Forex Technical Analysis

Forex technical analysis involves the use of indicators that are designed to measure historical data in different ways, and display it graphically on the charts offered by all major trading platforms.

Some of the most popular indicators used in forex technical analysis are Moving Averages, Moving Average Convergence Divergence (MACD), Volume, Accumulation/Distribution, Chaikin Money Flow, Bollinger Bands, Relative Strength Index (RSI), and Stochastics to name a few.

Technical analysis is quite popular since many believe that forex is the perfect market for traders that use these technical tools. However, the underlying assumption of forex technical analysis is that historical price action predicts future price action. Although I do use 2 technical indicators in my trading (purely for reference and not for entry or exit signals) I personally don't believe there is any validity to this assumption.

In my experience, the only reason forex technical analysis works at all, is because so many traders use common technical indicators in similar ways to generate entry and exit signals, that price movement becomes self-fulfilling prophecy.

For instance, if thousands of technical traders like to buy when the Relative Strength Index (RSI) drops below 20, indicating that the pair is oversold, then all the buying these traders create themselves can move the price of that pair upward. To me, this isn't a strategy, it's an occurrence that may or may not happen.

The RSI is a trend following oscillator. It gives an indication of whether a currency is "overbought" or "oversold" based on price action from the past. The problem is that determining the degree in which an asset is overbought or oversold is very subjective and can differ greatly among traders who practice forex technical analysis.

I really don't want to make my trading decisions using subjective information, or information generated by an indicator that is "following" the trend. Since this is the case with the RSI, the information it is providing is already obsolete and not useful to me as a short term trader.

Another problem with using the RSI, is that it is not telling us anything about the strength relationship between the 2 currencies in the pair we want to trade with respect to each other, or to each of the other major currencies they trade in pairs with. And that’s the most important information we need to make a trade on that pair.

We make money in forex by trading a currency pair that has a great imbalance of strength between the 2 currencies in the pair that we are trading.

This should be obvious in forex since when we trade a currency pair, we are simultaneously buying one currency and selling the other. If the currency we are buying in our pair is also being bought in all the other pairs that it trades in, and the currency we are selling is also being sold in all the other pairs that it trades in, we have a much higher probablity of making a profitable trade.

So we need an indicator that allows us to see the buying and selling strength of each individual currency with respect to the others in real-time. None of the traditional technical indicators can give us this crucial information because this is supply vs. demand information which is fundamental in nature and not reflected in forex technical analysis.

I can illustrate my point more clearly using the Currency Meter which is a tool that delivers the exact information we need to make profitable trades. The Currency Meter takes a free data feed and measures the actual buying and selling activity of each individual currency in real-time and displays it as a line chart with the higher numbers on the vertical axis indicating buying strength and the lower numbers indicating selling or weakness.

Look at the relationship between each of the currencies in the figure below that was captured during one of my trading sessions. Although the RSI was indicating an oversold condition for the EUR/USD at this time (RSI was at 18), because of the lack of an imbalance of strength between these 2 currencies, the probability of price movement is low, and I would not be interested in trading this currency pair at this time:

I did mention earlier that I use 2 technical indcators in my trading. I like to keep the 50 period Simple Moving Average (SMA) on my trading chart as an indicator of overall price direction.

An upward moving 50 period SMA on a 5-minute chart over a 2 hour time period indicates that the near-term direction of the price movement for that currency pair is upward. My general bias on that pair would be to go long if the opportunity presented itself. Remember, never swim against the tide!

The opposite would also be true of a downward moving 50 period SMA. My bias would be to take a short position if the situation presented itself. This does not mean that because the SMA is showing a particular price direction in the past that it will continue in the future. It is only a general guideline for setting bias.

An economic report could be released at any given time, and the result of that report could change the whole dynamic of the market and shift the relative strengths of each major currency with respect to the others. So although we have a bias, we still need to be aware of what is going on that can affect the forex market and be ready to make a shift if need be.

I also keep the Average True Range (ATR) indicator on my chart as a general measure of the volatility of a currency pair. I use this information as a loose guideline when estimating my profit target for a particular trade.

A pair that exhibits a higher level of volatility can yield a greater profit than one that is exhibiting low volatility at the time of my trade. More volatility means more risk, and thus more potential reward if I make the correct trade.

While forex technical analysis has its merits, I prefer strength trading and have found that it is a much more reliable method for producing repeatable, profitable forex trades.