How Does the Financial Technical Analyst Make Money? What Is a Trend?

1. How Does the Financial Technical Analyst Make Money?

Several requirements are needed to convert pure technical analysis into money. The first and most important, of course, is to determine when a trend is beginning or ending. The money is made by “jumping” on the trend as early as possible. Theoretically, this sounds simple, but profiting consistently is not so easy.

The indicators and measurements that technical analysts use to determine the trend are not crystal balls that perfectly predict the future. Under certain market conditions, these tools might not work. Also, a trend can suddenly change direction without warning. Thus, it is imperative that the technical investor be aware of risks and protect against such occurrences causing losses.

From a tactical standpoint, then, the technical investor must decide two things: First, the investor or trader must choose when to enter a position, and second, he must choose when to exit a position. Choosing when to exit a position is composed of two decisions. The investor must choose when to exit the position to capture a profit when price moves in the expected direction. The investor must also choose when to exit the position at a loss when price moves in the opposite direction from what was expected. The wise investor is aware of the risk that the trend might differ from what he expected. Making the decision of what price level to sell and cut losses before even entering into a position is a way in which the investor protects against large losses.

One of the great advantages in technical analysis, because it studies prices, is that a price point can be established at which the investor knows that something is wrong either with the analysis or the financial asset’s price behavior. Risk of loss can therefore be determined and quantified right at the beginning of the investment. This ability is not available to other methods of investment. Finally, because actual risk can be determined, money management principles can be applied that will lessen the chance of loss and the risk of what is called ruin.

In sum, the basic strategy to make money using technical methods includes

• “The trend is your friend”—Play the trend.
• Don’tlo se—Control risk of capital loss.
• Manage your money—Avoid

Technical analysis is used to determine the trend, when it is changing, when it has changed, when to enter a position, when to exit a position, and when the analysis is wrong and the position must be closed. It’s as simple as that.

2. What Is a Trend?

What exactly is this trend that the investor wants to ride to make money? An upward trend, or uptrend, occurs when prices reach higher peaks and higher troughs. An uptrend looks something like Chart A in Figure 2.1. A downward trend, or downtrend, is the opposite: when prices reach lower troughs and lower peaks. Chart B in Figure 2.1 shows this downward trend in price. A sideways or flat trend occurs when prices trade in a range without significant underlying upward or downward movement. Chart C in Figure 2.1 is an example of a sideways trend; prices move up and down but on average remain at the same level.

Figure 2.1 shows a theoretical example of an uptrend, downtrend, and sideways trend. But defining a trend in the price of real-world securities is not quite that simple. Price movement does not follow a continuous, uninterrupted line. Small countertrend movements within a trend can make the true trend difficult to identify at times. Also, remember that there are trends of differing lengths. Shorter-term trends are parts of longer-term trends.

From a technical analyst’s perspective, a trend is a directional movement of prices that remains in effect long enough to be identified and still be profitable. Anything less makes technical analysis useless. If a trend is not identified until it is over, we cannot make money from it. If it is unrecognizable until too late, we cannot make money from it. In retrospect, looking at a graph of prices, for example, many trends can be identified of varying length and magnitude, but such observations are observations of history only. A trend must be recognized early and be long enough for the technician to profit.

Source: Kirkpatrick II Charles D., Dahlquist Julie R. (2015), Technical Analysis: The Complete Resource for Financial Market Technicians, FT Press; 3rd edition.