To some, technical analysis seems like a foreign language, and it has its fair share of detractors. Yet the funny thing is, it’s still around, which suggests there must be some value in it. But does technical analysis make money?
Technical analysis can make money if applied in the correct way. That means choosing the right instrument to trade and having a robust strategy. Using sound risk management is also vital. It ensures you keep losses small while letting profits run.
If that’s got the dollar signs spinning, you might want to cool those jets. Technical analysis does make money, but it doesn’t work for everyone. We’ll get into that after summarizing what technical analysis is all about.
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
What Does Technical Analysis Involve?
Technical analysis uses historical price information to predict potential future price movements.
Technical analysts use that information to spot patterns suggesting trend changes or continuations. They also use indicators, calculated from prices, to identify such signals.
Thanks to technology, modern-day technical analysts no longer plot this information by hand. Computers and software do all the heavy- lifting. And that might account for its widespread usage in today’s markets.
But does everyone make money using it? Well, no. This brings us to the next point.
Does Technical Analysis Guarantee Profits?
Absolutely — not!
So, don’t go diving into the markets, assuming you’ve found the Holy Grail to market success. Do that, and you’ll be in for a hiding to nothing.
Let’s be clear about this. Technical analysis doesn’t guarantee that every trade you enter will make you money.
What it does do is enable you to identify high-probability trading opportunities. What you do with that information is pivotal to whether you’ll have a good chance of making money.
If you’re after guaranteed returns, that’s probably not what you wanted to hear. But stick with us because we’ll explain below what it takes to make money using technical analysis.
How Can You Make Money With Technical Analysis?
Remember what we said above. Technical analysis is a tool that will enable you to identify how price may move in the future.
But, there’s a whole lot more to making money using technical analysis than that.
So, here’s what you also need to consider if you want to maximize your chances of making money using technical analysis.
Select Your Market
When it comes to financial markets, there’s an almost endless choice of instruments to trade.
Based on research into technical analysis in markets, one thing seems clear. Technical analysis seems to work better on some instruments than others.
For example, let’s look at a 2020 study conducted by Ahmed S. Alanazi. In this study, Alanazi looked at two well-known chart patterns applied to twenty-four currencies. The study back-tested the patterns using nineteen years of data.
Researchers found the chart patterns produced positive returns on fourteen of the currencies. But ten currencies had negative returns.
In 2016, in a research paper, titled – ‘Technical Trading: Is it Still Beating the Foreign Exchange Market?’, researchers made a similar finding. In this paper, they looked at the indicators using forty-five years of data for thirty US dollar pairs. The researchers found the indicators worked better on some currency pairs than others.
So, selecting the right market to trade can make a difference to your bottom line.
Select Your Strategy
The thing about technical analysis is that there is a myriad of patterns and indicators you can choose from. It’s easy to look at too much and end up mired in confusion, leading to analysis paralysis.
Choose the Patterns or Indicators To Trade
So, don’t go overboard, overloading your charts with tons of indicators. Less is more, and more is, well, just a mess. The best starting point for most people is that age-old adage — keep it simple.
As an example, look back at the 2020 study mentioned above. The researchers used two popular and related chart patterns. They’re patterns from Japanese candlestick charting, the piercing line, and dark cloud cover.
The first is a sign of a market bottom, while the second signals a potential market top. So, these patterns portend reversals of a trend. As you saw from the study results, trading on those patterns alone proved profitable.
Similarly, in the 2016 study, researchers used moving averages. They’re one of the most popular technical analysis indicators around. Again, simple yet effective.
But the point is that you don’t need a chart full of indicators and patterns to make money with technical analysis. Of course, it’ll make your charts pretty. But it won’t make you profitable.
Make Sure You Understand the Rules of Trading Your Pattern or Indicator
Selecting a pattern or indicator to trade isn’t the end of the matter. Each pattern or indicator comes with its own set of rules that tell you when a signal triggers.
If you recall, the aim of technical analysis is to identify high-probability trading opportunities. And that’s why there are rules.
So, make sure you get familiar with the complete strategy.
Back-Test Your Chosen Strategy
With technical analysis indicators, there are several parameters you can adjust. In the 2016 study above, researchers found different settings worked with different currencies.
So, you’ll need to back-test your strategy. In fact, back-testing on your chosen market is a crucial part of any solid trading strategy. So, you should do it whether you trade chart patterns or signals generated by indicators.
Use Risk Management
As dull as it might sound, risk management is something you should never overlook. It can make the difference between surviving to take another trade and blowing up your account.
Essentially, risk management boils down to this:
- Don’t commit too much capital to a trade. So, don’t put all your money into a trade. Use only a percentage, say 1% to 2%.
- Use a stop-loss. A stop-loss will get you out of the trade if the market moves against you. It fixes your risk.
- Set your profit target before you enter the trade. This is the reward part of the risk/reward ratio.
You can see how setting a proper risk/reward can affect profitability from the 2020 study above.
In that study, researchers reported losses when using a 1:1 risk/reward ratio. But, using risk/reward ratios of 2:1 and 3:1 boosted profitability by significant amounts.
Maintain Your Discipline
Doubtless, you’re familiar with the phrase greed and fear. These two opposing emotions play a considerable role in driving market movements.
In theory, you should be able to overcome these emotions using technical analysis. Why? Because technical analysis provides you with a set of rules. They tell you when the pattern or indicator triggers a signal.
So, you have your entry point for a trade. You also know where you need to get out if it goes wrong and where you’ll take profit. That’s if you’ve followed the above advice and have your risk management strategy in place.
So, stick to your rules. Resist the temptation to move your stop-loss to stay in a losing trade. Equally, don’t let greed keep you in a trade beyond your predetermined profit target. You risk the price reversing against you and wiping out your profit.
Avoid Over-Trading
There’s an interesting study from 2014, titled – ‘Technical analysis and individual investors’, on this point. It found technical analysis usage seemed to go hand in hand with speculative trading.
Those researchers also found that this led to excessive trading, which harmed profitability.
In contrast, the investors who used technical analysis, but not for speculative trading, saw higher returns.
So, if you plan on using technical analysis for speculative trading, take heed.
The trader in the following video found out the hard way about the importance of everything discussed above:
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Conclusion
So, technical analysis does make money, but it doesn’t do it in isolation.
You need to back it up by back-testing your chosen strategy on the market you want to trade. You must also have sound risk management, plus the discipline to stick to your trading plan.
However, there are still no guarantees you’ll succeed. But, taking these steps will increase your chances of making money with technical analysis.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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