Technical analysis can be a very useful tool if used appropriately, when used to mark out trends and trend reversals, but we need to make sure that we don’t try to do too much with it.
Many people view the task of technical analysis is to use chart patterns to determine how an asset’s price will move in the near future, without seeming to think very much about why patterns they use are significant and what the underlying forces behind the patterns that we seek to understand even are.
This type of analysis studies current trends in momentum, or at least does so when it is us used properly. Past reference points, the sort of thing many technical analysts love to lean on, believing that the past will repeat, must be used sensibly if we are not going to corrupt recent data with data that is of limited or even no relevance.
If you don’t understand what we are really trying to do with technical analysis though, there is a tendency to impart a little too much magic into past data, and this contributes to its criticism, causing many to just discount it and seek a better way. The better way will need to include technical analysis, as we do need to pay attention to where the trading is going, but the more recent past and the actual trends within it needs to be our focus.
We can trade exclusively by using technical analysis and simply ignore fundamentals, as long as we are trading the current trends, when something is going up or down and we’re just observing that and don’t even care what the reasons behind it are. This even the case with forex trading, trading currency pairs and speculating on how their comparative value will move, and just riding the current momentum and not even needing to wonder why it is happening.
However, whenever we look back to past trends, we need to realize that these trends were driven by a different set of circumstances, and we therefore need to draw our comparative conclusions with real caution, as these things often aren’t tradable, especially with forex trading where the trading itself plays a less significant role than with other types of securities trading.
We can imagine a continuum of fundamental influence, where on the far end we have Bitcoin and other digital assets where the influence of fundamentals is completely absent, with price movements being purely driven by trading. On the other end of the scale would be forex trading, such as the U.S. Dollar Index, which measures the value of the dollar against other major currencies and is an index fund of sorts in the currency market.
There isn’t any other way to understand Bitcoin price movement other than from a technical perspective, but even then, we need to make sure that we keep this relevant enough. Since there are no fundamentals involved whatsoever, nothing else to stand in the way of price movement other than what we could call the mood of the market, this presents a great opportunity for us to discover the limitations of whatever technical analysis that we are using, to ensure that we are measuring the right things.
It is fairly easy to analyze a current trend, where we look to filter out the little zigs and zags that represent the noise in trading patterns and look to ensure that the main trend that we are watching is continuing, as well as recognizing and acting upon information that indicates a reversal of a trend on the balance of probabilities.
We never know anything for certain when it comes to the movement of asset prices, but we do not need to, as all we’re really after is to be able to predict what is more likely to happen than not, and go with that side. When done properly, this seeks to have us stay on the side of the odds, and succeeding in trading or investing always involves having the odds in our favor.
We can just seek to work with the current trend, but sometimes it can be helpful to observe past trends as well to see if they may influence the current one. The only way that this can happen is that if the market ends up trading this old information, where the trend collides with it and the past ends up winning because we end up trading on that instead.
We can use the simple example of a support point to illustrate this. Let’s say Bitcoin is trending down, and is now at a point or even several points where at the past it reversed. We never just want to assume it will reverse again, as we always want to seek confirmation, to see if the market is even paying attention to this and whether or not the past will be influential enough to produce another bounce at this price level.
There is no magic involved here, or even extraneous forces at all, only like-minded traders who see the potential for a bounce based upon the history we have and perhaps create enough demand on the long side to overcome the current downward pressure enough to cause a reversal in price momentum.
These past data do not have any power in themselves, they just exist as a point where people have hung their hats on in the past and may again. If they end up doing it again, and they may, that’s where the force comes from, and why we need to at least wait to see what happens with this first.
Depending on the strength and applicability of this past price data, we may even wish to make predictions ahead of time, and while we may even be able to say that it is more probable that we’ll see another bounce, we still should want to wait, as having the odds a little in our favor isn’t enough, as there is also the risk side to the trade to pay attention to.
Charts Confirm Reality with Technical Analysis
Jumping in during downtrends is compared by traders to trying to catch a falling knife, and the problem when you are sticking out your hand when the knife is heading toward it is that even though you may correctly believe that it is more likely than not to stop falling before it cuts us, if we are wrong, the injury we suffer will be more severe than normal.
Let’s say that we know that there is even a 2 in 3 chance that the reversal will stop at a certain support point from the past, and we are at that point right now. By jumping in now before we wait and see if this is going to be one of the 2 times that it stops or the 1 time in 3 that it doesn’t, we’re giving up the point between now and when we confirm which one that we’re going to see.
This amount isn’t going to be much, as all we want to do is see that the market is actually paying attention to the past enough, and look at it enough to halt the current downward trend and reverse it.
With the times that we are wrong, this will likely produce a bigger move against us than this little bit of confirmation that we are looking for, and this can hit us pretty abruptly even if we are watching the trade closely. This is like standing in the middle of the road where most people stop at the stop sign but some do not, and if they do not, they will be travelling pretty fast the wrong way and we’ll get run over.
The probabilities may therefore be on our side if we just jump in front of cars approaching stop signs, as most of them do, but we always need to calculate risk into the equation. It’s the risk/reward ratio that is not so favorable, it’s better to reduce it a lot by waiting a little and paying a little when we’re wrong to find out what the car will do, and jump on after we actually see it stop where we believe it will.
At this point, we can better define our risk, where if we need to jump out of the car, it’s just safer to do so when it is travelling at much lower speeds after the brakes actually get applied. If we get signs of a bounce and jump on and then see that the move is failing, we now have some room where we can get out around the same area if it moves sideways and with only a small loss if it seeks to take back that little buffer we waited for, before it breaks through and resumes its steeper descent.
Things get more complicated though when we add in differing fundamental conditions in the past to the mix, where the reliability of past price data gets watered down by these other influences. This is especially an issue with assets that are primarily driven by fundamentals such as currencies.
With Bitcoin, people trade this based upon price patterns and market expectations of them alone. With currency pairs, most of the trading and the action is instead driven by macroeconomic data and outlooks, the way that people incorrectly assume that stock prices primarily follow, with the difference being that with forex, the assumption actually does fit reality.
People buy Bitcoin and even stocks with the expectation of future price movement, where the expectation itself is the main driver of their prices. People expect Tesla to go up a lot in the future, they buy a lot of it, and it does go up.
Maybe Tesla is only producing a small fraction of the profits of their much larger competitors, the fundamental side of things, but the market doesn’t care and their actions overwhelm the market impact of those who trade on fundamentals, who see it grossly overpriced and have sold long ago and much lower if they dared to own it at all.
We can still trade the current trend with forex confidently, as it encompasses all these fundamental influences as well as everything else into its price, and the price trends that emerge do define the current direction of trading fairly well, even though the trading itself may not have that much of an impact. Macroeconomic changes do manifest in trends as well, and price measures everything.
The issue we run into when comparing past trends with forex is that the fundamental basis of past trends may be different, having us comparing two things that are quite distinct. In our example of a technical support point, we cannot really be that confident that a forex market will recognize these stop signs for instance just because it did way back when, because the things that matter can be very different.
An example of this would be to imagine that we were back in September of 2007, with the U.S Dollar Index dropping to the point where it stopped going down at the end of 2004. The fundamental circumstances were quite different in the fall of 2007 though, and whatever impetus that traders saw this support level producing was simply overwhelmed by the negative macroeconomic forces of the day, where we blew through this stop sign and saw the index go considerably lower before it finally started to recover almost a year later.
Even looking for a confirmation back then would not have served us very well either, as we did get a little move at the 80 level that the support was sitting at, going to 81 for a time before heading back down to around 71 before the actual bottom. There was a distinct downward trend from 91 to 71 though, a huge amount for a forex trade, and that one could have been played pretty easily without reminiscing about Christmas past, but we need to pay close regard to it being about this one and not past ones.
Only the Present Matters When Trading Currencies
With forex, the past just isn’t really that relevant, and the reason is actually simple. When forex traders see the past coming up again, they just aren’t anywhere near as willing to look away from present trends and alter their course as they might with other assets where we do pay more attention to these things, where circumstances other than price do not play as significant of a role.
Many technical analysts, most in fact, pay way too much attention to the past anyway, and we need to be careful when we just try to assume that stop signs will work enough to halt current momentum. This is not to say that these things aren’t sometimes good to know, but this just isn’t that influential with forex, to the point that this information just isn’t pertinent enough to serve as a reliable enough basis to act upon.
Technical analyst Andrew Addison of The Institutional View is digging out his charts and showing us why he believes his charts show that the U.S. Dollar Index will be dropping at least 10%. He starts by telling us that the chart has stalled at its 33-year average, as if a 33-year average of this index could ever matter.
Just seeing anyone even dare use such a thing to advise us gives us a good idea of why so many people see technical analysis even less useful than fundamental analysis is. For starters, this index is just an index and is a compilation of the action between the U.S. Dollar and other currencies, and while this index is traded, the vast majority of the trading that goes on with USD is with the other currency pairs directly, as in EUR/USD.
Why this matters is that this chart moves but not by people trading it directly but indirectly. Charts of indexes don’t function like a chart of one of its components, because the index is the sum of all the charts involved. Should the U.S. dollar index hit a resistance point though, its components aren’t going to be at one, and we cannot expect traders to start buying the Euro and sell USD because a different chart is at resistance, and it’s this plus the other individual charts of the currency pairs that move this index one, where if traders pay this much attention to resistance points on forex charts, the one that he is looking at is not even applicable.
This is not splitting hairs as using this index chart for patterns is useless and will only serve to misguide. Undaunted, Addison tells us that this index has stalled at its 33-year average. It’s not clear where he came up with 33 years, but even if this were a stock where people actually knew or cared where averages go, where the 50 day or the 200 day causes some people to react, 33 years is a ridiculously long time to look at anything, especially an index that doesn’t even represent the trading with an asset, with an asset that really isn’t traded by way of these patterns anyway even if we were looking at the actual charts, and going back 33 years to get your data.
For this to mean anything at all, we’d have to show that traders see this 33-year average of the index and set everything else aside that goes into their forex decisions, all the massive central bank action, all the banks that use this to settle foreign currency transactions, all the hedging that goes on where participants buy currency to manage risk, and everyone else would need to stop and realize that they need to be bearish now or bullish now based upon an average price since 1987 until today.
That one is a shoe-in for the bad technical analysis hall of fame if there were one, and while we’ve seen some pretty worthy candidates over the years, this may outdo them all by a good margin.
Addison’s claiming that we bounced off major resistance recently is also a contender, not just because there are no resistance points on this chart that the market will ever care about, and it’s only traders that ever care about these things and traders don’t really even move this market, it’s mostly because there is no major resistance or any resistance at that level. You can’t just look to some year long ago to get this as resistance points need to be maintained to remain valid and the path from there has not represented any confirmation.
For resistance to even be recognized, you have to see the market resist it, and this chart doesn’t show any resistance at all at this level or really any levels, it just goes its own way without regard for these things. We expect that actually since this sort of technical analysis doesn’t drive price at all on this chart, and they are absent because the market doesn’t pay attention to these things.
The fun isn’t over though, as Addison tosses his technical analysis hat and puts on one of a fundamental analysis, and tells us that he believes that the USD will sink because of the poor way that they have controlled the number of pandemic infections.
This isn’t even a real fundamental indicator, as would be things like interest rates or GDP growth or any sort of economic data. We’re not even sure why the number of those infected with COVID presently would even matter to currency traders unless they were overly concerned that we’ll lock things down like before, which is extremely unlikely to happen, and we should never be allowing the extremely unlikely to influence our financial decisions, especially not be the main reason behind them.
He speaks of some other countries flattening their curves where the U.S. hasn’t, even though the curve in the U.S. has actually flattened, and now that the increased testing has flattened as well, new infections per day have also flattened. Both the overall infection rate since the start and the daily new infection rate have both flattened at 8%, and this has never gone up since the start, in spite of all the popular misconceptions created by our fear-mongering media.
We’re still left to wonder why the U.S. having more COVID infections than some other countries should mean anything to forex traders in the first place. These things can scare the stock market but the forex market isn’t so prone to irrationality, as almost all the action is from mega sized traders like the world’s largest banks and countries who aren’t so easily spooked nor are looking to speculate like stock traders and investors are.
Addison also throws in a stock pick for us at no additional charge, the Taiwan Weighted Index, which is a hot pick presumably because it bottomed sooner than the S&P 500. It hasn’t done that badly and has just got even for the year and even put in a little gain, but we have no idea why it bottoming sooner would matter at all, and we need better reasons than that to want to buy something.
Our preferred major index, the Nasdaq 100, has answered the bell after a rare week of losing a couple of percentage points to the S&P 500, but has made that back already and is at yet another all-time high and up 25% on the year now. Neither the S&P 500 nor the Taiwan Weighted Index impress us very much, but we’d at least need to see a real technical move to favor either of these other indexes, which have performed markedly similar.
What puts the cherry on top of this is the fact that the Taiwan index only bottomed 5 days earlier than the S&P 500, which just isn’t a meaningful amount of time even if this sort of thing mattered.
As far as the U.S. Dollar Index goes, it has moved down a bit lately, but there’s nothing either on this chart nor in the real world that suggests it’s going down all that far. This recent dip is not being driven by any 33-year averages, but from the EU getting closer to a $858 billion recovery package, which is expected to stimulate their economy and produce things that the currency market does care about, which does not include Addison’s chart.
You can make money trading forex charts, but we prefer the real charts, not a conglomeration of them like this is, and the most we can do with them is to track and follow the current trend, not ones so long dead that they have cobwebs or just seeing them appear as apparitions.
The principle that things go down until they go up and things go up until they go down suits us just fine. Most technical analysts still use clubs to hunt, but the main part that they still need to learn is that they seek to make things so much more complicated than they need to be. The most that technical analysis can tell us is when a trend is over, where you stay on it as it continues and change trains when it changes, but that also happens to be all we really need to know.