What is Technical Analysis?

You may believe that technical analysis of stock will give you all the answers, but that is not the case. It is just one step. However, trading without stock technical analysis is like fighting a war without ammunition. You may be busy or you may be a beginner in markets; you cannot trade unless you get a grasp of technical analysis of stock market indices and specific stocks. The technical analysis of stocks is not rocket science but there are a basic set of rules on which it is based. Here is what stock technical analysis is all about.

Understanding Technical Analysis

Let us begin with understanding what is technical analysis in stock markets. Remember, technical analysis is a bit of mathematics, a bit of visual, and a bit of art too. If you are a short-term trader or intraday trader, then technical analysis is something you cannot do without. But, relax, it is not that complex nor is it beyond your understanding. Let us start with the basics.

Technical analysis is the study of chart patterns, graphs, and diagrams on a screen. The idea is to understand price and volume trends and pick stocks accordingly. Let me give you simple examples, Stock falls but each time it touches Rs.250, it bounces back. That is a support level. Stock B rises but each time it touches 400 on the upside it corrects. This becomes a resistance. These are the two simplest and most commonly used technical analysis indicators. The idea is to understand what technical analysis is conceptual.

Have you heard the adage, “Those who do not learn from history, are condemned to relive it?” In a way, technical analysis is something like that. There are years of wisdom and patterns hidden in price charts and the onus is on us traders to learn from these charts and interpret them convincingly. So, we come to the first point. Technical analysis is based on the premise that historical price trends tend to repeat over time. What you do in technical analysis is to sit with historical stock charts, look at price and volume data and then plot various trends. Based on past wisdom, you find patterns to trade for the future.

How is technical analysis differs from the fundamental analysis? Technical analysis believes that whether you talk about fundamentals or news flows or earnings surprises; they are all in the price and volumes. So, you don’t have to worry about all these balance sheets and income statements. Just identify the pattern and extrapolate to the future and you have a trading strategy right in front of you. Technical analysis does not give too much weightage to fundamentals as it believes that everything is at the price. Technical analysis believes that you just need to spot the section of the circle the price is currently in to make sound investment decisions. In short, technical analysis assumes that everything there is to know about a stock, is already in the price and you just need to locate the pattern to trade. When history repeats itself, why not just focus on historic patterns; that is technical analysis.

The most important assumption in technical analysis is that stock prices follow trends. It presumes that each stock chart has its unique price and volume trend. Prices will eventually gravitate towards this trend. Hence if you study patterns properly, you can decipher what will be the next price move of the stock. Technical analysis believes that patterns are kings and everything else is either noise or ripples to distract the trader. Any worthwhile data gets reflected in the stock’s price and in the stock chart too. Hence technical analysis sees merit in just studying chart patterns to gauge market trends.

Different chart types

Charts are figurative depictions of price patterns and volume patterns. Technical analysis makes extensive use of such charts to decipher and locate trends for future extrapolation. Here are four popular technical analysis charts.

1. Line charts have a stock price or trading volume on the y-axis and the period on the x-axis. Line charts are normally static and use the closing stock price for the construction of a line chart. This is the simplest form of technical analysis but it does miss out on many subtle trends.

2. Bar charts are somewhat similar to a line chart but more information and data-rich. Apart from the closing price, the bar chart also captures the highest price and the lowest price of the day or any such period. It captures the trend of prices better.

3. Candlestick charts are like bar charts but they are visually more appealing and presented to be more amenable to analysis. A candlestick chart is made up of rectangular blocks with lines coming out on both sides. The line at the upper end signifies the day’s highest trading price and at the line lower end signifies the day’s lowest trading price.

4. Point and figure charts or PFC charts are high-intensity charts used in the past but now they have been replaced by computer programmed charts, that are simpler. PFC chart displays volatility of stock price over some time. On the vertical axis, it displays several times stock prices rose or fell to a particular extent and the other axis is time.

Different components of technical analysis

Here we will look at two very important components of technical analysis viz trend line and trend length. We will also look at their roles in detail. Let us focus on the trend line first. The trend line connects all the tops or bottoms in stock charts with each other. In technical analysis, this trend line has a unique utility. Trend lines underline trends that are not visible in plain technical charts. For example, a zig-zag chart does not tell you much about whether the underlying trend is rising or falling. But if the technical analysis chart is combined with a trend line, it gives you a quick picture of whether the trend is upward or negative. Since trend lines are straight lines, they tend to smooth out the jaggedness in the charts and underline the trends hidden in the stock chart. It captures up-trends and even downtrends.

Let us now turn to trend length. This is an important aspect of technical analysis. In extrapolating patterns, it is not enough to spot trends, but you must also be able to project the length of these trends. Trend length will depend largely on whether it is a primary trend or a secondary trend. Let us spend a moment on that. Primary trends are the longest-lasting trends and bring about a radical movement in stock prices. This decisive move can be up or it can be down too. On the other hand, secondary trends are unable to create a meaningful impact. This can be a key deciding factor in trading strategy based on technical analysis.

Different types of indicators in technical analysis?

To be fair, there are innumerable number indicators in technical analysis, but we will stick to four of the most popular and broadly useful trends in technical analysis.

• The Moving-Average Convergence Divergence or MACD is the most widely used technical indicator. Apart from the trend, it also indicates the momentum of a stock. The MACD line compares the short-term and long-term momentum of a stock. For example, when the short-term line crosses the long-term line, it is a signal of bullishness and vice versa.

• The head and shoulders (H&S) are a technical analysis chart pattern that appears when a stock rises to a peak to form the first shoulder and then falls and then again rises to form the head and falls to create a shoulder. The H&S pattern suggests a big trend shift.

• A typical Gap occurs when a stock opens much higher or lower than the previous day’s closing price. It could be a positive gap or a negative gap. Gaps can create new support or resistance lines for the stock. One of the common trades in technical analysis is the trade of a gap being filled.

• Double Tops or Double Bottoms also hint at changing trends. A double top normally indicates future selling in the stock while a double bottom indicates that the stock is getting ready to trade higher. These are approximations and you need to use technical analysis charts for making real decisions.