The global daily turnover in the forex market was around $6.6 trillion in 2019. If you want a slice of the action, one tool you might consider using is technical analysis. But does it work in forex?
Technical analysis does work in forex. But success in predicting price movements may depend on various factors. One factor is the currencies traded. The technical tools chosen are another factor that can impact profitability. Also, the choice of trading strategies can affect returns.
If you’re not familiar with technical analysis, it can sound like mumbo jumbo. Terms like MACD, RSI, and Bollinger Bands, not to mention Ichimoku and Elliott waves, spring to mind. So, if you’re skeptic about technical analysis, you might find the evidence spotlighted below interesting.
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Table of Contents
What Is Technical Analysis in Forex?
For speculators and investors, technical analysis is a popular tool in forex markets. Of course, traditional fundamental analysis is another way to predict price movement. However, while they have the same aim, the methods of each analysis type differ.
Fundamental analysis in forex looks at economic, political, and social influences. In contrast, technical analysis in forex focuses on historical price information.
Technical analysis assumes that price already has the fundamentals baked in, and there isn’t any need to look at fundamentals when making buying and selling decisions.
So, how does technical analysis look at price information? Well, there are various ways in which technical traders use technical analysis.
Some look at price chart patterns. Others focus on technical indicators, which are mathematical derivatives of price.
Chart patterns you often hear about include head and shoulders and triangles. You may also have come across double bottoms and double tops. How about a cup and handle? Those are just a few.
Indicators include the MACD, RSI, and others mentioned above. But, there are many more from which to choose.
Who Uses Technical Analysis in Forex?
It might come as a surprise, but technical analysis in forex isn’t uncommon. Even the big players are in on the act.
A Bank of England survey from 1988 found it played a role in decisions made by 90% of chief forex traders who replied.
A later survey in 2001 found that 30% of US forex traders classed themselves as technical traders.
So, it seems clear that even the biggest players use technical analysis widely in forex.
How Do We Know Technical Analysis Works in Forex?
The topic has been the subject of much research through the years. And those studies reached different conclusions. But, most seem to come down in favor of the conclusion that technical analysis does work in forex.
While we’ve said above that technical analysis does work in forex, there are caveats.
For example, its effectiveness might depend on the currency you trade. Further, the technical tools you use and how you use them will also influence results.
What Technical Analysis Tools Work in Forex?
If we look through the research on the subject, we can get an idea of the strategies that seem to work.
However, bear in mind, just because something works over a period doesn’t mean it always gave positive results. There may be times when winning strategies start to fail.
Still, here are some of the technical tools that researchers have found work in forex:
Support and Resistance Levels As Reversal Points
A 2000 study, titled – ‘Support for Resistance: Technical Analysis and Intraday Exchange Rates’, looked at how well daily support and resistance levels worked in forex. The levels in question were ones that certain forex trading firms published. And they often varied across firms.
The study found that those levels were good indicators of intraday trend reversals. It noted that price bounced off some arbitrarily selected levels 56.2% of the time. However, prices bounced from those published by the firms in question 60.8% of the time.
In statistical terms, this difference was significant. It was unlikely to arise if the published support and resistance levels had no value.
So, this report is good evidence that support and resistance work in forex trading.
But performance varied across the firms. In other words, some firms were better at it than others.
Performance also differed across currencies. In this study, the yen seemed to react at the published levels more than the other currencies.
Chart Patterns – Piercing Line and Dark Cloud Cover
The piercing line and dark cloud cover patterns arise in Japanese candlestick charts. They denote potential turning points in markets.
You can get a good understanding of these patterns from the following clip:
A 2020 study, titled – ‘The profitability of technical analysis: Evidence from the piercing line and dark cloud cover patterns in the forex market’, of these patterns found some interesting results. It looked at these patterns in charts of twenty-four currency pairs between 2000 and 2018.
The study found that these two chart formations do work as reversal points in forex. But, of course, there were some caveats.
You Need To Get Your Strategy Right To Succeed
First, you have to use the right strategy to profit. In this case, the researchers found that using a 1:1 risk/reward ratio produced negative returns. In the study, this came out at a frightening -446%.
That’s not to say that the patterns lost money on all currency pairs. In fact, the patterns worked on eleven of the twenty-four pairs. The GBP/AUD stood out, returning 253% over the study period. It’s just that across all the currencies, there was a negative return on this risk/reward ratio.
In contrast, using a 2:1 risk/reward returned a total of 268%. That’s a vast improvement. Also, there were twelve profitable pairs within the basket of twenty-four. This return arose despite there being twice as many unprofitable trades.
The profitability increased even more with a 3:1 risk/reward strategy. At that level, there was a total return over the nineteen-years of 642%. This time, this was despite only one-third of trades being profitable.
Sometimes You’ll Lose
Second, the study found there were ups and downs in performance over the years under scrutiny.
This resulted in winning and losing years. So, there were some sustained winning streaks but sustained losing streaks also occurred. In particular, after a big losing year in 2001, six positive years followed. However, from 2008 until 2015, returns went into the red.
Technical Indicators
An extensive study in 2016, titled – ‘Technical Trading: Is it Still Beating the Foreign Exchange Market?’, applied technical analysis to thirty US dollar rates. The data covered forty-five years between 1971 to 2015.
It looked at over twenty-one thousand trading rules. The rules related to some of the most-often used technical indicators, as follows:
- Oscillators: Used to highlight overbought and oversold conditions that might reverse prices.
- Filter: A trend-following strategy. It involves buying or selling once the price rises or falls by a given amount.
- Moving averages: Used as trend-following indicators.
- Support-resistance: Used to find trend continuations rather than rebounds. The idea is the price should move in the direction of the break of a support or resistance level.
- Channel breakouts: Used to find support-resistance levels over time. Breaks suggest a continuation in the direction of the break
The researchers found that these technical indicators had statistically significant predictive value. And that was the case for twenty-six of the thirty currencies.
The best performing rules gave average annualized returns of 6.9%. This return was in developed currencies. There was an even more impressive return in emerging market currencies, where the average came in at 9.5%.
There were also differences in which technical rules performed best. For example, in developed currencies, moving average rules tended to do well.
In emerging currencies, filter and support-resistance rules gave the best returns. However, moving average strategies did well with risk-adjusted-performance.
But it’s important to note that performance varied between individual currencies. This highlights the need to select the right asset to trade, not just the right tools and strategies.
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Conclusion
As you can see, there is decent evidence that technical analysis does work in forex.
And it’s not just technical indicators, but price patterns can also work. The example we saw was the piercing line and dark cloud cover patterns.
But the studies that tell us technical analysis works in forex also provide a stark reminder. There’s no guarantee of success.
The studies highlight the risk of some significant losses. Much depends on the currency and the strategy chosen.
In other words, as with anything you do, you have to select the right tools for the job.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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