Trading decisions in forex markets should always be made after a sound technical analysis. Technical analysis essentially uses past price behaviour to guide decisions in forex trading. It should be kept in mind that positions based on technical analysis last a few hours or days; so it is a short horizon method.
Using Charting and Mechanical Rules in Technical Analysis
Technical analysis uses charting and mechanical rules to distinguish trends from shorter run fluctuations. Charting means that you graph the price history over a period, and predict future patterns in the data on the basis of past patterns. On the other hand, mechanical rules require you to use mathematical function based rules of present and past forex rates.
In charting, you must know how to identify the peaks and troughs. The highest value of the forex rate within a specified time period (a local maximum) is called the peak. The trough is the lowest value the forex rate has taken in the same period (a local minimum). Downtrends and uptrends are then ascertained through a series of peaks and troughs. A trendline is drawn, and has greater validation if more troughs touch the trendline without deviating too much from it.
As a forex trader, it is an unwritten rule to buy the foreign currency if an uptrend is on the chart or to sell it if a downtrend is the case. However, the analysis of data on the chart depends on individual perspectives. Hence, charting is more of a subjective method of technical analysis.
Mechanical rules is a more consistent and rigid form of technical analysis. It seeks to avoid the subjectivity of interpreting charts. Mechanical rules employ mathematical functions to seek trends. Forex traders then follow these trends.
A popular mechanical trading rule is the filter rule, which suggests buying a currency when it rises x% above its previous local minimum. The converse is also suggested; to sell a currency when it falls x% below its local maximum. The filter x generally varies between 0.5% to 3%, and is chosen by the forex trader based on past experience.
Another mechanical trading rule is the moving average rule. The average closing price of a forex rate over a defined number of previous trading days is called a moving average. In moving averages, traders do not concentrate so much on the short run, but look at establishing trends in the series.
The last mechanical trading rule is that of oscillators. These are useful in markets when the exchange rate does not have strong uptrends or downtrends. This rule advocates buying the foreign currency when the oscillator index takes a really low value. The opposite is also advocated i.e. selling the foreign currency when the oscillator index takes a really high value.
There are other types of technical analysis techniques as well, some of which are more complex than the techniques mentioned. The kinds of techniques used vary from trader to trader, but the idea is to understand the importance of technical analysis and leveraging it in your trading strategy.