Technical analysis is the main form of market analysis used by traders participating in financial markets.
Modern technical analysis has been around since the early 1900s with the formation of the DOW theory by Charles Dow. Since then there has been many different uses of technical analysis and what began as a simple tool for analyzing markets has grown into something which has multiple disciplines and interpretations.
Today’s article is going to be a kind of introduction into what technical analysis is, why people use it, the three assumptions technical analysis makes about financial markets and finally…… where traders go wrong with technical analysis.
What Is Technical Analysis ?
Technical analysis is one of two discipline traders use to trade the forex market.
Its centered on using price charts as the primary means for making trading decisions.
Nearly all retail traders trading the forex market are using technical analysis in their trading, the strategies they implement are all focused on using either price patterns to enter trades or price points to find locations they can use to take trades.
Whenever a trader makes a trading decision based on a price chart he is using technical analysis whether he realizes it or not.
Technical analysis itself has been around for hundreds of years. The first record of a person using a price chart to place trades was Muneshia Homma back in the early 17th century, since then many advancements have been made to the technical analysis theory which forms the basis for what we know today as technical analysis.
One of the big big breakthroughs came when Charles Dow formulated the Dow theory which came up with the idea financial markets move in trends, he also developed the method used to determine trend direction which is still implemented by most traders today i.e monitoring swing highs and swing lows.
In the 80s with the advent of computer technology a new form of technical analysis become popular.
Technical indicators have been around for decades but it was with the dawn of computers that they really took off and were put in use by traders around the world. Before computers were available if a trader wanted to use an indicator ( lets say a moving average for example ) they would have to manually calculate all the prices which was a really time-consuming process, When computers came into the mainstream indicator calculations could completed in minutes which made using indicators much more popular with traders in the market.
In addition to shorting the time it took to calculate different technical indicators traders were also able to create new indicators from scratch using the power of computers to mathematically find new price points which could be used to show information about the market prices which wasn’t available before.
Most of the technical indicators still in use by traders today come from the surge in popularity indicators suffered back in the 80s, where it not for this time things like the MACD – ATR – Bollinger Bands, probably wouldn’t exist for traders to use.
A Controversial Theory
Technical analysis itself has never been proven to actually work.
It remain a source of great controversy in financial circles with many academics testing different component of technical analysis to try to find out if using technical analysis can be profitable or not. Many of the great traders of our time have come out and said they have made most of their money using technical analysis but the majority of these made their money during the 80s when huge trends were present in the markets and making money was as simple as just following the trend.
Not only this, before the 90s the only things traders had to deal with in the market were other trades, nowadays we have computer algorithms which have reduced a large number of the edges which were present in the market before the 1990s.
If you bring a chart up of how the market used to move during the 70s and 80s you’ll see they move in a completely different way as opposed to what we see today. Back then there were big trends with little to no pullbacks or consolidations taking place whereas now the markets hardly manage to trend for any decent length of time before stalling and moving in the opposite direction.
The Three Technical Analysis Rules
The whole theory of technical analysis is based on three big assumptions about how financial markets work.
These assumptions reflect what technical traders in general believe about financial markets and make up the foundation of the technical analysis trading strategies they will use to trade the markets.
Some of these assumptions have caused controversy in the past when academics have tried to prove them as being right or wrong, I don’t necessarily believe the assumptions below are incorrect but I believe they can easily be misinterpreted if not understood correctly by the trader using technical analysis in their trading.
Price Discounts Everything
The first assumption technical analysis makes about financial markets is idea that the market price discounts all information about price direction.
Price discounts everything basically means any information which is known about the market is reflected in the current market price, anything which could affect the future direction of the market such as fundamental news has already been incorporated into the market price, therefore drawing conclusions about the future direction of the market using anything other than the market price is pointless.
When traders first hear the price discounts everything assumption they make the unfortunate mistake of believing all they need to focus on when analyzing their charts is the market price as it contains all the information they need to predict the market.
You’ll see later why this is incorrect and is the number one reason why traders use technical analysis in the wrong way.
History Repeats Itself
The second assumption is the belief that things which have happened in the past will happen again in the future,
Common technical analysis theory says there are patterns which repeat themselves over and over again in financial markets due to the traders in the market reacting to certain events in the same way. For the most part I believe this assumption is correct, the problem is the majority of the patterns traders use when trading are so well-known and obvious they are actually used against the traders themselves.
Take the head and shoulders patterns, one of the best known price patterns in the market is known and monitored by almost all traders using technical analysis.
If you didn’t already know a head and shoulders pattern gets its name from the way the swing structure of the pattern resembles the head and shoulders of a human.
When a clear head and shoulders pattern forms many traders will try to trade the pattern using the common entry criteria given out in technical analysis books which is:”Wait for a break below the neckline”. When the market breaks the neckline traders enter trades under the impression the market is going to move in the direction of the break, bank traders can also see the head and shoulders pattern and know how the retail traders trade it, so when it the neckline breaks and the traders go short, depending on how obvious the head and shoulder pattern is, the banks will use the sell orders to place their own trades and the market will move up, making all the traders who sold on the break of the neckline lose money.
It’s important to note price patterns will only be used against retail traders when their appearance is obvious, a clearly defined head and shoulder pattern is one in which the highs of the left and right shoulders are relatively equal and the high of the head noticeably sticks out from the two shoulders.
When the price patterns are not so obvious they can go either way, some may work out successfully while others might result in you losing money, there really isn’t any way to tell truth be told
Financial Markets Move In Trends
The final of the three assumptions technical analysis is based on, is the idea financial markets move in trends.
When the market has been moving in one direction for a long time its said the market has a higher probability of continuing to move in the same direction rather than reversing and moving in the opposite direction.
There is nothing wrong with the concept of financial markets moving in trends, it’s an assumption which is based upon fact, the problem is knowing the point where the market has entered a trend is different for all traders. Where you determine a trend has begun will be different to where I determine where a trend has begun, which means there is no definitive way for use to know if we are getting into the market at the beginning of a trend or at the end of a trend.
Where Traders Go Wrong With Technical Analysis
The big problem with technical analysis isn’t technical analysis itself, it’s what the traders using technical analysis expect to be able to do with technical analysis.
Traders using technical analysis believe they can predict the market using nothing but price, as like we have just seen one of the main assumptions technical analysis is based on is the idea that price discounts everything, therefore the only thing in the market which needs to be studied is the current and past price.
How can it be possible to predict the market using price when the only time a price change can occur is when people are placing or closing trades ?
It doesn’t make any sense !
This is where people using technical analysis go wrong, the market price doesn’t matter, whether we’re talking about the current price or the past price. What matters is knowing what action the traders participating in the market will take which will cause a price change to occur.
Take a look at the consolidation above.
Why did the market move out of this consolidation ?
Because one set of traders came into the market and placed buy trades which were bigger than the sell trades coming into the market from another set of traders. It doesn’t take a genius to figure that out ! But the real question is why did the traders place buy trades in the first place ?
Was it because they believed the market should move up ?
Did the market hit a support level which caused a reversal in the past ?
Or was it to make money ?
Obviously it was to make money, but how do you actually make money in the market ?
By making other traders lose !
So if the only way to make money is by making other traders lose money, knowing where traders are placing trades is the number 1 thing we need to be focusing on.
The only attention we need to be placing on the price is what does it mean for other traders ?
“What will retail traders do if they see the market make a large move up” ?
“If the market drops from its current location is it likely for retail traders to close their trades” ?
These are the types of questions you need to be asking yourself when looking at your charts, not ” I think the market will reverse at this resistance level” because by saying that you’re not thinking about the other traders in the market.
The only way for the market to turn upon reaching the resistance level is if other traders come into the market and sell, so you need to be thinking about the reasons as to why traders will sell when the market hits the resistance.
Technical analysis concepts like support and resistance – Fibonacci – even indicators are fine to use in your analysis so long as you relate them as to what they mean for other traders, if you think the market should turn when it reaches a technical level due to the fact that you have seen the market turn there in the past means you’re not trading from the right perspective.
When people trade support and resistance they’ll rationalize why the market turns at the levels with something like “if everybody buys the market will move up” the problem is the people who move the market i.e the banks will always trade against the retail traders, so if there is a really obvious support level in the market which any retail trader can easily see on their charts the banks will purposely sell when the level is reached because they know a large number of retail traders will buy, therefore by selling they can push the market below the support and make all the traders who went long lose money-making themselves a nice profit.
Price doesn’t move financial markets people do. It’s anticipating what the traders who use price to make their trading decisions are going to do which will make you a consistently profitable trader. Charts can only show you where the market has been, it cannot show where it may go in the future, you have to understand how other traders trades in order to figure out what action a trader may take if the market moves up or down as its his actions which will determine to what extent the price will change in the market.