Trading is a complex endeavour that involves many factors. The ability to analyse markets is something that allows traders to overcome trading difficulties. Technical analysis is widely used by traders to make informed decisions about the price movements of various assets, including stocks, currency pairs, and cryptocurrencies*.
Technical analysis and trading are inextricably linked, but while this method provides valuable insights, it also comes with a set of challenges. This FXOpen article discusses the challenges associated with technical analysis and suggests how traders can effectively overcome these challenges.
Three Main Assumptions of Technical Analysis
Technical analysis is based on the Dow Theory, which includes three basic principles and assumptions, namely:
- The market discounts everything. Technical analysis assumes that everything that happens and can affect the market is reflected in its price. This means that the price will tell you everything you need to know.
- Prices move in trends. According to technical analysts, even when the market is not moving in a uniform manner, prices will show trends, and this is independent of the time frame in question.
- History tends to repeat itself. Technical traders try to identify recurring patterns in price because they have made the assumption that what has happened before in its formation is likely to happen again.
Although technical analysis follows predetermined rules and principles, the interpretation of the results is not always right. Technical analysis is limited to the study of market trends and does not delve deeply into an instrument or industry to understand how it works. Critics of technical analysis argue that these assumptions may not be accurate. Below, you will learn more about the complexities of the analysis.
Subjectivity in Analysis
One of the main technical analysis problems is its inherent subjectivity. Traders often rely on various tools and indicators, such as moving averages, MACD, and Fibonacci retracements, to interpret price charts. The issue arises when traders misread patterns or interpret these tools incorrectly, leading to inconsistent results and trading decisions.
To mitigate this challenge, traders typically establish clear and objective criteria for their analyses. This includes identifying specific entry and exit points based on predetermined trading rules. In addition, referring to experienced traders or using algorithmic trading strategies can help reduce the impact of subjectivity.
Data Quality and Reliability
Forex, stock, and crypto* markets are known for their high volatility, which can result in irregular price movements and gaps in historical data. Traders often rely on past price movements to make predictions about future developments. When the historical data is incomplete or inaccurate, practical technical analysis becomes less effective.
Traders should be cautious about data quality, ensuring that they have access to reliable sources. The use of multiple data sources and cross-referencing will help identify and eliminate inconsistencies. In addition, the limitations of historical data should be recognised and not relied upon exclusively.
Over-Reliance on Indicators
Many traders become over-dependent on technical indicators, believing they hold the key to successful trading. Of course, technical analysis learning is important, and indicators are valuable tools, but relying solely on them can lead to trading errors. The problem is exacerbated when traders use too many indicators simultaneously, leading to information overload and conflicting signals.
The possible response to this challenge is to select a few key indicators that align with your trading strategy and combine their signals with other analysis tools, including price action and fundamental events. Over time, traders develop the ability to interpret price action without relying only on indicators. This is a skill that can provide a more holistic view of the market.
Limited Predictive Power
Technical analysis primarily focuses on historical price data and patterns to predict future price movements. However, it’s crucial to acknowledge that past performance is not always indicative of future results. The markets are influenced by a wide range of factors, including economic data releases, geopolitical events, and central bank policies, which can override technical signals.
To address this issue, traders should combine exploring technical analysis graphs with evaluating fundamental factors. Considering both technical and fundamental factors helps traders make more informed trading decisions and reduce the risk of being blindsided by unexpected market events. Traders need to stay informed and adaptive, even if they base their strategies on chart analysis.
Emotions play a significant role in trading, and technical analysis can sometimes exacerbate emotional decision-making. For example, if emotions overwhelm you during technical forex analysis, it may lead to mismanagement of trades and losses. Those who become too emotionally attached to their technical analysis may hesitate to cut their losses or take profits.
System hopping is another common problem that stems from excessive impulsiveness. Traders may switch from one system or strategy to another in search of quick profits. However, this can result in confusion and inconsistency. Sticking to a trading plan and avoiding impulsive decisions can help mitigate emotional challenges.
To overcome stress and prevent emotional decision-making, traders adopt disciplined risk management strategies, such as setting stop-loss orders and take-profit levels in advance. Traders calculate their risk-reward ratio to determine how much loss they can bear for the reward they are expecting.
Technical analysis can be time-consuming, especially for traders who engage in short-term trading strategies. Analysing charts, identifying patterns, and monitoring technical indicators in technical analysis is a demanding task. It could be difficult for traders with limited time to spare.
The first method is to use clear and reliable trading tools with user-friendly UI. Consider the TickTrader trading platform, where you can find both simple and advanced tools and trade various assets. Another solution is to consider longer timeframes, as they require less frequent monitoring. Additionally, using automated trading systems helps traders save time while still benefiting from technical analysis insights.
Technical analysis is an invaluable tool in the trader’s arsenal, providing a structured approach to analysing price movements. However, it’s essential to be aware of the challenges associated with this method and take proactive steps to address them.
Minimising subjectivity, using reliable data, avoiding over-reliance on indicators, and managing emotions help traders perform better in the market. Now that you know some valuable insights about trading, you can open an FXOpen account and start your journey with us.
*At FXOpen UK and FXOpen AU, Cryptocurrency CFDs are only available for trading by those clients categorised as Professional clients under FCA Rules and Professional clients under ASIC Rules, respectively. They are not available for trading by Retail clients.
This article represents the opinion of the Companies operating under the FXOpen brand only. It is not to be construed as an offer, solicitation, or recommendation with respect to products and services provided by the Companies operating under the FXOpen brand, nor is it to be considered financial advice.