Handbook of Exchange Rates

12.2 The Practice of Technical Analysis

12.2.1 The Philosophy of Technical Analysis

Technical analysts argue that their methods take advantage of market psychology as illustrated by the quotation from Pring (1991) above. In particular, technical textbooks such as Murphy (1986) and Pring (1991) outline three principles that guide the behavior of technical analysts.² The first is that market action (prices and transactions volume) “discounts” everything. In other words, an asset's price history incorporates all relevant information, so there is no need to forecast or research asset “fundamentals.” Indeed, technical purists do not even look at fundamentals, except through the prism of prices, which reflect fundamentals before those variables are fully observable. Presaging recent findings by Engel and West (2005); Murphy (1986) claims that asset price changes often precede observed changes in fundamentals. The second principle is that asset prices move in trends. This is essential to the success of technical analysis because trends imply predictability and enable traders to profit by buying (selling) assets when the price is rising (falling). This is captured in the technicians' mantra “the trend is your friend.” The third principle of technical analysis is that history repeats itself. Asset traders will tend to react in a similar way when confronted by similar conditions. This implies that asset price patterns will tend to repeat themselves.

Using these three principles, technical ...