You may think that you know what technical analysis is … it’s those lines and shapes all over your prices charts, right?
But we get so bogged down looking for the ‘best’ indicator and the ‘perfect’ signal, that we can lose track of what we’re actually looking at, what we’re asking our technical analysis to do, and what vital role these technical tools play in our trading.
It’s not possible to read indicators successfully without understanding what they’re telling us, and how. I’m not talking about getting our heads around all the maths and data – I’m talking about a much more fundamental understanding, so you’re working in tune with your indicators, not doing battle with them.
So, what is technical analysis for?
Technical analysis’s primary purpose is to determine a trend. We want it to help us judge which way the price will move, so we can buy, or sell, into that trend accordingly.
Even if you’re trading ranges or pullbacks, the technical analysis is all about entering at X, when the price is predicted to move up or down.
The second purpose of technical analysis is to give us a scale to work to. So, if we buy at X, how far will the price move? And in what timeframe? When should I exit the trade? Technical analysis gives us this information by looking at support/resistance levels, average daily ranges, Fibonacci retracements, etc.
So, if this is what we want from our technical analysis, how do we go about reading that information?
Technical analysis can be either subjective or objective
Subjective technical analysis is the kind of stuff that you may read one way, while the guy sitting next to you sees it completely differently.
One trader may draw a downtrend, while another reads a consolidation pattern … one trader sees a head-and-shoulder pattern, while the other sees an ongoing up-trend … one draws a Fibonacci retracement between the recent high/low, while the next trader picks a different high/low for his retracement reference.
Sure, many traders will tell you that this isn’t subjective. Instead, Trader A has read it correctly, while Trader B hasn’t. And they’ll quote a technical analysis text book to prove their point. But so much of this kind of chart reading is open to interpretation, and the experience of the trader … like which candle wicks to discount … and which timeframes to look at …
Objective technical analysis, on the other hand, is a lot tougher to argue with.
The price either is or isn’t above the 50-day moving average … the MACD histogram is either rising or falling … a stochastics crossover isn’t open to interpretation …
These are concrete signals printed onto our price charts.
Objective technical analysis is always going to be preferable to subjective readings. Apart from the fact that you can be confident you’re reading it ‘right’, it also has the advantage that thousands of other traders are reading the same key signals – and this makes much of technical analysis self-fulfilling. If enough traders are reading a ‘sell’ signal – the price is likely to start falling.
That said, there’s always a place for subjective analysis – but it’s important to be aware of which type you’re looking at.
But what are we actually looking at?
Sometimes with technical analysis, we’re watching the actual price level of our instrument … we might be watching the price move above a key resistance level … or the price hitting a moving average line …
Other times we’re watching the indicators, and reading the signals from those – for example, waiting for two moving average lines to cross, or the RSI level to move into oversold territory.
The more we step away from watching prices, and just watch indicators, the further we move from the price action. This is when traders can miss important information about support or resistance levels, or candlestick patterns.
With my Heikin Ashi Mountain system, I often find that I have to remind myself that I’m not actually looking at live prices on my charts – heikin ashi candles are subtly different from the real open/close/high/low levels of a candlestick. So, while I’m reading the signals from the heikin ashi candles – if I want to know the REAL price level, I’d need to refer to a bog-standard chart.
So, if I now have some understanding of WHAT I’m looking at … I now need to get my head around what that indicator is trying to tell me …
Indicators showing what has happened vs what might happen
There’s a lot of nonsense talked about leading and lagging indicators, with traders unfairly writing off a whole category of indicators as unreliable.
Lagging indicators are those that alert traders to a situation or trend that has already started, telling us that it’s time to sit up and take notice of these developments. This makes lagging indicators a concrete sign of what the price has done. However, quite often, when the indicator fires off its signal, the ‘development’ is already over, and the price has moved onto a new story.
Examples of lagging indicators are moving averages, MACD, Bollinger bands.
Leading indicators, on the other hand signal trend changes before they develop. If this makes them sound like some magical crystal ball … don’t start counting your profits too soon. It’s not uncommon for leading indicators to give false signals, so the readings they offer are just plain wrong.
Examples of leading indicators are RSI and Stochastics.
So how do we put it all together for success?
If you’d hoped that – by looking hard enough – you’d find a technical indicator that reliably told you what was going to happen, before the event … then you’re always going to be disappointed in technical analysis.
Making technical analysis work for you is a lot more nuanced than that. But that doesn’t mean it has to be tricky.
It’s about combining leading and lagging indicators, understanding what it is you’re looking at, and managing your risk so that you’re maximizing profits when the indicators get it right, and minimizing losses when they let you down.