Decoding the Technical Analysis Tools Used by Forex Traders

A jargon-free guide to commonly used tools

A foreign exchange ("forex") trader needs to view information that can't be gleaned from the usual price charts. They use technical analysis tools to gain additional insight and, although references to these tools sound like gibberish to the uninitiated, they are simple enough once explained.

Generally, they use statistics, chart overlays, and technical indicators to help forex traders make better-informed trading decisions. Some of the tools described below are unique to forex trading, while others are common to all markets and can be fine-tuned for trading currencies.

Session Highlighter

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The forex market is open 24 hours a day on weekdays, as there is always a major market open somewhere in the world. Every weekday, barring local holidays, Europe opens, followed by New York, then Sydney, and then Tokyo. London is open again before Tokyo closes. Many smaller markets open and close throughout the day and night. 

All these global markets vary in size, both in terms of their number of currency transactions and how many currency traders they have. That means each session in each market has different characteristics in their currency "pairs," or the comparison of the value of the home currency against another currency.

For example, the EUR/USD currency pair is most active during the London and New York sessions, because these currencies are associated with Europe and the U.S. But the USD/JPY sees steady action throughout the day, as traders in Tokyo, London, and the U.S. all actively trade this pair.

Many forex traders find it useful to separate the various sessions on their charts. A session highlighter shows the price action that occurred during the various sessions, by the minute or by the hour.  

Session highlighters can be integrated into forex trading platforms.

The session highlighter automatically draws vertical lines on the price charts when a major session opens or closes. Alternatively, the trader can use colors to visually highlighting the various trading sessions. 

Forex Volatility Tools

 A forex volatility tool shows how much a currency pair typically moves. A trader may want to look at average daily movement over 30 days, for example. The tool can show how much the pair typically moves each hour of the day, how volatile it is on a certain day of the week, and how its volatility has changed over time.

These tools provide insight into what can be expected on a particular day or at a particular hour. This information helps the trader assess whether a trade has a good chance of reaching a profit target.

A volatility tool can't tell the trader which direction the price will go, but it does indicate how much the price might move in either direction.

Forex volatility tools vary in complexity and format. For example, a trader may select a time period, and the tool will calculate a confidence level for the likelihood that the price will stay within that typical movement range.

Forex Position Summaries and COT Data

Some forex brokers provide up-to-date summaries of how their clients are positioned. A position summary may reveal that 60% of clients are long the EUR/USD, while 40% of clients are short.

A single comparison like this isn't all that useful, but watching how the ratio changes as the price moves can provide insight into how the price may move in the future. Eventually, traders must exit these positions, regardless of whether it's at a profit or loss. Current trader positioning can predict future positions, and thus, price moves.

Extremes in a currency pair, such as 90% long, can reveal that a trend reversal is coming. If 90% of traders are long, it means that most traders have already bought, which leaves very few out there to keep pushing the price up. When there is no one left to buy the price moves the other direction.

With some position summary tools, traders can look back in history to see which position ratios have signaled a change in price direction. If the current position ratios approach historically significant ratio levels, it could signal a price reversal.

Another way to view position summaries is through the Commitment of Traders (COT) report. Myfxbook is one resource that provides COT charges going back to 2006, so traders can see how various traders were positioned at major market turning points. This data may be used to anticipate future turning points in price.

Forex Correlation Tool

Some currency pairs tend to move together, while others tend to move in opposite directions. When two pairs tend to move similarly, it is called a positive correlation. When two pairs tend to move in opposite directions, that is a negative correlation.

Knowing the correlation between forex pairs is important. Traders often trade in multiple currencies. If their purchases all have a positive correlation to each other, the risk is multiplied, as is the potential reward. If you're long in two pairs that are negatively correlated, you've hedged potential risk and reward.

Independently moving pairs are "uncorrelated."

It should be noted that correlations are related to the direction, but not to the magnitude of price moves. Two currency pairs could be correlated, but one could move much more than the other. In other words, the one that moves more has greater volatility. Therefore, a study of correlations should also include a study of volatility.

Many online resources provide free forex correlation tables. Correlations change over time and can be measured on different time frames. Check correlations regularly, and look for correlations on the time frame you trade on.

For example, if you day trade on a one-minute chart, regularly check the correlations on one-minute and one-hour time frames if you are trading more than one pair. If swing trading on a daily chart, regularly check daily correlations.

Technical Indicators

There are loads of technical indicators that forex traders can add to their charts. Commonly used indicators include the MACD, RSI, and moving averages. There are also less commonly used tools such as the zigzag, moving average envelopes, and TTM Trend.

Zigzag

The zigzag indicator draws lines over price waves only when they meet a certain minimum movement threshold. By only highlighting major movements, these lines help filter out the noise of tiny movements so traders can focus on the larger price movements where the bigger profits lie. The zigzag can be customized to show how far the price has moved (in "pips" or percentages), which in turn can highlight tendencies in the price action. 

For example, a percentage retracement zigzag could show that a currency that typically retraces about 55% of a trending move on a pullback before moving in the trending direction again. A trader who notices such tendencies—and when such trends are broken—could improve the timing and location of entries and exits.

Moving Average Envelopes

Moving average envelopes are composed of three lines that are drawn directly over the price action. The middle line is a moving average, and the others are drawn above and below the moving average at an equal distance chosen by the trader. For example, a trader may use a 20-day moving average as the middle line and draw the upper and lower lines 5% away from the middle line.

When an envelope is calibrated to a specific pair, it can provide insight into potential trend changes and whether a trend is strong or weak. When the price is hovering near the upper band it highlights an uptrend. When it breaks out of the band, it could signal an overbought or oversold level that precedes a trend change. The moving average in the middle can often be calibrated to act as a support or resistance area—it's a rough point at which the price often stalls.

TTM Trend

Another technical indicator, TTM Trend, changes the color of the price bars on the chart based on whether short-term momentum is up or down. This tool can be used in conjunction with other trend-following strategies to capture large price moves.

For example, if the trend is up, stay in a long trade while the bars are blue. When the trend is down, stay in a short trade while the bars are red.

The Bottom Line

When most people hear "technical analysis," they typically think of technical indicators such as the MACD or RSI. However, technical analysis is also about extracting information from price formations, statistics, and other information.

Technical tools like the ones described here can be combined to make a better and more informed trading decision. Nobody has to use all of them. Your best bet is to review the tools and practice trading with them in a demo account. You'll find tools you need and discard the ones that you don't find helpful.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.