Traders in 2014 have a virtually unlimited arsenal of analysis tools at their disposal. While this can be a tremendous advantage. It can also work against traders if they are using those tools incorrectly.
One common misconception among traders today is that they confuse the terms price action and technical analysis. Both of these can be used to build profitable trading strategies, but there are subtle differences in their analysis that need to be understood.
Daniel Fernandez from Mechanical Forex wrote a post recently that contrasted price action with technical indicators. He did a nice job of explaining how each of the terms analyzes data differently and showing that both can be used successfully if they are properly understood.
Here is how Daniel describes price action:
Price action is generally defined as any interpretation of the market that arises from simple comparisons of raw market data.
He explains that price action basically refers to strategies that deal with raw market data. The example he provides is a strategy that compares the current price to the closing price from 10 days ago.
Price action analysis has the ability to react very quickly to changes in markets, however it can struggle with noisy market environments. It is also considered less likely to be exposed to curve-fitting, but that is a function of how many degrees of freedom are present.
Here is how Daniel describes technical indicators:
Technical indicators go through data and return values that are an overall simplification of the underlying price action.
The example he uses to explain technical indicators is the Stochastic Oscillator, which identifies where a price is in relation to its range over a certain period of time. This shows how technical indicators take market data and process it into a more usable form.
That type of processing allows technical indicators to do an excellent job of filtering out noise, but it can also make them slower to react to sudden movements. Technical indicators are generally considered more prone to curve-fitting, which is something that must be considered during backtesting.
Which Is Better?
Daniel concludes his post by suggesting that neither type of analysis is superior to the other. In his research, he has found that profitable strategies can be developed using either price action or technical indicators.
He believes that the best approach to strategy development is to use both types of analysis. He suggests using technical indicators as filters and price action to provide confirmations and quick exits.