Technical analysis is a discipline based around a few key principles and that lives by three main assumptions. This guide explores each one in detail.
Technical analysis is a popular methodology used by traders and investors to analyse the financial markets or securities. The practice solely relies on price movements and volume data to value securities under study.
I. Technical analysis principles
Technical analysis relies on the idea that market forces, made up of supply and demand, influence prices. Proponents rely on five main principles when it comes to technical analysis, these are:
- Market Forces – Supply and demand determine the final market price.
- Rational Factors – Collectively influence supply and demand, consequently affecting prices.
- Price Changes – Prices change to reflect periodic trends exhibited in the past and in the market as a whole.
- Patterns and Trends Are Repetitive – It’s possible to predict future price movements based on past data.
- Market Psychology – Emotions are real and play a significant role in influencing price movements.
II. Technical Analysis Assumptions
While technical analysis relies solely on price chart actions, it is also based on three main assumptions.
Price Discounts Everything
Technical analysts maintain that any fundamental information relevant to a given security, known or rumoured, is already factored into the underlying price. What this means is that anything that could affect the price, in the near term, has already been accounted for and thus won’t affect price in the near future.
Technical analysts base their analysis on price movement, which in this case is affected by supply and demand, rather than by earnings growth, revenue growth, or other signs of fundamental strength. The discounting process is carried out by professional market makers who constantly keep track of market conditions.
Price Moves in Trends
Technical analysts also maintain that price changes are not random. Instead, they follow a given trend, which can be either bullish/long or bearish/short, following identifiable patterns that tend to repeat over time. Whenever a trend is established, the underlying asset is likely to continue moving in a given direction until a new trend is established.
When it comes to price movements, technical analysts believe that price moves in short, medium, and long-term trends. For long-term traders who hold trades for days, weeks, or months, long-term charts such as hourly, daily, and weekly charts become most valuable. Short-term traders who hold trades for minutes should pay attention to short-term charts, which can be in five- and 15-minute periods.
History Repeats Itself
The basic idea in technical analysis is that history will always repeat itself, be it in the short term or long term. For this reason, technical analysts spend most of their time trying to understand past price movements to try and accurately predict future price movements.
The repetitive nature of price movements makes it possible to predict future price movements. The repetitive aspect is based on the fact that both human behavior and human history repeat themselves.
Classic chart patterns, such as channels and trends as well as rectangles, ranges, tops, and bottoms, are some of the results of predictable human behaviour. Technical analysts look for these patterns, because most of the time they provide a predictable outcome.
Sources & references
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