INTRODUCTION TO TECHNICAL
ANALYSIS
Learning objectives
After studying this chapter the student should be able to understand:
• The basis of technical analysis
• The strengths and weaknesses of technical analysis1.1 What is Technical Analysis?
1.1 What is Technical Analysis?
Technical Analysis can be defined as an art and science of forecasting future prices based on an examination of the past price movements. Technical analysis is not astrology for predicting
prices. Technical analysis is based on analyzing current demand-supply of commodities,
stocks, indices, futures or any tradable instrument.
Technical analysis involve putting stock information like prices, volumes and open interest
on a chart and applying various patterns and indicators to it in order to assess the future
price movements. The time frame in which technical analysis is applied may range from
intraday (1-minute, 5-minutes, 10-minutes, 15-minutes, 30-minutes or hourly), daily, weekly
or monthly price data to many years.
There are essentially two methods of analyzing investment opportunities in the security
market viz fundamental analysis and technical analysis. You can use fundamental information
like fi nancial and non-fi nancial aspects of the company or technical information which ignores
fundamentals and focuses on actual price movements.
The basis of Technical Analysis
What makes Technical Analysis an effective tool to analyze price behavior is explained by
following theories given by Charles Dow:
• Price discounts everything
• Price movements are not totally random
• What is more important than why
1.1.1 Price discounts everything
“Each price represents a momentary consensus of value of all market participants – large
commercial interests and small speculators, fundamental researchers, technicians and
gamblers- at the moment of transaction” – Dr Alexander Elder
Technical analysts believe that the current price fully refl ects all the possible material
information which could affect the price. The market price refl ects the sum knowledge of
all participants, including traders, investors, portfolio managers, buy-side analysts, sell-side
analysts, market strategist, technical analysts, fundamental analysts and many others. It
would be folly to disagree with the price set by such an impressive array of people with
impeccable credentials. Technical analysis looks at the price and what it has done in the past
and assumes it will perform similarly in future under similar circumstances. Technical analysis
looks at the price and assumes that it will perform in the same way as done in the past under
similar circumstances in future.
1.1.2 Price movements are not totally random
Technical analysis is a trend following system. Most technicians acknowledge that hundreds
of years of price charts have shown us one basic truth – prices move in trends. If prices were
always random, it would be extremely diffi cult to make money using technical analysis. A
technician believes that it is possible to identify a trend, invest or trade based on the trend
and make money as the trend unfolds. Because technical analysis can be applied to many
different time frames, it is possible to spot both short-term and long-term trends.
“What” is more important than “Why”
It is said that “A technical analyst knows the price of everything, but the value of nothing”.
Technical analysts are mainly concerned with two things:
1. The current price
2. The history of the price movement
All of you will agree that the value of any asset is only what someone is willing to pay for
it. Who needs to know why? By focusing just on price and nothing else, technical analysis
represents a direct approach. The price is the fi nal result of the fi ght between the forces of
supply and demand for any tradable instrument. The objective of analysis is to forecast the
direction of the future price. Fundamentalists are concerned with why the price is what it is.
For technicians, the why portion of the equation is too broad and many times the fundamental
reasons given are highly suspect. Technicians believe it is best to concentrate on what and
never mind why. Why did the price go up? It is simple, more buyers (demand) than sellers
(supply).
The principles of technical analysis are universally applicable. The principles of support,
resistance, trend, trading range and other aspects can be applied to any chart. Technical
analysis can be used for any time horizon; for any marketable instrument like stocks, futures
and commodities, fi xed-income securities, forex, etc
Top-down Technical Analysis
Technical analysis uses top-down approach for investing. For each stock, an investor would
analyze long-term and short-term charts. First of all you will consider the overall market, most
probably the index. If the broader market were considered to be in bullish mode, analysis
would proceed to a selection of sector charts. Those sectors that show the most promise
would be selected for individual stock analysis. Once the sector list is narrowed to 3-5 industry
groups, individual stock selection can begin. With a selection of 10-20 stock charts from each
industry, a selection of 3-5 most promising stocks in each group can be made. How many
stocks or industry groups make the fi nal cut will depend on the strictness of the criteria set
forth. Under this scenario, we would be left with 9-12 stocks from which to choose. These
stocks could even be broken down further to fi nd 3-4 best amongst the rest in the lot.
1.1.3 Technical Analysis: The basic assumptions
The field of technical analysis is based on three assumptions:
- The market discounts everything.
- Price moves in trends.
- History tends to repeat itself.
1. The market discounts everything
Technical analysis is criticized for considering only prices and ignoring the fundamental analysis
of the company, economy etc. Technical analysis assumes that, at any given time, a stock’s
price refl ects everything that has or could affect the company – including fundamental factors.
The market is driven by mass psychology and pulses with the fl ow of human emotions.
Emotions may respond rapidly to extreme events, but normally change gradually over time.
It is believed 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
“Trade with the trend” is the basic logic behind technical analysis. Once 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. Technical analysts frame strategies based on this assumption only.
3. History tends to repeat itself
People have been using charts and patterns for several decades to demonstrate patterns in
price movements that often repeat themselves. 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.
1.1.4 Strengths and weakness of Technical Analysis
1.1.4.1 Importance of Technical Analysis
Not Just for stocks
Technical analysis has universal applicability. It can be applied to any financial instrument – stocks, futures and commodities, fixed-income securities, forex, etc
technical analysis for trading 