Technical Analysis Demystified

The subject of technical analysis is often up for debate. ‘Does it actually work?’ is probably the question that comes up most often. Technical analysis is predicting future price movements based on historical price movements. In other words, using the past to predict the future. However, many are skeptical of this method and they have good reasons to be. I do not remember which, but this was an example I recall. A computer generated random up and down ticks. This was then presented to technical analysts as the historical price movements of a fictitious company. These analysts were able to extract information from this randomly generated chart and give predictions about future price movements. How is it possible to extrapolate something from nothing? Forbes published an article which I find illustrates the misconception of technical analysis quite nicely. Before we move on, take a look at the article.

Finished reading? Good. This brings me to my first point. Recall how we defined technical analysis. You are not trading the value of the company, but rather what others feel about the company. I often like to think of it as trading the market psychology. Candlesticks have grown in popularity because of their simplicity in outlining the market psychology. Beginner technical analysis books and courses often teach this. A strong green candle is a signal of rapid buying. If a candlestick has no real body (doji), then it shows indecision. In other words, the candlestick characteristics are really just modeled by other traders. When you trade off of technical analysis, you are trying to predict what other trades are going to do next. That does not mean you ignore the fundamental factors taking place. For example, the U.S. Dollar is very strong right now. It would not be wise to go short on any USD pairs. Instead, you seek to go long. In doing so, technical analysis can help you optimize your entry. Multiple time frame analysis can help you avoid buying into a down trend on a lower time frame. Instead, you can spot a relative low point (support level) to go in for a long entry.

Assuming that you went long, did the price reverse from the down trend and continue on up? If it did not and broke right through the support level, what would you have done? Chances are you would have closed out that trade and moved on. Before you blame this loss on technical analysis, it is time to debunk another assumption: It is NOT supposed to work! You must be wondering what the heck is going on here. If it is not supposed to work, then why use it at all? Let me answer it this way. You know that weather forecasts are not 100% accurate, yet you still carry an umbrella when the weatherman says there’s a chance of rain. Technical analysis works the same way; it is to prepare you for what is to come. Let us illustrate this with support and resistance levels. These levels do not work 100% of the time, but yet we keep an eye on them. Suppose you sold the pair EURUSD. You will draw the necessary support levels because these are high probability reversal price levels. You do not want to be paying back your profits so chances are you will close your trade out as the price approaches a support level. You may do partial closes in case the price breaks through a support level. The idea here is that technical analysis can help you set a trading plan. I do not like to base trade off of fundamental analysis because the time frames are too broad to be of much use. When a central bank announces an interest rate hike, it will take some time before we see the market reacting. Perhaps the market might not react at all due to some even bigger influence. Once you are in the right mindset, trading with technical analysis does have its benefits.

I think I understand why many of us fail to be in this mindset. I admit I started off mindlessly following the lessons taught in trading books. One book I would like to bring up is “Naked Forex: High-Probability Techniques for Trading without Indicators” by Alex Nekritin and Walters Peters. Keep in mind that there are many other books like this one. I took this book as an example because I just so happen to have the digital version of it and it is open right in front of me right now. This book is a good read for those wanting to get started in the price action branch of technical analysis. It goes over common chart patterns, channels, wedges, support and resistance, and so on. However, it will not get you into the right mindset. The problem with this book, not to mention many books out there, is that the author only shows when these analysis work. They only show the price successfully reverse from a support level or a big move breakout from a wedge. Beginners are rarely warned or presented with the case when these chart patterns fail. As a result, beginners often blame their failures on technical analysis.

Part 2 of this problem is that writers are rarely traders, hence why I am not in the book publishing business. You will not see me teaching chart patterns because I know better not to.

The Historical Data Fallacy
The Historical Data Fallacy

This is a screenshot of page 17 in “Naked Forex”. At this point in time, the author was presenting the argument against the use of indicators. They claimed that the naked trader (trading without indicators) would have optimized the entry at a later lower price. I too was persuaded by this chart at first, but then I questioned the naked buy signal. The candlestick indicated in the picture is the most optimal buy point because it was followed by a strong bullish candle. However, this is the case of the historical data fallacy. Yes, this candle does have a long lower wick signalling strong selling pressure failed to push the price lower. However, so did the 5th and 11th candle back yet you would have lost money if you went long there. I did a quick Google search for “Alex Nekritin”. Wow, he’s a trader for 10 years and suddenly decided to write a book – looks like trading isn’t generating any income for him as his book shows. I understand you may be reading this and wondering if it is a matter of difference in trading styles. I assure you it is not. If you really want to find out, go buy the book and prepare to be disappointed. I’ll save you some money and trouble with a quick summary of what his explanation was. He stated that the trader will “enter a trade based on current market price action, and often avoid the severe drawdowns associated with indicator-based
trading” (pg. 17). Interesting for him to make this statement when his justification for the naked buy signal. He wrote, “In this instance, the naked trader gets a very clear buy signal after the stochastic buy signal” (pg. 16). Aren’t you technically still basing the buy entry on the stochastic then? So apparently the author generated that naked buy signal by seeing that a buy signal was generated from the stochastic. Interestingly, the naked buy signal is just one candle before that 40 pip move upwards. Even more interesting, the author later discourages the indicator-based trading approach while his own buy signal was supposedly generated from the stochastic indicator.

I seek to take a different approach when sharing my analysis and this using real time triggers. When I am demonstrating a concept using historical data, I will treat it as if I am analyzing it in real time. Take a look below at one of my samples:

Real Time Analysis
Real Time Analysis

This was a chart that took me about 10 minutes to draw. You can see that the entry and exit techniques are better defined on trend-line and support and resistance boundaries. The benefit of technical analysis is the ability to create opportunities. If you were to look at the fundamentals side, it would have been one long order on this bullish pair. You would have suffered from dealing with the intra-day P&L fluctuations.

This chart also illustrates another aspect of technical analysis. Recall what I said earlier about technical analysis. It is not supposed to work. There is no obligation for it to work and so that is why you see and be prepared for fake-outs. In essence, technical analysis can prepare traders like you for whatever is to come. I like to think of technical analysis as creating a trading plan. Rather than developing a bias as illustrated in the Forbes article, it is better to pick out critical levels and trade off of the price reaction. For example, it is better to see how a price breaks out of a wedge rather than developing a bullish bias. If the price breaks lower from this consolidation, you short. If it breaks out higher, then you long. It is as simple as that; it just prepares you for what is to come. It can help plan your entry and exit techniques.

Planning a Trade
Planning a Trade

Let’s take a look at what is going on here. This is a chart showing EURUSD on a 15 minute time frame. On December 1, 2014, I identified a supply level and it tested quite a few times. Let’s take a look at the first test on December 5th. As the price barely enters this supply zone, we can set a trading plan. The plan is simple. We look to sell and we will close it out at a loss if price breaks out above this supply zone. This is what I mean by planning the trade. There is no obligation for this supply zone to work, but we have identified it to be a critical zone and shall monitor it carefully.

I have taken the price action approach with my explanations so far, but, of course, technical analysis comprises of a much bigger study. There are indicator based trading, Elliot Wave theory, Fibonacci retracements and extensions, pivot point trading, and more. I prefer to take the price action and supply and demand approach. I will use indicators and other methods as necessary, but I seek more to plan out each trade rather than forecast where the price will go. Nevertheless, each one of us has our own methods. One is not more superior than another. A hammer is not more superior than a screwdriver. They are simply tools to do different tasks and it is up to you to use them effectively.

Hopefully this will clear up some confusions and misunderstandings about technical analysis. This is quite a wordy post, but I have no intention of cutting it shorter. Don’t worry, future posts will be just as long (maybe, maybe not). Stay tuned for my next post on trading platforms.


A Pip For Your Thought?

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s