October 1987 saw the American equity markets grim as the Dow Jones dropped 22.6%, the highest one-day fall recorded to date. When America faced Black Monday, something interesting happened on the day prior. Stanley Druckenmiller, a portfolio manager of Dreyfus Corp, studied historical chart patterns of approximately 1,500 stocks and decided to move his investments out of equity, regardless of a previous week’s dip that most saw as a buying opportunity.
What Stanley saw in the historical records that day was a head-and-shoulders pattern, which indicates bear markets and major declines. Technical analysis (TA) of past performance and the assumption of history repeating itself saved him from becoming a victim of Black Monday.
Therefore, keeping Stanley in our memory, let’s understand the assumptions of technical analysis that can help investors make the right financial decisions.
What is Technical Analysis?
Before getting into the assumptions of technical analysis, it is important to brush up on a few basic concepts related to the topic, beginning with the meaning of TA.
The process of utilising various tools and techniques to ascertain the possible stock price movement. It is based on analysing the performance of a stock historically, through metrics like price, volume, etc.
Since technical analysis involves forecasting, it is based on certain assumptions. However, understanding the true nature of the assumptions of technical analysis begins with exploring the need for it.
Why Technical Analysis Depends on Assumptions
TA cannot function without assumptions, as the entire analysis is built on reading patterns in historical price action. Without considering that price is a complete reflection of all relevant market information or that collective psychology in markets is consistent, chart patterns would carry no predictive meaning.
This is a foundation that allows analysts to interpret recurring formations as signals. If such assumptions were not in place, past data would offer no insight into future trends, making the approach ineffective.
Core Assumptions of Technical Analysis
The logic behind TA stands on a few key assumptions. Here are some important ones to know:
- Market Discounts Everything
This idea comes from Dow Theory and it means that the current stock price is already a reflection of all known information like policy changes, company reports and public sentiment. The chart becomes a summary of everything the crowd believes, knows or fears. Only unexpected developments fall outside what the market has already priced in.
- Price Moves in Trends
This view holds that market movement is not random but follows a direction over time. These movements form the trends, whether upward, downward or sideways.
Analysts study it to understand how long a direction may continue before reversal. Each trend reflects changing sentiment and market conditions. By identifying this early, traders aim to follow the flow rather than fight it.
- History Tends to Repeat Itself
This belief is based on the idea that human behaviour in markets remains largely unchanged. Emotions such as fear and greed often drive repeated candlestick patterns in price action. Traders observe these recurring setups to predict how similar conditions might repeat again.
- Market Moves Are Not Completely Random
TA assumes that prices do not move in a fully unpredictable way. While short-term movements can seem distracting, in hindsight price often reacts to supply and demand in repeatable ways. This leads to trends and signals to emerge.
The randomness is not completely void,but it does not dominate every move. But if price movements were entirely random, there would be no way to analyse or respond to them using charts.
- Technical Indicators Capture Probabilities, Not Certainties
TA does not promise exact results. It shows what is likely to happen, not what must happen. Technical indicators like RSI or MACD show patterns that generally lead to certain outcomes, but they can also fail.
Since markets react to many factors that no chart can fully predict. For example, RSI may signal a continued uptrend, but a sudden geopolitical tension can reverse it. That is why risk control is essential when using TA.
Why These Assumptions of Technical Analysis Matter for Traders
- Sharper judgement: Patterns underline crowd behaviour. Understanding this helps read patterns with more clarity & purpose.
- Realistic outlook: Accepting that patterns show likelihood and not certainty, keeps traders grounded, not overconfident.
- Risk control: Knowing that no method is foolproof reinforces the need for risk management through stop-losses and position sizing.
- Sharper timing: Trusting that price reflects known information helps traders act with confidence when opportunities appear.
- Balanced approach: Awareness of these assumptions encourages traders to blend TA with other fundamental methods , for a more balanced & comprehensive approach.
Limitations Caused by The Assumptions of Technical Analysis
- Price patterns evolve: Price behaviour can change due to new variables, making old patterns unreliable at times.
- Self-fulfilling influence: A pattern may appear to work only because many traders act on it, not because it reflects true demand.
- Limited scope: Charts track external price movements but ignore balance sheets, revenue trends or sector-specific pressures.
- Less effective in isolation: Without support from other methods, its signals may lack depth or long-term reliability.
How to Use Technical Analysis Responsibly
Technical analysis is powerful, but as we discussed, it’s not foolproof. To use it effectively, blend charts with common sense.
- Check the bigger picture: Charts tell part of the story. Confirm signals with news and company fundamentals.
- Set limits clearly: Always decide upfront how much you’re willing to lose. Use stop-loss orders consistently.
- Stick to your plan: Don’t let emotions rule your trades. Follow your strategy, even when markets test your nerves.
- Be ready to adapt: Markets change quickly. Regularly review your methods and adjust them to stay relevant.
Use proper risk management
- Set stop-loss and take-profit levels: Define exit points by setting stop loss before entering a trade. Avoid reacting in the moment.
- Control position size: Limit exposure by risking only a small portion of capital on each trade.
- Account for volatility: Adjust risk levels based on how much the market is moving.
- Diversify when possible: Diversify across instruments or sectors. Avoid relying on any one outcome to carry the result.
FAQ
Markets respond to what people know, expect or fear. Price movements often follow a direction for a time. Certain behaviours tend to return in familiar conditions. Patterns suggest what may happen next, not what will. Charts react to activity but do not explain why it happens. Signals can guide decisions, though none are foolproof.
It depends on a few key ideas to make sense of price behaviour. Without them, charts become harder to interpret. Patterns may still form, but their meaning becomes unclear. The link between past and future weakens. Price movement loses context. Without that structure, the method becomes far less useful.
A trend shows where the market is generally heading. It helps traders decide when to enter or exit. Without it, price moves can seem unclear. It gives direction to patterns and signals. Many tools rely on knowing if the market is rising, falling or staying flat. It brings order to changing conditions.
No single approach works all the time. Market behaviour can change, often without notice. Setups that once held may collapse under pressure. Visual tools reflect sentiment, but do not guarantee any output. External events can override any chart. That’s why caution and position control remain vital.
The idea is that market behaviour often repeats in familiar ways. Certain price patterns tend to appear again over time. This happens because people react similarly in similar situations. Fear, hope and pressure tend to shape those moves. Traders study past setups to spot signs of repeat behaviour. It helps them prepare for what might happen next.
