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Technical Analysis: Three Premises

Three Premises of Technical Analysis

There are three premises on which the technical approach is based:

  1. Market action discounts everything.
  2. Prices move in trends.
  3. History repeats itself.

Market Action Discounts Everything: The statement “market action discounts everything” forms what is probably the cornerstone of technical analysis. Unless the full significance of this first premise is fully understood and accepted, nothing else that follows makes much sense. The technician believes that anything that can possible affect the price-fundamentally, politically, psychologically, or otherwise-is actually reflected in the price of that market. It follows, therefore, that a study of price action is all that is required.

The technician is claiming that price action should reflect shifts in supply and demand. If demand exceeds supply, prices should rise. If supply exceeds demand, prices should fall. This action is the basis of all economic and fundamental forecasting. The technician then turns this statement around to arrive at the conclusion that if prices are rising, for whatever specific reasons, demand must exceed supply and the fundamentals must be bullish. If prices fall, the fundamentals must be bearish.

Prices Move in Trends: The concept of trend is absolutely essential to the technical approach. The whole purpose of charting the price action of a market is to identify trends in early stages of their development for the purpose of trading in the direction of those trends. In fact, most of the techniques used in this approach are trend-following in nature, meaning, that their intent is to identify and follow existing trends.

There is a corollary to the premise that prices move in trends-a trend motion is more likely to continue than to reverse. This corollary is, of course, an adaption of Newton’s first law of motion. Another way to state this corollary is that a trend in motion will continue in the same direction until it reverses. The entire trend-following approach is predicated on riding existing trend until it shows signs of reversing.

History Repeats Itself: Much of the body of technical analysis and the study of market action has to do with the study of human psychology. Chart patterns, for example, which have been identified and categorized over the past one hundred years, reflect certain pictures that appear on price charts. These pictures reveal the bullish or bearish psychology of the market. Since these patterns have worked well in the past, it is assumed that they will continue to work well in the future. They are based on the study of human psychology, which tends not to change. Another way of saying this last premise-that history repeats itself-is that the key to understanding the future lies in a study of the past, or that the future is just a repetition of the past.

Source: Murphy, John. Technical Analysis of the Financial Markets; (c) 1999.