading strategy. Forex technical analysis is solely based on a self-fulfilling prophecy. It works better on higher time frames and there are never any guarantees, which is why it should be used in conjunction with other aspects.
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Forex analysis is used to design forex trading systems and consists basically of two elements: fundamental analysis and technical analysis. Technical analysis encompasses a wide range of techniques used to try and predict the following move of a certain currency pair. Technical analysis includes the use of pivot points, time cycles, trendlines, candlesticks formations, moving averages, typical chart patterns such as double top, head and shoulder, etc.
There are a lot of different aspects to forex technical analysis. It is not my intention to give advice on which technical patterns or indicators are better than others, but more to share with you some of my observations. In addition to this, we will look into testing trading systems based mainly on technical analysis.
First of all, it is important to understand that there is no magic to forex technical analysis, although it is often marketed in such a way. Technical analysis works only because it is similar to that of a self-fulfilling prophecy and ,in my opinion, nothing else. When this is taken into consideration, it only makes sense to use the most known ones and stay away from all the so-called "secrets" or new technical indicators, as an unknown technical indicator simply will not respond well to a self-fulfilling prophecy. A simple way to test the popularity is to do a search on Google for the name and look at the results.
How about fundamental analysis contra technical analysis; are there times when one supersedes the other? Yes, there is. The release of highly important forex fundamental data can be very dramatic events and technical analysis is of very limited use during these times. This is because the statistical techniques that technical analysis depends on are ineffective during the volatile times of the release and for about at least one hour afterwards. However, this all depends on the kind of news and the deviation from the expected number. But it should be kept in mind that these are definitely not good times to try and detect trends or their tops and bottoms. You are well advised to wait for calmer waters when technical analysis can be applied properly. As fundamental data releases can produce spikes of price movements in minutes, this is not the time to try and detect reversals, although some traders try to do just that.
Fundamentally, technical analysis produces more reliable results the longer the time frame used. This is especially true when the trading is following a regular pattern such as during "stable times". However, longer time frames can be more vulnerable to sudden sharp reversals, which is a serious problem. During volatile times, irregular trading patterns, much larger pip movements and spikes reduce the effectiveness of statistical analysis.
The most popular timeframes used by most forex traders are the hourly, four-hourly and the daily charts. Very short time frames below 1 hour do not lend themselves to statistical analysis very well. However, some traders do use them for other types of trading strategies such as scalping which is used by many expert advisors. The general idea behind any scalping method of trading is to reduce risk by getting into a trade and then out of it as quickly as possible. This type of action limits the risk exposure during a trade. This process is then repeated many times, always aiming for a small low risk gain. One of the main ideas of this strategy is to attack the markets during their off hours when they have settled into a tight and more predictable range pattern. The time period selected is between 9.00pm and 1.00am GMT. Typically the following currency pairs are traded: EURGBP, EURCHF, GBPCHF and USDCAD. Europe, UK, Switzerland, USA and Canada do not release any national fundamental data during this time period and thus the forex market can be very quiet with low volatility. However, as the liquidity is lower during these hours, the market is more prone to macroeconomic events, and it is important to keep in mind that large spikes easily can occur in these periods.
In addition to the specific timeframes, it should be noticed that Fridays often tend to respond poorly to any technical analytical approach, as well as fundamental news releases. Although I heard this many times before I actually started trading, I was still in front of my screen on a typical Friday. You can easily get chopped up in this trading period. One of the main reasons for this is probably that large institutions such as banks and hedge funds close their books for the weekend. It can be argued that they might be more prone to psychological aspects in order to reach breakeven or in an attempt to squeeze the last possible profit before the end of the week. Fridays can be a tough challenge. This is often true for Mondays as well, as a new week starts and a direction is to be decided on.
You should begin to understand that using technical analysis as a central part of your trading strategy is not so easy as first thought and prone to difficulties. So how do forex traders attempt to overcome this serious problem? It is important to understand that many technical analytical approaches are rather useless, and especially so if they are applied solely as a trading strategy. You will need to devise a forex strategy that is wrapped around your limitations and facilities and it should entail more than simply basing an entry or exit on technical analytical aspect. You also want to make sure that you don't fill up your screen with too many different indicators.
Although a large number of the technical approaches are nothing but hot air, there are several technical indicators that can be used to help you achieve a better trading foundation, including stochastic, RSI, Bollinger Bands, MACD, moving averages, etc.
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