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PTMC team 15.07 2015

Technical Analysis. Useful or useless?

Hey there, Protraders!

Technical analysis is the most widespread method of determining the price movement direction, which is based on the principles of graphic and statistical approach. Almost every new trader starts his way directly from the study of the graphic constructions on historical price data, analysis of different mathematical indicators, trends, various technical figures and patterns.

Why exactly the technical analysis?

In the first place, the popularity of this analysis is connected with the huge development of online trading, a wide variety of trading platforms, such as Protrader, which offer an extensive range of different technical indicators. Moreover, these indicators are so varied that even a beginner can develop his own trading strategy for any instrument.

Why exactly the technical analysis?

Typically, technical indicators are divided into several types:

1. Trend indicators. As the name implies, these indicators are used to determine trends and their directions. The most widespread indicators - moving averages or MA. A significant drawback of MA is that they are lagging behind the price, thereby showing already obvious (visually) trend. However, such an obvious drawback can be solved by using different types of MA (Simple, Exponential, Linear Weighted) as well as simultaneous use of MA with different averaging periods. Another interpretation of moving averages - is various oscillators (MACD, Awesome oscillator), which are based on the difference between moving averages of different periods.

Trend indicators in Protrader

2. Momentum indicators (Momentum, RSI, Rate of Change (ROC)). These indicators measure the strength and the speed of price fluctuations, as well as indicate whether the traded instrument is overbought or oversold. For example, the chart EUR/USD shows a variant of the use of these indicators. In particular, the RSI is set with calculation period of 9 days, and also the ROC indicator with a period of 50 days. These parameters are selected individually for each instrument and each timeframe.

 Momentum indicators in Protrader

3. Volume indicators (On balance volume (OBV), Volume, Market profile, Indicator of accumulation and distribution (AD)

Volume indicators in Protrader

4. Volatility indicators (Standard deviation, Historical volatility, ATR, Bollinger Bands)

Pic Volatility indicators in Protrader

5. Indicators of support and resistance (Fibonacci retracement, Gann grid, Pivot points drawing tools)

Indicators of support and resistance in Protrader

An important detail should be noted, that all the technical indicators cannot predict the future price movement, as they are built on the already existing data. They give an assessment of the current market state. Therefore, before performing the trade, you need to create a trading system or a strategy with strictly defined rules of entering the position, exiting from the position, position volume, etc.

Features of building the trading system

The whole trader's working process consists of four stages: observation, analysis, calculation and decision-making. But the organization of such process is directly connected with the creation of the trading system. The question is what is a trading system? Put simply, it is a set of indicators (instruments) which monitor the state of the market, transfer the incoming information (price or other indicator data) into understandable signals for the trader. Based on these signals, the trader makes a decision on opening (closing) a position.

Herewith, the trading systems are of two general types: trend following and mean reversion (or reversion to the mean). Each of these systems works on its areas, and usually does not work on the others. It should be understood that the universal trading systems that will simultaneously work on the trend and on the flat – does not exist.

For example, let’s consider the system that breaks the flat channel which was built on the Asian session. This strategy works more effectively on the main currency pairs (GBP/USD, EUR/USD), which are not related directly with Asian currencies (yen, yuan, Singapore dollar). The peculiarity of this strategy is connected with the different time zones of the exchanges, as well as with he number of participants on these exchanges, which provide a certain level of liquidity. Let’s say, that during the European session, the liquidity and trading volume are higher than on the Asian, and trading volume on the American session exceeds the volume on the European. The main trade centers during the Asian session are Tokyo, Singapore, Shanghai and Australia. The main participants are the Central Bank and commercial organizations, which exchange their profit in dollars into the national currency. One of the Asian session features is the liquidity and trading volume, where frequently the market becomes "thin" and large banks can move the price up to the key levels, or to the stop loss levels of other participants.

Zones of the Asian session are allocated below on the chart of the currency pair GBP/USD (including the intersection with the European session). The most popular trading strategy - is the breaking through of that range. The field of research for this strategy is very large:

  1. Trading in the direction of higher moving averages (by the trend) or vice versa, the return to MA (correctional strategy);
  2. Entrance to the position considering a certain level of volatility (ATR);
  3. Take profit and Stop loss can depend on the size of the selected range (for example, 60-70% of the range), different levels of support / resistance, volatility and time ("time stop") etc.

On this chart are marked ranges of asian trading session

Finished trading system can be taken only as an idea, but the selection of parameters, the completion under your own trading style is still needed in order to understand fully how it works. In the first place, you need to decide which system you want to develop (trend following, mean reversion), set the time frame, and select the necessary indicators.

For example, if you plan to create a trend system, the first thing you will need is indicators and drawing tools in order to define the trend, its strength and duration. The trend, as we already know, can be defined using moving averages or oscillators. You can also build a price channel from the sloping trend lines, and trade on its borders herewith considering support and resistance levels as potential reversal zones.

Creating a trend system in Protrader

One of the common trader's mistakes is to use the different indicators on the price charts and try seeing some patterns on the data of these indicators on the different market phases. This approach is totally wrong! You must not select signals based on the indicators, but the indicator must be selected by signals. First, you need to choose the trading area (e.g. trend), then to analyze this area in details in order to determine the beginning and end of the trend, as well as possible places to entry the trading positions. Roughly speaking, you need to understand all the key points on which the selected indicator must subsequently indicate. Thus, setting some indicator on the chart, you must understand in advance, what it will show you.

The picture below shows a chart on which an upward trend ("fan of moving averages" with different averaging periods indicates on this), and a downward trend are visible:

A chart on which an upward trend and a downward trend are visible

On the next chart you can see the same MA but with additional indicators that can be used to evaluate whether the asset is overbought or oversold.

Additional indicators that can be used to evaluate whether the asset is overbought or oversold

The key mistakes of technical analysis

After creating the trading system, the trader starts to launch it in real time, with confidence or hope for a higher profitability. But, as it often happens, receives one stop-loss after another. Therefore, it is necessary to understand the reasons of such failures and mistakes made when designing the system or during real-time trading. Let’s look at the key mistakes of technical analysis:

1. Individual psychological features of the trader:

  • patience and ability to wait for the right point to entry;
  • placing the correct types of orders (limit or market), with correct prices and necessary position amount;
  • an attempt to win back the losses instead of following to the plan.

2. Subjective opinions as to the correct plotting of:

  • trend lines and channels;
  • support and resistance lines;
  • properly configured indicator parameters for a specific asset and time frame.

Properly configured indicator parameters for a specific asset and time frame

3. The use of an excessive number of various indicators that give conflicting signals, and interfere to take an adequate decision.

The use of an excessive number of various indicators that give conflicting signals, and interfere to take an adequate decision

4. Incorrect backtesting of the system:

  • insufficient number of trades;
  • low profit factor;
  • excessive optimization of the indicators on the historical data, i.e. system fitting.

An unofficial standard when testing the system is a minimal number of trades from 250-300 or more, it is desirable that the distribution of the trades (long or short position) will be approximately equal. Another important metric that is ignored by new traders – is profit factor that calculated as the ratio of gross profit to gross loss. The higher the indicator value, the more profitable the system, herewith it is important to assess the profit factor over a longer period of the testing (one year or more). Unofficially it is believed, if the profit factor is greater or equal to 2, then the system can be used in real time mode. For example, gross profit by the strategy is $145 000, and gross loss is $67 500, therefore profit factor will be $145 000/$67 500 = 2,15.

5. Changing your own trading system during real trading without prior tests.

Technical analysis: pros and cons

As already mentioned, the whole technical analysis is based on several principles, namely:

  • “Memory of the market” – search of the recurring price patterns, graphic figures, levels of support and resistance is based on this principle.
  • Analysis of the crowd. The market makers work against the crowd; they close their huge positions by means of small speculators. The deceit is created using false "shots" of prices, thereby showing a continuation of the trend. On the base of this principle another type of analysis arose - volumetric analysis or trading by volume analysis and open interest.

Based on these principles, many traders have created the profitable trading systems. And it seems that we should find some good indicators and the profit will be guaranteed, but technical analysis has some disadvantages:

  • indicators can not predict the future course of the prices, they only give an assessment of the current situation;
  • technical analysis does not have the flexibility. Trader has to define a set of indicators and their parameters under each asset.
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