TECHNICAL ANALYSIS IN FOREX RATE FORECASTING

Technical Analysis provides visual measurement of trends and price activity in the financial markets. The most important factor in moving markets today is not supply and demand, but rather the forces which effectthe flux of supply and demand, namely market participant psychology. The application of technical study to the financial markets is the most efficient manner in which one can open a window to see the totality of market psychology, where people are buying and where they are selling.

Technical study is the study of this market action, for the purpose of forecasting future price trends. Technicians believe that the market discounts all news that most fundamental traders follow. For example, if XYZ company releases positive earnings for the quarter and then precipitously drops in price. An explanation for such activity, which we see increasingly often in today’s volatile markets, is that the positive XYZ company earnings were already factored “into the price”. Therefore, the technician approaches the markets as being efficient, and believing that an investor cannot get ahead by following the ‘old school’ fundamentals which may have worked in years past. The maxim 'buy on the rumour and sell on the news' was founded on such principles. We believe that the most efficient approach to investing in the modern day is applying a ‘techno-fundamental” approach.

Human psychology tends to remain the same historically in the face of certain situations. Therefore, basing investments on the expected price action following a technical formation makes sense, as the psychology of investors tends not to change over time. In other words, technicians believe that history repeats itself in these situations. The fundamentalists study what caused the market to move, while technicians study the effect. Technical patterns tend to repeat themselves as they are simply a plotting of shifts in supply and demand, and the forces that act upon same. These cycles, as the business cycle at large, tend to repeat themselves

The charts in Foreign Exchange Trading are usually drawn on the basis of daily prices. The prices of different currencies are quoted from different centres of the world for almost 24 hours a day. These prices keep on fluctuating constantly on the basis of the genuine commercial demand and supply as well as the speculative trading, which in turn depend upon various economic, political and financial factors.

While drawing a Bar Chart for a currency, the prices of the currency at three different stages, viz. the day’s highest rate, the day’s lowest rate and the closing rate are taken into consideration. On the graph the points indicating these three rates are joined by a vertical line to form a bar as shown in Diagram 1.

The Chart records every trading day with such line or bar. A Bar chart drawn for the period of a few days would look somewhat like the one shown in Diagram 2. it may be observed that the opening price for a day does not necessarily be the same as the closing price on the previous working day.

The Charts are analysed by studying the trends depicted by different types of configurations, which are as follows:-

The uptrend line is drawn along the daily lows and should connect as many points as possible. Within the trend certain reactions and deviations are common. As long as the market closes above the trend line the movement is intact. The trend is confirmed if the new rally closes above the high of the previous one as shown in Diagram 3.

This line is drawn along the peaks of daily Bar’s, connecting as many points as possible. The downward trend is confirmed as long as the rallies do not close above the trend line and the reactions close below the previous low as shown in Diagram 4.

When prices are rising, they may reach a point where a selling interest is created for profit booking etc. Renewed selling will stop the trend whenever it develops again and therefore prevent further rise as shown in Diagram 5.

When prices are declining they may reach a point where buying interest will be activated. This buying interest will support the market and be reactivated whenever the price drops back to this support level as shown in Diagram 6.

Symmetrical triangles can be characterized as areas of indecision. A market pauses and future direction is questioned. Typically, the forces of supply and demand at that moment are considered nearly equal. Attempts to push higher are quickly met by selling, while dips are seen as bargains. Each new lower top and higher bottom becomes more shallow than the last, taking on the shape of a sideways triangle. (It's interesting to note that there is a tendency for volume to diminish during this period.) Eventually, this indecision is met with resolve and usually explodes out of this formation (often on heavy volume.) Research has shown that symmetrical triangles overwhelmingly resolve themselves in the direction of the trend. With this in mind, symmetrical triangles in my opinion, are great patterns to use and should be traded as continuation patterns.

The ascending triangle is a variation of the symmetrical triangle. Ascending triangles are generally considered bullish and are most reliable when found in an uptrend. The top part of the triangle appears flat, while the bottom part of the triangle has an upward slant. In ascending triangles, the market becomes overbought and prices are turned back. Buying then re-enters the market and prices soon reach their old highs, where they are once again turned back. Buying then resurfaces, although at a higher level than before. Prices eventually break through the old highs and are propelled even higher as new buying comes in. (As in the case of the symmetrical triangle, the breakout is generally accompanied by a marked increase in volume.)

The descending triangle, also a variation of the symmetrical triangle, is generally considered to be bearish and is usually found in downtrends. Unlike the ascending triangle, this time the bottom part of the triangle appears flat. The top part of the triangle has a downward slant. Prices drop to a point where they are oversold. Tentative buying comes in at the lows, and prices perk up. The higher price however attracts more sellers and prices re-test the old lows. Buyers then once again tentatively re-enter the market. The better prices though, once again attract even more selling. Sellers are now in control and push through the old lows of this pattern, while the previous buyers rush to dump their positions. (And like the symmetrical triangle and the ascending triangle, volume tends to diminish during the formation of the pattern with an increase in volume on its resolve.)

A double top is formed when a currency advances to a certain level with high volume and after reaching a peak retreats i.e. falls, then comes up again to round about the same price with some pick up in volume and falls down a second time for a major decline. The happening of fall through the valley floor in the second activity is considered of major importance and when this happens enter a short position in the currency.

A double bottom is the exact reverse of a double top and here where the second rise takes place and cuts through the valley floor and moves up, go long in the position of the currency.

This type of formation is quite rare. The three highs need not have to be at the same price and the three valleys need not bottom out exactly at the same level. When the decline from the third top breaks through the level of valley floor sell the currency. One feature of the triple top is that the last leg does not penetrate the lowest point of the valleys. Instead, it gets reversed and goes back through the top. At that point one should buy the currency. A Triple Bottom is the exact reverse of Triple Top with all criteria seen upside down.

The head and shoulders pattern is generally regarded as a reversal pattern and it is most often seen in uptrends. It is also most reliable when found in an uptrend. Eventually, the market begins to slow down and the forces of supply and demand are generally considered in balance. Sellers come in at the highs (left shoulder) and the downside is probed (beginning neckline). Buyers soon return to the market and ultimately push through to new highs (head). However, the new highs are quickly turned back and the downside is tested again (continuing neckline). Tentative buying re-emerges and the market rallies once more, but fails to take out the previous high. (This last top is considered the right shoulder.) Buying dries up and the market tests the downside yet again. Your trendline for this pattern should be drawn from the beginning neckline to the continuing neckline. (Volume has a greater importance in the head and shoulders pattern in comparison to other patterns. Volume generally follows the price higher on the left shoulder. However, the head is formed on diminished volume indicating the buyers aren't as aggressive as they once were. And on the last rallying attempt-the left shoulder-volume is even lighter than on the head, signaling that the buyers may have exhausted themselves.) New selling comes in and previous buyers get out. The pattern is complete when the market breaks the neckline. (Volume should increase on the breakout.)

The head and shoulders pattern can sometimes be inverted. The inverted head and shoulders istypically seen in downtrends. (What's noteworthy about the inverted head and shoulders is the volume aspect. The inverted left shoulder should be accompanied by an increase in volume. The inverted head should be made on lighter volume. The rally from the head however, should show greater volume than the rally from the left shoulder. Ultimately, the inverted right shoulder should register the lightest volume of all. When the market then rallies through the neckline, a big increase in volume should be seen.)

HEAD AND SHOULDERS AS A REVERSAL PATTERN IN AN UPTREND (BEARISH)

Head and Shoulders Pattern spotted on 9/11/01

Moving average is one of the most simple technical tools among others. Although momentum is a simple technique as well, it is based on only two points and therefore is not as accurate as the moving average. A moving average will use all of the prices within a chosen time period. In order to trade many markets with a moving average (trend-following tool), it is necessary to have rules: when to buy, when to sell, crossing signals, long term average or short term average, envelops or Bollinger Bands. A trend-following tool enters the market after prices have clearly changed direction. It is not possible to capture the whole trend and profit from the entire rally, but a moving average shows you straight away what is going on this market.

A candle chart originated in Japan is the oldest charting technique ever used. Several centuries ago, candle charts have been created to follow the price of rice. This technique of plotting price data is an alternative to the familiar bar chart, providing an extra dimension of analysis. When the candlestick signals are mixed with traditional indicators or signals such as convergence or divergence, they turn out to be a very valuable tool for the investor. The secret behind Japanese candlesticks lies in the body "created by the price-movement" between the opening and the closing bell. Candlestick charting is not a new Holy Grail technique, but it is definitely very useful. The test over a long of time proves at least that this technique has a very strong basis. Candle charts can be used to identify price patterns (reversal and continuation patterns). The most accurate candlestick patterns are the ones composed of three candles. The strongest part of the Japanese candlestick charting technique is also its recurrence: it can be constructed for any time period.

The Elliott Wave Principle is a system of rules for interpreting and forecasting price action. Elliott has created a new language: wave 1, correction wave 2, impulsive wave 3. The basic Elliott Wave pattern: five waves in the direction of the main trend followed by three corrective waves. Waves are given numbers and letters to facilitate the identification. A complete Elliott Wave market cycle is composed of eight waves and is a part of the Fibonnacci Sequence, which reflects a constant relationship between its components. The Elliott Wave Principle and certain measuring techniques, with sometime an incredible accuracy, have fascinated some analysts and this technique has become their main technical analysis tool. They call themselves "Elliottist". Both Elliott and Fibonnacci discoveries have interesting aspects and financial markets seem to be driven by "Nature's Law". The stock market has a predisposition to establish patterns, which can be aligned with the form present in the Fibonnacci Sequence. The occurrence of Fibonnacci ratios in the markets is not a coincidence and you will learn how to take advantage of those numbers in your trading strategies

90 years after Dow's death, Dow Theory is still the best technical analysis tool to predict market directions. Dow Theory is considered as the grandfather of all technical analysts. Without this theory, technical analysts recognize they would be blind. We will focus on the general tenets of the theory and how to apply it to all the markets. The strongest part of the theory lies in the recurrence: whether we look at currencies, interest rates, indices or commodities, the investor immediately knows if the market is trending up or down. This theory can be applied to any time frame, from a five minutes chart to a monthly or yearly chart.The Dow Theory also covers the study of support and resistance. Most well-known patterns are also based on Dow's discovery. Not using Dow Theory is like driving a car without a brake pedal. The other strong aspect of the theory is its implementation to money management. Money management deals with the question of survival in the markets and increases the odds that the investor will survive and handle its capital. You will learn the basics of the Dow Theory and you will be able to follow any market and any time frame of related to this market.

Combining momentum indicators can warn of latent strength or weakness in the price being monitored, often well ahead of the final turning point. The methods of trend determination are considered extremely useful (Dow Theory, trendlines, price pattern and moving average), but all of them identify a change in trend after it has taken place. We will examine the general principles of the momentum, relative strength index (RSI) or stochastic. The concept of momentum is very similar to a ball thrown in the air. The speed at which the ball rises will sooner or later gradually diminishes until the ball finally reaches a temporary standstill. Prices, whether rising or falling, are following the same principle. Using indicators helps one to locate potential "standstill" and major turning point. From convergence to divergence signals, from oversold to overbought warning signals, indicators and oscillators are your radar device and warns the investor to adopt defensive action by partial profit-taking or the use of tighter protective stops. While the RSI will highlight oversold or overbought condition, the stochastic is the best trending tool ever invented. With the moving average convergence divergence (MACD), the investor sees straight away what is going on. A mix these indicators with the Dow Theory, patterns, bar chart or candlestick chart is essential.

The above are only a random selection of formations of graphic representations of price movements and their interpretations. One needs to be taking into account various changing parameters while evaluating the graphs and using them in rates forecasting. Thus one needs to exercise ones mind in the selection of which price to be represented in the graph – start of day, particular time of day, end of day, mean of the above etc.

Even the type of chart to be used, whether line chart, bar chart etc. should be carefully selected. As regards the period, rate movement captured in the graph may change during the day, during the week, during the month, during the quarter, during the year etc. Here again one has to be careful to ensure that the time span is representative and typical and that the particular time span chosen is not pertaining to a period during which an unusual event occurred. While interpreting the graph one may also study the volumes of business done at different price levels to find out specific price levels when large volume purchase or sales are triggered. This analysis may be done for different markets for the same currency or share prices etc. to study holding patterns. Again while viewing the graph one can study the rate of change in the price movement and its momentum, which can be used for projection of forecasted rates. In sum, one needs to take into account various parameters both in the construction as well as in the interpretation of price movement charts.