- Parent Category: Featured Articles
- Category: Traders' Notebook
- Written by Michael J. Carr, CMT, and Amber Hestla
From Art To Science
Professions are built on a body of knowledge and an underlying rationale that explains the reasons behind the knowledge. Technical analysis is a professional undertaking, but little has been written about its foundational principles.
To begin thinking about the philosophy of technical analysis, first of all, we must consider why traders believe it works. The major textbooks in the field acknowledge that technical analysis rests on three basic precepts:
- Market action discounts everything.
- Prices move in trends.
- History repeats itself.
These core beliefs date back at least into the 1800s and are a part of Dow theory. Some would argue that technical analysis can trace its roots to 18th-century Japan and the use of candlestick charts on rice futures contracts. There may be even earlier instances of technical analysis, but these three precepts lie at the core of any study of charts.
It’s all in the charts
Relying on candlestick patterns meant that the trader believed everything he needed to know was in the price chart. This meant that traders were considering the impact of weather on the crop, the possibility of disruptions in supply related to war or epidemics, and any other possible input to supply or demand. Economists quantified this belief into the efficient market hypothesis, and the first precept of technical analysis — “Market action discounts everything” — was recognized as an idea worthy of a Nobel prize.
Trends were a central theme in the idea behind candlestick charts and in the formulation of Dow theory. Technical analysis is grounded in the idea that trends exist and trend reversals dictate a need to change the ongoing investment strategy. Many indicators are designed to identify the direction and strength of a trend, and most research on technical analysis are dedicated to the second precept, “Prices move in trends.”
No investment methodology would work if the third precept, “History repeats itself,” weren’t true. Long-term investors and short-term traders attempt to find characteristics that worked in the past and assume they will work with some reliability in the future. Candlestick traders noticed certain distinctive shapes that occurred over and over again. When point & figure charts became popular, it did so because certain patterns proved to repeat themselves and these patterns offered clues to the future direction of prices. The same was true about bar charts, as repetitive patterns again proved to offer useful trading ideas.