The three principles of technical analysis

Unlike fundamental analysis, which is based on the observation of macroeconomic data and the analysis of economic relations, forex technical analysis is based on the simple idea that a currency’s price encompasses all relevant information impacting the forex market. This is why a technical analyst observes exclusively the history of a currency’s trading pattern. Technical analysis is based on the following three main principles.

The first principle says that market action discounts everything, or, as we said, currency’s price encompasses all relevant information impacting the forex market.

The second principle says that prices move in trends. Technical analysts believe that currencies move in trends, or in observable directions: upward, downward, or sideways. The basic definition of a price trend was originally introduced by Dow theory. An example of a currency moving in trend is represented by the behavior of the Cable soon after the 2016 Brexit referendum. Technical analyst recognized immediately a clear downward trend, after the referenum, and saw a great opportunity to sell the pound against the dollar. The Cable consistently moved downward.

Whenever a currency rises, sellers enter the market and sell the currency; hence the “zig-zag” movement in the price is observed. The series of “lower highs” and “lower lows” hints that a currency is in a downside trend. When the currency moves lower, it falls below its previous relative low price. When the currency moves higher, it can’t reach the level of its previous relative high price.

The third principle is that “history tends to repeat itself”. It is perhaps the most singular one, considering that psychological and sociological analyses are encompassed into this principle. The idea is that there is a silent communication language spoken by technical analysts (“cheap talk”) and a common belief on the effectiveness of technical analysis, if traders believe they can collectively repeat the behavior undertaken in the past by other investors in order to obtain the same profits.

In this perspective, it is not so important to understand why markets move in a certain way, emotionally or rationally. This principle works regardless of the causes. The self-fulfilling prophecies, i.e. the traders’ belief that the price of a currency, for example, will appreciate rather than depreciate, play a fundamental role in the process of defining a market trend, as the behavior of the traders repeats itself with certain frequencies and thus the price patterns of the currencies that can be observed on a graph. This hidden language allows traders to identify predefined patterns without too much effort, and thus to select the most profitable strategies.

It should always be remembered that technical analysis is not limited to creating graphs but always takes into account price trends. For example, many technical traders monitor investor sentiment surveys. These polls measure market participants’ attitudes, particularly whether the market is bearish or bullish. Technical traders use these surveys to evaluate whether a trend will continue or whether a reversal can occur; they are very likely to anticipate a change when polls signal extreme sentiment by investors.

For example, polls showing a strong rise are evidence that a bullish trend can be reversed; the premise is that, if most investors are bullish, it means that they have already bought, as they forecast higher prices. And since most investors are confident and have invested, only a few buyers are assumed to remain on the market. This creates the presence of a greater number of potential sellers than that of potential buyers, despite the bullish sentiment, and this suggests that prices will drop. It is an example of trading called “contrarian”.

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