What is technical analysis, and why should you use it when trading FX?

Dec 3 • Forex Trading Articles • 53 Views • Comments Off on What is technical analysis, and why should you use it when trading FX?

In forex trading, technical analysis is a method of research-analysis, to predict the direction of the price through the study of past market data; mainly price and volume.

The efficient-market hypothesis dismisses the efficacy and efficiency of technical analysis. The thesis proposes that markets are random and highly unpredictable; therefore, it’s impossible to apply technical analysis to obtain positive and profitable results with any certainty and regularity.

Without any doubt, novice traders will go through various stages of development, and trying out just about all technical indicators as part of a technical analysis based trading strategy, is an inevitable and essential part of your growth.

Many of us have seen charts with every technical indicator invented on, and there’s nothing wrong with this approach. If you don’t have a curiosity about the FX industry and you don’t possess intellectual curiosity, then you’re unlikely to succeed.

Sure, the more experienced traders amongst us might prefer to use vanilla charts with only price displayed, but identifying price-action is also a form of technical-analysis (TA) as is your choice of time-frame.

Price-action traders don’t take wild random guesses, they use the patterns price is displaying, perhaps by the use of Heikin-Ashi bars, to make their informed decisions. They predict what price will probably do next.

There are approximately fifty indicators on the MT4 charting package you open. You can add others if you access the various marketplaces and forums. Many are versions of the original technical-indicators created decades back by some very famous analysts and mathematicians. And this is a crucial point to make; you might doubt the use of TA in our modern, fast-moving marketplace, but the actual formula used to create the tools on our charts is correct, it’s mathematically pure.

These maths experts created their formulae to buy and sell mainly stocks and commodities in a pre-internet world, and they’re just as viable and robust in a modern context. Although initially designed before the internet and for weekly or monthly time-frames, in theory, they should work today on lower time-frames due to the maths.

The disciplined forex trader

Us mentors and analysts always preach about the disciplined FX trader. We’re all creatures of habit; we like routine and discipline. We instinctively know that to be successful, we need to create a solid framework in which to work. We need a reason to take action, we need a prompt, and we like to work with tools in which we have confidence.

The disciplined FX trader with the right mindset can make TA work by adopting and then adapting their mindest and technique, and we enhance this process by using strict money-management techniques.

The moving average convergence divergence (MACD)

Before we discuss an example of how to apply our “what gets you in gets you out” concept, let’s focus on a popular technical indicator, the MACD.

The moving average convergence divergence (MACD) is a trend-following momentum indicator. It reveals the relationship between two moving averages of a security’s price. The MACD gets calculated by subtracting the 26-period exponential moving average (EMA) from the 12-period EMA. The resulting calculation is the MACD line.

The MACD is an indicator mostly used for identifying trends. These trends can be daily, weekly or monthly. Your interpretation might alter depending on the style of trading you prefer; day-trading, swing-trading or position-trading.

Because the indicator uses two moving averages while creating a line, in theory, it delivers a signal making us aware of a change in the market and encouraging you to make a decision.

What gets you in gets you out

Despite its simplicity when you look under the bonnet of the MACD, it’s a highly sophisticated tool. Let’s walk through a suggestion of how we can use it.

We trade EUR/USD, and we can see a potential trend is developing on our one-hour time-frame revealing that price is beginning to rise. The direction may be changing due to the USA Fed announcing more monetary stimulus.

Let’s imagine that the EMAs inside the MACD begin to tighten, and the pattern starts to turn. The market has shifted from bullish to bearish. We wait for the precise time when the EMA and MACD lines cross to indicate the bulls are in ascendence. We hit the buy button, and we’re long.

Two days later, the reverse pattern develops, the MACD is displaying negative signals, so we exit our long order and bank the profit. We then re-enter by clicking the sell button having double-checked our criteria to enter are met.

Now this is a simple explanation of “what gets you in then gets you out”, but hopefully you can see the attraction. If you’re disciplined and follow this pattern of movement, then it’s a potential winner.

Sure, the more sophisticated amongst us might scoff. But we quickly recall that we’ve often used successful strategies that worked with only one simple moving average, underpinned by our interpretation of price action. So is the MACD any different? And us more sophisticated traders know that any TA trading method and strategy is only as good as the money-management technique we apply, a subject we’ll cover soon.

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