Before understanding why price action analysis is highly recommended, we need to understand what types of analysis there are on which a trader could trade. Broadly, two kinds of analysis come into play in the trading world – Fundamental and Technical Analysis.
Now that we know the basic types of analysis, you might be wanting to know why Price Action is supreme? Well, before knowing that, we should know why Fundamental Analysis is not so “supreme.” Although it is essential, it is not supreme.
Why Not Fundamental Analysis For Trading?
As the name suggests, this type of analysis enables traders and investors to gauge a company based on its books, profit margins, EBITDA, Cash Flow, and many other complex financial terms. But fundamental analysis could not trigger a perfect stimulation to enter a trade, nor could it grant us an ideal exit.
Apart from all these, with changing times, tampering software, and bribes coming into play, promoters can easily manipulate their books to look as charming as the sector leaders. Unfortunately, this has led many innocent investors to fall prey to their wrongdoings.
Let’s just take an example of a ‘fundamental analysis trap’ that took place in 2020.
A marketing agency started sending text messages and phone calls to different people telling them about a company, Omaxe Ltd., and its top-class financials. All the messages and phone calls claimed that the share prices of Omaxe Ltd. would double within two months.
Innocent retail investors started putting their hard-earned money into the company. Then one day, a solid profit booking came result – 20% lower circuit. Almost half a dozen lower circuits followed. Fast forward to about a month later, SEBI banned trading in the scrip. Whoever wished to exit their position would have to go through a lengthy process of signing a POA with the broker and then taking an exit via a call to order function.
Now, as a fundamental analysis believer, you would’ve been easily fooled by the show that these people put up. But as a technical analysis trader, you would have seen the bigger picture here. What’s that?
- The stock was in a heavy downtrend.
- Almost negligible volumes were present, and suddenly volumes started pumping up, not a healthy sign for buy.
- No solid buy signal was given by the chart, so why would a technical analysis believer buy something without a signal. Could you spot a pattern here? A falling wedge, flag, pole, or inverted head and shoulder, or any other bullish pattern was not present.
- If at all, a bearish flag was forming, indicating further fall. Still, people were loading it up like crazy.
So if you have been on the technical analysis side, you would’ve been saved from this scandal.
Why Is PRICE ACTION Important?
After reading the above example, you know why fundamental analysis is essential and why technical analysis is the messiah for traders. Here are some more legit backs to prove our ideology.
But before we go on to the lengths of how technical Analysis could help traders, we need to understand WHY technical analysis allows traders to be more profitable? For explaining this, we would be taking inspiration from Mark Douglas’s book Trading In The Zone. The author believes that fundamental analysis creates a “reality gap,” and technical analysis erases that gap. How? Fundamental research shows what could happen with a stock price based on its books. Still, technical analysis focuses more on what’s happening in the present and how it will turn out shortly. All of this is based on pure logical calculations and past behaviour.
Technical analysis almost always works because it identifies how the same repeatable behaviour patterns occur every time frame – minute to minute, daily, weekly, and even yearly.
To sum up, the technical analysis turns the market into an endless flow of opportunities.
Now onto why technical analysis is essential:
Perfect Entry & Exit
There are sure-shot chart patterns that occur from time to time on different charts and give you a perfect sell or buy signal. For example, below is the Happiest Minds Technologies Limited chart, which shows a Bullish Pennant pattern. The pattern would’ve rewarded well to anyone who’d shown conviction in it.
As per technical analysis, the targets in this pattern are as high as the length of the pole. In this case, investors earned multifold returns. Also, our stop loss would’ve been relatively small, making our risk to reward (RR) ratio favourable.
Similarly, Bank Nifty was in a falling channel motion for about a month. The breakout gave handsome returns to the traders.
Helps Avoid False Breakout
Often people get trapped in breakouts that don’t make a successful retest. Technical analysis helps you avoid these fakeouts. How? Volume action is an integral part of price action. An excellent technical analyser would always check and confirm a breakout with volume.
Give a read to our blog on how to trade the retest of a breakout on Trading Cafe India’s website to understand how volume plays a crucial role in making you a profitable trader.
Helps You Come Out Of A Losing Trade On The Right Time
In the history of the share market, there have been many shares whose price has now become negligible to their old highs. For instance, take DHFL, Laxmi Vilas Bank, and many others which got delisted. The investors’ money has now gone to zero. But technical analysis would have saved people from losing their hard-earned money. Similarly was the case with Yes Bank. See here how technical analysis would have rescued investors from losing all their capital.
So now you know why technical analysis is essential and how it helps you become a better trader over time. Take the help of technical analysis to cut your losses small and ride your winners for a longer time. Happy Trading…!!
If you want to understand and trade using the price action in the market like how we are doing. You can learn it better from our Mentorship programs and become an independent profitable trader like our students.