Before we can understand why price action analysis is so highly recommended, we must first understand what types of analysis a trader can use. In the trading world, two types of analysis are used: fundamental and technical analysis.
Now that we’ve covered the fundamental types of analysis, you might be wondering why Price Action reigns supreme. Before we get there, we should understand why Fundamental Analysis isn’t so “superior.” Although necessary, it is not supreme.
Why Isn’t Fundamental Analysis Used in Trading?
This type of analysis, as the name implies, allows traders and investors to evaluate a company based on its books, profit margins, EBITDA, Cash Flow, and a variety of other complex financial terms. However, fundamental analysis cannot provide us with a perfect stimulus to enter a trade, nor can it provide us with an ideal exit.
Aside from that, with changing times, tampering software, and bribes at their disposal, promoters can easily manipulate their books to appear as charming as sector leaders. Unfortunately, this has resulted in many innocent investors becoming victims of their wrongdoing.
Take, for example, a ‘fundamental analysis trap’ that occurred in 2020.
A marketing firm began sending text messages and phone calls to various people informing them about Omaxe Ltd. and its stellar financials. All of the messages and phone calls claimed that Omaxe Ltd.’s stock price would double in two months.
Innocent retail investors began putting their money into the company. Then, one day, a solid profit booking resulted – a 20% lower circuit. Following that were nearly a half-dozen lower circuits. After about a month, SEBI prohibited trading in the scrip. Anyone wishing to exit their position would have to go through a lengthy process of signing a Power of Attorney with the broker and then taking the necessary steps.
Now, if you believe in fundamental analysis, you could easily be duped by the show that these individuals put on. However, as a trader who uses technical analysis, you would have recognised the greater picture here. What exactly is it?
- The stock was in a downward spiral.
- There were hardly no volumes present, and then they abruptly increased, which is not a good sign for a buy.
- Why would a technical analysis believer buy something without a signal if the chart provided no firm buy indication? Is it possible to see a trend here?
- There was no falling wedge, flag, pole, or inverted head and shoulder pattern, or any other bullish pattern.
If anything, a bearish flag was forming, indicating that the price would continue to plummet. Even so, folks were cramming as much as they could into it.
What Is the Importance of PRICE ACTION?
After reading the example above, you should understand why fundamental analysis is so important and why technical analysis is the messiah for traders. Here are some more legitimate backs to back up our claims.
But, before we get into the specifics of how technical analysis might aid traders, it’s important to first understand WHY technical analysis makes traders more profitable. We’ll be using Mark Douglas’s book Trading In The Zone to explain this. Fundamental analysis, according to the author, generates a “reality gap,” while technical analysis closes it. How? Fundamental analysis predicts what will happen to a stock’s price based on its financial statements. Technical analysis, on the other hand, is more concerned with what is happening right now and how it is affecting the market.
Because technical analysis identifies how the same repeated behaviour patterns emerge every time frame – minute by minute, daily, weekly, and even yearly – it almost always works.
To summarise, technical analysis transforms the market into a never-ending stream of opportunity.
Now let’s look at why technical analysis is so important:
Exit and entry are flawless.
There are some chart patterns that appear on different charts from time to time and provide you with a fantastic sell or buy signal. The chart of Happiest Minds Technologies Limited, for example, indicates a Bullish Pennant pattern. Anyone who had demonstrated faith in the pattern would have reaped the benefits.
According to technical analysis, the targets in this pattern are as long as the pole. Investors profited in this case by a factor of ten. Furthermore, our stop loss would have been tiny, resulting in a favourable risk-to-reward (RR) ratio.
Similarly, for approximately a month, Bank Nifty was in a dropping channel. Traders profited handsomely from the breakout.
Aids in the prevention of false breakouts
People frequently become locked in breakouts that do not allow for a successful retest. You can avoid these fakeouts by using technical analysis. How? Price action is incomplete without volume activity. A good technical analyst would always double-check and confirm a volume breakout.
To learn more about how volume plays a critical role in making you a profitable trader, read our essay on Trading Cafe India’s website about how to trade the retest of a breakout.
Aids You In Getting Out Of A Losing Trade At The Appropriate Time
Many shares have now become negligible in comparison to their previous highs in the history of the stock market. Take, for example, DHFL, Laxmi Vilas Bank, and a slew of other delisted companies. The money of the investors has now been depleted to zero. Technical analysis, on the other hand, could have prevented people from losing their hard-earned money. Yes Bank was in a similar situation. See how technical analysis could have saved investors from losing their entire investment.
So now you understand why technical analysis is important and how it can help you improve as a trader over time. Use technical analysis to limit your losses and ride your winners for longer periods of time. Happy Investing…!!