When I wanted to enter the financial markets, I understood that each entity is shown as a diagram according to specific information. In the first months, I made some deals. I even made some profits, but to tell the truth, it was all accidental and with the help of an element called luck.
I knew that in the end, I was the loser in this case. But it made me curious to see how information can help us be winners. I did some research and found that there is knowledge that can help analysts make more profits. This knowledge is called technical analysis.
We will now master everything we need to know about technical analysis to increase our profitability. We will start with the basics, such as history, definition, principles, and the main subdivisions, to boost your success in the markets. Let’s begin.
What is the history of Technical Analysis?
Even now, we don’t have solid evidence about the roots of technical analysis. It is interesting to know that the written principles of technical analysis go back to Japan. It happened in the eighteenth century in the rice market!
From my research, I found out that Munehisa Honma wrote these principles. Some believe that experts used technical analysis even earlier, in the medieval period. However, charts were used for the first time in 1879.
Charles Dow is the founder of modern technical analysis. People consider Charles Dow, a journalist, as the father of technical analysis. In 1882, Charles Dow established the Dow Jones company with Edward Jones and Charles Bergstresser. Its office was near the entrance to the New York Stock Exchange.
The Dow Jones company provided bulletins and distributed them among their customers. On July 3, 1884, Dow released the first version of the stock index, which was based on the weighted average cost of the stocks. Dow’s passion was to use these indexes to predict the economy. His contributions resulted in a set of theories called Dow’s theories.
By recording prices and calculating averages, analysts discovered that transaction prices repeated with specific patterns. Expressions like the Double Top and Double Bottom for naming the patterns were first used by Charles Dow and then by his followers, such as William Hamilton, Samuel Nelson, and Robert Rhea in the 1920s.
In 1948 Robert D. Edwards and John Magee published the first version of the Technical analysis of Stock Trends book. In that book, they studied the technical patterns in stock charts. This book is also known as the technical analysis ‘bible’, and in 2018, the 11th edition was printed. In the 1950s, charts were not enough for analysts; thus, they devised complex mathematical tools.
This change of attitude resulted in the creation of indicators like moving averages and other tools and innovations. The Japanese “candlesticks” appeared in the middle of the eighteenth century, but for a long time, Western financial markets didn’t know anything about them.
In the next section, I learn about the definition of technical analysis, and its difference from fundamental analysis. Stay with me to investigate it all!
What is the definition of Technical Analysis?
There are several definitions of technical analysis. I tried to collect the most important of them. Here we will learn four of them.
- Technical analysis is the knowledge of studying time–price diagrams. It is the opposite of fundamental analysis, which studies the financial statements and economic parameters influencing a company’s profit-making.
- Technical analysis means studying a stock diagram’s past, predicting its future, and finally making the best decision at the time. This decision can be to buy, sell, hold, or exit from the market.
- Technical analysis means searching and discovering the laws of mathematics, patterns, and geometric shapes that sometimes appear on the price chart. Based on these, we can expect the price to display specific behaviors.
- Technical analysis means using the formulas and mathematical tools that help analysts. First, to find the market trend; second, to find better positions to buy and sell; and third, to avoid human sentiments and trade like a robot or machine.
What is the difference between fundamental and technical analysis?
Besides technical analysis, perhaps you have heard the phrase fundamental analysis. Perhaps some of your friends tell you that they are fundamental analysts, and some say they are technical analysts. In this section, I will throw some light on the distinction between them.
Fundamental analysis and technical analysis, the two main methods of looking at the markets, are at different ends of the spectrum. We use both methods to study and predict what will happen to stock prices in the future.
Like any investment strategy or philosophy, both have their fans and detractors. Like any investment or day trading strategy or philosophy, both have their fans and detractors.
Fundamental analysis is a way to judge stocks by determining their worth. Fundamental analysts look at everything from an industry’s economy and state to a company’s finances and how the manager runs it. Earnings, expenses, assets, and debts are all things that fundamental analysts care about.
Technical analysis is different from fundamental analysis because it only looks at the price and volume of a stock. The main idea is that all known fundamentals are already reflected in the price, so there’s no reason to pay close attention to them. Technical analysts don’t try to figure out what a security is worth.
Instead, they look at stock charts to find patterns and trends that can tell them what a stock will do in the future. Now we understand the concept of technical analysis and its difference from fundamental analysis. In the next step, I will try to focus on the main principles of technical analysis to immerse us in this pool of knowledge.
What are the basic principles of Technical Analysis?
It is interesting to know Technical Analysis has six main principles. Charles Dow stated them for the first time. They are also known as the six tenets of Dow’s theories.
Now let’s look into these principles. Perhaps these principles will attract you as they attracted me.
- The market moves based on how three trends add up
- The PRIMARY TREND is the “main movement” of the market. It can last for years.
- The INTERMEDIATE TREND lasts between three weeks and a few months, retraces the last primary move by 33–66%, and is hard to figure out.
- The MINOR TREND is the least reliable and lasts from a few days to a few hours. It is part of the market noise and can be manipulated.
- Market trends go through three phases
Whether the trend is going up or down, each has three clear phases. For a bullish or upward trend, the phases are revival of confidence (accumulation), response (public participation), and overconfidence (speculation).
The three stages of the primary bearish or downward trend are: giving up hope (distribution), selling because earnings are going down (doubt), and panicking (distressed selling).
- The stock market takes everything into account
Prices know everything. Prices are set before any information or expectations are understood.
- Averages must be backed up
Dow made the two averages when the US became a significant industrial power. One would show how well manufacturing is doing, and the other would show how those products are moving around in the economy.
The thinking was that if there was production, those who moved things around should also benefit, so new peaks in the industrial average needed to be confirmed by new peaks in the transportation average. Today, the roles have changed, but the connections between sectors and the need to confirm remain the same.
- Volumes back up trends
Dow thought that volumes could show the direction of price trends. When high volumes accompanied price changes, they showed how the prices “really” moved.
- Unless evident changes happen, trends will keep going
Dow thought that prices moved in trends, even if they changed all over the place daily and there was a lot of market noise. Trend reversals are hard to see coming until it’s too late because of how different trends are and how big they are. But a trend is believed to be continuing until there are clear signs that it is changing.
In the final section, I have tried to gather together the subdivisions of technical analysis principles. We will face these in the market and can apply them to earn more money.
What are the main contents of Technical Analysis?
In the final part, we will get familiar with the main content of technical analysis. Technical analysis consists of a variety of content. Analysts invented these techniques so we can use them today as practical tools.
These tools together help us reach a flawless technical analysis.
- Candlesticks or Japanese Candles
Candlestick charts came from Japan more than 100 years before bar and point-and-figure charts did. In the 1700s, a Japanese guy named Honma found that even though the price of rice was related to its supply and demand, traders’ feelings also had a big effect on the markets.
Candlesticks show this feeling by using different colors to show the sizes of price changes. Traders use candlesticks to make decisions based on patterns that show how the price will move in the short term.
We will learn about these candlesticks later in detail. Well-known candlesticks are Hammer, Hanging Man, Marubozu, Bullish Engulfing, Bearish Engulfing, Morning Star and Evening Star, Piercing and Dark Cloud Cover, Three White Soldiers, Three Black Crows, Shooting Star, Doji, and Harami.
- Models and Technical Patterns
Technical patterns are geometrical shapes in a diagram that can lead us to a profitable position. We will learn about these technical patterns later in detail.
Classic patterns include Supports and Resistances Lines, Trend Lines and Channels, Double Top /Bottom, Rounding Top/Bottom, Head and Shoulders, Symmetrical Triangles, Rising and Falling Wedges, Expanding Triangles, Ascending and Descending Triangles, Flags, and more.
- Indicators and Indicative Dealing Systems
In technical analysis, market indicators are used to predict how the market will move. Market indicators are ratios and formulas showing how stocks and indexes are doing now. We will learn about these Indicators and Indicative Dealing Systems later in detail.
Indicators like Moving Average (MA), Bollinger Bands (BB), Stochastic, Relative Strength Index (RSI), MACD, Zigzag, Fractal, Parabolic SAR, Ichimoku Kinko Hyo, ADX, ATR, CCI, and volume indicators like Money Flow Index (MFI), OBV, etc.
- Fibonacci Tools
The Fibonacci retracement tool draws percentage retracement lines based on how the numbers in the Fibonacci sequence relate to each other mathematically. These retracement levels show the levels of support and resistance that we can use to reach price goals. We will learn about these Fibonacci tools later in detail.
Tools include Retracement, Extension, and Expansion. Harmonic patterns are a subdivision of Fibonacci tools; we call them harmonic because they coordinate. Harmonic patterns include Gartly, Bat, Butterfly, Shark, Crab, etc.
- Elliott Wave Theory
Technical analysis uses Elliott Wave Theory to explain how stock prices move. Ralph Nelson Elliott developed a theory after he saw and identified wave patterns that happened over and over. We see waves in how stock prices move and how people act. In Elliott Wave Theory, all waves are somewhat impulsive or corrective.
Impulsive waves are those that increase the price and move upward, while corrective waves are those stopping the price from increasing. We will learn about the terms of Elliott Waves Theory later in detail.
Terms such as impulsive waves, simple, complex, extended, zigzag, flat, triangle, microwaves, superwaves, fractal structure, Elliott market cycles, Elliott wave inner structures, the relation between Elliott waves and classic patterns, etc.
Throughout this article, we learned the basics of technical analysis, such as its history, definition, guiding principles, and primary groups. I hope you are not tired, I’m not tired at all because it’s the start of wonderful things. Technical analysis is a vast subject, but you shouldn’t worry! We will cover it step by step to make more money. Stay tuned for further articles.