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The Hidden Secret Of Technical Analysis

May 26, 2008
Did you know that there is a whole 'other world' of technical analysis that most novice traders are either totally ignorant of, or fear to go due to the fact that it might actually require some work?

Well, there is! And I'd suggest that if most novices fear to go there, then perhaps it might be worth some investigation.

What is technical analysis? For most novice traders it seems to be one of, or a combination of, the two following approaches:

a.The art of defining recent price action through classical charting techniques such as the Dow Theory definitions of an uptrend and downtrend, and recognition of patterns such as channels, triangles, head and shoulders, cup and handles, and on and on, or

b.The art of representing price action through the numerous indicators available on your charting platform, such as moving averages, stochastics, MACD, and on and on.

This is great. It's a good start. But the fact is that no matter how we define the structure of the market, whether based on Dow Theory, or Elliot Wave Theory, or through an indicator based approach, it is important to remember that this structure defines PAST market movement. It's a simplification that allows us to quickly identify what happened in the past.

Profits come from future price action though, not past price action. So having defined past price movement, these traders then use general rules associated with that past price action to justify an entry into the market.

For example:

* "The break below the neckline in a head and shoulders pattern is a great entry short, with a target equal to the distance from the neckline to the peak of the head." - so having identified a breakout down, they enter short.

* "A moving average crossover is an indication of a change of trend" - so identifying the EMA 10 crossing above the EMA 20, the novice trader enters long.

Once again, this is great - hopefully at least better than random entry. These general rules for entry are fine if you're satisfied they provide a slight edge, and you have a complete understanding of the probabilistic nature of price movement, and an appreciation for the necessity of position sizing and risk management. You may well make some profits.

However I'd suggest that there's a whole other world of technical analysis that you're not seeing. That still won't guarantee success (the elusive Holy Grail doesn't exist, so stop looking), but it will provide further opportunity to increase your edge. Use of this hidden world of technical analysis will allow you opportunities to enter lower risk and higher probability trades. Lower risk trades through getting earlier entries closer to support and resistance areas, so you can safely place tighter stops. Higher probability entries, through analysis based more closely on the truth behind price movement rather than a general rule for pattern or indicator based entry.

So where do we find this 'other world' of technical analysis?

Look behind your indicators, or behind the classic charting patterns, and what do you find?

Price action!

It doesn't matter how we define past price action - an uptrend, a downtrend, a range-bound sideways trend, a head and shoulders pattern, an ascending triangle, wave 4 of a five wave pattern. It's just a label that describes an approximation of past market movement.

The label is not important. What is important is the nature of price movement behind the pattern or indicator overlay.

Too many people will say that, because the price is above the 50 period moving average, or because the 10 EMA is above the 20 EMA, or because they have identified a structure of higher highs and higher lows, the market is in an uptrend. They apply a label - uptrend. And that's it, end of story. No correspondence will be entered into. The market is in an uptrend, and they're looking for trades in the long direction.

Looking beyond the "uptrend" to see how price is really moving can allow us to see the internal strength or weakness of the trend. It can provide you with an insight into the fear, doubt or greed of the market participants that create the price action, which then creates the price trend or pattern, or moves the indicators.

I'm not saying you necessarily have to get rid of your indicators - just recognize them for what they are - a useful approximation of the market.

And recognize that if you want to improve your edge, you may need to look behind the pattern, look behind the indicators, look beyond the label, and see what price is really doing.

* Is the volatility of price movement changing, and what does that mean?

* Is the momentum increasing or decreasing? What does that mean?

* Is the momentum of this price move greater or less than the preceding swing, and what does that mean?

* Is the momentum of this price move greater or less than the previous swing in the same direction, and what does that mean?

* Let's go even deeper, and consider the thought processes and psychology of the people who are long (or short) in this trade, and currently sitting on a profit. Where are they looking to exit? Where are they going to take profits? Where are they going to place their stops? What does this mean for future price action?

* Let's consider the psychology of the traders who are currently fighting this move, sitting in drawdown, sweating on every tick and praying to the market Gods - "If you can just this once turn price around so I can get out at breakeven, I promise I'll never again take such a stupid trade". Where are these people trying to get out? At what point will the fear become so great that they'll just have to get out?

* Let's consider the psychology of the people sitting on the sidelines, having missed the start of the move. Some of these will be professional traders - where will they be identifying a low risk and/or high probability entry into this trend? Some of these will be novices - where is the absolute worst place to enter, having chased the market and entered simply out of fear of missing out on the move? Yes, some people do enter right at the very worst tick possible. Where potentially is that, and what does that mean for future market movement?

The answer to all these questions will make a great subject for future articles. For now I'd just like you to start looking beyond the indicators and patterns, and discover a whole other world of technical analysis - price action.

Examine the current internal nature of price movement - the speed, the momentum and the volatility. And consider how this is likely to influence the decision making of the novice traders who will be entering and exiting the market based on their own fear or greed.

And try to discover how you can use this information within your current strategy to lower the risk of entry, improve the probability of your entry being in the right place, and improve the management and exit of your position.

If you are interested in improving your current edge in the market, analysis of price action may be just what you're missing. Check it out now.

Happy trading,

Lance Beggs
About the Author
Would you like to learn more about how I trade the forex and equity index markets? Check out the articles, videos and trading resources on my website right now at www.YourTradingCoach.com
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