Introduction to Forex Technical Analysis (Part 2)

Below you’ll find the second and last part of our Forex Technical Analysis Introduction.

Moving Averages
A moving average, in technical analysis, is the most used indicators in a family of statistical techniques to analyze time series data.

A moving average series in Forex trading can be calculated for any time series, but is most often applied to currency prices or trading volumes. Moving averages are used to smooth out short-term fluctuations, thus highlighting longer-term trends or cycles. The threshold between short-term and long-term depends on the application, and the parameters of the moving average will be set accordingly.

Simple moving average
A simple moving average is the unweighted mean of the previous n data points. For example, a 10-day simple moving average of closing price is the mean of the previous 10 days’ closing prices.

In technical analysis there are various popular values for n, like 10 days, 40 days, or 200 days. The period selected depends on the kind of movement one is concentrating on, such as short, intermediate, or long term. In any case moving average levels are interpreted as support or resistance depending which side of the currency pair you are looking at.

In all cases a moving average lags behind the latest price action, simply from the nature of its smoothing. A Simple Moving Average (SMA) can lag to an undesirable extent, and can be influenced too much by old prices dropping out of the average. This is addressed by giving extra weight to recent prices, as in the Weighted Moving Average (WMA) and Exponential Moving Average (EMA) below.

Weighted moving average
In technical analysis a weighted moving average (WMA) has the specific meaning of weights which decrease arithmetically from highest weight for the most recent days, down to zero by an equal amount each time. It can be compared to the weights in the exponential moving average which follows.

Exponential moving average
An exponential moving average (EMA), sometimes also called an exponentially weighted moving average (EWMA), applies weighting factors which decrease exponentially. The weighting for each day decreases by a factor, or percentage, on the one before it.

The N periods in an N-day EMA only specifies the α factor. It isn’t a stopping point for the calculation in the way N is in an SMA or WMA. The first N days in an EMA do represent about 86% of the total weight in the calculation though.

Other weightings
Other weighting systems in Forex trading are used occasionally – for example, a volume weighting will weight each time period in proportion to its trading volume.

There are weighting systems designed using a combination of moving averages: The DEMA indicator (and TEMA indicator (Triple Exponential Moving Average) are unique composites of a single exponential moving average, a double exponential moving average, and in the latter case a triple exponential moving average that provides less lag than either of the three components individually. The TRIX indicator uses a triple-EMA in its calculation. This ends up as just a certain set of weights on past data, and a set quite different to a plain EMA actually.

MACD
MACD is a trend following indicator, and is designed to identify trend changes. It’s generally not recommended when your currency pair is in ranging market conditions. Three types of trading signals are generated:

• MACD line crossing the signal line
• MACD line crossing zero
• Divergence between price and MACD levels

The signal line crossing is the usual trading rule. This is to buy when the MACD crosses up through the signal line, or sell when it crosses down through the signal line. These crossings may occur too frequently, and other tests may be needed to be applied.

The purpose of the histogram is to help show when a crossing occurs, since when it crosses through zero the MACD crosses the signal line. The histogram can also help visualizing when the two lines are coming together. Both may still be rising, but coming together, so a falling histogram suggests a crossover may be approaching.

A crossing of the MACD line up through zero is interpreted as bullish, or down through zero as bearish. These crossings are of course simply the original EMA(12) line crossing up or down through the slower EMA(26) line.

Positive divergence between MACD and price arises when price makes a new selloff low, but the MACD doesn’t make a new low, ie. it remains above where it fell to on that previous price low. This is interpreted as bullish, suggesting the downtrend may be nearly over. Negative divergence is the same thing when rising, ie. price makes a new rally high, but MACD doesn’t rise as high as it did before; this is interpreted as bearish.

Divergence may be similarly interpreted on the price versus the histogram, ie. new price levels not confirmed by new histogram levels. Longer and sharper divergences (distinct peaks or troughs) are regarded as more significant than small shallow patterns in this case.

Looking at a MACD on a weekly scale before looking at a daily scale could be a great idea as well so as to avoid making short term trades against the direction of the intermediate trend.

Parabolic SAR
In Technical analysis, Parabolic SAR (SAR – stop and reverse) is a method to find trends in currency prices. It may be used as a trailing stop loss based on prices tending to stay within a parabolic curve during a strong trend.

The indicator generally works well in trending markets, but provides “whipsaws” during non-trending, sideways phases. A parabola below the price is generally bullish, while a parabola above is generally bearish.

Stochastic Oscillator
The stochastic oscillator is a technical analysis oscillator (or two oscillators) showing the latest closing price in relation to the trading range of the past N days. This concept is unrelated to a stochastic in mathematics or statistics.

Two oscillator lines are calculated, called %K and %D, each ranging from 0 to 100. %K is the closing price within the past N-days trading range, ranging from 0 when the latest close is a new N-day low, up to 100 for a new N-day high,

The usual “N” is 14 days, ie. a fortnight’s worth of past data, but this can be varied. Levels near the extremes 100 and 0, for either %K or %D, indicate strength or weakness (respectively) with prices making or approaching new N-day highs or lows.

Levels above 80 and below 20 can be interpreted as overbought or oversold, but not on their own, only with other factors. It is recommended to wait for a return back through those thresholds, ie. when the oscillator goes above 80, wait for it to fall below 80 before selling; or vice versa on going below 20 wait for a rise back above 20 before buying; which in effect means waiting for a bit of a reversal. Or alternately levels 80 and 20 might be traded when some other technical indicator suggests a non-trending market.

%D acts as a trigger or signal line for %K. A buy signal is given when %K crosses up through %D, or a sell signal when it crosses down through %D. Such crossovers can occur too often, and to avoid repeated whipsaws one can wait for crossovers occurring together with an overbought/oversold pullback, or only after a peak or trough in the %D line.

Some traders consider the basic %K and %D too volatile, giving too many signals and too many whipsaws. This is addressed by forming “slow” stochastics. %K values are first smoothed by a 3-day simple moving average, and then the %D formed by a further 3-day SMA on that. This “slowed” %K is the same as the “fast” %D, but it’s easiest just to think of the slow form as first
inserting an extra smoothing.

%K is the same as Williams %R, though on a scale 0 to 100 instead of -100 to 0, but the terminology for the two are kept separate.

Bollinger Bands
Bollinger Bands is a technical analysis tool which evolved from the concept of trading bands, and can be used to measure the relative highness or lowness of a currency pair price.
Bollinger Bands consist of:

• a middle band being a N-period simple moving average
• an upper band at K times a N-period standard deviation above the middle band
• a lower band at K times a N-period standard deviation below the middle band
Typical values for N and K are 20 and 2, respectively.

The bands give a reliable visual picture of a stock’s price volatility. No particular significance,
however, should be attached to a price touching the upper or lower band, as Bollinger himself has pointed out. These occurrences should be considered in relation to other factors before making investment decisions.

It is of interest to note that faulty interpretation of a price touching or breaching a band based on incorrect statistical assumptions has become so widespread that some Forex traders now use these events alone as trading signals and by so doing may have unwittingly injected significance into these band-touching events that would otherwise be absent.

When the bands lie close together a period of low volatility in the currency pair is indicated. When they are far apart a period of high volatility in price is indicated. When the bands have only a slight slope and lie approximately parallel for an extended time the price of currency pair will be found to oscillate up and down between the bands as though in a channel. When this behavior is found to regularly repeat in conjunction with a fairly steady broad market, a Forex traders may, with some validity, use a touch or near touch of the upper or lower band as an indication that a the price is nearing the limit of its trading range and therefore a price reversal is probable.

SOURCE: Part of this article was taken from Wikepedia in accordance with their GNU Free Documentation License.