The three basic assumptions of technical analysis
Technical analysis is based on three central assumptions about the behaviour of prices in the market. These principles form the foundation for many chart analysis methods and help traders better interpret price movements in trading.
The three basic assumptions of technical analysis are:
Below, you’ll see what these assumptions mean and why they’re important for technical analysis.
The market discounts all information
Technical analysis assumes that all available information is already reflected in the current price of an asset. Traders therefore focus primarily on charts and price movements instead of analysing extensive fundamental data as well.
Prices move in trends
Another core principle of technical analysis is that prices often move in a specific direction over a period of time. Many chart analysis methods aim to identify such trends early. Traders use tools such as trend lines, which are lines in the chart that make the course of a trend visible. They may also use trend channels, which show the possible range of movement of a trend, or indicators, which are mathematical calculations based on past prices.
These movements are referred to as trends:
uptrend: prices rise over a longer period
downtrend: prices fall over a longer period
sideways trend: prices move within a narrow range without a clear upward or downward trend
History repeats itself
The third assumption is based on the observation that certain patterns repeatedly appear in price movements. This is often due to the psychology of market participants. In similar market situations, many traders react in similar ways, creating comparable patterns in the chart.
Chart types: how to read charts correctly
For technical analysis, traders use different types of charts to visualise price movements. Each chart type presents price data differently and can help identify trends or patterns in the market.
Line chart
connects the closing prices of a period into a line
shows the overall price development of an asset very clearly
is well suited for quickly identifying long-term trends
Bar chart
shows the opening, high, low and closing price of an asset for each time unit
this representation is also called an OHLC chart (Open, High, Low, Close)
enables a more detailed analysis of price movement than a line chart
Candlestick chart
also displays opening, high, low and closing prices
the so-called candles use their shape and colour to show whether prices have risen or fallen
is one of the most popular tools in chart analysis because trends and potential reversal points quickly become visible
Common chart patterns
In chart analysis, there are several patterns that often indicate possible price movements and help traders make decisions. They can broadly be divided into reversal and continuation patterns.
Head and shoulders pattern
consists of three peaks, with the middle one higher (shoulder-head-shoulder)
often signals a trend reversal when the price breaks through the “neckline”
often indicates an upcoming end of an uptrend
Double top and double bottom
two consecutive highs followed by a price decline in a double top
two consecutive lows followed by a price increase in a double bottom
both patterns signal potential reversal points in price movement
Triangles
form when the price moves between two converging trend lines and the price range becomes increasingly narrow
symmetrical triangles indicate a continuation of the trend, while ascending or descending triangles can signal a breakout
particularly useful for traders speculating on breakouts
Flags and pennants
small continuation patterns that form after a strong price movement
flags move in a slightly downward sloping channel, pennants in a symmetrical triangle
usually indicate that the price will continue in the direction of the original trend
