Understanding Technical analysis is an art. To learn the art effectively, you need to first learn about the three basic principles of Technical Analysis. Following are the key assumptions of Technical analysis.
The first principle is “Market discounts everything”. Meaning, all the information – past, current, and even future – is discounted into the markets and is reflected in the prices of stocks and indexes. Everything including market news, data, and future expectations are reflected in the price.
As all the information is reflected in the stock price beforehand, a technical analyst is really interested in the price of the stock only. He is not worried about the reason for the news. To take a trading decision he just needs to see whether the candle is in green or red.
The second key principle is stock prices will form a pattern and trend and is likely to continue no matter which time frame is observed and analyzed. The price of a stock is more likely to continue in a similar trend to what occurred in the past rather than move in a random direction. Among various technical trading strategies and indicators, most are based on this second principle.
Basically, there are three trends in the market. If the market is rising, it will more likely continue to rise and it is an uptrend. If the market is falling, it will more likely continue to fall and we call it a downtrend. If the market is not going anywhere, it will more likely continue to stay within a range and it is called a sideways trend.
The third basic principle is “History repeats itself”. Technical analysts believe that price trend tends to repeat itself as it is bound by the behavior of the market participants. They react in similar ways every time the price moves in a certain direction.
As investor behavior repeats itself so often, technical analysts believe that the same price patterns will be deducted from the chart. With the help of these price patterns, traders can easily make their trading decisions. Many patterns in technical analysis like Head and Shoulders, Pennants, and Wedges are seen as highly successful among technical analysts.
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