Technical Analysis

A good point of view should have a directional view and should also include information such as:

• Price at which one should buy and sell stocks
• Risk involved
• Expected reward
• Expected holding period

Technical Analysis (also abbreviated as TA) is a popular technique that allows you to do just that. It not only helps you develop a point of view on a particular stock or index but also helps you define the trade keeping in mind the entry, exit and risk perspective.

Technical Analysis is a research technique to identify trading opportunities in market based on the actions of market participants. The actions of markets participants can be visualized by means of a stock chart. Over time, patterns are formed within these charts and each pattern conveys a certain message. The job of a technical analyst is to identify these patterns and develop a point of view.

Like any research technique, technical analysis stands on a bunch of assumptions. As a practitioner of technical analysis, you need to trade the markets keeping these assumptions in perspective.

Key points to be noted in Technical Analysis:

1. Trades – TA is best used to identify short term trades. Do not use TA to identify long term investment opportunities. Long term investment opportunities are best identified using fundamental analysis. Also, If you are a fundamental analyst, use TA to calibrate the entry and exit points
2. Return per trade – TA based trades are usually short term in nature. Do not expect huge returns within a short duration of time. The trick with being successful with TA is to identify frequent short term trading opportunities which can give you small but consistent profits.
3. Holding Period – Trades based on technical analysis can last anywhere between few minutes and few weeks, and usually not beyond that. We will explore this aspect when we discuss the topic on timeframes.
4. Risk ­– Often traders initiate a trade for a certain reason, however in case of an adverse movement in the stock, the trade starts making a loss. Usually in such situations, traders hold on to their loss making trade with a hope they can recover the loss. Remember, TA based trades are short term, in case the trade goes sour, do remember to cut the losses and move on to identify another opportunity.

Assumption in Technical Analysis:

1) Markets discount everything – This assumption tells us that, all known and unknown information in the public domain is reflected in the latest stock price. For example there could be an insider in the company buying the company’s stock in large quantity in anticipation of a good quarterly earnings announcement. While he does this secretively, the price reacts to his actions thus revealing to the technical analyst that this could be a good buy.

2) The ‘how’ is more important than ‘why’ – This is an extension to the first assumption. Going with the same example as discussed above – the technical analyst would not be interested in questioning why the insider bought the stock as long he knows how the price reacted to the insider’s action.

3) Price moves in trend –  All major moves in the market is an outcome of a trend. The concept of trend is the foundation of technical analysis. For example the recent upward movement in the NIFTY Index to 7700 from 6400 did not happen overnight. This move happened in a phased manner, in over 11 months. Another way to look at it is, once the trend is established, the price moves in the direction of the trend.

4) History tends to repeat itself – In the technical analysis context, the price trend tends to repeat itself. This happens because the market participants consistently react to price movements in a remarkably similar way, each and every time the price moves in a certain direction. For example in up trending markets, market participants get greedy and want to buy irrespective of the high price. Likewise in a down trend, market participants want to sell irrespective of the low and unattractive prices. This human reaction ensures that the price history repeats itself.