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Technical analysis is based on one simple concept: Previous price behavior can give you clues as to what price will do in the future.
If you think that this is a little too much like witchcraft and it could not possibly work, then consider this…
Forget for a moment that this is a Forex chart.
Let's just say that it's a chart of the price of…a certain type of pen.
When the price of the pen gets to 1.033 (the orange line), pen companies start producing more and supply increases. With more supply available, people have more choices for buying pens and the the market value of the pens will start to decrease.
Then supplies get low and prices start to go up again.
Makes sense right?
Now when you trade Forex, stocks or any other market, there are hundreds of factors that can come into play that can affect prices.
It's not just about supply and demand.
However, technical analysts believe that almost everything you need to know about these market forces is expressed on a chart. Market analysts can give all the opinions they want about what the market will do next, but the only thing that matters is what happens on the chart.
…at least that's what technical analysts believe.
A Quick Tutorial on Charting Types
Now let's take a look at the different types of charts out there. Some charts give you more information about what price is doing than others, so it's important that you understand the difference. Here are the graphs that most traders use.
Line Graph
A line graph only plots one price out of the: open, high, low and close. The closing price is usually used.
This can be useful with certain styles of trading, but it's generally not as useful as other types of charts because it only shows you one data point per time period.
Bar Graph
Bar graphs are generally more useful than line graphs because they show you three more pieces of information than a line graph:
- Open
- High
- Low
- Close
The mark on the left side of each bar is the open and the one on the right is the closing price. The top of the bar is the high and the bottom is the low.
Candlestick Graph
Candlestick graphs add a little more information to bar graphs. They present the same information, but they fill in the spaces between the open and the close.
This can make the price movement easier to see.
A lot of technical traders use a candlestick graph.
If you don't know which one to choose, start with a candlestick graph.
You can learn more about how read candlesticks here.
Other Graphs
Here are other graphs types out there that you can explore:
- Renko
- Area
- Baseline
- Ichimoku cloud
- Point and figure
Again, remember that there is no right or wrong chart type. You can even use one or more of these chart types at the same time. All that matters is what works for you and helps you make money consistently.
Now that you understand basic charting, let's get into how traders use charts to make trading decisions.
Price Action Trading Explained
Price action traders trade purely from the price patterns on the charts. There are so many patterns out there that it would be impossible to name them all here.
But these patterns fall into only 2 broad categories, so let's talk about these categories.
When you are learning to trade, it's important to keep these categories in mind, and not get too fixated on the specifics of each trading strategy. This will make it much easier to spot potential trades.
Trend
Trending patterns tell traders that the market will potentially continue the current trend. This can include patterns like wedges, trending pin bars and outside bars.
Here's an example of a wedge, or flag, formation in a downtrend. This could be a clue that the trend will continue…which it did in this example.
Countertrend
The second category of chart pattern is the countertrend pattern. These are patterns that can signal a reversal point in the market.
A popular one is the head and shoulders. Here's an example.
You can see the head marked with a “H” and the two shoulders on both sides. When the price breaks the orange line, that can be a signal to sell.
This pattern can also work in the opposite direction.
So that's a quick explanation of how price action trading works.
But that's not the only way to trade…
Trading Indicators Explained
Some traders like to use indicators to place trades. A few people online will tell you that indicators don't work because they are lagging signals.
Maybe some indicators are.
But there are also many traders who make a living trading using indicators. So before you write indicators off completely, learn how to test them and find out if they work…for yourself.
We will get into how to do that a little later.
For now, let's take a quick look at how indicators work.
An indicator is built on some sort of calculation of price.
One example what we can look at is the Relative Strength Index (RSI). You can read about how the indicator is calculated here.
The RSI can signal a reversal in the market, so it's a countertrend indicator.
However, I've found that the way that many books and blogs teach RSI trading doesn't work. You can read about my findings here.
That's a quick introduction to trading with indicators. There are a ton of them out there, so let's not get into specific ones just yet.
In the next section, I'll show you another type of trading that doesn't depend as much on price and chart patterns.
Let's Keep It Going!
Excellent, now it's time to move on to fundamental analysis…