×

Dollar index an example of dangers of chart analysis

Xaume Olleros | Bloomberg | Getty Images

The desktop computer revolution more than 30 years ago brought technical analysis and charting to the masses - the first charting packages were simple but they were a massive advance over what could be done by hand.

Over time, charting analysis programs have become both more sophisticated and easier to access. Charting has shifted from stand-alone programs to being integrated into many trade execution platforms and even the most basic of free online programs and brokerage-provided software include 30 to 50 technical indicators.

The result is that more people are dabbling in technical analysis without really understanding what is involved, because the pace of education has not kept up with the pace of change.

It's more than just not understanding how technical indicators are used, this very amateurish approach also includes the misplacement of trend lines, support and resistance levels. This is not helped by the popularity of some software that claims to automatically plot these lines.

These points are significant because moves above or below these levels are used as triggers for trade entries or exits. Getting the position correct is essential for trading success, and ignorance can be exceptionally dangerous and expensive in the financial markets.

A case in point is the line chart of the dollar index with a downtrend line. A respected TV financial commentator told viewers in Australia recently that the dollar index had broken out from the downtrend and the US dollar was poised to go higher.

So what's wrong with this dollar index chart? The trend line correctly starts from the peak in March 2015 but thereafter the placement of the line is wrong. It's wrong because the line placement ignores all of the price action in area A. You cannot simply exclude three months of price activity because it suits your preconceived notions of a current breakout. The placement of the trend line is simply a nonsense. It fails to define the true nature of price activity in this instrument.

A trend line uses three anchor points created by the peak highs in a downtrend, or the valley lows in a uptrend. A move above or below the line signals an increased probability of a trend change.

Since early 2015 the dollar index has been trapped between support near 0.93 and resistance near 100.5. This is rally-and-retreat trading as defined by short-term trends. The upside target is near 0.97. Our preference is to use a candlestick chart as this shows the daily price relationships and yields additional information about price activity.

When done by educated traders, charting and technical analysis looks easy. When applied by amateurs, these analysis methods give misleading results. Unfortunately, these users often go on to blame technical analysis for their failures rather than their own lack of expertise.

Daryl Guppy is a trader and author of The 36 Strategies of the Chinese for Financial Traders, available from guppytraders.com.. He is a regular guest on CNBC in APAC and a speaker at trading conferences in Asia, Australia and Europe.

Follow CNBC International on Twitter and Facebook.