Copyright Alpha Markets Ltd. Page 12+(Analysis+Met… · overall economic health and stability, showing the percentage of overall unemployment. In principle, a country with low unemployment

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Analysis Methods - Module 2

Welcome to this unit on Analysis Methods. In this module we will be explaining the two different forms of analysis used by financial traders, as well as how to interpret currency charts in order to identify trading opportunities.

Key Learning Outcomes:

- To understand the two different types of analysis methods used by financial traders and how you can look to implement them when trading.

- To understand the various types of currency charts available for you to use, as well as how to interpret them in live market conditions.

- To understand the key principles of Support and Resistance and how it is used to identify various chart patterns.

- To understand some of the popular technical indicators used by financial traders, as well as how to interpret them when trading.

Page 2 Copyright Alpha Markets Ltd.

Analysis Methods

An analysis method refers to the tools or methods used by traders to analyse the financial markets in order to help predict future market movement.

There are two types of analysis used by financial traders:

Fundamental Analysis Technical Analysis

Fundamental Analysis

Fundamental Analysis is the study of the fundamental reasons as to why a currency should behave in a certain way. This is conducted by looking at the economic factors that can affect the change of a currency.

A country with strong economic growth can be a fundamental reason as to why a currency should rise in value.

In contrast a country with a declining economy or recession may be a fundamental reason as to why a currency should fall in value.

A variety of data releases can indicate the state of a country’s economy and can have a direct impact on the value of a currency.These include:

Reports Government Policy

News Announcements

Interviews


Let’s take a look at some of the main fundamental data releases that are likely to have a dramatic impact on the Forex market.

- Consumer Price Index (CPI)

The CPI is used to measure the change in price of goods and services that are purchased by consumers. This data release is considered important as it can affect inflation targets used by central banks, which are likely to then have an impact on a currencies value.

- Retail Sales

Retail sales is another data release which is likely to affect a currency’s value. It is a primary gauge of consumer spending, which accounts for the majority of overall economic activity

- Purchasing Managers Index (PMI)

The PMI is a leading indicator of economic health, including both services and manufacturing data. It is derived from monthly surveys of private sector companies.

- Unemployment Rates

Unemployment rates are an important signal and indication of overall economic health and stability, showing the percentage of overall unemployment. In principle, a country with low unemployment rates may be an indication that a currency should strengthen in value.

It is worth noting that Nonfarm Payroll is one of the biggest economic news announcements released concerning the US Dollar. It reveals the change in the numbers of employment during the previous month, excluding the farming industry. This announcement is released on the first Friday of every month and is likely to have a large impact on the US Dollar currency pairs and the Forex market as a whole.


Interest Rates

A country’s interest rates is one of the biggest factors in determining the perceived value of a currency and a change in this figure could have a dramatic impact on the Forex market.

High interest rates can be a fundamental reason as to why a currency may strengthen, as there is likely to be more investment in countries with higher interest rates.

A country with low interest rates can be an indication of a struggling economy and currency, as there is likely to be less investment over other countries.

These various fundamental news announcements we have mentioned can have an immediate impact on the Forex market, potentially causing volatility. It is therefore important for financial traders to be aware of when this fundamental news is due to be released so that they can manage their positions accordingly.

To do this we can use a fundamental news calendar:

(www.forexfactory.com)

The fundamental news calendar, as shown above, displays the news announcements due each day. This includes information as to what the announcement is, as well as the likely impact that it will have on the corresponding currency.

Financial traders can monitor this information and manage their trading positions according to the potential impact of a data release.


Technical Analysis

Technical Analysis is the study of historical price movement and patterns in order to help predict how a currency pair may potentially react in the future.

This involves analysing currency charts and technical indicators in order to gain a better understanding of the state of the markets at any given time. This is considered the most commonly used form of analysis by independent traders.

Currency Charts

A currency chart is a visual representation of the price of a currency pair over a certain period of time. The time period of the currency chart will be shown on the X axis, with the value of that currency shown on the Y axis in PIPs.

There are three types of currency charts available to financial traders:

Line Chart

The value in PIPs of a currency pair is represented in the form of a line as shown in this chart. The chart shows that the current value in PIPs of this currency pair is 1.6465.

Bar Chart:

The value in PIPs of a currency pair is represented in the form of bars as shown in this chart. A bar tells us more information about the movement in price within a certain period.


Candlestick Chart

The value in PIPs of a currency pair is represented in the form of candles as shown in this chart. A candle tells us more information about the movement in price within a certain period and is one of the more popular currency charts used by financial traders.

A candlestick provides us with four pieces of information and a greater visual indication of the state of the markets within a certain time period. Each individual candlestick will represent a certain time period, which we can stipulate.

For example; the following candle may represent 30 minutes within the markets.

This candlestick shows us the price at which the candle opened; the highest point price reached within that 30 minute period; the lowest point price reached ;and finally the closing price for that 30 minute period.

If the closing price of a currency pair is greater than the opening price it indicates that the value of the currency pair has increased and will be shown in green when configuring the Alpha template.

This candlestick shows us the price at which the candle opened; the highest point price reached within that 30 minute period; the lowest point price reached; and finally the closing price for that 30 minute period.

If the closing price of a currency pair is lower than the opening price it indicates that the value of the currency pair has decreased, and will be shown in red when configuring the Alpha template.

There are various different types of candlesticks that you may need to be aware of when trading the Forex market.


Full Bodied Candle:

A large full bodied candle, as shown in these examples, is an indication that there is a large volume of either buyers or sellers in the market.

Financial traders may look to capitalise on this movement and volume within the markets.

Hammer Candle:

A hammer and inverted hammer candlestick can signify a potential reversal in price movement shown by a rejection of their respective highs or lows.

Financial traders may look for these types of candlesticks to help predict when a currency trend may reverse.

Long Legged Doji:

A long legged Doji candlestick can suggest indecision within the Forex markets with no clear volume of either buyers or sellers.

Financial traders may look for these types of candlesticks to help determine the current market conditions.

Dragonfly & Gravestone Doji:

A dragonfly Doji shows that price has moved significantly lower, however, has rejected that low and closed at roughly the same price as the opening price.

A gravestone Doji shows that price has moved significantly higher, however, has rejected that high and has closed at roughly the same price as the opening price.


Trends

It is widely regarded that trading with the trend provides a higher probability of successful and repeatable trading opportunities. There are three types of trend that can be found within the Forex market.

By establishing a clear trend, also known as a directional bias, financial traders can then begin to profit from either a rising or falling market. Let’s now determine how financial traders can technically look to identify the trend of a market.

Uptrend:

In the example below we can see that price has moved higher over a period of time, meaning that the value of the currency pair has increased. By identifying a series of higher highs and higher lows, financial traders can clearly determine an uptrending market.


Downtrend:

In the example below we can see that price has moved lower over a period of time, meaning that the value of the currency pair has decreased. By identifying a series of lower highs and lower lows, financial traders can clearly determine a downtrending market.

Sideways Trend:

In the example below we can see that price has moved sideways and can be considered range bound. This is can be been seen as price is not making any significant higher highs or lower lows.


Support & Resistance

Support and Resistance is one of the most basic yet fundamental principles of technical analysis. It is an indication of a possible ‘floor’ or ‘ceiling’ within the markets, caused by crowd behaviour and driven by the emotions of greed and fear.

When price fails to break below a certain level, this can be an indication of support or a ‘floor’ within the markets. In contrast, when price fails to break above a certain level, this can be an indication of resistance or a ‘ceiling’ within the markets.

Support:

The following example shows a clear level of support, which price is unable to break below.

In principle, financial trades may look to buy or take a long position when price is supported.

Resistance:

The following example shows a level of resistance, which price is unable to break above.

In principle, financial trades may look to sell or take a short position when price is at a level of resistance.


Break of Support & Resistance

When price breaks a clearly defined support or resistance level, there is likely to be a strong reaction by market participants. There is likely to be a surge in either buyers or sellers, with the previously broken level now acting in the opposite direction.

If price breaks a clearly defined support level, as shown above, there is likely to be a surge of sellers driven by the emotion of fear causing price to fall in value. The previously broken support level is now likely to act as a new resistance level, which price is then unable to break above.

In the example above, we can clearly identify a support level which price is unable to break below on several occasions. When price finally breaks the support level there is a surge of sellers, as signified by the large full bodied red candlesticks. The previous support level then acts as a new resistance level, which price is then unable to break above.

It is worth noting that the same principle applies in reverse, when price breaks a resistance level.


Chart Patterns

When analysing the financial markets, traders may look to identify Chart Patterns in order to establish the state of the markets at any given time. These include:

Reversal Pattern

A reversal pattern may be an indication that an established trend has finished and therefore a possible new trend may be developing.

For example, if a currency pair was in an uptrending market, financial traders may look for a reversal pattern to suggest a new downtrend may develop, so that they can then profit on the newly established trend.

Consolidation Pattern

A consolidation pattern suggests uncertainty within the markets and is an indication that volume within the markets is decreasing. There is likely to be a reaction when price breaks out of this consolidation.

These consolidation patterns can occur towards the end of key market sessions as the volume in market participants decreases.

Continuation Pattern

A continuation pattern is similar to a consolidation pattern and is usually identified within an established trend. This pattern suggests that when price breaks out of the consolidation pattern it is likely to continue in same direction as the overriding trend.

Again these patterns are likely to occur towards the end of key market sessions as the volume in market participants decreases.


Double Top (Reversal Pattern):

A double top is a reversal pattern created when price fails to break above a clearly defined resistance level on two separate occasions. This chart pattern suggests that an uptrend has finished and a new downtrend is likely to develop.

(1)

(2)

(3)(4)

1) Firstly we can see that there is a clearly established uptrend where buyers are in control, driving the value of the currency pair higher.

2) Price then hits a level of resistance on two separate occasions creating the double top chart formation pattern, as shown by the highlighted circles.

3) The next level to identify is known as the neckline level, which is the lowest point price has reached between the double top pattern as shown by the line. If price then breaks below the neckline, it would act as confirmation of the newly established downtrend.

4) The chart then shows how price has broken the neckline level acting as confirmation that a new downtrend has developed. Sellers then enter the market causing the value in price to decrease on that currency pair.


Double Bottom (Reversal Pattern):

A double bottom is a reversal pattern created when price fails to break below a clearly defined support level on two separate occasions. This chart pattern suggests that an old downtrend has finished and a new uptrend is likely to develop.

(1)

(2)

(3) (4)

1) Firstly we can see that there is a clearly established downtrend where sellers are in control, driving the value of the currency pair lower.

2) Price then hits a level of support on two separate occasions creating the double bottom chart formation pattern, as shown by the highlighted circles.

3) The next level to identify is known as the neckline level, which is the highest point price has reached between the double bottom pattern as shown by the line. If price then breaks above the neckline, it would act as confirmation of the newly established uptrend.

4) The chart shows how price has broken above the neckline level acting as confirmation that a new uptrend has developed. Buyers then enter the market causing the value in price to increase on that currency pair.


Triple Top (Reversal Pattern):

A triple top is a reversal pattern created when price fails to break above a clearly defined resistance level on three separate occasions. This chart pattern suggests that an uptrend has finished and a new downtrend is likely to develop.

(1)

(2)

(3)

(4)

1) Firstly we can see that there is a clearly established uptrend with buyers in control and driving the value of the currency pair higher.

2) Price then hits a level of resistance on three separate occasions creating the triple top chart formation pattern, as shown by the highlighted circles.

3) If price then breaks below the neckline, it would act as confirmation of the newly established downtrend.

4) The chart then shows how price has broken the neckline level acting as our confirmation that a new downtrend has developed. Sellers then enter the market causing the value in price to decrease on that currency pair.

The same concept applies in reverse in what’s known as a triple bottom chart pattern.


Rectangle (Consolidation / Continuation Pattern):

A rectangle is a consolidation pattern created when the volume of both buyers and sellers within the market decreases. This chart pattern can suggest uncertainty within the markets and financial traders may look for price to break out of a consolidation before entering a trade.

(1)

(2)

(3)

1) Firstly we can see that there is a clearly established downtrend whereby sellers are in control driving the value of the currency pair lower.

2) We can then identify a period of consolidation in the form of a rectangle pattern. This chart pattern indicates that the volume of buyers and sellers has decreased in value and is ‘boxed in’ between a support & resistance level. This pattern can typically occur towards the end of a key market session.

3) Price then breaks out of this consolidation pattern in the continued direction as the overriding trend. Typically, there is likely to be a strong reaction as price breaks out of the rectangle pattern.

It is worth noting that the same concept can apply in reverse in an uptrending market.


Triangle (Consolidation / Continuation Pattern):

A triangle is a consolidation pattern created when the volume of both buyers and sellers within the market decreases. This chart pattern can suggest uncertainty within the markets and financial traders may look for price to break out of a consolidation before entering a trade.

(1)

(2)

(3)

1) Firstly we can see that there is a clearly established downtrend whereby sellers are in control driving the value of the currency pair lower.

2) We can then identify a period of consolidation in the form of a triangle pattern. This chart pattern indicates that the volume of buyers and sellers has decreased in value, and is ‘boxed in’ between a support & resistance level. This pattern can typically occur towards the end of a key market session.

3) Price then breaks out of this consolidation pattern in the continued direction as the overriding trend. Typically, there is likely to be a strong reaction as price breaks out of the rectangle pattern.

It is worth noting that the same concept can apply in reverse in an uptrending market.


Technical Indicators

Technical Indicators are tools used by financial traders to help get a better understanding of how and why price may react at certain levels. These indicators can also be used to help determine when to enter and exit a trade.

Some of the more popular technical indicators include:

Moving Averages:

A moving average is a lagging indicator showing the average price of a currency pair over specific time frames or periods. Financial traders can stipulate the parameters of a moving average, which will then be automatically drawn on our currency chart or platform.

There are two types of moving averages that can be used when trading.

- Simple Moving Average (SMA)

An SMA is automatically calculated by adding up the closing price of the last ‘X’ number of candles and then dividing that figure by ‘X’. The following example shows two moving averages on one timeframe, which can be used to help determine both the long term trend and short term trend.


- Exponential Moving Average (EMA)

An EMA is similar to an SMA, however, it puts more emphasis on the most recent price action. The following example clearly shows the difference between both the 60 EMA and the 60 SMA when plotted on the same chart. The 60 EMA has more emphasis on the most recent price action or movement and is used by many financial traders in order to reflect a clearer market value when compared to the SMA.

Financial traders can use multiple moving averages on a single chart timeframe as they can help provide a visual indication of both shorter term and longer term trends. The Alpha Markets Chart Template uses three moving averages plotted on a 30 minute chart.

10 EMA (Black) - shows us the 15 minute trend of the last

20 candles

40 EMA (Yellow) - shows us the 1 hour trend of the last 20

candles

160 EMA (Red) - shows us the 4 hour trend of the last 20

candles

When the moving averages are aligned in the order shown above, it is a clear reflection of an uptrending market. However, if the moving averages were aligned in the reverse order, it can be a clear indication of a downtrending market.


Moving Average Crossover

When two moving averages cross it can act as an initial indication that a potential change in trend may be developing and therefore acts as an alert.

In the following example, the crossover of the 1 hour 20 (40 EMA) below the 4 hour 20 (160 EMA) is alerting us to the potential new downtrend.

(1)

(2)

(3)

1) Firstly we can identify an uptrending market as price is making higher highs and higher lows with buyers in control.

2) We are alerted to a possible new downtrend as the 1 hour 20 crosses below the 4 hour 20 moving average.

3) A new downtrend then develops as price starts making lower highs and lower lows.


In the following example the crossover of the 1 hour 20 (40 EMA) above the 4 hour 20 (160 EMA) is alerting us to the potential new uptrend.

(1)

(2)

(3)

1) Firstly we can identify a downtrending market as price is making lower highs and lower lows with sellers in control.

2) We are alerted to a possible new uptrend as the 1 hour 20 crosses above the 4 hour 20 moving average.

3) A new uptrend then develops as price starts making higher highs and higher lows.

Financial traders can use these moving average crossovers as potential alerts to newly developing trends. These distinct visual alerts enable traders to identify trading opportunities in a newly established trend.

Moving Averages - Support & Resistance

Previously in technical analysis we explained how support and resistance can affect the Forex market as price is unable to break above or below a certain level. Moving averages can also act as potential support or resistance levels from which price may react.

Therefore, financial traders can look to combine chart patterns with moving averages, when seeking to identify clearly defined support or resistance levels.


In the following example we can see how the 4 hour 20 (160 EMA) moving average is acting as a support level under which price is unable to break below on numerous occasions. Financial traders can look to use these support levels to help determine possible entry and exit points in a trade.

In the example below we can see how both the 1 hour 20 (40 EMA) and the 15 minute 20 (10 EMA) moving averages are acting as a resistance level from which price is unable to break above on numerous occasions.


Pivot Points

A pivot point is a leading indicator used to gauge market sentiment. It is calculated by using the open, high, low and close of a previous trading session.

The Alpha Markets Chart template uses a daily pivot, which is represented by the pink line in the example below.

The daily pivot (DP) helps traders to determine the market sentiment for each day. It is calculated by adding the open, high, low and close of the previous day’s trading session and dividing that figure by four.

Price above daily pivot - sentiment is positive

Price below daily pivot - sentiment is negative

It is worth noting that each step of the daily pivot represents one day’s trading range and is reset by your platform at 10pm UK time.

Daily Pivot - Support & Resistance

Daily Pivot, as well as other pivot points, can also act as support or resistance levels, which if broken, are likely to cause a reaction from market participants.


In the following example we can see that there is a strong reaction when price breaks below the daily pivot, resulting in a large volume of sellers. This demonstrates that when price breaks a support or resistance level there is likely to be a predictable reaction.

The same concept applies in reverse, as shown in the example below. Here we can see price has broken above the daily pivot resistance level resulting in a large volume of buyers. The daily pivot indicator then acts as a support level, which price is unable to break below, as highlighted.


Oscillators

An oscillator is used to gauge an indication of momentum, allowing financial traders to determine when price is trading at overbought or oversold levels.

In principle when a product is considered overbought - also known as over-valued - it may be considered the right time to sell that product.

In contrast when a product is considered oversold - also known as under-valued - it may be considered the right time to buy that product. The same principle can be applied to the financial markets.

The Alpha Markets Pro Chart Template uses what is known as the stochastic indicator, as shown below. There are five numbers to be aware of when using this indicator.

When price is trading close to the 80 or 100 level as highlighted, price may be considered overbought. In contrast, when price is trading at the 20 or 0 level as highlighted, price may be considered oversold. Financial traders can use this indicator to help gauge momentum within the markets.


The stochastic indicator will be displayed at the bottom of the charting platform when configured using the Alpha Template.

When price is trading at an oversold level, highlighted in green, this may be an indication to buy a currency pair.

In contrast, when price is trading at an overbought level, highlighted in red, financial traders may consider this an indication to sell a currency pair.

It is worth noting that financial traders may not base their decision on whether to buy or sell a currency pair on one indicator alone. However, by combining the various different indicators discussed so far, traders can begin to seek higher probability trading opportunities.


Fibonacci Indicator

Fibonacci was a famous Italian mathematician who discovered that there was a series of naturally occurring patterns and ratios that could be found throughout nature.

These same ratios can be applied when trading the financial markets as they can be used to provide a powerful indication of support or resistance levels.

There are many different ratios that can be applied, however the Alpha Markets Chart Template utilises the 38.2%, 50% and 61.8% Fibonacci levels.

Financial traders would manually apply the Fibonacci indicator to their charts in order to determine potential support or resistance levels from which price may pullback towards after a significant move within the markets.

In this example we can see that price has decreased in value and has therefore moved significantly lower.

To use the Fibonacci indicator, you would manually apply it from the swing high (point A) to the swing low (point B).

The software will then automatically plot the three Fibonacci levels onto our charting platform.

Price has then pulled back or retraced towards these ratios, acting as resistance, before continuing lower with the trend.

To help determine which Fibonacci level is likely to act as support or resistance, we can use our other indicators which are likely to also act as support or resistance.


In the example below price has moved significantly higher, increasing in value with buyers are in control. Financial traders could apply the Fibonacci Indicator to the chart in order to determine potential support levels for price to pullback towards.

The indicator will then automatically draw the three Fibonacci levels onto our charts, as shown below. We can then see how price has pulled back or retraced towards the 38.2% Fib level which then acts as support. Price then continues higher with the overriding trend.


Combining Technical Analysis

By using the elements of technical analysis and the various indicators that we have discussed, financial traders can start to build a higher probability overview of how price may react at certain levels.

The example below shows how we can combine the various elements of technical analysis in order to gain a better understanding of how price is likely to react at certain levels.

- In this example the double bottom chart pattern signifies that the previous downtrend has come to an end and therefore a new uptrend has been established when price breaks above the neckline level.

- Previously the 1 hour 20 (40 EMA) and the 4 hour 20 (160 EMA) were aligned signifying a downtrending market. The 1 hour 20 then crosses above the 4 hour 20 acting as an alert. This combined with the double bottom chart pattern indicates the probability of a new uptrend developing.


- By also analysing the daily pivot indicator, we can determine that prior to the cross over of the moving averages, sentiment was negative as price was trading below DP. However, as price breaks the neckline level, causing the cross over of the moving averages, sentiment is then positive.

By combining these various aspects of technical analysis, including chart patterns and technical indicators, financial traders can identify a high probability that a new uptrend has been established.

- In the example above, we can clearly identify a triple top chart formation as price has hit a strong level of resistance. This chart pattern signifies that a previous uptrend has come to an end and a new downtrend is likely to develop.

- Previously the 1 hour 20 (40 EMA) and the 4 hour 20 (160 EMA) were aligned signifying a uptrending market. The 1 hour 20 then crosses below the 4 hour 20, acting as an alert. This combined with the triple top chart pattern indicates the probability of a new downtrend developing.

- By also analysing the daily pivot indicator, we can determine that prior to the cross of the moving averages, sentiment was positive as price was trading above DP. However as price breaks the neckline level, causing the cross over of the moving averages, sentiment is then negative.

When combining all of these technical analysis techniques, financial traders can identify a high probability that a new downtrend has been established.


Analysis Methods - Summary

- Fundamental analysis is the study of the economic factors that can affect a currency’s value, conducted through various data releases and interviews.

- Technical analysis primarily focuses on the study of currency charts and involves establishing patterns and trends within the markets.

- Support and Resistance is a key principle of technical analysis and a break of these levels is likely to cause an impact on a currency pair’s value with a surge in either buyers or sellers.

- There are various indicators used by financial traders including moving averages, pivot points, oscillators and the Fibonacci indicator. These indicators help us gain a better understanding of the state of the markets, as well as help us identify potential levels to enter a trade.

- By combining the various analysis methods and principles discussed, financial traders can look to create a higher probability trade plan and understanding of how the markets are likely to react at certain levels.

Documents

Copyright Alpha Markets Ltd. Page 12+(Analysis+Met… · overall economic health and stability, showing the percentage of overall unemployment. In principle, a country with low unemployment