This is part two of a series on technical analysis. Click here for the series overview in part one.
Modern-day technical analysis is rooted in the writings of Charles Dow in the late 1800s, although the concept can be traced back hundreds of years. Amsterdam-based merchant Joseph de la Vega was among the first to reference concepts of technical analysis in the 17th century when he wrote about the Dutch financial markets.
Then in the 18th century, Japanese merchant Munehisa Homma developed candlestick charts, which were some of the first financial charts that were used to track trading patterns. Candlestick charts break trades into individual time periods, with each candlestick on the chart serving as a single day or other time period. The candlestick chart is sort of like a cross between a line graph and a bar graph, with the bottom of the candlestick showing the low and the top showing the high. Between each of them is a bar which shows the open and closing prices.
Most histories of modern-day technical analysis begin in the late 19th century with Charles Dow of Dow Jones & Company and Wall Street Journal fame. Those who wrote on technical analysis after him continued to build upon the principles he developed. As he researched market movements, he created the Dow Jones Industrial Average, which started in 1896 with only 12 companies of equal weighting. Today it contains 30 major U.S. firms of equal weighting, unlike other indices like the S&P 500, which takes into account market capitalization as well.
Dow also developed the principles that formed the basis for what later became known as the Dow Theory. The theory basically just states that there is a relationship between stock market trends and other business activities. Dow believed that if the Dow Jones Industrial Average and the Dow Jones Transportation Average are moving in the same direction, a significant change in the markets is occurring. If multiple indices are reaching new highs, it means a bull market is underway.
William Peter Hamilton
William Peter Hamilton was the fourth editor of The Wall Street Journal, and he also believed in the Dow Theory. In fact, he was one of the first to use Dow’s principles to predict the rise and fall of the market. He used long-term trends of four years or more to gauge the tide of the market and whether it was rising or falling. He also looked at weekly and monthly movements and ripples created by daily price changes.
Hamilton was quite accurate in his market predictions, although notably, he did call the 1929 crash one and two years early. The third time he called the crash was in 1929 just three days before it happened in the weeks before he died.
Ralph Nelson Elliott
Accountant and author Ralph Nelson Elliott developed the Elliott Wave Principle, which states that investor sentiment naturally moves back and forth between optimism and pessimism. He developed his principle after studying 75 years’ worth of stock market movements, including charts with yearly to 30-minute price fluctuations. He began his study in the early 1930s.
Elliott initially published his theory in the 1938 book The Wave Principle. His belief was that as the overall mood of the market swings back and forth, it creates patterns which roll out in phases. These phases include the impulsive or motive phase, followed by a correction.
The impulsive phase rolls out in five waves of lesser degrees, again alternating between motives and corrections. The first, third and fifth waves are impulses, while the second and fourth waves are smaller retraces of the waves that came just before them. Corrections are separated into three smaller waves consisting of a five-wave impulse, a retrace and then another impulse. In the case of a bear market, the waves move mostly downward with five down waves and three up waves. Corrections always move against the motive or impulsive waves that precede them.
Elliott waves are still used today to predict patterns in the market. The concept assumes that market psychology informs trading patterns, which then appear on charts in waves. Elliott waves share some similarities with the Dow Theory, although Elliott took a more granular approach to studying the markets by focusing on “fractals,” which are even smaller scales that repeat infinitely.
William Delbert Gann
Trader WD Gann developed a number of tools for technical analysis, including the Gann angles and the Master Charts, which are comprised of the Square of Nine, the Hexagon Chart and the Circle of 360. His methods of forecasting the markets were quite different from Dow’s in that he based his ideas on geometry, astronomy, ancient mathematics and even astrology. Because of this fact, there is some controversy over the importance of his contributions to technical analysis.
Richard Wyckoff was one of technical analysis’ biggest success stories. He founded and edited the Magazine of Wall Street and worked as editor of Stock Market Technique. As his wealth grew, he purchased nine and a half acres of property next to General Motors industrialist Alfred Sloan in New York. He also had a passion for educating the general public on Wall Street.
As a trader and teacher about the stock market, he became curious about the logic behind the market’s movements. He interviewed and researched some of the most successful traders of his day and studied their methodologies. One of his areas of emphasis was on risk and reward. He emphasized the need for stop losses and control over risk for every trade.
His use of technical analysis identified methods of capitalizing on larger bullish and bearish trends. He also studied why and how professional traders buy and sell assets and came up with the idea for the Composite Operator. The concept basically just means that experienced traders should take into account the entire story as it appears on the ticker tape as if all of it came from a single mind.
He also developed the Wyckoff Stock Market Course, which has been updated over the years and is still maintained by the Wyckoff Stock Market Institute.
Investor Jesse Livermore was another success story of technical analysis, although his success did not last. He eventually committed suicide and died penniless after losing money in the 1929 market crash and due to several personal and legal issues. He also went bankrupt after the 1907 market crash. In fact, he had just about as many big losses as big wins in the stock market, which demonstrates how important it is to manage risk continually on all trades. The first time he went bust was after only about six months of trading.
Livermore’s story is especially interesting because it demonstrates that you are never too young to study and learn technical analysis. He started trading when he was only 15 years old after running away from home. He began working at a brokerage firm, Paine Webber, when he was 14, and he started writing down calculations to predict the market’s movements.
He made his first profit off the stock market by making bets at bucket shops, which were establishments that allowed people to gamble on stocks without actually buying or selling any shares. When he reached the point at which he was making more money gambling than he was working at Paine Webber, he quit his job there to focus on trading full time. He won so often that the bucket shops barred him from gambling anymore.
Even though Livermore went bust many times throughout his trading career, investors still study his methods today. His technique involved always trading with the overall market trend, and he never made a huge investment until after testing his idea to see if the market would move in the same direction he predicted it would. He came to be known as the Great Bear of Wall Street after the 1929 stock market crash. Some even blamed him for the massive crash due to the huge short positions he had built up through several stockbrokers.
Writer and trader John Magee was among the first to focus on stock charts and use them in his decision-making to track historical movements. He charted everything from individual stocks to trading volumes and averages. He studied these charts as he made decisions about what to buy and sell. He examined the charts for patterns and shapes like flags, shoulders, bodies, triangles and more and then used them to decide which stocks to buy or sell.
Magee often avoided news headlines about the market by simply not reading newspapers. He was apparently concerned about how headlines might interfere with the signals he identified on the trading charts.
He also wrote the 1948 book Technical Analysis of Stock Trends, which is still available for purchase today. The latest edition of the book includes several technical theories like the Dow Theory, reversal patterns, channels, trends and more.