With everyone running out to trade Bitcoin and an overall heightened interest in trading, you’ve got to wonder how are these new traders making their decisions on whether to buy or sell? The answer is that most of them are using some form of Technical Analysis (TA). But, does Technical Analysis work? Sorta.
Technical Analysis has merit, but not in the way most people think it does.
Technical Analysis: Charting v.s. Indicators
Let me be clear here: Technical Analysis does not predict the direction of an asset. The real merit that Technical Analysis has is that it identifies the path of least resistance in a given Stock, Futures Contract, or Currency. Meaning, it helps you identify if the majority of market participants are likely to be buying or selling.
Technical Analysis alone will not make you rich. Technical Analysis in conjunction with various other forms of analysis (such as reading order flow, Fundamental Analysis, or using the Options Market) will aid in your ability to make proper market calls.
Drawing some lines on your charts, or using 7 different oscillators and indicators will not make you consistently profitable. In fact, it’s a good way to go broke– or at the very least, that method will keep you spinning your wheels without ever gaining any real traction.
Trade Price– Not The Chart or Indicator
I feel like a lot of traders (especially new ones) make this terrible mistake. They try a new technical system such as a moving average crossover or some oscillator, and when they get a “signal” (I use that word cautiously) they close their eyes, and buy/short at the market price.
The issue I have with this is that these traders are trading an indicator, and not price. Often times, in order to get a signal from an indicator, you have to wait for the timeframe to end for the indicator to produce a signal. By that time, the price movement (a.k.a. good opportunity) is over, and you end up being the sucker that the professional trader unwinds his position to.
The best opportunities fly in the face of most traders. Why? Most traders aren’t aware of what really matters in trading.
What Really Matters When Trading?
“So if Technical Analysis isn’t going to make me rich, what will?” The answer to that is simple: if you can buy it for less than you sold it, or if you can sell it for higher than you bought it, that is what will.
“Simplicity is the ultimate sophistication” – Clare Boothe Luce
I’m being slightly facetious. The reality is that a lot of people like to make themselves feel important by drawing tons of lines on their charts, or using a ton of indicators. It’s both comical and tragic to see some people’s trading screens when that’s the case. The point of trading is to make money.
I know it sounds like I’m hating on Technical Analysis, and to a certain degree I am. However, Technical Analysis is just one way that (while not best in isolation) can aid in keeping you on the right side of the trade. As I said when I began this article, Technical Analysis has it’s place, but it isn’t the end-all-be-all. It certainly isn’t a holy grail.
Risk Management And Technical Analysis
Technical Analysis is in effect a form of risk management. However, there are a few things that I think should be weighted equally to Technical Analysis, if not higher.
If you can buy something for less than you sell it, and have a repeatable way of doing it, congratulations you have found your trading style (read: edge). However, it doesn’t matter if you’ve found your edge, if you blow out your account and don’t have any money left. Keeping you in the game is priority number 1.
So how do you keep your risk in check?
Keeping Your Leverage In Check
If you haven’t read our article on how different levels of leverage affect your account, you can do so hear. Essentially, you should realize that over the course of each trading day there will be a certain level of volatility in the asset that you’re trading.
Some days will have higher volatility, and some days will have lower volatility, but there will be an average range that the asset your trading tends to trade in.
Your trading plan should account for how much volatility the asset you trade relates to the amount of leverage you typically use. If you’re using 50x leverage and trading Crude Oil (which can move 2-3% daily), you better be prepared to lose your account. Again, for the math behind that, check out this article on how too much leverage killed Kenny.
Take Profits: “Cut Your Winners Quick”
Common trading wisdom says that you should “cut your losses quick, and let your winners run”. In my personal opinion (meaning, I’m not giving you advice– what you do is totally your responsibility), I don’t think that’s accurate. This will make more sense when we talk about the Distribution Curve and probabilities below.
To be clear, I’m not saying that you should reverse that old saying to “cut your winners quick, and let your losers run”. No, no, no. What I’m saying is that when you have a profit… take it! Take your money, and run. I’m only half-joking here too.
When you’re in a trade, your mind and judgement tends to get clouded. Fear and greed start bubbling up, and it’s possible to make some really dumb decisions. When you have a profit, and the market isn’t giving you anymore, take your money. Come out of the trade, relax, reload, and reassess what’s going on.
If you do this, you’ll probably find that you’ll be making better decisions with a clearer head, and probably making more money too.
Technical Analysis In The Context of Trade Location
The main benefit of Technical Analysis is that it allows you to identify the path of least resistance. However, it also allows you to identify possible levels at which the market might turn (i.e. Support and Resistance). Typically these levels are around Daily, Weekly, and Monthly Hi’s and Low’s.
Trade location basically is the point at which you entered a trade where the risk was skewed relative to the possible reward. If you were to think of it in the context of the Distribution Curve, you would be buying and selling near the outer extremes of the Distribution Curve as price is likely to be rejected at these levels.
Use The Options Market For Your Analysis Instead
You don’t have to trade Options to make them useful to you. In fact, learning how Options trade is one of the most valuable things you can do for yourself. If you were to spend 5% of your time learning basic Technical Analysis and the other 95% of your time learning how Options trade, you’d be farther on your path towards profitability than focusing 100% of your time on Technical Analysis.
Why? Allow me explain, young grasshopper.
Options And The Distribution Curve
Options follow the Distribution Curve (also known as the Bell Curve). Essentially, what this means is that there are certain probabilities of certain outcomes happening. Typically it has to do with the underlying Stock that is being traded.
Knowledge of Options Translates To Trading Stock And Futures
Since Options are priced based on an underlying Stock or Futures Contract, we can use the probabilities of the Distribution Curve to our advantage. You see, each asset will trade in a particular range over a given period of time.
An asset will trade within 1 Standard Deviation of its price 68% of the time, within 2 Standard Deviations 95% of the time, and within 3 Standard Deviations 99% of the time.
If we are aware of the underlying Stock or Futures Implied Volatility (it’s expected range), then we can base our profit targets accordingly. What does this mean? It means that you should be cutting your winners when you have them, because price is likely not going to go up forever.
Statistically speaking, your winner will eventually revert and move in the opposite direction.
In my opinion (again, this isn’t advice), it’s best to take profits when you’re up money then relax, reload, and reassess.
Where Do You Go From Here?
I hope you haven’t come away from this article thinking that I’m hating on Technical Analysis. I’m not. I’m just saying there’s a lot more to it than drawing some lines, and putting 12 indicators on your chart. If you’re a shorter term trader, I would highly recommend looking into how Options work.
You’ll gain a better understanding of the odds and probabilities around price targets.
If you’d like to learn more, this is an absolutely phenomenal resource that surely won’t disappoint. Anyhow, thanks for reading!