“The illusion of randomness gradually disappears as the skill in chart reading improves.” – John Murphy
Technical analysis as we all know is the method of forecasting future price movements based on an examination of past price movements.
But just like weather forecasting, the technical analysis might not result in the exact predictions of the future.
It just helps to anticipate what is “likely” to happen to the price of a financial instrument over a period of time.
There are many successful traders in the world of financial markets who have achieved their trading goals through technical analysis.
Just learning the very basics of technical analysis i.e. chart patterns, indicators etc. are not enough.
In fact, one will rather incur losses even if they apply only the basics.
There are several requirements needed to convert technical analysis to trade successfully in the markets.
Determine the trend
The first and foremost important requirement is to determine the trend and more specifically when the trend is beginning or ending.
The actual money is made when we can perfectly time the entry and exits into the trend.
By ‘jumping’ on the trend as early as possible and riding it till it ends its rally, one can rip the maximum benefit out of the technical analysis.
Well, theoretically this can sound simple, but with practice, the proper identification of the trend becomes more easier.
Indicators indicate but not dictate
The indicators and measurements that technical analysts use to determine the trend are not crystal balls that can look into the future.
The indicators can indicate a future scenario of the price action but don’t perfectly predict the future.
Mostly it depends on the market conditions under which the technical tools are applied.
But, a trend may change direction without warning.
So, it is imperative that the technical trader should be aware of the risks and have proper money management skills to protect themselves from such occurrences of huge losses.
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Look from a Strategic Standpoint:
A technical trader must decide on two things:
- They must choose when to enter a position
- They must choose when to exit the position.
Looking deeper into these points we can arrive at two conclusions as to when a trader has to exit his or her position.
Either the trader will exit to book his profits or he will exit to cut his loss-making positions.
The trader has to choose when to exit the position in order to capture a profit when the price moves in his favor.
On the other hand, the trader also has to choose to exit his position at a loss when the price moves against his expectations.
So, a wise trader is one who is aware of the risks that the trend can differ from what he had predicted.
A wise saying by Dr. Alexander Elder about trading is that one should ‘Plan his trade and then trade his plan’.
Rightly so, making a decision of what price level to sell and cut losses before even entering into a position is a way in which the trader protects his capital against large losses.
Technical analysis provides the opportunity to study prices.
It determines a price point which can be established so that the trader knows that something is wrong rather with the analysis or the financial asset’s price behavior.
So the risk of the loss should be determined and quantified right at the beginning of the investment.
Finally, because the actual risk can be determined, money management principles can be applied that will lessen the chance of loss and the elimination of the capital of the trader.
So, finally, we can conclude that technical analysis is used to determine the trend, which way is it changing when it has changed, when to enter a position and when to exit it when the analysis is wrong and the position must be closed.
It’s as simple as that.