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

1.1 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 to 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 financial and non-financial aspects of the company or technical information which ignoresfundamentals 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

1.1.1 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 reflects 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 undersimilar circumstances in future.

1.1.2 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 fi ght 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, fi xed-income securities, forex, etc

Top-down Technical Analysis

Technical analysis uses 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 fi nd 3-4 best amongst the rest in the lot.

1.1.3 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.

1. 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 fl ow 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.

2. Price moves in trends

“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.

3. 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 is attributed to market psychology; in other words, market participants tend to provide a consistent reaction to similar market stimuli over time. Technical analysis uses chart patterns to analyze market movements and understand trends. 

1.1.4 Strengths and weakness of Technical Analysis

1.1.4.1 Importance of Technical Analysis

Not Just for stocks

Technical analysis has universal applicability. It can be applied to any fi nancial instrument - stocks, futures and commodities, fi xed-income securities, forex, etc

Focus on price

Fundamental developments are followed by price movements. By focusing only on price action, technicians focus on the future. The price pattern is considered as a leading indicator and generally leads the economy by 6 to 9 months. To track the market, it makes sense to look directly at the price movements. More often than not, change is a subtle beast. Even though the market is prone to sudden unexpected reactions, hints usually develop before signifi cant movements. You should refer to periods of accumulation as evidence of an impending advance and periods of distribution as evidence of an impending decline.Supply, demand, and price action Technicians make use of high, low and closing prices to analyze the price action of a stock. A good analysis can be made only when all the above information is present Separately, these will not be able to tell much. However, taken together, the open, high, low and close refl ect forces of supply and demand.

Support and resistance

Charting is a technique used in analysis of support and resistance level. These are trading range in which the prices move for an extended period of time, saying that forces of demand and supply are deadlocked. When prices move out of the trading range, it signals that either supply or demand has started to get the upper hand. If prices move above the upper band of the trading range, then demand is winning. If prices move below the lower band, then supply is winning. 

Pictorial price history

A price chart offers most valuable information that facilitates reading historical account of a security’s price movement over a period of time. Charts are much easier to read than a table of numbers. On most stock charts, volume bars are displayed at the bottom. With this historical picture, it is easy to identify the following:

• Market reactions before and after important events

• Past and present volatility 

• Historical volume or trading levels 

• Relative strength of the stock versus the index. 

Assist with entry point

Technical analysis helps in tracking a proper entry point. Fundamental analysis is used to decide what to buy and technical analysis is used to decide when to buy. Timings in this context play a very important role in performance. Technical analysis can help spot demand (support) and supply (resistance) levels as well as breakouts. Checking out for a breakout above resistance or buying near support levels can improve returns. First of all you should analyze stock’s price history. If a stock selected by you was great for the last three years has traded fl at for those three years, it would appear that market has a different opinion. If a stock has already advanced signifi cantly, it may be prudent to wait for a pullback. Or, if the stock is trending lower, it might pay to wait for buying interest and a trend Reversal. 

1.1.4.2 Weaknesses of Technical Analysis

Analyst bias

Technical analysis is not hard core science. It is subjective in nature and your personal biases can be reflected in the analysis. It is important to be aware of these biases when analyzing a chart. If the analyst is a perpetual bull, then a bullish bias will overshadow the analysis. On the other hand, if the analyst is a disgruntled eternal bear, then the analysis will probably have a bearish tilt. 

Open to interpretation

Technical analysis is a combination of science and art and is always open to interpretation. Even though there are standards, many times two technicians will look at the same chart and paint two different scenarios or see different patterns. Both will be able to come up with logical support and resistance levels as well as key breaks to justify their position. Is the cup half-empty or half-full? It is in the eye of the beholder. 

Too late

You can criticize the technical analysis for being too late. By the time the trend is identifi ed, a substantial move has already taken place. After such a large move, the reward to risk ratio is not great. Lateness is a particular criticism of Dow Theory.

Always another level

Technical analysts always wait for another new level. Even after a new trend has been identifi ed,there is always another “important” level close at hand. Technicians have been accused of sitting on the fence and never taking an unqualified stance. Even if they are bullish, there is always some indicator or some level that will qualify their opinion.

Trader’s remorse

An array of pattern and indicators arises while studying technical analysis. Not all the signals work. For instance: A sell signal is given when the neckline of a head and shoulders pattern is broken. Even though this is a rule, it is not steadfast and can be subject to other factors such as volume and momentum. In that same vein, what works for one particular stock may not work for another. A 50-day moving average may work great to identify support and resistance for Infosys, but a 70-day moving average may work better for Reliance. Even though many principles of technical analysis are universal, each security will have its own idiosyncrasies.TA is also useful in controlling risk It is Technical Analysis only that can provide you the discipline to get out when you’re on thevwrong side of a trade. The easiest thing in the world to do is to get on the wrong side of a trade and to get stubborn. That is also potentially the worst thing you can do. You think thatvif you ride it out you’ll be okay. However, there will also be occasions when you won’t be okay.

The stock will move against you in ways and to an extent that you previously found virtually unimaginable.

It is more important to control risk than to maximize profits!

There is asymmetry between zero and infinity. What does that mean? Most of us have very finite capital but infi nite opportunities because of thousands of stocks. If we lose an opportunity,we will have thousands more tomorrow. If we lose our capital, will we get thousands more tomorrow? It is likely that we will not. We will also lose our opportunities. Our capital holds more worth to us than our opportunities because we must have capital in order to take advantage of tomorrow’s opportunities.It is more important to control risk than to maximize profi ts! Technical Analysis, if practiced with discipline, gives you specifi c parameters for managing risk. It’s simply supply and demand.Waste what’s plentiful, preserve what’s scarce. Preserve your capital because your capital is your opportunity. You can be right a thousand times, become very wealthy and then get wiped out completely if you manage your risk poorly just once. One last time: That is why it is more important to control risk than to maximize profi ts!

How to know what to look for? How to organize your thinking in a market of thousands of stock trading millions of shares per day? How to learn your way around? Technical Analysis answers all these questions.

Conclusions

Technical analysis works on Pareto principle. It considers the market to be 80% psychological and 20% logical. Fundamental analysts consider the market to be 20% psychological and 80% logical. Psychological or logical may be open for debate, but there is no questioning the current price of a security. After all, it is available for all to see and nobody doubts its legitimacy. The price set by the market refl ects the sum knowledge of all participants, and we are not dealing with lightweights here. These participants have considered (discounted) everything under the sun and settled on a price to buy or sell. These are the forces of supply and demand at work.By examining price action to determine which force is prevailing, technical analysis focuses directly on the bottom line: What is the price? Where has it been? Where is it going?

Even though some principles and rules of technical analysis are universally applicable, it must be remembered that technical analysis is more an art form than a science. As an art form, it is subject to interpretation. However, it is also fl exible in its approach and each investor should use only that which suits his or her style. Developing a style takes time, effort and dedication,but the rewards can be signifi cant.