Understanding Price, Trends, Market Psychology
In this section we introduce you to technical analysis and its use in trading. Technical analysis is the study of the trend and market price charts over time. It is used in financial markets to evaluate and forecast future price movements of assets such as stocks, currencies, commodities, and cryptocurrencies.
Technical analysis is based on the belief that historical price data, trading volume, and other market-related information can be used to identify patterns and trends that help predict future price movements. It can be used on its own or in conjunction with fundamental and liquidity analysis to pinpoint entry and exit points and improve the odds of a successful investment.
What Is Technical Analysis?
While fundamental analysis is based on financial statements, technical analysis is mainly based on two variables: price and volume. The underlying idea is simple.
As the great technicians would say, “market discounts everything.” This concept comes from Dow Theory, developed by Charles Dow in the late 1800s. Thanks to technology and the ease of access to information, it is possible to understand how the market reacts to news and new information. Price represents investor psychology and the positive or negative sentiment toward a stock.
Technical Analysis and Fundamental Analysis
Fundamental analysis and technical analysis are two different approaches to investing, which however can be used in conjunction.
On one hand, with fundamental analysis, we look at the balance sheet, the profits of a company, and future cash flows. This helps define whether a company has potential for future growth and whether it is a solid investment.
Having said that, price growth does not necessarily happen immediately. Even strong companies may not see price appreciation due to market factors. For this reason, technical analysis focuses not on fundamentals, but on price action, trend, and momentum. The basic idea is that all market information, including balance sheet data, is already reflected in the price.
Origins of Technical Analysis
Technical analysis began to take off in the early 1900s, with origins traced back to Dow Theory. Charles Dow was one of the most important figures in the history of financial markets. He was a founder of the Dow Jones, the Wall Street Journal, and the inventor of the Dow Jones Industrial Average.
Dow Theory is considered one of the cornerstones of technical analysis and laid the groundwork for understanding market trends and price movements.
The Three Pillars of Technical Analysis
Technical analysis is based on three pillars.
First, prices discount everything. Prices result from the interaction between supply and demand and reflect all available information in the market.
Second, the market moves in trends. Markets do not move randomly but follow trends that remain valid until clear signs of exhaustion and reversal appear.
Lastly, history repeats itself. Investors are driven by human psychology, alternating between fear and greed. Because market participants behave in similar ways over time, past price patterns can provide useful indications for future price movements, even though they do not guarantee future returns.
Dow Theory Principles
Dow Theory is made up of six principles. The first principle states that the market discounts everything, meaning prices already take into consideration all available information.
Dow identified three types of market trends: primary trends, which are long-term trends lasting months or years; secondary trends, which are corrections within the primary trend; and minor trends.
Primary trends can be divided into three phases. In an uptrend, the first phase is accumulation, where smart money and institutions begin buying undervalued assets. This phase is often characterized by low volume and limited public interest.
The second phase is public participation, driven by positive news and growing interest from less sophisticated investors. The final phase is excess or speculation, where fear of missing out dominates and institutional investors begin taking profits.
In a downtrend, these phases are mirrored through distribution, public participation, and panic. Smart investors sell first, followed by broader selling pressure, until panic sets in and prices collapse.
A Real-World Example: Bitcoin 2017
The performance of Bitcoin in 2017 clearly illustrates this process. Before 2017, Bitcoin was little known and often associated with illegal activity. Around August 2017, Bitcoin exceeded $3,000 and received widespread media coverage.
Between August and November 2017, the price doubled to $7,000. From there, fear of missing out took over, and by December 19, 2017, Bitcoin reached nearly $19,600. Shortly after, the trend reversed and prices collapsed.
Smart investors exited with large gains, while those who bought near the top suffered heavy losses. Bitcoin remained in a prolonged downtrend until institutional interest returned in 2020.
Trend Confirmation and Volume
Another key principle of Dow Theory is that indices must confirm each other. A primary trend is confirmed when multiple related indices move in the same direction. Divergences weaken trend confirmation.
Volume must also confirm the trend. Volume typically increases when prices move in the direction of the primary trend and decreases when prices move against it. Low volume signals weakness.
Finally, a trend persists until there is a clear reversal.
Advantages of Technical Analysis
One key advantage of technical analysis is that it requires less information. Market events and news are already reflected in price and volume.
Technical analysis also provides tools to identify possible price changes and define key levels. These tools can help traders achieve better returns. The data required is easily accessible, with free platforms such as TradingView offering charting tools.
Technical analysis also allows traders to profit in both rising and falling markets, through long and short positions.
Disadvantages of Technical Analysis
Indicators are not perfect and can fail during unexpected events. In addition, combining multiple indicators can lead to conflicting signals and confusion.
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Conclusion
Technical analysis focuses on price, volume, and market psychology to understand trends and forecast potential price movements. Rooted in Dow Theory, it provides a structured way to analyze markets and identify opportunities. While it has limitations, technical analysis remains a widely used and powerful approach when applied with discipline and in conjunction with other forms of analysis.
You can ask QUIN to learn more about Technical Analysis.