What is Technical Analysis ?

Introduction to Technical Analysis:

Technical Analysis is the past study of market action, primarily through the use of charts, for the purpose of anticipating future price trends. It is a method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. In short, Technical Analysis studies the supply and demand in a market, in an attempt to determine what direction or trend will continue in the future. It tries to gauge the emotions of the people trading in market, and tries to find out the possible course of movement going ahead. There are lots of things which can be studied under technical analysis and people use it in different ways depending on their needs and understanding. Some use chart patterns, some use candlestick patterns, some use only indicators, and some use the combination of these.

Assumptions:

There are 3 main assumptions on which Technical Analysis is based:

1) The Market Discounts Everything

2) Prices Move in Trends

3) History tends to repeat itself

The Market Discounts Everything:

A major criticism of technical analysis is that it only considers price movement, ignoring the fundamental factors of the company. However, technical analysis assumes that, at any given time, a stock's price reflects everything that has or could affect the company -including fundamental factors. Technical analysts believe 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, and rest all is already discounted in the market already.

Prices Move in Trends:

In technical analysis, price movements are believed to follow trends. This means that after 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. Most technical trading strategies are based on this assumption. The whole purpose of charting the price action of a market is to identify trends in early stages of their development for the purpose of trading in the direction of those trends. There is a corollary to the premise that prices move in trends-a trend in motion is more likely to continue than to reverse.

History Tends to Repeat Itself:

One of the most important assumptions which Technical Analysis follows is that history keeps repeating itself and things which happened in the past would probably happen again in coming times. Most of the part of technical analysis is related to study of human psychology. Chart patterns, for example, which have been identified and categorized over the past one hundred years, reflect certain pictures that appear on price charts. These pictures reveal the bearish or bullish psychology of the market. Since these patterns have worked well in the past, it is assumed that they will continue to work well in the future. They are based on the study of human psychology, which tends not to change. Another way of saying this last premise: that “History repeats itself”, is that the key to understanding the future lies in a study of the past, or that the future is just a repetition of the past.

Why Technical Over Fundamentals ?

Fundamentals have some flaws such as :

1) It is for long term, and it does not define what long term is.

2) It does not quantify risk, i.e stop loss, which technical analysis does.

3) Lets take this example, A company which is listed may come out with its quarterly numbers every quarter, but of course the price of the stock would change every day the stock is traded, and hence it is necessary to gauge people's sentiments on a stock, which Technicals will help you.

4) In short, just see this following flow -

If you see, once the fundamentals are found out, valuations are done, there is perception about the company, which leads to volumes, and which finally lead to PRICE . So, clearly Price and Volumes are at the top of the pyramid, and this is what Technical Analysis is all about, directly focussing on the top of the pyramid, which is of utmost importance.

Advantage of Technical Analysis:

1) In fundamentals, you are only focussed on a particular sector, or few sectors, but Technicals once learnt can be applied to any sector, any asset class (commodities, equities, currencies, etc).

2) You can short in the market on negative view.

3) Technicals can give you 360 degree view of all markets which are traded.

4) There are lot of stocks which can be viewed and analysed and opportunities can be found out, unlike fundamentals.