Technical Analysis of Stocks
One of the greatest versatile features of technical analysis is the fact you can apply TA on any asset class as long as the asset type has historical time series data. Time series data in technical analysis context is the price variables’ information, namely open high, low, close, volume, etc.
Here is an analogy that may help. Think about learning how to drive a car. Once you learn how to drive a car, you can literally drive any car. Likewise, you only need to learn technical analysis once. Once you do so, you can apply TA’s concept on any asset class equities, commodities, foreign exchange, fixed income, etc.
This is probably one of the biggest advantages of TA compared to the other fields of study. For example, one has to study the profit and loss, balance sheet, and cash flow statements when it comes to fundamental analysis of equity. However, fundamental analysis of commodities is completely different.
If you are dealing with an agricultural commodity like Coffee or Pepper, then the fundamental analysis includes analyzing rainfall, harvest, demand, supply, inventory etc. However, the fundamentals of metal commodities are different, so it is for energy commodities. So every time you choose a commodity, the fundamentals change.
Anyhow, the concept of technical analysis will remain the same irrespective of the asset you are studying. For example, an indicator such as ‘Moving average convergence divergence’ (MACD) or ‘Relative strength index’ (RSI) is used the same way on equity, commodity or currency.
Understanding Technical Analysis
Technical analysis tools are used to scrutinize the ways supply and demand for a security will affect changes in price, volume, and implied volatility. It operates from the assumption that past trading activity and price changes of a security can be valuable indicators of the security's future price movements when paired with appropriate investing or trading rules.
It is often used to generate short-term trading signals from various charting tools, but can also help improve the evaluation of a security's strength or weakness relative to the broader market or one of its sectors. This information helps analysts improve their overall valuation estimate.
Technical analysis as we know it today was first introduced by Charles Dow and the Dow Theory in the late 1800s.1 Several noteworthy researchers including William P. Hamilton, Robert Rhea, Edson Gould, and John Magee further contributed to Dow Theory concepts helping to form its basis. Nowadays technical analysis has evolved to include hundreds of patterns and signals developed through years of research.
Technical Analysis is based on a few key assumptions. One needs to be aware of these assumptions to ensure the best results.
1) Markets discount everything: This assumption tells us that, all known and unknown information in the public domain is reflected in the latest stock price. For example, there could be an insider buying the company’s stock in large quantity in anticipation of a good quarterly earnings announcement. While he does this secretively, the price reacts to his actions, revealing to the technical analyst that this could be a good buy.
2) The ‘how’ is more important than ‘why’: This is an extension to the first assumption. Going with the same example as discussed above the technical analyst would not be interested in questioning why the insider bought the stock as long as he knows how the price reacted to the insider’s action.
3) Price moves in trend: All major moves in the market is an outcome of a trend. The concept of trend is the foundation of technical analysis. For example, the recent upward movement in the NIFTY Index to 7700 from 6400 did not happen overnight. This move happened in a phased manner, in over 11 months. Another way to look at it is that once the trend is established, the price moves in the trend direction.
4) History tends to repeat itself: In the technical analysis context, the price trend tends to repeat itself. This happens because the market participants consistently react to price movements remarkably similar way, every time the price moves in a certain direction. For example, in up trending markets, market participants get greedy and want to buy irrespective of the high price. Likewise, in a downtrend, market participants want to sell irrespective of the low and unattractive prices. This human reaction ensures that the price history repeats itself.
Using Technical Analysis
Professional analysts often use technical analysis in conjunction with other forms of research. Retail traders may make decisions based solely on the price charts of a security and similar statistics, but practicing equity analysts rarely limit their research to fundamental or technical analysis alone.
Technical analysis can be applied to any security with historical trading data. This includes stocks, futures, commodities, fixed-income, currencies, and other securities. In fact, technical analysis is far more prevalent in commodities and forex markets where traders focus on short-term price movements.
Technical analysis attempts to forecast the price movement of virtually any tradable instrument that is generally subject to forces of supply and demand, including stocks, bonds, futures, and currency pairs. In fact, some view technical analysis as simply the study of supply and demand forces as reflected in the market price movements of a security.
Technical analysis most commonly applies to price changes, but some analysts track numbers other than just price, such as trading volume or open interest figures.
Technical Analysis Indicators
Across the industry, there are hundreds of patterns and signals that have been developed by researchers to support technical analysis trading. Technical analysts have also developed numerous types of trading systems to help them forecast and trade on price movements.
Some indicators are focused primarily on identifying the current market trend, including support and resistance areas, while others are focused on determining the strength of a trend and the likelihood of its continuation. Commonly used technical indicators and charting patterns include trendlines, channels, moving averages, and momentum indicators.
In general, technical analysts look at the following broad types of indicators:
Price trends
Chart patterns
Volume and momentum indicators
Oscillators
Moving averages
Support and resistance levels
Underlying Assumptions of Technical Analysis
Technical analysis assumes that a security's price already reflects all publicly available information and instead focuses on the statistical analysis of price movements.
Technical analysis attempts to understand the market sentiment behind price trends by looking for patterns and trends rather than analyzing a security's fundamental attributes.
Charles Dow released a series of editorials discussing technical analysis theory. His writings included two basic assumptions that have continued to form the framework for technical analysis trading.
Markets are efficient with values representing factors that influence a security's price, but
Even random market price movements appear to move in identifiable patterns and trends that tend to repeat over time.
Today the field of technical analysis builds on Dow's work. Professional analysts typically accept three general assumptions for the discipline:
The market discounts everything: Technical analysts believe that everything from a company's fundamentals to broad market factors to market psychology is already priced into the stock. This point of view is congruent with the Efficient Markets Hypothesis (EMH) which assumes a similar conclusion about prices. The only thing remaining is the analysis of price movements, which technical analysts view as the product of supply and demand for a particular stock in the market.
Price moves in trends: Technical analysts expect that prices, even in random market movements, will exhibit trends regardless of the time frame being observed. In other words, a stock price is more likely to continue a past trend than move erratically. Most technical trading strategies are based on this assumption.
History tends to repeat itself: Technical analysts believe that history tends to repeat itself. The repetitive nature of price movements is often attributed to market psychology, which tends to be very predictable based on emotions like fear or excitement. Technical analysis uses chart patterns to analyze these emotions and subsequent market movements to understand trends. While many forms of technical analysis 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.
Limitations of Technical Analysis
Some analysts and academic researchers expect that the EMH demonstrates why they shouldn't expect any actionable information to be contained in historical price and volume data; however, by the same reasoning, neither should business fundamentals provide any actionable information. These points of view are known as the weak form and semi-strong form of the EMH.
Another criticism of technical analysis is that history does not repeat itself exactly, so price pattern study is of dubious importance and can be ignored. Prices seem to be better modeled by assuming a random walk.
A third criticism of technical analysis is that it works in some cases but only because it constitutes a self-fulfilling prophecy. For example, many technical traders will place a stop-loss order below the 200-day moving average of a certain company. If a large number of traders have done so and the stock reaches this price, there will be a large number of sell orders, which will push the stock down, confirming the movement traders anticipated.
Then, other traders will see the price decrease and also sell their positions, reinforcing the strength of the trend. This short-term selling pressure can be considered self-fulfilling, but it will have little bearing on where the asset's price will be weeks or months from now.
In sum, if enough people use the same signals, they could cause the movement foretold by the signal, but over the long run, this sole group of traders cannot drive the price.