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What is technical analysis?

Technical analysis understands market trends by observing historical prices and formulates trading strategies accordingly. Together with fundamental analysis, it is the main analytical method for analyzing financial markets.

Unlike fundamental analysis, which focuses on economic, political and financial development, technical analysis basically only focuses on charts and reasonably speculates on possible future market trends by studying historical price changes.

Traders who use technical analysis believe in the following three premises:

Market prices contain all the information people need to understand;

Prices fluctuate in a trending manner;

History will repeat itself.

These three premises are the basis for the effectiveness of technical analysis, and only when we conduct technical analysis can it help predict future market trends.

It should be noted that technical analysis is not 100% correct. In actual application, you may find that the trading decisions you make based on the results of rigorous technical analysis are opposite to the price fluctuation direction in the future market. This situation does not contradict the original intention of our technical analysis, nor does it mean that your technical analysis method is wrong.

The role of technical analysis is not simply to predict the rise and fall of market prices. Its real significance is to help traders better understand the market and formulate trading strategies to adjust the current market.

Common methods of technical analysis include chart patterns and technical indicators. We will open two other articles to introduce them. In this article, we will introduce a basic skill of technical analysis - identifying trends.

Why identify trends?

Just understanding the chart price cannot help us make trading decisions. You also need to know how to identify the price trend on the chart. There are three types of chart trends: rising, falling and consolidation. In the unilateral trend of rising and falling, people often adopt a breakthrough trading strategy, that is, only trade in one direction, buy up or buy down. In a consolidation trend, people often adopt a range trading strategy of selling high and buying low, selling when the price rises to the top of the consolidation range and buying when it falls to the bottom of the consolidation range. Therefore, it is particularly important for traders to judge whether the exchange rate trend is in a unilateral trend of rising/falling or in a range trend of consolidation. Only by accurately grasping the trend can we adopt the most correct trading method.

There are many tools to identify trends, and almost all technical analysis involves trend judgment. In this article, we first introduce how to draw trend lines, support/resistance lines in charts, and general rules for whether a trend has ended.

Note that although the minute chart can sometimes reflect some trends, we still recommend that you use technical analysis tools on longer-term charts because the price data of long-term charts is more comprehensive and more statistically reliable. For example, the price data on the hourly chart is more reliable than the minute chart, and the price data on the daily chart is more reliable than the hourly chart.

Trend lines, support lines and resistance lines

A trend line is a straight line that shows the trend of a currency pair, connecting two or more prices. In an upward market, a trend line is a support line; in a downward market, a trend line is a resistance line.

—>The resistance line is a line connected by resistance prices. If the exchange rate has risen to a price level and retraced several times, we consider it to be a resistance price. The more resistance points there are, the more reliable the resistance line is.

On the MT4 platform, we can find the tool for drawing trend lines on the toolbar above the platform.

The principle of drawing a trend line is to find the relevant highest and lowest points in the rising (falling) trend within the time period under consideration, and connect them with a straight line, where the price cannot cross the trend line. The longer the trend line is drawn, the stronger the unilateral force it represents, and the greater the possibility that the price will turn back after falling (rising) to the vicinity of the trend line.

Drawing a trend line can help us identify the current market trend more clearly. At the same time, I also need to use the trend line to determine whether a trend is still continuing.

Fundamental Analysis

Overview of Fundamental Analysis?

Technical analysis studies historical prices, and traders can make trading decisions by focusing on charts and prices. Fundamental analysis looks more complicated. It studies the core factors that affect a country's economy and currency exchange rate changes. It aims to predict foreign exchange price changes and market trends in a certain economic cycle by analyzing a series of economic indicators, government decisions and events.

In short, technical analysis reveals the power comparison between buyers and sellers in the foreign exchange market, while fundamentals analyze the market from the source of exchange rate changes: the impact of monetary capital flows and trade flows, news and economic conditions.

The factors that affect exchange rate changes involve social, economic and political aspects, which means that fundamental analysis may need to include a lot of analysis elements. This problem restricts many beginners of fundamental analysis, because it is not easy to always be sensitive to highly dynamic market fundamentals. But don't worry, as you study fundamental analysis more deeply, the concepts in the global dynamic economy will form a rough framework in your mind, and the short-term changes in market fundamentals are just constantly revising the details of this picture.

Of course, fundamental analysis does not target the exact market buying and selling prices. For example, when analyzing a country's employment report, we can have a relatively clear understanding of the country's overall economic situation, but if we want to obtain specific trading strategies such as entry points and exit points, we still need to use technical analysis methods. For this reason, many traders may choose to completely abandon fundamental analysis and rely entirely on technical analysis when they are overwhelmed by the large amount of information involved in fundamentals. This is a wrong approach. Trading without a certain understanding of fundamental factors is like a blind man touching an elephant. The price information you see on the chart may not be the truth of the market.

Long-term analysis in fundamentals:

When measuring the value of currency in long-term fundamentals, there are two classic analysis methods: purchasing power parity theory and balance of payments theory.

Purchasing Power Parity Theory

The Purchasing Power Parity Theory states that the exchange rate of two currencies should be equal to the ratio of the price levels of a basket of goods and services in the two countries. This is because if the actual prices of a group of goods in two countries are quite different, assuming that the transportation cost is zero, traders can make a profit by buying and selling one.

Exchange rate = commodity price in one country / commodity price in another country

For example: a can of Coke costs 1 US dollar in the United States and 100 yen in Japan. According to the Purchasing Power Parity Theory, the exchange rate = American Coke cost / Japanese Coke cost = 1:100

If the current exchange rate is 1:110, according to the Purchasing Power Parity Theory, the Japanese yen is undervalued and the US dollar is overvalued. Traders can buy goods in Japan for 100 yen and then transport them to the United States to sell them for 1 US dollar. The US dollars obtained are converted into 110 yen at the current exchange rate, and there is no risk of arbitrage of 10 yen. Therefore, the demand for yen will increase, which will eventually boost the appreciation of yen and the depreciation of the US dollar, and the exchange rate of USD/JPY will return to the level of 1:100.

It should be noted that Coke is just an example to illustrate the meaning of the theory. In fact, the purchasing power parity theory is not based on a single commodity, but a basket of goods and services. The combination of goods and services depends on the preferences of different analysts. At the same time, the purchasing power parity theory ignores some important factors that affect prices, including transportation costs, trade barriers, tariffs, etc., and it does not explain the data of non-traded goods. The purchasing power parity theory is generally only applicable to long-term forecasts of more than 3 to 5 years.

Balance of Payments Theory

According to the balance of payments theory, two main factors affect the change of exchange rates: trade flows and capital flows, that is, the current account and capital account in the balance of payments statement.

The current account reflects the import and export of goods and services in a country. When exports are greater than imports, the country is a net exporter. This means that there are more people buying the country's currency than selling it, because other countries need to buy the country's currency when importing goods from the country, and the demand for the country's currency will increase. Therefore, countries with trade surpluses have a greater chance of currency appreciation. On the contrary, net importing countries have more imports than exports. Importers in net importing countries need to sell their own currency to exchange for the currency of the exporting country, causing the domestic currency to depreciate.

The capital account reflects the inflow and outflow of investment capital in a country. If the net value of the capital account is a positive number, it means that the capital flowing into the country is greater than the outflow. When foreign investors invest, they need to convert their own currency into domestic currency. Therefore, a positive capital account will increase the demand for a country's currency and promote the appreciation of the country's currency. Conversely, if the capital account is a negative number, it means that the capital inflow is less than the outflow. Domestic investors need to convert their domestic currency into foreign currencies, which in turn suppresses the value of their own currency.

Capital flows can be divided into two types according to the form of capital: physical flows and portfolio flows. Physical flows refer to foreign direct investment. They will first convert their funds into the currency of the investing country, causing the currency of the investing country to appreciate. Portfolio flows are further divided into stocks and fixed income (such as bonds).

When a country's stock market is favorable, it indicates that capital is flowing into the stock market, and foreign capital will also be attracted, thereby increasing the value of the local currency. When a country's stock market is in a downtrend, it indicates that capital is withdrawing from the market, and foreign capital is also withdrawing, which is not good for the value of the local currency. Therefore, foreign exchange traders can follow the performance of global stock markets to predict the capital flow of countries in a longer-term range.

The fixed income market is similar to the stock market. The higher the yield, the more conducive to the appreciation of the local currency. The difference is that the fixed income market has a more stable and safe feature when the global economy is unstable. It has served as a refuge for global capital. Long-term traders should pay attention to analyzing the interest rate spreads in the fixed income market:

1. Detecting the interest rate spread of currencies - Euribor and Eurodollars

Investors can pay attention to the difference between Euribor and Eurodollars. Euribor is a fixed income asset that reflects short-term interest rates in Europe. Eurodollars refer to U.S. dollar deposits held in banks outside the United States. Because the United States and Europe have the most complete fixed income and stock markets, if the EIBOR is higher than the Eurodollar deposit rate, it will drive investors to sell U.S. assets and buy foreign assets, which will have a certain impact on the foreign exchange market. On the contrary, if the positive gap between EIBOR and Eurodollars narrows, that is, the interest rate of EIBOR decreases, the attractiveness of European assets will decrease, driving investors to sell European assets.

2. Fixed income gaps across Europe - Gilts, EIBOR and Eurodollars

Gilts are fixed income products issued by the British government. When buying and selling GBP/USD and EUR/GBP, you need to pay attention to the gap between Gilts, EIBOR and Eurodollars. When the positive gap between UK interest rates and European or US interest rates falls, the UK's fixed income investment opportunities will become less attractive to foreign investors. Investors will sell their pound-specific assets to look for other higher-return investment opportunities, causing pressure on the pound to fall.

3. Other countries - international fixed income market

Fixed income products and their yield gaps in countries other than the United States, the United Kingdom and Europe are also worth noting. For example, Australia and New Zealand have implemented high interest rate policies, which have caused investors to sell their local currencies to buy Australian dollars or New Zealand dollars. This activity will be more obvious when interest rates in other countries fall. On the contrary, if interest rates in the United States, the United Kingdom and Europe rise, funds may be transferred out of Australia and New Zealand, increasing their currency pressure.

When conducting medium- and long-term fundamentals, we need to consider more factors. For example, when analyzing the long-term trend of the US dollar, it is necessary to consider various aspects such as the Federal Reserve's monetary and interest rate policies, the US economic situation, and the impact of world geopolitical events on the United States. At this time, data news is particularly important. You can learn about a country's economic performance in the past period of time and the monetary and interest rate policies that the country is adopting from past data news, and use this to infer the trend of the country's currency in the future. Therefore, in order to accurately and comprehensively analyze the fundamentals, even if you do not trade news, you should keep an eye on important economic indicators in the economic calendar.

Fibonacci retracement line

Definition

Fibonacci retracement line is different from the previous technical indicators in terms of usage. Unlike the previous indicators, it can be used as long as it is loaded on the chart and the parameters are set. When using Fibonacci retracement line, investors need to identify a trend by themselves and then draw it on the trend. In the "Application Examples" section, we will also introduce how to draw Fibonacci retracement lines.

Function

Fibonacci retracement line provides us with a good method to predict support and resistance levels. The longer the uptrend or downtrend lasts, the more reliable the retracement line level is.

Some traders like to draw Fibonacci retracement lines for long-term and short-term trends on charts of different time periods. The closer the level of the long-term retracement line is to the level of the short-term retracement line, the more reliable the retracement line is.

Parameters

The 38.2%, 50.0% and 61.8% positions of an uptrend or downtrend are the most commonly used retracement levels. 38.2% is generally considered to be the least reliable level, which means that the exchange rate is unlikely to turn around when it reaches this level. The higher the percentage level (i.e. 61.8%) the exchange rate is close to, the greater the chance of its retracement.

Application Examples

If you find a rising or falling trend that has just ended on a chart (the 123 rule can be used to determine whether the trend has ended, please refer to the Novice Academy "Technical Analysis and Trend Judgment" for details), you can consider starting to use Fibonacci retracement lines to determine the next exchange rate support or resistance level
On the MT4 platform, you can find Fibonacci retracement lines in the toolbar above the platform.

Clicking this button connects the highs and lows of the trend on the chart. Here is an example of GBP/USD.

Support and resistance

Support refers to the support price that the exchange rate may encounter when it falls, thus stopping the decline and stabilizing the price. The corresponding concept is resistance, which is the pressure that the exchange rate may encounter when it rises, thus reversing to a falling price. It is necessary to identify support and resistance levels, because when the exchange rate approaches or effectively breaks through the support and resistance levels, it is a good time to trade. When the breakthrough fails, people often think that the trend may turn, and when the exchange rate effectively breaks through the support/resistance level, it is very likely to usher in a new wave of unilateral decline/increase.

The main ways to identify support and resistance levels are trend lines, previous highs/lows, pattern judgments, and technical indicator judgments.

Trend lines

In "Technical Analysis and Trend Judgment", we introduced how to draw trend lines. In fact, trend lines are a way to determine support and resistance levels: trend lines in an upward market are composed of a series of support levels. When the exchange rate falls back to the vicinity of the trend line, the support level on the trend line is very likely to provide support for the exchange rate; trend lines in a downward market are composed of a series of resistance levels. When the exchange rate rises to the vicinity of the trend line, the resistance level on the trend line is very likely to cause the exchange rate to fall again. Therefore, trend lines are a common way to determine support and resistance levels in a unilateral market.

Sometimes, when the price falls below the trend line, the trend line that originally provided support may become a resistance to the rise of the exchange rate in the future market.

The above picture shows that the rising trend line on the NZD/CAD daily chart has become a resistance to the subsequent exchange rate rebound.

In many cases, resistance and support levels may be transformed into each other. The original support level may become the resistance level later, and vice versa. This is especially common when judging support/resistance levels by previous highs and previous lows.

Previous high/previous low

When the exchange rate turns to decline or consolidate after completing a unilateral upward trend, it often forms a short-term highest price, which we call the "previous high price". The corresponding concept is the previous low, which is the short-term lowest price formed when the exchange rate turns to rise or consolidate after completing a unilateral downward trend.

The above picture shows the previous high and low on the AUD/CAD daily chart.

When judging support and resistance levels, people believe that the previous high may be the resistance level of the subsequent upward trend, and the previous low may be the support level of the subsequent downward trend. Because the exchange rate has turned back at the previous high position, when the price runs to the vicinity of the price again, it may turn back again, and the previous low is similar.

When the price repeatedly turns back at the previous low or high, the more times it turns back, the stronger the support or resistance of the price. If the foreign exchange market successfully breaks the support level and changes the trend, the original strong support level is likely to become a strong resistance level in the subsequent foreign exchange market. Vice versa.

The above picture is the weekly chart of AUDCAD. The exchange rate has been supported in the 0.99-1.00 area many times, and then the exchange rate has encountered resistance in the same position many times.

Morphology Judgment

Chart patterns often provide methods for judging support and resistance levels.

For example, the peak of the double top pattern can be regarded as a strong resistance level because the price returns twice at this position. The trough (neckline) can be regarded as a support level.

Technical indicator judgment

Some classic technical indicators can also be used to judge support and resistance levels. The most classic is the golden section line.

Market Participants

By understanding who is involved in the market, you will be able to better understand why and how prices are affected by news events. You will also have more confidence in your trades because there will always be buyers and sellers, no matter what the price of the trade.

Interbank

The interbank market consists of large commercial banks and securities dealers, and they account for 40% to 50% of total foreign exchange trading volume, making them the first in the list.

Being at the top and having the largest trading volume, they also enjoy the lowest spreads.

National Central Banks

Try to control money supply, inflation rates and interest rates, using their large foreign exchange reserves to stabilize domestic markets.

This means that national central banks also play an important role in the foreign exchange market.

Investment Management Firms

These firms typically manage large accounts on behalf of clients. For example, an investment manager may hold foreign stocks in his portfolio, so he needs to buy and sell several foreign currencies to pay for foreign securities.

That is, investment management firms also participate in the foreign exchange market for speculative reasons and profit from market fluctuations and trends by managing client funds.

Retail Traders

Retail traders trade indirectly through brokers or banks. Their transactions do not involve any physical delivery of currency and are considered to be purely speculative markets.

Non-Bank FX Firms

Refers to FX brokers that provide foreign exchange and international payments to individuals and companies. Non-Bank FX firms differ in that they do not provide currency transactions for speculative purposes, and clients deposit physical delivery of currency into bank accounts.