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Introduction To Technical Analysis

INTRODUCTION TO TECHNICAL ANALYSIS

Learning objectives

After studying this chapter the student should be able to understand:

  • The basis of technical analysis
  • The strengths and weaknesses of technical analysis

What is Technical Analysis ?

Technical Analysis can be defined as an art and science of forecasting future prices based on an examination of the past price movements. Technical analysis is not astrology for predicting prices. Technical analysis is based on analyzing current demand-supply of commodities, stocks, indices, futures or any tradable instrument.

Technical analysis involve putting stock information like prices, volumes and open interest on a chart and applying various patterns and indicators to it in order to assess the future price movements. The time frame in which technical analysis is applied may range from intraday (1-minute, 5-minutes, 10-minutes, 15-minutes, 30-minutes or hourly), daily, weekly or monthly price data for many years. There are essentially two methods of analyzing investment opportunities in the security market viz fundamental analysis and technical analysis. You can use fundamental information like fi nancial and non-financial aspects of the company or technical information which ignores fundamentals and focuses on actual price movements.

The basis of Technical Analysis

What makes Technical Analysis an effective tool to analyze price behavior is explained by following theories given by Charles Dow :

  • Price discounts everything
  • Price movements are not totally random
  • What is more important than why

Price discounts everything

“Each price represents a momentary consensus of value of all market participants – large commercial interests and small speculators, fundamental researchers, technicians and gamblers- at the moment of transaction” – Dr Alexander Elder. Technical analysts believe that the current price fully refl ects all the possible material information which could affect the price. The market price refl ects the sum knowledge of all participants, including traders, investors, portfolio managers, buy-side analysts, sell-side analysts, market strategist, technical analysts, fundamental analysts and many others. It would be folly to disagree with the price set by such an impressive array of people with impeccable credentials. Technical analysis looks at the price and what it has done in the past and assumes it will perform similarly in future under similar circumstances. Technical analysis looks at the price and assumes that it will perform in the same way as done in the past under similar circumstances in future.

Price movements are not totally random

Technical analysis is a trend following system. Most technicians acknowledge that hundreds of years of price charts have shown us one basic truth – prices move in trends. If prices were always random, it would be extremely difficult to make money using technical analysis. A technician believes that it is possible to identify a trend, invest or trade based on the trend and make money as the trend unfolds. Because technical analysis can be applied to many different time frames, it is possible to spot both short-term and long-term trends.

“What” is more important than “Why”

It is said that “A technical analyst knows the price of everything, but the value of nothing”.

Technical analysts are mainly concerned with two things:

  1. The current price
  2. The history of the price movement

All of you will agree that the value of any asset is only what someone is willing to pay for it. Who needs to know why? By focusing just on price and nothing else, technical analysis represents a direct approach. The price is the fi nal result of the fight between the forces of supply and demand for any tradable instrument. The objective of analysis is to forecast the direction of the future price. Fundamentalists are concerned with why the price is what it is. For technicians, the why portion of the equation is too broad and many times the fundamental reasons given are highly suspect. Technicians believe it is best to concentrate on what and never mind why. Why did the price go up? It is simple, more buyers (demand) than sellers (supply).

The principles of technical analysis are universally applicable. The principles of support, resistance, trend, trading range and other aspects can be applied to any chart. Technical analysis can be used for any time horizon; for any marketable instrument like stocks, futures and commodities, fixed-income securities, forex, etc

Top-down Technical Analysis

Technical analysis uses a top-down approach for investing. For each stock, an investor would analyze long-term and short-term charts. First of all you will consider the overall market, most probably the index. If the broader market were considered to be in bullish mode, analysis would proceed to a selection of sector charts. Those sectors that show the most promise would be selected for individual stock analysis. Once the sector list is narrowed to 3-5 industry groups, individual stock selection can begin. With a selection of 10-20 stock charts from each industry, a selection of 3-5 most promising stocks in each group can be made. How many stocks or industry groups make the fi nal cut will depend on the strictness of the criteria set forth. Under this scenario, we would be left with 9-12 stocks from which to choose. These stocks could even be broken down further to find 3-4 best amongst the rest in the lot.

Technical Analysis: The basic assumptions

The field of technical analysis is based on three assumptions:

  1. The market discounts everything.
  2. Price moves in trends.
  3. History tends to repeat itself.

The market discounts everything

  • Technical analysis is criticized for considering only prices and ignoring the fundamental analysis of the company, economy etc. Technical analysis assumes that, at any given time, a stock’s price reflects everything that has or could affect the company - including fundamental factors.
  • The market is driven by mass psychology and pulses with the flow of human emotions. Emotions may respond rapidly to extreme events, but normally change gradually over time. It is believed that the company’s fundamentals, along with broader economic factors and market psychology, are all priced into the stock, removing the need to actually consider these factors separately. This only leaves the analysis of price movement, which technical theory views as a product of the supply and demand for a particular stock in the market.
  • “Trade with the trend” is the basic logic behind technical analysis. Once a trend has been established, the future price movement is more likely to be in the same direction as the trend than to be against it. Technical analysts frame strategies based on this assumption only.

History tends to repeat itself

  • People have been using charts and patterns for several decades to demonstrate patterns in price movements that often repeat themselves. The repetitive nature of price movements
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