The Technical Analysis Of Trading – Basics & Differentiation

No big words are needed to explain the basic concept of technical analysis.

Technical analysis in trading involves predicting future price changes from past price movements. For this purpose, traders interpret various price patterns, either directly on the chart or indirectly via indicators.

A characteristic of technical analysis is that no one cares about the why!

At its core, technical analysis is about identifying trends and trend changes. Chart analysts are not interested in why something is trending or the trend is turning. So technical analysis does not ask: What exactly led to this price movement?

Technical Analysis in Action: Drawing Trend Lines Correctly (Video Tutorial)

The Extra Sausage: Seasonalities

Seasonality analysis is another method for deriving trading opportunities. In this form of decision making, for or against a trade, seasonal trends in the financial markets are analyzed. They occur statistically in almost all asset classes. They are particularly pronounced in the commodity markets.

Seasonal analysis is an ideal supplementary tool for technical analysis. It can be used as an external indicator for or against a trade and combined with all analysis methods.

Behind the trenches lurk the “fundis

A widespread and contrary approach to the technical analysis of financial markets is the so-called fundamental analysis. The price chart plays only a minor role in this type of investment decision. What is important, however, are fundamental figures on companies or economies. In order to highlight the benefits of technical analysis, it is worth making a direct comparison with fundamental analysis.

Technical analysis vs. fundamental analysis

The fundamental analysis involves a close examination of reports from the audit companies, profit and loss accounts, regularly published balance sheets, management, dividend policy, sales, the competitive situation and production capacity utilisation. But there is more! A fundamental analyst also follows the decrees and communications of the Ministry of Economy and Finance, monitors production indicators, price statistics and much more. There is a lot of work behind a good fundamental analysis and the results provide a lot of food for discussion.

All the analysis methods or values just mentioned come together in an estimate of the fair value of the company. If the “fundi-analyst” comes to the conclusion that the current price is above its estimated value, he sees this as a buying opportunity for the security and vice versa.

With so many figures, many fundis are smoking their skulls and the legitimate question is: Is it worth the effort, because: Often the fund-timer buys his stock and watches it fall below his buying price… and falls and falls.

He must then admit to himself: Despite extensive and careful analysis, he was completely off track at the time of purchase.

How did this happen?

Fundamental factors have an undisputed influence on the supply and demand situation. What the fundis do not take into account, however, is the current mood of the market participants. Mood implies irrationality and stock market prices are influenced to a large extent by irrational decisions made by people.

The stock market price, on the other hand, reflects all the emotions of the market participants and the fundamental situation. A stock market price reflects the moods of thousands of people. Rational moods, irrational moods. It reflects the needs of investors who elude the possibilities of rational analysis.

Nevertheless, all these factors ultimately manifest themselves in an event that must be described as rational: the share price. Everyone sees it and can judge where it stands. It is the price that buyer and seller agree on and carry out a transaction in the security in question. It contains all the decisive information. Among stock exchange traders, there is often talk of information that is “estimated” (anticipated) in the price.

This includes all available information from fundamental analysis, as well as investor sentiment about a security or market.

Stockbrokers look to the future and they form the price based on the expectations of investors. While the fundamental analyst is still busy analyzing the current state of a company.

For you as a prospective technical analyst who bases his decisions on the price, it means keeping an eye on price trends. As long as a trend has not been broken, you can assume that it will continue. No matter what assessment a fundi may come to, because the unpredictable factors influencing stock prices are powerful because human emotions are powerful. But every trend on the stock market ends at some point.

Why? Emotions just alternate. This usually happens on the stock market with the appearance of certain patterns. And exactly these patterns in the price chart are examined by technical analysis, or the so-called chart technique.

Such patterns are quite reliable and occur in a similar way, because people do not change their basic behaviour such as panic, greed, euphoria and fear. Our emotional behaviour patterns have remained the same for thousands of years and they will probably still move stock market prices in a thousand years time just as they do today.

Differentiation between technical chart analysis / chart technique and technical analysis
A fine distinction within technical analysis has already been mentioned above, but now I’ll make it concrete: For technically oriented traders, there is still the subcategory chart technique or chart analysis.

Where is the boundary between these two methods?

If a trader speaks of the so-called chart technique or technical chart analysis, it is exclusively about the use and interpretation of the pure price chart (security price).

Well-known chart technical approaches are the Dow theory, market technique or also the Japanese candlestick patterns. In addition, the classic chart technique includes the well-known and popular chart patterns (SKS, W formation etc).

The technical analysis of the financial markets, on the other hand, is primarily concerned with the use of technical indicators (e.g. RSI, Fibonacci Fans etc.) These are derived to a large extent from the price chart. A software program uses formulas from the price data of the chart to calculate new forms of presentation of the price data and prepares them visually.

Usually, these artificially calculated data are placed as additional charts below the main price chart of a security. In some cases, they are also directly visible in the main chart. This makes it possible to include additional criteria for or against a trade in the decision-making process at a glance.

The main tools and chart patterns of these two technical analysis methods,
and their proper use, I’ll explain in detail in a moment.

Technical Analysis vs. Fundamental Analysis: The Pro’s and Con’s at a glance

Advantages Of Fundamental Analysis:

  • It is based on tangible economic figures of the company and the overall economic environment.
  • It is very well suited for long-term investments, as it attempts to calculate the intrinsic value of a company (the stock market price tends to aim at this value in the long term). This intrinsic value can be used as an anchor price (orientation price) for entries and exits in stock trading.

Fundamental analysis tries to answer the question of the quality of a company, or the overall economic situation (the basis of a good investment).

Disadvantages of fundamental analysis:

  • It takes time (not optimal for short-term trading).
  • It requires good knowledge and skills in interpreting company figures.
  • It is only conditionally suitable for managing the risk of a trade after entry.
  • It does not take into account current market sentiment (bullish, bearish, euphoric, fearful), but stock prices are also driven by investor sentiment, not just by rational facts.

Advantages Technical Chart Analysis:

  • It can be used for very short-term trading.
  • It does not require any knowledge of business and macroeconomic relationships.
  • It plays into the hands of visually inclined people who are not number crunchers by nature.
  • It is well suited to managing the risk of a trade (stop loss, trail stops, determination of target zones based on past price movements).

Disadvantages Technical Chart Analysis:

  • There are innumerable interpretation possibilities of the price trend (sponginess). For this reason, you must think very carefully about which chart analysis methods you want to use.
  • Now that you know what Technical Analysis is looking for and why there is a logical reason to use it, we will now go into the details of Technical Analysis and take a close look at the most important and useful tools.

Technical chart analysis (the most important tools)

Trendlines are used to connect highs and lows. They thus serve to visualize price trends in the chart. Modern chart software automatically forms a trend channel from these. My opinion on this: Divided. Trend lines can be helpful when they are clearly identified. Problem: The unique identification. In practice you will quickly notice: Almost every trader draws his favorite line on the chart. In the way that is best for him. Then he usually adjusts it constantly to unimportant extreme points and the line always runs differently. The benefit of this? Hardly available, except for pure chart analysis purposes. How so? Because as a trader you find chart markers that hardly anyone else finds important.

Support and resistance lines

These lines are horizontal painting art. Trend lines, however, run diagonally. So you connect local low or high points, which are at almost identical price levels. My opinion on this: Joah, that’s better. Why? Because these chart levels can be nailed down more clearly and thus more market participants concentrate on the same zones to make their decisions. Advantage: At these points in the chart process there are usually more stop orders in the market. You can use this. Either by hoping that the price will be kept above or below these levels by important market players. Or, for fast profits in the direction of the triggered stop orders, if the prices break the level.

Chart Pattern

That’s where it gets controversial. The fact is that every financial market really always forms similar chart formations. But! I stress the adjective similarly. It does not mean the same. This is the biggest disadvantage of chart patterns: It is – as so often – the subjectivity of the observer. There are a few, relatively clear course formations. Mostly, however, these patterns are so far-fetched in the chart that the viewer does not know exactly how to interpret a situation on the chart. The formations that still need to be interpreted most clearly are

Double tops and bottoms

Picture: This chart shows a classic raised floor (two circles). When I trade this chart formation, I do not hope for an increased hit rate. I use double bottoms or tops to enter the market with a small meaningful initial stop loss (below the local bottom price low) and thus establish a good risk/reward ratio. Ideally, I trade with overriding trends. As a result, the CRV will continue to increase as long as the trend is not far advanced. Being able to assess the trend progress well is a valuable skill as a trader. My opinion on chart patterns: Yes, as a discretionary trader they do occasionally influence my decision-making. But for autotraders they are hardly productively usable.

Elliott Waves

Now the controversy about the suitability of technical analysis is escalating to breathtaking heights. The so-called Elliott waves are a direct development of the Dow theory. I’m sorry: But whoever came up with this story must have been a real marketing genius, or had too much time.

Trading with Elliott Waves in brief

You count and count and count, look stupid out of your Floortrader Jacket and keep counting. Then you revise your counting from the beginning and suddenly nothing is right anymore. What do you do then? You start counting the waves again. Until you realize you must have miscounted again. Fortunately, this doesn’t happen on printed paper charts these days. Just the need for erasers… whatever. However, Elliott waves are the most complicated, subjective and difficult form of technical analysis to learn. And no one can tell you for sure whether forecasts made with them are even 1% above chance in the long run. My opinion on this: More work for questionable and uncertain value, you can hardly do as a trader. And for fast intraday trading they are rather a nuisance to me.

Chart types

Another possibility for technical analysis is provided by the different representations of price movements in the chart. The trader’s universe of analysis ranges from simple line charts to renko and candle charts. Probably the most used variant are candlestick charts. Many claim: From these you as a trader can derive great patterns most easily. I have to interject here: This statement is not completely wrong, but candle charts actually provide more than that. Candlesticks probably provide us traders with most of the information about the actual price action on the stock market, in a compact and quickly accessible essence. I myself also use this useful form of presentation of prices. Nevertheless, I only pay attention to very few candle chart formations, which originate from Far Eastern Japan. My opinion on this: Candle charts are quite suitable. However, they are also not very suitable for concrete price forecasts.

Technical indicators

Let’s get to the most popular technical chart analysis tool of modern times. These are the so-called technical indicators. The holy grail of almost all trading beginners. Why are they so popular anyway? I don’t really know. I haven’t done a survey on them yet. But I can halfway put it together.

Indicators are ideal for bake-testing

  • They are technical and number-heavy (many people hope that this will increase confidence and security in their trading)
  • And indicators are marketed in a way that puts the cards on the table for newcomers: With little effort, a high degree of accuracy and therefore profits

What more do you want?

Basically, there are two categories of technical indicators:

  • Oscillators
  • Trend followers

Oscillators are observed in sideways markets to signal turning points in the price based on oversold or overbought values. Trend followers, on the other hand, are used to confirm prevailing price trends or define new trends. Fact in this hocus-pocus game is: Almost all of these indicators are derived from pure price charts and are calculated based on data from the past. These supposed prodigies of technical analysis do not provide you with additional information about the state of the market. Technical indicators are cleverly prepared summaries of the price trend.

My opinion about this technical analysis tool

The predictive power of individual indicators is zero! The trader is merely pretended to have a security that does not exist. This makes them simply superfluous for me in terms of trading success. And let’s be honest: Do you really need a calculated indicator to correctly assess the trend? Total nonsense. If you want to work with indicators for decision making, you should actually use relevant ones. They have to be calculated independently and please don’t trust only one of them. Such Indis can be:

  • Moving averages
  • Average True Range (ATR)
  • Volume
  • trick or treat
  • Relative strength of a value (but read directly from the price trend)
  • Various fundamental data
  • Possible sentiment indicators

Technical analysis – a small settlement (uh summary)

Much of the technical analysis methods are worthless if you just look at them in isolation, derive price forecasts from them and orient your trading towards the occurrence of these price forecasts. However, this is exactly the forecasting power of technical analysis tools. And it’s the reason why most traders turn to them. And why is that? We humans hate uncertainty about future events. What is important in this context is the definition of forecast. For me, a real price forecast is: If a minimum price movement in a targeted direction can be predicted in more than 50% of the cases without triggering the stop loss beforehand. The stop must not be changed after opening a trade and must not be greater than the price target. And now? I will open your eyes.

The Coin Flip Experiment

At this moment you are surely asking yourself: Why is he leaning so far out of the window? Watch it, Trader! Nobody wants to be important here. Besides the questionable suitability of technical analysis for forecasting purposes, I actually have an even more important reason to hang myself far above the parapet of my trader window. And I would like you to hear about it. Some time ago I started a so far unique long-term live experiment. The thesis to be refuted was:

And what do you need price projections for, if the thesis really holds up? You can probably guess what is coming…

The unbelievable becomes a certainty (a crazy result)

I could not actually refute this thesis. After one year of maturity, and exactly 250 trades, the return was around +81%. And I had no influence on the direction of a single trade! In my Trading Blog you can find the track record. The result is not scientifically based, but a real announcement. What do you say now? If it were really so important for your trading success to be able to correctly predict the prices before entering the market, something like this might not be possible. I hope you agree with me here? Then why should you as a trader waste your energy looking for technical analysis setups with real predictive power? To me, they are misdirected resources. How you can still use Technical Analysis productively is explained in the next paragraph.

Market entry affects the profit factor of the trading approach both through the hit rate and through its function to influence the respective stop loss size of a trade. Depending on how aggressively a trading idea is played, the initial Stop Loss increases or decreases and the CRV changes (provided the Stop Loss is not set arbitrarily).

The shock waves of the experiment (and their effect on my trading)

The outcome of the experiment has changed my basic view as a private trader. In the past, my conviction was: I absolutely must find trading setups with a high hit rate. Today, I know that top returns are only possible if I can keep a lot of profits on well-running trades and extremely cheap on badly performing trades. Besides, I now believe: You don’t have to master much more than the basic movement patterns in the price chart, which Charles Dow also described a hundred years ago. The pure price action of the prices is enough. Market techniques have refined these and today teach them in a thoroughly practical context. You don’t have to be able to interpret an order book either if you don’t want to do market making. That is my statement! And I will gladly bet against anyone who says otherwise.

Use technical analysis wisely in trading

If you want to work with technical analysis as a trader, you should combine some well-chosen tools with other – among themselves independent decision criteria – and absolutely bring them in connection with the superior price course (trend, trend progress, correction, range market). Make sure that as many market participants as possible come to similar interpretations and that at least a kind of ‘self-fulfilling prophecy’ could arise. And: Use mainly such tools of technical analysis, which can help you to filter out important stop marks in the chart. With this you can control your CRV very well and only trade with the smallest possible ISL (Initial Stop Loss).

How did the coin flip setup perform so well?

This is a very good question. As you have seen: Not by good price forecasts before market entry. One answer might be: Through clever risk management at all levels (entry, exit, position size see Traders’ article issue no.5 2016 p.66)

No forecast advantage = No advantage (as a trader)

Wrong! Through a well-considered time of entry (not direction), a well thought-out and strictly adhered to risk limitation as well as a flexible trade management, an advantage could very well be worked out. All trades were entered shortly after market opening. Here the CRV is consistently very good, as the main movement of the trading day is still to come. A good CRV lowers your risk when trading in the long run, because it increases the average profits. The trade management was designed to take immediate risk from the position as soon as prices did not move as expected. As a result, I was able to reduce the average losses to around 0.7 R. All actions were based on new, very simple information of the price chart after the entry (e.g. broken important horizontal price zones, closing prices of candles of important time frames, price acceleration, time component etc.). It is about a constant new guessing of probability shifts. This has nothing to do with a real, nailed down price forecast.

The fusion power plant for trading profits

The powerhouse for your long term trading success is the ratio between profits and losses. With all healthy trading strategies that implement directional bets (speculation on a price movement in a certain direction), one thing has always struck me: Average gains exceeded average losses. In my CoinFlip experiment they were exactly 1.97 times as high.

Profits big – losses small = permanent profits

Be aware of the following: If you play an ‘either/or scenario’ (initial stop loss or take profit is triggered) with a CRV of 1:1, you need a real predictive advantage with your entry to be profitable. If you are speculating on a 3:1 CRV, you need a bigger forecast advantage and not a smaller one. Therefore, trades with further target zones are not necessarily the better choice and an active trade management can bring advantages. You must, within the bounds of possibility, always get the maximum profit out of each trade and make the losses as low as possible. Your complete trading strategy should be tailored to this goal.

The profit frequency is totally overestimated

The hit rate – popularly defined – plays almost no role in the success of your trading. You can almost ignore it! Why? In the generally valid version, it can be easily manipulated by the exit from a trade, and loses its significance with regard to the quality of an entry level setup. A lot of profitable trading strategies produce a value of around 50 percent in the long run (I emphasize long term: in the short run there can be a series of losses and gains). I do not exclude the possibility that very experienced discretionary traders can actually predict the price trend better than by chance. But believe me: none of them will bend it just by using a technical analysis tool. As a trader, you need the feeling for the big picture (basic sentiment, superior market phase). This is the only way you can know when to work with which strategies. And this big picture of the market is something that technical analysis does not convey to you clearly.

The 2,6,2 pattern

If you take a closer look, you will usually notice a particular pattern in the profit and loss distribution of robust retail trading strategies. Out of ten trades, two to three end up in ISL (Initial Stop Loss). Four to six deliver smaller losses or gains and again two to three trades push your account with big gains. The ‘solala trades’ match each other to a black zero. Your success as a trader will therefore depend on how much higher you can push the remaining big winning trades as opposed to the ISL losses. To score points, there are exit strategies such as scaleout in case of losses, pyramidizing in case of wins and of course clever trailing stops. I would say: Exit contributes 80 percent to the expected value of a trading strategy. The remaining 20 percent is provided by a well-considered entry into a position. The absolute return, on the other hand, is significantly influenced by the number of good trading opportunities and the risk per trade (position size). Whether or which technical analysis tool you use for your trading is of secondary importance.

What you should take with you from the experiment (Takeaways)

  • The trading direction is irrelevant for your profitability.
  • Practice active trade management and thus coordinate your respective trade risk with new information from the price development (about the position size or exit).
  • Only implement trading ideas where you can determine a small but reasonable initial stop loss (the real advantage of a good entry).
  • Do not wait for too much confirmation of the price behaviour when you open a position. In many situations, this will significantly worsen the CRV. In contrast, the forecasting performance for a trade hardly improves.

Closing bell

With this article I would like to help you to get a new way of thinking about trading. Away from the perfect entry to get good price forecasts – towards the perfect entry to enter the market early and with a small stop. Be careful if someone wants to teach you that you have to predict prices exactly to be successful as a trader. My experiment impressively suggests the opposite. Lasting profits are created by good risk management skills. Cheers

Your turn!
What technical analysis tools are you using when trading: chart patterns, indicators or resistance lines? Add them to the commentary field!

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