The assumptions of technical analysis
Let’s dig a little deeper into what we’re doing when we conduct technical analysis. We are making three core assumptions, which we’ll go through now.
1. The market discounts everything
When you make this assumption, you assume all public information is already reflected in the price of an asset. If you didn’t you be a fundamental analyst and price and value would not be the same.
This is why technical analysis is more suited to highly liquid, efficient markets, like FX and indices, where the moment any news comes out it is immediately reflected in the price. If every factor that impacts price is factored in, then why analyse anything else.
2. Prices move in trends
What we’re subscribing to by making this assumption is if the price is in a trend, then the next tick is more likely to be in the direction of the trend than not. If this weren’t the case then establishing whether a price is trending would not be insightful – technical analysis is set up to assess the direction of the trend for this reason.
We discussed the way market participants behave and how it drives trends in our course Trends, Support and Resistance so we won’t go over that again here. The technical analyst is assuming the psychology of the market participants is continuous and not reassessed after every movement in price.
3. History tends to repeat itself
What technical traders are doing here is making the assumption that market participants are more likely to react in a similar way to the way they did in the past than not. Technical traders are trying to identify repeatable patterns in the price because they have made the assumption that what happened before when it formed, is likely to repeat this time. Remember, all information is reflected in the price so the price is the only place to look for these patterns.
When technical traders find a repeatable pattern starting to form, we have an insight and assume the price is more likely to play out as it when those market participants last encountered this situation.
- There are three core assumptions that underpin technical analysis.
- 1. The market discounts everything – it is assumed all public information is already reflected in the price of an asset.
- 2. Prices move in trends – if a price is trending it is more likely the next tick is in the direction of the trend.
- 3. History tends to repeat itself – if a repeatable pattern is found in the price then it can be used as an insight the next time that pattern develops.
