Forex Investment and Currency Trading

Relax. Noting is especially scientific or particularly complicated about technical analysis. Many in the market use the term science to describe the mechanics of various technical tools, but technical analysis is far more art than science.

Each tool in technical analysis has a number of concrete elements that we need to outline before you can start interpreting what they mean. Unless you’re developing your own systematic calculations behind various indicators. Far more important is understanding what the indicators are measuring and what their signals mean and don’t mean.

Momentum oscillators and studies

Momentum refers to the speed at which prices are moving, either up or down. Momentum is an important technical measurement of the strength of the buying or selling interest behind a movement in prices. The higher the momentum in a down move, for example, the greater the selling interest is thought to be. The slower the momentum, the weaker the selling interest.

Currency traders use momentum indicators to gauge whether a price movement will be sustained, potentially developing into a trend, or whether a directional move has run its course and is now more likely to reverse direction. If momentum is positive and rising, it means prices are advancing, suggesting that active buying is taking place. If momentum begins to slow, it means prices are advancing more slowly, suggesting that buying interest is beginning to weaken. If buying interest is drying up, selling interest may increase.

Momentum takes on added significance in currencies because no viable way of assessing trading volume on a real-time basis exists. In equity and futures markets, volume data is an important indicator of the significance of a price move. For example, a sharp price movement on high volume is considered legitimate and likely to be sustained, while a similarly sharp move on low volume is discounted and viewed as ore likely to reverse.

Momentum indicators fall into a group of technical studies known as oscillators, because the mathematical representations of momentum are plotted on a scale that sees momentum rise and fall, or oscillate, depending on the relative speed of the price movements. A variety of different momentum oscillators exist, each calculated by various formulas, but they’re all based on the relationship of the currency price to preceding prices over a defined period of time.

Momentum oscillators are typically displayed in a small window at the bottom of charting systems, with the price chart displayed above, so you can readily compare the price action with its underlying momentum.

Fibonacci retracements based on the move down show resistance levels for the recovery higher. Note that 38% level held for while, but after it broke, prices moved to the 61.8% retracement level, before breaking and testing the 76.4%, where the recovery failed.

You can identify future support and resistance levels by drawing Fibonacci retracements of prior directional price moves on your charting system.

Overbought and oversold

Momentum oscillators have extreme levels at the upper and lower ends of the oscillator’s scale, where the upper level is referred to as overbought and the lower level is referred to oversold. No hard definitions of overbought and oversold exist, because they’re relative terms describing how fast prices have changed relative to prior price changes. The best way to think of overbought and oversold is that prices have gone up or down too fast relative to prior periods.

Many momentum indicators suggest trading rules based on the indicator reaching overbought or oversold levels. For example, if a momentum study enters overbought or oversold territory, and subsequently turns down or up and moves out of the overbought or oversold zone, it may be considered a sell or buy signal.

Just because a momentum indicator has reached an overbought or oversold level does not mean that prices have to reverse direction. After all, the essence of a trend is a sustained directional price movement, which could see momentum remain in overbought or oversold territory for a long period of time as prices continue to advance or decline in the trend. Momentum is only an indicator. They is to wait for confirmation from prices that the prior direction or tend has, in fact, changed.

Divergences between price and momentum

Another useful way to interpret momentum indicators is by comparing them to corresponding price changes. In most cases, momentum studies and price changes should move in the same direction. If prices are rising, for example, you would expect to see momentum rising as well. By the same token, if momentum begins to stall and eventually turn down, you would expect to see prices turn lower, too. But relatively frequently, especially in shorter, intraday timeframes (15 minutes, 1 hour, or 4 hours), prices diverge from momentum (meaning, prices may continue to rise even though momentum has started to move lower).

When prices move in the opposite direction of momentum, it’s called a divergence. Divergences are relatively easy to spot – new price highs are not matched by new highs in the momentum indicator, or new price lows are not matched by new lows in the momentum study. When a new price high or low is made, and momentum fails to make a similar new high or low, the price action is not confirmed by the momentum, suggesting that the price move is false and will not be sustained. The expectation, then, is that the price will change direction and eventually follow the momentum.

When prices make new highs, and momentum is failing or not making new highs, it’s called a bearish divergence (meaning, prices are expected to shift lower – move bearishly – in line with the underlying momentum). When prices are making new lows, but momentum is rising or not making new lows, it’s called a bullish divergence (meaning, prices are expected to turn higher – bullish – in line with momentum).

Divergences are great alerts that something may be out of kilter between prices and the underlying strength or momentum of the price move. Whenever you spot a divergence between price and momentum, you should start looking more closely at what’s happening to prices. Are stop-loss levels begin run in thin liquidity conditions? Or has some important news just come out that has sent price moving sharply, and momentum will eventually catch up?

In a trending environment, prices may continue to move in the direction of the trend (that’s what a trend is), but a t a slower price, causing momentum to diverge. To know for certain, you need to wait for confirmation from prices before you enter a trade based on a divergence.