Last Updated on 18 November, 2020 by Samuelsson
Many traders who are introduced to technical analysis are amazed by the way it seems to structure and make sense of price movements. The world of technical analysis is filled with varying concepts that all try to make sense of the behavior of markets. But does technical analysis work?
Yes, technical analysis works, but not always! That is because technical analysis is merely a tool that traders use to define market behavior. Thus, technical analysis will only work if it defines profitable market behavior! This is the most important thing traders must realize before they can make technical analysis work for them!
So, what separates a profitable trader from a losing trader? Let’s have a look at this and much more!
What Is Technical Analysis?
Technical analysis is the study of market price data that aims to find patterns that have some predictive potential. There are many patterns that most market participants have not noticed, and that you can take advantage of in your trading.
When traders refer to technical analysis, they typically mean anything of the following.
- Technical Indicators
- Price Action
Trading indicators are what most new traders discover at first, Many find them especially alluring due to their promise of providing accurate information about where the market is headed next. As we will learn soon, this is true to some extent, but not completely.
Price action simply is the study of price graphs in search of recurrent patterns that can be used to forecast price movements. Price action traders look at the close, open, low, and high of the desired period in order to find these patterns.
Candlesticks and candlesticks patterns are examples of price action trading. There are many candlesticks patterns that traders have come up with in order to easier spot and act on patterns in price data.
Chart patterns are also included in this category.
Do Any of These Work?
Technical analysis aims to provide tools for traders to define what the market does. In large, most of the market behavior is random and holds no predictive potential whatsoever. This randomness, naturally, is mirrored in the market data that we base our trading decisions on.
If we watch random market action and take it for true market behavior, we are bound to believe in and trade patterns that will not work in the future, since it is random. This is something that you need to understand to be able to use technical analysis in any useful way!
Both trading indicators and price action have the potential to define false market behavior. It does not have to do with the type of technical analysis you employ, but as soon as you are dealing with historical market data, you could fall into this pitfall!
In fact, most of the concepts in technical analysis do not work, but are based on false beliefs of what the market should do in a given moment. Imposing one’s views of how things should work on the market is one of the things that keep many traders from achieving long term success. The market works as it does, regardless of what you think is true.
Everywhere on the internet and in books, you will find rules on how certain indicators of concepts in technical analysis can be used by traders. A lot of these claim to be correct, and showcase market tendencies that could be traded profitably. In some cases, there is some truth in what is being said, but most often, there is not. Sometimes the concepts describe a market tendency that exists but is not refined enough to be traded as is.
The latter type of market tendency, is what traders often refer to as an “edge“.
The Goal of Technical Analysis: The Edge
The edge is simply an advantage that you have in the markets. An edge could be to buy once the market gets oversold, and sell once it gets overbought. In fact, traders who perform trading based on this very tendency, trade something called “mean reversion”.
Mean reversion is the tendency of some markets to perform exaggerated movements in one direction, that is then compensated by a reversion of the short term trend. Equities, in particular, have a tendency to revert to the mean, and there are many trading strategies that utilize this behavior to make money on going long once the market is about to turn around.
Let’s assume that we know of this tendency of the market, and want to capitalize on it. What we need to do is to come up with criteria that define the oversold region where we want to buy, as well as the overbought condition which is when we want to sell.
This is where technical analysis helps us in defining the conditions where the market is likely to move in our direction. In other words, the goal of technical analysis is to come up with rules that define an edge in the market!
The Process of Finding Technical Analysis That Works
In order to find out what technical analysis that works, you will have to sift through a lot of ideas. As we have mentioned earlier, most of the things do not work very well or at all, so you will need a lot of patience to find something that works!
Let’s have a look at the process of building a trading strategy that involves technical analysis!
1.Finding An Idea
This firsts step is to find an idea that you want to test. In this step, many traders make the mistake of trying to fit their idea to their views of the market. If you are an experienced trader with a lot of experience, you will certainly have gained a lot of knowledge over the years of what works and not.
However, as a novice trader who has not yet become profitable, trying to judge whether something has worked or not, will impede your progress. The markets seldom work as we expect them to, and you will be surprised how many times you find they behaved in the opposite way to what you anticipated.
Many beginning traders ask themselves how they ever are going to be able to come up with enough ideas. However, once you start, this rarely is an issue. As you find your first idea, it quickly sparks news ideas, and before you know it, you are standing there with more ideas to test than you could ever have thought of!
In order to find trading ideas, we recommend that you have a look at our collection of trading edges. Having a look at the logic could probably spark quite a few ideas for you!
Another place where you might find trading ideas is on trading forums. In our article on trading forums, we have gathered the top 20 trading forums on the Internet!
2.Converting the idea into Technical Analysis
Now that you have an idea, it is time to convert that idea into technical analysis. We want to find conditions that define our idea as closely as possible, by using trading indicators, price patterns, or anything else you deem suiting!
What you need to be aware of, is that an edge in the market can take many forms. For instance, there are many ways to define mean reversion. You could define it as x number of down days, measure the distance from the close to a moving average, or anything else you come up with. You will find that despite these methods all try to define the same edge, some will work much better than others. In the end, that means that there really is an endless number of conditions to try!
3.Testing the Strategy
Now it is time to put the strategy to the test. This is when you find out if it works or not.
To make it all very easy, it could be said that there exist two types of strategy testing:
- Forward Testing
Forward testing basically means that you let the strategy sit for a while, and validate its performance once it has had some time to generate new trading signals on fresh data. Forward testing could also include paper trading, which means that you take the signals as if you were trading the strategy for real, but trade with fictitious money.
Forward testing has the benefit of not letting your knowledge of recent market action interfere with the validation, since the future is unknown.
While forward testing is good at removing your biases from the strategy creation process, it has one major disadvantage.
It takes a lot of time.
In order to validate your trading strategy you preferably want several years of data to be sure that the edge can survive various market environments. Waiting so long to trade a strategy that you have developed simply does not work.
This is were backtesting has a major advantage.
Backtesting is when you define the rules and look at historical data to see if the strategy has worked historically. The major benefit of this method is that it lets you evaluate the idea on many years of data without waiting.
The best way of backtesting is with a dedicated backtesting software, like Tradestation. However, you could also backtest through excel, or simply go through historical data by hand and record the trades as they happened historically.
However, backtesting comes with one big flaw, which is curve fitting. As we have gone into before, curve fitting will make you believe that you have an edge when you really do not, which could end in losses if you trade that strategy live!
The best way to backtest a strategy is to use a combination of both forward and backtesting. That way they compensate for each other’s shortcomings, and you get the best of both worlds!
Why Technical Analysis Is Not Enough on Its Own
While having an edge defined through technical analysis is one of the most important things in the market, it is not enough to become a profitable trader. In addition to an edge in the market, you will also need to master the following concepts:
- Position Sizing
Position sizing is crucial in trading and is what determines how much you are willing to risk on a trade.
Risk too much and you will soon be out of the game.
Risk too little, and your returns will not be nearly as great as they could be.
Striking a balance between risk and return one of the hardest things in trading. However, if you were to choose between taking excessive risk and risking too little, the latter is by far the best option.
An example of the Important of Position Sizing
Let’s assume that we have three traders, who both trade the same trading strategy. The trading strategy is based on technical analysis and has a historical winning percentage 0f 80%.
Trader 1 is quite an aggressive trader, who decides to risk 20% of his account on each trade
Trader 2 is not as aggressive and risks 8% of his capital on every trade.
Trader 3 is more risk averse and decides to not risk more than 2 % of the account on every trade.
Le’s assume that the trading strategy goes into a drawdown. From the statistics, we know that 8 of 10 historical trades were winning trades. However, that does not mean that winning and losing trades will be evenly distributed. In a worst-case scenario, you could suffer maybe 10 losing trades in a row, without there being anything wrong about it!
Let’s then assume that we had a streak of 10 losing trades. What would then happen to our traders?
Trader 1 Would be out of the game after just 4 trades
Trader 2 Would just survive until the end of the losing streak, but would be left with very little capital. Even if this trader indeed did survive, the capital has now run so low that it is practically impossible to recoup the losses.
Trader 3 would survive the losing streak with a moderate but perfectly manageable drawdown at 20%.
By now you probably understand the importance of not risking too much!
The topic of trading psychology is one of the very important and often overlooked parts of trading. The only traders who succeed are those who are persistent and manage to look past common biases. Once you delve into the topic of trading psychology you will find that many of the things that hold you back come from withing.
Here is a list of a few common biases in case you want to continue your research on this topic!
- Loss Aversion
- Anchoring Bias
- Recency Bias
- Post-purchase rationalization
- Confirmation Bias
- Bandwagon Effect
- Hindsight Bias
Technical analysis indeed does work.
Issues arise when traders believe in anything they hear, just because it is technical analysis. The correct way of viewing technical analysis is as a tool to define market behavior. The corollary becomes that technical analysis could define both profitable setups, as well as losing ones!