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The three basic premise on which technical analysis is based:
1. Market Action discounts everything
2. Prices move in trends
3. History repeats itself
1. Market action discounts everything
At first glance, this statements may seem absurd but if we try to look harder at what exactly the technical analyst is trying to say, we may see that it is not so different from the fundamental analyst. What the technical analyst is claiming is that market action reflects the shifts in demand and supply. If demand exceeds supply then prices should rise and if supply exceeds demand then prices should fall (this action is also the basis of all economic and fundamental forecasting). The technical analyst concludes that if prices are rising, the fundamentals are bullish and if prices are falling the fundamentals are bearish. Hence the technical analyst believes that since the current price reflect all shifts in demand and supply, it is sufficient to study the movement of the prices itself. The charts in themselves do not cause markets move up or down, the charts only reflect the bullish or bearish sentiment of the market.
2. Prices move in trends
The concept of trend is absolutely essential to the technical analyst. The purpose of studying charts is to identify trends or a changes in a trend at an early stage in order to invest/trade in the direction of those trends. The technical analyst believes that a trend in motion is likely to continue than to reverse.
3. History repeats itself
Studying chart patterns reflect bullish or bearish psychology of the market in the past. What the technical analyst is really saying is that human psychology tends not to change and hence a study of the past is a key to understanding future price movement, or in other words the future is a repetition of the past.
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