• Which camp are you in?
• Why technical analysis works
• PLUS: A head and shoulders in gold
As I was saying yesterday, when it comes to technical and fundamental analysis, I like a bit of both. That’s certainly the case when choosing overall direction – i.e. do I want to be long or short?
But for actual trade entry and exit – what we call timing – it’s the charts that lead the way.
And today I thought we should take a closer look at why technical analysis works.
There’s a bunch of people out there who say it doesn’t work. They say it’s all mumbo-jumbo – and that looking at charts is just looking at history and trying to ‘guess’ the future.
Well, as I explained yesterday, that’s kind of true. At least the history part is – I wouldn’t say ‘guessing’ is fair, though. It’s more measured analysis, using previous price action and reaction, as a guide to where it could go in the future.
Here’s a bit about what I said yesterday (and then we’ll go a little further):
“…chart analysis gets mocked by some people as ‘dark arts’ and ‘self-fulfilling rubbish’. Some try to write off technical traders, saying all they have to go on is history.
“Well that’s exactly it. It’s one of the premises technical trading is based on:
“History repeats.
“Not necessarily exactly. But price often follows patterns that have happened before. And often those patterns happen again. That’s an opportunity to make money.
“And I know plenty of traders who make a killing out of using historical charts to predict where price should be heading. And buying or selling accordingly.
“For now, there are a couple of powerful, undeniable concepts I want to touch on that technical traders use to make money.” [You can read the rest of that article here.]
Now I don’t know which camp you’re in?
Are you a pure chartist or are you chart-sceptic and prefer to focus on the fundamentals (economics, central bank policy, company accounts, etc.).
Or maybe you’re like me and use both types of analysis to spot your trades (and fine-tune your entry and exit)?
But today I want to delve a little more into why I believe technical analysis works – and when it’s useful.
If you’re a chart fan, I hope what we’re going to look at chimes with you. And if you’re a little sceptical, perhaps, at least, it’ll provoke some thought. Maybe you’ll consider looking into technical analysis some more.
Why does technical analysis work?
It’s all about price action – where the price has been before – and how it is displayed on the price charts. Price charts are simply pictures of where the price has been in the past.
The reason it’s useful to look at a chart is that you can see levels where a rising price has stopped and reversed (resistance) or a falling price has stopped and reversed (support).
And it’s this support and resistance that forms the basis of technical analysis.
Knowing that price has reacted in this way in the past, traders will mark lines on their charts at those levels. And if a lot of traders are doing it, these lines can be rock solid – you can map your trades with them.
Here’s a daily chart of USDJPY (dollar/yen) taken yesterday:
Image may be NSFW.
Clik here to view.
Source: IG.com
Technical traders can look for price approaching those levels to work out trades. It may be that they look for the price to reverse at that support or resistance level. See how price has often reacted at those levels that have been significant in the past.
Or you can look to enter a trade if the price breaks through what was previously support or resistance… and continues.
There are strategies for both. And there are also established chart patterns that we see time and again which are great for picking out trend reversals or continuations.
These patterns have a great track record for spotting decent big moves. And I want to show you what I mean with one of the most powerful reversal patterns, called the head and shoulders pattern.
As I often say, it’s better to trade with the trend than against it. Following the trend is (as Jesse Livermore put it) the line of least resistance.
So you should trade with the trend as long as you can – and get out when you have confirmation that it has ended. That’s the best way to make money on big moves.
The thing about the head and shoulders is that you’re looking to get into a new trend – once you’ve had confirmation.
You aren’t trying to nail the start of the new trend. You want a clearer, more convincing trend to trade – so you miss out on the first part and wait until it is more established.
That’s OK. Because often, these patterns have a long way to run after you get the confirmation.
To show you what I mean, here’s a chart I found. I’m not sure what it’s of – but it’s a typical one and so a good example to show you what the head and shoulders pattern looks like:
Image may be NSFW.
Clik here to view.
The key thing about this pattern is that once you have confirmation of the trade being on (breaking the neckline) they tend to move the same distance as the height of the pattern from the top to the neckline.
Why is that? I’ll go into further detail with some more examples soon… and as always, I’ll be keeping an eye out for specific trades using these patterns. To get those specific trade ideas, upgrade to Profit Watch Pro.
Here’s one I’ve been looking – it’s on the four-hour chart for gold priced in dollars:
Image may be NSFW.
Clik here to view.
Source: IG.com
It’s not perfect. But it’s got the right combination of falling peaks that indicates a possible trend change.
Note how since price broke down through the neckline, it then came back up to test it… before resuming the move lower. That’s another familiar characteristic of these patterns.
I’m not trading this but let’s see how it plays out as an exercise. If that red support line around $1,220 gives way, then the $1,203 target is in the crosshairs.
At that point the price may find a bit of support. If it doesn’t, there may be even further to run on this down leg for gold.
Clik here to view.
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The post Why a break of this line could trigger a move down for gold appeared first on The Daily Reckoning - UK Edition.