Updated: Nov 6
Technical analysis is the study of past price patterns in order to identify trends and predict future price movements.
Technical analysts believe that the collective actions of all the participants in the market, both human and computer-driven, establish patterns that can be identified and used to make predictions.
While there are many different techniques that can be used in technical analysis, one of the most important is charting. Charting involves plotting historical price data on a graph in order to identify trends and patterns.
Once these patterns are identified, technicians can use them to make predictions about where prices are heading in the future.
Technical analysis of the Financial Markets by John Murphy is an encyclopedia in itself. If you are someone who is serious about studying technical analysis and applying them, then this is where you start.
Philosophy of Technical Analysis (TA)
John has explained in simple language why the study of technical analysis is important. He says there are three premises on which technical analysis is based.
Market action discounts everything.
Price moves in trends
History repeats itself
The analogy given here is intriguing. A technician believes that anything that affects the price is already reflected in the price in the markets. A market in itself does not cause prices to move up or down. Price move based on the psychological bullish or bearish view of market players. It is more compelling than market price discounts everything; then, it is important to study market price.
Logical reasoning is given that price moves in trends until they show signs of reversal. When you study price trends, you are looking at the past with the presumption that they may also repeat in the future. The reasons for these are simple; price movements are caused by supply and demand created by the psychology of market players. It is only just to say that the psychology of demand and supply does not change.
He goes on to say you cannot deny the fact that market price tends to lead the known fundamentals present now. The unknown fundamentals are what gets priced in due course.
John believes technicians believe that technical analysis is superior to Fundamental analysis as market price discounts fundamentals as well. He lists various advantages of technical analysis and provides reasons for them.
Timing (Entry/Exit in trades)
Flexibility and Adaptability of technical analysis
Technical analysis applied to different trading mediums
Technical analysis applied to different time dimensions
Less reliance on market averages and indicators
John discusses the ramifications of Dow’s theories and how well they apply in today’s market environment as well. Dow gave more importance to closing prices as they average the intraday penetrations on either side.
Dow’s theory should not be mistaken to let you capture market tops or bottoms. That was not the intention of the theory. The intended value of this theory was to use stock market direction as a barometer reading of general business conditions.
Dow was among the first to recognize the usefulness of stock market averages as a leading economic indicator. The basic tenants of Dow’s theory are listed below.
1. Averages discount everything
2. The market has three trends (Primary, secondary, and minor)
3. Major trends have three phases (Accumulation phase, Public participation phase, and Distribution phase)
4. Averages must confirm each other
5. Volume must confirm the trend
6. A trend is assumed to be in effect until it gives definite signals it has reversed
A Basic Understanding of Charts and Trends Made Easy
John has described the basic concepts of chart construction and trends in simple language. Even a layman or someone new to the financial markets can understand these basic concepts.
He talks about the various types of charts and their components. These let us understand some very basic concepts of trends easily. A fair bit of understanding is provided to understand trends. You can surely claim to have understood the first-grade level of basic concepts of chart construction and trends in the markets.
These basic concepts let you easily understand the in-depth study of technical analysis. Every concept described in understanding trends is like a building block in your arsenal in the study of technical analysis.
Patterns Speak Volumes and Can Show You The Way.
John goes on to give importance to price patterns. It is not sufficient that you identify the trends in technical analysis. You further want to look for patterns that are formed by price. These patterns tend to repeat themselves, which confirms the fact that history repeats itself.
It does a great deal of help in identifying these patterns that let technicians foresee future patterns. A technician may be unable to predict to what extent a price pattern may last.
However, a study of these patterns does let technicians identify major patterns. The two major patterns are reversal and continuation. Then there are transaction periods that give you a fair idea of the next pattern.
He goes on to describe each of these reversal and continuation patterns. Readers can get accustomed to the various price patterns in the chapters ‘Major reversal patterns’ and ‘Continuation patterns. Images of these patterns are included for ease of understanding.