Technical analysis provides the very foundation for pure price-action trading and the Lazy Trader methodology, so it may sound surprising when I readily admit that technical analysis has its limitations. I’ll even go a step further by saying that technical analysis is in no way a “perfect” science, and that sound analysis alone can’t guarantee our success in the markets.
Despite its limitations, though, we’re devoted proponents of technical analysis who use candle charting tools and technical principles every trading day, and wouldn’t dream of trading the markets without them. I just happen to think that it takes some proper context to recognize what technical analysis can do for traders, and what it can’t. So that’s the basis for our discussion today…
What follows are a few ways to leverage the power of technical analysis as a foundational component of your larger trading methodology, as well as areas where you and your strategy must drive trading decisions, because technical analysis alone cannot.
Technical Analysis Reflects Market Psychology
People have used chart-based representations of price and volume action across financial and other markets since as far back as the 17th and 18th centuries. The key distinction, however, is that from the beginning, and continuing to this very day, technical analysis has aimed to provide insight regarding the psychological and other forces that drive these markets, not to predict any given market’s next move(s).
For example, within the Lazy Trader methodology, the pin bar reversal is a primary chart pattern used to signal potential, high-probability trading opportunities. But we don’t take trades simply because of the pin bar reversal itself; the reason for the trade is the underlying market psychology that’s signalled by the pin bar reversal. That is, that price has tested a given level and was decisively rejected, subsequently heading back very close to the opening price from that day or time period. From there, price is decidedly more likely to reverse due to the psychology that created the last bar. And essentially, the high-probability reaction is what we’re trading, not the chart pattern itself.
Technical analysis is also rooted in three (3) main assumptions:
- The market discounts everything: All factors, from fundamental forces, to news and economic data, are already “priced in”
- Price moves in trends: Includes short-, medium-, and long-term trends which can exist independent of one another
- History is often repeated: Price is more likely to act in a manner consistent with past performance than to act erratically
Identifies (Approximate) Levels of Key Support & Resistance
Because of the repetitive nature of price behaviour, key areas of support and resistance to which price is repeatedly drawn tend to appear on the chart of any asset. And using technical analysis principles, traders may draw trend lines, or use Fibonacci retracements, all-time highs or lows, moving averages, or a host of other indicators to isolate such levels for the purpose of trading. These levels, though, are only approximate, and regarding key technical levels as being exact is a mistake that can plague and frustrate any trader. For example, what if price approaches, but doesn’t formally touch the precise support or resistance level? Do you still have grounds for a trade?
This is yet another area where technical analysis is useful for traders, but doesn’t do all the work for us. Trading at or near key technical levels requires judgment, maybe some patience, and most of all, well-defined trading rules that you’ll follow each time.
So if, for example, a pin bar reversal occurs at or near a key support or resistance level—even if it comes up a bit short of a formal test, or the wick pierces the level—as a rule, we’ll likely be inclined to take that trade. This is especially true since we’re trading most often on longer time frames like the daily, and will have the luxury of seeing the day’s closing price and then placing the trade end of day, when we won’t be taken out by a possible intraday continuation. See why incorporating technical analysis within the parameters of your own, well-designed trading methodology is important?
Creates a Framework for Structuring Trades
Besides just analysing the markets and isolating potential trading opportunities, technical analysis principles may also be used to set up, execute, and manage your trades. In fact, key psychological and technical levels are routinely used by traders to protect their entries and stop losses, as well as determine when (and where) to adjust risk, particularly when practising active, or “combative” trade management.
From referencing previous support and resistance levels, to utilising candle construction to structure trade parameters, here’s how technical analysis may figure into traders’ most important decisions regarding trade execution, management, etc.:
- Entry point: Our pin bar reversal trading strategy requires price to break above the high (for long trades) or below the low (for short trades) of the previous bar in order to trigger a formal entry. Using the charts and key technical markers in this fashion insures that continuation of the prior day’s move occurs before we’re triggered into a given trade, which imparts a level of confirmation and promotes more confident trading
- Stop loss placement: A hard stop loss may be placed, for example, at the pin bar’s high (for short trades) or it’s low (for long trades), allowing enough room for a trade to move in our favour, while also using technical analysis to determine a logical stop-loss price that, if breached, would clearly invalidate the initial idea
- Initial and longer-term price targets: Using technical analysis and the repetitive nature of the markets, traders will often opt to establish initial price targets for their trades at recent swing highs or lows, for example, or perhaps at Fibonacci retracement points. The trader may choose to book profits by selling a portion of their position at this juncture. Meanwhile, longer-term price targets may be established using medium- or longer-term swing highs and lows including the all-time high or low for the asset being traded
- Trailing stop location(s): We’ve recommended before that active trade managers trail a stop above the high of every second seller bar (for short trades) or below the low of every second buyer bar (for long trades)
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