Decoding the Technical Analysis Tools Used by Forex Traders
A jargon-free guide to commonly used tools
A foreign exchange, or "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 but can be fine-tuned for trading currencies.
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.
Global markets vary in size, in both their number of currency transactions and how 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.
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.
There are numerous session highlighters available which can be added to the forex trading platform. MT4 is among the most popular.
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, or 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.
Forex volatility tools vary in complexity and format. One example is Oanda's Value at Risk Calculator. The trader selects a time period, and the tool calculates 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 percent of clients are long the EUR/USD, while 40 percent 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 at a profit or loss. Therefore, current trader positioning can predict future positions and thus price moves.
Extremes in a currency pair, such as 90 percent long, can reveal that a trend reversal is coming. If 90 percent 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.
Oanda.com provides currency position ratios as well as historical position ratios. With these tools, traders can look to 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.com provides COT charges going back to 2008, 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 move in opposite directions, and some move totally independent of each other. When two pairs tend to move in a similar fashion, it is called a positive correlation. When two pairs tend to move in opposite directions, that is a negative correlation. If two pairs move independently, they are uncorrelated.
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, risk is multiplied as is the potential reward.
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, and yet one moves way more than the other. That is, the one that moves more has greater volatility. Therefore, a study of correlations should also include a study of volatility.
Mataf.net, Myfxbook.net, and Oanda.com all 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 1-minute chart, regularly check the correlations on 1-minute and 1-hour time frames if you are trading more than one pair. If swing trading on a daily chart, regularly check daily correlations.
There are loads of technical indicators that forex traders can add to their charts. Commonly used indicators include the MACD, RSI, and moving averages and there are less commonly used tools such as the zigzag, envelopes, and TTM Trend.
The zigzag indicator draws lines over price waves of a certain size. These lines help filter out the noise of tiny movements so that traders can focus on the larger price moves 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 typically retraces about 55 percent of a trending move on a pullback before moving in the trending direction again. A trader who notices such tendencies could improve the timing and location of entries and exits.
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.
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 hitting the upper band it highlights an uptrend. The moving average in the middle can often be calibrated to act as a support or resistance area (that is, not an exact level but a rough point at which the price often stalls).
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.
A Final Word
When most people hear "technical analysis," they think of technical indicators such as the MACD or RSI. But technical analysis is also about extracting information from price formations, statistics, and other information.
Technical tools 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.