The Mystery of Technical Analysis

How Not To Do Technical Analysis
How Not To Do Technical Analysis

Introduction

Many new traders (and non-traders), and even professional fundamental traders, have the wrong idea of what role technical analysis plays in trading.

They believe it is some kind of crystal ball that will reveal hidden secrets about price action and tell them where price is headed next.

Some people either believe so strongly in this crystal ball idea and eventually blow up their account from risking too much on trades they are over-confident in — or they find the whole concept so ridiculous that they believe technical analysis is superstitious hocus-pocus not to be taken seriously.

Both of these interpretations are very shallow views that completely miss the point. No serious technical trader claims to know for certain where markets are heading just because he draws some lines on his chart.

In fact, you should be wary of those who do—because it reveals that they themselves do not understand the purpose of their own tools.


What Is Technical Analysis?

Technical analysis is the art and science of using visual indicators and pattern identification to determine what price has done, what it is currently doing, and what it might be likely to do next.

It provides a way to visually quantify what price is doing in terms of market psychology and positioning.

It tells you what traders and algos have done in the past, where traders are trapped and fearful, where they are enthusiastic and where they are shy.

It is not, like some people think, a fool-proof method of predicting the market. It is much more complicated than that.

Technical analysis is a method for determining risk context, detecting repetitive patterns and timing market entries optimally.

How Really Not To Do Technical Analysis

But above all else: technical analysis is a tool professional traders use to determine where to put their stop-loss. By definition that implies that pro traders are uncertain where price is headed!

So rather than try to outsmart the market with lines and boxes, which is as ridiculous as it sounds, they use technical analysis to determine favorable risk-to-reward setups with at least a half-decent probability of success.

They don’t need to win on every trade to come out ahead. They know that all they need is at least a decent chance of being correct with an asymmetrical reward to their risk, and they’ll do ok.

That does not require a crystal ball of any kind.

But many scam artists take advantage of people’s gullibility in regards to technical trading, which adds to its negative notoriety.

They imply that if you master technical analysis (after paying them a hefty fee to learn their secrets), all your trading dreams will come true and you will never lose a trade again.

Unfortunately, when it comes to the markets, there is no fool-proof way to determine market direction. But technical analysis can help you to navigate the seas of the markets without losing your bearings – if you know how to employ it appropriately.


Managing Expectations
(& Risk)

As with all complex things in life, markets are inherently chaotic and unpredictable.

If they weren’t then all of us would be making a fortune consistently. And yet, in spite of this ever-present uncertainty, some technical traders manage to extract extreme amounts of profit out of the markets on a yearly basis.

How do they do it if technical analysis doesn’t really tell them where price is going to go?

Well, the answer lies in their money management. Professional traders are wrong all the time. In fact, most of them are wrong upwards of 50% of the time.

The secret of their ability to extract profits from the markets while being wrong as often as they are right lies in their approach to risk management—not necessarily their abilities of market prediction.

Obviously getting the market direction right is a key ingredient to a winning trade, but it is not correct directional bias alone that will make you a successful trader.

Technical analysis gets a bad wrap in many places, particularly in the crypto and stock fundamentals community — usually by traders who have been burned too many times going all-in on flag patterns and head & shoulders.

Or by people who have seen too many traders post their technical analysis charts and found them to be wrong more often than they are right and therefore conclude that drawing lines on your chart is unreliable at best and a completely futile endeavor at worst.

But this is the wrong interpretation of the role of technical analysis in trading. Technical analysis, like any tool, is only as effective as the operator and their knowledge of how to operate it properly.

And like a weather report, your analysis is only as good as the reality of the present conditions, which are changing constantly.

You can make an educated guess at what those market conditions are and what effects they are likely to produce, but you would be crazy to think that you can be certain about your assumptions.

Like weather, a lot can change in the markets in a very short period of time, often without warning. As such, it is important to understand that diligent risk control is the key to trading any technical system successfully, no matter how good it is.


Contextualizing Risk

As Merritt Black, head of futures trading at SMB Capital, says: context is king.

Technical analysis is not (just) a way to determine market direction. Far more importantly, it is a method for traders to determine risk context in the markets.

It helps traders identify high-probability trading zones in the market that offer good risk-to-reward profiles. Meaning that if they happen to be right on this trade and price indeed goes where they think it could, then it will be well worth the risk of being wrong.

They ignore opportunities in any zone that does not meet this contextual criteria.

This is extremely important, because as traders, we obviously take a lot of trades. If our winners do not make up for our inevitable losses on balance, then we cannot be profitable.

Consider a coin toss that pays 2:1 for heads and -1 for tails. Just because it’s a great bet doesn’t mean that tails can’t show up ten times in a row, or that you should bet all of your money on one toss!

Even though this is a fantastic wager that guarantees you will make money over time, you still better manage your risk capital according to the odds — or you might not be able to keep tossing the coin long enough to make any money.


Accepting Uncertainty

The cold hard truth is that no matter how good you are at breaking down a price chart, you are going to be wrong – and often.

Even the best and most sophisticated technical analysis setups do not indicate that the trade will win, or even that the market will respect the analysis in the slightest.

All experienced traders know that the market is its own beast and drawing lines and placing indicators over it does not constrain it or force it to comply.

If you have any sense as a trader, that idea should amuse you. We have all experienced our best setups fail and watched in confusion as our most confident analysis was completely ignored by price action.

When this happens, we typically feel bad. We all like to be correct in our diagnosis. But we need to keep our projections of self-worth out of trading. Being wrong about a market call does not mean you did something wrong. It simply means it didn’t pan out this time.

The true role of technical analysis is not to determine where the market will go with a degree of certainty, but to simply give you a framework to operate within so that you can plan your trade.

Without this framework and structured method of consistent analysis, how do you know when you are wrong on your trading idea?

When you lose all your money? When the trade goes against you so much that it begins to hurt? When the unrealized loss hits an arbitrary dollar or point amount?

Of course not. This is not how professional traders operate.

Instead they use technical analysis to identify market conditions and context so that they know which setups in their trading plan are most likely to play out successfully, and more importantly, what they need to see before they determine that the setup has failed.

Then they calculate how much capital they’re willing to risk to see the trade play out, for good or ill. And that’s all they need to know to make money.


Path of Least Resistance

When you see a talented professional trader perform their analysis it can often seem in hindsight that they knew exactly what was going to happen.

They draw a bunch of lines on their chart and sometimes price does exactly what they say it will.

But the truth is, they had no idea that price was going to do what they thought it was going to do. All they did was visually define likely potential scenarios.

They used previous experience and their skills at analyzing price action to determine risk context and market positioning, which unveiled the path of least resistance.

All they knew was that price was likely to do what their analysis said it would. There was never any guarantee that price would do exactly what they predicted.

No matter how certain you might be about a trade, and no matter how many variables might align to form the perfect setup, there is always a chance that an unexpected event might happen to completely invalidate your analysis and cause the market to reverse on you.

It only takes one other trader with a massive account balance who disagrees with your thesis to invalidate your analysis no matter how correct it was – potentially in a matter of minutes.

When that happens to a professional trader, rather than hold on to the trade because they have extreme confidence in their analysis, they exit the trade and take the small loss without hesitation — because they have extreme confidence in their trading plan.

They know that even though their technical analysis failed them this time, that does not mean that their approach doesn’t work.

It just means that this trade was one of the many losses they are guaranteed to take in their career, so they better keep it small and accept it without a second thought so that they can stay in financial and emotional shape to take advantage of the next trade.

And so you clear your charts, rinse and repeat the process again, not knowing whether the next trade will be the start of a losing streak or if it will make up for your previous loss.

Such is the life of a trader—where no matter how confident you are in your talents and abilities at market analysis, uncertainty always lurks around each corner, ready and waiting eagerly to disrupt your carefully laid plans.


Conclusion

All of this is not to say that developing your technical analysis skills is a pointless endeavor. Quite to the contrary, I believe technical analysis is the most valuable tool in trading.

But before you employ technical analysis you should be certain you understand its limitations and true intended purpose or else you will run into psychological obstacles.

I personally rely exclusively on technical analysis for my trading. But I never share my technical analysis with other traders expecting them to be able to – or even want to – use it to trade themselves (like many rookie traders do on TradingView and other social trading platforms).

That is a silly assumption to make since we all have different trading strategies, different risk tolerance, different biases, different timeframes, different goals and different ways of interpreting the market.

We each need to take responsibility for our own trading decisions. I couldn’t care less what other traders see in the markets and they should care less what I see.

What matters most is not necessarily your method of interpretation, but the consistency and efficacy of it.

If what you do works well enough to make you money while constraining your drawdown over the long-term, then that is a good system — even if it is wrong extremely often or someone disagrees with your approach.

The point of technical analysis is simply to frame price action in a way that makes sense to you, so that you can trade it in a way that is effective for you.

The goal is to turn a blank canvas like this:

Into actionable information, like this:

This is a trade I took recently based on simple price action theory. I entered at 67c, and sold most of my position at 82c. In hindsight, it looks like I knew exactly where price was going. And it is tempting to think that I did.

But the truth is I had no idea.

All I knew was that price was in a bullish trend and likely to go higher, and that I wanted to be long from as close to support as possible. I used price action, volume and moving averages to define ‘support’.

Then, once I decided where I wanted to enter, I determined that if price did indeed go higher, then it was likely to struggle at previous resistance – so I would be a seller at 82c – and that if it got all the way down to 62c, I wanted to be out, because then the trend (and my trade thesis) may have been violated.

Without all of that information, I would have had no idea what my position size should be, what price would be my optimal profit target, and what price would invalidate my thesis (act as my stop loss) – which are three of the most important aspects to successful trade execution.

I wasn’t fixated on where the market was going. That was only one piece of the puzzle. I was far more focused on the underlying process and what to do if I was wrong.

Here is a copy of the hand-written plan I made for my trading journal a few days after I’d entered the trade and it began to pan out as anticipated:

As you can clearly see, all the childish lines I drew on the chart did not move the market.

Rather, the lines contextualized where the market might move, if the trend continued – and outlined how I intended to act on it.

It was a simple plan based solely on price action and volume, and to my own surprise the trade panned out perfectly—making up for the preceding times that it didn’t.

And if I had been wrong, as I often am, I wouldn’t have cared. I wouldn’t have been embarrassed. I wouldn’t have lost faith in my system.

I would have taken my small loss, and moved on to the next opportunity.

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