Last Updated on 7 April, 2022 by Samuelsson
The History of Technical Analysis
A lot of traders make use of technical analysis to analyze the market and find trading opportunities, but many do not know the origin. Ever wondered how technical analysis came about?
While many traders, especially from the West, think it all started with the Dow Theory, the history of technical analysis can be traced to the Amsterdam market of the 17th century and Japanese rice trading in the early 18th century. However, the Dow Theory contributed a lot to explaining this way of analyzing the markets.
In this post, we will take a look at the following:
- What is technical analysis?
- Understanding the basis for technical analysis
- How it started: the history of technical analysis
- The early history of trading
- The Dow theory
- The Elliot wave theory
- The rise of mathematical indicators
What is technical analysis?
Technical analysis is a method of analyzing the market to identify trading opportunities by focusing on the historical market data — price and volume — instead of studying the security’s fundamentals, such as the business model, financial statements, macroeconomic factors, and the rest.
By focusing solely on the market action, a trader can spot price trends, waves, and patterns, as well as volume changes, which could help him determine how the price might move in the near future. With this knowledge, he can position himself to take advantage of that price movement.
Technical analysis is used to ascertain the ways supply and demand for a security will affect changes in price, volume, and implied volatility. This form of analysis is different from fundamental analysis, which focuses on external factors that can affect the security’s price. Fundamental analysis focuses on macroeconomic factors, financial statements, business models, and corporate management. Technical analysis, on the other hand, believes that the market data is a valuable indicator for what is likely to happen in the future.
So, a technical analyst charts the market data and uses the information on the chart to find trading opportunities. While technical analysis is often used to generate short-term trading signals from various charting tools, it can also be used for long-term investing when the analysis is done on a longer timeframe, such as the monthly chart.
Understanding the basis for technical analysis
Technical analysis is based on three main assumptions:
- Market action discounts everything: Technical analysts believe that all relevant information is that can affect the market is already reflected in the price and volume changes.
- Prices move in trends and countertrends: The price moves in trends, which can be up, down, or sideways. With every trend, there are countertrend waves or pullbacks.
- History repeats itself: Technical analysts believe that price action is repetitive, with certain patterns reoccurring. This is because, given similar market situations, investors collectively repeat the emotions and behaviors that were exhibited by the investors that preceded them. this creates recognizable patterns, which a technical trader can identify and use to make trading decisions.
How it started: the history of technical analysis
Technical analysis has a long and rich history. But in this post, we will study it under the following sections:
- The early history of trading
- The Dow theory
- The Elliot Wave Theory
- The rise of mathematical indicators
The early history of trading
Some people trace the origin of technical analysis to the ancient Assyrian trading stations and Greek markets. it was believed that there was evidence of speculations in their commerce and that they kept track of price fluctuations.
However, a more prominent indication of the use of technical analysis could be seen in Joseph de la Vega’s description of the Dutch markets in the 17th century. An Amsterdam-based diamond merchant, financial expert, philosopher, and poet, Joseph de la Vega wrote his masterpiece, Confusion of Confusions, in 1688.
The text, which focused on general investment advice, has become a guiding light for the origin of the modern-day technical analysis, as it contains detailed descriptions of puts, calls, pools, and speculations. In the book, De Vega described how he used such techniques to predict stock price movements in the Amsterdam stock exchange.
Another early evidence of technical analysis could be seen in Homma Munehisa’s use of the candlestick patterns to predict the price of rice on the Japanese exchange in the early 18th century. Homma Munehisa was a wealthy rice merchant and trader from Sakata, Japan. He became wealthy speculating on rice prices on the exchange using a technical analysis method (candlestick patterns) he developed.
In Edo-period Japan, traders used technical analysis in a bid to profit from Osaka’s rice futures market. Initially, only physical rice trading was carried out, but from the beginning of 1710, a futures market was established where coupons represent future rice delivery.
Homma flourished as a trader in this secondary market of trading rice coupons and developed techniques that evolved into the candlestick patterns that chartists use today to plot the price action. In Japan, candlestick charts are called Sakata charts — named after Homma’s native place. The candlestick chart clearly shows open, high, low, and close price data and are drawn in a way that resembles a candle with wicks on both ends showing the difference between the open/close price and the high/low price.
In his book, The Fountain of Gold —The Three Monkey Record of Money, which he wrote in 1755, Munehisa described early forms of technical patterns. He explained that trends and reversals are related to human emotions. Some of the candlestick chart patterns he used were Night and morning stars; the advancing three soldiers; and many others. The Japanese government recognized Munehisa’s ability as an expert trader in the rice market and made him a financial advisor to the government. Homma was also awarded the rank of honorary Samurai.
Meanwhile, during that period in China, people were using the rules established by Confucian manuals to forecast price movements in the markets of Imperial China. For example, in one manual titled “Essential Business”, it was stated that no item will remain expensive for over one hundred days and no item will remain cheap for one hundred days, and traders used it in making their decisions. There are also other instructions in the manual that showed merchants how to identify market movements and understand associations between price movement and volume.
The Dow theory
While evidence of the use of technical analysis could be seen in Amsterdam and London before the 18th century, technical analysis in the US market only came in the late 19th and early 20th centuries. It was Charles Dow who was credited for pioneering technical analysis in the US stock market. A co-founder of the Dow Jones & Company, Charles Dow, developed the Dow Theory when he was studying the movement of an index of the industrial and transportation stocks listed on the market in 1896.
He closely analyzed American stock market data and published some of his findings in The Wall Street Journal editorials. Dow observed patterns and business cycles and found out that if the Dow Jones Industrial Average (DJIA) climbs to an intermediate high, the Dow Jones Transportation Average (DJTA) is expected to follow suit within a reasonable period.
So, he came up with the “Dow Theory, which states thus:
“The market is in an upward trend if one of its averages (i.e. industrials or transportation) advances above a previous important high and is accompanied or followed by a similar advance in the other average.”
Dow recorded the highs and lows of his daily, weekly, and monthly trades and studied the patterns about the market’s peaks and troughs. For example, when the Dow Jones Industrial Average (DJIA) climbs to an intermediate high, the Dow Jones Transportation Average (DJTA) is expected to follow suit within a reasonable period. If this doesn’t happen, the uptrend is considered unreliable.
He believed that the stock market as a whole was a reliable measure of the state of the economy, so by analyzing the overall market, one could accurately gauge the prevailing economic conditions and identify the direction of major market trends and the likely direction of individual stocks. While the theory has evolved throughout decades, it still forms the basis of present-day technical analysis.
Charles Dow passed away in 1902 and could not publish his complete theory on the markets, but many of his followers published his works and conducted further research on the editorials over the next century. Some of his followers with significant contributions to the theory include William Hamilton, Robert Rhea, E. George Shaefer, and Richard Russell.
In the 1920s, William Hamilton refined the Dow Theory after he succeeded Charles Dow as the Editor of The Wall Street Journal. He wrote several editorials and books where he explained the theory in detail. For example, in 1922, he wrote The Stock Market Barometer to explain the theory in detail.
He explained the Dow Theory using a metaphor to relate the market trends to ocean waves. A long-term trend of four years or more was referred to as the tide of the market, which could be rising (bullish) or falling (bearish). Market trends that lasted a few months or weeks were the shorter-term waves. And, the day-to-day fluctuations were like the sporadic flashes of water in the rough ocean. He used the railroad average and the industrial average as barometers of market trends, and the direction of these averages indicated the bull and bear market with accuracy.
Apart from Hamilton, Robert Rhea in “The Dow Theory”, written in 1932, provided more insight into the theory. Many other traders and analysts after them also wrote about the theory. One of them was E. George Schaefer in his 1960 book, “How I Helped More Than 10,000 Investors To Profit In Stocks.” Another was Richard Russell’s “The Dow Theory Today”, which was written in 1961.
The Elliot wave theory
The Elliot wave theory was invented by Ralph Nelson Elliott. Elliott began his career as an accountant in the mid-1890s. He rose quickly in his career, attaining executive positions at private companies, after which he established a successful consulting business.
The U.S. Department of State appointed him to the post of Chief Accountant for Nicaragua (which at the time was under American control). It was during his time in Central America that he contracted a debilitating illness, which forced him to retire early and subsequently dedicate himself to the study of the American stock market.
Elliot studied 75 years of historical stock market data using yearly, monthly, weekly, daily, hourly and half-hourly charts. Note that this was in the 1930s when there was no computing power for analyzing charts and keeping records. So, he did all the analysis manually. Despite the common belief at that time that the market movement was random, Elliot suspected that there was some underlying order to how they moved. He later proposed that market prices unfolded in specific patterns and trends. This was considered a revolutionary idea at that time.
From his research, he created rules regarding price swings, which he applied to the markets, and as his confidence grew, he began to share his ideas publicly. It was on March 13, 1935, that he sent out a telegram after market close stating that the American stock market is making a final bottom. The day after, March 14, 1935, the Dow Jones Industrial Average made its lowest closing price for that entire year. In fact, the market began a rise that lasted almost two years, almost doubling the value of the Dow.
With this prediction, Elliott became more confident in his method of characterizing price waves. Note that, at the time in history Elliott made the prediction (1935), America was in the middle of The Great Depression, and the idea that the markets could rise seemed unthinkable. But Elliot’s waves theory was able to pin the bottom of the market to within one trading day.
Subsequently, Elliot wrote a book with Charles J. Collins and titled it “The Elliot Principle”. With the book, Elliott Wave Theory was officially born. The theory proposes that the stock price trends reflect the deeper psychology of investors. It says that stock price movements can be predicted because they move in repeating up-and-down patterns called waves that are created by investor psychology or sentiment, with each set of waves belonging to a more extensive set of waves that resonate with the recurrent pattern.
The theory identifies two different types of waves: impulse waves (also known as motive waves), which move in the direction of the trend, and corrective waves or pullbacks, which are countertrend moves or retracements.
Ralph Elliott died in 1948, but many financial professionals continued to give predictions based on the Elliott Wave Theory. For example, in the early 1970s, a young analyst at Merrill Lynch, Robert Prechter, discovered Elliott’s work and re-introduced it to the public through his own newsletters and books. He even won the U.S. Trading Championship in 1984 using the Elliott Wave strategy.
The rise of mathematical indicators
Apart from the technical analysis methods we have discussed so far — the candlestick method from Homma, the Dow Theory from Charles Dow, and the Elliot Wave Theory from Ralph Elliot — many other technical analysis methods have been developed over the years. Many of those are based on technical indicators, which are mathematical calculations using price and volume data. Here are a few of the most common indicators used in technical analysis:
Moving averages: A moving average is a calculation used to analyze data points by creating a series of averages of different subsets of the full data set. The reason for calculating the moving average of a security is to help smooth out the price data so that the trend can easily be detected. There are different types of moving average indicators based on the method of calculation. The common ones are the simple moving average, the exponential moving average, and the linear-weighted moving average. The use of moving averages to smoothen data is as old as the study of mathematics and statistics.
Stochastic: The stochastic indicator is a momentum oscillator that compares a particular closing price of a security to a range of its prices over a certain period. It oscillates between 0 and 100 and is used to generate overbought and oversold trading signals. The sensitivity of the oscillator to market movements can be reduced by adjusting that period or by taking a moving average of the result. The indicator was created by George Lane in the 1950s.
RSI: The relative strength index (RSI) is a momentum oscillator used in technical analysis. It measures the magnitude of recent price changes by comparing the up and down closing prices over a given period. It can be used to gauge overbought or oversold conditions in the price of a security. The indicator was created by J. Welles Wilder Jr. and was explained in his 1978 book: New Concepts in Technical Trading Systems.
MACD: The moving average convergence/divergence (MACD) is a trading indicator used in the technical analysis of security prices. It is designed to show changes in the strength, direction, momentum, and duration of a trend. So, it is both a trend-following and a momentum indicator. It was created by Gerald Appel in the late 1970s.
OBV: The on-balance volume (OBV) is a technical trading indicator that uses volume flow to predict changes in stock price. It uses volume data to show where the momentum lies in the price action. The indicator was first created by Joseph Granville in his 1963 book: Granville’s New Key to Stock Market Profits.