Technical Analysis: A Primer

Technical Analysis

History repeats itself

Technical analysis is all about studying patterns in historical market data, in order to
find out recognizable trends to predict future. This means charting historical market
data (price & volume) and trying to find out some repetitive patterns, and hoping that
it will again be repeated in future. By doing this, a technical analyst is actually
studying the market behaviour under various supply and demand scenarios.

“They are a reflection of the trend in the hopes, fears, knowledge, optimism,
and greed of market participants. The sum of total of these emotions is
expressed in the price level, which is, as Garfield Drew noted, “never what they
(i.e. stocks) are worth, but what people think they are worth”

Price of a stock depends on its supply and demand. If more people are interested in
buying ITC, compared to the number of people willing to sell ITC, its price will
increase. Technical analyst, while looking at historical patterns, is actually studying
different supply & demand scenarios and trying to figure out at what price, supply is
more than demand and vice versa. Suppose in a particular stock, the analyst is able to
locate a pattern of behaviour historically. He concludes that in the future, when the
same supply and demand scenarios play out, the stock price will once again behave as
it did historically. According to technical analysis, this will happen because people are
consistent in making their choices, when exposed to similar situations. So when they
are exposed to similar demand and supply situation, they will behave in exactly same
fashion as they did last time and as a result, stock will follow the predicted path.

Technical analysis helps you build a good POV (point of view) about the market. By
POV we mean it can help you in deciding good entry & exit points, holding period
and risk-reward ratios. It is best used for identifying short term trading opportunities
in the market, but is also used for fine-tuning entry and exit points of long term trades.
Thus, it is more about finding short term repetitive trading opportunities, to give you
consistent returns. One of the most important things to keep in mind is that in
technical analysis we are dealing with probabilities, not certainties. So it is a good
habit to practise it with strict stop losses.

Fundamental Analysis

Following the herd isn't always bad

As explained above, Technical Analysis deals with the study of historical patterns in
price and volume data. On the other hand, Fundamental Analysis requires examining
various characteristics (fundamentals) of a company and determining what should be
the price of its share. Once the price is determined, we can use this derived price to
compare it with the current market price. If the price determined through fundamental
analysis is lower than the current market price, then stock is currently overvalued and
price is supposed to come back to the fundamental price in long term. Thus, we should
sell the stock. On the other hand, we will buy a stock when the price determined
through fundamental analysis is more than the current market price, as we expect the
price to move towards fundamental value in the long term. Let’s take an example to
make this difference between fundamental and technical analysis clear.

Suppose you want to buy Bluetooth speakers. There are many brands available in the
market and you are not sure which one to pick. In this scenario, you have following
two options:

Option 1:

Visit the showrooms of all brands, try out different variants, do the bargaining and
finally buy the product when you are satisfied.

Option 2:

Go to any online shopping portal (market) and check out which model has received
highest rating. Online portals have this option where users can rate the model, based
on their personal experience after buying. In this process, you don’t need to go to each
showroom to bargain and try different variants. All the hard work is already done and
you just need to buy the product with highest rating, believing that users who have
rated the product have already done all the analysis and are happy with their purchase.
In this option, chances of you getting a good deal on Bluetooth speakers are very high.

Option 1 is similar to Fundamental analysis where you research few companies

thoroughly before making your decision. The advantage is that it will help you
understand business of the company where you are putting your hard earned money
and you will be more confident about your investment. At the same time, the problem
with this technique is that you can only research few of the companies and there is a
high probability that you might miss some of the best trading opportunities.

Option 2 is very similar to Technical Analysis where you look for patterns and
preferences in the market. The biggest advantage of this method is its scalability. You
can quickly and easily apply this method on various stocks and asset classes to pick

your investment. However, following the herd may not be a good strategy always 

Technical Analysis (ii)

Price reflects everything

Let’s try to understand more about technical analysis in this post. In our first post on
technical analysis, we introduced what technical analysis is and how it helps you make
a good point of view about any trade/investment. Here we will be focusing on
versatility of technical analysis and some assumptions which are used while applying
technical analysis.

Consider an analogy. Think about learning how to swim. Once you learn swimming,
you can literally swim anywhere. On the similar lines, Technical Analysis (TA) is the
skill you need to learn just once and you can apply this across different asset classes.
By asset classes, we mean stocks, bonds, currency, commodity etc. The underlying
concept of Fundamental Analysis will keep on changing, depending on the asset class,
whereas the basic concepts of Technical Analysis will remain same irrespective of the
asset class.

Before going into how it works and how it should be applied, let us look at some of
the assumptions used in the technical analysis

1. One of the most important assumption of Technical Analysis (TA) is that price
reflects everything. It means that price of a stock will contain all the
information and if you are analyzing it, then you don’t need to analyze other
factors. You must be thinking how this is possible, as there are many factors
like profit, balance sheet, management which affects a company. But technical
analysis assumes that just like you, other investors in the market also know
these things and have already studied these factors. Thus, as others already
know about these factors, the price has already changed to reflect it, assuming
that they would have already acted upon this information.
2. Technical analysis assumes that price movement follows a trend. Once a trend
is established, it is expected that price will move in the same direction, unless
trend changes. If using technical analysis you have concluded that a stock is in
uptrend, then the price will keep on increasing unless the uptrend is reversed.
We will be learning about finding and establishing these trends, in following
articles.
3. Technical Analysis believes that history repeats itself. This means that patterns
in stock price will keep on repeating themselves. The rationale behind this
assumption is that investors and traders behave in the same fashion, again and
again, when they are exposed to similar situations. So if there was some pattern
observed last time, when price of a particular stock crossed 52 week’s high, it
is likely that same pattern will be observed again because all the investors will
behave in the same fashion, as they did last time, to this information.

To establish trends and patterns, and analyze market movements, technical analysts
use charts. In the chapters ahead, we will be covering different types of charts used by
technical analysts and the process of identifying trends and pattern.