Why Does Technical Analysis Work?

Once you’ve got your hardware set up ready, you’ll need to know what kind of odds you’re up against. This will help you plan your strategy accordingly. Currency traders usually use technical analysis to determine the risk factors involved. Technical analysis describes different ways of predicting the future of the underlying market based on its history.

Unfortunately, technical analysis is not an exact science. Many prominent scientists label it as ‘voodoo science’. They claim that due to market efficiency, if you use TA to find your entry positions, you’re no better off than someone who chooses those positions randomly. Market efficiency means that all the available information is already calculated in the market prices, and that you can only guess how wills the price behave in the future. The “voodoo science” theory would make sense if it wasn’t for a fact that there is a significant number of traders who are able to consistently make profits in currency markets.

Those traders use technical analysis as their main tool. Since any trader has or can have access to the same TA tools we have to ask how can a small group of traders consistently win and the other larger group, more or less consistently lose in the currency trading game. What is it that winning traders know about technical analysis that gives them the upper hand? The answer is simple: Technical Analysis works but not necessarily for the reason most people believe. Many successful traders don’t want to share this secret.

TA works because many people use it, and successful traders are able to predict how will other people react on different TA indicators and signals. In other words, while the losing traders are using TA to determine their trades, winning traders are winning because they know how the losers are going to react based on this data.

For example, when a price goes below one of the key moving averages, MA, many traders will sell to protect themselves against additional losses. By doing so, they will drive the price of that instrument/currency lower and that will prompt some traders to start short selling in anticipation of further decline. Prices continue the downward trend, forcing traders who were long on that particular instrument/currency to sell their positions because it is going below their stop limits. This creates a domino effect as the price continues to decline.

However, at this point, successful traders realize that most of the current price action was created artificially. They start to enter the positions on the buy side and more often than not price starts to reverse.

The losing traders have already sold their positions based on the TA tools. The winning traders buy the instrument/currency because they understand that fluctuation was temporary, and they seize the opportunity based on the losing trader’s reactions. No TA tool by itself will give you reliable buy or sell signals.

There is no Holy Grail or magic black box that will give you the perfect, accurate signal. However, combining of the right group of TA indicators with discipline and adequate trading capital has been the road to fortune for many traders. There is no reason why you cannot emulate their success. Technical Analysis is similar to studying history. Historians are usually able to make the most accurate predictions of future and outcomes of events. Usually the past repeats itself.

History proves that people historically behave in the same manner in the similar situations. Great empires start to fall when everybody starts thinking that they are invincible. The same thing happens in currency markets. Every time when there has been a long lasting bull market in any major currency, new experts come from the woodwork claiming that this time it is different, that for this currency sky is the limit, fundamentals are strong there are hundred reasons why this currency should continue to appreciate. And now everybody starts to buy this currency more and more. Money is borrowed, leveraged and put into this currency. However, when no fresh money is coming in to feed this beast, it has to start to feed of itself.

There comes the bear. If traders who were among the last to join the party looked at the charts of previous times, they would have noticed that many technical indicators were behaving similarly as they had in the past.

When you’re unprepared and unaware of historical facts, history is doomed to repeat itself. This is the last lesson you want to learn the hard way when entering the currency trading battle. If you learn while in the battle, not beforehand, your chances of success will most likely be lost.

We will now examine the most important TA indicators and how can they be effectively used in predicting future movements in currency prices.

Price Chart

The price chart is a basic TA tool. Its horizontal axis indicates time and the vertical axis indicates price. Figure 7.1. shows EUR/USD daily line chart for period from June to October 2003. It is the most simple price chart because it doesn’t show price behavior inside the time intervals.

Figure 7.2. shows EUR/USD daily bar chart covering period from June to October 2003. Bar chart shows us more information than line chart since it is possible to see approximate price behavior inside the intervals. We can see price at the start, price at the end, highest price and lowest price of each interval (in this case it a one day interval).

The price chart that is most widely used among active traders is the candlestick chart. It reveals basically the same information as the bar chart. Figure 7.3. is an example of a daily candlestick chart. Note that those intervals with opening prices higher than closing prices are in white color and intervals with opening prices lower than closing prices are in red color.