The dangers of over-analysing the market

It can lead to analysis paralysis, indecision and losses.
Image: Matthew Lloyd/Bloomberg

Many of the world’s most successful traders spend years refining their trading technique to strip away complexity and arrive at a simple trading style.

“The problem that we find with a lot of people new to financial markets is that they study technical analysis and learn dozens of different ways to interpret the market using charts,” says Hardus van Pletsen, CEO of online broker QuickTrade, a Financial Services Conduct Authority-licensed over-the-counter derivatives provider (ODP).

“They load up their charting programmes and it looks like a Christmas tree it has so many lines and colours. We teach newcomers to the market that knowing what these indicators are is important, but trying to interpret too many of them at the same time will just confuse you. We have found that people who over-analyse the market don’t know what to do, and often make bad trading decisions that result in losses.”

Some of the best traders rely on nothing more than a candlestick chart, and they trade only in the direction of the market. If the market is trending bullish, only long trades are allowed. They look for areas of consolidation in the charts with a 1:2 risk-reward ratio. In other words, they are prepared to risk $100 in the hopes of making a $200 profit.

Most of the best traders place far more emphasis on risk than on technical analysis.

Some use trend lines to determine the direction of the market, and then fine-tune their entries by waiting for the price to consolidate.

This is shown in the chart of the euro-US dollar below. “When the rising red trend line is broken by the down-moving price, we have entered a short-term bear trend and therefore will only short the market until the trend changes,” says Van Pletsen. “The horizontal light blue line indicates an area of consolidation, so we would enter a short sale at this level.

“We are looking to make twice as much profit as we are prepared to risk, so we would place a stop-loss outside of the consolidation range, say at 1.0756. Our take profit level will have to be double the distance from our entry to the stop-loss, so it will need to be at around 1.07186.”

Source: MetaTrader 5

“One does not need to get complicated in developing a trading style and one can use minimal technical indicators, or none at all – just relying on good old candlestick charts,” says Van Pletsen.

The main thing is to focus on your risk-reward ratio.

“If you make $200 for every $100 you lose, you can still end up in profits, even though you may be losing more than 50% of your trades. And that is how the most successful traders do it. They see it as a numbers game, where profits are steadily accumulated.”

There are many investors who trash technical analysis, opting instead for the directional crumb trails left by earnings and dividends. Technical analysts are not particularly concerned about this, believing all the information you need to know about the company, index or forex pair is contained in the price chart. There are many technical analysts who have been extremely successful simply by understanding chart patterns and when to take a trade.

“We’ve done quite a bit of study into traders on our platform, and what separates the winners from the losers. It’s clear that the winners have a system which is based predominantly on the charts, and it’s not so much that they have more winning than losing trades, than the profits from their winning trades outstrip the losses from their losing trades. You can win just 30% of the time, and provided your profits from these winning trades exceed the losses, you’re going to end up a winner. But to do this you have to ensure that your wins are big and your losses are small.”

Van Pletsen suggests the following four steps to prevent over-analysis.

  1. Simplify your trading system by getting rid of unneeded indicators on your price chart. Many successful traders work with nothing more than trend lines. Don’t clog up your price chart with too many indicators.
  2. Educate yourself. Simplifying your trading style does not mean skimping on the education. Understand what the technical indicators represent, and the fundamental factors driving earnings and dividend growth in a company.
  3. Select a company, index or forex pair for trading. Many traders stick with a single index, such as the Nasdaq, or euro-USD. Do not spread your attention over too many trading instruments. Stick with the ones you know, and develop a trading style that mirrors the price movements of your chosen instrument. It could be as simple as trendlines, or moving average cross-overs (when a short-term moving average crosses a longer-term moving average, this often produces a trade in the direction of the cross-over).
  4. Set stop-loss and take-profit levels when you enter a trade. This ensures you remain disciplined as a trader. You should aim for a 2:1 risk-reward ratio, meaning you expect to make $200 profit for every $100 risked on a trade. This also means understanding how much capital to risk when entering a trade (never more than 2% to 5%). Develop a firm understanding of position sizes, says Van Pletsen, to make sure you do not burn through your capital in just a few trades.

“It’s important to know that there are many successful traders who make a very good living from trading. Our analysis of our client base shows the successful ones have these four things in common,” says Van Pletsen.

Brought to you by QuickTrade.

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