Technical analysis is the best universal technique of market analysis ever existed. This discipline is based exclusively on the study of price charts, having the assumption that prices discount all, then, that they already contain all the possible political, economic and sociological events connected to economy.
Technical analysis is an universal approach, it could be applied to equities, to raw materials, to indices, and to any other future instrument exchanged on the market. The name "CHARTISTS" indicates precisely the peculiarity of the technical analyst, that is the one who studies and interprets only the graphs, without considering any other factor.
TECHNICAL ANALYSIS: DOW THEORY
The father of technical analysis was Charles Dow, a mathematical analyst who formulated his theories after years of study and based only on the observation of price charts. His theory, called "Dow Theory" is based on five fundamental pillars:
1. The indices discount everything
2. The market moves following trends
3. The indices must confirm each other
4. The volumes should support the trend
5. The current trend remains valid until you do not have a clear proof of its inversion
These are the 5 key points of technical analysis, let's see now to go into detail to better understand each individual item.
THE PILLARSOF THE DOW THEORY
The indices discount all
The indices reflect the market, ie, the behavior of investors. Investors operate in the market according to future expectations, this makes the price movements swollen of future expectations, then it is as if the current price already describes the most likely future macroeconomic scenarios.
The market moves following trends
The market trends are three:
- Primary trends
- Secondary trends
- Minor trends
The average length of a primary trend ranges from one year to two years, however, have been observed longer duration trends.
The primary trend can be either bullish (bull market) or bearish (bear market). Together, these two trends form the economic cycle.
How a primary trend is developed
Accumulation phase: this phase is the first phase of a bull market, the securities pass from weak hands to strong hands and prices begin to rise. This phase still describes a very marked pessimism deriving from the prices decrease in the previous bear phase that is ended. The more competent investors, in the accumulation phase, buy from the discouraged ones that prefer to sell because they are convinced that the bear phase continues. At this stage there is a constant rise in volume, that means that we are going to enter in the bull phase.
Intermediate phase: In this phase, the prices continue to rise, investors buy increasing the rise in prices, the volumes increase and economic conditions are reflecting market trends.
Distribution phase: this phase is the last stage of a bull market. Volumes, although still very high, begin to decrease. Savvy investors know that the end has come and spend the titles to the masses, the "park of oxen," that is, the ordinary people who are attracted to investing in what they perceive (late) market optimism. The prices here soon begin literally to collapse, leaving room for the new phase bear.
These trends have a statistical life ranging from 3 weeks up to nine months. Secondary trends are going in the opposite direction of the main trend. The secondary movements give rise to low points in price that are growing in a bull market, and define the decreasing points of maximum in a bear market.
These last only few weeks. Represent some fluctuations in intermediate trend, are often unpredictable and random.
The indeces must confirm each other
Dow has observed the dynamics of two main indices: Industrial Average and Transportation Average. He noted that if both indices exceeded a previous maximum, then you could talk about bullish trend (bull market), otherwise you could suggest a trend's weakness. The same thing applies to the bull market: if both indices exceed a previous minimum we are in a bear phase.
The volumes should support the trend
The trading volumes always follow the main trend: in a bull market, for example, volumes are increased and they decrease only during the correction phases. If the price is rising, but the volume goes down, then, the trend we are observing is not strong, then it is likely that there is a short reversal.
The current trend remains valid until you do not have a clear proof of its inversion.
This appears to be a key point of the theory: a trend is valid until there are no clear signals of reversal. The clear signals are represented by a decrease in volumes, by the price that fails to exceed a previous maximum point, by the break of trend lines and some indicators. Also, what helps a lot is to analyze other markets directly connected to economy: raw materials market, stock market, bond market.
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