Last Updated on 17 November, 2020 by Samuelsson
Technical analysis is something that many people stumble upon when delving into the world of trading. However, before you start learning technical analysis, asking the question “is technical analysis useful”, might be a good idea!
Yes, technical analysis is very useful. It enables you to quantify the behavior of the market into rules and turn them into well working, profitable trading strategies. Still, it is important to test everything before trading, since most information on technical analysis found on the internet is garbage.
So, how should you go about using technical analysis? It indeed can be challenging for a beginner to know where to start! In this guide, we will go into what most guides and gurus will not tell you and learn to differentiate between useful and useless technical analysis!
As previously stated, there are heaps of advice on technical analysis on the internet. As such, we may start to ask whether the information presented is up to date.
A Short History of Technical Analysis
As a concept, technical analysis is several hundreds of years old, starting with rice traders who noticed that there where certain recurrent patterns in the price of rice, that they could take advantage of.
As we entered the computer era, computers made it possible to make calculations on price data in a way that had not been possible before. That is partly why we began to see how technical analysis increased in popularity among traders.
At that time, many questioned technical analysis and believed that it simply did not work. There was also a more widespread adoption of the idea of an efficient market, which did not leave any room for technical analysis. This was because market inefficiencies, which technical analysis to a large extent builds on, cannot occur in a market that is fully efficient.
However, today, few question the idea of technical analysis and it has become widely accepted!
Reasons to Why Technical Analysis Might Not Work
Much of the technical analysis of the past that worked very well then, does not work anymore. Markets change behavior, and as the golden concepts of the past get publically known, they tend to work less and less well, until they completely vanish.
Now, since the concept of technical analysis is so old, there inevitable will remain a lot of concepts that are outdated. Still, some people present them as concepts that work well today. In fact, very much of the technical analysis that is presented does not work if you were to employ it in your trading today.
Here are some of the reasons why some concepts in technical analysis may not work:
- It was made up and has never worked
- It used to work, but markets have changed.
- The technical analysis presented is “just one piece of a puzzle”
The first reason is easy to understand. Many traders like to impose their often erroneous views of what the market should do once this or that happens, and present it as truth without properly testing it.
The second one does not require much explanation either.
However, the third reason might require further elaboration.
How Technical Analysis Can be ” just one piece of a puzzle”
By this, we simply mean that the information presented was not thought to be a complete trading strategy from the beginning. In other words, it was never made for you to follow on its own. Instead, it was thought to represent a small edge in the market, that you could elaborate on further to find something worth trading.
For example, if you were presented with a bullish signal, you might not want to trade it alone. Instead, you might want to add a filter to increase the win rate.
You very rarely stumble upon free trading systems that work, and most ideas that have some merit to them will need to be refined!
How Traders Use Technical Analyses the Wrong Way
What most traders do, is that they learn a wide range of different commonplace concepts of technical analysis, and try to use them in their trading. These concepts could be things like candlestick patterns, chart patterns, and trading indicators. Very often they come with very strict rules as to how they should be used.
This approach will not work very well. The presented technical analysis might not work in the first place or the presented rules or concepts, as we mentioned earlier, could be puzzle pieces that need to be refined..
Using concepts in technical analysis, without knowing if they work could be devastating and will not make you a profitable trader.
In addition, many traders tend to focus only on the trading entry, and tend to forget about the exit and risk management. Those are at least as important as knowing when to enter a trade!
How You Should Use Technical Analysis
Instead of taking the technical analysis you read and learned for truth, you should use it as inspiration. Take the concept and turn it upside down! Reverse the logic completely and see what happens! Sometimes you might even find that the logic works better that way!
Be creative and test all sort of ideas you can come up with. Never neglect an idea before you have tested it You should strive to not be stuck in preconceived ideas about how something should work! Test it yourself, and let the market guide you in what works and not!
The right way of using technical analysis is not by adhering to very specific rules that you hear about. Instead, it is a tool you can use to define market behavior and come up with profitable trading strategies that you can use later.
So how do you test to see what works and not?
How to Know What Technical Analysis that Works
In order to know what technical analysis works and not in the markets, you could do two things.
- Paper trade your idea
- Backtest your idea
Both of these aim methods aim to simulate what would have happened if you had traded real money. That way, you can avoid losing money on trading strategies and concepts that do not work! Let’s have a look at the two!
Paper trading means that you use a virtual account and take the trades as if you were trading for real. That way you will soon have a track record that you can use to validate or disprove your trading idea.
Backtesting, on the other hand, is the practice of looking at past data to simulate how the trading idea would have performed in the past. There are many software on the market that can do this for you, and most require you to learn a coding language. We prefer to use TradeStation since it has powerful features, an easy coding language, and is well established on the market.
Even if we recommend you to learn a coding language, it is possible, to some extent, to backtest without coding. Here is an article where we list some code free backtesting software!
The Importance of Backtesting
The importance of backtesting technical analysis cannot be stressed enough. Most traders do not know if what they are trading holds or not, and therefore end up trading losing trading systems. By employing backtesting you get to know what technical analysis that works and not, and can avoid trading the latter.
However, backtesting comes with its own challenges in the form of curve fitting, and if not dealt with correctly, it could make you believe in trading strategies that do not work at all!
You can read more about curve fitting in our article on curve fitting!
Technical analysis is very useful if employed correctly. The mistake that most traders make is to regard the concepts and ideas that are taught as solid knowledge, which never is the case. Markets change all the time, and the truth of today might not hold true tomorrow. Therefore it is paramount to backtest or paper trade everything before you go live!
If you enjoyed this article you might also like our other articles answering common questions traders have!