Fundamentals of Stock Market: Tutorial-4

Introduction to technical analysis

Earlier as we mentioned there are two methods to determine the price of stock: fundamental analysis and technical analysis. Fundamental analysis involves analyzing the characteristics of a company in order to estimate its value. Technical analysis takes a completely different approach; it doesn’t care one bit about the “value” of a company or a commodity. Technical people are only interested in the price movements in the market.

Despite hundreds of tools, technical analysis just studies supply and demand in a market in an attempt to determine what direction, or trend, will continue in the future. In other words, technical analysis attempts to understand the emotions in the market by studying the market itself, as opposed to its components. If you understand the benefits and limitations of technical analysis, it can give you a new set of tools or skills that will enable you to be a better trader or investor.

In this tutorial, we’ll introduce you to the subject of technical analysis. It’s a big topic, so we’ll just cover the basics, providing you with the foundation you’ll need to understand more advanced concepts down the road.

Definition of technical analysis

Technical analysis is a method of evaluating securities by analyzing the data generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security’s fundamental value, but instead use charts and other tools to identify patterns that can suggest future activity.

Just as there are many investment styles on the fundamental side, there are also many different types of technical traders. Some rely on chart patterns; others use technical indicators and oscillators, and most use some combination of the two. In any case, technical analysts’ exclusive use of historical price and volume data is what separates them from their fundamental counterparts. Unlike fundamental analysts, technical analysts don’t care whether a stock is undervalued - the only thing that matters is a security’s past trading data and what information this data can provide about where the security might move in the future.

The field of technical analysis is based on three assumptions:

1.     The market knows everything

2.     Price moves in trends.

3.     History tends to repeat itself.

4.     Market predicts the real economy before few months

1. The Market knows Everything

A major criticism of technical analysis is that it only considers price movement, ignoring the fundamental factors of the company. However, technical analysis assumes that, at any given time, a stock’s price reflects everything that has or could affect the company - including fundamental factors. Which means market knows the fundamental of the companies also it knows what’s going on inside the company. Technical analysts believe that the company’s fundamentals, along with broader economic factors and market psychology, are all priced into the stock, removing the need to actually consider these factors separately. This only leaves the analysis of price movement, which technical theory views as a product of the supply and demand for a particular stock in the market.

2. Price Moves in Trends

In technical analysis, price movements are believed to follow trends. This means that after a trend has been established, the future price movement is more likely to be in the same direction as the trend than to be against it. Most technical trading strategies are based on this assumption.

3. History tends to repeat itself

Another important idea in technical analysis is that history tends to repeat itself, mainly in terms of price movement. The repetitive nature of price movements is attributed to market psychology; in other words, market participants tend to provide a consistent reaction to similar market stimuli over time. Technical analysis uses chart patterns to analyze market movements and understand trends. Although many of these charts have been used for more than 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves.

Not Just for Stocks Technical analysis can be used on any security with historical trading data, this includes stocks, futures and commodities, fixed-income securities, forex, etc. In this tutorial, we usually analyze stocks in our examples, but keep in mind that these concepts can be applied to any type of security. In fact, technical analysis is more frequently associated with commodities and forex, where the participants are predominantly traders. Nowadays Institutes are spending billions of dollars on mathematical modeling which use various math techniques like regression, Curve fitting n differential equations to predict the market movements. Mathematical models are the future of technical analysis.

Now that you understand the philosophy behind technical analysis, we’ll get into explaining how it really works. One of the best ways to understand what technical analysis is (and is not) is to compare it to fundamental analysis. We’ll do this in the next section.

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