Assumptions made in technical analysis

Technical analysis is based on several assumptions about the way markets work.

The market discounts everything

A major assumption of technical analysis is that everything that is known about a stock — past, present and potential future influences — is reflected in the price that market participants are prepared to pay for it. Changes in price reflect changes in opinions of these influences, which affects supply and/or demand for a security.

Prices move in trends

Another major assumption is that prices tend to move in trends. This is contrary to an academic theory that price action is random and that market information is disseminated immediately and efficiently and is acted upon in a rational manner. In the real world, market information is taken up at different times by various market participants, leading to perhaps increased or decreased demand for, or increased or decreased supply of, a security over a period of time as participants form an opinion based on that information. This inefficient uptake of information leads to trending action. Market information is also not always acted upon in a rational manner by participants. Irrational emotional factors, such as fear, greed and ‘group mentality....