Technical analysis is the analysis of price data and statistical indicators that are based on that data. The data shows the flow of supply and demand. The supply and demand indicate current beliefs and ideas generated by human behavior and mentality.
The professionals in forex technical analysts categorize price patterns and indicators based on historical data and assume with a reasonably high expectation that they will occur again at some point in the future. This theory is based on the fact that human behavior is natural and, although it adapts and develops over a long period of time, it essentially remains same. Technical analysts center on the herd mentality and how it influences the humans. It is after all very hard to hold an opinion contrary to popular consensus especially in the public area where you have to make your opinions known as you do in the forex trading.
A Little Bit of History Repeating
Mark Twain once said that “History doesn’t repeat itself-at best it sometimes rhymes”. Although Forex Technical Analysis is based on patterns that have previously occurred to predict the future no two patterns are exactly the same. How can they be with so many input variables, we are talking about hundreds or even thousands: trading methodologies, the number of participants, the participants themselves, order sizes, market liquidity, the list goes on. We all know that no two pairs of palms are ever the same but they are similar enough for you to recognize which are of the young lady and which one of a professional baseball player. The is true for forex patterns and indicators: no two are exactly the same but they are similar to be classified and categorized so that the outcome can be predicted with some degree of accuracy.
One of the major discussions around the forex technical analysis is that it is self-fulfilling. Consequently if enough traders use TA they will influence the move they endeavored to predict in the first place, thus harming its efficiency. It doesn’t really matter which side of the fence you sit on here, the fact is that to a some extent the self- fulfillment is expected but it doesn’t necessarily guarantee the success or failure of the technical analysis.
If a price pattern appears in the chart not every forex trader sets up exactly the same entry point and stops at exactly the same time. Otherwise the market would not function they way it does. Price would jump instantly causing massive slippage and partial fills and then collapse when the forex traders claim their profits. The opposite of this would of course be true if TA was considered as a poor method.
In reality with enough technical skills and knowledge, with a strong trading strategy and reliable pattern recognition you have a good basis for a profitable trade. The fact that traders use different entry techniques, price patterns, technical indicators or no technical analysis whatsoever means that there is just enough self fulfilling prophecy present to give technical analysis profit potential.
Forex Psychology and Herd Mentality
Your ability to read market psychology and human herd mentality this is an integral part of forex trading. Technical analysis is designed to generate a means to evaluate this psychology and the resulting action in the form of price or indicator patterns.
The forex traders can use these patterns to make a prediction as to the next likely direction price will adopt. Therefore TA says that herd mentality is predictable to a degree and does repeat itself with enough accuracy in order to highlight trade opportunities.
There is always a place for fundamental analysis in trading, even if this analysis is as basic as knowing when data will be released. In just the same way that technical traders react differently to the same price chart, fundamentalists will react differently to the same piece of news. Market reaction to fundamental news can be unpredictable and violent and the resultant price action will add another variable to the potential success of technical analysis.
Technical Analysis and Time-frames
TA applies to all time frames. The general agreement is that the most important price patterns and indicator set-ups are the ones that happen on the longer time frames, such as daily or weekly charts. Whether you trade in short, medium or long-term time frames will depend on your individuality as a trader. However it is always makes sense for traders to analyze all time-frames so they can be aware of the entire picture.
Technical Analysis and Trading Systems
When using TA to design a trading system one should remember that forex patterns are not ATM machines. TA focuses on predicting the future using the data of the past. That is about it. It is even more useful to see TA as means to determine the entry and exit trading points. On the one hand you may think that trying to predict the future and setting up entry and exit points are the same thing, but altering the phrase you use to describe your objective brings about a profound psychological change on your part.
Predicting the future using the data of the past leads to your evaluation being right or wrong. And this is a huge difference. Not only do we humans hate to be wrong but we hate it even more when we stake money on it.
In turn any negative emotion can have a negative bearing on your trading. Losing a trade (and money) will make you go back to your TA and your collection of price charts to find out what on earth went wrong. You will certainly see that the pattern you used for your entry was slightly different (it always is) and therefore you could have entered differently or not at all.
This is the first stage of doubting which can lead to all sorts of psychological problems. Now suppose your pattern was just an entry point: If you have set your risk and target based on solid money management then you have given yourself the opportunity to profit from the potential you have identified, nothing more, nothing less. Now you must wait for an exit signal or for your target/ risk threshold to be reached. In effect you are reacting to signals the market gives you or flowing with the market. You are participating and not anticipating. Therefore you cannot be right or wrong. Ego, fear and greed will not be a part in your decisions.
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