Table of Contents Chapter 1 : Understanding Technical Analysis Chapter 2 :
Assumptions Of Technical Analysis Chapter 3 : Uses Of Technical Analysis
Chapter 1
Understanding Technical Analysis There are basically two different
methodologies for understanding the market and predicting its future trend. The
first one is called fundamental analysis and the second is technical analysis.
Fundamental analysis involves studying the financial position of a company, its
potential performance in the future, the book value of its assets and other
financial ratios. Thus, it analyses the share price with respect to the
fundamentals of a company and predicts the future price movements based on
the potential earning capacity. Fundamental analysis requires information about
balance sheets, cash flow statements, growth patterns and future plans of the
company. It also requires a study of the industry to which the company belongs
and the economies in which it has its businesses. All these parameters are
factored in while predicting the price movement of the scrip. On the other hand,
technical analysis is concerned with plotting patterns in the price movement of a
scrip and then predicting the future direction of its price. Thus, if a scrip is
witnessing a rise in its overall price trend, analysts may buy the scrip if it looks
like there is potential for a further price rise. However, if the underlying trend in
price is moving downwards, and remember that the trend may change from rise
to fall, it may be time to sell off your holdings so that you can reenter the market
when the price has fallen substantially. This way, analysts construct trading
strategies, i.e. decisions on when to enter and exit the market, based on the
underlying direction or trend the scrip is displaying. The important thing in
technical analysis is to understand charts and technical indicators which help to
forecast price movements. Technical and fundamental analysis are not mutually
exclusive and certainly do not have diverse objectives. Both approaches aim at
helping you to make a profit from your trading strategy and maximize your
returns on a consistent basis. Thus, an understanding of fundamentals as well as
technicals is imperative to develop a broad understanding of the market before
you make your moves. This book intends to explain the concepts related to
technical analysis in a simple and lucid manner so that even beginners can make
a start in the field. As the field of technical analysis is vast and the available tools
innumerable, once you are comfortable with the concept, you can gain deeper
insights into the exciting and rewarding field and develop your own trading
strategies. Let us first have a look at the definition of technical analysis.
Technical analysis can be defined as the process of evaluating the price of a scrip
on the basis of market variables such as price trends, traded volumes and open
interest, etc. Thus technical analysis tends to identify and predict trends at an
early stage of the cycle so that you can enter the market much before others
when past trends indicate future rise. Technical analysis also helps you to exit
from the market when trends indicate a reversing pattern and prices start to fall.
This early stage prediction can reap benefits as you buy the scrip when it is still
available at a relatively low price and are able to sell it off at a higher valuation.
In order to carry out technical analysis, data of the historic prices of a share and
volume of shares traded as available from stock exchanges is depicted by way of
charts and future trends are predicted based on past patterns. Thus, price and
volume constitute the two most important variables for technical analysis.
Generally, technical analysis is based on daily, weekly or monthly price and
volume movements as a tick by tick replay of the market, in terms of each and
every trade, is not available.
Chapter 2
Assumptions Of Technical Analysis Technical analysis is based upon certain
assumptions which must be kept in mind. These assumptions form the very
foundation of this method of analysis and need to be understood by learners and
practitioners alike while doing or using technical analysis. Following are the
assumptions followed in technical analysis:
The stock market discounts everything: One of the criticisms leveled
against technical analysis is that it does not consider the fundamental factors
such as financial position of the company, its future earning potential, book
value, reserves and other ratios while forecasting the market price. However,
technical analysis is based on the assumption that the stock market discounts all
these and other factors in stock prices and it is a reflection of the true or fair
price of the scrip based on company specific factors as well as general and broad
economic parameters, which have an effect on the market price. As the market
price is assumed to inherit all these factors, only price movement needs to be
analyzed, which is a matter of demand and supply of the scrip.
Stock prices move in trends: Trading strategies developed based on technical
analysis are based on the assumption that stock prices move in trends and such
a trend once established is regular and follows the pattern. In other words, stock
prices will not move away from the trend established based on technical
analysis. This directional movement of price is one of the important assumptions
on which technical analysis is based. This is because if price movements are
random and do not follow any pattern, there is no way to predict their future
trend.
History tends to repeat itself: This is another important premise of the whole
theory of technical analysis. In simple words, the assumption means that human
psychology of dealing with a particular situation does not change even with the
passage of time. Thus, in a bull run, the frenzy that takes the market to dizzy
heights will be repeated over and over again in all bull runs. So is the case with
bearish market, where traders and investors will continue to hammer valuations
even further down defying all logic and explanation. It is this repetition of
behavior that forms an important element of understanding technical analysis.
Chapter 3
Uses Of Technical Analysis An important element of technical analysis is to
find out the trend of price movements and plot it by way of a chart. This helps in
determining when the markets have peaked and when the direction will reverse
and start falling. One of the important benefits of this analysis is to time the
market with a fair amount of consistency. Thus, technical analysis can help you
to enter the market when it has touched the bottom or near about and also exit
when it peaks and a reversal in direction is expected. In a way, it provides great
profit making opportunities for investors, if they consistently follow patterns.
Another advantage of technical analysis is that it helps you develop your
strategies over different time horizons, such as short term, medium term,
weekly, monthly and so on, based on past trends observed. This way you can
plan your investment decisions well in advance and trade accordingly. It is also
possible to identify scrips which are most likely to outperform the market based
on past trends through technical analysis. Conversely, it pays well to exit the
laggards if they are consistently falling behind the market returns. Technical
analysis is useful not only in the stock market but in other markets also, such as
currency, commodities, futures and options and so on. It helps people to take a
position across different products and sectors based on past patterns and reap
the benefits when prices move on predicted lines. However, like all good things
in life, technical analysis is also not without imperfection. Technical analysis is
not a perfect science and it may fail in making the right predictions. Thus, you
should be careful in its application in real life situations, just the way you are
about your other decisions. Technical analysis can also fail at times. It pays well
to remember that it is a good idea to take into account a number of indictors or
trends while making your investment decisions. With its shortcomings
notwithstanding, technical analysis remains one of the most important tools for
predicting the future trends.