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Published by j.bernardino, 2018-01-08 08:54:23

Technical-Analysis

Technical Analysis


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Technical Analysis



Technical analysis is the technique employed for forecasting future profitable market conditions
based on the study of historic market data. In its most popular incarnation, technical analysis looks

for repeating patterns in price, that are then relied upon to result in predictable reactions in the
market in the future.


Technical analysis has gained enormous popularity in recent decades, particularly with the advent
of computers and reliable charting platforms, and is arguably now the most utilized method of
market analysis. Practitioners of technical analysis far outweigh in sheer numbers the practitioners

of fundamental analysis as unique standalone disciplines. As far as amateur retail traders are
counted, easily 90% of them adopt what they would categorize as technical analysis for their trade
strategies and decision making. In a recent CompleteCurrencyTrader.com survey, 97% of those

questioned, classed themselves as purely technical traders.


However, it should be noted that in the same survey, 98.3% of those questioned, believed that
technical analysis involved to some degree the forecasting or predicting future price “direction”. It is
in this regards that concern is raised, and the reasoning behind the inclusion of this chapter in the

course.

Careful attention should be paid to the wording of the opening paragraph. Technical analysis is

attempting to forecast future “profitable market conditions”. There is no mention of predicting
future “price direction”. It is a subtle difference which is easily overlooked and even more easily

misinterpreted, but it has huge ramifications for the way in which a practitioner will pursue the
discipline of technical analysis.


Over the decades, amateurs, novices, poorly skilled educators, and even those who would be classed
as professionals in many respects, have all in large deviated from the true principles of technical
analysis and now widely practice the activity of “shape analysis” in an attempt to predict future

price direction and “high probability” trades.

Arbitrary shape analysis (which we will elaborate on shortly) has surpassed genuine technical

analysis as the most widely used method for determining trading strategies amongst the retail
fraternity. For the struggling amateur attempting to locate sound techniques and knowledge, the

overwhelming misunderstanding of what technical analysis really is, is proving to be a huge
obstacle to success. To this end, the objective of this chapter is to educate the trader about the myths


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and inaccurate teachings surrounding technical analysis, and to further inform you of genuine and
statistically relevant aspects of technical patterns.


First of all, it would be wise to discuss the origins of technical analysis so as to understand its
underlying principles, which in turn will help us appreciate why it has been so quickly & easily

misinterpreted and changed in to a diverse selection of predominantly meaningless methodologies.


It is thought that technical analysis originated in some form as long ago as the 17th century in the
Dutch markets, and also in Japan in the early 18th century (which developed in to the modern-day
candlestick method). It gathered pace and popularity from the early 20th Century onwards, and it is

from this period that most of the better-known methods were developed and built upon (Dow
theory, Elliot wave, Gann, Donchian, etc).


The starting premise behind technical analysis is that markets are comprised of humans, and prices
are merely a reflection of human actions (buying and selling). The theory goes that people in a

crowd will act with a collective mentality, and their behavior, actions, and reactions, can all be
predicted when the crowd is confronted with certain situations. This idea is often referred to as
“mass psychology” or “crowd behavior”, and its study is a recognized branch of the science of social

psychology. There is overwhelming empirical evidence to support the notion that human beings do
indeed act in predictable ways when part of a crowd under certain circumstances.


On that basis, it is theorized that financial markets are in essence nothing more than a crowd of
people, and therefore the crowd will often act in a predictable and unified manner when confronted
with certain situations in the market just as they do in the outside world. Advocates of this idea

suggest that the crowd behavior manifests itself in price as people submit their orders to the market
en masse, thus forcing price behavior to change in response to human behavior. If it was possible to

observe crowd behavior by identifying patterns in price behavior, then it would be possible to
anticipate future repeats of the same behavior and exploit them for profit.


So, began the study of price charts. Practitioners of technical analysis, research and study past prices
in an attempt to identify patterns which repeat often enough to suggest they are the result of crowd
behavior, and once identified, strategies are developed to try to profit from those patterns.


The plethora of methods used for analyzing past data, plus the myriads of apparent patterns which

have been identified by various individuals over the years, has led to a confusing landscape for





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aspiring traders to negotiate their way through. The most sensible way to assess the situation is to
look at the evidence and facts, rather than attempt to sift through conjecture and hearsay.


There are a number of very important points one should be aware of in regard to technical analysis.
Of all the trading strategies which use technical analysis at its core which have ever been tested

scientifically – including Elliot wave, Dow, Candlesticks, moving averages etc. – none have ever
proven conclusively to offer any statistically relevant edge in being able to forecast or predict future

price direction. In other words, no publicly known method of technical analysis has ever shown it
has an ability to predict future price direction with greater than 50% accuracy, i.e. a coin flip is just
as accurate, or put another way; no one has ever shown they can predict the future price direction.


There have been a number of studies which have concluded that certain technical strategies can
predict future price direction with an edge of 0.5% (50.5% accuracy), but these studies have been

questioned or disputed by many in the industry. In short, the academic and professional trading
communities are split on an opinion of whether technical analysis offers any reliable value, but no

evidence has ever been presented to support the notion that a “shape” on a chart offers any
predictive power of the future.


If we stick with the facts, we can conclude that the publicly known technical strategies (some of
which have been in use for more than a Century) have never been proven to be able to predict future
price direction, despite widespread and prolonged use and extensive testing & scrutiny.


The other major element we need to be aware of is the fact that technical analysis was first conceived
and used in speculative markets. Markets which were, are, and will continue to be very different

from the currency market.


The whole concept of repeatable and predictable human behavior in markets relies on the
assumption that the participants are indeed behaving as a crowd. For that to be true, the “crowd”
must be aware of and paying attention to the same things which are influencing their behavior. In

the case of financial markets, those influencing factors would be; earnings; yields; dividends; news
announcements; trends; crashes, etc., etc. In largely speculative markets such as stocks’, there is an
argument that these theories could hold true and provide some advantage (although again no hard

evidence has ever proved this to be the case).


If the majority of participants were speculative traders, it is even feasible to theorize that if they are
all watching the same price charts and all see the same pattern (read “shape” such as head &



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shoulders for instance), they could all react the same way and thus the pattern becomes somewhat of
a self-fulfilling event. You will often hear amateur traders attempt to justify use of a futile technical

tool like Fibonacci lines by stating that even if the lines by themselves are meaningless (which they
are), they could hold value because they become self-fulfilling prophecies as traders all see the same

thing and act on it and therefore the “pattern” is valid.

In such markets, it is “possible” for mass psychology to be in play, and it is “possible” that

repeatable human behavior will manifest into repeatable price behavior. If this is true, then patterns
may well exist which could assist in predicting future price direction based on past patterns which
are likely to repeat themselves. Again, this is all “possible” but there is no proof (empirical or

anecdotal) that it actually happens.

However, the spot forex market is predominantly a non-speculative marketplace, which makes it

unique from every other financial market. Most participants and most of the actively traded volume
have nothing whatsoever to do with speculation about price direction. What that means is the

majority of participants (the crowd) are not aware of or paying attention to, the same things.

The majority of participants in the spot forex market are acting with business, pleasure, or economic

reasons (all are utilitarian) and have no concern for profiting directly from their trades. Hence, they
are utterly oblivious to past, present, or future prices, and are certainly not watching or reacting “en
masse” to developments within market prices.


Refer back to the market structure chapter to look at the facts. Only 18% of spot market participants
are speculators. 82% of traders are not looking at price charts at all and are not concerned with

future price direction. Of the 18% of speculators, how many do you think are looking at the same
charts, same time frames, using the same technical analysis tools, and are going to react in exactly

the same way? When you break down the small minority of speculators and consider all the
variation they will be using (different charts, time frames, and any combination of hundreds of
technical indicators) how many do you think are looking at the same thing at the same time and

reacting the same way in order to manifest crowd behavior?

On this basis, the entire principle on which technical analysis is built goes straight out of the

window when it comes to currency trading. Currency charts may look like any other market chart,
but the activity which creates the market prices (and therefore the candles/bars) is fundamentally

different to that which creates other market prices.




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All academic and scientific studies have concluded there is no repeatable or predictive pattern to the
way international businesses, holiday makers, online payment processors, or any of the other

hundreds of thousands of people who exchange currencies each day for business or pleasure, act or
behave. Furthermore, there is no repeatable or predictive pattern to the way central banks decide to

intervene with their behemoth transactions.

In simple terms, the evidence collated by reliable and thorough sources, states that human behavior

and future price direction are universally unpredictable in the forex market. The jury is still out as to
whether the possibility exists in other markets, but the evidence is conclusive for forex. Future price
direction cannot be predicted with statistical accuracy! Fact!


The fundamental differences which separate the currency market as unique from every other market
in history, seem to be forgotten or ignored by most amateur traders when then try to adapt trading

or analytical strategies from “other” markets to forex. Forex is a unique environment and must be
approached with a different perspective when attempting to trade in it speculatively. More

importantly, techniques which may work in other speculative markets, do not necessarily work in
the non-speculative spot currency market.


Understanding the above facts, immediately gives the trader an enormous advantage, which we
intend to build on through the rest of this chapter and beyond. The educated trader can completely
bypass the futile types of analysis and instead concentrate on worthwhile strategies which are of real

value in the currency market.

Below is a sensible definition of technical analysis which it would be beneficial to bear in mind:


“To identify repeating patterns in price which have a greater than 50% probability of resulting in

future market conditions which can be exploited for profits”.

As was stated at the start of this chapter, careful attention should be paid to the words and phrases

in the above definition. The correct employment of technical analysis has nothing whatsoever to do
with trying to predict price direction. Genuine technical analysis merely attempts to identify

patterns in the market which lead to profitable opportunities……. patterns which repeat and can be
predicted.


Such minor distinctions can be confusing at first glance to a trader who has been exposed to the
more widespread and mainstream misunderstanding of technical analysis. The following pages aim
to make clear the difference.


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The first thing to be aware of with paramount importance at all times when engaged in technical
analysis and pattern recognition is why prices move in the currency market. Prices do not move in

response to moving averages; they do not move in response to the shape of a candle or bar; they do
not move in response to support lines, trend lines, or any other lines drawn on a chart; they do not

move because an oscillator is above or below a certain level. Prices move only in response to limit
orders being consumed or otherwise removed from the market auction (BID’s and OFFER’s). To that
end, any patterns we look for need to be centered on that underlying principle of price movement….
order flow!


Fortunately, there are numerous repeatable patterns which predictably lead to market conditions

which are favorable for extracting profits from. Logically, before a trader can identify one of these
patterns which lead to profitable market conditions, they must first define what constitutes such a
condition to begin with. To assist with this, we will quickly address the basic requirements needed

to make a profit from a currency trade.


• Prices must move

It is impossible to make a profit if prices remain at the same level after a trader enters a trade. In

order to realize a profit (or indeed a loss), the price must change to a different level after the trader
first enters. To that end, quiet market periods where prices tend to remain the same or move
“sideways” in a tight range, are not as conducive for profit making as periods where prices tend to

trend in one direction for a prolonged period.

• Price movements must be of sufficient magnitude to exceed trading costs


Any price move must be large enough that it covers the cost of spreads and commissions. If for

instance the price moved 3 pips, but the spread was 5 pips, there is no opportunity to profit from the
move. This is obviously an extreme example but it illustrates the consideration, particularly for
intraday traders executing trades with small targets on certain pairs. Furthermore, losses are

counted as trading expenses and therefore any price move must be of sufficient magnitude to cover
previous losses incurred in a trading strategy.


• There must be sufficient liquidity to execute trades


Even when prices are moving, there needs to be enough liquidity to allow market orders to execute
at or near the price which they were submitted. Reduced liquidity (primarily depth) can result in




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excessive slippage or partial fills either on entry or exit, which in turn can result in losses instead of
profits.


The previously stated conditions are quite basic and self-explanatory, and in layman’s terms could
be condensed to say that for a market to pose a profitable opportunity, it should be trending and

liquid. *For this purpose, we will describe “trending” to mean the price is rising or falling with
enough magnitude to exceed any trading costs including losses – i.e. it is moving far enough to offer

a profit*

Note that we are not concerned with selecting the right side of the market to be on, or for how long

to stay in a particular trade. Those are considerations to be made at a later stage of strategy
development, and we will cover that in detail throughout the remainder of the course. For now, we
are only occupied with defining and understanding what constitutes a profitable market condition.

Without the above conditions in place, no profits are possible regardless of entry and exit criteria;
therefore, the first priority of any technical analysis is to identify periods and conditions which

confirm the above points.

The first thing to try and identify are periods when the market prices are moving a lot and times

when they are not moving very much. This should be analyzed from the perspective of the time
frame objective of the trader. For instance, a trader interested in trading less frequently using daily
charts may want to discover if certain times of the month are more or less quiet than others, or even

whether certain months of the year show more movement than others.

Conversely an intraday trader with much smaller time horizons should look for patterns whereby

days of the week, or even hours of the day differ from each other. Having stated that, it is probably
obvious where we are heading with this example. It’s no secret that on an intraday basis, certain

periods are a lot more active with much more price movement than others.

There are typically 3 main market trading sessions recognized by market participants: Australasia,

Europe (dominated by London), and the US. The Australasian market session is regarded as the
time when the financial centres in New Zealand, Australia, Japan, and other Far East countries are
open. The European session is when Frankfurt, London, Paris etc. are open for business. And the US

session covers the working hours of New York and Chicago etc.


These various market sessions immediately present repeatable patterns which can be relied upon to
a very high probability of resulting in certain market conditions day in, day out. It’s well known that



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the Australasian session is the least active, whilst the London/European period is the most active,
with the US session in between the two. The average range of prices from the high to low of the

London/European session is significantly greater than what is seen during Asian market trading.
This is true for 99% of days. That is a genuine, quantifiable, proven, indisputable repeating pattern.

It can be predicted with near 100% certainty that between 0800-1700 GMT every day, there will be
significantly more price movement/trends, and higher liquidity, than is seen between 2200-0700
GMT.


That pattern has nothing whatsoever to do with the position of lines on a chart, or the shape of a
candle/bar, or the cycle of an oscillator. The pattern can be attributed to a genuinely relevant set of

conditions, i.e. there are more market participants during the London working day than there are
during the Asian day.


London is the financial capital of the world, with a large number of international banks, businesses
and stock exchanges operating from there. Also, with it being positioned in-between New York and

Asia, it has the added advantage of bridging time zone gaps. A combination of such factors means
that London now trades higher volume in all asset classes than any other financial centre in the
world.


As a result, many large businesses now choose to deal with London based firms, brokers, dealers,
banks etc., for their currency needs, and so during the London working day, many more currency

exchanges take place than at any other time of day. In response to this higher demand to trade, it
naturally followed that more dealers and market makers operate to provide liquidity during the

London hours, and therefore there is much greater liquidity available during this period.

This translates to mean there are greater price moves (more trends) and higher liquidity during the

London session than there is during the Australian session, thus by the definition above as to what
constitutes a profitable market condition, we can conclude that the London session presents more
opportunity to profit than any other session.


There is sound logic and hard evidence supporting the pattern which manifests itself with regards
different market sessions. Furthermore, the pattern repeats daily and is certainly more than 50%

accurate at forecasting profitable conditions. This is the epitome of the kind of “real” pattern
technical analysis is looking for.







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Identifying that first and perhaps most obvious of patterns, can then lead to the discovery of many
more, often more subtle patterns of equal value. For instance, a trader should consider the behavior

of various individual currencies and corresponding pairs during different market sessions. It stands
to reason that individual currencies are likely to trade in greater volume during the market session

which encompasses the nations who use the currency. For example, the JPY is likely to be traded
with more volume when the Japanese market is open, compared to when it is closed. Likewise, the
EUR will probably be more active during the European session.


The reasons behind this are again grounded in sound logic. Japanese businesses deal in Yen, and so
during their normal working day they will typically be exchanging JPY back and forth with other

currencies as part of their daily business. For this reason, there is often a lot of activity in pairs which
are crossed with JPY. It is common to see the EURUSD remain in a tight price range throughout the
whole Asian session because Japanese businesses are rarely exchanging those currencies, but at the

same time the AUDJPY will have increased activity on it (compare the price ranges and levels of
liquidity between the EURUSD and the AUDJPY during the Asian session). Similarly, the EURUSD
will come alive during the European afternoon/US morning, because both home nations are awake

and trading their respective currencies as part of normal everyday business activity.


It is just such patterns which technical analysis seeks to identify. Once a trader knows the patterns,
the frequency with which they repeat, and the kinds of conditions which arise from them, it is far
easier to generate profits from most strategies.


Just consider the advantages an educated trader has over a novice that has never conducted any

meaningful technical analysis. After conducting comprehensive analysis of market sessions,
currencies, currency pairs, intraday time frames etc., a trader will know precisely what hours of the
day present the best conditions to profit from. They will also know which currencies are best traded

at certain times, which pairs to trade at certain times, and perhaps equally important they will know
which hours, pairs, or even days to avoid trading on.


For example, the savvy trader will know that perhaps London lunch times are not good conditions
to trade the EURGBP pair, or European bank holidays present very poor market conditions with
little opportunity to profit. The novice trader would be totally unaware of such patterns and may

blindly trade in conditions which meet none of the basic requirements for being able to profit.


Knowledge of the above kinds of patterns really can mean the difference between a profitable and
non-profitable strategy. There are many simple systems which generate consistent and reliable


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profits when traded during the London session or on certain pairs, but result in spectacular losses
when traded on other pairs or during the Asian session.


There are so many factors which influence a strategies profit/loss. Reduced liquidity on one pair
compared to another. Reduced liquidity on one currency compared to another. Reduced liquidity

during certain market hours compared to others. Spread costs on different pairs. Profit potential on
various pairs (how far does the price normally travel per day/session). Differing levels of volatility

between pairs and hours of the day……. etc., etc.

These are the types of genuine patterns that technical analysis “should” be concerned with finding.

These are patterns produced by real market activity, and reveal real opportunities based on actual
market microstructure, order flow, and supply and demand. In short, this kind of analysis identifies
patterns produced by price, i.e. the market, and the things that move market prices ……orders!


Sadly, few technical analysts practice real pattern recognition. Most are now concerned with shape

analysis, which is an altogether different discipline and one which according to all the available
evidence is utterly worthless for making profits in forex. Of course, such analyst’s think they are
identifying patterns, and most wholeheartedly believe what they are doing actually works. (Try

talking with a believer in Fibonacci lines if you want to witness a display of staggering mental
blindness, denial, cognitive dissonance, and outright refusal to acknowledge reality).


Human beings have an inherent evolutionary predisposition to see patterns everywhere they look,
even when no pattern actually exists. This tendency is a throwback to our survival mechanisms.


Our ancestors needed to recognize signs of danger in order to survive. Individuals who could not
recognize the signs of danger invariably had fewer children than those who could. For millions of

years, human ancestors were very much part of the food chain, and humans themselves (the past
100,000 years) lived in real danger of being eaten by predators such as the sabre toothed tiger and
cave lions. Any ancestral relative who could not recognize the signs of a nearby predator would

likely find themselves promptly eaten, and thus did not survive to reproduce and pass on their trait
of poor pattern recognition. On the other hand, our ancestors who were very good at seeing the
signs of danger could take the necessary precautions to avoid it, and therefore lived to reproduce.

Their offspring naturally inherited the trait to see the patterns of danger. Since the cost of not seeing
danger when it was present was so much greater than the cost of seeing danger when none was

present, our ancestral survivors would often “see” more dangers than actually existed. All modern




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humans are descendants of those survivors and so we are genetically programmed to identify
patterns where none may exist.


Most people are not aware of this predisposition and therefore do not appreciate their natural
tendency to mistake randomness for patterns. It is for this reason that the vast majority of technical

traders now “see” patterns in arbitrary, thoroughly meaningless shapes, and traders who do not
guard against this are likely to trade foolishly.


A study of any random data (dice rolls, coin flips, number generators etc.) will reveal a series of
shapes which repeat themselves over and over again. For example, a dice rolls of 2 sixes in a row

followed by a 4 will appear time and again over the course of several thousand rolls. A coin flip of 3
heads in a row followed by 2 tails and then a head, will recur again and again with a large enough
sample size.


If every dice rolls and every coin flip was recorded in the form of a chart, these occurrences could

appear to be repeating patterns, but they are in fact completely random shapes derived from
completely random numbers. Such shapes offer zero predictive power for what random numbers
will appear next in the sequence; they present zero anticipatory value as to when the shape will next

manifest itself; they provide no advantage to be able to profit if betting on future numbers was
allowed. These “shapes” will easily be misinterpreted as patterns by individuals who are not aware
of the human tendency to recognize patterns where none exist.


This is precisely what most traders do with the random shapes that manifest themselves in price
charts. They assume the repeating shape must be a pattern, and then waste time, effort, and money,

attempting to devise a trading strategy founded on meaningless data. This is perhaps the largest
contributing factor to the astronomical failure rate amongst traders (amateur and professional alike).


Yes, a head and shoulders shape may appear time and again, but it has zero predictive power for
where price will go next. That is a meaningless shape, not a pattern of any use.


If a trading strategy is centred on the flawed concept of trying to derive meaning from arbitrary

shapes which appear at random, then the odds of success are reduced to almost zero before the
trader has even got started. Decisions based on this type of analysis have no more weight or
relevance than a decision based on the outcome of a coin toss, which likely explains the reason why

no scientific examination has ever found a technical strategy which can predict future price moves
with more than 50% probability.



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So, we can see why the natural tendency for humans to see patterns where none exist, plus the
misinterpretation of the definition of technical analysis, has led to the technique being corrupted in

to a discipline far removed from its true purpose. While the real purpose was to identify repeating
patterns in price which have a greater than 50% probability of resulting in future market conditions

which are favorable to making profits, it has been mistakenly used to identify repeating shapes in
price data which have a greater than 50% probability of predicting future price direction.


Traders are now using random shapes to try and predict the future. When described in that manner
it is little surprise that so many people fail so miserably.

Real practitioners of technical analysis are not using shapes to predict the future direction of prices;
they are using patterns to identify market conditions necessary for making profits. There is a huge
distinction between the two activities; a distinction which separates winning traders from losing
traders. Later chapters and modules of this course will teach you how to exploit the market
conditions which technical analysis identifies as offering the best opportunities for profits.



















































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