One fine morning, one of my friends called me out as it was his first day of trading and I was there to help him in technical analysis.
The very first question he asked was how these chart patterns and technical indicators can help forecast the price conditions.
What actually works behind the concept of technical analysis that traders are able to examine and identify the market conditions?
This lets me frame this article.
So, come with me to know why technical analysis can be beneficial and worth trying before investment.
Technical analysis, I would say is the Key tool to measure stock price and the trend it is following or may follow in future. It involves an intense study of market action with the help of various mathematical tools like graphs, charts, indicators and chart patterns.
It is a technique of forecasting the market action and price trend and in return will help you to make secure entry and exit from the market. The whole concept is to ensure proper timing, with a belief that market works more on timings than on anything else.
When I said these all things to my friend he laughed and said “OK fine I agree but what if I wish to invest for long term. Will technical analysis be helpful.”
Even Long Term investors need technical analysis
I admit that technical analysis contradicts with fundamental analysis, where one examines the fundamentals of a company like earnings, balance sheet, dividends, cash flow, management and estimates the price worth of stock.
Through technical analysis, one cannot determine the intrinsic value.
If you wish to use technical analysis you can make money from the trend which can be estimated and involving observation of financial market over past years and hopes that trends will repeat in future.
But then what makes long-term investors who follow fundamental analysis to analyze trend through technical indicators.
Despite all the information provided in the fundamental analysis it won’t help you to estimate the best time you should enter the market or will not help you to know its behavior and despite good intrinsic value, you may face loss in your trade.
So whether you are long-term investor or short-term trader technical analysis is a must tool each of us needs to follow.
Professional traders and fund managers use sophisticated techniques among which commonly used are charts and chart patterns. Price pattern and market trend identified through charts are diagnosed through various tools like moving average, trend lines, Relative strength index, MACD etc.
Some of the well-known chart pattern used for estimations are head and shoulder or double top/ bottom reversal pattern and look for lines of support, resistance channels and observe the formation of flags, cups and handle pattern.
Most of the technical analysis is based on price trend, volumes, and open interest. These are the primary factors that become predominant in analyzing and estimating the market, rest all are secondary.
This helps to analyze market sentiments and how investors are behaving and are going to behave. Behavioral Economics is a key part of the technical analysis as market sentiments drive the trend and bring market fluctuations.
The fundamental principal behind technical analysis involves
Stocks move in trends: The price of stock never remains stagnant. With time it moves up and down. The philosophy behind this is discussed in subsequent headings.
Volumes move with the trend: With the changing price trend of stocks, the volume changes. Rising trend lead to increase in purchase volume and vice versa.
Trend Persists: Trends have a tendency to stay before reversal of trend take place. Investors book their profit within this period.
Some of the well-known theory like Dow Theory and Elliott Wave theory has been the basis of the establishment of technical analysis.
As an investor, you need to understand that there is no unique formula through which market actions can be examined. These techniques can only assist you to forecast to a certain level of accuracy but may vary drastically as human behavior is unpredictable.
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Philosophy behind technical analysis
Technical analysis works on the principle of the psychology of market and supply/demand in the market. Psychology or market sentiments decide the bullish or bearish nature of traders which will drive the market in either upward or downward direction. Analyzing the sentiments you can predict the trend in which market will move.
The philosophy behind this analysis can be picturized in three premises:
1) Market actions discounts everything
2) Stock price move in trends
3) History repeats itself
MARKET ACTIONS DISCOUNTS EVERYTHING
This is the most predominant phase which if not understood or examined, the rest becomes useless. The analyst believes that anything that anything that becomes a factor for fluctuation in market price is reflected in the price chart of the market, which may be any possible factors including political, psychological, fundamental factors.
Technician claims that any change in price action reflects the shift of supply and demand. If demand exceeds supply, prices should rise and if supply exceeds demand, prices should fall. This forms the basis of all economic and fundamental forecasting.
This brings investors to a conclusion to determine the bullish or bearish trend as per the rise and fall of supply and demand of shares.
Here charts play a major role helping investor by reflecting the bullish or bearish psychology of the market.
Analyst simply observes the data reflected by charts and use some of the technical tools to recognize where the market is likely to go.
STOCK PRICE MOVE IN TRENDS
This is the fundamental principle of the market that short-term flows in a trend that may be upward, downward or sideways or some combination. You need to accept this before starting any type of analysis.
The whole purpose of charting the price action of the market is to identify the trend at an early stage and their reversal points so that proper entry and exit can be made.
An analyst needs to judge the bottom and top of a trend so that sufficient profit can be booked with the trend.
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HISTORY REPEATS ITSELF
The approach to technical analysis has a major concern with human psychology and behavior. Chart patterns studied over past 100 years reveals the bullish and bearish psychology of the market.
Since these patterns have worked well in past it is assumed that will work same in the future. Analyst tries to recognize that type of chart pattern forming and with past knowledge they forecast the future trend.
The only thing I would like to conclude is that you should not depend on a single tool to decide market condition. To get the best result you need to analyze chart patterns and verify your result with at least 3-4 different types of technical indicators. Not just this is it worth of purchase need to be identified through its intrinsic value. All you need to careful in the market is, you need to be very quick but not in a hurry.