Technical analysis (TA) is undoubtedly challenging. As a trader, you know that errors are an inevitable part of the game, and losses are an unavoidable reality. However, some mistakes are more easily avoided than others, particularly those made by beginners.
The best traders maintain an open mind, remain rational and calm, and stay true to their game plan while continually assessing the market. By developing these qualities, you can manage risks, analyze mistakes and play to your strengths, all while constantly improving your craft. To succeed, it's important to maintain a level head, particularly when the going gets tough (which it undoubtedly will).
With this in mind, let's take a look at how you can avoid the most common missteps in TA to stay ahead of the game!
What is Technical Analysis?
Technical analysis (TA) is a widely used approach to assess financial markets, including stocks, forex, gold and cryptocurrencies.
Despite the apparent simplicity of its fundamental principles, mastering technical analysis is a challenging task, and mistakes can be costly. Just like any other skill, mastering TA takes time and effort and it's normal and common to make mistakes. However, in the world of trading and investing, even a single mistake can result in a substantial capital loss. While it's crucial to learn from mistakes, preventing them is even better.
This article will outline some of the most common errors beginners make when using technical analysis to trade or invest.
As you go through the article, you might notice that you are guilty of some of the mistakes, but acknowledging and learning why these are wrong is a step forward to having better investment practices.
1. Refusing To Cut Losses
To stress the significance of cutting losses, commodities trader Ed Seykota was quoted saying:
"The elements of good trading are: (1) cutting losses, (2) cutting losses, and (3) cutting losses. If you can follow these three rules, you may have a chance."
Although it seems obvious, it's essential to emphasize that in trading and investing, the number 1 priority is to always protect your capital.
Starting out with trading can be overwhelming. Consider the following approach: the first step isn't to win, but to not lose. Therefore, it might be favorable to begin with smaller position sizing, or not even risk real funds. Crypto trading platforms such as Binance Futures offer a testnet where you can test your strategies before using your hard-earned funds, commonly known as paper trading. This way, you can protect your capital and risk it only after producing consistent, good results.
Setting a stop-loss is vital; your trades should always have an invalidation point, a place where you acknowledge that your trade idea was wrong. If you don't adopt this mindset in your trading, you're unlikely to succeed in the long run. Even one poor trade can severely affect your portfolio, and you might end up holding a losing bag while hoping for the market to recover.
2. Overtrading
As an active trader, it's easy to fall into the trap of thinking that you must always be in a trade. However, successful trading often involves extensive analysis and prolonged waiting. In some instances, you may wait an extended period for a reliable signal to emerge, and that is perfectly acceptable. In fact, according to Jesse Livermore, a pioneering day trader, "Money is made by sitting, not trading."
Resist the urge to enter a trade solely for the sake of it. Sometimes it's more profitable to do nothing and wait for an opportunity to present itself, especially in certain market conditions. By doing so, you'll preserve your capital and be ready to deploy it at a moment's notice when the appropriate trading opportunities arise. It's important to remember that these opportunities will always return, so patience is a virtue.
Another common trading error is over-emphasizing lower time frames. While there are many successful short-term traders, analysis conducted on higher time frames are typically more accurate than analysis done on lower time frames. Lower time frames tend to produce a lot of market noise and may lure you into making impulsive trades more frequently. Although risky strategies like scalping may yield short-term profits, they're not recommended for beginners and typically result in poor risk/reward ratios.
3. Revenge Trading
Every trader and investor has fallen to the trap of revenge trading – the act of trying to quickly recover from a significant loss - at some point in their career. Whether you're a technical analyst, day trader or a swing trader, emotional decision-making can be disastrous for your portfolio.
Staying calm in the face of market turmoil is easier said than done. However, the best traders know how to remain level-headed, even in the most trying of times. After all, the very nature of technical analysis requires an analytical approach to the markets. Emotional trading decisions can quickly derail the most carefully laid trading plans.
If you want to excel as a trader, it's essential to keep a logical and analytical mindset. Avoid knee-jerk emotional reactions and focus on making rational, data-driven decisions. After suffering a big loss, it's particularly important to resist the temptation to immediately jump back into trading. Taking time off can help you regain a clear head and make more informed trading decisions when you're ready to start trading again.
4. Refusing To Change Your Mind
To excel as a trader, you must learn to be adaptable and not be afraid of changing your mind. Market conditions can shift unexpectedly and repeatedly, so it is vital to stay abreast of such changes and adjust your approach accordingly. What worked before may not work again, and it's your job to recognize that. As Paul Tudor Jones, the famed trader, remarked, "He who assumes each of his positions is wrong every day."
One excellent practice is to question and scrutinize your positions, looking for their potential weaknesses. This way, your investment theses and decisions become more thorough and nuanced.
Additionally, cognitive biases can significantly impact your decision-making, impairing your judgment and limiting the range of possibilities you can consider. It's crucial to understand and acknowledge the cognitive biases that may influence your trading plans to mitigate their effects more effectively.
5. Disregarding Extreme Market Conditions
There are instances when technical analysis (TA) loses its predictive power due to extreme market conditions, such as black swan events or scenarios driven by mass psychology and emotions. These events can create significant imbalances between the supply and demand of the market, making it difficult to predict market movements.
As an example, consider the Relative Strength Index (RSI), which is a commonly used momentum indicator. Typically, when the RSI is below 30, it is considered an oversold signal. However, this doesn't necessarily imply a clear trade signal. Instead, it indicates that the sellers are currently dominating the market's momentum, indicating an imbalance towards the selling side.
During extraordinary market conditions, the RSI can reach extreme levels, even dropping to single digits, nearing the lowest possible reading of zero. However, this doesn't automatically indicate an imminent market reversal. Therefore, making impulsive decisions based solely on technical tools during these conditions can lead to significant financial losses.
It's essential to take a comprehensive approach during such conditions, taking into account other factors, and not just rely on a single tool. Blindly following analytical tools without considering market conditions and other relevant factors can be detrimental to your investment portfolio, especially during black swan events, when the price action can be exceptionally difficult to predict.
6. Neglecting The Probabilistic Nature Of Technical Analysis
Technical analysis doesn’t deal in absolutes; it deals in probabilities. This means that whatever technical approach you’re basing your strategies on, there’s never a guarantee that the market will behave as you expect. Maybe your analysis suggests that there’s a very high probability of the market moving up or down, but that’s still not a certainty.
You need to take this into account when you’re setting up your trading strategies. No matter how experienced you are, it’s never a great idea to think the market will follow your analysis. If you do that, you’re prone to oversizing and betting too big on one outcome, risking a big financial loss.
7. Blindly Following Other Trader’s Calls
Improving your craft is an essential aspect of mastering any skill, particularly when trading the financial markets. While following the experiences of technical analysts and traders can be an excellent way to learn, to become consistently profitable you must also find your own strengths and build on them. This unique combination is known as your edge, and is what distinguishes you as a trader.
If you read interviews with successful traders, you'll find that their strategies differ considerably. One strategy that works perfectly for one trader may be unfeasible for another. The financial markets present countless ways to profit; you need to find the one that best suits your personality and trading style.
While trading based on someone else's analysis may succeed a few times, blindly following other traders without understanding the underlying context will not work over the long term. However, this does not imply that you should not learn from others. The crucial aspect is whether you agree with the trade idea and whether it fits into your trading system. You must not blindly follow other traders, no matter how experienced or reputable they are.
Mastering technical analysis is a journey that demands patience, perseverance, and a willingness to learn from your mistakes. As you refine your strategies and develop your own unique approach, you will uncover your strengths, expose your weaknesses and gain greater control over your investment and trading decisions.
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