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The Logic of Technical Analysis

The Logic of Technical Analysis What is Technical Analysis? · Technical analysis involves the forecasting of exchange rate movement based solely upon statistics and price patterns Simply put, technical analysis is the analysis of the market based on price action. While fundamental analysis looks at economic factors and geopolitical conditions (such as economic numbers, capital flows, and key political events) in an attempt to forecast exchange rates, technical analysis relies on the statistics and patterns in price movement for its forecast. Technical analysis has gained great popularity in recent history, especially as trends in computerized trading continue to develop and active traders continue to refine their strategies to best assess what is going on in the market at all times. In today’s marketplace, technical analysis has become an essential tool for any aspiring trader. Why Technical Analysis Works · Extremely popular, and hence offers insight into what many traders are doing · More clear-cut and less controversial than fundamental analysis · A simple way of making trading decisions Many traders believe that technical analysis is a self-fulfilling prophecy – in other words, it works solely because it is popular and is used by many traders. For example, many technical traders put a 20 day moving average line on charts not because the moving average itself is statistically important, but rather because it is an extremely common indicator used by active traders of all sizes.

The rationale is simple: if so many traders are basing their decisions off moving averages and other indicators, then those indicators must be watched closely, for they offer insight into what a vast majority of traders in the market are doing. Because of this rationale, traders should focus on the most popular indicators in the trading community, and should use them in the most common way. This is the best way of tapping into the “psychology” of the market – in other words, it is a simple but highly effective way of understanding what other traders are up to, and how the market may move because of it. Contrary to popular belief, it is NOT a study that requires complex mathematics or computer algorithms. Rather, it is a study that requires looking at the same tools other traders use to understand what is happening in the market. Below is a list of the most common indicators, all of which will be covered in the lessons that follow:

• Key Candlestick Patterns
• Fibonacci Retracements
• Moving Averages
• RSI
• Stochastics
• MACD
• Bollinger Bands
While it may seem intimidating, technical analysis is actually fairly simple – often far simpler than fundamental analysis. It simply requires an abundance of the two traits that are most necessary to be a successful trader: discipline and patience. Different Time Frames Technical analysis tools will be valid on all time frames, but we strongly recommend using daily charts for most of your analysis. Medium term positions based on daily charts, using hourly charts for more precise entry points, have two advantages over short term positions based on 5 or 15 minute charts. 1) The spread is less significant for a longer term position. 5 pips out of a price target of 20 is a huge obstacle to overcome on trade after trade. 5 pips out of a 100 pip target is manageable. 2) Longer term charts are statistically much more reliable, since they are based on more data. Indicators have a higher degree of reliability on a daily chart than on an hourly chart or 15 minute chart. Trading on a weekly or monthly chart would likely be more accurate from a technical standpoint than a daily chart would be, but a slower time frame also means less precise entry points, and the wider stops necessary to trade a monthly chart are often beyond the capacity for many accounts. We recommend as a general rule risking no more than 2% of your account balance on a single trade, and this is sometimes difficult with a monthly or weekly chart.

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