What is Technical Analysis in the Stock Market - First Demat

Everything that you must know about Technical Analysis in the Stock Market

Technical Analysis is a trading discipline that predicts the direction of stock prices by studying market data history. This can include studying related elements such as volume, price movement, etc. Often, it is required to generate the majority of the short-term trading signals to help estimate the stock’s strength and weakness in comparison to the market at the broader level.

It is mostly applied to price changes, but also applied in trading volume and open interest figures.

Core Idea

In short, the prime aim of technical analysis is to forecast market behavior, based on which a trader can decide to invest matters and gain financial profits.

Why should you know Technical Analysis?

Suppose you want to invest your money in a company but can’t decide on the company. In that case, you will try to know more about it using news, discussing with your colleagues, etc. But won’t be able to decide because you lack information. Here, technical analysis comes into play to connect the dots you want to. After knowing the past market trends of a company with other characteristics, you might be able to decide which company you will invest in. 
So, let’s start knowing about it, starting with its assumptions.
 
Underlying Assumptions

1.The market discounts everything
 It means that a company's stock price indicates or prices out all the components that can affect that company in a given time frame. This includes all its fundamental factors and broad economic factors like market psychology.
2. Price moves in trends
 It means that regardless of the time price is being observed, it is more expected to follow a past trend than being against it or move erratically.
3. History tends to repeat itself
According to this, the nature of price movement is repetitive and accounted by market psychology, which is based on human emotions. This is treated as predictable. Therefore, the technical analysis examines its trend using chart patterns and subsequent market movements.

Ways to approach Technical Analysis

There are mainly two different ways to approach technical analysis:

1. Top-Down
 This approach focuses on the overall economy before individual stocks. It is used to emphasize short-term gains over long-term. Thus, based on a macroeconomic view.
2. Bottom-Up
 Contrary to the above approach, this approach focuses on individual stocks over the overall economy. It is opposite to the macroeconomic view.

Steps to do Technical Analysis of Stocks

 1. Understand all assumptions 
  At times people don’t pay much attention to the assumptions and jump forward. Remember that assumptions not only reflect limitations but also  help to understand the underlying concept. So, understand them well first.

 2. Identify trends via charts and graphs of stock prices
  It helps to identify the trend of prices. 
  How to identify trends?
  Spotting trends involves observing trend lines. These are lines that are obtained when we join the successive highs and lows each in a stock price vs. time chart.
  After getting the trend lines, the next step is to observe the type of trend.
 
  Various types of trends

  Uptrend 
  In this, successive highs and lows increase.
  Downtrend 
  In this, successive highs and lows decrease.
  Horizontal    
  In this, successive highs and lows don’t change much relative to corresponding to previous values.

3.Learn about specific phrases for patterns on charts 
  Doing this will save your time as you don’t need to give time to repeat individual details.

Examples:
A Head and Shoulders pattern indicates the reverse of a trend.
A triple top pattern indicates three failed attempts that lead to a trend reversal.
Other patterns include Cup and Handle patterns, Double top patterns, Triangle, Wedge, and Flag patterns.

4.Understand concepts of Support and Resistance  
Support is the lowest price a stock reaches before buyers come in and drive the price up.
Whereas, resistance is the highest price a stock reaches before the owner sells their shares and causes the price to fall again.
Knowing these helps to confirm the trend’s existence and identify when the trend reverses itself.

5.Notice the volume of trades
The movement of trade volume with respect to price indicates the validity of a trend or if it’s reversing itself.

6.Use moving average to filter out minor price variation
 A moving average is a series of calculated averages measured over successive, equal time periods. It removes insignificant highs and lows and makes it easier to see overall trends.

7.Use indicators  
 They support the trend information and add another factor to your decision to buy or sell stocks.

Types of Technical Analysis

There are two principal types of Technical Analysis:

Chart patterns
In this subjective form of technical analysis, technicians see and observe different patterns on a chart and identify the areas of resistance and support. These patterns predict where the price is headed, following a breakout from a specific price point and time.

Types of Charts

Many types of charts are used for the technical analysis of stocks. Some of them are:

Line Chart: These are the most basic form of charts. In this, a single line that moves from left to right links the closing prices. Usually, only the closing price is graphed and a single point represents the closing price. It doesn’t provide much insight into intraday price movements.

Bar Chart: It is also called open-high-low-close (OHLC) charts. In this, a series of vertical lines indicate the price range during that time range. They help traders discover patterns because this chart takes open, close, low and high, all prices into account. In this, the horizontal dash on the left side of the horizontal line represents the opening price, whereas dash in the right side of the line indicates the closing price. Moreover, the line is often coloured black or green, if the closing price is higher than the opening price. In the opposite case, it is represented in red.

Candlestick Chart: This chart is named so because the component that shows price looks like a candlestick. It has a thick body with a line extending above and below it, respectively known as upper shadow and lower shadow. 
In this, the top of the upper shadow and the bottom of the lower shadow represents the high and low price respectively. This type of chart has the most significance at the top of an uptrend or the bottom of a downtrend. These are the cases when the patterns often indicate a trend’s reversal.However, a drawback of these charts is that they take up more space than the OHLC charts.

Technical Indicators 
These are a statistical form of technical analysis. In this, technicians apply several mathematical formulas to derive a series of data points from past prices, open interest data, and volume. Different indicators focus on determining different information, and depending on that they can be grouped into 3 main categories:

Trend-following indicator: They are used to measure the strength and spot the trend of a trading market. Popular trend-following indicators consist of moving averages, MACD, and the ADX.

Momentum indicators: They are used to measure the strength of recent price moves in comparison to previous periods. They fluctuate between 0 and 100, providing signals of overbought and oversold market conditions. They return a selling signal when prices start moving strongly higher. This might be profitable in ranging markets but returns false signals during strong trends. Examples: the RSI, Stochastics, and the CCI.

Volatility indicators: They measure the volatility of the underlying instrument. It is a crucial tool for today’s trading because the traders are usually chasing volatility across different markets and find profitable trading opportunities. Its examples are the ATR indicator and Bollinger Bands. 
   
Difference between Technical and Fundamental Analysis

Fundamental analysis and Technical analysis are important finance subjects. But these are on opposite sides when it comes to approaching the markets.

Differences in beliefs about the best approach
In technical analysis of stocks, the best approach is to follow the trend as it forms through market action, whereas in fundamental analysis, it is believed that the market overlooks value.

Differences in point of focus
Technical analysis focuses on historical price trends, whereas fundamental analysis focuses on the company’s financials.

Differences in underlying assumptions
The technical analysis primarily assumes that a stock’s price already reflects the company’s fundamental factors and focuses on statistical price analysis, while fundamental analysis analyses the company’s financial statements to determine fair business value.

Differences in considered inputs 
Technical analysis has only stock’s price and volume as inputs because it assumes that all factors are factored in stock price. On the other hand, fundamental analysis involves the study of all factors, and the economy and industry conditions are taken into consideration.

Differences in time approach
Fundamental analysis is a long-term approach, whereas technical analysis is a short-term approach.

Do’s and Don’ts in technical analysis 

Do’s

Know about its history 
This might sound counterintuitive, but it’ll help you to understand how it was used in the early days.

Specify entry and exit levels 
Use technical analysis as a tool to fix specific entry and exit points before making investments.

Use two or more indicators
It is recommended because two or more indicators can help confirm your findings. However, they may challenge your original assumptions also. In both ways, it will help you learn about them.

Measure risks
On learning the way to study charts properly, you can start to determine the amount of risk you can take on each trade and the ideal risk to reward ratio.

Don’s

Don’t complicate the process
Don’t guess and use technical analysis without understanding it.

Don’t use it to get rich quick
Technical analysis is a tool used in trading for a firm purpose. Don’t use it with the purpose of becoming rich quickly.

Don’t take shortcuts
Don’t jump to conclusions without studying the product’s price history.

The notion of a magical indicator
Don’t think that one indicator will always work.

Benefits of Technical Analysis

Saves time
As technical analysis assumes that all factors are already priced into the market, one spends less time on irrelevant data and spends more time on execution, focusing profits, and managing losses.

Inexpensive
Technical indicators are relatively inexpensive. It can be used by one person up to the desired end for more analysis and strategy creation.

Based on strategy
Without using technical analysis, traders would depend on news and fundamentals. But, using it, one can systematically understand the way to place and close their position.

Limitations of Technical Analysis

History doesn’t repeat itself exactly
A major point of criticism about technical analysis stems from its assumptions. History doesn’t repeat itself exactly. Price pattern study is doubtful. So, it can be neglected and prices can be better modeled when assumed that it will move randomly.

The two considered factors don’t always give necessary information
The assumption that the market discounts everything has pitfalls. Some analysts don’t expect that historical data and volume consist of any crucial information.

Self-fulfilling prophecy
It works in some cases because it has a self-fulfilling prophecy. At times, it leads to short-term selling pressure on traders. In this case, it has little control to determine the stock’s price after weeks or months from now.

Conclusion

You might have understood about technical analysis to a good extent by now. However, finance is a vast field and you can’t expect to know everything about it in just one article. So, here are some books and courses that will help you understand and use them to the maximum extent.

Best books for Technical Analysis

Getting Started in Technical Analysis by Jack Schwager 

Technical Analysis Explained by Martin Pring

Technical Analysis of the Financial Markets by John Murphy

Technical Analysis By Using Multiple Timeframes by Brian Shannon

How to Make Money in Stocks by William O’Neil

You can also learn about it via any technical analysis course. Just do a little research about the course before enrolling yourself.

Practice and develop your skills
It can’t be emphasized much. No skill can be developed without practice. So, apply the principles you have learned through backtesting to see your learnings.