Principles of Technical Analysis

What is Technical Analysis?

Technical analysis is described as the study of market action, mainly through the use of charts, for the purpose of forecasting future price trends.

The Three Key Principles

Technical analysis is based on three fundamental principles:

  1. Market Action Discounts Everything
  2. Prices Move in Trends
  3. History Repeats Itself

1. Market Action Discounts Everything

This principle means that the price reflects all available information in the market. Everything that affects an asset (such as a share, currency, or commodity)—including economic, political, social, and psychological factors (often called the fundamentals)—is already reflected in the price.

This principle also encompasses hidden fundamentals, which is information not known by all market participants.

  • If prices are rising, the fundamentals must be good (demand is greater than supply).
  • If prices are falling, the fundamentals must be bad (supply is greater than demand).

2. Prices Move in Trends

This principle originates from Charles Dow theory. Dow concluded that prices move in zigzags rather than straight lines, creating three basic trend types:

  • Uptrend: Characterized by a general upward price movement.
  • Downtrend: Characterized by a general downward price movement.
  • Range: Characterized by a sideways price movement.

3. History Repeats Itself

This principle refers to the consistent nature of investor behavior, which tends to repeat itself over time. This behavior creates identifiable price patterns that can be studied to predict similar future patterns.

Since basic human psychology does not change (or takes centuries to do so), emotions like greed and fear consistently show up at market tops and bottoms. This means that patterns which worked in the past will continue to work in the future.

Detailed Summary

Technical analysis is defined as the study of market action, primarily utilizing charts, to forecast future price trends. This approach rests on three core principles: Market Action Discounts Everything (meaning the current price reflects all known and hidden information); Prices Move in Trends (based on Dow Theory, prices move in uptrends, downtrends, or sideways ranges); and History Repeats Itself, asserting that unchanging investor psychology (driven by greed and fear) leads to repetitive and identifiable price patterns usable for future prediction.

Key Takeaways

  • Technical analysis studies market action using charts to forecast future price trends.
  • It is based on three fundamental principles.
  • The first principle, Market Action Discounts Everything, states that the price already reflects all relevant information (economic, political, social, and fundamental factors).
  • Price movements reflect the balance of supply and demand (rising prices mean good fundamentals/high demand; falling prices mean bad fundamentals/high supply).
  • The second principle, Prices Move in Trends (derived from Dow Theory), identifies three trend types: uptrends, downtrends, and sideways ranges.
  • The third principle, History Repeats Itself, relies on the consistent nature of investor psychology (greed and fear) leading to recurring, predictable price patterns.