Technical analysis is based on the premise that the historical price action of an asset can be used to predict the future price action of that asset. With forex having such a large volume of transactions over a period of 24 hours, it is an ideal market to analyze using technical analysis. The volume of data included increases the statistical significance of the price action, making predictions based on technical analysis more accurate.
In technical analysis, price action is depicted visually on a chart. Traders then use various tools including trend identification and mathematically derived indicators that help them predict the future movements of price.
Although forex is often referred to as an ideal market for technical analysis, it should be noted that the same tools and indicators can be used in any market. Hundreds of books have been written discussing the particulars of technical analysis as it applies to equities, commodities, and currencies, but here we will be focusing solely on currencies and the forex markets.
Because of the large number of traders, including immense banks and hedge funds, participating in the foreign exchange markets, there are rarely any inconsistancies that can be exploited in the currency markets. Any disconnects are generally corrected within seconds or less, as the markets these days are being constantly scanned by computer software that looks to take advantage of even the smallest discrepancy.
The fact that all the known information is already included in forex exchange rates is what makes it so attractive to technical analysts. The fact that there are rarely discrepancies in the forex market means traders can focus on the flow of capital and the trend within the market; two things that technical analysis is perfect at uncovering.
The major objective of many technical indicators is to determine if a currency pair is in a trend, that is consistently moving in one direction or another, or if it is moving sideways. This is typically done by drawing trend lines that connect important historical price points. These points are important because they show where price has been unable to move either higher or lower. Technicians call these areas resistance and support and they are used to determine when a trend is beginning, when it could continue, and when it may be ending.
When looking for a trend, it is the major currency pairs such as the EUR/USD and USD/JPY that have historically shown the greatest tendency to trend. Conversely, those currency pairs that are crosses (they don’t include the USD) are the most likely to become range bound. Traders can use this knowledge to create strategies that take advantage of the naturally tendencies of currency pair.
There are literally dozens (perhaps hundreds) of indicators that can be used together with resistance and support to determine the future direction of currency exchange rates. Learning how to use each indicator deserves an entire lesson or book to itself and is beyond the scope of this introductory article. If you wish to learn more about technical indicators, we recommend you begin with our Forex Tutorials or even better, our Forex eBooks.