What is Technical Analysis of Stocks?
Technical Analysis can be defined as an art and science of forecasting future prices based on an examination of the past. It is an analysis of historical market data, including price and volume. It is based on that prices are determined by the interaction of demand and supply. With the help of both Behavioral Finance and Quantitative Analysis, Technical Analysis of Stocks aims to use past performance to predict future market Behavior. Chart Pattern and Technical (Statistical) Indicators are the two most common forms of Technical Analysis Stocks.
- The time frame in which technical analysis is applied may range from Intraday(1-minute,5minutes,10-minutes, 15-minutes, 30-minutes or hourly), daily, weekly or monthly price data to many years.
- Technical Analysis of Stocks is a blanket term for a variety of strategies that depend on the Interpretation of price action in a stock.
What makes Technical Analysis an Effective Tool
The following theories given by Charles Dow makes Technical Analysis of Financial Markets
- Price discounts everything
- Price Movements are not totally random
- What is more important than why
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 Financial and Non-Financial aspects of the company or Technical Information which ignores Fundamental and focuses on actual price movements.
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.
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 -price move in trends. If price were always random, it would be extremely difficult to make money using Technical Analysis.
Basic Assumptions in Technical analysis
1. 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 reflects everything that has or could affect the company -including Fundamental Factors.
2. Price moves in trends
“Trade with the trend ” is the basic logic behind the 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 Analyst 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
Importance of Technical Analysis
Not Just for Stocks
Technical Analysis has universal applicability. It can be applied to any Financial Instrument like Stocks, Futures and Commodities, Fixed-Income Securities, Forex, etc
Focus on Price Fundamental Developments are followed by Price Movements . By Focusing only on price action, Technicians focus on the future.
Support And Resistance Charting is a technique used in the analysis of Support and Resistance level
Weaknesses of Technical Analysis
Analyst Bias Technical Analysis is not hardcore science. It is subjective in nature and your personal biases can be reflected in the analysis. It is important to be aware of these biases when analyzing a chart.
Open to Interpretation Technical Analysis is a combination of science and art is always open to interpretation. Even though there are standards, many times two technicians will look at the same chart and paint two different scenarios or see different patterns.
Too Late You can criticize the Technical Analysis for being too late. By the time the trend is identified, a substantial move has already taken place . After such a large move, the reward to risk ratio is not great . Lateness is a particular criticism of Dow Theory