Key Principles of Technical Analysis
Technical analysis is based on the principle that prices tend to move in trends, repeat patterns over time and the market discounts everything – that is all known and unknown information is already reflected in the current price. There are three assumptions on which technical approach is built on:
1. The Market Discounts Everything
The technical analysis works on the basis that, all the variables that may have some form of impact on a security, such as economic indicators, corporate earnings, political happenings, market mood and even unanticipated occurrences have already been discounted in the current market price.
In this perspective:
- Prices offer rational due diligence and investor psychology.
- As much as new information may be introduced in the market, it is soon incorporated into the price using the behavior of buyers and sellers.
- Thus, it can be profitable just to study the price movements itself without even having to evaluate each and every piece of information.
2. Prices Move in Trends
The other belief which forms its basis is that markets do not drift aimlessly. Rather, prices tend to follow recognizable patterns:
- Uptrend: Higher lows and higher highs.
- Downtrend: Sequence of lower highs and lower lows.
- Sideways/Range-bound: The price movement is relatively unstable but within a particular range.
As soon as a trend is identified, it is believed to persist in the same direction unless it starts manifesting clear signs of a reversal. One of the biggest strategies in technical analysis is trend-following; where indicators (e.g., MACD, RSI) moving averages and trendlines assist traders in validating the strength and direction of a trend.
3. History Repeats Itself
Pattern recognition is a key feature of technical analysis who work on the notion that people in the market can be predicted to act in certain ways because of psychology and these behaviors will repeat. Recurring price patterns can commonly be caused by fear, greed, hope and panic and may include:
- Head and Shoulders
- Double Tops and Bottoms
- Triangles and Flags
These chart patterns have been seen over many decades and technicians think that they reflect the mass emotional behavior of market participants and that it creates opportunities to predict them.
Rationale behind Technical Analysis:
Market Reactions and Efficiency
The argument of technical analysts is that the market does not always provide a perfect efficiency, but it responds to new information very quickly – and such responses can be observed in price movements. Instead of attempting to discern the news or earnings reports, technicians observe the reaction of the prices, and they think this reaction speaks louder than the information itself.
Pattern Recognition and Statistical Probability
Technical analysis tries to predict the likelihood of some outcomes by studying past price action and looking for repetitive setups. There is no pattern that is foolproof, however, certain formations over time have yielded expectable results. The statistical tools and risk management allow traders to take advantage of these probabilities.
Focus on Price Action and Market Psychology:
Technical analysis considers the market as a fluid entity which is motivated by supply and demand. By observing:
- Price developments
- Volumes of trade
- Support and resistance levels
Technicians are able to obtain the sentiment of the market and make correct trading decisions.
It is a style that does not attempt to guess why a market is moving (that would be basic analysis territory) but rather focuses on what the market is doing and where it probably will head to next.
In Essence:
Technical analysis views financial markets as a self correcting mechanism. The price action is the wisdom, fears and expectations of all the people in the market. The traders seek to know which way prices are likely to go in future by observing the way they had reacted in the past under comparable conditions.
It is a philosophy that is based on observation, pattern recognition and probability statistics rather than prediction based on a cause-effect relationship.
Conclusion:
Technical analysis is a must-have tool used by traders and investors who do not regard market trends, patterns, and behavior to fundamental underlying factors. Its advantage is its versatility – it can be applied to any asset type, time horizon or market environment – and hence it is a useful complement (or alternative) to fundamental analysis.