Why technical analysis works
Technical analysis is popular with many traders, but it is essential to understand why it works. Technical analysis is a method of analysing past price movements to predict future prices.
Markets fluctuate because there are traders who sell and buy at various times. Often, technical analysis only works well if many traders use the same methods. If more traders trust and trade on a particular technical pattern, the predictive performance of that pattern becomes more reliable.
Suppose many traders act on the signals from the same technical analysis, the likelihood of similar patterns forming in the future increases. For example, if many traders believe they should buy when the price breaks above the moving average, the pressure from a large number of buy orders could, in itself, push the price higher.
So, a core strategy of trading is to predict the behaviour of other traders, as this can determine the direction of short-term price movements. You can understand other traders by reading news, blogs, books and analyst reports. Studying other traders' strategies, you will better understand how the market moves.
How to use technical analysis more effectively?
1. Use simplicity
Using more indicators is rarely better. Also, there is no perfect indicator that will always make money. Having a clear trading plan will make it easier to execute trades and follow your trading rules.
2. Understand the difference between trending and ranging markets
Understanding the current market conditions is key to understanding which form of technical analysis is best. Even when the same indicator is being used, technical analysis of the market can make a difference in the way you trade. For example, if the market is in an uptrend, place a buy order when the price exceeds the moving average. However, suppose the moving average appears to be moving sideways. In that case, a reversal trade can be made when there's a divergence between the price and the moving average. This takes advantage of the price's natural tendency to move back towards the moving average.
3. Check economic indicator announcements
Technical analysis can be used more effectively by keeping track of economic indicator announcements. News such as the release of an economic indicator can transform demand and market prices, as well as invalidate predictions from previous price patterns. Knowing which economic indicators are due to be announced, as well as current expectations of the strength of that indicator, are important for a trader to know and understand. Traders aware of the economic indicator releases are much better placed to judge which forms of technical analysis to use at the appropriate time.