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The Basis of Technical Analysis
The Dow Theory established the groundwork for modern technical analysis at the turn of the century. Dow Theory was assembled from Charles Dow’s works over a number of years rather than being given as a single, comprehensive synthesis. Three of Dow’s several theorems are particularly noteworthy:
- Price discounts everything
- Price movements are not random
- “What” is more important than “Why.”
Price Discounts Everything
The strong and semi-strong versions of market efficiency are comparable to this theorem. According to technical analysts, all information is completely reflected in the present price. The price represents the fair value and ought to serve as the foundation for analysis since it already takes into account all relevant facts. Investors, portfolio managers, buy-side and sell-side analysts, market strategists, technical and fundamental analysts, and many more all contribute to the market price, which ultimately represents their collective expertise. To argue with the price established by such a remarkable group of individuals with perfect credentials would be foolish.Technical analysis utilizes the information captured by the price to interpret what the market is saying with the purpose of forming a view of the future.
Price Movements Are Not Totally Random
Most technicians agree that prices trend. Yet, most technicians also acknowledge that there are times when prices don’t trend. If prices were always random, it would be difficult to make money using technical analysis. In his book, Schwager on Futures: Technical Analysis, Jack Schwager states:
“One way of viewing the situation is that markets may witness extended periods of random fluctuation, interspersed with shorter periods of nonrandom behavior… The goal of the chart analyst is to identify those periods (i.e. major trends).” (p. 12)
Trending and trading ranges in Oracle (ORCL) example chart from StockCharts.com
A technical analyst believes that it’s possible to identify a trend, invest, or trade based on the trend and make money as the trend unfolds. Because technical analysis can be applied to different timeframes, it’s possible to spot short- and long-term trends.
The chart of ORCL illustrates Schwager’s view on the nature of the trend. The broad trend is up, but it’s also interspersed with trading ranges. In between the trading ranges are smaller uptrends within the larger uptrend. When the stock price breaks above the trading range, the uptrend is renewed. When the stock price breaks below the low of the trading range, a downtrend begins. In the chart above, price broke below the trading range, but it was a short-lived downtrend. The uptrend resumed until the next trading range.
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