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Charts are useful tools for investors and traders as they offer insight into herd behavior. In a book written in 2004, author James Surowiecki explained how crowds make better decisions than individuals. Markets are embodiments of Surowiecki’s thesis as the current price of an asset is the level where buyers and sellers meet in a transparent environment.
When it comes to the global foreign exchange market, buyers and sellers of currencies determine the rates of one foreign exchange instrument versus others on a real-time basis. At the same time, governments manage the level of currency volatility to maintain stability. Technical analysis can be particularly useful in the currency markets as technical levels can provide clues about levels where government intervention is likely to occur.
Technical analysis includes support and resistance levels where currency pairs tend to find lows and highs. At the same time, price momentum indicators often signal where exchange rates are running out of steam on the up and the downside.
Technical analysis can breakdown at times when black swan events occur.
Futures are a Microcosm of the OTC Market
In the world of foreign exchange, the over-the-counter market is the most liquid and actively traded arena. The OTC market is a global and decentralized venue for all aspects of exchanging the currency of one country for another; it is also the largest market in the world. In April 2019, the average trading volume was $6.6 trillion per day. The OTC market operates twenty-four hours per day, except for weekends.
Futures markets for currency pairs are smaller, but they reflect the price action in the OTC market. When it comes to technical analysis, the futures market provides a window into the price trends and overall state of the strength or weakness of one currency versus another.
The weekly chart of the dollar versus the euro futures contract displays the price action in the currency pair since late 2017. The bar chart on the bottom reflects the weekly volume, which is the total number of transactions. The line above volume is the open interest or the total number of long and short positions.
When volume and open interest are rising or falling with the price, it tends to be a technical validation of a price trend in a futures market. When the metrics decline with rising or falling prices, it often signals that a trend is running out of steam, and a reversal could be on the horizon. Volume and open interest are two technical metrics that aid technical traders looking for signs that a trend will continue or change.
Technical Analysis Can Fail at Times
Technical analysts look for areas of price support and resistance on charts. Support is a price on the downside where a market tends to find buying that prevents the price from falling further. Resistance is just the opposite, as it is the price on the upside where a market tends to experience selling that prevents it from rising further. When a price moves below support or above resistance, it often signals a reversal in a bullish or bearish price trend.
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