$50
3 pips
$50
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Those new to trading forex may wonder why technical analysis works so well to predict future levels of exchange rates. They might question why just looking at the basic data of currency exchange rates or trading volume levels over time can have any predictive value whatsoever. They might also not understand how to use the various technical indicators that involve quantitatively assessing some aspect of how prices change, or why such indicators can yield useful trading signals.
This healthy sort of skepticism makes perfect sense to novice traders first exposed to the more advanced topic of technical analysis. Nevertheless, many more experienced forex traders swear by the effectiveness and efficiency of using technical analysis in predicting future forex rates. As a result, technical analysis has taken a permanent place aside fundamental economic analysis and economic indicators as an established way of looking at and forecasting future exchange rate movements.
An Explanation
Although many people have attempted to explain why technical analysis works, often in quite different ways, perhaps the best explanation arises from the idea that the exchange rates seen in the forex market represent the equilibrium point at which buying pressure equals selling pressure for the currency pair involved. If either buyers or sellers start to predominate, the rate will move appropriately.
Furthermore, the flow of information into the consciousness of the market’s many participants tends to occur efficiently as a result of news services and real-time pricing. As a result, the forex rates seen in the currency market respond rapidly to new economic and political events as they occur, and they even take into account or “discount” events that are rumored to be about to occur.
This means that the exchange rates observed soon discounts all of the available information pertaining to each currency pair, and the rates do this efficiently and on a continuous basis. This general concept underlies what a technical analyst intends to communicate when they say: “Price discounts all.”
Why Read the News?
Most personal forex traders do not have the time, information systems, background or inclination to be reading detailed economic reports, scanning news wires for the latest news flashes or constantly having their finger on the pulse of the market like a professional forex market-maker might need to. They generally want to have a life instead.
Using technical analysis can provide a workable solution for such armchair traders. All they have to do is make the reasonable assumption that all such available information gets quickly priced into the currency rates by the trading pros whose job it is to do so.
This really takes the pressure off when it comes to watching the news. Basically, the observed forex rate will most likely not change as one might expect based on the old news they have access to because the information has probably already been discounted by the market. As the saying goes, “Buy the rumor, sell the fact.”
Human Behavior Repeats Itself
Besides the assumption that the prevailing forex rates take into account all available relevant information, the other fundamental reason why technical analysis works has to do with the repeatability, and hence predictability, of human behavior when people act as a group. The crowd mentality seen operating in the currency marketplace tends to demonstrate certain patterns of behavior, which in turn show up visually in exchange rate movements plotted over time.
Since these observable rate patterns tend to repeat themselves time and time again, the results can help forecast the future behavior of exchange rates. While that may indeed be true, the trick to this form of technical analysis lies in correctly identifying which pattern the market is trading in.
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