What Is Technical Analysis?
The term “technical” refers to the analysis of an asset’s past trading activity and price fluctuations, which, according to technical analysts, may be useful predictors of future price movements. It can be used for any asset with historical trading data, which implies stocks, futures, commodities, currencies, and cryptocurrencies.
Charles Dow, founder and publisher of the Wall Street Journal and co-founder of Dow Jones & Company, was the pioneer of technical analysis. Dow contributed to the development of the first stock index, namely the Dow Jones Transportation Index (DJT).
Dow’s concepts were published in a series of Wall Street Journal editorials, and after his death, they were compiled into what is now known as the Dow theory. Notably, through years of research, technical analysis has evolved to include the patterns and signals we recognize today.
The validity of technical analysis is contingent on whether the market has priced in all available information about a particular asset, implying that the asset is fairly valued based on this information. Traders who employ both technical analysis and market psychology believe that history will inevitably repeat itself.
Technical analysts may employ fundamental analysis in their trading strategy to determine if an asset is worth approaching, and they may supplement their decisions with analysis of trading signals to maximize profits. Fundamental analysis is the study of financial data affecting the price of an asset in order to forecast its future development. Fundamental analysis of a company’s stock may involve examining its earnings, industry performance, and brand value.
As technical analysts seek to identify bullish and bearish price movements in order to aid traders in making more informed decisions, they are tasked with identifying bullish and bearish price movements.
What is Dow Theory and the Six Tenets of Dow Theory?
In 1884, Charles Dow helped establish the first stock market index. The Dow Jones Industrial Average (DJIA) is a price-weighted index that tracks the 30 major publicly traded companies in the United States. It was created after this index. Dow believed that the stock market was a reliable indicator of economic business conditions and that, by analyzing it, significant market trends could be identified.
The contributions of several other analysts, including William Hamilton, Robert Thea, and Richard Russell, have altered Dow’s theory. Some aspects of Dow’s theory, including its emphasis on the transportation sector, have lost prominence over time. While traders continue to monitor the DJT, it is not considered a primary market index, as the DJIA is.
The theory has six major tenets, known as the six Dow theory tenets. Let’s examine them one by one in the sections that follow:
- The Market Reflects Everything
The first tenet of the Dow theory is one of the fundamental principles of technical analysis, which states that the market reflects all available information in asset prices and prices such information proportionately. For instance, if it is anticipated that a company will disclose positive earnings, the market will price the asset higher. The principle is similar to the Efficient Market Hypothesis (EMH), which states that asset prices reflect all available information and trade at their fair value on stock exchanges.
- There Are Three Kinds of Trends in the Market
Dow’s theory also suggests that there are three types of market trends. Primary trends are significant market movements that typically persist for months or years. Primary trends can be either a bull market or a negative market, in which the prices of assets increase or decrease over time, respectively.
There are secondary trends within these primary trends that may act against the primary trend. The secondary trends can be pullbacks in bull markets, where asset prices temporarily decline, or rallies in bear markets, where prices rise momentarily before resuming their downward trend.
There are also tertiary trends, which typically last a week or less and are often regarded as market noise that can be ignored because they do not affect long-term movements.
- Primary Trends Have Three Phases
Traders can discover opportunities by analyzing various trends. During a bullish primary trend, for instance, speculators can capitalize on a bearish secondary trend to purchase an asset at a lower price before it continues to rise. Recognizing these trends is challenging, particularly in light of the Dow theory, which states that primary trends have three phases.
The first phase, the accumulation phase for a bull market and the distribution phase for a bear market precedes a contrary trend and occurs when market sentiment is still predominantly negative in a bull market or positive during a bear market. During this phase, savvy traders recognize that a new trend is beginning and either accumulate in anticipation of an upward movement or distribute in anticipation of a downward movement.
The second phase is known as the public involvement phase. During this phase, the market as a whole recognizes that a new primary trend has begun and either begin purchasing additional assets to capitalize on upward price movements or begins selling to limit losses during downward price movements. In the second phase, prices swiftly increase or decrease.
During bull markets, the ultimate phase is known as the excess phase, and during bear markets, it is known as the panic phase. During the excess or hysteria phase, the general population continues to speculate as the trend approaches its conclusion. Those who comprehend this phase begin selling in anticipation of a bearish primary phase or purchasing in anticipation of a bullish primary phase.
|
Bull Market |
Bear Market |
|
|
Accumulation or distribution phase |
Marked by negative sentiments |
Marked by positive sentiments |
|
Public participation phase |
Wider market participants start buying |
Wider market participants start selling |
|
Excess/panic phase |
Thoughtful market participants anticipate a bearish trend and start selling |
Thoughtful market participants anticipate a bullish trend and start selling |
Although there is no assurance regarding the consistency of these trends, numerous investors take them into account before making decisions.
According to the fourth tenet of Dow theory, a market trend is only confirmed when both indices indicate the beginning of a new trend. According to the theory, traders should not presume a new primary upward trend is commencing if one index confirms a new primary upward trend while another index remains in a primary downward trend.
At the time, the Dow’s primary indices were the Dow Jones Industrial Average and the Dow Jones Transportation Average, which would naturally tend to correlate given the close relationship between industrial activity and the transportation market.
According to the fifth tenet of Dow theory, trading volume should increase if the price of an asset is moving in the direction of its primary trend, and decrease if the price is moving in the opposite direction. Trading volume is a measure of how much an asset has been transacted over a given period and is regarded as a secondary indicator, with low volume indicating a weak trend and high volume indicating a strong trend.
If the market experiences a secondary bearish trend with low volume during a primary bullish trend, the secondary trend is relatively feeble. If the trading volume during the secondary trend is substantial, this indicates that more market participants are beginning to sell.
- Trends Are Valid Until a Reversal Is Clear
The sixth tenet of Dow theory suggests that trend reversals should be viewed with suspicion and caution, as primary trend reversals can easily be confounded with secondary trends.
What Are Candlestick Charts?
Traders have access to multiple types of indicators for examining and analyzing market trends in cryptocurrencies. As a result of the essence of candlesticks, crypto candlestick charts provide more data.