Technical Analysis is a study of the past price movements to predict the future price trend. This means that the past direction of prices of a share (determined by the market forces known as ‘demand’ and ‘supply’) tells us how the share is going to move in the future, as well as the reasons, fundamental or technical, which can lead to a rise or a fall in the share price. For example, if a company is expected to post good results, it will be reflected in a corresponding rise in its share price, owing to buying by the informed investors. The opposite of this also is equally true. In this case, what is largely at play or responsible for the share price movements is one or more fundamental factors. But technical factors, mainly governed by the Laws of Demand & Supply, can also lead to sharp movements in share prices. These factors, closely linked to human mind or emotion, work on mass psychology. The theories of technical analysis are based on the concept that under a given set of circumstances almost all minds tend to work in the same direction. And these theories, more often than not, help in correctly predicting share price movements.
Although technical analysis has been in practice in the West as well as some Asian countries like Japan for more than 150 years, it has become popular in India only in the last 10-15 years. The oldest branch of technical analysis, candlestick techniques, was used by Japanese traders as early as in the 18th century. Modern technical analysis has been developed around Dow Theory. And technical tools and theories have been further enhanced in the past couple of decades with the advances in computer technology.
This study of share price movements is primarily based on the concept: “history repeats itself”. The repetitive nature of price movements is attributed to market psychology. In other words, market participants reaction to similar market stimuli is consistent over time. Technical analysis uses chart patterns to analyse market movements and understand trends. Though many of these charts have been used for more than 100 years, they are believed to be still relevant because they illustrate patterns in price movements that often repeat themselves.
The market is considered a primary indicator that generally leads the economy by six to nine months. So, if the objective is to keep pace with the market and predict the future price trend, it makes sense to focus on price movements. And by doing so, technical analysts automatically focus on the future. More often than not, change is a necessity. Even though the market is prone to sudden knee-jerk reactions, it usually sends out hints before significant movements. A technical analyst refers to periods of accumulation as a sign/signal of an impending advance and periods of distribution as a sign/signal of an impending decline.
Many technical analysts use the open, high, low and close for a security over a specific timeframe while analysing its price actions. Every bit of information gleaned from the market behaviour, when taken separately, tells something, if not much. However, taken together, bits of information such as the open, high, low and close reflect the forces of supply and demand. Share/security prices are driven by supply (down), which is synonymous with bearish/selling, and demand (up), which is synonymous with bullish/buying. Typically, higher prices reflect increased demand and lower prices reflect increased supply.
Simple chart analysis can help identify support and resistance levels, which represent key junctures where the forces of supply and demand meet (covered in detail later). These are usually marked by periods of congestion (trading range) where the prices move within a confined range for an extended period, telling us that the forces of supply and demand are deadlocked. When prices move out of the trading range, it signals that either supply or demand has started gaining the upper hand. If prices move above the upper band of the trading range, demand (bulls) wins and if they move below the lower band, supply (bears) wins.
A price chart presents plenty of valuable information even to a tried-and-tested fundamental analyst. It is an easy-to-read historical account of a security’s price movement over a period of time. On stock charts, which are much easier to read than a table of numbers, volume bars are generally displayed at the bottom. This historical picture makes it easy to identify the following:
Technical analysis can help investors time a proper entry point. Some use fundamental analysis to decide what to buy and technical analysis to decide when to buy. No doubt, timing can play a key role in investors performance in the market. And technical analysis can help them recognize demand (support) and supply (resistance) levels as well as breakouts. Simply waiting for a breakout above resistance or buying near support levels can help investors improve returns on their investment.
To sum it up, Technical Analysis
Although there are some universal principles and rules that can be applied, technical analysis is more of an art than a science. As an art form, it is subject to different interpretations. Besides, it is flexible to approach: every investor should use it the way that suits his or her style. Developing a style takes time, effort and dedication, but its rewards can be significant.