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
Economic forecasting
Less reliance on market averages and indicators
Dow Theory
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.
Basic tenants
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.
John describes various implications of these patterns based on where they are formed. He makes understanding the study of patterns easy by doing this. You will be left wondering what they mean if you only knew what these patterns are. It is equally important to know what implications patterns have depending on where they are formed.
The patterns that are described in these chapters are listed below.
Reversal Patterns
1. Head and shoulders reversal pattern
2. The importance of volume
3. The inverse head and shoulders
4. Complex head and shoulders pattern
5. Triple Tops and bottoms
6. Double tops and bottoms
7. Variation from the ideal pattern
8. Saucers and spikes
Continuation patterns
1. Triangles
2. The symmetrical triangle
3. Descending triangle
4. The Broadening formation
5. Flags and Pennants
6. The wedge formation
7. The rectangle formation
8. The measured move
9. The continuation head and shoulders pattern
10. Confirmation and Divergence
These Tools and Indicators are your Friends
The cornerstone of technical analysis and its beliefs are better understood with the help of various tools and indicators. John further makes things easier for the learners by describing various tools and indicators that will assist in decoding this philosophy.
You may not find a better compilation of these indicators and tools all in one place. He has taken into consideration the minutest of details a technician would not want to avoid in hindsight. A simple yet comprehensive interpretation of these tools and indicators is given on how they are studied in tandem.
Some examples are the interpretation of volume & open interest, volume & price patterns, and trends and reversals, to name a few. These tools and indicators can be used to broaden the horizon to weekly and monthly charts as well. A study of short-term charts can be used to see how price is moving in relation to its long-term trend with long-term charts (Time periods).
John strongly believes that technicians should study charts to perform thorough trend analysis. The proper process is to analyze the longer range of trends and gradually work to the near term. You don’t have to constantly revise conclusions if you are studying long-term to short-term trends.
An elaborate compilation of various tools, indicators, and chart types is presented in a structured manner that makes reading all the more interesting. The importance and interpretation of each of these tools help traders do a comprehensive study of prices and trends.
Volume & Open Interest
Long/Short term charts
Moving Averages
Oscillators
Point & Figure charts
Japanese Candlesticks
Elliott Wave Theory
Time Cycles
Conclusion
The market is not driven only by the sentiments of market players.
Technical elements play an important role as well. Using various technical tools and studying their implications in tandem is very important to succeed in the Financial Markets.
To know more about the content, please read the book!
Guest Post - Written by Mr. Lal Bajaj, Bangalore
Get the Mini Trading Guide
A 5-day email course with amazing tips on trading, different trading instruments, and how to finalize a trading system. Get a best-selling eBook and online course by signing up for free.