• David Yocum

Theory and History of Technical Analysis - CMT Level 1, Section 1

Are you interested in studying with me as I prepare to take my Level 1 CMT exam? Get a deep understanding of how professional technical analysts approach the markets by following this series. Skip to:

1. Chapter 1 - The Basic Principle of Technical Analysis - The Trend

2. Chapter 2 - Dow Theory

3. Chapter 3 - History and Construction of Charts This article contains the learning objectives from Section 1, Chapters 1-3 of CMT Level 1: An Introduction to Technical Analysis. John Wiley & Sons, Inc., 2020. Everything typed in bold is taken directly from the learning objectives of these chapters and is being used for educational purposes only.

 

Chapter 1 - The Basic Principle of Technical Analysis - The Trend Written by Charles Kirkpatrick II and Julie Dahlquist in 'CMT Level 1: An Introduction to Technical Analysis. John Wiley & Sons, Inc., 2020'

What is a trend? A trend is a movement in price that sustains in one direction for a long enough period of time to allow a trader to be profitable. An upward trend would be identified by making higher highs and higher lows. A downward trend would be identified by making lower lows and lower highs. Trends are what technical analysts look for to identify in stocks to take advantage of for a profit.

Why is trend significant?

Trend is significant because a trader wants to be trading in the direction of that trend to make a profit until the trend is proven to be no longer valid. Identifying primary, secondary, short-term, and intraday trends Primary trend: several months to years Secondary trend: several weeks to months Short-term: days

Intraday: minutes or hours Describing the basic beliefs behind the art of technical analysis The basic belief behind technical analysis is that price moves in trends and is a technical analyst's job to identify proper buy and sell points within a trend until that trend is no longer applicable to a chart. Here are the 6 key points that technical analysts believe, stated in the CMT Level 1: An Introduction to Technical Analysis. John Wiley & Sons, Inc., 2020 1. Price is made through the interaction of supply & demand 2. "Price discounts everything". This means that technical analysts believe that price is always in coordination with all available market data, often referred to as an 'efficient market'. 3. "Prices are nonrandom". This means price often travels in similar trends to what it has in the past. This accounts for seasonality and other trends found throughout history. 4. Technical analysts assume that price often trades in similarity to past price movements. They referenced the quote by Mark Twain that says "History rhymes: It does not repeat". 5. Price moves in fractals. Larger timeframes often have similar trends as smaller timeframes. 6. "Emotions are affected by earlier emotions through emotional feedback. What is a Fractal in terms of price action?

Merriam-Webster defines a fractal as "any of various extremely irregular curves or shapes for which any suitably chosen part is similar in shape to a given larger or smaller part when magnified or reduced to the same size". How does this apply to price action? Within trends, there are more trends. Within those trends, there are even more trends. A 10-week period has a trend, while within those 10 weeks, price has its own trend. Think about a 1-minute chart, even those are trends within the bigger trends.

 

Chapter 2 - Dow Theory

Written by Charles Kirkpatrick II and Julie Dahlquist in 'CMT Level 1: An Introduction to Technical Analysis. John Wiley & Sons, Inc., 2020'

Key Terms RWH - Random Walk Hypothesis

EMH - Efficient Markets Hypothesis

Describe the history of Dow Theory


Charles Dow was the founder of modern technical analysis and the first ever to create an index that tracked U.S. stocks. He never formally created 'Dow Theory' however it wasn't until after his death that others studied his work and created theories based on his research and analysis. It is important to note that the market does not always fully resemble previous markets, in fact, a normal market doesn't resemble another market at all. It shows similar harmonics and patterns over history but never the same. Discuss the basic principles of Dow Theory


"Robert Rhea presented three hypotheses based on Dow Theory: 1. The primary trend is inviolate

2. The averages discount everything

3. Dow Theory is infallible" (Charles Kirkpatrick II and Julie Dahlquist, page 17)


One of the main theories of Dow Theory is that the market always consists of an uptrend, top, downtrend, and bottom. Retracements and consolidations are always a piece of these market movements. Another key theory is that the economy and its health should be used to explain price action. The last important theory is that price trends. (Refer here for the definition trend)


Identify the three basic types of trends identified in Dow Theory as defined by time: primary, secondary, and minor Primary trend: several months to years (most important)

 

Secondary trend: several weeks to months Dow described secondary trends as they are dangerous and more speculative because of the fact that many believe a secondary trend is actually the start of a new primary trend though this is often not the case.

 

Minor trend: days


Dow said that the minor trend - daily price movements - is illogical compared to the long-term movements of the market.

 

Identify the three basic trend patterns of all prices: upward, downward, and sideways


1. Primary trend - bull and bear markets

2. Secondary reaction - a move against the primary trend (the most deceptive)

3. Daily fluctuation - least important

Primary uptrends vs. primary downtrends Primary uptrends (bull markets) are characterized by first, recovering and becoming hopeful from a bear market. This is then followed by a series of good corporate earnings when investors become aware of a new bull market. Lastly, the market will be driven on hope and expectation which will be the end of the bull market. Primary downtrends (bear markets) are elongated movements to the downside with rallies throughout. This ends once the market discounts the worst that could happen. First, investors abandon their stocks and start to expect poor market performance. Secondly, stocks begin to have poor earnings. Lastly, distressed investors sell because they believe the worst is yet to come.


Describe the "ideal market picture" according to Dow Theory


In an ideal market, there is an uptrend, top, downtrend, and bottom. There are retracements and consolidation throughout these different stages.


Express the concept of confirmation in Dow Theory


The concept of confirmation has taken different shapes since Dow was around as we now have more indexes to follow rather than the industrial and railroad averages. Comparing these averages, if one was making new highs while the other was making new highs, this is confirmation of a primary uptrend. If one is making highs while the other is making lows, this is to be ignored until a clear thesis is made - both averages moving together. Nonconfirmations come in a bull market when prices fail to make new highs after a secondary reaction and vice versa for bear markets. This is a warning that there may be a shift in the primary trend direction.

$SPY and $QQQ Covid Example - Confirmations

Explain the role of volume in Dow Theory


Volume is not an indicator you can solely trade off of however it is important to mix it with price action. In a bull market with low buying volume followed by larger selling volume, this could be an example of overbought conditions. On the other side, during a bear market, if price begins to rise on large volume while declining on low volume, this can be an indication of the end of the bear market. It is important to note that the creators of Dow Theory believed that volume was a secondary consideration meaning that price trend is still the main observation to utilize for overall sentiment.

 

Chapter 3 - History and Construction of Charts Written by Charles Kirkpatrick II and Julie Dahlquist in 'CMT Level 1: An Introduction to Technical Analysis. John Wiley & Sons, Inc., 2020'


List advantages of reviewing price information in chart format


Charts simply show the history of price over a given period of time.


Review the data points required to construct line, bar, and candlestick charts Reliable charts come from the credibility of the exchange you receive the price data. In this day in age, any popular broker or charting platform has reliable feeds from exchanges that transact enough shares to make them reliable sources to see accurate price information.

Describe how to construct line, bar and candlestick charts Because I have written an entire article on 'How to Read a Stock Chart' going over different chart types and why they are important, please click here to read an in-depth response to this learning objective.


Explain the differences between arithmetic and logarithmic scales and their uses


Arithmetic Scale - This is also known as a linear scale in which a stock charts price units on the y-axis (vertical axis) scales at the same price intervals. For example, from bottom to top, $0, $10, $20, $30, $40, etc. *Arithmetic scale is the most commonly used chart

Logarithmic Scale - Best used for looking at long-term charts. The logarithmic scale is also viewed on the vertical axis of the chart however the difference comes with the intervals. Rather than being a set dollar amount in between grids, it is a set percentage. For example, from bottom to top, $10, $20, $40, $80, $160, etc. Notice that the intervals each changed by 100% rather than a set dollar amount. This helps in cases where there is extreme volatility in which price makes large percentage moves. This simply helps even out the view of a chart.

Arithmetic Scale on $TSLA
Logarithmic Scale on $TSLA
 

Thank you for reading my notes on "Theory and History of Technical Analysis - CMT Level 1, Section 1". Stay tuned for my next article on Section 2 "Charts, Trends, and Patterns". If you enjoyed this article and would like to receive free updates on new articles published, feel free to subscribe at the bottom of any page! You can also find me on Twitter and YouTube @yocumscharting.



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