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An Introduction to Forex Technical Analysis

By Frances Coppola

For businesses, understanding the principal drivers of exchange rate movements can be key to managing cash flow and FX risks. To achieve such understanding, businesses may wish to know how traders – who are the principal drivers of exchange rate movements – incorporate forex technical analysis into their trading decisions.

Traders predict exchange rate movements using both “fundamental” and “technical” analysis. Businesses may be more familiar with fundamental analysis, since it is concerned with how exchange rates respond to the same economic indicators and world events that businesses incorporate into their own planning. But they may be less familiar with forex technical analysis, which uses historical exchange rate patterns – and a lot of math – to predict future exchange rate movements.

 

This article provides an introduction to forex technical analysis for businesses.

 

Forex Technical Analysis Begins with “Pricing In” of Currency Exchange Rate Moves

 

Paradoxically, the story of forex technical analysis begins with fundamental analysis. A forex economic calendar is a principle tool of forex fundamental analysis. Traders use economic calendars to help them decide their bid and offer rates in light of forthcoming events such as central bank interest rate decisions and Treasury budget announcements. Because of this, exchange rates tend to move in advance of key events. This is known as “pricing in.”

 

For example, if traders think that the Federal Open Markets Committee (FOMC) is going to raise U.S. interest rates, they may adjust their bid/offer rates for the U.S. dollar upwards. Thus the U.S. dollar exchange rate may rise days or weeks before the interest rate is announced, rather than at the time of the announcement. The FX market is said to have “priced in” the interest rate rise.

 

The concept of “pricing in” is key to forex technical analysis. The Efficient Market Hypothesis says that everything that can be known about the fundamentals of a currency both now and in the future is priced into its exchange rate.1 Since every historical exchange rate thus includes not only historic fundamental information but traders’ expectations of future fundamental information, historical exchange rates can be a guide to future exchange rates.

 

However, the FX market can be volatile. In the very short term, currency exchange rates can move up and down in unpredictable ways. Technical analysis tries to look through this forex “noise” to identify longer-term trends.

 

Identifying FX Patterns and Trends with Forex Charts

 

Forex charts are key tools in technical analysis, so if you are not familiar with forex charts, take a moment to review this piece. Forex technical analysts look for patterns in forex charts that help them to identify exchange rate trends. Sometimes the trend is obvious, such as the rising trend shown in this USDJPY chart:2

 

Forex Technical Analysis

 

But oftentimes, as this EURCHF chart illustrates, the trend is less easy to see:3

 

Forex Technical Analysis

 

However, the fact that history tends to repeat itself comes to the rescue. Technical analysts have a library of recognized forex patterns that historically have tended to result in certain outcomes. Discerning one of these patterns in a chart can therefore indicate the likely direction of travel for an exchange rate. Patterns can either signal a reversal of the exchange rate trend or a continuation of it. A pattern that historically results in the exchange rate rising is a “bullish” pattern, while a pattern that results in the exchange rate falling is “bearish.”

 

Bearish patterns include a “head and shoulders” pattern, which usually means that a rising exchange rate trend is about to reverse. The EURCHF chart above shows an example of a “head and shoulders” pattern in mid-July 2018. Here’s a close-up of the relevant portion:4

 

Forex Technical Analysis

 

In this close-up, the trader’s preferred position is “short” the euro, which implies an expectation that the exchange rate will fall and is therefore bearish. So “head and shoulders” is a bearish reversal pattern.

 

Typical bullish technical analysis patterns include bull flag, bull pennant and cup-and-handle. The USDJPY chart above shows a bull pennant at the beginning of August. Here’s a close-up of the relevant portion:

 

Forex Technical Analysis

 

FX Street’s commentary accompanying this chart says that the USDJPY exchange rate is starting to rise. This would continue the preceding upwards trend. Bull pennant is thus a bullish continuation pattern.5

 

Double tops and double bottoms are reversal patterns that are, respectively, bearish and bullish. Double top tests “resistance” twice before falling: the EURCHF “head” shown in the EURCHF close-up above is a double top. Conversely, a double bottom tests “support” twice before rising. Triple tops and bottoms are similar forex technical analysis patterns but have three “bounces” instead of two.

 

Triangles and wedges are common forex technical analysis patterns that can be bearish or bullish depending on the direction. In a triangle or a wedge, there are two trend lines – an upper and a lower – which gradually converge. In an ascending triangle the lower trend line is steeper than the upper trend line, while in a descending triangle the upper trend line is the steeper. Ascending triangles are bullish, since the trend lines will converge in a rising direction, whereas descending triangles are bearish. They may be either reversal or continuation patterns. Symmetrical triangles give nothing away.6

 

For example, in the first USDJPY chart above, the period from late March through mid-April is an ascending triangle which eventually resulted in a sharply rising exchange rate. It is a bullish reversal triangle.

 

Wedges usually break out in the opposite direction from the angle of descent, so a descending wedge is bullish and an ascending wedge is bearish.7 They may be reversal or continuation patterns depending on the previous trend. For example, in the February-March time frame of the first EURCHF chart there is a descending wedge which reversed the previous downward trend, resulting in a sharply rising exchange rate. This is a bullish reversal wedge.

 

Support and Resistance in Technical Analysis

 

Patterns on forex charts can be defined by “support” and “resistance” levels. Thus, in the first EURCHF chart above, the exchange rate several times appears to “bump along” a line at around 1.14925. This is known as a “support” level. It is the level at which buying starts to exceed selling, so the exchange rate stops falling and may reverse.

 

Of course, exchange rates can break through support levels. On the EURCHF chart, there is a second support level shown at about 1.142. This is because the EURCHF exchange rate has just broken through the 1.14925 support level, so forex technical analysts are looking to the next lower historical support level, which was hit but not broken at the end of May.

 

The EURCHF chart also shows that the exchange rate has several times hit a ceiling, along which it has “bumped along” before falling. This is called a “resistance” level. For example, from mid-April to mid-May, the EURCHF exchange rate hit a resistance level at 1.2000, tested it, then eventually fell. During that time, buying and selling activity was roughly balanced, but from mid-May traders switched from buying the euro to selling it.

 

As with support levels, currency exchange rates can break through resistance levels. When a currency exchange rate breaks through a resistance level, that resistance level becomes a support level when the exchange rate next starts to fall. Similarly, when a currency exchange rate drops through a support level, that support level will be a resistance level when the exchange rate rises again. Patterns thus tend to be persistent and repeating.

 

Other Forex Technical Indicators

 

Support and resistance are not the only indicators that technical analysts use to help them understand and predict forex movements. There are numerous additional indicators that can help give a more detailed picture of the currency exchange rate world. “Leading indicators” precede exchange rate movements and can help to predict them, while “lagging indicators” respond to exchange rate movements and can therefore confirm existing trends.

 

Here are some of the most widely used indicators.

 

Simple Moving Average (SMA) is the average price over a set time period, for example 20 days. It is a lagging indicator which is useful for confirming the direction of a trend. Multiple SMAs for different time periods can help to identify trend changes, since trends often change when longer-period SMAs cross shorter-period SMAs.

 

Exponential Moving Average (EMA) is like an SMA but it weights the most recent data points higher8, and thus responds more quickly to exchange rate movements than SMA. Trend reversals are indicated by a longer-period EMA crossing a shorter-period EMA.

 

Moving Average Convergence-Divergence (MACD) is the difference between an exchange rate’s 26-day and 12-day EMAs. When the difference shrinks, the EMAs are “converging”; when it increases, they are “diverging.” It is a lagging indicator used to identify trend strength and reversal.9

 

Relative Strength Indicator (RSI) is a measure of “momentum,” or the speed of exchange rate changes. It indicates whether the currency is “overbought,” suggesting that the exchange rate is likely to fall, or “oversold,” indicating it is likely to rise. It is a leading indicator.10

 

Bollinger Bands are lines plotted one standard deviation above and below an SMA, often used to measure market volatility. Bands widen when volatility rises and shrink when it falls.11

 

Fibonacci retracement uses the ratios in the Fibonacci sequence, discovered by mathematician Leonardo Fibonacci in the 13th century, to identify expected support and resistance levels. As Investopedia says, “For reasons that are unclear, these [Fibonacci] ratios seem to play an important role in the stock market, just as they do in nature, and can be used to determine critical points that cause an asset's price to reverse.”12

 

Stochastic Oscillator compares the closing exchange rate of a currency pair to its price range over a trading period such as 14 days. It is a measure of momentum and can be used to identify potential trend reversals.13

 

A marked-up technical forex chart typically includes some or all of these, in addition to support and resistance levels, and recognizable patterns. For example, here is a marked-up EURCHF chart from Action Forex for March 2017 to July 2018, showing several support and resistance levels, an ascending wedge in May 2018, EMA (red line), MACD and RSI:14

 

Forex Technical Analysis

 

The

Takeaway:

Forex technical analysis can be complex and may require strong mathematical skills. Fortunately, most forex charts include preset technical indicators, and many forex chart providers also supply technical analysis and commentary. A basic understanding of forex charts and technical indicators may thus be sufficient to enable businesses to use technical analysis effectively when managing their currency exchange rate exposures.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.

Sources

1. “Efficient Market Hypothesis,” Investopedia; https://www.investopedia.com/terms/e/efficientmarkethypothesis.asp
2. “USDJPY,” DailyFX; https://www.dailyfx.com/usd-jpy
3. “EURCHF,” DailyFX; https://www.dailyfx.com/eur-chf
4. “EURCHF: Head and shoulders confirmation for short position,” Trading View; https://www.tradingview.com/chart/EURCHF/JXFaIEYg-EURCHF-Head-and-shoulders-confirmation-for-short-position/
5. “USDJPY Forecast: Pennant breakout confirmed,” FX Street; https://www.fxstreet.com/analysis/usd-jpy-forecast-pennant-breakout-confirmed-201808010122
6. “Analyzing Chart Patterns: Triangles,” Investopedia; https://www.investopedia.com/university/charts/charts5.asp
7. “Analyzing Chart Patterns: The Wedge,” Investopedia; https://www.investopedia.com/university/charts/charts7.asp
8. “Exponential Moving Average – EMA,” Investopedia; https://www.investopedia.com/terms/e/ema.asp
9. “Understanding the MACD indicator,” Babypips; https://www.babypips.com/learn/forex/macd
10. “Understanding momentum indicators and RSI,” Investopedia; https://www.investopedia.com/investing/momentum-and-relative-strength-index/
11. “The Basics of Bollinger Bands,” Investopedia; https://www.investopedia.com/articles/technical/102201.asp
12. “What is Fibonacci retracement, and where do its ratios come from?” Investopedia; https://www.investopedia.com/ask/answers/05/fibonacciretracement.asp
13. “Stochastic Oscillator,” Investopedia; https://www.investopedia.com/terms/s/stochasticoscillator.asp
14. “EURCHF Outlook,” Action Forex; https://www.actionforex.com/category/technical-outlook/eurchf-outlook/

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