The explosion in trading of financial assets (stocks and bonds) has reshaped the way analysts and traders look at currencies. Economic variables such as growth, inflation, and productivity are no longer the only drivers of currency movements. The proportion of foreign exchange transactions stemming from cross border-trading of financial assets has dwarfed the extent of currency transactions generated from trading in goods and services. The asset market approach views currencies as asset prices traded in an efficient financial market. Consequently, currencies are increasingly demonstrating a strong correlation with asset markets, particularly equities.
- Understanding Technical Analysis
The two primary approaches of analyzing currency markets are fundamental analysis and technical analysis. Fundamentals focus on financial and economic theories, as well as political developments to determine forces of supply and demand. One clear point of distinction between fundamentals and technicals is that fundamental analysis studies the causes of market movements, while technical analysis studies the effects of market movements.
Technical analysis examines past price and volume data to forecast future price movements. This type of analysis focuses on the formation of charts and formulae to capture major and minor trends, identify buying/selling opportunities, and assessing the extent of market turnarounds. Depending upon your time horizon, you could use technical analysis on an intraday basis (5-minute, 15 minute, hourly), weekly or monthly basis.
The Basic Theories
- Dow Theory
The oldest theory in technical analysis states that prices fully reflect all existing information. Knowledge available to participants (traders, analysts, portfolio managers, market strategists and investors) is already discounted in the price action. Movements caused by unpredictable events such as acts of god will be contained within the overall trend. Technical analysis aims at studying price action to draw conclusions on future moves.
Developed primarily around stock market averages, the Dow Theory holds that prices progressed into wave patterns, which consisted of three types of magnitude—primary, secondary and minor. The time involved ranged from less than three weeks to over a year. The theory also identified retracement patterns, which are common levels by which trends pare their moves. Such retracements are 33%, 50% and 66%.
- Fibonacci Retracement
This is a popular retracement series based on mathematical ratios arising from natural and man-made phenomena. It is used to determine how far a price has rebounded or backtracked from its underlying trend. The most important retracement levels are: 38.2%, 50% and 61.8%.
- Elliott Wave
Ellioticians classify price movements in patterned waves that can indicate future targets and reversals. Waves moving with the trend are called impulse waves, whereas waves moving against the trend are called corrective waves. Elliott Wave Theory breaks down impulse waves and corrective waves into five primary and three secondary movement respectively. The eight movements comprise a complete wave cycle. Time frames can range from 15 minutes to decades.
The challenging part of Elliott Wave Theory is figuring out the relativity of the wave structure. A corrective wave, for instance, could be composed of sub impulsive and corrective waves. It is therefore crucial to determine the role of a wave in relation to the greater wave structure. Thus, the key to Elliot Waves is to be able to identify the wave context in question. Ellioticians also use Fibonacci retracements to predict the tops and bottoms of future waves.
It was developed by Larry Williams. This system attempts to measure overbought and oversold market conditions.
The %R always falls between a value of 100 and 0. There are two horizontal lines in the study which represent the 20% and 80% overbought and oversold levels.
Indicator values ranging between 80 and 100% indicate that the market is oversold.
Indicator values ranging between 0 and 20% indicate that the market is overbought.
But we have to take in consideration that overbought does not necessarily imply time to sell and oversold does not necessarily imply time to buy so, it's very important that if an overbought/oversold indicator, such as Stochastic or Williams %R, shows an overbought level, the best action is to wait for the futures contract’s price to turn down before selling.
So, you sell when %R reaches 20% or lower (the market is overbought) and buy when it reaches 80% or higher (the market is oversold). However, as with all overbought/oversold indicators, it is wise to wait for the indicator price to change direction before initiating any trade.
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