Technical Analysis

  • A general discussion of the limitations of technical analysis and how to properly apply this element into your trading strategy.
  • Technical analysis is solely based on a self-fulfilling prophecy.
  • It works better on higher time frames and there are never any guarantees, which is why it should be used in conjunction with other aspects of analysis.
Forex analysis is used to design forex trading systems and consists basically of two elements: fundamental analysis and technical analysis. Technical analysis encompasses a wide range of techniques used to try and predict the following move of a certain pair. Technical analysis includes the use of pivot points, time cycles, trendlines, candlesticks formations, moving averages, typical chart patterns such as double top, head and shoulder, etc.

There are a lot of different aspects to technical analysis. It is not my intention to give advice on which technical patterns or indicators are better than others, but more to share with you some of the observations I have made. In addition to this, we will look into testing trading systems based mainly on technical analysis.

Technical Analysis

First of all, it is important to understand that there is no magic to technical analysis, although it is often marketed that way. Technical analysis works only because it is similar to that of a self-fulfilling prophecy, and (in my opinion) nothing else. When this is taken into consideration, it only makes sense to use the most known ones and stay away from all the so-called “secrets” or new technical indicators, as an unknown technical indicator simply will not respond well as a self-fulfilling prophecy. A simple way to test the popularity is to do a search on Google for the name and look at the results.

How about fundamental analysis contra technical analysis; are there times when one supersedes the other? Yes, there is. As explained in Chapter 3, the release of highly important fundamental data can be a very dramatic event and technical analysis is of very limited use during these times. This is because the statistical techniques that technical analysis depends on are ineffective during the volatile times of the release and for about (at least) one hour afterwards. However, this all depends on the kind of news and the deviation from the expected number. But it should be kept in mind that these are definitely not good times to try and detect trends or their tops and bottoms. You are well advised to wait for calmer waters when technical analysis can be applied properly. As fundamental data releases can produce spikes of price movements in minutes, this is not the time to try and detect reversals although some traders try to do just that.

You also need to realize that the statistical methods used in technical analysis perform much better and are far more reliable using time frames longer than one hour and upwards. Many new traders attempt to detect technical formations such as double tops, head and shoulder, triangle break outs etc. using 1, 5, 10 or 15 minute time frames. However, this is not a good practice as these short time frames produce very unreliable statistics.

Fundamentally, technical analysis produces more reliable results the longer the time frame used. This is especially true when the trading is following a regular pattern such as during “stable times”. However, longer time frames can be more vulnerable to sudden sharp reversals, which is a serious problem. During volatile times, irregular trading patterns, much larger pip movements and spikes reduce the effectiveness of statistical analysis. The most popular timeframes used by most forex traders are the hourly, four-hourly and the daily charts.

Very short time frames below 1 hour do not lend themselves to statistical analysis, very well. However, some traders do use them for other types of trading strategies such as scalping which is used by many expert advisors. The general idea behind any scalping method of trading is to reduce risk by getting into a trade and then out of it as quickly as possible. This type of action limits the risk exposure during a trade. This process is then repeated many times, always aiming for a small low risk gain. One of the main ideas of this strategy is to attack the markets during their off hours when they have settled into a tight and more predictable range pattern. The time period selected is between 9.00pm and 1.00am GMT and typically the following currency pairs are traded: EURGBP, EURCHF, GBPCHF and USDCAD. Europe, UK, Switzerland, USA and Canada do not release any national fundamental data during this time period and thus the forex market can be very quiet with low volatility. However, as the liquidity is lower during these hours, the market is more prone to macroeconomic events, and it is important to keep in mind that large spikes easily can occur in these periods.

In addition to the specific timeframes, it should be noticed that Fridays often tend to respond poorly to any technical analytical approach, as well as fundamental news releases. Although I heard this many times before I actually started trading, I was still in front of my screen on a typical Friday. You can easily get chopped up in this trading period. One of the main reasons for this is probably that large institutions such as banks and hedge funds close their books for the weekend. It can be argued that they might be more prone to psychological aspects in order to reach breakeven or in an attempt to squeeze the last possible profit before the end of the week. No matter what the reason behind this phenomenon is, just know that Fridays can be a tough challenge. This is often true for Mondays as well, as a new week starts and a direction is to be decided on.

You should begin to understand that using technical analysis as a central part of your trading strategy is not so easy as first thought and prone to difficulties. So how do forex traders attempt to overcome these serious problems? It is important to understand that many technical analytical approaches are rather useless, and especially so if they are applied solely as a trading strategy.

You will need to devise a forex strategy that is wrapped around your limitations and facilities, and it should entail more than simply basing an entry or exit on technical analytical aspect, while you also want to make sure that you don’t fill up your screen with too many different indicators.

Although a large number of the technical approaches are nothing but hot air, there are several technical Indicators that can be used to help you achieve a better trading foundation, including stochastics, RSI, Bollinger Bands, MACD, Moving averages etc..

None of them can predict the forex market accurately all of the time. The best way to proceed is to select a technical indicator, one at a time, and use a plan to determine its win:loss ratio and expectancy value, when implemented into a trading strategy. We have already studied the RSI, DMI and stochastic crossover in chapter 4 and noted their strengths and weaknesses. However, none of these indicators guarantee success standalone and must be integrated into a trading strategy. There are a lot of books about technical analysis, which will give you all the information you need. One book which I highly recommend on this subject is Brian Shannon’s book on Technical Analysis. (

Once you have chosen a technical indicator, you need to fully test your trading system. To achieve this, you need to back-test your forex trading system using historical data for the currency pair of interest. Select the first entry configuration of your trading system e.g. you intend to enter a trade immediately within the same timeframe that a stochastic crossover occurs. Then back-test this condition against historical data that should be long enough to provide at least 30 of these entry occurrences. Back-testing can be done manually but if you do this, you must attempt at all costs to record your results accurately using your trading logbook and not let your emotions influence this process in any way. Using an automated back-testing system can overcome this problem, but this is likely to incur weaknesses in other areas. This is a trial an error process.

Once you have recorded at least 30 results, you then need to determine the expectancy of this configuration of your forex trading system as described in chapter 1. You will then need to select other configurations of your forex trading system e.g. entering trades during the timeframe after the crossover or entering when the trade is a certain number of pips in advance of the crossover etc.

Be as imaginative as possible. Calculate and compare your expectancy results of all your configurations. If none of your trials produce a satisfactory positive expectancy value then you will need to experiment with other trading indicators, or look for other possible areas to apply some level of modifications. Once you have finally obtained a forex trading system whih shows good potential for profits, you will then need to deploy the principles of money management in conjunction with your system’s expectancy value in order to determine how much you should risk per trade.

This next concept is extremely important. You must never, under any circumstances, be tempted to keep extending your stop loss outwards in an effort to preserve the life of your trade. Not only are you risking an increasingly larger portion of your budget but you could also place your trade in limbo. This is in fact the main reason why so many traders blow their entire budgets. Even if you were lucky enough to keep your trade live, you could then experience limbo trading if the market moves hundreds of pips away from your trade’s initial entry point and your trade is stuck open with a large floating loss..

When selecting a method for technical analysis, you need to be aware of all the above points in order to design a successful trading strategy.