To be a successful investor you need to increase your odds of making profitable trades, while using appropriate risk management to ensure that the sum of your winning trades is larger then the sum of your losses, and hopefully by a wide margin. Technical analysis if used correctly can greatly increase those odds, and for it to be used correctly one needs to first abandon the notion that there is any predictive power in it. One should not be looking for the ultimate indicator or set of indicators hoping to find something that will tell them where the price of a equity (or any other financial instrument) will go next, because this search is likely to be frustrating, futile, and could lead to an unsuccessful trading strategy. Another dangerous habit which should be avoided is trying to pick market tops and bottoms. Traders look at certain technical indicators and see that the levels that they have reached are in line or have exceeded the levels of previous market tops and bottoms and based on this they will enter a trade. However, trends, be them up or down are never the same size, in either percentage gained or lost, or in time taken to complete. Often trends continue for far longer than many expect and leave certain technical analysis indicators in overbought or oversold levels for extended periods of time, so it is very dangerous and often a near impossible task to successfully and consistently pick tops and bottoms.
To make the most out of technical analysis it is essential to understand what a price chart reflects and what useful information traders can extract from it. Firstly, technical analysis makes use of two primary variables, price and volume, and virtually all technical indicators are derived from the data of these two variables. Price is understandably the most important of the two, but volume can also reveal a lot about the underlying price movements. A good analogy regarding price and volume, which was presented in this interesting article, is that volume is the fuel driving the move. As the tank gets emptier (less volume) the likeliness for the trend to continue decreases as the lower volume reflects the fact that there are less buyers and sellers willing to make trades at the current levels. Price on the other hand being the most important variable in technical analysis reflects all the information that is known about the financial instrument, by all market participants, at any one point in time. The movement of price over time, be it on a monthly chart, a daily chart, or even a minute chart, reflects the changing psychology of traders regarding the instrument under study.
Analyzing these components of a chart; price, volume, and price change over time, can dramatically increase the probability of entering a winning trade. To do this one must first and foremost identify the underlying trend. If you are a short term day trader, then you need to identify the short term trend such as hourly, 15 minute, or even 1 minute, if you are a longer term trader who holds positions for weeks or more, then you need to identify the longer term trends such as daily, weekly, and monthly. The reason that it is so important to identify the underlying trend is because like an object in motion, trends are more likely to continue then to reverse, and trading against the prevailing trend is one of the surest ways to lose money and quickly. The trend can be identified in a number of ways the easiest and best of which is to look for a series of well-defined higher highs and higher lows in an uptrend, or lower lows and lower highs in a downtrend.
Moving averages are also useful in trend analysis. The slope of a moving average, or the level of price with respect to a certain average (price should be above in an uptrend and below in a downtrend), can also help determine the trend. Another use of moving averages to identify the trend is for an uptrend you want to see the shorter period averages above the longer period ones, and vice versa for a downtrend. The more one analyzes and examines charts the better they will become at identifying whether the trend is up, down, or in a consolidation. Consolidations are periods of sideways price movement which don't show consistent higher highs or lower lows. Markets consolidate often and sometimes for prolonged periods of time, and it is usually wise for traders to stay on the sidelines while the market is consolidating. Entering during a consolidation is risky as often these times see high levels of volatility which can quickly stop you out of a position, while other times see very little price movement, thus limiting any profit potential. So it is best to first see evidence that the consolidation period is over, and a new trend is forming before entering.
After one has identified whether price is moving in an uptrend, downtrend, or consolidation, further analysis of charts must be done to increase the probability of entering a winning trade even more. One should look for more supporting evidence in the form of indicators, trend lines, support and resistance levels, price patterns, candlestick patterns, or volume levels that further suggest that price will continue to move in the direction of the trend. Trend lines or support and resistance levels can be especially helpful, if price has just recently broken and closed above or below a resistance or support level, this improves the chance that the trend will continue. However, if one is considering going short for example, but notices that there are significant levels of support that price must break below to continue downward, then the probability of a successful short trade has likely decreased (or at least the size of the move). Next lets assume that a trader considers going long (as an uptrend has been identified), and a bearish price pattern presents itself such as a head and shoulders pattern , or double top , while a reversal to a downtrend is certainly not guaranteed, the probability of a successful long trade is now lower. It should be remembered that often price patterns present themselves and really have no effect on the subsequent price moves, but it is important to analyze and pay attention to them as the more one analyzes charts the better they become at picking out the important patterns.
Ultimately, how technical analysis should be used for entering positions is first traders should identify the primary and relevant trend, and then apply further filters to limit their entries even more. One trap that some technical traders fall into is looking for the perfect setup where all indicators and patterns line up, these setups, however, do not often reveal themselves and looking exclusively for them may lead to frustration and the missing of many good opportunities. Probably the most difficult thing about trading is finding the right balance between looking for the correct setups and taking enough appropriate risks to allow for profit potential, but hard work and dedication does lead one to finding the correct balance. To conclude, technical analysis will not provide you with predictive power, but if used correctly, it will help increase your ratio of winners versus losers. And if one increases their probability of entering winning trades, along with using stringent and well thought out risk management and exit strategies, then they will greatly increase their chances of becoming very successful and profitable investors.
Just a final note, while this article primarily discusses using technical analysis for entering positions, one must realize that this is really only one half of the puzzle. A successful trading strategy must also involve a well thought exit strategy for both profitable trades and losses.
Ultimately, how technical analysis should be used for entering positions is first traders should identify the primary and relevant trend, and then apply further filters to limit their entries even more. One trap that some technical traders fall into is looking for the perfect setup where all indicators and patterns line up, these setups, however, do not often reveal themselves and looking exclusively for them may lead to frustration and the missing of many good opportunities. Probably the most difficult thing about trading is finding the right balance between looking for the correct setups and taking enough appropriate risks to allow for profit potential, but hard work and dedication does lead one to finding the correct balance. To conclude, technical analysis will not provide you with predictive power, but if used correctly, it will help increase your ratio of winners versus losers. And if one increases their probability of entering winning trades, along with using stringent and well thought out risk management and exit strategies, then they will greatly increase their chances of becoming very successful and profitable investors.
Just a final note, while this article primarily discusses using technical analysis for entering positions, one must realize that this is really only one half of the puzzle. A successful trading strategy must also involve a well thought exit strategy for both profitable trades and losses.
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