Introduction to Technical Analysis- Part 1: Overview
Technical analysis has two very diverse origins, developing over the course of time to produce the subject we know today. The first recorded use of technical analysis was done by the early 18th Century rice traders of Japan. The technique that is perhaps best known for the Candlestick chart, although a number of other techniques such as Ichimoku charts and Kagi charts are also still in use today.
The other origin, particularly for western technical analysis, is the work of Charles H Dow. On July 3rd 1984, he produced his first publication of the stock market averages, which has evolved to the modern day Dow Jones Index, and has led to the development of similar indices around the world. Down himself never wrote a book about technical analysis, but he did put his thoughts down in a number of editorials. It was from these editorials that Dow’s Theories were formalised and then published in 1932 by Robert Rhea in a book titled ‘Dow Theory’.
Dow Theory has six basic tenets;
1) Everything is discounted in the price — All news, views, hopes and disappointments are factored into the price.
2) Markets have three trends — The primary trend — over 3 months, the secondary trend 3 weeks to 3 months & the minor trend less than 3 weeks. The lengths of these are variable depending on which time period of your trading.
3) Major trends have three phases — The first is the accumulation phase where astute investors buy into the market. Bad news is still coming out but the price is not falling any more. Then there is the trending phase when trend followers, such as technical analysts, join the initial move. Finally, there is the distribution phase when a wider range of investors, such as the public, join the market. At this time, astute investors begin to take profit on their positions and the trend comes to an end.
4) The averages must confirm each other — Dow was referring to his Road and Rail averages. He noted that, for a sustained change in trend of one average, it had to be confirmed by a change in the other average. We can use this theory by looking at related markets to confirm trends and trend reversals.
5) Volume must confirm the trend — Volume is a secondary indicator but the volume should also expand the direction of the trend and vice versa.
6) A trend is assumed to be in effect unless there are definite signals that it has reversed.
From Dow’s theories, we can make three basic assumptions. These assumptions must be accepted to fully understand technical analysis.
1) Market price action discounts everything — All news, views, hopes and disappointments are factored into the price.
2) History repeats itself — All markets are driven by human psychology (i.e. greed, hope and fear). As the psychologist Schiller said, ‘Anyone taken as an individual is tolerably sensible and reasonable, but as a member of a crowd he at once becomes an idiot”
3) Prices move in trends.
Technical analysis has stood the test of time and is essentially a graphical analysis of crowd psychology. Methods may have evolved through time and complex mathematical models may have been applied to the markets, however the basic principles remain the same.
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