Perception vs Reality, Part 3: Technical Analysis vs Price Action

So this week comes the final part of my exploration of the huge differences between our Perceptions of trading and the actual Reality. A couple of weeks ago when I wrote the first part of this series of articles, you may have wondered why I was making such a huge deal of something which most active traders in the world have never given a moment's thought about, but that's fine with me. I also know that the majority of the world's active traders struggle to achieve consistent profits in the market, as well. I learned very quickly in my own trading career that if most people lose money in the Forex markets, then doing what they do was not going to help me in any way whatsoever, as I would end up just like them! I had to learn how to think differently, to let go of what I thought I should be doing and understand the things that I needed to be doing to be successful. Part of this huge shift in mentality came from understanding my own perceptions of trading and searching deeper to understand what really made the difference in my trading. Two weeks ago we explored the difference between Value and Price and continued last week with an investigation of being a consistently profitable trader rather than a consistent winner. Click here for Part 1 and here for Part 2. This week is the final piece: Technical Analysis vs Price Action.

One of the most confusing issues I faced when I started my education in the markets with Online Trading Academy was on the topic of Technical Analysis. When first introduced to the subject, most new traders find themselves mesmerized by the "magical" nature of trend lines, chart patterns and technical indicators. Suddenly they are faced with a whole host of different tools to help them predict where price is headed next, and as we all know, there can be a serious danger of falling into the "holy grail" syndrome of searching for the perfect set of signals which work every time. This, in my opinion, is not a good place to be, as I have been there and it is a bad path to take. You see, technical analysis can be so powerful in helping us to find high probability, low risk trades, but only if used in the correct manner.

Most novice traders completely ignore the reality that all technical indicators are lagging behind price. You see, if we take something like a typical oscillator in the form of the RSI (Relative Strength Index), we have to remember that we can't just use it to tell us when to take trades. It will give us numerous overbought signals (telling us to sell) and oversold signals (telling us to go long), but if we used every single one without combining this with some other form of analysis, we would soon find ourselves on the wrong side of the market and suffering heavy draw downs. The reason behind this predicament is simply due to the fact that these indicators are always lagging behind price as previously stated. Think about this: For the RSI to give a trader a buy signal, price itself will have had to move down in the first place so as to tell the RSI to signal oversold. Then when it leaves the oversold area of the indicator and sends the green light to the trader to go long, remember that price will have already had to start moving higher to give the signal to the indicator in turn. Therefore, anyone using the RSI alone to take trades will find themselves buying into a market which has already started to rally. As I have said in numerous articles, the safest and best way to make money is to buy before everyone else and sell before everyone else. The indicator also suffers from the weakness of not being able to recognize trends across the bigger picture. If you are taking a buy signal on a 15-minute chart from the RSI, the RSI itself is not taking into account where price is on the higher time frames.
Let's say you have just bought on a 15-min chart, but on the daily chart you have been in a sustained downtrend, then the odds are heavily stacked against you and the chances of a loss are higher.

This theory is also applicable to chart patterns. Take the classics like the Head and Shoulders, Double Top and Cup and Handle. While they are all powerful and consistent signs of trend reversals, we also forget one other vital thing: We are only aware of the chart pattern once it has formed, offering us very little use of it in the world of real trading. So why do most new traders rely on technical indicators and chart patterns? Primarily because they see them as a crutch to lean on, giving confidence to make the decisions for them.
Their emotions get in the way of taking practical trading decisions which respect true price actions, as most winning trades feel uncomfortable to enter. It is herd mentality at its peak and a perception which will damage the account in the blink of an eye. They read all the technical analysis books about all those wonderful patterns and tools and start using them purely because the author of the book said it's okay to do so...safety in numbers is at the core of the human psyche.

However, as I stated at the start of this newsletter, consistent professional traders make money by not doing what everyone else is doing. They take the time to explore the reality of market movements and make it their priority to understand the true nature of Price Action. Understand this, markets and prices only turn in any environment when there is an imbalance between Supply and Demand. If demand exceeds supply, prices have to rise and if supply is greater than demand, then prices have to fall. It really is as matter of fact as that. The professional trader needs only to understand this most fundamental of principles and they are already headed in the right direction for success. Let's look at a recent example of activity with GBPUSD:

As we can see, the currency pair had been enjoying a steady rally from 1.5900 to around 1.6440. By applying some classic technical analysis tools, we can see that there are numerous reasons to go long again at 1.6300. First, it has been in an uptrend and gives a nice pullback entry. Second, it is testing an established trend line low point in a clear upside channel. Third, all Moving averages are in sequence with the 50 and 200 now crossing and finally the CCI (Commodity Channel Index) has left Oversold. Moving on to our next chart, though, we can see that things didn't go according to plan:

The trend line was broken, resulting in a likely stop out and the pair fell to a price of 1.6240, some 60 pips away. Now, sticking to the tools we are using, we can see that another long opportunity has presented itself, this time at a current price of 1.6240. Reasons to go long: Moving Averages still crossed, price is at a previous resistance area which should now become support, and the CCI is now heavily oversold and just leaving its zone. In technical analysis terms, it is fine to have another shot at the long trade. But how did it end up after the second attempt?

As we can see from this chart, price once again fell through the 1.6240 area like a hot knife through butter, resulting in another loss.
Now looking where price had been at the highs of 1.6440 and where it is at the time of writing this article, we are now as low as 1.6150, a good 300 pips down. Would it have not been better to be short instead of long? Easier said than done maybe, unless we remove all the technical indicators and focus on price action itself. Instead of trying to justify reasons to be a buyer with trend lines, CCI and Moving Averages, would it not have made more sense to look at the chart and see what price was showing us? When GBPUSD was at 1.6440, it reached an objective area where Supply was previously greater than Demand. The high probability trade was to go short when prices were high after everyone else had bought it. By being one of the very first to sell, we have the lowest possible risk and highest potential reward.

This is a trade that I found with my students in the ongoing Extended Learning Track (XLT) - Forex program and currently, we are in this trade starting with 3 lots and hitting our first, two profit targets, banking a total of 450 pips and running a further 200 pips on the remaining lot - all for an initial risk of 30 pips per lot (90 pips total), as you can see by the P/L displayed. Am I showing you this to show off? Not at all as trades like this present themselves to us multiple times each week. The reason I am showing you this is to illustrate the difference between understanding price and using technicals. They are two completely different things and unless you fully understand these differences, then it is unlikely that your trading career will progress much further. Understand the difference between what you think you know (your perception) and what you know to be true (the reality). Trust me, it can only help in the long run.