How to Use Technical Analysis in Forex and Stock Trading?

Category: Technical Analysis | Sunday, February 10th, 2008

Technical analysis is the science or skill of forecasting of the future movements of the price using the past movements and data.

Obviously the past movements can not guarantee the future movements and so technical analysis is not a hundred percent accurate and surefire forecasting but if you learn the technical analysis properly, you can make more correct predictions and so you will be in profit at the end.

Technical analysis rules, techniques and tools are 99% the same in the stock and forex market. So if you learn technical analysis, you can use it both in stock and forex market.

It is impossible to cover everything about the technical analysis in one article. So here I just try to talk about technical analysis in general but write more detailed articles about it.

If you read my daily forex market analysis reports, you will see that technical analysis is the main thing that I use in the market analysis.

I do not use indicators in the big time frames like 4 hours, daily and weekly charts because I believe indicators are too delayed to be used on big time frames. They show the signals far after a breakout and a big move happens. So it can be too late to enter to any trade.

In technical analysis we work on the price charts. The price chart is a two dimensional chart. The vertical axis shows the price and the horizontal axis shows the time.

We have different kinds of price charts:

1- Tick chart
2- Line chart
3- Candlestick chart
4- Bar chart
5- Heikin-Ashi chart
6- Kagi chart
7- Renko chart
8- Point & Figure Chart

There are some other kinds of charts but as they are not common, I have not mentioned them in the above list. Even Heikin Ashi, Kagi, Renko and Point & Figure are not very common too but as I like to talk about them because I believe some of you will become interested in using them.

Line, candlestick and Bar charts are very common and I think candlestick chart is the most common chart and it becomes more popular everyday.

Technical analysis is based on the analysis of the charts. Finding the trends, support and resistance levels and also consolidations like triangles, wedges, pennants, double and triple tops and bottoms, head and shoulders and … can be done through the technical analysis rules and when you can achieve to find these things on your charts, you will be able to predict the next direction and movement and so you can take the proper position.

Technical analysis becomes even more helpful and valuable when you enrich the result with some other tools like candlesticks and Fibonacci levels. You can do your technical analysis on a simple line chart. It will not make any difference because you will find the same trends and formations but when you do in on a candlestick chart and pay enough attention to the candlesticks’ signals, your analysis will be stronger.

If you don’t know about the candlesticks’ signals, please read one of my other articles which is about reading the candlesticks’ signals:
Learn to read the candlesticks signals

Also read my Fibonacci article to learn how to use Fibonacci levels on the charts:
How To Use Fibonacci Numbers in Forex and Stock Trading

1- Trend:

Trendlines are the general direction of the price. When the price goes up, we have uptrend and when it goes down, we have downtrend.

You can find several small trends inside a big trend. Additionally each time frame can have its own trends which can be different from other time frames. For example while you have an uptrend in the daily chart, you can have a downtrend in the one hour chart.

Finding the trends is the first thing we do in technical analysis.

Look a this big uptrend we have in EUR-USD since the end of the 2005:

Now look at the small uptrends and downtrends inside the same big uptrend:

2- Support:

Support is a level that doesn’t let the price go lower.

Look at the strong support that we have had in EUR-USD since 2006. As you see the price has gone up any time that it has touched this support level:

However a support level can be broken down. Usually when a support line becomes broken down, the price goes much lower but it is important to know that when a support level becomes broken down it will act as a resistance and sometimes the price goes up several times to retest the broken support.

Look at the broken support in the below chart:

The same chart with a higher magnification:

See how a broken support was retested as a resistance in the Eur-USD one hour chart:

3- Resistance:

Resistance is a level that doesn’t let the price go higher.

Like the support level, the resistance level can be broken up and then act as a support.

Look at the resistance level (the red line) in the below chart.

And see how this resistance became broken up and then was retested as a support line:

It is time to tell you that finding support and resistance levels is the foundation of technical analysis. Everything that we do in technical analysis is based on the support and resistance levels we find on the charts. Even patterns like triangles, wedges, pennants, double and triple tops and bottoms, head and shoulders and … are created by support and resistance levels.

Some important questions:

- Why do we have support and resistance levels in the market?
- Why do the price goes up as soon as it touches a support level and goes down as soon as it touches a resistance level?
- What causes a support or resistance level becomes broken?

These are the questions that could be formed in your mind. It doesn’t make any difference in your trades if you know the answer of these questions or not. You just need to know what a support/resistance level is and how it acts. But it is always useful to know more than the basic.

You can be a good driver even if you know nothing about the engine and gearbox but professional drivers have to know about engine, gearbox and all other parts of the car. That’s why they are called professional drivers. You can be an ordinary trader or a professional trader. Professional traders know a lot about the psychology of the market.

So why do we have support levels in the market?

We have support and resistance levels in everything. For example in the weather changes. It becomes hot in summer but it has a limit in different regions. It doesn’t go up as much as it can. There is a resistance level in different areas. Every year the temperature goes up, retests the resistance and then goes down. It is the same in Winter. The temperature goes down but it doesn’t go lower than a special level in different regions (support).

What prevents the temperature from going above or below a special level? There are different factors like atmosphere and geographical conditions.

It is the same as the forex market and all other kinds of markets.

Traders buy and buy and buy and the price goes higher and higher and higher but can the trader keep on buy for good? Or will they find a seller to sell his/her shares to them anytime that they want to buy?

Definitely not because they have limitations. They can not afford to buy more than a special limit and when most of the buyers reach their limit, they stop buying and start selling gradually and so the price will be stopped from going up and starts going down gradually. Then the other buyers who had kept their positions, becomes realized that the price will not go higher and will go down. So they sell and the price goes down much faster.

On the other hand, when you want to buy, a seller should be found at the other side of the market. Otherwise you can not buy. And it is clear that you can not find a seller at any condition and time and visa versa.

This cycle will be repeated over and over but each time when the buyers reach their limit level, they stop buying. When we have an uptrend - like the EUR-USD chart you see above - each limit will be higher than the previous one because the buyers become stronger and their buying limit goes higher because they have made profit in their previous trades. So we still have a limit level but this level is higher than the previous level.

When you connect the buying limits (tops) to each other, you will have a resistance level:

Support level has the same story. It is the level that all the buyer finish selling and then start buying and so the price goes up again. When you connect the selling limits (bottoms) to each other, you will have a support level

But what causes a support or resistance level becomes broken?

There are so many factors that cause a support or resistance level becomes broken. A positive or negative change in the economic condition is the most important factor. For example a big country like USA decides to attack Iraq. This tells the traders and investors that the economic situation of USA will be encountered with some problems because of the heavy expenses of war. So they stop investing in USA and they stop buying USD.

On the other hand, those who already had bought USD start selling because they believe if they don’t do it, they will lose a lot when the value of the USD goes down. Also some of the investors who had invested in USA, take their money out because they are fearful that the US economy will go down and so they can not make any profit or they will lose. So the value of the USD goes down against the other currencies and so several strong support/resistance levels becomes broken.

Anyway! You’d better to know what causes the price to go up and down but for trading according to the technical analysis, we just need to find the support and resistance levels and know when it is the time to buy or sell.

When you find the support and resistance levels through technical analysis, you wait for the price to retest the support. If it can not break down the support and goes up, you take a long position and if it breaks down the support, you take a short position.

Also when the price retests a resistance line and can not break it up, you take a short position and if it breaks up the resistance, you take a long position.

When the price goes up or down for a while, it just stops going up or down and makes some small fluctuations. All these events has physiological reasons related to buyer (Bulls) and sellers (Bears). For example buyers stop buying and wait for the other traders. If other traders keep on buying, the price will go up and so those who have been waiting, start buying too. This waiting period in the market makes a consolidation in the price charts and when the price goes up again, the consolidation will be known as a continuation signal.

Consolidations show the uncertainty of the market. The price doesn’t know if it should go up or down. It is the time that we have to plot the support and resistance levels and wait for the breakouts.

Consolidations makes different shapes and patterns. I just mention some of the patterns that becomes formed by the support and resistance levels but I will write different articles for each of them.

Double Tops
Triple Tops
Double Bottoms
Triple Bottoms
Head and Shoulders
Ascending, Descending, Symmetrical Triangles
Ascending and Descending Wedge
Flags or Pennants

Some of the consolidations work as continuation signals. For example flags or pennants are continuation signals. It means the price will keep on moving to the same direction that it has been moving before the formation of the flag.

Some other patterns are reversal signals. For example Head and Shoulders and Double Tops that are formed at the top of an uptrend are reversal signals and the price should go down after these patterns but sometimes they fail to act as reversal and so the price keeps on moving to the same direction.

I do not want to make this article so long and I will explain about all the patterns in different articles. Stay tuned!

Further Reading:

30 Comments:
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Comment by Ignatius

2008-02-10 16:48:02

i love this. thanks. it has made me see the importance of support and resistance, i trade technical and make profits but without support and resistance, i think this will make me more professional.