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Why is the foreign exchange market the best market to use technical analysis?The foundation behind using technical analysis is to find trends when they first develop, which allows the trader to ride the trend until it ends. The foreign exchange market is typically composed of trends and is, therefore, a place where technical analysis can be effective. Traders are able to speculate on both up and down trends in the foreignexchange market because it is possible to buy a currency and sell against another currency. This aspect of currency trading works well with technical analysis, because technical analysis helps determine where the trends are and which way they are going, thus giving the trader a chance of profiting from the market, regardless of its direction.In comparison to the equities and futures markets, technical analysis is much more common and popular within the foreign exchange markets, which causes the traders to pay attention. The market partly moves because of all the technical analysis performed.For example, according to technical analysis, if a currency pair decrease, then the majority of traders will sell the pair, causing it to drop further.Support and ResistanceAt the core of all technical analysis theory are two very simple concepts: support and resistance. Support can be defined as a “floor” through which the currency pair has trouble falling below. There is no scientific formula for calculating support; it is something that is typically “eyeballed” by traders, and hence involves somewhat of asubjective element.Resistance, on the other hand, is simply the opposite: it is the upper boundary through which a currency pair has trouble breaking. Similar to support, resistance levels are somewhat subjective. Generally, if the market reaches a certain number of times and cannot sustain a break above that level; it can be identified as resistance. The reason why price has trouble breaking these levels is the presence of actual orders around these levels. A support level is simply a price area where buy orders tend to be, and so it takes more than normal selling pressure to break that level. Similarly, a resistance level is a price area where sell orders tend to be, and so it takes more thannormal buying pressure to break that level.Support and Resistance in Range-bound Markets One simple way to use support and resistance in trading is to simply trade the range: in other words, traders can simply buy at support level, and sell at resistance level. A keyadvantage of this is that the FX market is range-bound a majority of the time, making it an attractive strategy for many market conditions.The downside of range-bound trading, though, is twofold:Range-bound trading generally does not yield substantial gains on a per-trade basis. When the market breaks out of the range, it often will make big moves. As a result, traders using range-bound strategies can suffer large losses when the market breaks out of the range.The chart below illustrates the concept of range-bound trading.Support and Resistance in Momentum MarketsAnother way to use support and resistance is to trade outside of the range; in other words, to anticipate a breakout. This involves placing orders to buy above resistance and to sell below support. The rationale is that the market will gain momentum once it breaks out of the range, and thus by placing orders just below or above of support or resistance, traders may be able to profit if the market continues to move out of the range and they are on theright side of the market. Momentum trading is a bit counter-intuitive, as it involves buying at a higher price and selling at a lower price.Below is a chart that illustrates the concept of momentum trading.OscillatorsOscillators are a class of mechanical trading tools that offer indications of when a currency pair is overbought or oversold. A popular oscillator is the Relative Strength index.Relative Strength IndexThe relative strength index (RSI) is a momentum indicator that measures a currency pair's strength relative to its won recent past performance. As the indicator is front-weighted (more importance is given to the most recent data), it typically provides a better velocity reading than other oscillators. RSI is less affected by sharp movements, and filters out a lot of "noise" in the Forex market. Many traders also use this indicator as a substitute for volume confirmation, since the over-the-counter structure of the FX market does not allow for real-time volume reporting.The basic formula for calculating RSI is as follows:100-[100/ (1+U/D)]U = average of upward price changeD = average of downward price changeTo obtain U (or D), add closing values for the up (down) days anddivide this total by the time period under study.RSI's levels are between 0 and 100. Most traders use 30 as an oversold condition and 70and as overbought condition, although some traders may use 20 and 80. When choosingthe settings for RSI, traders should typically use the default time period of 14, since thatis what the market as whole tends to look at.There are five different uses for RSI:Top and Bottoms - Overbought and Oversold conditions are usually signaled at30 and 70.
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