A useful question to consider before entering the market is: “Does this trade make financial sense according to my Risk Management plan?”
Ideally, the answer should always be yes. In the following sections, we will outline how we apply technical analysis, or chart trading (both terms will be used interchangeably), to the financial markets while adhering to a strict risk management and trading plan.
According to the renowned analyst John J. Murphy, technical analysis is: “The study of market action, primarily through the use of charts, for the purpose of forecasting future price trends” (Murphy, 1999).
Technical analysts focus on identifying patterns in price movements and buyer or seller activity by using charts and various tools, rather than attempting to determine a financial instrument’s intrinsic value.
By analysing price charts technically, we gain insights into:
- An indication of market direction and a mechanism for timing
- A logical point of trade entry using charts
- A means to determine risk and a realistic way of assigning profit targets
- The determination of a risk/reward relationship
Technical analysis can be applied to every financial instrument. Technical analysts believe that an instrument’s fundamental components, along with broader economic factors and market psychology, are already ‘priced in’, eliminating the need to analyse these factors separately. This leaves only the analysis of price movement, which technical theory views as a product of supply and demand for a particular instrument in the financial market.
Technical Analysis is Based on Three Assumptions
- The market discounts everything.
- Price moves in trends.
- History tends to repeat itself.
1. The Market Discounts Everything
A key critique of classical technical analysis is that it focuses solely on price movements and overlooks fundamental factors influencing the financial markets. Nonetheless, technical analysis operates under the assumption that all relevant information, including fundamental influences, is already factored into the price of a financial instrument at any moment. Consequently, this method can effectively stand alone in market analysis.
2. Price Moves in Trends
Technical analysis is based on the belief that price movements tend to follow identifiable trends. Once a trend is established, it is more probable that future prices will continue in that direction rather than reverse. This concept forms the foundation of many technical trading strategies, including trend trading. Additionally, traders often seek to capitalise on ‘counter-trend’ movements to take advantage of market opportunities.
3. History Tends to Repeat Itself
A fundamental principle of technical analysis is the notion that history often repeats itself, especially regarding price movements. This repetitive behavior is linked to market psychology, suggesting that market participants typically respond in consistent ways to similar market stimuli. Technical analysts employ chart patterns to study and interpret market movements, recognizing trends that frequently recur. Despite their long history of use, these chart patterns remain relevant as they consistently illustrate recurring price movement patterns that traders can exploit.
Technical analysis provides a powerful toolkit for understanding and navigating the financial markets. By focusing on price movements and recurring patterns, traders can gain valuable insights into market direction, timing, and potential entry and exit points. The core principles of technical analysis—assuming the market discounts everything, recognising that prices move in trends, and understanding that history tends to repeat itself—offer a structured approach to market analysis that can be applied across various financial instruments.
