First Principles of Technical Analysis

As Market Technicians, we must remember that despite our best efforts, the methods we employ are not perfect, nor will they ever be. Technical instruments, tools, and analysis are our best attempts to gauge supply and demand, and yet no person or group of people is able to know and accurately assess the infinite factors that combine and fluctuate to generate the forces of supply and demand – which exclusively determines what way, how fast, and far a stock or security will go.

There is no crystal ball or get-rich-quick methods in technical analysis.

 

 

The Market Technician’s duty is to interpret action while possessing a keen sense of judgement and perspective. A chart – while one of the best sources of data to analyze for technicians – is not perfect; it does not have all the answers, nor does it present its use value instantly and easily. It is possible to technically analyze the markets ad infinitum with so many combinations, indicators, and pliable variables – not to mention the innumerable indicators that are not widely used and those which have not yet been invented. These dizzying possibilities tend to short-circuit judgement as they attempt a purely mechanical approach to analyze what is not a purely mechanical cause-and-effect relationship. With so many various technical systems and forms of analysis, it is important to remember the First Principles of technical analysis.

 

The First Principles are those methods that are the most useful as they are simplistic and easily rationalized. They do not lend themselves to perfection or attempt to precisely time the day and time a stock will move and by how much. These methods work well together and supplement each other. Below are the First Principles of technical analysis, as originally outlined by Robert Edwards and John Magee in their pioneering work: Technical Analysis of Stock Trends.

 

The First Principles of Technical Analysis

 

1.  Area Patterns or Formations – These chart patterns, along with volume, indicate changes or continuations of the supply-demand balance. They can indicate the probability of moves in the same direction, in no direction, or in the reverse direction. These patterns can be described as the visual representation of periods where energy or pressure is accumulated. These periods more often than not give way to periods of movement where prices are propelled consistently in continuous motion, either up or down. The patterns can also be the representation of periods when pressure is dissipated and exhausted, which lend themselves to cause mean reversion in price or periods of consolidation and a lack of activity. In either case this knowledge can be transmuted to profits, the avoidance of losses, and the optimal use of time and money. Some of these patterns even go as far to indicate how far their pressure will push prices through minimum price targets that are established. Volume is a factor. But recall that volume is important only when it is an extreme deviation from the norm; it is also relative. Point and Figure area patterns are equally valid here, although volume analysis is not taken into consideration.

 

Ascending triangle in the Dow Transports broke out to the upside circa 1997

 

2. Trend Analysis with Trendlines - Together with Area Patterns, trend analysis helps determine the general direction in which prices have been moving. Additionally trendline analysis signifies when the trend deviates, as well as provides the Market Technician implications of its deviation. Trend analysis independent or in conjunction with area patterns may be used to signal to investors when to enter and exit positions. One of the great strengths of trendlines is that they often provide a reliable defense against premature relinquishment of profitable long-term positions.

 

2 1/2 year chart of Wynn. Simple trendline analysis would have kept you in the stock in recent market decline.

 

3. Support and Resistance – These levels are created by the previous commitments of market participants. Where are the levels where many shares changed hands over time? The levels have a two-fold purpose and use for market technicians. First, they are important because they indicate where it makes the most sense to initiate a position through entries that coincide with the least amount of risk. Second, they are useful in determining where price action is likely to slow down or retreat, and possibly reverse course. This is useful in determining where to take profits due to the likelihood that a stock will experience a sudden increase in supply or demand, as well as what levels it makes sense to scrutinize more than others.

 

Example of support and resistance annoted on a chart

 

4. Broad Market Background – What is the market as a whole telling you? What are the strongest and weakest areas of the market? This principle includes Dow Theory as well as sector analysis and relative strength. Dow Theory indicates to the technician the overall market trend, and therefore dictates the types of positions that are the most likely to succeed, as well as signals when these positions should be exited or reversed (depending on your strategy). It is important to remember that over time, the stock of good companies will tend to decline when all stocks are declining, and the stock of poor companies will tend to rise when all stocks are rising. Charles Dow originally noted that the stocks of the market move together like schools of fish, and this is why his theory is so valuable. Additionally, it is helpful to understand the strongest and weakest sectors of the market, as the stocks that make up a sector also generally move together. The investing implications are different in up and down markets, but only in opposite effect.

 

Charles H. Dow - the father of technical analysis and Dow Theory

Summary

 

All four of the First Principles of technical analysis can be used in conjunction, and the resulting analysis will always be stronger when they are used together when possible, in proportion to the number of principles used. As Market Technicians, it is important to revert to these First Principles in times of doubt and uncertainty. “Stick to your guns,” as Edwards and Magee stated. That is not to say that recent technical developments and other momentum principles are not valid – they are, though they should rarely if ever be used in isolation. Combining all four First Principles with modern indicators, oscillators, and moving averages can generate profitable set-ups when used in conjunction, as well as shorter-term entry and exit signals to give the market technician a valuable edge.

 

Disclaimer: I am long Wynn Resorts at the time of this posting.

 

 

4 thoughts on “First Principles of Technical Analysis

  1. With the amount of overwhelming information and trading systems advertised or offered, this simplistic view of TA is certainly refreshing. Keep the good posts coming. Cheers.