The basics of technical analysis have been developed by American journalist Charles Dow who is the forefather of technical analysis. In this lesson, we will talk about the basic principles of technical analysis.
Initially, investors used Dow's principles in stock exchanges. However, they began to apply them to other markets over time. Dow’s principles became popular after they were improved and combined into the Dow theory.
The Dow theory includes six basic components:
1. There are three primary kinds of market trends
Charles Dow defines a trend as a consistent price movement in one direction during a certain period. He suggested classifying the trends by duration and depending on trajectories of market quotes, distinguishing three types of trends in each group:
Classification Trend Characteristics
duration Long-term or primary movement The most important trend, lasting from one to several years
Medium-term or medium swing Lasts from three weeks to three months
Short-term or minor movement Lasts from several days to three weeks
movement of quotations Uptrend or bullisht Prices rise
Downtrend or bearish Prices decline
Flat Prices consolidate and change insignificantly
According to Dow, each trend consists of 3 phases:
Accumulation.
This phase comes after a long-term decline or a long-term sideways trading in the market. Rookie traders are prone to sell assets at low prices. At the same time, experienced investors capture the bottom and buy the assets. During this phase, market behavior remains moderate due to few "in-the-know" investors and low trading volumes.
Participation.
During the participation phase, the market participants become more active. Some savvy traders catch on to the opinion of those "in-the-know" investors. Here we usually see sharp price movements because more market players start trading.
Implementation or excess.
The trend becomes definite to all traders. We can see rampant speculation in the market and the savvy investors lock in profits. They sell their cheaply acquired assets and generate profits amid growing demand.
2. Trends are confirmed by volume.
Charles Dow paid attention to trading volumes when defining the trend. When significant price movements occur with high volume, Dow believed the trend may continue or start a new one. When a market moves on low volume, this is not a trend at all.
3. Trends exist unless proved otherwise.
Markets do not move in a straight line and sometimes the price may move against the trend. However, the trend remains in play unless we see strong reverse signals. Such price moves should be perceived as a temporary retracement or “market noise.”
4. Indices must confirm each other.
Dow used the two indices, the Dow Jones Industrial Average and the Dow Jones Transportation Average. They were seen as a key gauge of economic activity. According to the principle, traders should scrutinize the market as well as collateral and related markets. If the trend reverses, it should be confirmed by all markets.
5. Market discounts all news.
This principle states that price changes occur due to economic news and reports. Moreover, the markets may price in all information available to the public.
6. History tends to repeat.
When studying market behavior, Charles Dow found out that there was a correlation between price changes and market psychology. Most traders conduct trading based on their experience, and prices change according to patterns based on historical data.
Now you know the basic components of the Dow theory, let's study the classical axioms of technical analysis. They were formulated in the early 1980s by American financial analyst John Murphy, based on the already known concept.
Considering all the above, we can define technical analysis. It is the study of asset or market action to forecast future price direction using price charts, trends, or volume indicators.
Initially, investors used Dow's principles in stock exchanges. However, they began to apply them to other markets over time. Dow’s principles became popular after they were improved and combined into the Dow theory.
The Dow theory includes six basic components:
1. There are three primary kinds of market trends
Charles Dow defines a trend as a consistent price movement in one direction during a certain period. He suggested classifying the trends by duration and depending on trajectories of market quotes, distinguishing three types of trends in each group:
Classification Trend Characteristics
duration Long-term or primary movement The most important trend, lasting from one to several years
Medium-term or medium swing Lasts from three weeks to three months
Short-term or minor movement Lasts from several days to three weeks
movement of quotations Uptrend or bullisht Prices rise
Downtrend or bearish Prices decline
Flat Prices consolidate and change insignificantly
According to Dow, each trend consists of 3 phases:
Accumulation.
This phase comes after a long-term decline or a long-term sideways trading in the market. Rookie traders are prone to sell assets at low prices. At the same time, experienced investors capture the bottom and buy the assets. During this phase, market behavior remains moderate due to few "in-the-know" investors and low trading volumes.
Participation.
During the participation phase, the market participants become more active. Some savvy traders catch on to the opinion of those "in-the-know" investors. Here we usually see sharp price movements because more market players start trading.
Implementation or excess.
The trend becomes definite to all traders. We can see rampant speculation in the market and the savvy investors lock in profits. They sell their cheaply acquired assets and generate profits amid growing demand.
2. Trends are confirmed by volume.
Charles Dow paid attention to trading volumes when defining the trend. When significant price movements occur with high volume, Dow believed the trend may continue or start a new one. When a market moves on low volume, this is not a trend at all.
3. Trends exist unless proved otherwise.
Markets do not move in a straight line and sometimes the price may move against the trend. However, the trend remains in play unless we see strong reverse signals. Such price moves should be perceived as a temporary retracement or “market noise.”
4. Indices must confirm each other.
Dow used the two indices, the Dow Jones Industrial Average and the Dow Jones Transportation Average. They were seen as a key gauge of economic activity. According to the principle, traders should scrutinize the market as well as collateral and related markets. If the trend reverses, it should be confirmed by all markets.
5. Market discounts all news.
This principle states that price changes occur due to economic news and reports. Moreover, the markets may price in all information available to the public.
6. History tends to repeat.
When studying market behavior, Charles Dow found out that there was a correlation between price changes and market psychology. Most traders conduct trading based on their experience, and prices change according to patterns based on historical data.
Now you know the basic components of the Dow theory, let's study the classical axioms of technical analysis. They were formulated in the early 1980s by American financial analyst John Murphy, based on the already known concept.
- Murphy developed three principles:
- Reflection or information accumulation.
Technicians do not study fundamental, political, psychological, or other factors that may affect the markets because they are already priced into the quotes. This means that analysts do not need to consider what factors have influenced the supply and demand.
Analysts consider the fact that the price has changed. They try to figure out in what direction it may move next using charts as a means of analysis. - Trend or price direction.
As we already know, markets move in trends. Many technical analysis techniques are aimed at defining the trend and smoothing out market noise. Technical analysis helps determine and follow the trend throughout its temporary existence in the market. One can significantly improve their trading performance by following the trend. - Trend cycles.
Technical analysis is a tool assisting to define price patterns, occurring in the markets from time to time. These patterns can reveal what happened in the market and help make forecasts about future price moves.
For example, in the past, a certain movement of quotations signaled a continuation or a reversal of the trend. Thus, in the future, if a similar situation occurs, it will signal the same movement of the quotes. In this connection, technical analysts should always monitor such patterns on charts.
Considering all the above, we can define technical analysis. It is the study of asset or market action to forecast future price direction using price charts, trends, or volume indicators.
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