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TECHNICAL ANALYSIS

Flaws in Trading with Classical Technical Analysis

Flaws, Trading,  Classical, Technical Analysis, powerful tool, fx trader, forex Technical-Analysis-Volume

This article highlights some flaws in classical technical analysis when applied to Forex and shows how to improve price action reading in order to better spot and trade trend reversals.

Technical Analysis is a powerful tool, which a trader can use when it comes to speculating on the Forex market. Most traders consider it to be only a way to read price movements using some principles. I consider technical analysis, and especially price action (a part of technical analysis), to be more than that. Reading price action gives traders the possibility to identify patterns and forecast future movements, but it also gives insights on what investors think and feel in certain market conditions and how they are going to act.

In time, economies change, triggering changes in investors’ mindset. Thus the way we read price action should be adapted to current market conditions. This is also the reason why a strategy will not work forever. It has to be tuned all the time, so it will continue to provide good entry and exiting signals. The same should happen with price action reading.

Technical Analysis was first applied in the stock market. Analysts found price patterns which have been used in the same manner for the last 115, or more, years. When price patterns were first identified, they were combined with volume patterns. When analyzing the price movement of a stock, analysts had the possibility to also check traded volumes. This is still valid for stocks. But when it comes to Forex, nobody can check volumes. Still, most Forex traders apply the same price patterns.

They do this because they work. But this does not mean that the probability of them being right remains the same as for stocks. From my experience I can say that it drops considerably. This is one of the flaws I believe needs to be taken into consideration when applying a classical price action on today’s Forex charts.

Price patterns

There are two big categories of price patterns: Reversal Price Patterns and Continuation Price Patterns. The biggest flaws are, in my opinion, in the first category – Reversal Price Patterns.

A reversal pattern is supposed to announce when a trend is going to be reversed. Some examples of reversal patterns are: Diamond Pattern, Broadening Formation, Double Top/Bottom, Triple Top/Bottom, Head and Shoulders and Inverted Head and Shoulders. These are really easy to spot, especially the most common among them the Double Tops/Bottoms and the Head and Shoulders.

Flaws, Trading,  Classical, Technical Analysis, powerful tool, fx trader, forex Duble Top

Figure 1. Double Top

Flaws, Trading,  Classical, Technical Analysis, powerful tool, fx trader, forex Head and ShowlderFigure 2. Head and Shoulders

Flaws, Trading,  Classical, Technical Analysis, powerful tool, fx trader, forex inverted H&SFigure 3. Inverted Head and Shoulders

 

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