While technical analysis is useful to analyze various price charts and historical price data of financial instruments, there are a number of risks that new traders should be aware of before applying this method of analysis.
The risks of using technical analysis are:
- The risk of applying the wrong technical analysis indicators to a specific market environment.
- The risk of not using technical analysis objectively.
- The risk of using technical analysis without a proper understanding of how it works.
- The risk of focusing too much on technical analysis on the shorter term timeframes of price charts without viewing the bigger picture or the higher timeframe analysis too.
- The risk of technical analysis causing confusion due to over analyzing or using too many indicators.
These are the 5 most notable risks with technical analysis that traders and investors should be aware of before applying it to trading and investing.
1. Applying The Wrong Technical Analysis Indicators To A Specific Market Environment
The first risk of technical analysis is traders that use technical analysis can sometimes apply the wrong trading indicators to a specific market environment.
Examples of applying the wrong technical indicators to a specific market environment include:
- Using a breakout/trend following trading indicator when the market is in a mean reversion state: Breakout or trend following technical indicators should not be applied when a market is in a mean reversion state as it will lead to many losing trades and cause the indicators to be far less effective. e.g. Using breakout chart patterns when the overall markets are in mean reversion state.
- Using a mean reversion technical indicator when markets are trending:Technical indicators that indicate market extremes and overbought or oversold conditions tend to be far less effective when the overall market is trending strongly in one direction. e.g. Using the RSI indicator when markets are strongly bullish or bearish.
2. Not Using Technical Analysis Objectively
Another risk is not using technical analysis objectively when analyzing financial markets.
This risk causes traders to use technical analysis to confirm a trader’s bias rather than applying it objectively.
Examples of not using technical analysis objectively are:
- A trader or investor analyzes a stock and thinks the stock is a great one to own. Then, they look at every technical indicator indicating a buy signal regardless of what the overall market might be indicating.
- A trader or investor thinks a currency is terrible based on some comments from a government official. Then, they look for all indicators that indicate a shorting signal without properly analyzing the overall market.
3. Using Technical Analysis Without A Proper Understanding Of How To Apply It Correctly
Another risk is using technical analysis without understanding how to apply it properly.
This is a common risk new traders face as they erroneously believe they understand how to apply a trading indicator or chart pattern when in reality they do not.
Examples of traders using technical analysis without a proper understanding include:
- Using the Ichimoku Cloud erroneously for trade signals: Many new traders use the Ichimoku Cloud indicator in the wrong manner to generate buying and selling signals.
- Using the wedge chart pattern incorrectly for trade signals: New traders sometimes trade the falling wedge pattern and the rising wedge pattern in the wrong way, buying before the price of a financial instrument reaches the breakout point of the wedge or shorting before the price of a market reaches the break down point. This can create capital losses for traders and investors.
4. Focusing To Much On The Shorter Term Technical Analysis Timeframes Without Viewing The Bigger Picture
Another risk with using technical analysis is focusing and relying exclusively on technical analysis of the shorter term timeframe rather than also looking at the longer term technical analysis price charts of a financial instrument.
New traders are especially prone to this issue.
Examples of the risk of focusing too much on the shorter timeframe technical analysis of price charts include:
- A trading indicator on a 1 minute price chart is indicating a short trade signal while the daily price chart is at a major support level: Focusing on the short term could give a shorting trade signal while the higher timeframe chart is indicating the price is at a big support line where it will struggle to go lower.
- A technical trading indicator on a 5 minute price chart is indicating a buying trade signal while the hourly price chart is at a major price resistance level: Focusing too much on the short term could give a buy trade signal when the price is at a major resistance level meaning the price of the financial instrument could struggle to go higher.
5. Technical Analysis Causing Confusion
Another major risk with technical analysis is it can cause confusion for a new trader or investor.
New traders often start out by using far too many trading indicators to help govern their trading decisions and as they get more experienced they remove them down to just a handful.
Examples of technical analysis causing confusion include:
- Adding too many overlay indicators like moving averages and having them clutter the view of the price action: To many overlays can block the view of the price charts and cause confusion.
- Adding conflicting trading indicators that cause mixed signals: Using too many technical indicators can cause mixed signals with one indicator signaling a buy while another signals a short trade.
Conclusion
Understanding and addressing these technical analysis risks before they become a problem is crucial to ensure no trader or investor is affected by them.
To help manage these risks, new traders should practice on a trading simulator or demo account to practice preventing these risks in a risk free environment.