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What is technical analysis, and why does technical analysis work?

Technical analysis (TA) describes different ways of predicting the future of the stock market based on its history. Unfortunately, technical analysis is not an exact science. Many prominent scientists label it as "voodoo science". They claim that due to market efficiency, if you use TA to find your entry positions, you’re no better off than someone who chooses those positions randomly. Market efficiency means that all the available information is already priced in to the stock, and that you can only guess how the price will behave in the future.

The "voodoo science" theory would make sense if it wasn’t for the fact that there are a significant number of investors/traders who are able to consistently make profits in the stock market. These investors/traders use technical analysis as their main tool. Since any investor/trader has or can have access to the same TA tools, we have to ask how a small group of investors/traders can consistently win and the other larger groups, more or less, consistently lose money in the stock market. What is it that winning investors/traders know about technical analysis that gives them the upper hand?

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The answer is simple: Technical Analysis works but not necessarily for the reason most people believe. Many successful investors/traders don’t want to share this secret. TA works because many people use it, and successful investors/traders are able to predict how other people will react on the different TA indicators and signals. In other words, while the losing investors/traders are using TA to determine their positions, the winning investors/traders are winning because they know how the losers are going to react based on this data. For example, when the price of a stock goes below one of the key moving averages, (MA’s) many investors sell that stock to protect themselves against additional losses. By doing so, they will drive the price of that stock lower and that will prompt some investors/traders to start short selling that stock in anticipation of further declines. Prices continue their downward trend, forcing investors/traders who were long on that stock to sell their positions because it is going below their stop limits. This creates a domino effect as the price continues to decline. However, at this point, successful investors/traders realize that most of the current price action was created artificially. They start to enter positions on the buy side and more often than not the price starts to reverse. The losing investors/traders have already sold their positions based on the TA indicators and/or signals. The winning investors/traders buy the stock because they understand that the fluctuation was temporary, and they seize the opportunity based on the losing investors’/trader’s reactions.

No TA indicator by itself will give you reliable buy or sell sigals. There is no Holy Grail or magic black box that will give you the perfect, accurate signal. However, the combination of the right group of TA indicators with discipline and adequate trading capital has been the road to fortune for many investors/traders.

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