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Task №1. Introduction to technical analysis. Dow Theory.

As you should have already realized, trading in financial markets involves the ability to predict future price movements, assess the probability of a trend reversal, and keep track of latest developments that can influence the further course of events. As the nature of commercial trade exchanges evolved over time, market strategists created numerous manual and automated techniques for analyzing and forecasting market behavior, allowing traders to increase their chances of making profit.

From now on, we begin to study these methods, and the first thing we should explore is technical analysis.

However, before we proceed to specific tools and techniques used in technical analysis for trading in foreign exchange, commodity and other financial markets, first we need to define what technical analysis actually means and where it comes from.

In the mid-19th century, organized exchange markets started emerging and taking shape. In essence, these represented special places where traders could make deals on various tangible and intangible assets in accordance with a unified set of rules and regulations. The outstanding feature of such marketplaces was the fact that in 99% of cases trade participants were rather unconcerned as to who their counteragents were, the decisive criteria being price and volume. An exchange house is a typical example of an organized market.
Such a scheme for facilitating trades increased market liquidity, thus improving the opportunities for striking profitable deals. As a result, most exchange players did not simply purchase or sell specific goods for certain prices. They started making such transactions on a regular basis, i.e., several times a day, a week, or a month, following the universal principle “buy lower, sell higher”. In order to achieve success in this business, you must predict how the market will behave in the future. In other words, a well-developed forecasting ability allows you to make the right strategic decisions, whether to sell, buy or hold a particular trading instrument.

In the very beginning of technical analysis, there were nearly as many different methods and strategies as there were traders. As decades went on, however, some of these techniques did not withstand the test of time while others, on the contrary, became increasingly popular. Market analysis eventually split into two major areas, fundamental and technical analysis.

Fundamental analysis is the study of various fundamental factors (so-called fundamentals) related to the financial instruments being traded such as economic and political conditions, interest rates, GDP, employment, production, manufacturing etc.
Technical analysis is the research of market dynamics with the help of graphic charts aiming to forecast future price movements.
The notion ‘market dynamics’ includes three primary sources of information at the disposal of technical analysts, i.e., price, volume, and open interest.
As it may be rather hard to measure real volume and open interest in the currency market, the most important and accurate data source for us is price. This brings us to another definition.
Technical analysis is the study of previous price fluctuations intended to predict future exchange rate movements (in the context of forex trading). Price movement is the key statistical factor in the world of technical analysis, because it is the only precise measurement of investors’ sentiment that reflects the ratio of demand and supply in the market.

Technical analysis owes its widespread popularity to being a flexible, comprehensive, and universal tool that makes a trader’s life so much easier. Below we list out a number of arguments in favor of applying technical analysis.

  • It works in any financial exchanges, from soybean markets to corporate stocks and currency trading.
  • An experienced player may trade in several markets at the same time, trying to increase profitability and offset losses. There is never enough time for detailed analysis of each separate market. Technical analysis is the only effective way to monitor all trading floors simultaneously.
  • Today, there is an enormous variety of technical analysis methods to suit the needs of any trader. Analysis itself can be viewed as a kind of construction set with numerous details, allowing to create a custom-tailored and unique trading system.
  • Technical analysis may also be regarded as a sort of creative occupation that can be quite fascinating and absorbing. With a reasonable approach, it can boost your profits several-fold.

Most methods and indicators used in technical analysis are based on the so-called Dow Theory. It was developed in the late 19th century by the well-known American journalist and investor, Charles Dow. He also invented the famous stock market index, named after him the Dow Jones Industrial Average. In order to learn how to make reliable predictions about future market trends, you need to understand crowd psychology, which is a crucial aspect of the Dow Theory.

Before moving on to particular systems of technical analysis, we will introduce some of the underlying market principles, as suggested by the Dow Theory.

The underlying premise proposed by Dow that technical analysis is built on states that everything is already included in the market price, i.e., all fundamentals and important factors, from traders’ sentiment to CPI reports, are reflected in currency exchange rates.

Another basic principle is historic recurrence that may be expressed in the famous saying ‘history repeats itself’. The history of price fluctuations helps technical analysts to foresee further changes.
Methods of technical analysis may be used on different time frames and are applied to various trading instruments such as currencies, stocks, commodities etc. When choosing a specific technique for predicting price dynamics, it is important to consider particular features of the asset you are going to trade on.

To sum it all up, technical analysis refers to a set of tools and indicators used for predicting future price fluctuations and identifying trend changes based on past records.

Questions for revision
  1. What are the two major types of market analysis?
  2. What is technical analysis?
  3. What is the main object of technical analysis?
Literature

Dow Theory

Elliott Wave Theory


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