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Strengths and weaknesses of technical analysis

Nick Goold

Technical analysis is a valuable tool when trading forex and CFDs, but it also has its advantages and disadvantages, which should be understood and used accordingly. Whichever technical analysis you use, you must always remember to have a risk management plan.

Technical analysis advantages

Advantage 1) Easy to understand

Many traders use technical analysis because it provides clear trading rules. For example, buying when the price breaks above a moving average. By displaying indicators on a chart and using technical analysis to understand the relationship between the price and the indicator, it can be clear where to buy and sell.

Advantage 2) Applicable to many markets

A strategy that works well in one market can also be tried in other markets. Trying a successful strategy in other markets is good for risk diversification. Expanding profit growth opportunities can also be a significant advantage.

Advantage 3) Quick execution

Technical analysis can be done very quickly. Compare this with fundamental analysis, which requires time-consuming reading of news and reports. Constructing automated trading systems based on technical analysis rules and algorithms is also possible.

Advantage 4) Clear entry signals

Technical analysis provides a clear numerical indication of where to buy and sell. Good technical analysis successfully captures recurring market patterns and enables repeatable trades with relatively simple rules. Bad technical analysis produces complex trading signals which can be too confusing to make good trading decisions.    

Advantage 5) Strategy optimisation

As technical analysis focuses on price movement patterns, the effectiveness of strategies can be back-tested using historical data. You can also test different strategies and determine which gives you the best chance. The same strategy can then be optimised for that particular market by changing the parameters and trying it out. You can do it all in a short period of time.

Disadvantages of technical analysis

If future price movements are a simple an extension of past price movements, historical data can be used to predict future prices by testing which strategies have been the most profitable in the past. For example, if you try 100 strategies, you may find two or three that are profitable. However, what has worked in the past using historical data will not necessarily work in the future. You can lose a lot of money if you are confident that it will work this time and cut corners on risk management.

Disadvantage 1) Ever-changing chart patterns

Markets repeat patterns, but these patterns are constantly changing, making it difficult to make money in the long term by always making the same trades. For example, suppose you can make large profits using simple moving averages in a strong trending market. However, if you use the same simple moving average strategy when the market enters a range, you will lose a lot of money.

Disadvantage 2) The myth of the perfect indicator

Traders who experience only losses assume that if they use the right indicators they will be able to make money and reduce their losses. However, most traders' losses are due to poor risk management and missed trades caused by the stress of losing while trading. There is no perfect indicator that can make profits in any market.

Disadvantage 3) Indicators showing opposite signals

Many traders assume that the best indicator for long-term profits is seemingly difficult to find and that combining multiple indicators is optimal. They also feel that if they can understand complex theories using advanced mathematics, and they can become an evergreen trader. In reality, however, strategies that take a lot of time and effort to construct do not always work. When multiple indicators are displayed on a single chart, it is difficult to decide which one to look at and trade. For example, if the moving average is a sell signal, but the RSI shows a buy signal, you will not know how to trade, leading to losses.