The General Principles
Technical analysis is the study of the market movement, most often through charts, done in order to forecast future pricing movement. The term “market movement” incorporates three major sources of information available to a technical analyst, namely: price, volume, and open interest (applicable to futures markets). Let’s develop these three major postulates on which a technical analysis is based:
- Rate (price) accounts for everything. Any factor affecting the price (economic, political, or psychological) is already accounted for by the market and included in the price. Therefore to make forecasts, studying price charts is all that is needed.
- Price movement is subject to trends (price movement direction). The main aim of studying price performance charts is to identify these trends at early stages of their development and trade according to their projected dynamic performance.
- History repeats itself. The rules which held in the past also hold now and will hold in the future
Three types of trends (tendencies)
|"Bullish" – prices move upwards||
|"Bearish" - prices move downwards|
|"Sideways" (flat, whipsaw) – there is no definite direction in the price movement|
The Major Laws Governing Price Movement
- The current trend will more likely last than change direction
- The trend will move in the same direction until it weakens
The Major Types of Charts
- Linear – the linear chart only shows the closing prices for every consecutive period. It is recommended for reviewing short periods (up to several minutes).
- Bar chart – the bar chart shows maximum price (the top of the column), minimum price (the lower part of the column), the opening price (sideway lines to the left of the column) and the closing price (sideway lines to the right of the column). It is recommended for reviewing time periods of 5 minutes and more.
- Candlestick – it is built like the bars chart.
The Dow Theory
Initially, Charles Dow set out principles to use in analyzing the American indices he created for industry and railway firms. However, the majority of Dow’s analytical conclusions can be successfully adapted to the analysis of financial markets. The Dow Theory’s Major Concepts
- Indexes account for everything. According to the Dow Theory, any factor capable of affecting supply and demand will invariably affect the index performance. Naturally, these events are unpredictable; nevertheless, they are immediately accounted by the market and affect the indexes’ performance.
- There are three types of trends on the market. During upwards trends, every consecutive peak and every consecutive fall is higher than the previous one. During downwards trends, every consecutive peak and fall is lower than the previous one. During sideways trends, every consecutive peak and fall is at about the same level as the previous one. Dow also identified three trend categories: initial, consecutive, and small. According to Dow the most important category features initial trends, or major trends, which last for at least a year, and sometimes for up to several years. The consecutive or intermediary trend adjusts from the major trend, and usually lasts anywhere from three weeks to three months. Such intermediary corrections are from one to two thirds (often a half) of the distance that prices cover during their previous (major) trend. Small or short-term trends last less than three weeks and are often short-term volatility stretches within the intermediary trend.
- The major trend has three phases. The first phase is the accumulation phase, when the most far-sighted and well-informed investors start to buy, as the market has already absorbed all unfavorable economic information. The second phase starts when those who use the technical methods of tracking trends join the game. The economic information becomes ever more optimistic. The trends enter their third or final phase when the public at large gets involved and the market becomes overactive, fueled by mass media. Economic forecasts are full of optimism. The volume of speculations keeps growing. And this is when the informed investors who accumulated at the end of the previous trend, before others wanted to “accumulate”, start to “distribute”. And the trend comes to an end.
- Indexes should conform to one another. Here Dow meant industrial and railway indexes. He believed that any important signal to increase or decrease the market rate should be reflected in both indexes.
- The volume of trade should support the character of the trend. The volume should increase towards the direction of the major trend.
- The trend acts until it clearly signals that it has changed.
Trend Analysis. The Major Concepts
The trend or tendency is a certain movement of price in one or another direction. In real life, no market moves in a direct line. The market dynamics is a series of zigzags: up then down, up then down. The direction of performance of these ups and downs is what makes the market’s trend.
The major rule: "The trend is your friend ". The conclusion: “Do not work against the trend”
The resistance lines Resistance
Resistance lines unite various market maximums (peaks). They occur when buyers no longer can or want to buy this product at higher prices. The sellers’ pressure exceeds the buyers’ pressure, and as a result, growth is topped, and prices begin to fall.
Support Lines Support
Support lines bring together important market minimums, which occur when sellers no longer can or want to sell this product at low prices. Having reached these prices the desire to buy is rather strong and may withstand the sellers’ pressure. The fall is suspended and the prices start growing again.
Resistance If the support line is crossed downwards, it becomes a resistance line. If the resistance line is crossed upwards, it becomes support line.
Channel Lines Upwards
Channel In situations when prices fluctuate within two straight parallel lines (channel lines), we can talk about an upwards trend