How to Use Technical Analysis the Right Way.
Stop using Technical Analysis the wrong way and follow these tips.
Technical Analysis is a fascinating way of analyzing markets. It serves as a great complementary tool to Fundamental Analysis and it relies mostly on charts and indicators. Unfortunately, many retail traders misuse it, thus, causing catastrophic results and giving it a bad name. Technical Analysis is now regarded as a pseudo-science rather than a serious skill. This is of course not the case. My personal and professional experience with it prompted me to start writing about the correct way of using it. If you need a refresher before reading, consider the below article:
A gentle introduction to Technical Analysis.
Have you ever seen one of those complicated charts with so many lines and shapes that seemed too fancy and some sort of…
Always Start on the Higher Time Frame.
When performing Technical Analysis, you should remember that the higher time frame supersedes the lower time frame. This means that a monthly resistance is stronger than a weekly resistance which in turn is stronger than a daily resistance. How is this important? Well, sometimes, you will find that on a daily time frame (i.e. daily bars), the market is on support but is also close to a monthly resistance. This is a dangerous setup and you’re most likely facing resistance than lying on support.
Whether it’s a graphical or a mathematical support/resistance level (e.g. Bollinger Bands level), you must always take this into account so that you’re coherent across your trading framework. Here’s an example to illustrate what I mean:
The above chart is using monthly price bars and we can clearly see a resistance level around the area of 0.9300. However, on the below chart that uses weekly closes, we can see a support on the Bollinger Bands moving average (which is also the 20-Week MA).
And if we switch to the Daily time frame, we can see that we are actually breaking the lower Bollinger Bands that was acting as support. So, which direction are we likely to see?
Well, this incoherence begs for the trader to see another currency pair in order to find a clear configuration as opposed to the one above. We can also check for correlated pairs and try to find more insights there that give information as to what to do with the EURGBP. The ideal is to find confirming signals on the three horizons and while that can be rare, it is the optimal solution. Getting a neutral bias on one or two horizons is also an acceptable reason to proceed with the analysis and trade.
Do not Rely too much on Graphical Analysis.
I encourage you to make a small zone that connects the extremeties of the candles and one that connects the closes. That way you’ll have an area that accounts for the noise around it. See the below chart:
This takes into account some excess and some closings to form a subjective zone. It’s always better than just taking one level that is supposed to cover all. I would also warn that graphical analysis should be thought of in another way. How? Here’s the intuition that is taught in technical analysis:
A strong support/resistance level is defined as a level that has been respected by prices at least 3 times and hence the probability that prices will react well from it next time is high.
But is that the way how are we supposed to think about them? Here’s my personal interpretation and opinion
I believe that it’s quite the contrary. When this “support” or “resistance” has already been tested quite a few times, I believe that prices are giving us a signal that they want to breakout and more often than not, they breakout on the third or fourth attempt.
This is why graphical supports and analysis do not generally work (at least over time). A clear ascending channel doesn’t provide support and resistance levels, it provides downside and upside confirmation levels. Here’s an example to illustrate my point, we can see that on the GBPJPY, there’s a clear support zone that we are around. Naturally, one might think of going long.
But, personally, I need much more than this very simple technique to tell me to go long (namely fundamentals, sentiment, and other technical tools). Here’s what happened next:
Be careful with graphical supports and resistances!
Check Whether Markets are Ranging or Trending.
Markets alternate between being in a range and being in a trending. There are different strategies for each state and knowing which state we are in is vital into following a successful strategy. It is absolutely vital to know whether we are trending or ranging. The best method in my opinion that serves as a confirmation of the current state is the visual representation:
Some people like to use moving averages, but will they really show you anything more than what the price is showing? Others like to use the ADX. Alright, but it is still price-derived and hence lagging. All it does is show you the previous state.
Your best bet is to look at the chart and determine whether we are in a trend or in a range. If we are approaching a strong level, then we might need to take action (a bigger action if we’re in a range as it will likely react from the level). The question that matters: Will we continue being in this state or will we change? And that requires more complex analysis.
Do not Toy too Much with the Default Parameters of Certain Indicators.
Many indicators act as self-fulfilling prophecies, their default parameters are the most followed ones and thus, the ones that are most seen by traders. Of course, it is important to note that technical indicators do not forecast markets because they are simple price-derived calculations. However, they do add a confirmation factor into the analysis. Maximizing our odds for a profitable trade can also be through looking at what most people look. This is to say that it’s probably better to look at a 14-period RSI than a 93-period RSI. You can also back-test and see which period works best for the analyzed asset. Just be careful of overfitting your parameters.
Use Moving Averages to their Potential.
Moving averages are one of the simplest yet best ways to find support and resistances that confirm your bias. Some pairs work better with short-term moving averages while others work better with long-term moving averages. Some traders prefer Fibonacci-based moving averages like 13, 21, 34, and 55 while others prefer simple ones like 20, 60, 100, and 200. My approach is that I try as many as I can and see which one is currently showing the most reactions. Then, I back-test the good ones as standalone strategies. I do not expect a winning one but a moderately performing strategy is enough because it will only form a part within a bigger framework. Let’s see an example:
From the above chart, it can be seen that the 200-Day moving average (in purple) is the one that provides the best reactions. It is also apparent that the 100-Day moving average doesn’t look to provide much as the market is always surpassing or breaking it. This is just a simple example and in practice, we should test more than just three.
Do not be Afraid to Experiment with Exotic Methods.
Many technical strategies do not make a lot of economic sense and are the result of extensive back-testing and data mining. Some are genuine and tend to work while others seem to only work when specific conditions are met. Trend-following is a type of trading that is:
- Searching for buying opportunities during a rising market.
- Searching for selling opportunities during a falling market.
I’ve written about one of my favourite trend-following strategies here:
Another exotic technique I constantly use is Harmonic Analysis. Harmonic patterns tutorials and books are everywhere around the internet. If there’s one source I would recommend, It would be Scott Carney’s books. They are very well explained with lots of examples. We will see here the simplest pattern (for a more thorough review, see the link below). The ABCD is a reactionary pattern which is also the continuation of the simple ABC corrective Elliot wave.
The principal Fibonacci retracements (left) and reciprocals (right) we’re interested in are shown in the table below:
0.382 | 2.240
0.500 | 2.000
0.618 | 1.618
0.707 | 1.410
0.786 | 1.272
0.886 | 1.130
It should be clear that the Fibonacci reciprocal is simply 1 / X of the Fibonacci retracement. Many harmonic patterns exist and they differ in complexity and it refers to three legs defined by two impulse waves and one correction wave between them before the last corrective wave is forecasted. The optimal target for an ABCD pattern is 38.2% of the whole length of the pattern. The chart below shows a trading configuration on the EURGBP pair through the hourly time frame. The trader should notice the pattern around mid-way between the C point and the D point. The grey box is subjective and takes into account early and late reversal, that is, if we expect prices to reverse around 0.8900, the grey box also known as Potential Reversal Zone — PRZ — can be between 0.8890 and 0.8910. The target is as mentioned before lies at the 38.2% retracement level of the whole ABCD move, we trace the target level as soon as prices touch the PRZ level.
Huge shortcut: Do not memorize the reciprocals or any retracement. You should know that using simple maths logic would lead you to know that it’s a symmetrical pattern, i.e. AB equals the CD leg and hence you can use the Fibonacci expansion tool to measure a leg and its correction and then project it at a 100.00% level. This is why the ABCD pattern is also referred to as AB=CD or Elliot wave’s corrective zigzag. As a rule of thumb, the 0.618 | 1.618 symmetry works better from my experience.
Harmonic patterns in the FX market. How to detect them? Focus on ABCD’s
Harmonic patterns tutorials and books are everywhere around the internet. If there’s one source I would recommend, It…
Learn the Proper way to Count Elliot Waves.
Elliot Wave Analysis is one of the most famous theories in Technical Analysis but many perform it the wrong way. First, this theory is not meant to provide trading signals nor does it really predict market direction. It is simply a way to help us know whether we are in an impulse move or in a corrective move. This means that we are interested in knowing whether we’re supposed to follow the trend or start thinking about going against it. The below shows an example of the expected full Elliot move:
The three rules that are never to be forgotten for the wave count to be correct are:
- Wave 2 never retraces more than 100% of wave 1.
- Wave 3 cannot be the shortest of the three impulse waves which are wave 1, 3, and 5.
- Wave 4 does not overlap with the price territory of wave 1, except on rare occasions where it’s accepted.
So, how to really profit from this theory? Well, take the below example.
Around the fifth wave at the bottom of the chart, we should start to be cautious with any short positions. This doesn’t mean go long immediately, but it’s just a signal that says, according to the wave theory, we might have finished our impulse move. Elliot wave theory should be combined with Fibonacci levels so that their effectiveness is further confirmed with another famous technique.
Learn the advantages and limitations of Candlestick Patterns.
Candlesticks are a great supplement to your analysis. They are best used on a higher time frame to confirm your shorter-term trading. What does this mean? If you have a Doji on a monthly chart and you’re planning a tactical short (going short for a few days to weeks), then this can give you more conviction into your trade knowing that on a monthly time horizon, you have a reversal pattern. I do not recommend using them on the same time frame as your trades.
Throughout the huge field of pattern recognition trading, we find some very popular technical patterns that always come up in every technical analysis class, but do they really work? That is, on their own. Remember that, when we say a bullish candle, we refer to a green-colored (or a white one) one and the same thing goes with bearish candles (red or black body).
This is a bearish pattern formed from two candles. The first candle is a bullish candle while the next one is bearish. Typically, the opening price of the bearish candle is above the closing price of the previous candle and it should close around its body. The greater the penetration of the bearish candle, the greater the probability of a top to occur.
This is the counterpart of the dark-cloud. It is a bullish pattern. We see this pattern in a falling market, the first candle is bearish and the second one has to be bullish. Normally the second (bullish) candle opens lower than the first candle and should close at around half the length of the previous candle. This strikes a resembles with the bullish engulfing pattern, except that, with the latter, the body has to completely cover the previous candle’s body.
The morning star
The morning star is a bullish reversal pattern, thus occurring at the bottom of the market. It is composed of three candlesticks:
- The first candle should have a big body and should be bearish.
- The second candle has a small body that does not touch the first candle’s body.
- The third candle should be bullish and should have a body that is inside the first candle’s body.
The evening star
This is the counterpart of the morning star, and it’s a bearish reversal pattern. Basically, it has the same steps as the morning star:
- The first candle should have a big body and should be bullish.
- The second candle has a small body that does not touch the first candle’s body.
- The third candle should be bearish and should have a body that is inside the first candle’s body.
Sometimes the second candle can be a doji and it is perfectly fine to use it the same way as a morning or evening star. We call this pattern a doji star. When we say the body of the candle should not touch the previous candle’s body, we mean a gap. Gaps are discontinuations in prices that occur due to sudden strengths of movement or a lack of liquidity.
The Harami which means pregnant in Japanese is a two-candle pattern. It has a relatively small body which follows a full body candle, that is why it’s called a Harami.
Three black crows and Three white soldiers
The three black crows’ pattern is a pattern composed of three consecutive bearish candles that typically have their openings within the prior session’s body (and not tails). The three white soldiers’ pattern is the counterpart of the three black crows. It is therefore a bullish pattern.
Gaps are discontinuations between prices and there is a belief that they have to be filled at some point in time. They are very valuable and have many types. A common gap is the one that occurs in ranging market and typically gets filled. A breakout gap signals a new trend and a runaway gap reinforces that trend.
The Tasuki is pattern formed by two candles that gap higher or lower. The color of the candles does not matter. What we should know is that this is a continuation pattern.
A basic and interesting candlestick pattern is the doji. It signals market neutral conditions or confusion. If a market is trending upwards and a doji appears, it could signal a correction or even a reversal. It’s simply when the opening price equals the closing price which results in a ‘+’ candlestick shape. The Tri-Star is probably the rarest pattern of all. It is formed by three consecutive doji lines in a top or bottom. The middle doji has to be the either the highest at a top or the lowest at a bottom.
Tower tops and bottoms
A tower top occurs when there is an uptrend going and we notice the bodies of candles getting smaller and ranging until we see a big bearish candle that might start new trend. A tower bottom occurs when the there is a downtrend going and we notice the bodies of candles getting smaller and ranging until we see a big bullish candle that might start a new trend.
Try Adding a Graphical Touch to your Indicators.
In one of the above points, I have advised not to rely too much on graphical analysis. This is true as it can only serve as a confirming method to your analysis (whether your analysis is based on pivot points or other types of support/resistance levels). But what about drawing the graphical levels on your indicators? In my experience, I have found that this method adds value especially that the indicators are not always around oversold and overbought levels.
The above chart shows a descending resistance on the RSI. By encountering resistance on the momentum indicator, we expect that we’re also under resistance in the price chart. This is what happened in the next chart when the indicator has reacted from its descending resistance. Now, it is important to know that a price-derived indicator does not lead prices. This technique is simply a gauge into the momentum’s direction of the asset. I am not saying that the RSI dragged the market with it.
These are just some of the elements that need to be improved while performing Technical Analysis. I believe that by proper education and research, we can Make Technical Analysis Great Again.