With such erratic up and down price movement, it usually does not take long for many traders to realize that chart analysis is a lot more art than science. This is evident with other chart patterns as well.
One popular chart formation that gets a lot of attention is the head- and-shoulders bottom or top (Figure 4.2). Traditional technical analy-
sis says that a break of the neckline projects an additional move from the neckline equal to the distance from the top of the head to the neckline—in this case, roughly four points between the head and the neckline on the EUR/USD chart. Added to the neckline, the projected target is about 127. Is this really a head-and-shoulders bottom after prices kicked back below the neckline to test that breakout point? It is too early to jump to that conclusion on this chart. Meanwhile, the trader is left in a quandary about the market’s prospects for becoming an uptrend.
Chart patterns suCh as “head-and-shoulders” provide priCe Clues. it may be a subjeCtive observation on this euro Chart, but this is a head-and- shoulders, a Chart formation popular in traditional teChniCal analysis that helps traders spot breakout points and potential priCe targets.
The USD/CHF pair in Figure 4.3 provides a few more examples of chart patterns. First is the flag, a brief correction in the uptrend that traditional analysis suggests is the halfway point of the move. At the time the flag occurs, that is not known, of course, but in this case that market axiom did turn out to be a correct assessment of the situation.
The next pattern in Figure 4.3 is the double top or M top (turn the formation upside down, and you have a double bottom or W bottom). The market hits a high, backfills, and then makes a new run at that high, which proves to be tough resistance. With the M top, the second high is usually lower than the first high. When prices drop below the interim low, the top is confirmed, and a downtrend is expected. As with the head-and-shoulders pattern above, prices do not exactly cooper- ate, rallying back to the breakout line on this chart. Such is the fickle nature of chart patterns.
source: vantagepoint intermarket analysis software (www.tradertech.com)
Figure 4.3.
Chart formations Come in many forms. this Chart of the usd/Chf pair features several Common teChniCal analysis patterns—a flag forma- tion that sometimes oCCurs at the midpoint of a trending move, an m top that suggests sell when the interim low is broken, and a 50 perCent retraCement of a prior move that often aCts as a support level.
The third technical analysis point to note on Figure 4.3 is a 50% retracement of the upmove, which technical analysts traditionally see as a strong support area. In this case, it was. Prices bounced off that support on schedule, just as analysts who look for that type of retrace- ment would have expected. It is one of several retracement areas that analysts project by using Fibonacci numbers and ratios.
Having prices perform as technical analysts expect them to is far from a sure thing. Spotting trendline breaks and top or bottom formations tends to be quite subjective, relying on the eye of the beholder. Chart signals usually are not as obvious as they might seem when you look at the price action with the benefit of hindsight. Even if you recognize a chart pattern, interpreting what it projects and then making a trading decisions based on that analysis are just as subjective. Because the chart pattern aspect of technical analysis is so subjective, back-testing is not really possible, so there is no way to measure the accuracy of this method of analysis.
adding TeCHniCal indiCaTors
Traders then typically start to look for something more quantitative on which to base their analysis. In looking beyond basic chart patterns, many traders turn to technical indicators, which may be able to detect changes in market momentum or strength or weakness that are not obvious when looking at a price chart. Many of today’s analytical soft- ware packages usually include dozens of built-in indicators that are just a click of a mouse away so you do not have to do the calculations yourself or even comprehend how they were computed. Although these indicators can be back-tested and can be helpful in market analysis, they do share some general shortcomings:
• First, most are based on only one thing: past prices. As a result, they are all lagging indicators and not forward- looking indicators.
• Second, using several indicators together may improve trad-
ers’ perspective, but because they are looking at basically the same thing, adding more indicators does not necessar- ily result in better analysis. In fact, it may lead to another
technical analyst’s catch phrase, “Paralysis by analysis,” which may cause traders to “freeze” and actually make it harder to make a trading decision.
• Third, it is easy to curve-fit or over-optimize the parameters
of an indicator to the past price action. When traders exam-
ine historical price data, they may adjust the parameters to find those that performed best in the past, only to discover that they do not work quite so well in actual trading. • Finally, no matter what traders may see in promotional
material, no one indicator is the elusive Holy Grail for traders, because there just is no such thing as the Holy Grail.