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Currency Trading Basics: The Psychological Utility of Technical Analysis

Posted by Joseph Trevisani on Aug 26, 2013 9:00:00 AM

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Technical Analysis, Traders and the Market

Technical analysis is sometimes treated as if it contains a grain of secret knowledge or portrays an intrinsic truth about a currency. It is often inferred that a specific chart formation will produce a specific price movement.

Technical analysis does nothing of the sort.  A chart is a reflection of past prices; it cannot predict future movement.  A currency does not move up of down because of a formation on a chart.  Currencies move because market participants, you and I, the traders, make assumptions about future market behavior based on the record of past behavior that is contained in a chart.

 It is crucial to remember that the translation mechanism for technical analysis runs from the information contained in a chart, through the analysis of that information to the behavior of market participants.

Another way to approach this idea is to ask, just who is the ‘market’ and what is it trying to accomplish.  Over 90% of the daily volume in the FX market is speculative.  This means that everyone in the market, the hedge fund manager, the interbank trader at his station and the retail trader in her home, is trying to do exactly the same thing, take home daily trading profits. 

If every market participant is attempting to do the same thing, namely wring trading profits from the day’s activities how do they all go about it? 

The first thing every trader does, in Zurich, in Tokyo, in Riyadh, in London, in New York,  and in all points between, the first thing I did every day I sat on an interbank desk, was to pull up my charts and look for trends and trading opportunities.   Every trader looking for profit opportunities is looking at the same charts. Everyone sees the same price history. Everyone identifies the same chart formations.

And, this is the key: the majority of traders will come to the same conclusion based on these factors.

If euro has been in an up channel for two weeks and is approaching the bottom of the channel most traders looking for an opportunity in euro will bet on the continuance of the trend and the maintenance of the channel.  They will place buy orders just above the floor of the channel.   Most of the time the charts will be proven correct. The euro will indeed bounce from the floor of the channel.

It will rebound not because, for instance, the ECB is expected to raise rates at some future date or because of an improvement in the EU economy, but because of the match between the goals, information and assumptions of the market’s traders. 

Traders need profits. All charts contain identical information and all traders operate with very similar assumptions about market behavior based on chart formations. 

If enough traders place their buy orders above the bottom of the channel it becomes likely that the euro will bounce off the floor of the channel and continue the upward channel formation,  barring external events of course. 

There is powerful self-fulfilling logic in technical analysis, it works, because everyone trading believes it will work and makes their trading decisions accordingly. 

For a retail trader that is the most accessible and effective trading strategy that exists.

Remember, charts do not predict currency movements. They predict the actions of the individuals trading that currency.

 

Joseph Trevisani

Chief Market Strategist

WorldWideMarkets

 

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