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Trading Using Technical Analysis

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Technical analysis, as the term applies to trading, studies the use of price data or chart patterns to make trading decisions. This chapter explains why many people unjustly criticize traditional forms of technical analysis. It then describes some profitable ways to use technical analysis to develop mechanical trading strategies.

WHY IS TECHNICAL ANALYSIS UNJUSTLY CRITICIZED?

Many of the people who say that technical analysis does not work are either fundamentalists or skeptics who believe that the markets are random and cannot be predicted. They point to the fact that the published rules in many introductory books on technical analysis are not profitable when backtested. This is true; but these simple rules are not the indicators used by professional traders. When used correctly, technical analysis can make money for traders. Let's take a close look at some examples of the misuse of computer-based technical analysis.

Moving Averages

As a first example, consider a simple moving-average crossover system. This system works as follows:

  1. Calculate a short-term moving average.
  2. Calculate a longer-term moving average.
  3. When the short-term moving average crosses above the long-term moving average, then buy.
  4. When the short-term moving average crosses below the longer-term moving average, then sell.

Moving-average crossover systems work well in trending ...

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