Forex Market: Technical Analysis and Tools in Currency Trading

Forex: Technical Analysis and Tools in Currency Trading

Technical analysis consists primarily of a variety of technical studies, each of which can be interpreted to generate buy and sell decisions or to predict market direction.

Technical analysis is applied only to price action in market trading and has become the primary tool with which to successfully trade shorter-term price movements, and to set stop loss and profit targets.

  • Support and Resistance Levels
    One use of technical analysis, apart from technical studies, is in deriving "support" and "resistance" levels. The concept here is that the market will tend to trade above its support levels and trade below its resistance levels.

    If a support or resistance level is broken, the market is then expected to follow through in that direction. These levels are determined by analyzing the chart and assessing where the market has encountered unbroken support or resistance in the past.

  • Popular Technical Analysis Tools
    • Moving Averages (MA): Indicators used to smooth price fluctuations and identify trends. The most basic type of moving average, the simple moving average, is the average of the past x bars ending with the current bar;
    • Moving Average Convergence Divergence (MACD): Indicator that utilizes moving averages to identify possible trends and an oscillator to determine when a trend is overbought or oversold;
    • Bollinger Bands: Bands that are placed x moving average standard deviations above and below a simple MA line;
    • Fibonacci Retracement Levels: Indicator used to identify potential levels of support and resistance;
    • Directional Movement Index (DMI): A positive line (+DI) measuring buying and a negative line (-DI) measuring selling pressure;
    • Relative Strength Index (RSI): Momentum oscillator that is plotted on a vertical scale from 0 to 100;
    • Stochastics: Momentum oscillator that measure momentum by comparing the recent close to the absolute price range (high of the range minus the low of the range) over a period of x bars;
    • Trendlines: Straight line on a chart that connects consecutive tops or consecutive bottoms of prices and is utilized to identify levels of support and resistance;

  • Calculating Profit
    The objective of trading is to buy a market instrument and later sell the same market instrument for a higher price. In case of margin trading, trader can also sell a market instrument first and later buy the same market instrument for a lower price. Either way, trader has to close position in order to lock in the profit.

    Let us assume that you open a long position by buying a market instrument for 129.38 (quantity of 10000) and few hours after that, you close the position by selling it for 129.52 (same quantity of 10000). These two trades would bring you profit of (129.52 - 129.38) * 10000 = 1400.
    We can also say that these two trades would bring you 14 "points" profit. A "point" is the smallest increment in an instrument's price.

    For the instrument in the above example, one point is 0.01 and for an instrument denominated with 4 decimals, one point would be 0.0001. Expressing position profits in points is often very useful for quick calculations and estimates.
    One point, from the example position above, would bring you 0.01 * 10000 = 100 profit, denominated in the same currency the market instrument is denominated in.

    In case of Forex, currency pair denomination will be in the counter currency (JPY is the counter or quote currency in the USD/JPY pair) and you may need additional currency conversion to get profit calculated in the currency your trading account is denominated in.

  • Margin Requirements
    Margin requirement is only applicable to margin trading. It allows you to hold a position much larger than your actual account value. Margin requirement or deposit is not a down payment on a purchase. Rather, the margin is a performance bond, or good faith deposit, to ensure against trading losses.

    Trading platforms often perform automatic pre-trade checks for margin availability and will execute the trade only if you have sufficient margin funds in your account.

    In the event that funds in your account fall below margin requirement, most trading systems will automatically close one or more open positions. This prevents your account from ever falling below the available equity even in a highly volatile, fast moving market.

    For example, you may be required to have only $1,000 in your account in order to trade position that would normally require $20,000. The $1,000 (5%) is referred to as "margin". This amount is essentially collateral to cover any losses that you might incur.

    Margin should reflect some rational assessment of potential risk in a position. For example, if a market instrument is very volatile, a higher margin requirement would normally be justified.

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  • Overnight Interest
    Overnight interest is only applicable to margin trading. Trading on margin means that a trader borrows money to buy or sell a market instrument using actual account value as collateral. Traders generally use margin to increase their purchasing power so that they can own more market instruments without fully paying for it.

    Considering that trading on margin involves borrowing money, trader has to pay interest on the loan. That interest is referred to as Overnight Interest and is generally charged based on number of days a position on margin was held.

    Most trading systems will charge daily interest portion at the end of each trading session and charge three times more on Monday or on other preset weekday (if market is closed on weekends).
    In case of Forex, Overnight Interest is calculated as interest rate differential between interest rates for particular currencies that make the currency pair that is being traded.

    For example, if a trader wants to sell USD/JPY on margin, he or she will have to pay 4.0% (e.g. U.S. interest rate at 5.0% subtracted by Japanese interest rate at 1.0% makes the interest rate differential) of the amount borrowed per year to hold the position.

    Before trading on margin, it is highly recommended to get information on exact interest rates charged for borrowing money and how that will affect the total return on investments.

Also Read..» The Basics in Forex Trading..


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