The purpose of technical analysis is to carry out price forecasts. By processing historical market data of any instrument, you can try to anticipate how it should be traded. There are several premises in favor of the reliability of technical analysis that are based on the experience and prolonged observation. These premises are the following:
1. A market trend in motion is more likely to persist than to reverse.
This is obvious by simply looking at any price chart. Of course the aim of any trader is to be aware of the overall market direction, to lock into the prevailing trend and trade it for profit.
2. Markets are discounting mechanisms.
In other words, technical analysts assume that market fundamentals are already represented in the price so what you perceive in the charts is a reflection on any fundamental variable impacting the market. Nowadays, with instant communications this is truer than ever.
Either the unidirectional price move during a trend or the rapid reaction to any new fundamental data throws evidence that markets show up human behavior. From the above premises we can derive that human psychology is always at work in the markets and that technical analysis aims to visualize and quantify it.
3. What has happened in the past will happen again.
This third premise is based on the assumption that human behavior as well as human psychology never change, and that price will reflect it through the repeated emergence of certain price action patterns and trends.
Price action, as a result of human decision making, can be thus considered as being purposeful. Although some people believe that price movement is completely random and unpredictable, technical analysts are always prone to identify and quantify those behavior patterns by examining past markets. While markets are unpredictable in essence, market participants are typically considered to adhere to certain habits, which are rarely broken. As a trader, your goal is to make use of this information in order to gain a slight advantage over the eventual unpredictability of the market.
Drawbacks of Technical Analysis
Despite the fact it represents a true edge for the trader, technical analysis presents some disadvantages. Those who oppose technical analysis point out several problems related to the application of its methods.
1. The failure to know the underlying fundamentals.
A common argument is that technical analysis is aimed at predicting a certain outcome for a chart pattern, ignoring the reasons of the movements which are due to fundamental factors. This is an obvious limitation of technical analysis and any trader feeling uncomfortable with this handicap should find support in the next Module dedicated to fundamental analysis.
2. The lack of scientific objectivity.
Although some theories offer a certain objectivity to the analysis, other studies may not necessarily lead to an objective interpretation. That is why technical analysis is sometimes referred to as being more an art than a science. It is also where individual and mass biases come into play.
In the previous Module [link Module 3], we wrote about the self-fulfilling prophecy referring to the fact that the more people approaching markets with technical analytical methods, the more likely the expected move in price occurs. This is a common argument that points out the lack of a proven thesis. The fact that traders operate with different time horizons, different expectations and risk profiles makes it difficult to find a common approach to the self-fulfilling prophecy.
3. The uniqueness of the pattern occurrences.
Another legitimate argument in favor of the unreliability of technical analysis is based on the true observation that past price action upon which technical methods are based does not often repeat exactly the same way. This can lead to incongruities in the analysis and to inconsistency in the methods.
At this point, however, you should ask yourself whether these arguments can be dealt with in order to make money in the markets. Of course they can, and we are going to show you how!
It's true that traders will never be 100% correct when using any strategy based on technicals. However, more often than not technical studies do create a positive expectancy.
A valuable lesson is undoubtedly that analysis doesn't make the whole trading plan. A proper money management and a trained attitude to stick to the rules are elements which offer additional edges to include in the trading plan. Therefore, don't worry excessively about the above mentioned drawbacks - technical traders have learned how to deal with them.
2. Technical Indicators
There is no reason to complicate things when learning technical analysis. That is the reason why we will study only a few common indicators. This, in turn, will allow us to study their nature in depth and see what implementations and parameters make them more effective.
You don't need to devote your time collecting price data to make use of technical indicators. Through Swissquote's Trading Platform, any trader can access numerous technical tools.
Just open the navigator window and click and drop the indicator on the desired chart window.