7 common mistakes in Technical Analysis (TA)

1. Introduction

While the fundamental concepts of technical analysis are relatively easy to grasp, mastering them requires a certain art. Without caution and learning from one's mistakes, users run the risk of losing a significant portion of their capital. Learning from mistakes is valuable, but avoiding unnecessary errors can make the process much smoother.

7 Mistakes in Technical Analysis (TA)

This article will address some of the most common mistakes in technical analysis. If you’re new to trading, why not start by learning some basic concepts of technical analysis?

The following article covers the most common mistakes that beginners make when trading with technical analysis.

2. Not Cutting Losses

Investor Ed Seykota once said:

“The core elements of trading are: (1) cutting losses, (2) cutting losses, and (3) cutting losses. If you can adhere to these three principles, you may have a chance of winning trades.”

This may seem like a simple step, but it is critically important. When it comes to trading and investing, protecting capital is always the top priority.

Starting with trading can be challenging. A solid approach that users can consider when beginning to trade is: “In the early stages, focus on not losing money rather than making a profit.” By doing so, users can protect their capital and only take risks when they consistently achieve positive results.

Setting a stop-loss is very straightforward. Trading needs to have an invalidation point. This is when users should accept that their trading idea was wrong. If this mindset is not applied, users may make mistakes in the long run.

3. Overtrading

A common mistake among traders is the belief that they always need to be in a trade. Trading involves both performing analysis and patiently waiting! With some trading strategies, users may need to wait a long time to get a reliable signal to enter a trade. Some traders might make fewer than three trades a year but still achieve superior returns.

Trader Jesse Livermore once said:

“Money is made by sitting, not trading.”

Avoid entering a trade just for the sake of it. Users don’t always need to be in a trade. In fact, under certain market conditions, it can be more beneficial to do nothing and wait for a new opportunity. This way, users can preserve their capital and be ready to act when potential trading opportunities arise again. It’s important to remember that opportunities will always return, as long as users can patiently wait.

Another similar trading mistake is focusing too much on lower time frames. Analysis performed on higher time frames is generally more reliable than analysis on lower time frames. While there are successful speculators and short-term traders, trading on lower time frames often presents a poor risk/reward ratio. And since it’s a high-risk trading strategy, it’s certainly not recommended for beginners.

4. Revenge Trading

It’s quite common for traders to try to recover losses immediately after a significant loss. This action is called revenge trading.

It’s easy to stay calm when things are going well, or even when you make a small mistake. But can you remain calm when everything goes wrong? Can you stick to your trading plan even when others are panicking?

Remember the word “analysis” in technical analysis; it implies a methodical approach to market analysis, doesn’t it? So why make hasty and emotional decisions? If you want to be one of the best traders, you need to stay calm even after major mistakes. Avoid making emotional decisions and focus on maintaining a logical mindset.

Trading immediately after a large loss tends to lead to more losses. Therefore, some traders might refrain from trading for a period after a large loss. This way, they can start fresh and return to trading with a clearer mindset.

5. Being Too Stubborn to Change Thinking

To be a successful trader, don’t be afraid to change your thinking. Market conditions can change rapidly, and one thing is certain: they will continuously change. A trader’s job is to recognize these changes and adapt to them. A strategy that works well in a specific market environment may not apply in another.

Consider legendary trader Paul Tudor Jones discussing his positions:

“Every day I assume every position I have is wrong.”

It’s good to try to consider the other sides of your arguments to identify potential weaknesses. This way, your investment arguments (and decisions) can become more comprehensive.

This also brings up another point: awareness of bias. Bias can heavily influence your decision-making, cloud your judgment, and limit the range of possibilities you consider. Make sure to understand at least the cognitive biases that might affect your trading plan, so you can mitigate their impact more effectively.

6. Ignoring Extreme Market Conditions

There are times when the predictive characteristics of TA become less reliable. These could be black swan events or other extreme market conditions driven more by emotions and crowd psychology. Ultimately, markets are driven by supply and demand, and there can be times when markets are extremely imbalanced, skewed heavily to one side.

For example, take the Relative Strength Index (RSI), a momentum indicator. Generally, if the index is below 30, the asset might be considered oversold. Does this mean it’s an immediate trading signal when the RSI falls below 30? Absolutely not! It only means that the market momentum is currently driven by the selling side. In other words, it indicates that the sellers are stronger than the buyers.

The RSI can reach extreme levels in abnormal market conditions. It can even drop to a single digit—close to the lowest possible reading (zero). Even an extreme oversold reading does not necessarily mean that a reversal is imminent.

Blindly making decisions based on technical tools reaching extreme levels can lead to substantial losses. This is especially true during black swan events when price movements can be particularly hard to read. During such times, the market may move continuously in one direction or the other, and no analytical tool can catch it. This is why it’s always important to consider other factors and not rely solely on one tool.

7. Forgetting That TA Is a Game of Probability

Technical analysis is not about certainty. It’s about dealing with probabilities. This means that any technical method you use in your strategies will never guarantee that the market will behave as you expect. Your analysis might show a high probability of the market going up or down, but that’s still not a certainty.

You need to account for this when setting up your trading strategies. No matter how experienced you are, you should never assume that the market will definitely follow your analysis. If you do, you risk placing too large of a bet on a single outcome and risking heavy losses.

8. Blindly Following Other Traders

Continuously improving your technique is essential if you want to master any skill. This is especially true for trading in financial markets. In fact, the ever-changing market conditions make this necessary. One of the best ways to learn is to follow experienced technical analysts and traders.

However, for sustainable growth, you also need to identify your strengths and build on them. We can call this your personal identity, what sets you apart from others as a trader.

If you’ve read many interviews with successful traders, you’ll notice that they have quite different strategies. In fact, a strategy that works perfectly for one trader may be completely unfeasible for another. There are countless ways to profit from the market. You just need to find the one that best suits your personality and trading style.

Joining a trade based on someone else’s analysis might work a few times. However, if you blindly follow other traders without understanding the underlying context, it will likely not be effective in the long run. Of course, this doesn’t mean you shouldn’t observe and learn from others. The key is to agree with their trading ideas and assess whether they align with your trading system. You should not blindly follow other traders, even if they are experienced and reputable.

9. Conclusion

Remember, trading is not easy, and approaching it with a long-term mindset generally yields better results.

Becoming proficient in trading is a process that takes time. It requires a lot of practical experience in refining trading strategies and learning how to develop your own trading ideas. By doing so, you can identify your strengths, pinpoint weaknesses, and take control of your investment and trading decisions.

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