Smashing the myths surrounding technical analysis

Highlights 

  • Technical analysis uses price and volume data of a security to forecast its future price movements.
  • Long-term technical analysis is generally more effective due to a relatively lower level of noise on the price charts.
  • Maintaining a high risk-to-reward ratio compensates for a lower accuracy, hence making overall trading profitable.

Technical analysis is an approach to find profitable investment opportunities in the market. A technical analyst primarily uses the price chart of the security that is to be analysed along with its volume data to derive a conclusion on whether to invest in it or not.

Price chart of a security with a technical indicator

Image Source:  © Dragon345 | Megapixl.com

In its basic essence, it helps to gauge investors’ sentiments, which lead to an action of either a buy or a sell order, which in turn, gets reflected in the price of the security in question. However, there are a few misconceptions which need to be cleared out before you dive into technical analysis. Here are top three myths that you need to steer clear of.

Read More: What is the significance of technical analysis in portfolio building?

  1. Technical analysis is only for short-term trading

Most investors think that technical analysis is helpful only for the short term, and for the long term, fundamental analysis is used as fundamentals of a company do not change quite frequently.

Smashing the myths surrounding technical analysis

However, that does not degrade the effectiveness of technical analysis for a long-term analysis. In fact, more often than not, long-term analysis is generally more effective due to a relatively lower level of noise on the chart when compared with a shorter time frame.

  1. It accurately predicts future price

Its very important to drum this into your head that technical analysis never predicts the future price accurately, nor does fundamental analysis. If anything, it only helps one to understand the current trend of the security and estimates a highly probable future direction, and sometimes targets too.

The forecasts are always ‘probable’ and never ‘certain’. Therefore, every analysis must have a buffer of losses in case prices do not move as per the analysis.

  1. You need a higher win rate

Most investors think making money using technical analysis is only possible if you have a high accuracy. This couldn’t be farther from the truth. Some of the most successful traders in the world have an accuracy of less than half.

In short, less than 50% of their trades go right. So how do they make money? The key is risk-to-reward ratio which is the basically how much you are making on your winning trades versus the amount generally lost on a losing trade. Maintaining a high risk-to-reward ratio compensates for a lower accuracy, hence making the overall trading profitable.

Read More: Five reasons for relying on technical analysis

Bottom Line

Technical analysis is one of the widely used approaches in financial markets to spot high-probability trades. However, if one were to believe the above-listed myths and rely solely on technical analysis, it would not guarantee success in the markets. Hence, it is important to see the wood for the trees and keep everything in mind while using technical analysis for investing success.

Read More: Components of Technical Analysis

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