One of the two general approaches used in selecting select which securities or assets to invest in or deciding when to buy or sell a particular security asset is technical analysis. This paradigm centers on attempting to predict future price movements using historical data. It can be difficult to learn and use for beginners. Nevertheless, for those who are interested in maximizing the benefits that come from it, it is first important the basics to have a firm grounding of what it can and cannot do. This article discusses the core principles of technical analysis.
Understanding the Core Principles of Technical Analysis
The underlying principle behind technical analysis centers on a belief that the price of a particular security or asset and the volume at which it is traded reflect all relevant information affecting its future performance. This defining tenet comes from insights from market psychology, behavioral economics, and quantitative analysis. Those who use this approach look at the historical price movements and trading patterns of the security or asset to make investment or trading decisions. The following are its three specific core principles:
1. Market Actions Discounts Everything
One of the three core principles of technical analysis centers on the premise that all relevant information, including fundamental factors, economic data, and investor sentiment, is already reflected in the current price of a security or asset.
Take note that “market action” refers to the buying and selling activity that takes place in a market and is reflected in price movements and trading volume, while “discounts” mean taking into account future expectations and applying present value.
Nevertheless, by analyzing the movements of price and volume of trades, those who practice this approach believe that they can pinpoint patterns and trends from historical data that can help them predict or forecast future price movements.
2. Prices Move in Trends and Countertrends
Another principle centers on an assumption that prices tend to move in trends. The trends can either be upward, downward, or sideways. Furthermore, within these trends, there are temporary price movements or reversals called countertrends.
Upward trends are also called uptrends and downward trends are also called downtrends. Sideways are also called consolidation and they indicate pauses, buildup, or trend confirmation. The trends can be short-term, intermediate, or long-term.
It is also worth mentioning that the notion that prices move in trends means that they do not move in a straight line. Nevertheless, by understanding both trends and countertrends, technical analysts use them as signals to make buying and selling decisions.
3. Historical Price Tends to Repeat Itself
Technical analysts also believe that price action or the movement of the price of a security or asset is repetitive and demonstrates reoccurring patterns. They study chart patterns and chart formations on historical data to determine historical trends.
Note that there is an assumption that specific patterns from the past repeat over time due to human behavior and market psychology. This does not mean that prices move in fixed patterns, but rather are influenced by recurring emotional responses.
Hence, based on human psychology, the assumption is that hat similar price patterns in the present might trigger similar emotional responses. Recognizing these patterns enables the anticipation of potential price movements and predictions.
Takeaways and Pointers from the Principles of Technical Analysis
It is important to highlight the fact that the principles of technical analysis provide a framework for how to approach this investing and trading paradigm. However, for a deeper understanding, an interested individual also needs to familiarize himself or herself with the various terminologies, including tools and indicators, that are used for describing and recognizing trends and patterns. Some examples include moving averages, support and resistance levels, and chart patterns.
Furthermore, although there are several real-world examples attesting to the advantages and effectiveness of technical analysis, it is not a perfect science. It is a helpful approach but it is not a perfect tool. It is important to take into consideration other approaches, such as fundamental analysis, or factors that influence the performance of securities and assets. Some investors and traders utilize a combination of technical analysis and fundamental analysis.