Part 1 - Technical Analysis and Fundamental Analysis

There are basically two different methodologies for understanding the market and predicting its future trend. The first one is called fundamental analysis and the second is technical analysis. Fundamental analysis involves studying the financial position of a company, its potential performance in the future, the book value of its assets and other financial ratios. Thus, it analyses the share price with respect to the fundamentals of a company and predicts the future price movements based on the potential earning capacity. Fundamental analysis requires information about balance sheets, cash flow statements, growth patterns and future plans of the company. It also requires a study of the industry to which the company belongs and the economies in which it has its businesses. All these parameters are factored in while predicting the price movement of the scrip.

On the other hand, technical analysis is concerned with plotting patterns in the price movement of a scrip and then predicting the future direction of its price. Thus, if a scrip is witnessing a rise in its overall price trend, analysts may buy the scrip if it looks like there is potential for a further price rise. However, if the underlying trend in price is moving downwards, and remember that the trend may change from rise to fall, it may be time to sell off your holdings so that you can re-enter the market when the price has fallen substantially. This way, analysts construct trading strategies, i.e. decisions on when to enter and exit the market, based on the underlying direction or trend the scrip is displaying. The important thing in technical analysis is to understand charts and technical indicators which help to forecast price movements.

Technical and fundamental analysis are not mutually exclusive and certainly do not have diverse objectives. Both approaches aim at helping you to make a profit from your trading strategy and maximize your returns on a consistent basis. Thus, an understanding of fundamentals as well as technicals is imperative to develop a broad understanding of the market before you make your moves.

This book intends to explain the concepts related to technical analysis in a simple and lucid manner so that even beginners can make a start in the field. As the field of technical analysis is vast and the available tools innumerable, once you are comfortable with the concept, you can gain deeper insights into the exciting and rewarding field and develop your own trading strategies.

Let us first have a look at the definition of technical analysis.

Technical analysis can be defined as the process of evaluating the price of a scrip on the basis of market variables such as price trends, traded volumes and open interest, etc. Thus technical analysis tends to identify and predict trends at an early stage of the cycle so that you can enter the market much before others when past trends indicate future rise. Technical analysis also helps you to exit from the market when trends indicate a reversing pattern and prices start to fall. This early stage prediction can reap benefits as you buy the scrip when it is still available at a relatively low price and are able to sell it off at a higher valuation.

In order to carry out technical analysis, data of the historic prices of a share and volume of shares traded as available from stock exchanges is depicted by way of charts and future trends are predicted based on past patterns. Thus, price and volume constitute the two most important variables for technical analysis. Generally, technical analysis is based on daily, weekly or monthly price and volume movements as a tick by tick replay of the market, in terms of each and every trade, is not available.

ASSUMPTIONS OF TECHNICAL ANALYSIS

Technical analysis is based upon certain assumptions which must be kept in mind. These assumptions form the very foundation of this method of analysis and need to be understood by learners and practitioners alike while doing or using technical analysis. Following are the assumptions followed in technical analysis:

The stock market discounts everything:
One of the criticisms leveled against technical analysis is that it does not consider the fundamental factors such as financial position of the company, its future earning potential, book value, reserves and other ratios while forecasting the market price. However, technical analysis is based on the assumption that the stock market discounts all these and other factors in stock prices and it is a reflection of the true or fair price of the scrip based on company specific factors as well as general and broad economic parameters, which have an effect on the market price. As the market price is assumed to inherit all these factors, only price movement needs to be analyzed, which is a matter of demand and supply of the scrip.

Stock prices move in trends:
Trading strategies developed based on technical analysis are based on the assumption that stock prices move in trends and such a trend once established is regular and follows the pattern. In other words, stock prices will not move away from the trend established based on technical analysis. This directional movement of price is one of the important assumptions on which technical analysis is based. This is because if price movements are random and do not follow any pattern, there is no way to predict their future trend.

History tends to repeat itself:
This is another important premise of the whole theory of technical analysis. In simple words, the assumption means that human psychology of dealing with a particular situation does not change even with the passage of time. Thus, in a bull run, the frenzy that takes the market to dizzy heights will be repeated over and over again in all bull runs. So is the case with bearish market, where traders and investors will continue to hammer valuations even further down defying all logic and explanation. It is this repetition of behavior that forms an important element of understanding technical analysis.

USES OF TECHNICAL ANALYSIS
An important element of technical analysis is to find out the trend of price movements and plot it by way of a chart. This helps in determining when the markets have peaked and when the direction will reverse and start falling. One of the important benefits of this analysis is to time the market with a fair amount of consistency. Thus, technical analysis can help you to enter the market when it has touched the bottom or near about and also exit when it peaks and a reversal in direction is expected. In a way, it provides great profit making opportunities for investors, if they consistently follow patterns.

Another advantage of technical analysis is that it helps you develop your strategies over different time horizons, such as short term, medium term, weekly, monthly and so on, based on past trends observed. This way you can plan your investment decisions well in advance and trade accordingly. It is also possible to identify scrips which are most likely to outperform the market based on past trends through technical analysis. Conversely, it pays well to exit the laggards if they are consistently falling behind the market returns.

Technical analysis is useful not only in the stock market but in other markets also, such as currency, commodities, futures and options and so on. It helps people to take a position across different products and sectors based on past patterns and reap the benefits when prices move on predicted lines.

However, like all good things in life, technical analysis is also not without imperfection. Technical analysis is not a perfect science and it may fail in making the right predictions. Thus, you should be careful in its application in real life situations, just the way you are about your other decisions.

Technical analysis can also fail at times. It pays well to remember that it is a good idea to take into account a number of indictors or trends while making your investment decisions.

With its shortcomings notwithstanding, technical analysis remains one of the most important tools for predicting the future trends. It will remain so as history repeats itself. Hence, it is time to take a look at the concepts of technical analysis for a better understanding.