Technical analysis is a broad discipline involving the use of graphs, charts, and other graphical tools in order to make better sense of complex trading signals and patterns. Technical analysis can be used to predict future price movements based on the past, or to simply identify possible trading opportunities. Technical indicators are typically used to watch over the past trends and predict future movements based on their patterns. Examples of technical analysis tools include moving averages, historical relative strength index (RSI), and other statistical oscillators.
The Simple Moving Averages (SMA) and the Simple Average True Range (SATR) are two of the most common statistical tools used in technical analysis. The SMA gives an idea of the average price action over a defined period, while the SATR gives an idea of current prices over a longer period. Trading strategies that make use of these indicators typically employ a variant of the following techniques. They may employ trend analysis to detect possible buying and selling signals, or they may make use of support and resistance levels to confirm buying signals.
Most trading indicators make use of moving averages and their variations in order to detect strong or weak areas. Some, such as the Simple Moving Average (SMA) directly measures the price action over a defined period, while others like the Simple Average True Range (SATR) does so using a more elaborate moving average calculation. Because the distance between the lowest and highest values can vary significantly, the SATR attempts to compensate for varying distance by weighting more recent closing prices more heavily than older ones. Traders interested in using more than one indicator will find it necessary to select moving averages and other analytical tools that can be used in conjunction with one another. For example, traders who employ the trend indicator in combination with the moving average can expect the resulting signal to have greater validity.
Divergence or Correlation An alternative approach to testing trading strategies is to analyze price patterns with respect to a number of well-defined confluences. Confluences are the differences in price made by the deviation of a mean line from the average value, which can be a positive or negative divergence. Traders interested in trading price patterns can make use of candlestick charts, line charts, or the parabolic SAR technique. These techniques rely on the ability to identify divergences in price patterns and to extract the positive or negative divergence points for further analysis.
Volatility Forex trading strategies that rely on the ability to detect and measure volatility are also prone to false readings. Volatility is a measure of the rate of change of price over time. The interpretation of volatility is complicated, but traders should note that the higher the volatility, the greater the chance that the price action will deviate from the average trendline. Because of this potential problem, many traders prefer to focus on low volatility prices instead of higher volatile ones. Unfortunately, high volatility may also create profit potential at the expense of losses in an equity security.
Relative Strength Index (RSI) There are many trading strategies that attempt to exploit the relationship between price movement and relative strength index (RSI). Most technical indicators based on moving averages have been developed to correlate the price action with the strength index. Trading strategies that exploit these charts can generate profit signals based on the relationship between price movements and relative strengths of the moving averages.
Momentum Divergence Analysis Momentum divergence is another important indicator for technical analysis. Momentum refers to the rate of change of price made by an asset over a period of time. The more momentum divergence there is, the stronger the potential for price movement. When there is a high degree of momentum divergence, that suggests that the price action is highly sensitive to extraneous external factors, which in turn can cause significant price swings. Momentum divergence is particularly useful for identifying trading strategies that are based on a consolidation strategy.
Finally, one other trading indicator that most technical traders will want to avoid is the trend line itself. Trend lines are typically drawn using mathematical tools. The function of the trend line is to intercept the price movements and draw a line connecting the high and low points. Trading strategies that rely on the trend line as a signal to trade must therefore be avoided.