Technical Analysis
Technical analysis uses historical price data and chart patterns to forecast future price movements. Widely used in Forex because it is non-discretionary, systematic, and applicable across all time frames. This chapter covers Dow Theory, chart types, trend analysis, patterns, and key indicators.
Dow Theory and the Philosophy of Price
Dow Theory, developed by Charles Dow in the late 19th century, forms the philosophical foundation of technical analysis. Its core tenets:
1. The Market Discounts Everything: All available information — economic, political, psychological — is already reflected in the price. Therefore, studying price is studying all known factors.
2. Prices Move in Trends: Markets trend. An uptrend is defined as a series of higher highs and higher lows; a downtrend as lower highs and lower lows. Trends persist until a clear reversal signal appears.
3. Three Phases of a Trend: - Accumulation (smart money enters quietly) - Public Participation (majority joins, price accelerates) - Distribution (smart money exits into retail buying)
4. Volume Confirms the Trend: In an uptrend, volume should increase on rallies and decrease on pullbacks. Divergence between price and volume is a warning sign.
5. A Trend Remains in Force Until It Reverses: Do not fight the trend without clear evidence of reversal.
- Price discounts all information — no need to look for external 'hidden' causes
- Uptrend: higher highs + higher lows; Downtrend: lower highs + lower lows
- Three phases: Accumulation → Participation → Distribution
- Volume should confirm price moves; divergence warns of weakness
QAccording to Dow Theory, how is an uptrend defined?
Chart Types — Candlesticks, Bars, and Lines
Price charts are the core tool of technical analysis. The three main chart types represent OHLC (Open, High, Low, Close) data in different ways.
Line Chart: Plots only the closing price. Simplest view — good for identifying the overall trend direction but loses intraday price information.
Bar Chart (OHLC): A vertical bar represents the high-low range. Small horizontal ticks mark the open (left) and close (right). More information than a line chart but harder to read quickly.
Candlestick Chart (Japanese): Originated in 18th-century Japan (rice futures markets). The thick body represents open-to-close range; wicks (shadows) show high-low range. Colour coding (green/white for bullish, red/black for bearish) makes sentiment immediately visible.
Candlestick patterns — Doji, Hammer, Shooting Star, Engulfing, Morning Star — provide short-term reversal and continuation signals widely used by Forex traders.
- Candlestick body = open-to-close range; wick = high-low extreme
- Bullish candle: close > open (green/white body)
- Bearish candle: close < open (red/black body)
- Doji: open ≈ close — indecision; often precedes reversals
| Pattern | Appearance | Signal |
|---|---|---|
| Bullish Engulfing | Small bearish candle followed by large bullish candle | Potential bullish reversal |
| Bearish Engulfing | Small bullish candle followed by large bearish candle | Potential bearish reversal |
| Doji | Very small body, long wicks | Indecision; reversal risk |
| Hammer | Small body at top, long lower wick | Bullish reversal at lows |
| Shooting Star | Small body at bottom, long upper wick | Bearish reversal at highs |
| Morning Star | Bearish → Doji → Bullish (3 candles) | Strong bullish reversal |
Annotated diagram showing how to read a candlestick: open, high, low, close, body, and wicks for both bullish and bearish candles.
QWhat does a Doji candlestick indicate?
Trend Lines, Support & Resistance
Support and resistance are price levels where buying or selling pressure tends to be concentrated — they represent the market's memory.
Support: A price floor where demand is expected to emerge. Previous swing lows, round numbers, and moving averages often act as support.
Resistance: A price ceiling where supply is expected to enter. Previous swing highs, psychological levels (e.g. 1.2000 in EUR/USD), and Fibonacci extension levels act as resistance.
Role Reversal: When price breaks convincingly through support, that level often becomes new resistance — and vice versa. This 'flip' is a key concept in Forex trading.
Trend Lines: Drawn by connecting swing lows in an uptrend (or swing highs in a downtrend). A valid trend line requires at least two touches; three touches provide stronger confirmation. A break of a trend line signals potential trend change.
Channels: Parallel trend lines (one connecting highs, one lows) define a price channel. Traders buy at channel support and sell at channel resistance.
- Support = demand zone; resistance = supply zone — based on market memory
- Role reversal: broken support becomes resistance and vice versa
- Trend line validity: minimum 2 touches (3+ is stronger confirmation)
- Round numbers (e.g. 1.2000) act as psychological support/resistance in Forex
Chart showing a price series with annotated horizontal support and resistance levels, touch points, and an uptrend line connecting swing lows.
QWhat is the 'role reversal' concept in technical analysis?
Key Technical Indicators
Indicators are mathematical calculations derived from price (and sometimes volume) data. They fall into two broad categories: trend-following and oscillators.
Moving Averages (trend-following): The Simple Moving Average (SMA) averages closing prices over N periods. The Exponential Moving Average (EMA) applies more weight to recent prices. Popular periods: 20-day (short-term), 50-day, 200-day (institutional benchmark).
MACD (Moving Average Convergence Divergence): Plots the difference between a 12-period EMA and 26-period EMA, with a 9-period signal line. Crossovers generate buy/sell signals; divergence from price warns of trend exhaustion.
RSI (Relative Strength Index): Oscillates between 0 and 100. Readings above 70 suggest overbought; below 30 suggest oversold. RSI divergence (price making new highs but RSI declining) is a powerful reversal signal.
Bollinger Bands: A 20-period SMA with upper/lower bands at ±2 standard deviations. Price tends to revert to the mean; a band breakout suggests strong momentum.
No single indicator is sufficient. Professional traders use confluence — multiple indicators and price levels aligning simultaneously — to increase signal quality.
- 200-day SMA: the most-watched moving average for long-term trend bias
- MACD crossover: bullish when MACD line crosses above signal line
- RSI > 70 = overbought; RSI < 30 = oversold — but trend can persist
- Bollinger Band squeeze (bands narrowing) often precedes breakout
| Indicator | Type | Signal Type | Common Settings |
|---|---|---|---|
| SMA | Trend-following | Crossovers, support/resistance | 20, 50, 200 periods |
| EMA | Trend-following | Faster response than SMA | 9, 21, 55, 200 periods |
| MACD | Momentum/trend | Line crossovers, divergence | 12/26/9 |
| RSI | Oscillator | Overbought/oversold, divergence | 14 periods |
| Bollinger Bands | Volatility | Band breakouts, mean reversion | 20 SMA, ±2σ |
| Stochastic | Oscillator | Overbought/oversold crossovers | %K=14, %D=3 |