“The Forex market is the most liquid in the world…” the Guru continued, “so technical analysis is especially applicable.”
My eyes lit up. That was exactly what I wanted to hear. “Yes!” I thought to myself. Forex trading is going to be sooo much better than stock trading.
“Now look at chart example 2A. What chart patterns can you see? List them out…” the Guru instructed us with the confidence and charm of a young Tony Robbins.
We looked down at our chart handouts, and started drawing lines on them.
Double top, bear flag, inverse head and shoulders. Technical analysis sure is fun!
Beginner Traders Love Technical Analysis
Among all aspects of trading, technical analysis (TA) is the one that typically gets the most attention because it’s visually stimulating and gives traders a sense of control.
These days, anyone can pull out a price chart and draw all kinds of indicators, shapes and lines on it, in less than a minute. You can play around with a hundred different colors, settings and indicator combinations, and continuously tweak them to suit your preferences.
The ability to manipulate almost everything on a price chart gives traders a sense of being ‘in control’, and is something we can quickly get addicted to.
This is why, I think, retail traders tend to fill their charts with a variety of indicators, shapes and patterns. The more of these there are, the safer trading feels.
However, the most important thing on the price chart is the one thing we have absolutely no control over — the market price.
The Indicator Illusion
If you look at a random ink blot long enough, you’ll start seeing patterns in it. That’s what human brains have evolved to do.
More often than not though, the meaning you derive from those patterns says a lot more about your personal perspective, than the reality of the world you’re trying to understand.
In applying a variety of technical analysis tools to price charts, I suspect that the majority of retail traders are doing the same thing. They’re trying to find patterns in market prices that are, for the most part, random.
“But I can see a clearly defined ‘head and shoulders’ pattern on the chart!” you might say.
And you’d be right. That might indeed be a textbook example of a ‘head and shoulders’ pattern. But… so what? Trading is about anticipating the future, not about what you’re seeing right now.
You see, it’s not the identification of chart patterns (or indicator signals) that’s the problem… but what you think it means, that is.
Most people are taught in their early days of trading, for example, that a double bottom pattern indicates an impending price reversal… or that a moving average crossover indicates a change of the trend.
But why would it?
Convenient Answers To Difficult Questions
Given time, pockets of order will form out of randomness, just like how an infinite iterations of a monkey banging on a typewriter will eventually produce the complete works of Shakespeare.
The average retail trader will take one look at these “works” and conclude that the monkey possesses a rare talent. In reality though, he has been fooled by randomness.
Technical analysis is a convenient answer to the difficult question of: “how do I predict the future with a reasonable amount of accuracy?”
Unfortunately, few people take the trouble to examine the validity of technical analysis. How often does it correctly predict future market prices? As far as I can tell, the answer is ‘not often enough’.
This said, technical analysis provides easy answers that people want to believe in.
Well… how are those beliefs working out for you?
When Theory And Practice Diverge
Technical analysis theory is simple, specific and straight-forward. Real-world market prices however, move in complex, messy and erratic ways.
If you’ve been trying to trade with TA alone for more than 6 months you’d probably have noticed a significant deviation between TA theory, and the real world that it attempts to describe and predict.
It is probably not a coincidence then, that the majority of retail traders rely solely on technical analysis, and that most of them walk away with less money than they started with.
You see, the implicit assumption of TA is that only a minority of traders are aware of, and apply it. Because if TA is common knowledge and everyone applies it, the potential for profit would be rapidly arbitrarged away.
In other words, If everyone is trading in the same way, who are they making money off of? The answer is no one.
Technical analysis theory assumes that Reflexivity does not exist. Unfortunately, the world’s richest trader George Soros, disagrees with that assumption.
How I Trade
At this point, I should probably mention that I do apply some TA concepts to my trading… but they are not the primary way in which I identify trade setups.
In order to effectively anticipate market prices, you’ll first have to understand what drives them… and it should quickly be apparent to any rational person that market prices are not driven by TA any more than his future actions are driven by his prior footsteps.
You see, technical analysis is merely a way to describe and perceive market prices on a limited dimension, just like a how a photograph of a forest captures how it looks, but does not convey the temperature, humidity, or sounds of the place.
To use another example, trying to understand the Forex market based on TA alone is like trying to understand a juicy beef steak based solely on its picture. Until you explore the other dimensions of smell, sound and taste, you will never get the full story.
Such is the case with technical analysis, market sentiment, and economic fundamentals. Once you learn how to interpret economic indicators, they provide valuable insights to financial markets that TA is completely oblivious to.
This is why I base my trading decisions on a variety of dimensions, with economic fundamentals and sentiment being the prime considerations.
So if your trading performance has been less than satisfactory, consider looking at the other aspects of trading that you’ve previously ignored.
Try incorporating economic fundamentals into your trading… and you might be surprised how much they will enhance your understanding and application of technical analysis.