This question is as old as technical analysis itself. From Charles Dow, who is considered the father of technical analysis in the western world, to Jesse Livermore (the legendary bear of Wall Street), there is a long list of profitable traders who based their trading solely on technical analysis. But up till today, people still ask whether technical analysis is profitable.
So, it wouldn’t be out of place if you are wondering whether technical analysis works and if that is all you need to succeed in trading the financial markets. Some may even be wondering if they need to combine it with fundamental analysis. Here’s the thing: trading based on technical analysis can be profitable, but it depends on what you make of it. But you must know one thing — it does not matter how you analyze the market, if you don’t have the necessary skill and don’t play by the rules, you won’t get anything out of the market. More on that later.
So, in this post, we will discuss the following:
- What technical analysis is
- How it works
- The right way to use technical analysis in trading
- How to create a trading strategy that works
- What you need to make technical analysis work
- Tips for technical analysis trading
What is technical analysis?
Technical analysis is a method of studying the market to identify tradable opportunities by analyzing the way the price moved in the past and how it is moving presently so as to be able to predict what it might do in the future. It involves either analyzing the raw price data as you see them on the chart or using some tools and indicators, which are mathematical calculations based on price data.
Many experienced traders do their analysis with the price and volume data alone or in combination with the indicators, but beginner traders often start learning technical analysis with indicators. There are different indicators available to traders, including the default ones that come with the trading platforms, such a moving averages, stochastic, ATR, and many others, as well as the custom indicators created by traders with coding skills to suit their specific ideas — you can create yours with the MQL language if you want.
For price action analysis using only the price data and some drawing tools, different traders focus on different things. Some may focus on analyzing the candlestick patterns and use them to identify tradable opportunities. Candlestick patterns are shapes formed by a single candlestick or a group of candlesticks, which can tell who dominated the market during those trading sessions.
There those who focus on chart patterns, which are identifiable structures formed by a combination of price swings. Patterns, like the head and shoulder, double top, wedges, and so on, can present quality trade signals if you can learn how to identify and trade them.
Apart from the usual chart patterns, there are specialized chart patterns that are based on the Fibonacci ratios. They are called the harmonic chart patterns because they follow a specific ratio that can help you to identify where the pattern would complete before the price even gets there — the potential reversal zone.
Technical analysis can also be in the form of Elliot Wave analysis. Here, traders analyze the individual price swings and classify them into Impulse Waves and Corrective Waves. The impulse waves are in the direction of the trend, while the corrective waves, also known as pullbacks, move against the trend. To do this analysis correctly and use it in your trading, you should be able to identify the trend and the specific price waves and also know when each wave is about to end and switch to the other wave.
How does technical analysis work?
Now that you know what technical analysis is and the different forms it can take, let’s take a look at how it works.
Here’s the thing: Technical analysis works on the basis of human psychology and the fact that humans tend to repeat their actions. Another factor is that humans like to identify patterns in everything in life, and the financial market is not out of it. Continue reading to find out what we mean.
The forex market is made up of people trying to exchange one currency for another for many different reasons — for business, holiday plans, speculation, and others. But speculative trading receives the most attention. In speculative trading, most traders try to do what others are doing, so there is a sort of herd mentality in the market.
When most people are buying a particular currency pair, the pair will start trending upwards, and if most people are selling the pair, it will start trending downwards. This is especially true if institutional traders who have the capacity to move the price are trading in the same direction. Hence, it is the herd mentality that drives the price.
Moreover, as the market participants interact with each other in the market, it creates different shapes of candlesticks that represents what happened in the market in each trading session — remember, each candlestick represents a trading session, which can be a day, 4 hours, 1 hour, etc. as the price moves, it creates different swings that, in combination, may assume an identifiable structure.
Now, these shapes, patterns, and structures are seen by all traders with the technical analysis skills to identify them. Since these technical traders already associate those shapes, patterns, and structures with the price moving in a specific way, whenever they see them on their charts, they would trade in a way that fulfills their expectations.
In other words, on seeing the head and shoulder pattern, many technical traders would go short in expectation of a downward price movement. With many sell orders flooding the market, the price is forced to move downwards, thereby fulfilling their expectation. Hence, one can say that technical analysis works as a self-fulfilling prophecy.
What we just described focused on price action analysis, but it doesn’t matter how the technical analysis is done; as long as there are enough traders who associate the supposed signal with a particular manner of price movement, they would act in a way that brings that expected price movement. So, indicator analysis works the same way.
For example, if there enough who believe that a golden cross (an upward moving average crossover) or a bullish stochastic divergence would bring an upward price movement, whenever any of those signals appears, they would place buy orders, and if their orders are big enough to move the market, the price would move upwards, thereby fulfilling their expectation.
The right way to use technical analysis in trading
You have seen how technical analysis works, and of course, it can be very profitable if you use it the right way. While there may be mixed results from academic research on the profitability of technical analysis, experienced technical traders know that technical analysis works so well when used the right way. But what’s the right way?
The first thing to consider when trading based on technical analysis is the timeframe you will analyze the market and manage your trades. You will find things more comfortable if you choose a timeframe that suits your personality. Here’s what we mean: Are you someone who likes to be active in the market all the time, enjoys working in a high-pressure environment, and is capable of making quick decisions in the heat of the moment, trading on the lower timeframes may be your best bet. But if you are the type that has to think things through before making a decision and don’t like to be monitoring the market all day, you are best suited for higher timeframes like the daily timeframe.
Next, focus on the aspects of technical analysis that interests you. It is normal to start out with indicators, as that is the easiest to learn at that stage, but once you start getting how things work, find out the sort of technical analysis you are most attracted to, which works for you. It could be candlestick patterns, chart pattern, Elliot waves, or even a combination of any of them with some indicators. Focus on what suits your style and master it.
It is possible that you may prefer to create your own unique way of analyzing the market by combining different technical methods that suits your personality. For instance, you may combine candlestick analysis with Elliot wave, chart pattern, or harmonic pattern analysis. In this case, you use any of those methods to spot an opportunity in the market, while you use candlestick analysis to know the exact moment to enter a trade.
Whatever method you choose, create clear-cut criteria for what constitutes your trading setup and write them down. This becomes your trading strategy, which you must always try to adhere to. Having a clear-cut strategy helps you to maintain a rule-based trading, thereby keeping subjectivity to a minimum.
One more thing though; don’t ignore fundamental analysis, especially if you are a day trader. It is possible to combine your technical analysis with fundamental analysis. But even if you don’t want to combine both, you should at least know the time important economic data or political news is to be released so that you stay away from the market until volatility returns to normal.
How to create a technical analysis trading strategy that works
For you to trade profitably using technical analysis, you need to create an objective strategy with all the criteria clearly spelled out. To do that, you need to follow the following steps:
Do your research: You have to study what others have been doing in the market to find out what works, what does not work, and why. Interestingly, there are lots of free resources you can use on the internet — from trading blogs and ebooks to trading forums and research papers on the technical analysis of the financial markets. One place you can find a lot of free research work is www.ssrn.com. You can go through the papers and look for strategies that have been proven to work and find out why they work.
Extract some trading ideas: One interesting thing about some of these resources is not just that they provide some trading strategies, but also they show the back-tested result of the strategy. But that does not mean that the strategy will be suitable for your personality and style of trading. However, you can extract the trading ideas and fine-tune them to suit your style. Some broad trading ideas that have been proven to work include value trading and momentum trading — these are another way of saying pullback reversals and breakout strategies.
Create your trading strategy from those ideas: With the trading ideas you like and considering your personality and preferred style of trading, you can create an objective trading strategy with clear-cut criteria that suits you. Your strategy must specify the markets to trade, the timeframe, trade entry rules, stop loss size, profit target, criteria for a premature exit, and any other trade management rules. But don’t make it too complicated; the simpler, the better.
Test your trading strategy: Even if you copied a tested trading strategy without changing anything, you still need to test the strategy yourself. You should never trust the result of others in something like this, and here’s why: One, it may not be accurate, or there may be too much curve fitting, which will make it useless in live trading. Another reason is that when you test the strategy yourself and be sure it has an edge, it gives you a sense of ownership, which helps you to trust and implement it better. So, you should back-test the strategy on your chart by going back in time to see where the trading criteria were met and what the result was on each occasion. If the performance was good enough, you may have a good strategy to start with.
But does working in back-testing mean that it will work in real-time trading? Obviously, no, which is why you need to front-test the strategy in real-time. Open a demo account and trade the strategy consistently. After trading a reasonable sample size, you review the performance of your strategy to know if it has an adequate positive expectancy, and if need be, make some modifications, trade another sample size, and review again.
But a good trading strategy that has an edge in the market is not enough to become a successful trader. There is more to trading than a strategy with an edge.
What you need to stay profitable when trading with technical analysis methods
Of course, a good technical analysis strategy with a positive expectancy is very important in becoming a profitable trader. But it is not enough. Two traders may have the exact same strategy and trade at the same time but end up with different results — one may be making profits while the other may be in a big drawdown.
This is where the individual’s trading skills and ability to stick with the trading wisdom of old come to bear. The person who has what it takes and does the right things succeed, while the one who doesn’t gets thrown out of the game. So, what are those things that make the difference? Here, you have them:
1. Money management rules
The Oracle of Omaha once said that in this game, there are only two rules: The first one is to protect your capital, and the second one is not to forget the first one. To succeed in trading, you must survive long enough to meet the opportunities that will work in your favor. And, managing your trading capital very well is your primary survival strategy.
One trading wisdom you should follow is not to risk more than 1% of your trading capital in any trade. With that, you can stay long enough in the game to become profitable, provided your strategy has a positive expectancy. No matter how good your strategy is, there will be a time you will get a prolonged losing streak. Assuming you have a streak of 11 or 12 losses, and you are risking 10% of your capital per trade, you will have 100% of your capital and be out of the game. But with 1% risk per trade, you will only have a 10% loss and will still be in the game.
2. Trading psychology
Yes, you have a great strategy, and you are wise enough to risk only 1% of your capital per trade, but if you don’t have what it takes to consistently execute your trading plan well, you will still end up losing because you will be liable to making trading errors, such as trading without a stop loss, jumping the guns, chasing trades that you missed, getting carried away by streaks of wins, or becoming afraid to take the next trade when you have a losing streak.
To succeed in trading, you have to develop the traders’ mindset. And what does that mean? It means focusing your mind on executing your strategy as flawlessly as possible without bothering about the outcome of each trade because you know that the outcome of one particular trade does not matter.
Trading is a statistical game. Each trade has a probability of being a winner or a loser. If your strategy really has an edge, the odds of being a winner becomes higher than that of being a loser. But there is no way under the sun to know which particular trade would be a winner or a loser. But at the end of a large sample size, you would either have more winners than losers, or your winners made far more money than the losers such that even if there were more losers, you are still in profit.
If you realize this, you will know that what matters is to focus on the execution process. There is no point bothering about the outcome of each trade.
Tips for technical analysis trading
Here are some tips that can help you improve as a technical trader:
- Choose the technical analysis method that suits you: Technical analysis means different things to different people. For you, it may be all about indicators or even a specific group of indicators, like the moving averages. Find out what it is for you and stick to it. What matters is having a method that you can effectively and consistently implement without getting confused along the line.
- Have a few strategies for different market conditions: Create more than one trading strategy because the market condition often changes from time to time. What works in a trending market will not work in a ranging market. So, it will make sense if you have a few strategies that can handle different market conditions — when the market is trending, you use the strategy for a trending market, and if the market is in a range, you trade the strategy for that market condition.
- Have a routine: You need to have a trading routine that you keep to. It can help you trade systematically and avoid some silly mistakes that can affect your result. Your routine may be to check your previous trades, open your watch list and select the markets to analyze, cross-check your trading panels to be sure that you don’t have an outrageous lot size on your one-click panel, and then start your analysis for the day.
- Protect your capital: Your capital is your ticket to the game. If you blow it, you are out of the game until you can raise another capital, which would have been used for something else. Do not bet with more than 1% of your capital in any trade, and make sure you always use a hard stop loss when you are in a trade.
- Think in probabilities: Trading is a game of probability. Each trade only has a chance of being a winner, just as it also has a chance of being a loser. There is no certainty in the outcome. The only thing you can control is your execution process, making sure that every trade setup counts. So, focus on the process and ignore the outcome until you reach your sample size.
- Review the performance of your strategy at regular intervals: Trade in sample sizes and review your trades when you complete a sample size. You can choose a sample size of 50 trades or 30 trades. After every 30 trades (if that is your sample size), you analyze the performance of your trading strategy and make the necessary modifications if need be.
- Continue researching and learning: Learning never stops, so make sure you make out time to do more research. Even if you are an intraday trader, you won’t spend all day executing your trades; you can always create some time for research. It is very important in your trading journey, as there is always something new to learn about the market.
Sure, technical analysis is profitable if well executed, but that is not the only thing you need to succeed in trading. You need to know how to preserve your trading capital by not exposing more than 1% to risk in any trade. This means trading the right lot size for your trading capital and using a hard stop loss to make sure that you don’t risk more than you intended. Also, you must have the right trading mindset and control your emotions.