What is technical analysis?
With this kind of analysis the main thing trader does is using tested mathematical models or formulas to predict the direction of market. In case, if the average value of price for last 7 days was higher than the current value of price, trader might assume market price will move up or ‘go bullish’ in order to get close to the average value. In similar approach, there are thousands and thousands of indicators or tools all trying to predict the direction of market. This is well known thing for any experienced trader and it’s one of good news for new traders, cause all s/he believes is picking a single golden indicator and make a looooo…t of money. Well it’s always vice versa. In fact almost 95% of participant loose all their money in few days.
Why technical analysis alone always fail?
The answer is simple but yet awkward, market prices are not only probabilistic processes but also non-linear processes. You might have been trading for while and still get puzzled with these terms.
So, what are probabilistic processes?
These are processes where a single input variable has no definite valid outcome but a range of results based on probability distribution. Before your brain go nuts, let us refer to our previous average example, we might observe that the average value of market price for last 7 days was higher than the current price but we can not be 100% sure market will move close to it’s average value. The correct view is that, there will be a certain probability that the current price will move towards it’s average. So, since every action and reaction scenarios in the market are purely probabilistic processes, indicators can’t tell you the exactly direction of price but they can only tell you the probability of market direction based on observed historical data. Previous statistics might indicate that, there are 70% chance for this indicator being correct but yet a trader might incur consecutive 20 losses caused by the other 30%.
What are non-linear processes?
In simplest layman language, non-linear systems are those which lack proportional relationship between input and output variables. If you are still confused, the system is non-linear if a slightly change in input variables have a tremendous effects on the output, with this phenomenon it’s impossible to have long-term predictions on how system will react base on various inputs. Back to our example, the calculated value of average market price was higher than the current price, following that we might assume market will move toward its 7 days average, but we will not know how slow or quick price will respond to input conditions plus any other minor new input variable to the system might complete shutter our predictions. To summarize this, all indicators are typical designed for linear processes but the real market is non-linear, therefore no indicator will be able to generate predicted returns in long-run without external intervention of trader actions.
So, should we burry all technical analysis?
Should we ignore moving averages, support levels, resistance levels, supply and demand zones and thousands of other technical tools and indicators?!
Well, Nop! Big Nop!
It might seemed pointless or contradictory but the key point is that, ‘There is NO indicators or technical analysis which is a holy grail or able to turn an ordinanary trader into a profitable trader.’ All technical analysis does is providing a detailed statistical view on how market reacted previously based on previous scenarios but it doesn’t tell how or when or to which extent market will react if some of previous actions happen again. At the end, its not about technical analysis but the mentality trader carry when doing technical analysis.
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Kindly share with other traders or comment your thoughts about the topic.