The primary task of technical analysis of financial markets in general and the Forex market in particular is finding a trend on a plotted chart. The Dow theory discerns three types of trends: long-term, medium-terms and short-term trends. The type of a trend depends on the scale of the chart at hand. If it is a trend found on a monthly chart, then it is considered a long-term trend. If it is a weekly or a daily chart that we analyze, a trend on them is a medium-range one. Short-term trends can be seen on hourly or minute charts.
Regardless of the type, each trend can be either ascending (rising, bullish, or uptrend) or descending (declining, bearish, or downtrend). A market can also display absence of a trend (a sideways) when the bull and bear momentums are equalized for a period of time, and the price has no pronounced ascending or descending dynamics.
Forex currency rates are ever-changing in wave-like fluctuations. The wave charts always clearly show local (or ‘swing’) lows and highs. The price in the swing low determines a horizontal line called the support level, and in the swing high, the resistance level.
The support and resistance levels are very important for technical analysis of the Forex market. The more often the price returns to a certain level, the more significant the level is for the market. This has to do with trading psychology that attaches more importance to a level that is reaffirmed with time by the price returning to it. As it often happens, a broken out support level becomes a new resistance level, and vice versa.
The first level from the bottom is the support level and was confirmed twice by the market. The same applies to the second level from the bottom. Please note that at different points in time the third level from the bottom is first the resistance level, then the support level. The fourth level from the bottom is the resistance level and was twice confirmed by the market as well.
Importantly, the support and resistance levels are not exact values, and determining them is a work of creation. It is up to each trader to decide which level determining criteria to use. A level is considered to be broken out if the closing price of a trading period did it. Historical data of Forex currency quotes, though, shows many examples of a closing price breaking out a level only to return to it in the trading sessions to follow. Therefore, a level breakout by itself does not represent a signal to buy or sell; the same signals need to be received from other technical analysis tools. To trade on Forex successfully, use a combination of technical analysis tools.
If we connect two consecutive lows of a chart (the points that correspond to the support levels) and obtain a line with a positive slope ratio (from the left bottom corner to the right top corners of the chart), the line is called a support line of an uptrend. If the subsequent lows are also located on this line, it becomes more significant to the market. The more lows are located near the support line, the higher the probability that the subsequent lows would also be located near the line.
Essentially, the support line determines an ascending trend. A breakout of this line may signal a trend reversal and as such is much more important than breakouts of levels. Remember the catchphrase we have mentioned earlier, “the trend is your friend". The ability to promptly recognize a trend reversal is the key to successful trading on Forex or any other financial market.
Beside trends, technical analysis makes extensive use of channels. A channel is a corridor within which the price oscillates. To determine a channel of an uptrend, another line is plotted through the chart’s high in parallel to the support line. Both these lines (the support and the parallel one) determine the up channel. To profit on Forex, currency needs to be bought on the lower border of the channel and sold on the upper border. Caution is advised, however, since the price approaching the channel border may break out the line instead of bouncing off it. This is when the trend reverses, and you may sustain losses. Therefore, beside determining the channel itself, make use of other technical analysis tools that signal trend validation or reversal.
A downtrend is established in a similar manner. If we connect two consecutive highs of a chart (the points that correspond to the resistance levels) and obtain a line with a negative slope ratio (from the left top corner to the right bottom corners of the chart), the line is called a resistance line of a downtrend. It essentially determines a descending trend. If another line is plotted through the chart’s low in parallel to the resistance line, these two lines would determine a down channel.
Trading in the down channel makes use of the same principles as when trading in the up channel – buy the currency on the lower border of the channel and sell on the upper border. Bear in mind that the downtrend will reverse sooner or later, so it is important to look out for a trend reversal signal.
As was mentioned earlier, the market may display absence of a trend. In such a case the price still oscillates but it is impossible to determine the support line of an uptrend or the resistance line of the downtrend. On the chart, this is represented with a horizontal range (sideways channel) and plotted with two parallel horizontal lines within which the price oscillates.