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How Technical Analysis Works

Principles of Technical Analysis

There are three fundamental principles that serve as the bedrock for technical analysis. These principles have been observed and established over many years, and can be relied upon. They are: –

  • the market discounts everything,
  • the market exhibits trends, and
  • history repeats itself.

We’ll talk about each of these in turn. First, what does it mean that the market discounts everything? It means that any factors that you can find out that affect the price have already been found out and are included in the price, by market action.

This is an astonishingly powerful idea which may at first sight seem unbelievable. What it is saying is that things such as how many products are selling, whether the exports are doing well, any other relevant facts about a company and its business are all taken account of and included in the market price.

Bear in mind that technical analysis is to do with short-term price movements. This principle does not say that a company cannot increase the value of its shares over time by performing well. After all, that’s what investing is about. But this principle does say that at any moment in time all the things you know or could find out about a company are already priced in. The market has dictated an acceptable price.

Now this couldn’t be better for a technical analyst. This means you don’t need a squad of research assistants looking up all the company data, just so you can see whether a share is going up or down tomorrow. Short-term trading and technical analysis is all about what the market, that is the bulk of traders, think about a price. It doesn’t even matter if, for example, a company is going down the tubes, as long as the market thinks it’s performing well the price might rise!

If news happens, such as an announcement of a big deal, or a recall of a defective product, of course the share value could change to reflect that. It’s new information, and all the “market discounts everything” says is that the current information is in the price. But barring any such announcements, the day-to-day price reflects accurately the current perception of value.

It sounds too simple. However, it does work. Consider, all that it is really saying is that supply and demand is in action, setting the price. With a high demand, the price will rise. If there’s too much supply and no buyers, the price will go down. Whatever makes the supply and demand vary does not have to concern the technical analyst, as he has all the information he needs from the market action that follows.

Another way of looking at it is that we are letting the market tell us what direction it is going. Far too many people try trading, and are convinced that they can, by common sense, tell which way the market should go. The news is that the market doesn’t care which direction you think it “should” go. It will go whichever way it wants, and as long as you observe the clues you should be able to profit from that.

The second principle is that the market exhibits trends. We’ll go into what a trend is to a technical analyst in a later chapter, but you probably already have a general idea. All this principle means is that if the price is rising, it is quite likely it will keep rising, if it is falling, it will keep going down, and if it’s staying around the same level then it will probably do the same, sometimes known as moving sideways. It’s really like Newton’s laws of motion, a body at rest stays at rest unless acted upon by an external force, and a body in motion will, again, remain in motion unless something acts on it. Unless there is some event that will change the trend, don’t expect the trend to change.

This is a simplification, of course, as trends won’t go on for ever, but many good trading systems are based on the idea that you can jump onto a price movement and ride it for a time. A trend doesn’t always go up or down smoothly, you can expect the chart of the price to fluctuate, but if you look at a number of charts you will find more often than not that trends tend to continue.

The third idea, that history repeats itself, means nothing more than people don’t change. Whatever someone’s reaction is to a certain market move is today was probably the same as someone else’s reaction to the same market move 50 years ago. You will learn that trading is a psychological game, and man’s psychology, on the average, hasn’t changed.

Certainly, individuals’ choices can differ. Trading is not an issue of certainties, but merely probabilities. But just as in Isaac Asimov’s Foundation trilogy, mass psychology will produce fairly predictable results. This is another essential for technical analysis to work.

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