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5 Popular Technical Analysis Theories

Patrick Stockdale
Written by Patrick Stockdale | April 18, 2022

There are some common and frequently used theories in technical analysis that can be applied to help analyze the capital markets.

Each theory offers a unique perspective on technical analysis.

The 5 most popular theories in technical analysis are:

  1. Dow Theory
  2. Elliott Wave Theory
  3. Wyckoff Theory
  4. Hurst Cycles Theory
  5. Gann Theory

These are the main theories of technical analysis that new traders can learn to see it is useful for them to apply in their own trading or investing strategy.

1. Dow Theory

The Dow theory is a theory created by Charles Dow that states that the market is in an uptrend if one of the averages marks a higher high in the price while a higher high is simultaneously created in the other average.

It also states that the market is in a downtrend if the market marks a lower low in the price of two averages simultaneously.

The averages include the Dow Jones Industrial Average and the Dow Jones Transportation Average.

Dow Theory has 6 main tenets including:

  1. The market discounts everything: This is the belief that the markets reflect every possible factor that affects supply and demand.
  2. The market has three trends: Dow theory stipulates that the market has 3 trends, primary, secondary and minor.
  3. Major trends have 3 phases: Dow Theory indicates that there are 3 phases within a trend. The first is the accumulation phase, the second is the mark up phase and the third is the distribution phase.
  4. The averages must confirm each other: When one of the averages makes a higher high, the other average should also confirm by also making a higher high in the price.
  5. Volume must confirm the price trend: Any new price trend should be confirmed by large volume. Large volume signals institutional buying or shorting.
  6. Trends continue until a definitive reversal signal: This is the belief that a trend in motion tends to continue in that same motion until a clear sign of a trend reversal. In Dow theory, a trend reversal would be if both the averages simultaneously made a lower low or higher high.

2. Elliott Wave Theory

Elliott Wave theory, developed by Nelson Elliott, is a form of technical analysis theory that states that the price of financial markets moves in repetitive wave patterns in the longer term.

These waves relate to shifts and changes in investor sentiment over time.

Elliott wave theory indicates that financial markets move in two distinctive waves including:

  • Impulse Waves: These are price movements or waves that move in the same direction as the main trend. It consists of 5 smaller sub-waves within it.
  • Corrective Waves: These are price movements or waves that move against the main trend. It consists of 3 smaller sub-waves within it.

The Elliott Wave theory is used in many trading and investing strategies today.

3. Wyckoff Theory

The Wyckoff theory, developed by Richard Wyckoff, is a theory that outlines the various key elements in the market cycle of a financial market.

Wyckoff theory categorizes market cycles into 4 different market periods or phases including:

  • Accumulation Phase: This is the first phase where price action is trading sideways and large traders are building their positions in a financial market.
  • Markup Phase: This is the second phase where the price of a market is rising and traders attempt to bull any pullbacks of the bullish price trend.
  • Distribution Phase: This is the third phase where the price fails to break out to new highs and traders are taking profits on their trades. The price action is sideways or is in a rangebound environment during this phase.
  • Markdown Phase: This is the fourth phase where the price of the market enters a downtrend.

Wyckoff theory has three main laws(1):

  1. The Law Of Effort
  2. The Law Of Cause And Effect
  3. The Law Of Supply & Demand

Many traders incorporate Wyckoff theory with other technical indicators in their trading strategy.

4. Hurst Cycles Theory

Hurst cycles theory is a technical analysis theory developed by JM Hurst that provides a road-map of recurring trend changes at all time frames within financial markets

The objective of Hurst's cyclic theory is to identify when a low in the price of a market will occur with the timeframe for a prediction being dependent on the wave length of the market cycle being analyzed.

Hurst cycles theory consists of 8 principles (2):

  1. The Principle Of Cyclicality
  2. The Principle Of Commonality
  3. The Principle Of Summation
  4. The Principle Of Harmonicity
  5. The Principle Of Synchronicity
  6. The Principle Of Proportionality
  7. The Principle Of Nominality
  8. The Principle Of Variation

5. Gann Theory

Gann theory is a technical analysis theory developed by William D. Gann that states that the prices of financial markets move in various different angles and the price changes in financial markets are related to geometry.

Gann angles are based on the 45-degree angle, also known as the 1:1 angle.

The most common gann angles used are:

  • 2:1
  • 3:1
  • 4:1
  • 8:1
  • 16:1
  • 1:4
  • 1:8

The gann angles are used to help predict the future price movement in a capital market.

Conclusion

A new trader or investor should practice applying these technical analysis theories by using a demo trading account or trading simulator.

This allows for the learning of these technical analysis theories in a live market environment without risking real money.

Some of these theories are used in trading and investing strategies to this day.

A technical analysis theory can be useful in practice when used in conjunction with other technical analysis indicators and tools.