Technical analysis is based on an examination of the price and volume movements of individual stocks, sectors, or the market as a whole. By charting historic information the technical analyst is searching for clues as to what direction the market, sector or stock will move next. Distinctive patterns emerge in charting which are used to make market direction or momentum decisions. Technical analysis may be applied to anything that is traded, whether it be stocks, bonds, commodities, or currencies. There is no desire in pure technical analysis to examine the qualitative and quantitative factors affecting an industry as with fundamental analysis.

Technical analysis is based on two fundamental assumptions. First, all historic price and volume patterns exhibited by a stock represent the total market perception of what is known or knowable about the individual stock. Thus, past price and volume behaviour is indicative of future movements. Second, the market does not move in a random manner. Long-term patterns develop in the market which have sub-trends within them. An adept technical analyst is able to identify and exploit trend defining patterns. Given the assumptions which underlie technical analysis, a technician aims to identify trends, changes in trends, and target price levels for each newly developed trend pattern.

There are many types of technical analysis. Market technicians depend on more than just price and volume data for identifying turning points in the market. Dow Theory, Elliot Wave Theory, pattern identification, moving averages, advance/decline, charting styles, odd lots, short selling, put/call ratio, relative strength indicators, Fibonacci levels are all tools of the technical analyst. Very few technicians rely solely on one form of technical analysis. Several are used in conjunction with one another in order to confirm market movements or trend changes.

Dow Theory

The initial form of technical analysis is referred to as Dow theory. This theory was developed by Charles Dow, founder of the Dow Jones financial news service and the initial editor of the Wall Street Journal. Dow Theory is predicated on the idea that a market has discernible cycles. The cycles average four years, but may vary in length (2-10yrs). Each cycle is divided into primary, secondary and minor trends.

The primary trend in Dow theory refers to the long-term directional movement of the market. Established up trends in the market are referred to as bull markets, and average two and a half years. Downtrends in the market, having an average duration of a year and a half, are referred to as bear markets. While the duration of either of the primary trends may vary, identifying the long-term market trend is the essential task of Dow theorists.

Buy Signal

Sell Signal

Secondary patterns emerge in Dow theory which are counter to the established primary trend. In a bull market, a secondary trend may be identified as a retracement of between 10% and 66% of the previous price move up. A secondary trend is not as long lived and may last from several weeks to several months. Should any of these characteristics be violated a change in market direction and sentiment may be taking place.

The minor trends in Dow theory are inter-day or inter-week movements in price activity which are inconsequential to either the secondary or primary trends. The minor trends are of interest to contrarians and professional traders who have the experience and ability to enter into a significant number of day trades. The individual investor may have difficulty in the inter-day trading market due to transaction costs.

Elliot Wave Theory

Elliot Wave theory is an outgrowth of the original technical market analysis of Dow Theory. Elliot Wave theory postulates that the market movements of each cycle are defined and predictable. A bull market is defined by a five wave movement. Bull markets are characterized by three major moves with the trend, interrupted by two secondary style moves against the trend. Bear markets are characterized by a three wave structure, two major moves with the trend and a single secondary move against the trend.

Elliot Wave theory is a highly subjective form of technical analysis. Each practitioner may use a different starting point for the wave count they use. As well, wave structures may be complicated by three wave corrections and waves within waves. The complexity of Elliot Wave theory has made it difficult for many investors to use reliably. However, there are many recognized practitioners who publish daily comments for market professionals and other subscribers.