Technical analysis comprises of two components-
1) Chart patterns-
They are used to analyse historical price action to predict prices in the future. The direction of a trend can be categorised as
(i) Bullish trend- Higher tops and higher bottoms
(ii) Bearish trend- Lower tops and lower bottoms
(iii) Range-bound- Narrow price movements
Chart patterns can be categorised as bullish, bearish, reversals, continuation and candlestick formations.
2) Technical Indicators-
Technical indicators on the other hand add value to chart patterns by confirming the direction of a trend either by way of volumes, momentum, overbought/ oversold levels, crossovers and convergence/ divergence.
Technical indicators are developed by analysing past and present data such as open, high, low, close and volumes and are derived into formulas, they are represented graphically and are placed above, below or merged with the price data of a forex pair.
Before looking at some of the popular indicators, let’s understand the two basic functions of technical indicators.
a) Leading indicators-
Indicate price direction before it actually occurs. These indicators send out buy signals ahead of the beginning of a new trend and sell signals when prices look overstretched.
Some of the popular indicators are
- Price oscillator
- Ultimate oscillator
- Pivot points
b) Lagging indicators-
These indicators follow price action and confirm the trend only after it actually occurs. They are referred to as trend following indicators.
Some of the popular ones are
- Moving average crossovers
- Moving average convergence divergence (MACD)
Both these indicators have their advantages and disadvantages and are employed under diverse market conditions
Trading strategies using oscillators-
Oscillators are technical indicators that vary between ranges set at predefined values. They are popular because of their ability to identify trends even before they occur and are therefore used as leading indicators.
Oscillators vary in the way they predict trends. While some of them spend extended periods of time in overbought/ oversold areas and trend only when large price action takes place, others behave differently and trend more often.
As leading indicators, oscillators identify if the price has rallied rapidly or depreciated sufficiently and are due to correct when they enter the overbought/ oversold areas.
Oscillators also generate signals as leading indicators by suggesting a trend reversal in the form of divergence. A positive divergence occurs when the exchange rate declines and the indicator rises while a negative divergence is observed when the exchange rate rises and the indicator declines.
In some oscillators, centreline crossovers are also interpreted as buy/ sell signals. A crossover above the centreline from below is an indicative signal to buy while a cross-under the centreline from above is considered to be a sell signal.
Based on the types of signals, oscillators are segregated into
Frequently used oscillators-
1) Relative Strength Index (RSI)-
The relative strength index is a highly popular indicator. As an oscillator, it calculates current price strength to the previous day’s closing prices. RSI can be used to verify overbought/oversold levels, general entry/ exit points and indicate potential price reversals by displaying divergences. By default, RSI is calculated across a 14- day period.
2) Price oscillator (POSC)-
POSC charts the relationship between two moving averages (default: 14- day and 24 day). Buy signals are generated when the indicator moves above the zero line from below and the sell signals when the indicator moves below the zero line from above.
POSC also indicates positive and negative divergences
3) Moving average convergence divergence (MACD)-
MACD is employed to identify bullish/ bearish trends. The indicator is plotted as two trend lines based on two moving averages; 12- days and 26- days.
When a new trend occurs, the 12- day reacts first and crosses the 26- day moving average, signalling a cross- over. The 12- day then begins to diverge from the 26- day, often indicating that a new trend has formed.
4) Ultimate Oscillator (UOS)-
UOS is a momentum oscillator which captures momentum across three different timeframes; short, medium and long- term. This oscillator reduces the drawbacks of commonly used oscillators that rise at the beginning of a new trend but begin to form bearish signals even when prices continue to advance.
UOS generates buy/ sell signals, indicates overbought/ oversold levels and acts as a leading indicator by signalling divergences.
5) Trix oscillator-
Trix is a momentum oscillator that displays the rate of change of a triple exponentially smoothed M.A. The oscillator filters insignificant price movements that can often result in poor trading decisions. Buy signals are generated when the indicator crosses the horizontal line from below and sell if the indicator drops below the horizontal line from above.
Another way of using the indicator is to apply a signal line to prompt signals during cross- overs. Buy when the signal line crosses the TRIX line from below and sell if the signal line crosses the TRIX line from above.
6) Commodity Channel Index (CCI)-
CCI measures price in relation to its moving average. This indicator is similar to Bollinger bands without the upside and downside limits.
CCI determines overbought/ oversold levels in addition to divergences