Principles of forex technical analysis

Technical analysis has some basic principles. First of all some words about technical analysis.

Technical analysis refers to methods that aim to forecast prices of securities in financial markets using charts or quantitative techniques. There are many different methods utilized in technical analysis but they all rely on the same principles, namely that price patterns and price trends exist in the market that can be identified and exploited.

Charles Dow's Dow Theory is one of the earliest examples of technical analysis. The realm of technical analysis has been expanded by many further market participants. Still, new theories and tools are produced and existing tools are being enhanced.

Technical analysis is less concerned with why a price is moving (poor earnings, difficult business environment, poor management, etc. or other fundamentals) than it is on the fact that the price is moving in a particular direction. To a technician, profits can be made in any market by positioning yourself in the direction of the price trend.

If the price trend is up, then look for opportunities to buy, if the price trend is down, then look for opportunities to sell. Similarly, if a particular price pattern was identified in the market, a technician would position himself to take advantage of the expected move that follows that pattern.

Technical analysis is based on three underlying principles:

1. Market action discounts everything

This means that the actual price is a reflection of everything that is known to the market that could affect it, for example, supply and demand, political factors and market sentiment. The pure technical analyst is only concerned with price movements, not with the reasons for any changes.

2. Prices move in trends

Technical analysis is used to identify patterns of market behaviour which have long been recognised as significant. For many given patterns there is a high probability that they will produce the expected results. Also there are recognised patterns which repeat themselves on a consistent basis.

Three types of trends are distinguished in technical analysis:

• 'bull trend' - upward movement of price (by analogy with a bull, who pokes up with the horns);
• 'bear trend' - downward movement of price (by analogy with a bear, who hits down with a paw);
• 'flat' or 'range' or 'trendless' - price is not moving up or down, but remains within a certain interval.

As a rule, prices are not moving linearly u or down. However, on the bull trend prices grow higher and faster, than they fall. On the bear trend it is vice versa.

Basic principles of price movement can be applied to trends:

• an active trend will continue with a higher probability, rather than change its direction;
• a trend will be moving in one direction until it gets weaker.

3. History repeats itself

Chart patterns have been recognised and categorised for over 100 years and the manner in which many patterns are repeated leads to the conclusion that human psychology changes little with time.

Some academic studies of financial markets suggest that technical analysis has little worthwhile predictive power. Still, technical analysis has a loyal and dedicated following especially amongst active traders who defend the practice and believe it can be profitable and there are some scientific studies that support technical analysis.