Technical Analysis for FX Options W hat is Technical Analysis? - PDF document

Technical Analysis for FX Options

W hat is Technical Analysis? • Technical analysis, also known as charting, is an attempt to predict future prices, by studying the trading history of a traded security (currencies, equities, commodities, etc.). • Technical analysts evaluate securities by analyzing the statistics generated by market activity, such as past prices and volume, and use charts and other tools to identify patterns that can suggest future activity.

Using Technical Analysis • Technical analysis assumes that, at any given time, the currency’s price reflects everything that has or could affect the currency - including fundamental factors, along with broader economic factors and market psychology are all priced in, removing the need to actually consider these factors separately. • • This only leaves the analysis of price movement, which the chartists view as a product of the supply and demand. • Although there are many different methods and tools used in technical analysis, all of them rely on the assumption that price patterns and trends exist in markets, and they can be identified and exploited.

I nterpretation of Technical Analysis The underlying assumptions of technical analysis can be described in three ways. The market discounts everything. • Over a period of time price reflects all information impacting the currency, and its future potential direction. Price tends to trend or form patterns. • Most technical trading strategies are based on this assumption. This means that after a trend has been established, the future price movement is more likely to be in the same direction as the trend than to be against it. History tends to repeat itself. • Price trends occur and reoccur in patterns that are fairly predictable. • The repetitive nature of price movements is attributed to market psychology.

Candlestick Charts • Candlestick charts are one of the most popular graphical charts. They provide a variety of information about the current market prices, and they are relatively easy to read and understand. Candlestick charts are used by short and long term traders alike, and are used by many different trading systems. • There are only two groups of people in the market - buyers and sellers. • One can use the candles to figure out which group is in control of the price action.

• This image shows how candlesticks are constructed. The highs and lows of the time period are called the "wicks" and the open and close form the "body". The candle itself is the "range". When the currency closes at the bottom of the range we conclude that the sellers are in control. When currencies close at the top of the range we conclude that buyers are in control.

Trends • In any given chart, one can notice that price does not tend to move in a straight line in any direction, but rather in a series of highs and lows. • In technical analysis, it is the movement of these highs and lows that constitute a trend. Trends can also be divided into three separate stages: Primary or major trend. It is the most important trend to investors who want to buy and hold currencies for a longer time Secondary trends are counter trend movements in the direction of the major trend. These counter movements cause price to correct back to a more realistic price value. Once these counter trends are over the primary trend is resumed. Intermediate trends are that part when price swings both, in the direction and against the direction of the primary trend. The intermediate trends are important to investors to spot the best price level to enter the primary trend or to add to their positions. Minor trends. The day to day price fluctuations within these moves are called minor trends. These minor trends are important to day traders who want to exit trade after the end of the day.

Types of Trends • It is important to be able to understand and identify trends so that you can trade with rather than against them. • Two important sayings in technical analysis are "the trend is your friend" and "don't buck the trend," which shows how important trend analysis is for technical traders. There are three types of trend – • Uptrend - when each successive peak and trough of the price movement is higher, it's referred to as an upward trend. • Downtrend - If the peaks and troughs are getting lower, it's a downtrend. • Sideways/ Horizontal trends - When there is little movement up or down in the peaks and troughs, it's a sideways or horizontal trend. • One can say that a sideways trend is actually not a trend on its own, but a lack of a well-defined trend in either direction.

Trend Lines • A trend line is a simple charting technique that adds a line to a chart to represent the trend in the market. • These lines are used to clearly show the trend and are also used in the identification of trend reversals. • An upward trend line is drawn at the lows of an upward trend. • This line represents the support that price forms every time it moves from a high to a low. This type of trend line helps traders to anticipate the point at which price will begin moving upwards again. • A break of this trend line is the simplest indication of a change of trend towards the downside. • Similarly, a downward trend line is drawn at the highs of the downward trend. • This line represents the resistance level that price faces every time it moves from a low to a high. • Likewise a break of this trend line is the simplest indication of a change of trend towards the upside.

Support and Resistance • The support and resistance levels are important in terms of market psychology and supply and demand. • These are the levels at which a lot of traders are willing to buy the currency (in the case of a support) or sell it (in the case of resistance). When these levels are broken, the supply and demand and the psychology behind the price movement is thought to have shifted, in which case new levels of support and resistance will likely be established. • Once a resistance or support level is broken, its role is reversed. If the price falls below a support level, that level will become resistance. If the price rises above a resistance level, it will often become support. • For a true reversal to occur, however, it is important that the price make a strong move through either the support or resistance.

I ndicators • Indicators are calculations based on the price of the currency that measure such things as trends, volatility and momentum. • Indicators are used as a secondary measure to the actual price movements and add additional information to the analysis. • They can be used in two main ways: to confirm price movement & chart patterns, and to form buy and sell signals.

Moving Averages • Most chart patterns show a lot of variation in price movement. This can make it difficult for traders to get an idea of the currency's overall trend. • One simple method traders use to combat this is to apply Moving Averages. • A moving average is the average price of the currency over a set amount of time. By plotting the currency's average price, the price movement is smoothed out. • Once the day-to-day fluctuations are removed, traders are better able to identify the true trend and increase the probability that it will work in their favor. • Since moving averages rely on historical data for calculation, they have a lagging effect. The drawback of moving averages is these lags which can delay buying and selling decisions. • Therefore averaging is typical choice between desired level of smoothing and the percentage of lag that a trader is willing to tolerate.

Types of Moving Averages Three types of moving averages exist. These are Simple moving averages (SMA) • • Weighted moving averages (WMA) • Exponential moving averages (EMA). Each of these averages should be judged upon its own merits. • There are also time periods when any of these is an appropriate choice.

Use of Moving Averages • Moving averages can be used to quickly identify whether the currency is moving in an uptrend or a downtrend depending on the direction of the moving average. • When a moving average is heading upward and the price is above it, the currency is in an uptrend. • Conversely, a downward sloping moving average with the price below can be used to signal a downtrend.

Another method of determining momentum is to use a pair of moving averages. When a short-term average is above a longer-term average, the trend is up. On the other hand, a long-term average above a shorter-term average signals a downward movement in the trend.

Another major way moving averages are used is to identify support and resistance levels. It is not uncommon to see a currency that has been falling, stop its decline and reverse direction once it hits the support of a major moving average. And a move through a major moving average is often used as a signal by technical traders that the trend is reversing.