Technical

Analysis: Basics

Technical Analysis Meaning:

Technical Analysis is a means of examining and predicting price movements in the
financial markets, by using historical price charts and market statistics. Technical
Analysis is a research technique to identify trading opportunities in the market
based on the action of market participants. Charts and its patterns over the time will
exhibit the actions of market with particular message. It is based on the idea that if a
trader can identify previous market patterns, prediction of future price may be
formed. Technical analyst employs many methods, tools and techniques; one of the
popular tools is a chart. Through charts price patterns and market trends are
identified.

Technical Analyst helps us to identify patterns and develop a point of view on the
actions of the market under certain assumptions listed below.

1. Market discounts everything: Stock prices quoted in the market are getting
adjusted to known and unknown information in the public domain. For
example: when finance minister presents budget in Indian parliament the
prices of stocks of a particular industry keeps dangling based on the
presentation made by the finance minister. Another example assume that
there is an insider who knows some information about inside details of
company buys large number of stocks secretly, the prices of these stocks
reacts.
2. The ‘how’ is more important than ‘why’: Technical analysis or analyst
would be trying to find reasons for changes in the prices of stock in the
market. For example; consider the example given above. Technical analyst
would not be interested to find out why the insider bought the stock instead
he would be interested to know how the prices reacted to the insider’s
action.
3. Price moves in trend: It is believed that the prices trend directionally like
up, down or sideways. Trend is the fundamental aspects of technical analysis
and it is assumed that all major moves in the market is an outcome of a trend.
Once the trend is established, the price moves in the direction of the trend.
For example the upward or downward movement in the indices from one
level to another level does not happen overnight rather it happens in a
phased manner over a period of time. Dow through Dow theory originally
propounded the basic definition of a price trend.
4. History tends to repeat itself: It is believed that investors collectively
repeat the behavior of the investors who preceded them and expected or
assumed that the market participants reacts to price movements in a similar
way, each and every time the price moves in a certain direction. This is what
called in technical analysis the price trend tends to repeat itself. For example;
when market has upward trend, participants get greedy and want to buy
 though the high price. Likewise, when prices move down, participants want
to sell irrespective of lesser prices. This human reaction ensures that the
price history repeats itself.



Expectations from Technical Analysis:
1. Trades: Technical Analysis is not to be used for identifying long term
investment opportunities instead it is to be used for identifying short-term
trades. Fundamental analysis is better for long-term investment
opportunities. Fundamental analyst can use technical analysis to calibrate
the entry and exit points.
2. Return per trade: Technical analysis would help to identify short term
trading opportunities, which can give small but consistent profits. Larger
return is not possible within a short duration of holding investment.
Technical analysis is based on trades usually short term in nature.
3. Holding Period: Technical analysis will help for the trade, which can last for
few weeks.
4. Risk: Generally participants in the market would initiate a trade for some
reasons; but when there is an adverse movement the trade would give loss.
Whereas trader would hold on to their loss-making trade with the hope to
recover the loss. But technical analysis based trades are short term, when
prices are not favorable; it would cut the losses and move on to identify
another opportunity.

Need for Market Summary:

Indian Stock Market is open from 09.15am to 15.30pm for a total period of 6 hour
15 minutes every working day; which would account for millions of trades. Every
minute there is a trade gets executed for every stocks listed in the stock exchange.
Therefore the question is as a market participant should we keep track of all the
different price point at which it is traded. It is practically not possible to have charts
with every trading points executed at a particular time; even it is graphed it will be
of no use as the graph will be cluttered with many points and therefore, there is a
need for a summary of the trading and not the details of all different price points.
This summary is possible by tracking the open, high, low and close price actions in
the market.

The Open Price: It is the first price at which the markets open for traded and
executed.
The High Price: It is the highest price at which a market participant is willing to
transact on the given day.
The Low Price: It is the lowest price at which a market participant is willing to
transact on the given day.
The Close Price: It is the final price at which the market closed for a particular day.
The close price indicates the strength of intra day and which is most important price
because it has to be compared with the opening price. If the close price is higher
than the open price it is a positive day, otherwise it will be a negative day. This close
price would be show the market sentiment and reference point for the next day’s
trading.
All these prices like open, high, low and close are the main data from the technical
analysis point of view. Each price would be plotted on the chart and analysed
individually to arrive at the investment decision.

Description and Characteristics:

Technical analyst using charts study technical indicators, moving averages and look
for forms. Through charts they search for archetypal price chart patterns like head
and shoulders or double top/bottom reversal pattern and forms like line of support,
resistance, channels and more formations like flags, pennants, balance days and cup
and handle patterns. They also widely use market indicators; some of which are
mathematical transformation of price; these indicators are used to help assess
whether an asset is trending and if it is trending to determine the probability of its
direction and of continuation. Technical analyst also looks for relationship between
price and volume indices and market indicators like moving average, relative
strength index, and MACD. They also study correlations between changes in Options
and put/call ratios with price.

Technical analysis has many techniques like Candlestick analysis; using one
technique would automatically ignore the salient features of other techniques and
therefore, many technicians combine elements from more than one technique. Some
others use subjective judgment to decide which pattern a particular instrument
reflects at a given time and other employ a mechanical or systematic approach to
pattern identification and interpretations.

Through recognition of chart patterns the technicians employs models and trading
rules based on price and volume transformations like Relative Strength Index,
Moving Averages, regressions, inter-market and intra-market price correlation,
business cycles, stock market cycles etc. The fundamental principle is that the
market’s price reflects all relevant information impacting that market and therefore,
technicians look at the history of a security trading pattern rather than external
factors like economic, fundamental and news events.


Right Approach: We have already seen in the previous sections that there are two
types of investors based on the period of their investment namely: short term and
long-term investor. Investors who are parking their money for the short duration is
called as short term investor and who keep them for long duration may be beyond
twelve months is called as long term investor. Short term investor would be
adopting top-down approach whereas long term investor would use bottom-up
approach.

Top-down Approach: It is a macro economic analysis to look at the economy in
general before focusing on individual securities. First an investor would focus and
analyze the economy and it is present day conditions to see whether economy is
down sliding or moving up to identify the policy and support of government. Then
investors would identify the sectors, which are favorable for investment in the given
economic conditions, and finally investor would analyze the company in particular
for buying stock. The principle aim is to have short-term gains not on the long term
valuations. For example; in the present day situation economy is sliding or not
growing by looking at the Gross Domestic Production (GDP); reasons for such
situation is very much evident that is due to Corona virus global economy is affected
and its impact is seen in Indian economy. Many sectors like travel industry, hotel
and hospitality industry, manufacturing firms are very badly affected. In this
juncture investor needs to identify the company for his or her investment.

Bottom up Approach: Under this approach, the investor would focus on individual
stocks instead of analyzing macroeconomic factors in the first instance. Here
analyses would help to identify the stock that appears fundamentally interesting for
potential entry and exit points. For example: an investor through analysis find an
under valued stock in the downtrend and determine the entry point through
technical analysis with an intension of holding them for long term view on their
trades.

Different types of traders prefer to use different forms of technical analysis for
example; day traders would be using simple trend lines and volume indicators,
whereas swing or position traders use chart patterns and technical indicators. Some
other traders who are using automated algorithms may have different requirements
for the use of combination of volume indicators and technical indicators.


Steps for technical analysis:

Step1: Identify a technical analysis strategy or develop a trading system.
The investor is expected to identify as a first step a strategy or develop a trading
system. For example; first time investor may take a strategy to follow a moving
average crossover on a particular stock price movement. Consider 50d ay and 200
day moving averages, if the short term 50 day moving average goes above the long
term 200 day moving average, then the investor would be buying the stock as it
shows an upward price trend and generated buy signal. The opposite of this true for
sell signal.


Step2: Identify tradable securities that fit with the technical strategy
Strategy mentioned above is ideal for highly liquid and volatile stocks not for illiquid
or stable stocks. Different stocks or contracts require different parameter choices.
For the above strategy different moving averages like a 15 day and 50 day moving
average would be the ideal ones.

Step3: Find the right brokerage account for executing the trades
Determine the correct trading account that will support the selected security like
common stock, penny stock, futures, options etc. The stock selected should be of
capable for tracking and monitoring by keeping costs low to avoid eating into
profits. For the above strategy, a basic account with moving averages on candlestick
charts would work.
Step4: Select an interface to track and monitor trades
Different levels of functionality are required for traders depending upon their
strategy. Day trader requires a margin account that would provide access to quotes
and market maker visibility. For the above strategy, a basic account is preferred
Step5: Identify any other applications that may be needed to implement the
strategy:
In order to maximize performances other features are needed. Some traders may
need mobile alerts or access to trading while others may be interested to take
advantage of automated trading system.

Advantages of Technical Analysis:

1. Helps to identify the signals for price trends in the market.
2. It works out a methodology for locating the best entry and exit points in the
market.
3. Technical analysis has created self-fulfilling trading rules.
4. More buyers and sellers are congregating through the use of same indicators
for finding support and resistance levels.
5. The quantum of data required for technical analysis is less than what is
required for fundamental analysis.
6. It is easier to time the entries and exits for trade using technical analysis as it
focuses on new trends and trend reversals.
7. Technical Analysis provides early signals and paints a picture about the
psychology of investors and traders regarding what they are doing.
8. It is quick and less expensive. It provides quick result for traders who use
1minute, 5 minutes, 30 minutes and 1 hour charts.
9. Technical Analysis provides lots of information and helpful for short term
trading, swing trading and long term investing. Charts provide a lot of
information that helps the traders and investors to build their positions and
take trades.


Disadvantages of Technical Analysis:

1. There is a possibility for unpredictable market behavior.
2. No definitive guarantee for any analysis like fundamental or technical
analysis, which will be accurate.
3. Historical price patterns give us an insight into an asset’s price trajectory but
no promise of success.
4. Traders should use a range of indicators and analysis tools to get the highest
level of assurance possible.
5. Always there is a need for risk management strategy in place to protect
against adverse movements.
6. Possibility to get mixed signals and two different indicators will provide
contradictory information. This will cause confusion in trading decisions.
7. Technical analysis do not do well with explosive trends and highly volatile
and illiquid markets and securities.