Forex Tips - Technical Analysis And Mass Psychology - How To Be One Step Ahead Of Others
A lot has been written about the effectiveness of technical analysis in trading. The academic community, for instance, has not accepted technical analysis as a scientific discipline. Fundamental analysis supporters also refuse to recognize it as a valuable trading tool.
And still, technical analysis is the most common used approach to trading, especially when it comes to forex trading. The liquidity and versatility of the forex market make it a paradise for "technicians". Technical analysis is also the basis of many automated forex trading systems. The question is whether technical analysis is indeed the right way to trade the forex market?
Well, I think that a good forex trader should know every aspect of trading, and that includes fundamental analysis. Economic forces influence the relatively strength of each currency and it is essential to be familiar with them. At the same time, technical analysis, which focuses on the price (in forex- the ratio between two currency pairs) is also important at least for one major reason - it reflects the state of mind of the mass in every given moment. For example, support and resistant levels actually create a psychological area. When support or resistant level is penetrated, the psychological barrier falls and the mass push the market in the same direction (up or down). In many cases, the price is stopped exactly at the level of a previous swing high (potentially creating a double top pattern) or swing low (double bottom).
Another commonly seen phenomenon is a support line turns into a resistance line and vice versa. Here is, for example, the GBP/USD 4H graph of May 19, 2008 (link to illustration graph is at the end of this article).
See how the red resistance line turns into a strong support.
Is this a mere coincidence? Probably not. The mass first identified the red line as a resistance area and promptly after the resistance has been penetrated, the same line remains and becomes support. So a critical mass of traders gave this line exactly the same meaning (first - resistance then- support) and a "collective mind" has been born. This "collective mind" is now keeping the spot above the support, at least for a while and long enough for smart traders to identify the opportunity and exploit it for making money.
Graphs always tell us a story. We only need to understand the psychology of the crowd behind them and act accordingly. It is not an easy task. Some say reading the graphs is a combination of art and science which takes years to master. All true, but by trying to understand the psychology of the mass one can gradually develop a habit of being always one step ahead of the herd.
GPB/USD 4H illustration graph.
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Added: May 24, 2008
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