Chapter 1: Chart Analysis Fundamentals
Module 1: Technical Analysis Foundations
Chapter 1: Chart Analysis Fundamentals
Introduction
Welcome to the first chapter of your journey into technical analysisA method of forecasting future price movements based on the study of historical price data, charts, and indicators.! In this chapter, we will explore the fundamental building blocks that form the foundation of all technical analysisA method of forecasting future price movements based on the study of historical price data, charts, and indicators. in forex trading. Think of these concepts as the alphabet you need to learn before you can read and write in the language of the markets.
Technical analysisA method of forecasting future price movements based on the study of historical price data, charts, and indicators. is the study of price movements and patterns on charts to predict future price behavior. Unlike fundamental analysisA method of evaluating currencies by analyzing economic, social, and political factors that may influence their supply and demand., which looks at economic factors, technical analysisA method of forecasting future price movements based on the study of historical price data, charts, and indicators. focuses only on price action and chart patterns. The core belief of technical analysisA method of forecasting future price movements based on the study of historical price data, charts, and indicators. is that “price reflects everything” – meaning all known information about a currency pairTwo currencies quoted together, showing the relative value of one against the other (e.g., EUR/USD). is already reflected in its price.
By the end of this chapter, you will understand the different types of charts used in forex trading, how to select appropriate timeframes, identify supportA price level where buying interest is strong enough to prevent the price from falling further. and resistanceA price level where selling pressure is strong enough to prevent the price from rising further. levels, analyze trends, recognize basic chart patterns, and understand the role of volume in your analysis.
Types of Charts and Their Applications
Charts are the canvas on which price movements are displayed. Different chart types show price information in different ways, each with its own advantages.
Candlestick Charts
Candlestick charts are the most popular chart type among forex traders. Each “candle” shows four important price points for a specific time period:
- Open: The price at the beginning of the time period
- Close: The price at the end of the time period
- High: The highest price reached during the time period
- Low: The lowest price reached during the time period
The rectangular part of the candle (called the “body”) shows the open and close prices. If the close is higher than the open, the body is usually colored green or white (bullish). If the close is lower than the open, the body is usually colored red or black (bearish).
The thin lines extending from the top and bottom of the body (called “wicks” or “shadows”) show the high and low prices.
Candlestick charts are excellent for seeing price action clearly and identifying patterns that may signal reversals or continuations in price movement.
Bar Charts
Bar charts (also called OHLC charts – Open, High, Low, Close) display the same four price points as candlestick charts but in a different format:
- A vertical line shows the high and low prices
- A small horizontal line on the left shows the opening price
- A small horizontal line on the right shows the closing price
Bar charts provide the same information as candlestick charts but in a more compact form. Some traders prefer bar charts because they can display more price data in the same space.
Line Charts
Line charts are the simplest chart type, showing only the closing price for each time period. These points are connected by a line to show the overall price movement.
While line charts provide less information than candlestick or bar charts, they can be useful for:
- Getting a clean view of the overall price trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend). without the “noise” of intraday movements
- Identifying key supportA price level where buying interest is strong enough to prevent the price from falling further. and resistanceA price level where selling pressure is strong enough to prevent the price from rising further. levels more easily
- Seeing the big picture when analyzing longer timeframes
Renko Charts
Renko charts filter out minor price movements and focus only on significant price changes. Unlike time-based charts, Renko charts create a new “brick” only when price moves a predetermined amount.
- A new up brick is created when price rises by the brick size amount
- A new down brick is created when price falls by the brick size amount
- No new bricks are created during periods of sideways movement
Renko charts are excellent for:
- Filtering out market noise
- Clearly identifying trends
- Reducing false signals
- Focusing on significant price movements
Timeframe Selection and Significance
The timeframe you choose for your charts has a significant impact on your analysis and trading decisions. Each timeframe shows a different perspective of the market.
Common Timeframes in Forex Trading
- Long-term timeframes: Monthly (MN), Weekly (W1)
- Medium-term timeframes: Daily (D1), 4-Hour (H4)
- Short-term timeframes: 1-Hour (H1), 30-Minute (M30), 15-Minute (M15)
- Very short-term timeframes: 5-Minute (M5), 1-Minute (M1)
Choosing the Right Timeframe
Your choice of timeframe should depend on:
- Your trading style:
- Long-term investors: Monthly, Weekly, Daily
- Swing traders: Daily, 4-Hour
- Day traders: 4-Hour, 1-Hour, 30-Minute
- Scalpers: 15-Minute, 5-Minute, 1-Minute
- Available trading time:
- If you can only check charts occasionally, use longer timeframes
- If you can monitor charts continuously, shorter timeframes may be suitable
- Personality and psychology:
- Longer timeframes typically involve fewer but larger trades
- Shorter timeframes involve more frequent but smaller trades
Remember that shorter timeframes contain more “noise” (random price movements), while longer timeframes filter out this noise and show more reliable patterns and trends.
Support and Resistance Identification Techniques
SupportA price level where buying interest is strong enough to prevent the price from falling further. and resistanceA price level where selling pressure is strong enough to prevent the price from rising further. are fundamental concepts in technical analysisA method of forecasting future price movements based on the study of historical price data, charts, and indicators.. They represent price levels where the currency pairTwo currencies quoted together, showing the relative value of one against the other (e.g., EUR/USD). has historically had difficulty moving beyond.
What is Support?
SupportA price level where buying interest is strong enough to prevent the price from falling further. is a price level where buying interest is strong enough to overcome selling pressure, causing the price to stop falling and potentially reverse upward. Think of supportA price level where buying interest is strong enough to prevent the price from falling further. as a “floor” that prevents prices from falling further.
SupportA price level where buying interest is strong enough to prevent the price from falling further. levels form because:
- Buyers see value at that price level
- Previous sellers may be taking profits
- Psychological price levels (like round numbers) attract buyers
What is Resistance?
ResistanceA price level where selling pressure is strong enough to prevent the price from rising further. is a price level where selling interest is strong enough to overcome buying pressure, causing the price to stop rising and potentially reverse downward. Think of resistanceA price level where selling pressure is strong enough to prevent the price from rising further. as a “ceiling” that prevents prices from rising further.
ResistanceA price level where selling pressure is strong enough to prevent the price from rising further. levels form because:
- Sellers see value at that price level
- Previous buyers may be taking profits
- Psychological price levels attract sellers
How to Identify Support and Resistance
- Historical Price Levels: Look for areas where price has reversed multiple times in the past.
- Swing Highs and Swing Lows:
- Swing highs (local peaks) often become resistanceA price level where selling pressure is strong enough to prevent the price from rising further. when price approaches them from below
- Swing lows (local valleys) often become supportA price level where buying interest is strong enough to prevent the price from falling further. when price approaches them from above
- Round Numbers: Prices ending in 00 or 50 (like 1.2000 or 1.2050) often act as psychological supportA price level where buying interest is strong enough to prevent the price from falling further. or resistanceA price level where selling pressure is strong enough to prevent the price from rising further..
- Previous SupportA price level where buying interest is strong enough to prevent the price from falling further. Becoming ResistanceA price level where selling pressure is strong enough to prevent the price from rising further. (and vice versa): When price breaks through a supportA price level where buying interest is strong enough to prevent the price from falling further. level, that level often becomes resistanceA price level where selling pressure is strong enough to prevent the price from rising further. in the future. Similarly, broken resistanceA price level where selling pressure is strong enough to prevent the price from rising further. often becomes supportA price level where buying interest is strong enough to prevent the price from falling further..
- Trendlines: Drawing lines that connect multiple swing lows (for uptrend supportA price level where buying interest is strong enough to prevent the price from falling further.) or swing highs (for downtrend resistanceA price level where selling pressure is strong enough to prevent the price from rising further.).
Strength of Support and Resistance
Not all supportA price level where buying interest is strong enough to prevent the price from falling further. and resistanceA price level where selling pressure is strong enough to prevent the price from rising further. levels are equally strong. The strength depends on:
- Number of touches: The more times price has respected a level, the stronger it is
- Timeframe: Levels on higher timeframes are generally stronger than those on lower timeframes
- Volume: Higher volume at a level indicates stronger supportA price level where buying interest is strong enough to prevent the price from falling further./resistance
- Recency: More recent levels tend to be more relevant than older ones
- Psychological significance: Round numbers or significant percentage retracements
Trend Analysis Fundamentals
A trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend). is the general direction in which a currency pair’s price is moving. Identifying trends is crucial because trading with the trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend). typically offers higher probability setups.
Types of Trends
- Uptrend: Characterized by higher highs and higher lows. Each peak is higher than the previous peak, and each valley is higher than the previous valley.
- Downtrend: Characterized by lower highs and lower lows. Each peak is lower than the previous peak, and each valley is lower than the previous valley.
- Sideways/Ranging Market: No clear directional movement. Price oscillates between relatively horizontal supportA price level where buying interest is strong enough to prevent the price from falling further. and resistanceA price level where selling pressure is strong enough to prevent the price from rising further. levels.
How to Identify Trends
- Visual Inspection: Simply looking at the chart can often reveal the trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend). direction.
- Trendlines:
- In an uptrend, draw a line connecting the swing lows
- In a downtrend, draw a line connecting the swing highs
- Moving Averages:
- When price is above a moving average, it suggests an uptrend
- When price is below a moving average, it suggests a downtrend
- When two moving averages cross, it may signal a trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend). change
- Higher Highs and Higher Lows (or Lower Highs and Lower Lows): Analyzing the structure of swing points.
Trend Strength
The strength of a trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend). can be assessed by:
- Slope: Steeper trendlines indicate stronger trends
- Duration: Longer-lasting trends show more conviction
- Volume: Increasing volume in the direction of the trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend). suggests strength
- Pullback behavior: Shallow pullbacks that hold above supportA price level where buying interest is strong enough to prevent the price from falling further. (in uptrends) or below resistanceA price level where selling pressure is strong enough to prevent the price from rising further. (in downtrends) indicate strength
Trend Reversals
Trends don’t last forever. Signs of potential trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend). reversals include:
- Break of trendline: When price closes beyond the trendline
- Break of structure: When an uptrend makes a lower low or a downtrend makes a higher high
- Divergence: When price makes new extremes but indicators don’t confirm
- Chart patterns: Formation of reversal patterns (which we’ll discuss next)
Chart Patterns Introduction
Chart patterns are specific formations on price charts that have historically led to predictable outcomes. They fall into two main categories: continuation patterns and reversal patterns.
Continuation Patterns
These patterns suggest that the current trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend). will continue after a period of consolidation or indecision.
- Flags and Pennants:
- Form after a strong price move (the “flagpole”)
- Represent short consolidation periods
- Resolution is typically in the direction of the prior trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend).
- Triangles:
- Symmetrical Triangle: Converging trendlines with similar slopes
- Ascending Triangle: Horizontal resistanceA price level where selling pressure is strong enough to prevent the price from rising further. with rising supportA price level where buying interest is strong enough to prevent the price from falling further.
- Descending Triangle: Horizontal supportA price level where buying interest is strong enough to prevent the price from falling further. with falling resistanceA price level where selling pressure is strong enough to prevent the price from rising further.
- Rectangles:
- Price consolidates between parallel supportA price level where buying interest is strong enough to prevent the price from falling further. and resistanceA price level where selling pressure is strong enough to prevent the price from rising further. levels
- Breakout direction determines whether it’s bullish or bearish
Reversal Patterns
These patterns suggest that the current trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend). is likely to reverse.
- Head and Shoulders:
- Forms at the end of an uptrend
- Consists of three peaks with the middle peak (head) higher than the two surrounding peaks (shoulders)
- Neckline connects the lows between the peaks
- Breakdown below the neckline confirms the pattern
- Inverse Head and Shoulders:
- Forms at the end of a downtrend
- Mirror image of the regular head and shoulders
- Breakout above the neckline confirms the pattern
- Double Tops and Double Bottoms:
- Double Top: Price reaches a high, pulls back, then reaches a similar high before declining
- Double Bottom: Price reaches a low, rebounds, then reaches a similar low before advancing
- Confirmation comes when price breaks the level of the pullback between the two tops/bottoms
- Triple Tops and Triple Bottoms:
- Similar to double tops/bottoms but with three attempts at breaking through a level
- Often indicates stronger resistanceA price level where selling pressure is strong enough to prevent the price from rising further./support than double tops/bottoms
Pattern Confirmation
Chart patterns are not confirmed until price breaks out of the pattern. Key confirmation signals include:
- Breakout: Price moving beyond the pattern boundary
- Volume: Increasing volume on the breakout
- Retest: Successful retest of the broken boundary from the opposite side
Volume Analysis Basics
Volume represents the number of units (lots) traded during a specific time period. While the forex market is decentralized and true volume data isn’t available, most platforms provide “tick volume” (the number of price changes), which serves as a reasonable proxy.
Why Volume Matters
Volume provides context to price movements:
- High volume movements are considered more significant and more likely to continue
- Low volume movements may lack conviction and be more prone to reversal
- Volume trends can confirm or contradict price trends
Basic Volume Principles
- Volume should confirm the trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend).:
- In healthy uptrends, volume should increase during price advances
- In healthy downtrends, volume should increase during price declines
- Volume spikes often occur at key turning points:
- Climactic volume at market bottoms (capitulation)
- Exhaustion volume at market tops
- Volume precedes price:
- Decreasing volume during a trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend). may signal weakening momentum before price reverses
- Increasing volume during consolidation may signal an impending breakout
Volume Indicators
Several indicators can help analyze volume:
- Volume Bars: Simple representation of volume for each period
- On-Balance Volume (OBV): Cumulative indicator that adds volume on up days and subtracts volume on down days
- Volume Moving Average: Moving average of volume to identify above/below average volume
- Chaikin Money Flow: Measures buying and selling pressure based on where price closes within its range and the volume
Practical Application: Putting It All Together
Let’s walk through a basic chart analysis process that combines all the concepts we’ve covered:
- Identify the chart type and timeframe that suits your trading style
- Determine the overall trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend). by looking at higher highs/lows or using moving averages
- Mark key supportA price level where buying interest is strong enough to prevent the price from falling further. and resistanceA price level where selling pressure is strong enough to prevent the price from rising further. levels based on previous swing highs/lows and other techniques
- Identify any chart patterns that may be forming
- Check volume to confirm your analysis
- Look for potential entry points based on trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend)., supportA price level where buying interest is strong enough to prevent the price from falling further./resistance, and patterns
- Determine potential exit points (both for profit targets and stop losses)
Remember that technical analysisA method of forecasting future price movements based on the study of historical price data, charts, and indicators. is not about finding a perfect system that works 100% of the time. It’s about identifying high-probability setups that give you an edge over many trades.
Summary
In this chapter, we’ve covered the fundamental building blocks of technical analysisA method of forecasting future price movements based on the study of historical price data, charts, and indicators.:
- Chart types: Candlestick, bar, line, and Renko charts each offer different perspectives on price action
- Timeframes: Your choice of timeframe should align with your trading style and available time
- SupportA price level where buying interest is strong enough to prevent the price from falling further. and resistanceA price level where selling pressure is strong enough to prevent the price from rising further.: Price levels where buying or selling pressure has historically been strong
- Trends: The general direction of price movement, identified through various methods
- Chart patterns: Specific formations that suggest continuation or reversal of the current trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend).
- Volume: Provides context and confirmation for price movements
These concepts form the foundation upon which all technical analysisA method of forecasting future price movements based on the study of historical price data, charts, and indicators. is built. In the next chapter, we’ll explore how to analyze multiple timeframes simultaneously to gain a more comprehensive view of the market.
Key Terms
- Candlestick: A chart type showing open, high, low, and close prices for a specific time period
- SupportA price level where buying interest is strong enough to prevent the price from falling further.: A price level where buying interest is expected to overcome selling pressure
- ResistanceA price level where selling pressure is strong enough to prevent the price from rising further.: A price level where selling interest is expected to overcome buying pressure
- TrendThe general direction in which a market is moving (uptrend, downtrend, sideways trend).: The general direction in which price is moving
- Chart pattern: A specific formation on a price chart that suggests a particular future outcome
- Volume: The number of units traded during a specific time period
- Timeframe: The time period represented by each candlestick or bar on a chart