Topics covered in this chapter:
- Studies and theories used by traders for proper technical analysis.
- Purpose and drawbacks of technical analysis.
- How to read the charts under the scope of technical analysis in order to generate high probability trades.
- Integrating price action into technical analysis.
- How to deal with lagging and non-lagging indicators.
- Matching indicators across different time frames.
After studying the chapter 04 from Unit A, you may feel that although measuring supply and demand gives adequate pictures of future prices movements, it does not guarantee currency trading success and you may need to structure your analysis further.
Technical analysis helps you to organize the overall market picture while it lays the path to rule based trading. Having a technical approach will be very important, specially during your first attempts to develop a personal trading style.
There are a lot of ways to analyze market information through technicals and the potential variables are endless. Understanding how to wade through this data is vital at this stage. We will therefore not present you a technical analysis manual but rather insist on the flexibility of a few common indicators and the roles they can play in a trading system. This practical approach will prepare you for the more advanced Units of the Learning Center.
Technical analysis offers the ability to do some things not easily achieved otherwise. That is the reason why many traders include it among their trading tools arsenal. But still many aspiring traders don't fully understand the advantages of technical analysis - and refuse to differentiate between analysis and the other components of a trading plan such as money management and trade execution.
In its essence, a Forex price chart is a simple sequence of up and down pips forming visual patterns. Technical analysis aims to identify these patterns and measure their outcome in terms of probabilities. However, the repeated occurrence of such patterns would imply a certain consistency of the outcomes. But in reality, there is no absolute consistency as each pattern is somehow unique - even if it has some similarities with other patterns.
This underlying dilemma will be present along this chapter and many ideas about how to deal with it will be disclosed.
1. The Purpose of Technical Analysis
The purpose of technical analysis is to carry out price forecasts. By processing historical market data of any instrument, you can try to anticipate how it should be traded. There are several premises in favor of the reliability of technical analysis that are based on the experience and prolonged observation. These premises are the following:
1. A market trend in motion is more likely to persist than to reverse.
2. Markets are discounting mechanisms.
In other words, technical analysts assume that market fundamentals are already represented in the price so what you perceive in the charts is a reflection on any fundamental variable impacting the market. Nowadays, with instant communications this is truer than ever.
Either the unidirectional price move during a trend or the rapid reaction to any new fundamental data throws evidence that markets show up human behavior. From the above premises we can derive that human psychology is always at work in the markets and that technical analysis aims to visualize and quantify it.
3. What has happened in the past will happen again.
This third premise is based on the assumption that human behavior as well as human psychology never change, and that price will reflect it through the repeated emergence of certain price action patterns and trends.
Price action, as a result of human decision making, can be thus considered as being purposeful. Although some people believe that price movement is completely random and unpredictable, technical analysts are always prone to identify and quantify those behavior patterns by examining past markets. While markets are unpredictable in essence, market participants are typically considered to adhere to certain habits, which are rarely broken. As a trader, your goal is to make use of this information in order to gain a slight advantage over the eventual unpredictability of the market.
Joseph Trevisani remarks that markets are a human invention, therefore:
... they are a uniquely human form of expression.. The continued appearance of these ratios in market behavior is an empirical phenomenon. These theories of market behavior maintain that the appearance of these ratios in the movements of markets is not coincidence but witness to patterns that have predictive power in describing future market movement.
No doubt you've already heard people say that technical analysis is never an exact science. However, ignoring it completely excludes an edge with a certain level of expectancy. You won't win every trade but by trading systematically only when the odds are in your favor, the true edge of technical analysis will reveal itself.
You should keep in mind that the theoretical knowledge you are going to receive in this chapter should be added to a thoughtful strategy in order to reach good results in trading. The subject of trading strategies will be presented in Unit 3. Technical analysis is just a piece in the overall trading plan you are building with the help of the Learning Center.
Drawbacks of technical analysis
Despite the fact it represents a true edge for the trader, technical analysis presents some disadvantages. Those who oppose technical analysis point out several problems related to the application of its methods.
1. The failure to know the underlying fundamentals.
A common argument is that technical analysis is aimed at predicting a certain outcome for a chart pattern, ignoring the reasons of the movements which are due to fundamental factors. This is an obvious limitation of technical analysis and any trader feeling uncomfortable with this handicap should find support in the next chapter dedicated to fundamental analysis.
2. The lack of scientific objectivity.
Although some theories offer a certain objectivity to the analysis, other studies may not necessarily lead to an objective interpretation. That is why technical analysis is sometimes referred to as being more an art than a science. It is also where individual and mass biases come into play.
In Chapter A4, we wrotte about the self-fulfilling prophecy referring to the fact that the more people approaching markets with technical analytical methods, the more likely the expected move in price occurs. This is a common argument that points out the lack of a proven thesis. The fact that traders operate with different time horizons, different expectations and risk profiles makes it difficult to find a common approach to the self-fulfilling prophecy.
3. The uniqueness of the pattern occurrences.
Another legitimate argument in favor of the unreliability of technical analysis is based on the true observation that past price action upon which technical methods are based does not often repeat exactly the same way. This can lead to incongruities in the analysis and to inconsistency in the methods.
At this point, however, you should ask yourself whether these arguments can be dealt with in order to make money in the markets. Of course they can, and we are going to show you how!
It's true that traders will never be 100% correct when using any strategy based on technicals. However, more often than not technical studies do create a positive expectancy. You don't need much more than that.
A valuable lesson is undoubtedly that analysis doesn't make the whole trading plan. A proper money management and a trained attitude to stick to the rules are elements which offer additional edges to include in the trading plan. Therefore, don't worry excessively about the above mentioned drawbacks - technical traders have learned how to deal with them.
James Chen writes in one of his blog posts:
A good remedy against paralysis by analysis is a combination of solid risk control and money management. Technical analysis is very helpful in setting risk management measures like a logically-placed stop loss that's not too tight and not too loose, and a good reward-to-risk ratio. And money management is an absolute essential for any trader who wants to be successful. With these prudent measures in place, traders need not be paralyzed by the trade entry process. A trader will never come anywhere close to 100% correct, even with 50 indicators, oscillators, trendlines and squiggly lines pointing in the same direction at the same time. But that's OK, as long as risk and money management are in good order.
This is not at all to say that traders should ever just jump into trades without first doing their proper analysis. As mentioned, that is an evil in and of itself. But I know of several traders that are utterly unable to pull the buy/sell trigger unless all of the many stars in the galaxy are perfectly aligned. This almost never happens.