What are the Principles of Technical Analysis

What are the Principles of Technical Analysis

What are the Principles of Technical Analysis

Modern technical analysis develops from certain generally accepted principles. These principles come from Dow Theory. For that, let's see more about Dow Theory.

In 1897, Charles Dow developed two market averages such as the stock index, namely "Industrial Average" which has 12 blue-chip shares and "Railroad Average" consisting of 20 railroad companies. Now both are known as the Dow Jones Industrial Average and the Dow Jones Transportation Average.

Dow Theory was produced from a series of articles written by Charles Dow in The Wall Street Journal between 1900 and 1902. Dow Theory was originally only used as a barometer to determine general business conditions, not used to predict stock prices. However, now it is a general principle that is believed by modern technical analysts. Development of Technical Analysis today finally uses this theory as a basis


Dow Theory has 6 key important assumptions:

1. Market Action Discounts Everything

The stock price reflects all the information available to it. When there is new information, market participants quickly translate information in the form of price adjustments. As such, markets generally discount and reflect all information held by market participants.

2. The Market is Comprised of Three Trend

There are three trends in the market, namely primary trend, secondary trend, and minor trend. In the primary trend, the market can move up (bullish) or down (bearish). Primary trends usually last more than one year to several years. Secondary trend is a correction to the Primary trend. This correction usually lasts for one to three months. Minor trends are short-term price movements that last from 1 day to 3 weeks. Secondary trends can be said to consist of several minor trends. Dow Theory says Primary and Secondary trends cannot be manipulated. While the Minor trend has the possibility of being manipulated (for example, the stock price is driven by a large institution), because of that the Minor trend can give the wrong direction

3. Primary Trend have Three Phases

Dow Theory said that the Primary trend has three phases. The first phase occurs when certain investors make massive purchases to anticipate economic recovery and long-term growth. Most investors still feel this phase as grim. Only certain investors make purchases because they have their own beliefs. The second phase is marked by increasing company revenues and improving economic conditions. Investors are starting to accumulate shares. The third phase is marked by the company's revenue reaching its peak and excellent macroeconomic conditions. Retail investors are starting to feel safe to participate in stock investments. They believe stocks will grow higher, so they buy more shares. Currently there is a euphoria of shares, where public investors buy far more. In this phase, investors who make purchases in the first phase start selling their shares to anticipate a decline in share prices.

4. The Averags Must Confirm Each Other

Stock index prices (Industrial Average and Transportation Average) must confirm each other so that valid trends occur. Both averages must exceed the peak of the previous Sencodary trend, so that the trend can be confirmed. If this assumption is applied in the IHSG, you might be able to check the LQ45 index, consumption index, infrastructure and banking because the largest capitalization of IHSG is in these sectors.

5. The Volume Confirms the Trend

Dow Theory is focused on price movements. Volume is only used to confirm an uncertain situation. Volume must increase according to Primary Trend movements. If the Primary trend is down, the volume must increase when the market falls. Vice versa, if the Primary trend is rising, then the volume must increase when the market moves up.

6. A Trend Remains Intact Until it Give a Definite Reversal Signal

Uptrend is shown by a series of price movements that managed to reach a higher peak (Higher high), and down no deeper than the previous decline (Higher low). In order for a reversal to take place, the price must at least fail to reach a previous peak (formed lower high), and a deeper decline than the previous correction (formed lower low). When a reversal in the Primary trend is shown together by the Industrial Average and the Transport Average, the likelihood of a reversal and continuing into the trend is even greater. However, the longer a trend lasts, the likelihood that a trend will continue to be smaller

So it can be concluded that:
- Bullish / uptrend where prices tend to move up, formed from a series of HIGHER HIGH and HIGHER LOW (higher peaks and higher valleys).

- Bearish / downtrend where prices tend to move down, formed from a series of LOWER HIGH and LOWER LOW (lower peaks and lower valleys)


an example of a bullish market

formed from a series of higher high (HH) and higher low (HL)

example bullish market

an example of a bearish market

formed from a series of lower high (LH) and lower low (LL)

an example of a bearish market

then how to know that a trend is over? It's very easy to do. For example the transition from bearish to bullish occurs when it has formed higher highs and high lows. While the transition from bullish to bearish occurs when a lower high and lower low are formed

Bullish Reversal

formed higher high and high low

bullish reversal

Bearish Reversal

formed lower high and lower low

bearish reversal

the principles in Dow Theory above were originally specific to the stock market. But in general it can be applied to various financial instruments. It can be concluded that technical analysts believe that prices move in certain patterns, so that they are used as a guide for transactions in the financial world

in Dow Theory is closely related to the support and resistance that you must learn too

 

Next read 3 Types of Forex Charts Every Trader Needs to Know

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