on the 4-Hourly USDCAD Bar Chart.
Source: MetaTrader 4
Refer to Figure 1.26. Here is the same chart of the USDCAD again. But this time, we see the underlying beauty and symmetry of price, tempered and forged by the expectation, psychology, biases, and emotions of all market participants. To a trained eye, a simple chart of price action is as beautiful as any work of art. For technical analysis is, in itself, an art.
Figure 1.26 Underlying Market Symmetry on the 4-Hourly USDCAD Bar Chart.
Source: MetaTrader 4
1.6 BASIC ASSUMPTIONS OF TECHNICAL ANALYSIS
Technical analysis is based on a few fundamental assumptions. The first assumption is that market action, which includes price action, reflects all known information in the markets. The market discounts everything except acts of God.
This means that the markets can only discount:
• Known information
• Expectations about known information
• Expectations about potential events
The market cannot discount:
• Unexpected events
• Unknown information
Market action is representative of the collective trading and investment decisions of all market participants, which directs the flow of supply and demand in the markets.
This implies that the technical analyst need only refer to the charting of market action, since all known information and expectation about such information has already been discounted by the markets. The actual cause or underlying reason driving demand or supply is irrelevant, as it is only the effect of such action that really matters, that is, prices rising or falling.
Some detractors of technical analysis contend that the assumption that all information is absorbed or discounted by the market is flawed. They argue that, with the exception of illegal insider trading, price cannot possibly discount an unexpectedly large block purchase of shares in the market before it occurs. The detractors are in fact perfectly correct in their contention, except for the fact that the markets do not actually discount unknown information or unexpected events. The market can only react to what is known or expected, which includes insider activity. It does not react to what is unknown or unexpected. Although insider information is nonpublic, it is still considered to be known information, since the action of insider buying and selling impacts market action and as such represents information in the markets.
It may be more realistic to think of the market as in a continuous process of assimilating and adjusting to new market information, rather than an unrealistic full-blown discounting of all information instantaneously.
What Are the Markets Really Discounting?
It is not merely news, economic releases, or corporate data that the markets are discounting. The assumption is that it discounts everything. This includes:
• Information about actual events
• Expectation about actual events
• Information about expected events
• Expectation about expected events
• Expectation about the possibility of unexpected events
Some also argue that there are many other forms of discounting like buying the rumor and selling on the fact. They are curious as to what the expectation should be in such a case. Should the expectation be that prices will appreciate once the good news is released or should the expectation be that prices will fall once the good news is public knowledge (since everyone is in fact selling on good news)? How would we know if the market is discounting the:
• Rumor itself
• Expectations about the rumor
• Expected good or bad news
• Actual news
In reality, the market discounts all of the above. Regardless of what the markets are discounting, be it quantifiable or otherwise, the end result is that price and markets action will ultimately reflect the collective expectation of all participants.
Market Discounting versus EMH
Efficient Market Hypothesis (EMH) states that for a market to efficiently discount and reflect all information perfectly, all of its participants must act on all information in the same rational manner instantaneously. Does this definition of EMH also apply the basic assumption in technical analysis that the market discounts everything?
Detractors of EMH contend that the act of discounting everything is not realistic or is largely impossible. They argue that the problem lies in the action taken by the participants. Not all participants will react to the same event or information in the same way, and in fact, some participants may act on it in a contrary fashion, that is, shorting the market rather than going long. They also argue that not all of the participants will react at the same time. Some will take preemptive action or act in anticipation of the event while other participants will act during the actual receipt of the information. There will also be participants who may react long after the information is released. Hence, trying to achieve a certain level of coordinated action for efficient discounting will be virtually impossible.
The detractors of EMH also contend that for the markets to discount all information effectively, all participants must have access to that information and must act on it. The market will otherwise be unable to discount or reflect all information effectively. This requirement itself presents a difficult challenge. They argue that it is virtually impossible to get all of its participants to act on all of the information. It is also unrealistic to expect all participants to have access to that information, and even if they do, we cannot expect the participants to be standing by at all times in readiness to act on such information. They further argue that information is never free. It is unrealistic to expect that all participants are able to afford the information, let alone all information.
There is a very subtle difference between efficient discounting in EMH and basic market discounting in technical analysis. As far as market discounting in technical analysis is concerned, there is no requirement of perfect efficiency except for the requirement that it discounts everything that becomes known to it, which includes the sum total of all actions taken by its participants, be it in a timely or untimely, rational or irrational fashion. Market action itself represents the ultimate truth and is a direct consequence of the market discounting all information known to it, regardless of whether the information is perfectly efficient or otherwise. The market continues to discount all information and expectations of such information as and when it unfolds and becomes known to the market. The term efficiency therefore, as far it applies to the basic assumption in technical analysis, refers to very act of discounting all information as it becomes known to the market, regardless of the type, quality, or speed at which it receives the information. For the technical analyst, price is (always) king and represents the ultimate truth in the market. The markets are never wrong. All market action is considered perfect and efficient under the basic premises of technical analysis. Hence, we see that the term efficient does not carry the same meaning or implications as in the case of EMH. In EMH, efficient has a very specific meaning.
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