Technical Analysis : The Fundamentals Of Technical Analysis
Technical analysis is appointed to analyze market movement (the movement of prices, volumes and open interests) using the information obtained for a past time. Mainly, it is the chart study of past behavior of currencies prices in order to forecast their future performance. It is one of the most significant tools available for the forecasting of financial markets. Such analysis has been an increasingly utilized forecasting tool over the last two centuries.
The main strength of technical analysis is the flexibility with regard to the underlying instrument, regarding the markets and regarding the time frame. A trader who deals several currencies but specializes in one may easily apply the same technical expertise to trading another currency. A trader who specializes in spot trading can make a smooth transition to dealing currency futures by using chart studies, because the same technical principles apply over and over again, regardless of the market. Finally, different players have different trading styles, objectives, and time frames. Technical analysis is easy to compute what is important while the technical services are becoming increasingly sophisticated and reasonably priced.
Prior to this historic open market intervention, technical analysis provided ample selling signals.
The Fundamental Principles of Technical Analysis are based on the Dow Theory with the following main thesis:
- The price is a comprehensive reflection of all the market forces. At any given time, all market information and forces are reflected in the currency prices.
- Price movements are historically repetitive.
- Price movements are trend followers.
- The market has three trends: primary, secondary, and minor. The primary trend has three phases: accumulation, run-up/run-down, and distribution. In the accumulation phase the shrewdest traders enter new positions. In the run-up/run-down phase, the majority of the market finally “sees” the move and jumps on the bandwagon. Finally, in the distribution phase, the keenest traders take their profits and close their positions while the general trading interest slows down in an overshooting market. The secondary trend is a correction to the primary trend and may retrace one third, one-half or two-thirds from the primary trend.
- Volume must confirm the trend.
- Trends exist until their reversals are confirmed. Figure 5.1. shows example of reversals in a bearish currency market. The buying signals occur at points A and B when the currency exceeds the previous highs.
Cycles of currency price change are the propensity for events to repeat themselves at roughly the same time and are an important ground to justify the Dow Theory.
Cycle identification is a powerful tool that can be used in both the long and the short term. The longer the term, the more significance a cycle has. Figure 5.2. shows a series of three cycles. The top of the cycle (C) is called the crest and the bottom (T) is known as trough. Analysts measure cycles from trough to trough.
Cycles are gauged in terms of amplitude, period, and phase. The amplitude shows the height of the cycle, the period shows the length of the cycle, the phase shows the location of a wave trough.
Volume and Open Interest
Volume consists of the total amount of currency traded within a period of time, usually one day. For example, by year 2000, the total foreign currency daily trading volume was $1.4 trillion. But traders are naturally more interested in the volume of specific instruments for specific trading periods, because large trading volume suggests that there is interest and liquidity in a certain market, and low volume warns the trader to veer away from that market.
The risks of a low-volume market are usually very difficult to quantify or hedge. In addition, certain chart formations require heavy trading volume for successful development. An example is the head-and-shoulder formation. Therefore, despite its obvious importance, volume is not easy to quantify in all foreign exchange markets.
One method to estimate volume is to extrapolate the figures from the futures market. Another is “feeling” the size of volume based on the number of calls on the dealing systems or phones, and the “noise” from the brokers’ market.
Open interest is the total exposure, or outstanding position, in a certain instrument. The same problems that affect volume are also present here. As it was already mentioned, figures for volume and open interest are available for currency futures. If you have access to printed or electronic charts on futures, you will be able to see these numbers plotted at the bottom of the futures charts.
Volume and open interest figures are available from different sources, although one day late such as the newswires (Bridge Information Systems, Reuters, Bloomberg), newspapers (the Wall Street Journal, the Journal of Commerce), Weekly printed charts (Commodity Perspective, Commodity Trend Service).