Introduction
Technical analysis is the examination of past price action, price movement and trading
volume behaviour to anticipate what price action is likely to occur in the future.
As opposed to fundamental analysis, technical analysis believes that the market
already factors in all available information related to the company and discounts
it in the current price level. Technical analysts use charts and graphs to analyse
the price and volume movement and behaviour over different time periods to identify
similar patterns of trading which are likely to occur again. Technical analysis
focuses on what is happening in the market rather than why is it happening. Technical
analysis considers the price action as paramount to help identify the dominant market
sentiment and discern patterns of trading that potentially indicate the way the
price is likely to move. Technical analysts use charts and graphs to visualize the
price movement to spot known patterns or formations that provide a clue to future
price movement.
Core Principles of Technical Analysis
The core principles of technical analysis are as follows:
- Market discounts all information in the price action: This principle
asserts that all the information that may be relevant for the stock price is already
factored in the price. This is in contrast to fundamental analysis which emphasizes
detailed analysis of financial information and finding the intrinsic or fair value
of a stock. Technical analysis considers the reaction of market participants and
the price that the market is willing to pay for a stock as more important.
- Price moves in trends and price movement is not random: another
core principle is that the price moves in trends. This means that if the price is
moving down, then it will continue to move lower, or conversely, if it is moving
up, it will continue to move higher, or it will move in a sideways or trading range.
This seems simplistic and self-evident. However, this is important as traders and
technical analysts buy and sell on the assumption of this continued movement in
the direction of the current trend. Unless there is a significant change in direction
of the price movement, this is expected to continue. Here is an example of a chart
that depicts price movement representing trends and trading ranges over a period
of time:
- “What” is more important than “why” for price movement:
Given the core principle of the market discounting all information in price, technical
analysts are more interested in what price action has occurred, rather than why
it has occurred. Therefore if the price of a stock has fallen by a large amount,
it is more important for technical analysis to understand how much is the movement,
the extent of the movement, the levels that may have been broken, etc., rather than
why the price has fallen.
- History tends to repeat itself: Technical analysts believe that
market participants repeat their behaviour and trading decisions. Such repeated
behaviour forms patterns that can be identified by visually plotting price action
on charts. This helps in analysing the price movement effectively.
- Volume is very important: Volume is of tremendous importance in
technical analysis since this is a reflection of the supply and demand for a stock.
Price action which is accompanied by high volume is more important than any price
changes on low volume. Therefore analysis of price movement is done considering
the volume of trading as well.
Approach and Steps in Technical Analysis
The approach for technical analysis is top-down and is similar to fundamental analysis,
although each analysis looks at different aspects:
- Broad market analysis: is done by technical analysts to examine
market indices which represent how the overall market is doing in terms of price
movement and dominant market sentiment. Therefore overall long term trends such
as a bull market or a bear market is determined by such broad market analysis
- Sectoral or industry analysis: is the next step which is done through
study of sectoral indices and the trends for the industries or sectors that they
are representing. Different sectors or industries may be exhibiting different trends
at the same time. Sometimes a sector may be bullish despite overall market being
in a bearish trend.
- Individual stock analysis: is the final step in which the trading
movement and patterns of the individual stock is analysed. Again each stock may
exhibit a unique trend by its price action and trading behaviour.
This analysis is done by plotting and visualising the prices over different time
periods. It becomes easy to identify the price trends and patterns on the charts
visually. Technical analysts use a variety of charts to distinguish formations and
patterns which might provide clues to future price changes. Therefore analysts hope
to be able to make the right trades to profit from such predicted future movements.
Chart based analysis is the primary tool used for technical analysis.
Here is an example of a stock chart which shows the price of the stock visualized
and plotted with the price over a time period. In addition, the volume of stock
traded and some additional information is also plotted as different lines and histograms.
Chaikin Money Flow (CMF) indicator plotted on the chart with 3 moving averages
Key Motive
Technical analysis is concerned with analysing price movements and price action
to discern trends and patterns that might help predict future price movement. Technical
analysts are interested in ascertaining the trend and direction of the price movement
and determining whether it will continue to move with the trend in future. The trends
could be short term or long term, and there could be different patterns. However,
the key idea is to understand the current movement and spot any patterns that exist
or may be forming to be able to predict the future trend in order to buy and sell
stocks to make a profit. The analyst tries to identify these likely patterns or
trends that help in providing entry and exit signals to capitalise and make a profit.
Concepts and Terms Related to Technical Analysis
Some of the key concepts related to technical analysis include:
- Support levels: are price levels where the stock finds support
and increased demand from buyers and the stock price tends to bounce back up from
these levels.
- Resistance levels: on the other hand are those price levels where
there is increased selling and the stock finds it difficult to cross those levels
and therefore falls back from these levels.
- Overall trend: is the dominant trend or direction of the price
movement in the market. This is also sometimes referred to the long term trend.
- Relative strength: shows the performance of the stock relative
to the market.
- Chart patterns: Chart patterns are distinctive patterns or formations
made by the price movement or in some cases by indicators derived from price or
volume information.
- Breakout: Breakout refers to the price movement when the price
breaks through the support or resistance level. Such instances are important as
they signal new trends being formed or reversal of existing trends.
- Momentum: This refers to the rate of change in price. Typically
stocks that are heavily traded and are often quite volatile in their price movement
are said to be momentum stocks.
- Volume: refers to the quantity of stocks traded. Volume plays a
very important role in technical analysis and therefore any price movement accompanied
by high volume is considered to be very important.
- Chart or graph: Charts or graphs are the main tool of analysis
for technical analysis. Charts allow the analyst or trader to visualise the price
action. While there are many types of charts, at its simplest a chart plots the
price on one axis and the time duration on another axis to show how the price has
moved over time.
- Chart types: Technical analysts use a number of different chart
types for analysis. Each chart provides a unique view of price or volume information
and is useful for identifying patterns or price movements. Some of the popular chart
types include: OHLC (Open High Low Close), Line Chart, Candlestick, Point and Figure,
Heikin Ashi, Renkor, Kagi charts.
- Overlays: refer to supplementary information that is overlaid or
superimposed on a chart to provide additional insight. Examples of such overlays
include support and resistance levels, trend lines, channels,
Moving Averages and the
Parabolic SAR.
- Indicators: refer to additional calculated values which are plotted
above or below the main chart in the form of oscillators, indicators, indices, etc.
Typically these are values that are derived by calculation and provide additional
insight on momentum, trends, demand and supply, volume, or market sentiment. Examples
of indicators include the
MACD,
Stochastic Oscillator,
Fractal Chaos Oscillator,
On Balance Volume and
Chaikin Money Flow.
Here is a chart showing support and resistance levels and how stocks break above
or below them:
Application of Technical Analysis
Technical analysis is used by traders to help take decision for trading including
entry and exit decisions. Since technical analysis examines price action and attempts
to identify patterns of trading behaviour, it can be applied to a wide range of
financial securities, and for different time periods. The analysis technique is
very versatile and can be applied at economy, sector or stock level. The core principles
and the desired insight remain the same. In all the applications, the technical
analyst examines the current price movement to determine levels or chart patterns
that might help to predict likely future movement in order to enter into trades
that will generate profit. The single minded focus of technical analysis on current
price movement and on market behaviour, demand and supply makes it relatively simple
and easy to follow, understand and apply.
Advantages
Technical analysis has some distinct advantages. These are discussed below:
- Clear focus on price action: The clear focus on price helps simplify
the analysis to reviewing the price action since the analyst is trying to anticipate
the price movement in the future. This does not need the level of knowledge and
understanding required for fundamental analysis, for example.
- Analysing supply and demand and effect on price: Technical analysis
focuses on the demand and supply for the stock and tries to ascertain the underlying
sentiment of the buyers and sellers. This helps to predict which way the market
may move. The analysis does not factor in any concept of intrinsic or fair value
or other such information.
- Automated through easy to use software: Another key aspect is that
a lot of the analysis can now be automated using computers and specialized software.
Therefore the earlier time consuming process of plotting charts and discerning signals
manually has been replaced by automation. Therefore charts can instantly plot the
price, volume and indicator information for fast analysis.
- Visual analysis: Charts are the primary tool for technical analysis.
Charts and graphs are much easier to analyse than large amounts of text or tables
of numbers. Almost all information is pictorially visualised through lines, bars,
indicators, overlays and patterns which are easy to remember, identify and use.
- Specific actionable recommendation: Another advantage of technical
analysis is that charts and patterns provide some clear buy and sell signals at
specific entry and exit levels.
Disadvantages
However, technical analysis also has some disadvantages:
- Subjective: Like fundamental analysis, it is open to interpretation
and is sometimes quite subjective. Therefore what appears as a pattern to one analyst
is often interpreted differently by another analyst.
- Oversimplification: One criticism of technical analysis is that
it oversimplifies market movements in the form of trends and patterns. This is not
fool-proof or guaranteed. Therefore relying on this can lead to trading losses.
- Patterns identified late: Sometimes the signals can only be identified
after the price has moved significantly and is therefore too late. Therefore relying
on such patterns or levels may not be profitable as the price action may already
have occurred by the time the pattern is identified.
- Analyst preference: Sometimes technical analysts can get too involved
with specific patterns, charts, levels, or stocks and therefore interpret the information
to suit their preconceived notions.
- Too many patterns, levels, indicators: Different analysts have
their preferred chart types, patterns, indicators, etc. Over time many different
chart types, patterns, indicators and strategies have been developed by different
analysts, authors and traders. This has led to a plethora of such tools and techniques.
Sometimes different tools and techniques give conflicting indications to future
price movement.
Conclusion
Technical analysis is a powerful and useful technique in understanding the price
movements of financial securities over different time periods. It has a clear focus
on price movement and price action and tries to identify repetitive patterns of
trading behaviour to profit from trading based on this insight. There are a wide
variety of tools and techniques used in technical analysis that help technical analysts
and traders. However, technical analysis should be used with caution as it is not
fool-proof. As with all analysis, a thorough study and understanding of the concepts
is needed. It can be useful for determining entry and exit levels for trades and
can also be used along with fundamental analysis.