With technical analysis – the art of studying price and volume through visual charting and mathematical indicators – gaining momentum, I thought it would be prudent to take a moment to discuss the three underlying foundations of modern technical analysis and why they’re important.  Let’s examine them:

1.  Prices Move in Observable Trends

Prices have direction, or flow, which is observable through price pulses (waves) that form swing highs and swing lows.  Objective measuring of these respective swing highs and swing lows constitute rudimentary measuring of the direction of a security’s or market’s price.  Often a linear regression line or analysis through certain moving averages can also be beneficial in assessing a market’s overall direction.

The basic premise – as described by Charles Dow and many others – is that “the observed trend should be assumed to continue until the weight of the evidence has shifted in favor of a reversal.”  In other words, you’ll have greater ease in trading if you trade in the direction of an observed trend.

Price moves through imbalances in supply and demand, and these imbalances lead to price expansion and contraction as perceived “value” is discovered to be at a progressively higher or lower price.

2.  Market Action Discounts Everything

“All information (knowns and ‘unknowns’) is already factored into price, or is discounted immediately.”

As such, price and the auction process is an efficient discounting mechanism such that new information and even rumors of new information are acted upon instantly and assimilated by traders, investors, and funds as they interact in a market.

This principle also gives rise to the concept “Buy the Rumor, Sell the Fact” and helps explain why a stock price might fall when a positive earnings report or other seemingly good company news is released.

Chartists argue that the current price (and its movement) reflect the purest assessment of a company or a particular market, and that price study is a ’shortcut’ to complex fundamental analysis that can yield a clearer picture.  Charting also allows for instant cross-market analysis, eliminating the need to be an expert on a particular company, industry, sector, commodity, or foreign economy.

3.  History Repeats Itself

Price patterns (such as triangles, double-tops) were created by investor behavior at a certain time, and the similar currents that formed those patterns in the past tend to repeat into the future according to the underlying supply/demand picture a particular pattern creates.

Investors cycle through greed and fear (among other emotions) and a larger market cycle plays out indefinitely in response to similar information.  To put it crassly, investors tend to make the same mistakes over and over again (such as getting overly excited after a long market advance and getting overly pessimistic after a sharp market correction… or buying at market tops and selling at market bottoms).

Certain events trigger similar behaviors which appear as documented patterns (such as the head and shoulders) on price charts.  The Elliott Wave “Five Wave” impulse pattern may also help explain this (as investor psychology shifts from disbelief to realization to over-optimism).

Conclusion:

This is just a simple list of the three ‘academic’ reasons for the support of technical analysis (charting) as a market discipline which continues to grow in popularity.  For more information, check out the Wikipedia article on Technical Analysis which restates these points and draws more history and information on the page, as well as providing a good list of introductory books for more serious study on the topic.

Published by Corey Rosenbloom of Afraid to Trade.