The Right Way to Use Technical Analysis in Trading

Technical analysis is a powerful tool for traders, often used alongside fundamental analysis to make informed trading decisions. However, its effectiveness relies on understanding and applying it correctly. This article explores key principles and strategies for using technical analysis effectively, ensuring you make the most of market opportunities while minimizing risks.

Understanding the Power of Technical Analysis

Technical analysis helps traders by providing a structured approach to trading, allowing them to identify patterns, trends, and potential turning points in the market. It is not a foolproof method to make a profit, as no single tool can guarantee success. Instead, it serves as a valuable supplement to other forms of analysis, such as fundamental analysis, to create a more comprehensive trading strategy.

Always Start on the Higher Time Frame

One of the most critical principles in technical analysis is beginning your analysis on the highest time frame possible. The key reason for this is that higher time frames provide a more accurate picture of the overall trend. On a higher time frame, such as the monthly chart, key levels of support and resistance are clearer and more prominent than on lower time frames. Here’s an example to illustrate this:

Example: EURGBP

Consider the EURGBP pair, which we will analyze using different time frames:

Monthly Chart: Clear resistance around 0.9300 (Graphical Resistance). Weekly Chart: Bollinger Bands and 20-Week MA support level (Support). Daily Chart: Breaking lower Bollinger Bands (Support Broken).

The incoherence between these time frames highlights the importance of always checking across multiple horizons to ensure a consistent trading framework.

Avoid Overreliance on Graphical Support and Resistance

While graphical support and resistance levels can be useful, relying too heavily on them can be misleading. A strong support or resistance level is often defined as one that prices have respected multiple times. However, my personal opinion is that after extensive testing, prices more often than not breakout from these levels on the next attempt. Instead of considering them as definitive levels, think of them as confirmation points. For instance, in the GBPJPY example, a clear support zone existed:

Graphical Support: Suggests a bullish opportunity. Actual Outcome: Continued bearish movement.

It’s crucial to corroborate these levels with other forms of analysis, such as fundamental data, trend confirmation, and other technical indicators.

Identify Market Trends vs. Ranges

Markets frequently shift between ranging and trending states. Understanding which state the market is in is essential for formulating a successful trading strategy. Visual representation is the most reliable method to determine the current market state:

Range: When the market oscillates within a clear support and resistance level. Trend: When the market consistently moves in one direction, away from its mean price.

For example, the EURCHF clearly shows two distinct states: ranging and trending. Simply using moving averages or ADX (Average Directional Movement Index) can be misleading, as they are lagging indicators that only show the previous state rather than the current one.

Optimize Indicator Parameters

Many traders use popular default parameters for technical indicators, but this can lead to overfitting and false signals. Instead, try to understand which parameters work best for the specific asset you are analyzing. For instance, using a 14-period RSI is generally better than a 93-period RSI because it balances between being too sensitive or too insensitive to market changes. Back-testing can help determine the optimal period for different indicators.

Maximize the Use of Moving Averages

Moving averages are simple yet powerful tools for identifying support and resistance levels. Short-term and long-term moving averages can be used to confirm your overall bias and form a comprehensive trading plan. It’s also beneficial to experiment with different types of moving averages, such as Fibonacci-based or simple averages, and back-test their performance. In the EURUSD example, the 200-day moving average was found to provide the best reactions, whereas the 100-day moving average showed less support.

Technical analysis is a complex yet rewarding field. By following these guidelines and continuously refining your approach, you can develop a robust trading strategy that enhances your chances of success in the ever-changing market.