Technical analysis is in use by roughly 95% of retail traders trading the forex market, 90% of these traders are consistently losing money. One of the reasons I feel these traders are losing is due to them using technical analysis incorrectly.
In my previous article on technical analysis I walked you through the three assumptions technical analysis makes about how financial markets work, while these assumptions are for the most part true I’m going to show you where they are flawed and why to some extent their meaning is ambiguous in the context of the market.
At the end of the article I’ll show your why using basic technical analysis like the majority of traders use will make you predictable to the bank traders in the market and by understanding why technical analysis makes traders predictable will allow you to see how institutional traders look at the market.
The Flaws In Technical Analysis
Whilst the three main assumptions technical analysis makes about how financial markets work are sound and logical, there do happen to be a few flaws which makes the traders following technical analysis susceptible to losing money if they have no knowledge on what the flaws are and the reason why the assumptions are flawed in the first place.
Why Price Doesn’t Discount Everything
I talked a lot at the end of my last article as to why the market price doesn’t matter and how its the actions of the traders who are causing the market price to change which should be you main focus when trading the forex markets.
The big problem with the “price discounts everything” assumption is the way It’s basically saying you can predict where the market is going to move if you spend time analyzing the market price.
To naive traders the idea you can predict the market using nothing but the price makes sense, which is why virtually all of the strategies in use by retail traders focus on using price points such as support and resistance or price patterns like pin bars and engulfing candles to predict where the market is going to move.
On occasion the market will move in the direction the trader using price based trading systems anticipates, this tells him it is possible to predict the market using price as he assumes the reason the market has moved is due it encountering his technical level. What he fails to realize is the real reason the market has moved is because of things which are taking place behind the scenes in the market, things which cannot be seen on a price chart.
People placing trades is what causes the market to move, mainly bank traders placing trades against retail traders.
Knowing where and when bank and retail traders place trades is the key to predicting where the market will move, the only way to understand how other traders trade is by studying them. If we study the market price as per the price discounts everything assumption, then we are looking at the effect of price change rather than the cause, which is traders placing trades.
Does History Tends To Repeat Itself ?
The next flaw in the three technical analysis assumptions is the idea that history tends to repeat itself.
Its worth mentioning, this isn’t really a flaw in terms of whether things do or do not tend to repeat themselves in the market, its more of a flaw in the traders interpretation of what this means for their trading method.
When traders see something happen in the market which they have seen happen before they assume the reasons behind the thing happening are the same as they were previously. If a trader sees a bullish pin bar form on their charts, they believe the reason why the pin bar has formed is exactly the same as the reason any other bullish pin bar they have seen previously formed.
Its said a bullish pin bar forms due to people buying, hence the wick on the bottom of the pin. This is true, but what actually caused the buying ?
Was it bank traders taking profits off sell trades ?
Maybe the market ran into sell stops ?
Or was is due to bank traders placing buy trades ?
The trader using technical analysis is not going to know which of these three reasons has caused the pin bar he is currently seeing to form and if the pin bars he has seen before were created because of the same reasons. If doesn’t know why the pin has formed then he can’t determine whether it’s a high probability setup or a low probability setup which means he has a higher chance of losing money as he doesn’t understand why he is taking a trade.
Do Financial Markets Really Trend ?
There is absolutely nothing wrong with the idea financial markets trend, It’s clearly evident they do exist and have existed all throughout time.
The big flaw comes from the rules which surround trend trading itself.
The main one being:
“Once the trend has been in place for a reasonable length of time its likely to continue moving in the same direction in the future”
There are two really big problems with this statement….
The first is how do you determine when a market has been trending for a “reasonable length of time”?
Is it when the market has moved 1000 pips in the same direction ?
It is when the market has been trending in the same direction for 100 days ?
Or is it when the market looks like it has gone up or down for a long time ?
And which trend are we actually talking about here ?
The daily trend ?
The 1 minute trend ?
The 4 hour trend ?
The way each trader determines how long a market has been in a trend differs from person to person, there is no quantifiable method people use to define how long a trend is, do you know when a market has been trending for a “reasonable length of time” ?
Probably not…. why ?
Because no method exists which can define when a market has been trending for a long time, its left up to individual traders to work this out using their own discretion.
The funny thing is the majority of retail traders all see a trend taking place at roughly the same time, you can see where retail trader begin trading in the direction of the trend by looking at where bank traders are taking profits.
Its subjective statements like this which put traders on the backfoot when trying to make consistent profits from the markets.
They see the statements and think “hey that makes sense” then go off and trade the markets under the impression the statement is true yet is actually really ambiguous and has no real meaning in the market.
Technical Analysis Makes Traders Predictable
Retail traders who use common technical analysis i.e candlestick patterns – support and resistance – normal trend trading rules – price patterns – indicators are very predictable.
Their predictable because when and where the traders using the concepts above will enter the market are easily known. If a bullish pin bar appears at a support level you can guarantee a large number of retail traders will place buy trades, if an obvious head and shoulders pattern forms in the market retail traders will be ready to place trades once the neckline breaks.
In a zero sum environment like the forex market knowing where people are likely to place trades is of huge importance. if I know the only way to make money is by making other traders lose money, having knowledge of where and when traders are likely getting into trades provides me with a big informational advantage.
Retail traders using technical analysis do not care at all about what other traders are doing, one of the main assumptions of technical analysis is the market price reflects all know information about the market, therefore in order to predict where the market is going to move technical analysts must draw a conclusion from current and past prices, they don’t focus at all as to about what other traders in the market are doing because they believe the market price contains all the information they need to predict future prices.
Moving averages are calculated from past prices, which means the traders using them to place trades are making their trading decisions based off price rather than what other traders are doing.
By putting a common moving average on our charts we can see where moving average traders are going to get into their trades. The orange box above shows the point where the 5 day average crosses below the 20 day average, when moving average traders see this occur they will place short trades because they believe the market is about to fall.
If I knew all of these moving average traders were going short, I know I can come into the market and buy up all of their sell orders which will push the market higher and force the traders to close their losing sell trades, which could make me a significant amount of profit depending on how many traders actually went short.
This is how simple it is to figure out when traders are entering trades, everyone knows how to place a moving average on their charts but its the change of perspective from analyzing price to analyzing other traders which allows us to see the real value in having a moving average on our charts.
Why Do Traders Believe Technical Analysis Works ?
The reason why traders believe technical analysis tools work is because there will be many occasions where the market encounters a technical level and moves off in the direction the level predicted, such as the market hitting a support level then proceeding to move higher.
When the market encounters a technical level and goes off in the direction the level anticipated traders assume the reason why the market has reversed is due to it hitting the level, they don’t understand its bank traders making a trading decision based on what retail traders are doing which has caused the market turn and it just happens to be the technical level falls inline with the point where this decision has been made.
The banks haven’t come into the market and placed trades because they believed the level would turn the market back in the opposite direction, they’ve come into the market due to them having enough buy or sell orders available to complete a trading action. It could be taking profits or it could be them placing trades the main point is their actions depend on how many orders are in the market, it has nothing to do with the technical level itself.
When traders who see the market react to technical levels it reinforces their belief that technical analysis works and all the assumptions technical analysis is based on are true, if technical analysis didn’t work then the market wouldn’t have turned when it hit the level.
If a trader who believes in technical analysis was asked “why did the market move up from here” he would reply with “because it hit the support level”.
Here’s the same image but with the support level removed.
For what reason did the market move up now ? The support level has gone, the trader can’t say the market moved up because it hit support because the support level isn’t there, therefore there must be a different reason.
Any time you place something on your charts whether it be a support or resistance level a supply or demand zone or a technical indicator you’re not putting something on your charts which actually exists, your simply putting what YOU believe exists onto the charts.
If what you believe exists is based on concepts which actually makes sense within the context of the market, such as a supply or demand zone as per the understanding in my article, then there wont be a problem, but if you put a tool on your charts which doesn’t make sense in the context of how the market works then you will be trading under false illusions which are likely to hold you back from making money.
Technical analysis is a good theory but as with any theory it has its flaws. If you have no knowledge of what these flaws are then you are likely to be trading from an improper understanding of how the forex market works. Using technical analysis in its current format is absolutely fine but you must always look at it from the perspective of how other traders are using technical analysis, what is a trader going to do if he sees a pin bar form at support ? Will a large number of traders place buy trades due to the pin ? If they do is it really feasible to believe the market is going to move up when we know the only way for the banks to make a profit is to make other traders lose ?
Always ask yourself these types of questions when looking at the market, they will keep you focused on what other traders are doing as opposed to analyzing the market price which we know isn’t important.