Technical analysis is the study of past market price data to make trading decisions. It allows traders to react to particular market conditions to make better decisions, waiting for the moving average crossover to signal when to take a long trade, or waiting for the price to break below the trend line to take on a short position, for instance. The technical analysis trader is watching the market and reacting when a certain technical condition is met.
There are some key assumptions within Technical Analysis that differentiate it from the Fundamental Analysis school of thought:
1. Markets tend to move in trends.
This is a basic principle underlying the theory of technical analysis, and most of the indicators and oscillators, trendlines, and chart patterns are ways of discovering the trends, its reversals, and its ranges.
2. Price is determined by the interaction of supply and demand, the causes of which are numerous and mostly irrelevant to the technician.
When demand increases, price goes up, when demand decreases price goes down. A key factor behind supply and demand is buyer and seller expectations, and expectations result from human decisions based on information (perceived, accurate or otherwise), emotions (greed, fear and hope) and cognitive limitations such as behavioural bias.
3. Price discounts everything. Market action is always correct.
Price discounts all information related to the currency pair, as well as the interpretation of expectations derived from that information. Instead of trying to consider all the economic factors that will influence the demand for EURUSD, such as GDP, Inflation, Interest, Unemployment, Debt of the Euro Zone versus that of the US, the technical analyst believes that the all these factors are already factored into the price of the currency pair. Moreover, the fluctuations of the closing price of EURUSD reflects the hopes, disappointments, and knowledge of everyone trying to trade that currency pair, and the effects of coming events can be anticipated in its price movement. Price not only reflects the information on the currency pair, but also the rational and irrational interpretation of that information, and the expectations derived from that information.
4. Price discounts two basic human emotions, fear and greed.
Both emotions make traders overly optimistic or overly pessimistic towards immediate past price history, causing prices to expand beyond equilibrium for emotional reasons to eventually revert to the mean and then expand beyond the mean in the opposite direction, constantly oscillating back and forth with excessive investor sentiment. All this excessive investor sentiment creates and sustains the trend beyond the statistical confines of randomness or chance events to the good fortune of the cool-headed technical trader able to capture it.
5. Price patterns tend to repeat themselves.
Prices are nonrandom, and thus past prices can be used to predict future price trends. They assume that history in principal will repeat itself and that humans will behave similarly to how they have behaved in similar situations. Thus, prices tend to form into patterns and have predictable results, yet these results are never identical and are thus subject to interpretation by the technical analyst.
6. Price patterns are fractal.
Regardless of time frame or period, patterns occur with very similar, though not identical shapes and characteristics, which allows traders to see the same patterns on five-minute charts as he sees on daily charts. These patterns suggest that the behavior that produces them is dependent on the participant’s point of interest, with the pattern in a five-minute bar being the result of other traders looking at that smaller time horizon. Each group of participants is defined by their investment period and has its own little world of patterns that may or may not affect each other but will be similar in shape.
Ultimately, the above assumptions lead to the idea that price action discounts all economic information, interpretation, and expectations, even the emotions of fear and greed, and that the tools of technical analysis can be used to study price action to determine its trends and its patterns, as these have occurred in the past to see how they will repeat themselves in the future, in fractal ways on different time periods.
The heart of technical analysis is the focus on the trend, trying to visually determine when the market trending upward so we can take on a long position, or if the market is trending downward so we can take a short position, all the while trying to minimize the ever-present, almost unavoidable danger of the sideways (directionless) market.
Trends can be obvious to see in hindsight, but the ideal is to be able to spot a new trend at its onset, to buy on an uptrend or sell on a downtrend, then spot its end and exit. But this ideal is hard to achieve. There is always the risk of spotting the beginning of a trend too late, missing out on potential profit, or spotting the end of a trend too late, failing to capture the potential profit. Yet if the analyst jumps on the trend too early, he runs the risk that it is a false trend that whips him back to his stop loss, and if he exits out of a trend too early he runs he risk that the trend will continue and he will lose out on potential profits. Thus there are risks in getting in too early and too late, just as there are risks in getting out too early and too late. Accurately timing the trend and its changes can be considerably tricky.