What are the Limitations of Technical Analysis in Forex Trading?

To analyze the forex market two basic approaches can be made. One is the fundamental analysis that looks at growth factors of the country whose currencies are being traded. The second is of course technical analysis that analyzes chart patterns and indicators. While both are important in their own unique ways, the fact remains that for a beginner technical analysis is fundamental in context. In this article I will try to explain the limitations of technical analysis in forex trading.

What is technical analysis?

When you use technical analysis in forex trading you are actually using a set of technical indicators. These technical indicators could be for example Bollinger Bands, Pivot points, Moving Average or any of the other indicators you may have come across. And what do these technical indicators do? They help you determine when to enter or exit a trade of a particular forex currency. It is alright using these technical indicators as long as you are careful in the sense that you understand their importance correctly. You simply cannot download a technical indicator and then apply it blindly to your forex trading methodology. That would be a terrible mistake. You need to understand their significance. In other words, what I am trying to tell you are, technical indicators whatever they are, should constitute just a single part of your overall trading strategy. You could very well look at technical indicators as something that pin-points the exact entry and exit points of the currency you are dealing with. But the point is you should never reckon with these technical indicators in isolation. Doing so would be espousing the cause of the very limitations that these technical indicators possess.

Limitations of technical indicators

In order to study the forex limitations, consider for a moment an example of Moving Averages. You could well be using the 35 day, 50 day, 100 day or 200 day moving average. But the significant point you have to remember is that they could be valid only on a daily graph basis. For example some analysts would advise you to trade in the direction of the cross as for example when a 50 day moving average is crossed by the 13 day moving average, as it is usually interpreted as a good signal for doing so. But the problem is, apart from the fact that such crosses do not occur regularly, even if it were to happen it would work soundly only on a daily graph. The point is you should never lead yourself to a situation where you could well be imagining that you saw a cross arise, and reverse or uncross. This is something that could very well happen. Neither should you be looking at the moving average and anticipate that a cross would eventually arise. In other words, never use these indicators to work out a prognosis or else you would not be in tune with the market you wish to trade. Always consider these indicators as just a part of your trading strategy. Use them in conjunction with fundamental analysis. Therein lays your success in forex trading.
Now let's consider the example of the Bollinger bands. It works just fine in a range bound market where prices predictably oscillate between the two bands. Bollinger Bands too have their limitations. For example, the tag of the upper Bollinger Band is by itself not a whole-hearted signal to sell. It is just an indicative tag. Its just that, and nothing more, and nothing else. Similarly the tag of the lower Bollinger Band is not a whole-hearted signal to buy. Again it is only a tag, just indicative and nothing more. If for example, you try to "sell at the tops" and "buy at the bottoms" you could be in trouble if prices move further away from your initial entry point. This is perhaps a major limitation of the Bollinger Band as a technical indicator.

Conclusion:

Successful forex traders should understand the limitations of technical analysis. More importantly it should constitute just one part of your overall trading strategy. Recently I read an article about a survey conducted amongst major players that influence foreign currency markets. According to this survey, only 21% of forex traders use technical analysis as compared to 41% of forex traders who use fundamental analysis. Needless to say, the best course of action would be to use a combination of both.