Technical Analysis Overview

Assumptions in the technical analysis of stocks

1. Market prices reflect all the information about a stock

Earlier, we said that fundamental analysis concerns itself with financial and other information about a stock. Technical analysis of stocks, though completely detached from fundamental analysis, works on a similar premise. If you are a technical analyst, you believe that all investors are aware of everything there is to know about a stock. They actually use this information when making buy/sell decisions. This information subsequently gets reflected in the stock’s price and ultimately the stock chart. This is why they only study chart patterns to gauge market trends, and not concern themselves with fundamental factors.

2. Stock prices follow trends

Technical analysis of stocks is based on the idea that each stock chart has its own unique trend. Prices move only within this trend. Every move in the stock price will indicate the next move. Let’s take the hypothetical example of a ripple. When you throw a stone in a pond, you know that consecutive ripples will get formed as soon as the stone hits the water. After a few ripples, the trend will die out. However, the next time you throw a stone, a similar ripple will appear again. Similarly, even for stock charts, you know the trend from past experiences. Naturally, the move in either direction may be larger or smaller than before, just like ripples. If you throw a larger or a smaller stone, ripples too will be larger or smaller respectively. However, the pattern of these ripples will not change dramatically.

3. Patterns tend to repeat themselves

The last assumption that validates a technical analysis is that trends are repetitive. In other words, suppose a stock chart moves in a hypothetical pattern- A-B-C. So, each time we reach ‘C’, we will again start from ‘A’, and then go to ‘B’ and eventually ‘C’. This pattern will repeat itself without fail.

Only once you make this assumption can you predict future stock prices based on technical analysis. Without this assumption, there is no way to tell where the price will go next by simply looking at a chart.

Important technical indicators for Technical Analysis

• Charts:
Price and volume charts are the most typical tools that are used as technical indicators for technical analysis. A volume chart depicts the number of shares of a company that were bought and sold in the market during a day. For the purpose of technical analysis, you may choose one of the traditional line or bar charts, or alternatively, use a candlestick chart. A candlestick chart is a special kind of chart that is particularly relevant for technical analysis. It is in the form of a series of consecutive candles. We will discuss candlestick charts in detail in the section on stock charts. Charts are used together with trendlines. Trendlines indicate the direction of movement of a stock over a period of time.

• Moving Averages:
Moving averages are calculated to remove sharp, frequent fluctuations in a stock chart. Sometimes, stock prices can move very sharply in a small period of time. This makes it hard to discover a trend in the stock chart. To remove the impact of this, and make a trend more prominent, an average of a few days price is calculated. For example, if a five-day pattern of a stock’s price is Rs.50, 53, 47, 45 and 52, it is difficult to tell the direction in which prices have actually moved. However, if you can calculate the average of these prices and compare them with the average of the next five days and the previous five days, you can ascertain a broad trend. This kind of moving average is called simple moving average (SMA). Other commonly used moving average concepts are exponential moving average (EMA) and linear weighted average (LWA). It may be noted though, that moving averages are calculated for longer durations. 9/20/50/100/200 days moving averages are more common.

• Momentum Indicators:
Momentum indicators are statistical figures that are calculated based on price and volume data of stocks. These technical indicators act as supporting tools to charts and moving averages. Once you are through with forming an opinion about a stock based on the other tools we have discussed, you can use these indicators to confirm your views. Some momentum indicators are signs that occur before the price move you expected occurs. They confirm that the price is indeed going to move as you thought it would. These are called leading indicators. Other signs come after the stock has started moving in a particular direction. They are called lagging indicators. They confirm that the stock will continue moving in this direction. Indicators are also used together with moving averages.

Conclusion

There will always be an element of market behaviour that is unpredictable. There is no definitive guarantee that any form of analysis – technical or fundamental – will be 100% accurate. Although historical price patterns give us an insight into an asset’s likely price trajectory, that is no promise of success. Traders should use a range of indicators and analysis tools to get the highest level of assurance possible, and have a risk management strategy in place to protect against adverse movements.