Marketsforu Education - How to Read Charts (Technical Analysis)
Technical Analysis is the practice of analysing past price action (visualised in the form of charts) in order to assess the probabilities of future market direction.
Beginner traders often hear "technical analysis" and "fundamental analysis" mentioned as opposing choices, as if a trader must believe in one or the other. In reality, many of the highest performing traders have combined concepts and techniques from both to form a cohesive professional trading strategy.
Technical Analysis focuses on (recent) historical price in order to identify opportunities in directional bias. Fundamental Analysis focuses on economic data and world events, the core logic behind large institutions' desire to hold one currency or asset vs another currency or asset... in order to identify opportunities in directional bias.
The two approaches clearly end with the same basic goal: to look for reasons to believe a market is likely to rise or fall in the near future in order to profit from it.
There's also no reason why any trader can't practice both techniques in order to avoid placing all your strategic eggs in one basket, so to speak.
Beyond the advantages of strategy diversification, consider that stubbornly believing in one approach over the other is akin to a dentist who only believes in pulling teeth but refuses to perform a filling. They are two separate skills used to pursue a common goal.
The Basics of Charting
Technical Analysis has been in the trading Zeitgeist for most of the past century, originating at a time when Wall Street professionals would draw charts by hand.
Today, the prevalence of Technical Analysis is go great that practically every trading platform on the planet offers some form of charting or is integrated with a platform that offers charting.
While it's never a good idea for a professional trader to follow the herd, it's also wise to learn the basic vocabulary of the herd so you can be aware of opportunities to trade against them.
In recent decades, the most popular type of charts used for Technical Analysis is the Japanese Candlestick chart, named for the shape of the "candles" that represent price action that happened within a particular time frame:
For example: If your candlestick chart is set to "1 Minute", then each of the candles you see would represent one minute of price action (the highest price of the minute, the lowest of the minute, the price when the minute began, and the price when the minute ended.)
Likewise, if you choose a "1 Hour" timeframe, each candle would represent one hour of price action.
Basic Price Action
At the most basic level, price action consists of analysing price to identify three possible market conditions:
1) Up Trends: Signified by progressively higher highs and higher lows.
2) Down Trends: Signified by progressively lower lows and lower highs.
3) Sideways / Consolidation: Every other pattern that doesn't fit either of the above.
Beginners often get confused when they see, for instance, an uptrend in the 5-Minute time frame and a downtrend in the Daily time frame - at the same time. This happens often.
Trends begin and end in stages, beginning with failures to break a price level at the lowest time frames (individual ticks) and gradually washing upward into the higher time frames.
Depending on your approach, strategy, and personality, it may suit you better to trade in a lower or higher time frame. We often recommend that beginners experiment with different styles before choosing a particular approach.
While typical trading gurus love to promote the ideal of trading only "with the trend", it's worth noting that many of the most accomplished professional traders made their biggest gains doing the opposite. It does, however, take a tremendously developed sense of discipline to resist holding onto losing trades for irrational reasons (holding and hoping it'll turn around).
If you choose to fade the trend and look for turn-around opportunities as a beginner, there's no real reason not to. After all, a large percentage of the followers of "follow the trend" gurus are consistently losing money. However, you should start by writing a note to yourself that reads, "cut your losses, live to trade another day" and stick it to the corner of your monitor.
Never hold onto losing trades... especially if your style is trading counter-trend.
One of the oldest techniques for Technical Analysts is the Trendline. Trendlines are one of the most subjective methods of chart-reading but it allows many traders to quickly visualise their view of the current market conditions.
Here's an example of a Trendline drawn for a Down Trend:
Practically every trading platform that includes charting functions will also include tools for the trader to manually draw straight lines on the chart.
Trendlines are the first steps for a beginner trader to understand the concept of support and resistance.
Support is the concept of identifying an expected "ground level" of price action. For example, in a biased trend channel, the trendline at the bottom of rising price action or the trendline over the top of falling price action both illustrate this phenomenon. Support in these cases are the wind at the back of the trend.
Resistance is the opposite: It's the wind blowing directly in the face of the trend, keeping it in check and slowing it down. This is the area where price is over-extended on a short-term basis and is likely to pause for a retracement. In an uptrend, the resistance would be an imaginary (or actually drawn) trend line that lies over the top of the peaks where price struggles to continue upward and turns around for downward retracements. In down trends, they are the opposite.
In sideways, rangebound markets, Support is simply the horizontal line below the range and Resistance is the horizontal line above it.
It's important to learn early on that the concepts of Support and Resistance are approximate. Especially in markets such as currencies, you'll find that they're a "zone" rather than a specific price.
In general, there are a number of "natural" support/resistance price levels.
Round Number Support/Resistance
Round numbers are the "big figure" prices.
On the EUR/USD, if the current market is "Bid: 1.23458 / Ask: 1.23461", the "big figure" (the big "00" level) below is 1.2300 and the one above is 1.2400.
Notice the last digit is insignificant. This is because the "pip value" of a currency pair is always the 4th decimal point (except for JPY-quoted pairs, whose pip value is the 2nd decimal point, partly because the single Yen is actually domestically used as an equivalent to the cent or pence rather than dollar or pound.)
Pips are the FX equivalent of the penny on American shares in the post-decimalised era. In fact, when professional bank traders quote the EUR/USD market in the above example, one would say the bid is "45" and ask is "46". The last "8" in the bid and the last "1" in the Ask are "fractional pips" or "sub-pips" and are insignificant to price action because they're different across any particular liquidity pool.
The "big figure", in the example quote, is currently "1.23" and goes without saying for bank traders because, during normal volatility conditions, the market won't instantly jump from 1.2345/46 up to 1.2401 or down to 1.2299. (Even during a panic, you'll usually see the levels in between get rammed into by market fear a few times before breaking to those levels.)
So if you're a day trader or scalper, pay close attention to the big "00" levels. More so than any other price level, you'll see the market struggle to break these levels in the vast majority of cases when they're approached.
This is a natural product of human psychology.
When a multinational corporation like Sony or General Electric wants to exchange a few tens of millions of Euros for US Dollars, they'll ask their bank to try to sell at a big round number. Beyond simple psychology, not only does it not factor into their minds to ask the big bank to sell at some random price level like "1.2367", it's also impractical because they're not dealing with only one or two lots.
Due to the sheer size of their transaction, the bank trader will have to trickle this volume gradually. So if Sony wants to sell their hand around 1.2400, and the market has been gradually trending up to 1.2400, it'll stall around the 1.2400 "zone" and produce a "trying to break through the wall... but can't quite do it" effect, at least on the first couple of attempts.
Aware of this phenomenon, many highly-capitalised professional traders also like to "park" their limit orders in these areas to catch the first retracement or two upon the initial approach of the big figure zone. This strategy further reinforces the phenomenon of natural support and resistance in this price levels.
Most trading platforms include a wide variety of commonly used technical indicators. These are mathematically calculated visualisations of the prices shown on the chart.
Beginners often encounter the most popular of them, including the moving average (an average of a chosen number of candles).
The key to understanding every technical indicator is that they're inherently derived from the price information already on your screen. For many beginners, the simplest of technical indicators can serve as a "training wheel" to understand recent past price action in order to better assess the current market conditions and trends.
It's easy for a beginner to mistake some of the natural phenomenons of a technical indicators as "signals" to buy or sell. They aren't. (It also doesn't help that many gurus with no experience trading profitably tend to teach this misinformation.)
For instance, the moving average crossover - the moment when a shorter timeframe average crosses above or below a longer timeframe one - is often touted as a signal to trade in the direction of the cross.
When a short moving average crosses over a longer moving average, it only means that the more recent average price has risen above the longer term average price. This happens in actual down trends turning into up trends as well as in many range-bound situations, so it's a lot like driving while staring at your rear view mirror and nothing else. It's only part of the picture.
While some tutorials love to make the moving average crossover an example of "simple" trading, most traders will find that those examples are easily cherry picked and won't match the reality the trader will face in a real market.
Technical indicators are among the most popular tools, so don't rely on them to find your real potential as a trader. They can make valuable contributions to your analysis if you use them as one of your tools... but if you make them your only source of trade signals, they can be a major disappointment.
In recent years, many traders have joined a "backlash" against all technical indicators and advocate the opposite extreme: "Trading naked" or "pure price action". (Whatever you call it, the basic concept is to take all the mathematically-derived indicators off your charts and trade using nothing but price action.)
This approach is relatively short sighted and a lot like throwing the baby out with the bath water. Most traders end up struggling with the pure price action approach because it's yet another way to pay attention to only one thing.
For the same reason drivers must look at the road as well as the dashboard, rear view mirror, etc., the trader should look at multiple sources of information to make trading decisions.
Combined with a strong understanding of fundamental analysis (including the significance of economic data) as well as basic price action reading, natural support and resistance levels, and your own instincts as you develop into a more experienced trader; mastering technical indicators that suit your personality can be one of many useful weapons in your arsenal.