Every Forex Trader will have their own strategies in order to help them make money in the Forex market. We could easily divide the Forex traders in 2 major categories. First, the traders who will analyze all the related economic news to help them forecast the direction of the market commonly know as Fundamental Analysis.

However, an overwhelming amount of Forex traders, are using what we call Technical Analysis at least in part if not as a primary tool in helping make their trading decisions. Technical Analysis can therefore be used to decide everything for buy and sell signals, setting stop loss and profit target, especially for short term traders which will ignore any other fundamentals.

In this article, divided in 2 part, you’ll get a basic understanding of the different use of Technical Analysis in Forex Trading.

Pivot Point
Pivot points are frequently used by Forex traders as a means to calculate resistance and support levels which are, in turn, used as visual cues to execute trades. With the use of an arithmetic program (pivot point calculator), Forex traders will try to anticipate price movements.

As a technical analysis tool, pivot points have proven themselves to be far more effective in currency trading than equities markets. This is largely due to the fact that price movements in the trillion dollar foreign exchange market are not generally subject to the kinds of manipulation that stem from unforeseen insider trading, corporate mismanagement, misrepresentation, or the actions of institutional investors.

Basic Forex pivot point trading is based on two prevailing tendencies. If a day’s price action begins above the pivot point, prices will tend to stay above that point (fulcrum) until it reaches a resistance point. Conversely, if a day’s pricing action begins below the pivot point, the price will tend to stay below that point until it reaches a support point. A resistance level is a price that tends to prevent further upward movement. A support price is a price action point that tends to prevent further downward movement.

In its simplest form pivot point trading is based on these two tendencies and is also knows as “trading between the lines”. The most popular and hence the most successful form of pivot trading is based on reversals. Simply put, when price approaches a pivot above, a trader waits for a reversal at that point and sells. The opposite is true when price action is moving downward. The patient pivot trader waits for a bounce off the pivot of support and places an order to buy.

If the market opens or later trades at the extremes R2 or S2, pricing will exhibit a tendency to trade back toward the pivot point. Hence, traders tend to avoid buying high (at R2) or selling at the low (S2). The wisdom of this is even greater the further the price moves away from the day’s pivot point.

There are a number of formulas traders use to calculate resistance and support levels and they are based on a variety of factors but those based on price are the most popular if, for no other reason, they are the easiest to calculate. Pivot trading begins with the calculation of the pivot point which is an average of the previous day’s high, low and closing price. While the Forex is a 24 hour market, “closing” is generally defined as 5 p.m. EST which coincides with the closing of the New York Stock Exchange. However, traders use various closing times, 12 a.m. EST also being a popular reference point for calculations.

In the following formula “H” represents the previous day’s high, “L” represents the previous day’s low, and “C” represents the previous day’s closing price.

Pivot Point = (H+L+C)/3

Support & Resistance
Support and resistance levels are points where a chart experiences recurring upward or downward pressure. A support level is usually the low point in any chart pattern (hourly, weekly or annually), whereas a resistance level is the high or the peak point of the pattern. These points are identified as support and resistance when they show a tendency to reappear. It is best to buy/sell near support/resistance levels that are unlikely to be broken.

Once these levels are broken, they tend to become the opposite obstacle. Thus, in a rising market, a resistance level that is broken, could serve as a support for the upward trend, whereas in a falling market; once a support level is broken, it could turn into a resistance.

Once the day’s pivot point has been calculated, traders turn to the calculation of the initial resistance (R1) and support (S1) levels which assumes that trading will continue pretty much in the same range as the previous day.

Resistance Level 1 = (2*PP)-L
Support Level 1 = (2*PP)-H

A second set of resistance and support points, R2 and S2, are used in the event that the price breaks through the previous day’s trading range and continues until it meets a second higher level of resistance or lower level of support.

Resistance Level 2 = (PP-S1) + R1
Support Level 2 = PP - (R1 - S1)

Some traders attend to the calculation of extreme price fluctuations (R3, S3) but only a small minority of them actually trade on them because such price movements are a sure sign of volatility.

Resistance Level 3 = (PP-S2)+R2
Support Level 3 = PP - (R2-S2)

Some calculators also generate midpoints - trading levels that lie at the midpoint between R2 and R1, S2 and S1, R1 and PP, and finally S1 and PP. As long as trading ranges are not too narrow, these reference points hold the same relative importance as their paired resistance and support levels.

M1= (S2+S1)/2
M2= (S1+PP)/2
M3 = (R1+PP)/2
M4 = (R2+R1)/2

Fibonacci Retracement
Fibonacci retracement is a very popular tool among Forex technical traders and is based on the key numbers identified by mathematician Leonardo Fibonacci in the 13th century. However, Fibonacci’s sequence of numbers is not as important as the mathematical relationships, expressed as ratios, between the numbers in the series. In technical analysis, Fibonacci retracement is created by taking two extreme points (usually a major peak and trough) on a currency pair chart and dividing the vertical distance by the key Fibonacci ratios of 0%, 38.2%, 50%, 61.8%, 78.6% and 100%. Once these levels are identified, horizontal lines are drawn and used to identify possible support and resistance levels.

For reasons that are unclear, these ratios seem to play an important role in the Forex market, just as they do in nature, and can be used to determine critical points that cause the price to reverse. The direction of the prior trend is likely to continue once the price has retraced to one of the ratios listed above.

Trend Lines & Channels
Trend lines are a simple and widely used technical analysis construction drawn on the currency pairs charts in Forex trading.

A trend line is a bounding line for the price movement of a currency pair. The principal trendline is an upsloping line drawn through lower extremes of price that is in an up trend, or its mirror image, a downsloping line drawn through the upper extremes of the price action that is in a down trend.

The other, less widely used type of trendline is an upsloping line drawn through high extremes in an uptrend, or a down sloping line drawn through lower extremes in a downtrend.

Trend lines are used in many ways by traders. One way is that when price returns to an existing principal trendline it may be an opportunity to open new positions in the direction of the trend, in the belief that the trendline will hold and the trend will continue further. A second way is that when price action breaks through the principal trendline of an existing trend, it is evidence that the trend may be going to fail, and a trader may consider trading in the opposite direction to the existing trend, or exiting positions in the direction of the trend.

In the next part of our Technical analysis article, we’ll talk more about Moving Averages, MACD, Parabolic SAR, Stochastic Oscillator and Bollinger Bands.