There’s a myth that the more you know about different analysis approaches–indicators, trendlines, candlestick patterns, chart pattern, etc–the better trader you’ll be. This isn’t the case. While some knowledge of the market is required to trade, analysis and trading are very different things. At first this may seem counter intuitive, but understanding the difference will help your trading.
The Different Goals of Trading and Analysis
The goal of a trader is to implement a specific action when a specific set of market conditions develop. This is called the trade setup. When it occurs the trader enters a trade, with defined risk and a profit expectation. If the profit expectation doesn’t compensate for the risk, the trade isn’t taken. The trader must also determine the position size of a trade, so risk is limited to a small percentage of account capital.
Most traders focus one or two trade setups, which they have tested in a certain market and time frame, so they know the setup is likely to produce a profit over many trades based on the probabilities of the setup.
Analysis on the other hand may look at various markets, conditions and time frames, attempting to predict where a market could go, even when a precise setup isn’t present. Rarely do analysis methods have a probability attached to them, as a trade setup would. For example, does divergence on the MACD really indicate a price reversal is likely? Maybe, maybe not. The only way to answer the question is to look at the asset you trade and determine if the divergence could have helped make more money over many trades. This would require testing specific trade parameters.
Analysis is based on generalities. Trading has to be precise. Trading requires placing a stop loss order and picking an exact entry point. Analysis doesn’t require this level of specificity, because there’s no money on the line. Analysis can be performed in any market, based on common technical analysis knowledge. Trading shouldn’t take place in any market that hasn’t been tested for compatibility and profitability with a particular strategy/trade setup.
Prediction Doesn’t Equate to Profits
As some of the points above elude to, predicting the market doesn’t guarantee profits. Some analysts make great predictions about where the market will go, yet they’ll admit they’re lousy traders. Many traders aren’t good forecasters, but are very profitable traders.
If you anticipate a stock will rise, you could be correct. But since there’s no way to know for sure, trading takes on a psychological element that analysis doesn’t. If you think a stock will move from $10 to $10.20 over the course of the afternoon, you need to decide when to enter. You also need to establish a point where you cut your loss if it turns out you’re wrong. You also need to determine how you’ll get out of a winning trade if it doesn’t reach your profit target, or exceeds it. Trading your analysis is far more difficult than coming up with the analysis.
Evidence Doesn’t Improve Trading
With so many analysis tools, you’ll always find what you’re looking for to help confirm your opinion. If you believe an asset will rise, some indicator or analysis method, somewhere, will help you confirm that. Seeking out evidence won’t improve your odds of a successful trade.
Assume a trader has a specific trade setup she uses. Unless that trade setup occurs, she does nothing. When it does occur though, she sets an entry, stop loss order and profit target. She knows the trade has a 60% chance of being successful, and that winning trades are two times greater than losing trades–a very profitable strategy (based on testing this strategy and practicing it in a demo account).
That’s all the evidence this traders needs. Incorporating an RSI or a MACD to confirm doesn’t provide any additional information, because the odds on the trade are already known. Over time the trader may find the RSI or MACD can filter out some trade signals, improving the win rate of the strategy to 63% (for example). Determining the usefulness of the indicator takes time though, and the trader still needs precise entry and exit points so they can see the difference in performance when adding an indicator.
A documentary about the Chicago floor traders–Floored: Into the Pit–eludes to how many floor traders have little education or knowledge about the markets. Yet the profitable traders manage to find certain patterns or tendencies they exploit. Knowing more doesn’t equate to making more, just as knowing very little doesn’t mean you can’t be profitable. The key is knowing the right things, mainly having a specific strategy, sound risk management and proper position sizing.
Simplify to Become a Better Trader
Trading is seeking out the same trade setup(s) over and over again, and executing a trade in regards to that setup with precision. This includes defining the risk, entry point, position size, and how you’ll get out profitable trades. Analysis won’t necessarily help you that, only testing variations of your strategy will show you which method works best over many trades.
If you have a method that works, stick to it. Avoid the trap of thinking that finding more “evidence” to confirm your opinion will make you a better trade. If anything, this often distracts traders from what’s working. Focus on only a few trade setups, having the proper position size and good reward-to-risk and/or win-rate ratios. This is the path to become a profitable trader (see: Keep Your Day Trading Simple: Here’s How to Do It)
Implementing the same setup over and over again seems easy, but the human tendency is deviate away from this approach. Understanding how trading psychology works will give you some insights into keeping yourself on track, so you don’t get distracted by the thousands of analyses and analysis approaches out there that won’t necessarily improve your trading.
Ashish is a Founder of processtrends.com He loves to do SEO and Day Trading. This both are his full time passion or professions.