Similar to other research techniques, technical analysis (TA) is based upon a certain bunch of assumptions. When practicing TA, you need to conduct your trading, taking those assumptions into perspective. It is the best method you can use to identify short-term trades, as it is not so effective when looking for long-term trades. Since they are short-term in nature, you shouldn’t expect huge returns within a short period of time.
So, what is it?
In the simplest terms, technical analysis means the study of financial market action where you look at price changes occurring on a day to day or week to week basis or any other extended time periods which are represented in graphical form via charts.
TA mainly involves the following things:
- A technical analyst examines the price action of financial markets instead of focusing on the fundamental factors which influence market prices.
- Technicians believe that even if all relevant information of a particular market or stock is available, they still cannot have a precise market response based on that information alone.
- Technical analysts believe that all the relevant information is reflected or discounted in the price, with the exception of any shocking global news such as natural disasters.
How technical analysis can help you make a profit
As mentioned before, technical analysis lets you anticipate what happens to the price of a financial instrument over a period of time. But, just like any other form of forecasting, it is prone to mistakes, resulting in inaccurate predictions of the future. Despite this, technical analysis can help you turn profits if you grasp the concept properly.
It helps traders to have a strategic outlook
As mentioned before, entering and exiting a position are the important two decisions that you have to make while conducting technical analysis. As a technical trader, you either exit the trade to lock in your profits or to cut your loss-making positions. Here, you have to choose when to exit the position to ensure the maximum gains when the price moves in your favor. Alternatively, you may have to exit your position at a loss when the price moves in the opposite direction than what you expected. Thus, you should always be aware of the risk that a trend can move against predictions. To protect your capital against large losses, you have to determine at which price level to sell and cut your losses before entering into a position.
The role of indicators
TA makes use of technical indicators, which are used to determine trends. But you should not treat them as concrete predictions for the future. They merely indicate a future scenario of the price action. This depends on the market conditions prevalent at the time of applying the indicators. However, a trend can change direction in an instant without warning. It’s thus imperative for you to be aware of the risks and take proper risk management tips to protect yourself from large losses.
It helps us to determine trends
Determining the trend is one of the first requirements of using TA, more specifically, when the trend is beginning or ending. The main opportunities for profit arise when you can perfectly time entry and exit into the trend. To reap the maximum benefits from technical analysis, you have to jump on the trend as fast as possible and look to ride it till it ends the rally.
Where does technical analysis go wrong?
TA can be a trader’s best friend if done right, but it is also hard to grasp the various concepts involved. There are instances when professional traders have also succumbed to a wrong decision due to faulty analysis. However, those are rare, and the maximum mistakes are committed by newcomers. There are some specific areas in which technical analysis can go horribly wrong, either due to the trader’s fault or a combination of other factors.
Not making use of Ratios of 1:3 or more
You can achieve a good risk to reward ratio for your trades if you risk less than what you make. This should be a crucial element in your trading strategy as trading should always be aimed at profits over losses. You should keep the following things in mind while using technical analysis.
- Never add to losing positions as the positions that seem small at first can soon add up and become very large when doubling down.
- Always look for strategies that have small losses and large gains in the ratio of 1:3.
- The infamous martingale system, which entices a lot of novice traders, is a good example of a strategy with a bad risk: reward ratio which should be avoided.
The risk of emotionally driven trades
Despite having a concrete strategy in place, some traders tend to make trading decisions based on their emotions. This is something that plagues both novices and professional traders equally. Emotional responses such as excitement, fear, and anxiousness can bring out a fundamental flaw in traders, which ends up affecting the quality of technical analysis conducted.
It’s pretty common to see traders using technical analysis to immediately look for profits after they incur a significant loss. This phenomenon is known as revenge trading. Trading immediately after a big loss leads to the possibility of incurring even more losses. Emotional based trading is the single biggest impediment to conducting profitable technical analysis, where traders rely on their emotions rather than following the analytical approach to trading.
There are a myriad of educational resources on the net which provide trading courses and tips on how to conduct successful technical analysis. Even though there are many novice traders who start their trading journey just by using a few common or simple technical indicators, it requires a lot of in-depth knowledge; practice coupled with good money management skills to be consistently successful. Technical analysis is merely a tool and forms one part of a giant puzzle.