The basics of technical analysis

The history of technical analysis dates back to the 19th century. It was first mentioned by Charles Dow in an article in the Wall Street Journal. The development in the field of technical analysis of financial markets was the time of the Great Depression, when there were many researchers of price charts, such as Elliott, Gunn, Wyckoff and others. Some of them even wrote their own books, such as “Technical Analysis of the Future Markets: Theory and Practice” by John Murphy or Schwager "Technical Analysis". A new wave of popularization of this approach started with the advent of computers in the 70s, when the first indicators for trading and other mathematical methods of price analysis were invented.

What is technical analysis?

Technical analysis is a method of analyzing financial markets based on the use of price charts and mathematical formulas. TA does not involve fundamental analysis, since theoretically the price already takes into account all economic, financial and news factors.

Technical analysis is used in online trading to predict future prices of stocks, currencies, commodities and other assets based only on the analysis of their past price action.

The TA is based on three postulates:

1. Price takes everything into account.
2. Price movements are subject to trends.
3. History repeats itself.

Let’s go into a little more detail about each of them.

The basic principles of technical analysis

History repeats itself

Technical analysis is based on the assumption that past prices in the market repeat their movements in the future. Therefore, traders use data from the past to predict future changes. In the example below the price has repeatedly “pushed back” from the given price range, which, in turn, allows us to make an assumption that the same thing will happen next time.

“Experts” of TA are sure that price fluctuations are not accidental and eventually become trends and formations (patterns, regularities).

And here it is worth mentioning, the price indicators work! Sometimes 😉 Just like a broken clock that is right twice a day.

For this reason, ironically, the price chart can actually give “signals” as well. And chart patterns work, too. This is called a self-fulfilling prophecy.

Prediction that indirectly affects reality in a way that ends up being true. In other words: a prediction that appears to be true but is in fact not, can greatly influence people’s behavior in such a way that their subsequent actions themselves lead to the fulfillment of the prediction.

So how is it expressed in TA? People notice that a certain indicator becomes oversold and decide to buy. The price goes up. They begin to believe even more in their theory and gain more volume because they think that the price will keep going up. As they buy, they keep pushing the price up until the indicator shows that it is overbought. Then people start to sell and the price goes down.

The price reflects everything

A popular theory you might have come across is the Dow Theory. It is the basis for TA, based on the writings of Charles Dow and his theory of market behavior. The main rule of Dow theory is that price takes into account EVERYTHING that happens in the market: past, current and expected events.

There is no arguing; indeed, there is a lot put into the price, especially into the overall price of the whole market. However, there is always a but.

Remember, the market is about three parameters:

1. Time
2. Price
3. Volume

And the price is the consequence of a conventional battle of volumes. Price is meaningful when there is supply and demand. Price is also meaningful when you have enough volume to think about the price difference. But the primary thing that matters is the volume of supply and demand. Because if there is none, it does not matter what the last price in the market is. All the same, the volume cannot be realized.

The trend has a tendency to continue

Technical analysis of markets is based on the assumption that the trend will continue. According to this principle, crypto traders try to enter the market if they see a certain trend: upward or downward due to price changes.

But the reality is that trends exist only in history, only as a trace of former imbalances:

• With a strong preponderance of buyers pushing the price upward, we can see traces in the form of an upward price trend.
• If buyers and sellers are on an equal footing, the price fluctuates at the same level.
• A strong preponderance of sellers pushing the price down forms a downward price trend.

Therefore, it is more correct to say that your friend is not a trend, but an imbalance. And the trend is the shadow of your friend. Using trend indicators that follow the shadow of the friend is a little strange, admit it.

Using graphs

In technical analysis, online traders mainly use price charts to analyze the market. The trader searches for different formations on these charts: trends, patterns, support and resistance levels, reversal patterns, etc.

Why do trader’s price movements become similar to some geometric figures? Why does the trader fit the chart into geometric shapes?

This is apophenia!

Apophenia is an experience consisting of the ability to see structure or connections in random or meaningless data. The term was introduced in 1958 by the German neurologist and psychiatrist Klaus Conrad, who defined it as an “unmotivated vision of connections” accompanied by a "characteristic sense of inadequate importance.

Read more about this definition in Lesson 3 of the course, and think about what you see on the graphs :)

Using the indicators

There are many different indicators in TA and even more variations: moving averages, indices, oscillators, and others. They are used to confirm the trend direction and determine entry and exit points for trades.

Conclusion

What could be easier than setting up a couple of indicators and working on the trend? At each price approach the trend line to open and close transactions according to the signals of the indicators, close after a few percent and repeat until the trend is over, or trade beautiful figures from textbooks on technical analysis.

In fact, everything described above refers only to trading in probabilities. Knowing only the price, it is impossible to conclude about supply and demand. Trend lines are just fantasies, just like patterns and TA figures. Indicators are based on the price history, they will always be late and do not give the necessary information to the trader.

It is “good” to explain the past with the help of technical analysis, but it is of no use. Most people do exactly “drawing” because TA is very common and people think that having learned all the figures and having adjusted the indicators they will earn. But only a few are eager to understand supply and demand, the only law that works in the market.

Learn more about why technical analysis does not work and how to learn to analyze the market with the help of objective volume analysis in the 3rd lesson of the intermediate level.