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Does Technical Analysis Really Work?

Technical analysis charting softwareImagine watching CNBC and a stock analyst comes up and mentions that a particular stock is trading near it's 200 day moving average and a bounce to the upside is expected. To any layman and logical thinking person, it may sound utterly ludricrous that a line on a chart can actually halt the drop of a stock. Especially one which has just missed their quarterly earnings expectations, but lo and behold when the stock begins trading, after a brief spike below the 200 MA, the stock catches a bid and begins to rise instead! Voodoo Magic? Manipulation? Or is it just TA showing it's true colors? Lets examine why this happens:

How Market Participants Trade and Make Decisions

Most day traders, scalpers, proprietary traders etc, do not know or care about the fundamentals of a stock. All they're after is to catch momentum, be it up or down, to capture a couple of pennies, ticks or pips of the move. Most of these traders understand basic TA so when a popular technical indicator triggers a signal, imagine the rush of orders suddenly coming into the market. The market makers have no choice but to adjust the price accordingly to accommodate this new demand and hence the price will bounce off where the TA indicator triggered the signal. The smart money, on the other hand, are cognizant of both the fundamentals and technicals of the stock and they will use this opportunity to either sell on strength or buy on weakness, depending on the situation and their overall strategy. Sometimes, to add fuel to the fire, black box trading systems and High Frequency Trading (HFT) systems may also be triggered helping to create a sustained momentum. Eagle-eyed scalpers and day traders can often anticipate correctly these sudden rush of orders and profit handsomely by playing with the momentum created.

What Are Some Popular Technical Indicators

Moving Averages are used by almost every trader because they give a simple and easy visual understanding of whether prices are trending up, down or in a trading range. The most popular ones are the 5, 20, 50 and 200 period MAs. Futures traders love daily pivot points. These are especially effective while trading the S&P 500 e-mini futures (ES). A good ES scalper can make 4-8 ticks per trade at these pivot points.

Fibonacci levels are also widely used and a good trader will keep track of these levels at the higher timeframes eg. daily charts even while scalping. Other popular indicators that tend to have an effect on price when they are triggerred include MACD, MACD Histogram, RSI, Stochastics and Woodie's CCI.

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