Technical analysis, as we know it today, is a vital part of forex trading. It is a standard market analysis tool popular with short-term traders. These are guys whose timeframes do not allow fundamental analyses hence the need to study the market trends via available data.
The frontrunners of technical analysis included one of the famous names in trading, Charles H. Dow. The Dow Theory was one of the original means of technical analysis. And although it wasn’t a foolproof trading tool, the Dow Theory set the stage for other market gurus to further develop technical analysis and grow it to the vital tool it has become today.
In its primary sense, technical analysis points to the study of how a market behaves. It doesn’t consider the items but rather the metrics involved such as price and volume of goods trade. This way, technical analysts can graphically come up with a representation of market behavior over time and eventually be able to predict future trends.
Technical analysis looks at the numbers surrounding trading assets. From this study, you should get a rough idea as to how much money is changing hands and the direction all of it is headed. Once you know the general market trajectory, you can buy into the market and ride the trend to profit.
History And Significance Of Technical Analysis In Trading
Technical analysis has been around since traders started taking records of market data. One of the primary data considered during any technical analysis procedure is the price of a commodity, currency, or stock.
Since prices vary over time, it became essential to note down when these prices became unfavorable and when the tides changed. As a result, record keeping became the pillar of technical analysis and until today, technical analysis relies heavily on historical data to forecast future market behavior.
Analyzing past market behavior helps traders understand and explain why a market behaves in a certain way. With a broader understanding of market dynamics, traders can predict future market trends and capitalize the same for profit.
Today, technical analysis has undergone hundreds of years’ worth of development to become the powerful tool it is today. However, the credit lies squarely with the frontrunners of technical analysis.
Founders Of Technical Analysis
Charles Dow
He is arguably the most prominent frontrunner of technical analysis methods in trading. The Dow Theory is one of Charles Dow’s notable works, and it was one of the first postulates to point out market trends and their overt influence in the market.
Alongside Edward Jones and Charles Bergstresser, they founded the Dow Jones & Company, a publishing firm most notable for its flagship publication, The Wall Street Journal, among several other financial books.
One of the company’s assets was Charles Dow himself, an established reporter at the time. He was famed for his ability to break down complex financial topics for the general public to digest.
Additionally, Charles Dow is also credited with the development of the Dow index, also known as the Dow Jones Industrial Average. The index gauges the performance of stocks of thirty listed companies in the US.
The Dow theory was by far the most critical contribution of Charles Dow into financial markets. As a reporter, he based his argument on the numerous financial editorials he penned at the time. Following his death in 1902, work on his theory continued unabated and this time William Hamilton was at the helm.
In his theory, Charles Dow posits how investors can gauge the stock market’s health and performance to get an idea of the business environment further. Unlike today, data was hard to come by and at most scanty and, you would be hard-pressed to identify market trends. Charles Dow was the first person to confirm trends in the market.
Because of the significant role played by market trends, the Dow theory holds water one hundred years since the passing of its founder.
Principles outlined in the Dow Theory
1. The market discounts all news
The behavior of stock prices and other indices reflects the information available on that market. This principle also includes companies’ revenue reports, inflation, and expert opinions on the same. As such, you are better placed on studying price action as opposed to burdening yourself with balance sheets and revenue reports.
2. There are three trends in the market
Since the Dow Theory was the first to point out the essence of market trends, it went on to further divide them into three classes:
· Primary trend
This is the primary trend which you can see. In the current market setup, computers are widely used to plot market trends and as you glance at these images, you will be able to spot the prevailing market trend. A primary trend spans several years and as such, will show the long-term trajectory that the market follows.
· Secondary trend
Secondary trends tend to follow opposing directions from the main course. They are considered modifications to the dominant price movement. Secondary trends do not last as long as the primary ones and could span a couple of weeks or even months. If the market has a primarily upward trend, then a bearish trajectory could be the secondary trend.
· Minor trend
As its name goes, minor trends are mere fluctuations in the market. Smaller patterns oppose secondary trends and have a rather brief timeframe.
3. Trends follow three phases
For a trend to form and distinguish itself, it usually goes through three stages. On the onset of developing a primary uptrend in a bullish setting, traders buy into the market against the prevailing market judgment. This is the accumulation phase.
As business improves, more buyers are drawn into the market. As the market outlook improves gradually, market prices go up. This forms the public participation phase.
The third and final phase is the panic phase. During this time, buyers are scrambling to get a piece of the pie, as it is evident that potential returns are promising. However, the final stage is mostly a speculative one for newer market entrants. For the original investors, it is the best time to cash-in on their profit and exit the scene.
4. Indices confirm each other
All market indices need to be on the same page to confirm a prevailing trend. To cement your belief in a specific pattern, all markers need to point in one direction. Just as in the case of indicators, using only a single index gives flawed results hence the need to include several that agree with each other.
5. Volume confirms the trends
Volumes are essential when describing the prevailing market trend. An upward trend is proven right only if there is a price increase as well as increased volume in the market. The opposite holds for downtrends.
6. Trends will continue until conclusive signals suggest otherwise
Apparent reversals are hard to miss. Therefore, regardless of minor trends appearing, the primary trend holds. However, reversals do happen albeit for a brief time, then the primary trend resumes.
William P. Hamilton
Another proponent of the Dow Theory, William P. Hamilton, in his book, The Stock Market Barometer, provides further insight into technical analysis as Charles Dow imagined.
The Dow Theory is an all-time favorite when it comes to understanding market trends. Following in the footsteps of Charles Dow, Hamilton expounds on Dow’s postulates in the classic, The Stock Market Barometer. He offers a glimpse into the prevailing market at the time and, in the process, gives incredible insights as he observed in the market.
In a nutshell, William Hamilton used the three types of trends to confirm with a higher degree of accuracy, the prevailing bullish or bearish market inclination. As a result, he was able to predict the 1929 financial crash three days to D-day, and sadly, his death as well.
The late Hamilton, like Charles Dow, was a financial reporter and served as the fourth editor of The Wall Street Journal.
Robert Rhea
Another proponent of the Dow Theory, Robert Rhea, put Charles Dow’s postulates into action. He did so by coming up with a Dow Theory indicator that would guide traders in investing in the market.
Rhea was quite successful at implementing the Dow Theory in his market calls. In 1932, he predicted the market decline and, five years later, also foresaw the rise in 1937. Because of his success, Robert Rhea penned the investment classic about the popular theory, The Dow Theory.
Edson Gould
There are many ways you can make money while trading. As the frontrunners of technical analysis developed the tool widely used today in various markets, you would expect them to profit significantly from the same methods. However, in the case of Edson Gould, this wasn’t the case.
Gould was one of the earliest and most acclaimed market technicians of all time. His fame is mainly credited to his uncanny ability to predict the stock markets in issued reports accurately.
In 1922, Gould joined Moody’s Investor Service as an analyst intent on developing a way to predict stock market movement. With difficulty, he struggled to recognize significant trends in the stock market until finally stumbling upon what is now known as the ‘Gould-en rule.’
Gould’s analysis of the stock market was pretty far-reaching as he even considered Newton’s Laws among other Physics fundamentals. Financial data is often the go-to means for forecasting the stock market but, as Gould realized, held little sway when trying to predict actions in the short-term future.
Upon reading the French book, The Crowd, Gould realized how intertwined the stock market was with human psychology, more so considering the masses. Since crowd psychology is often harder to predict, using it to conclude, the market’s next move won’t yield any fruits.
Usually, an economy with plenty of money changing hands is prosperous and increase the chances of a bullish situation holding out. On the flip side, when people aren’t spending their money, the reverse holds as there are no more buyers in the market.
The only way you can make money in light of the influence of crowd psychology is to remove yourself from its sphere of influence. Investors are better placed when they focus their energies on proven strategies or companies with a proven track record of success.
‘Gould-standard’ companies are those that showcase strong earnings regularly. Others fall short of these rewards and as such, are considered hunks of lead.
Edson Gould often spoke of the stock market as one that reacts with great emotion. Following the crowd, psychology is a recipe for disaster, and there is little chance of generating long-term wealth.
Edson Gould is also notable for inventing Speed resistance lines. These are trendlines used to point out support and resistance areas in the market.
John Magee
The author of Technical Analysis of Stock Trends is well-known for his use of charts in trading. Moreover, John Magee’s book is considered the ‘bible’ of technical analysis, lending significant credence to his role in the development of technical analysis over time.
Charts are valuable tools used in trading, and Magee knew so. He drew charts for any type of data available. Trading volumes, stock prices, and averages were among the data sets used to generate graphs.
With the data presented graphically, Magee was then able to identify a wealth of shapes on the charts. Patterns, flags, weak triangles, shoulders, etc. were just some of the items John Magee was interested in when analyzing the data.
Magee is one of the most dedicated traders who relied solely on technical analysis to trade. What is surprising, however, Magee managed his portfolio on his emotions rather than reliable analysis. He, however, took care of his clients’ portfolios employing his analysis acumen.
The Takeaway
Charles Dow is primarily recognized for the Dow theory from which technical analysis as we know it was born. Several financial reporters and seasoned traders have contributed to expanding the scope of technical analysis with others developing critical technical indicators.
However, each of these founding fathers of lent valuable insight into technical analysis. The result is the modern technical analysis that enables all types of traders to reap from the market.
Technical analysis is a vital part of trading and is critical in several markets globally. It is often stated that history repeats itself and nowhere is this truer than on the trading floor.
Armed with the right data and tools to analyze the same, like John Magee, you will be able to tell apart trends and patterns in the market. As always, markets undergo alternating periods of both bullish and bearish inclinations.
Like Charles Dow and his companions in the trade, the onus is on you to identify these market trends as well as the timelines surrounding it all. Capitalize on them to be successful in the trading arena.