What is Technical Analysis?
Technical analysis is a method used in financial markets, primarily for analyzing and forecasting the future price movements of various assets, such as stocks, currencies, commodities, and cryptocurrencies. It relies on the study of historical price charts and trading volumes to make predictions about future price movements. Technical analysts believe that past price and volume data can provide valuable insights into future market trends.
In addition to fundamental analysis, technical analysis is also used for analysing securities and taking decisions based on this analysis. One of the basic differences between fundamental analysis and technical analysis is that the former involves the analysis of the characteristics of a company for estimating its value while the latter involve the determination of price movements of the stock in the market. Technical analysis refers to a method of analysing the securities of an organisation by assessing the data generated in the market.
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Technical analysis is based on past prices and volume of securities. Technical analysts depend on charts and other tools for determining the patterns of behaviour of a security in order to predict its future movement. Therefore, as you can see, technical analysis rely on the past performance of the stocks and markets to predict their future performance.
In technical analysis, the analyst studies the supply and demand of securities to find patterns and use the patterns to predict the future movement of the securities. In simple words, the technique tries to predict the future movements of the market by studying the market and finding patterns. Therefore, technical analysis is statistical in nature.
Following are the major underlying assumptions of technical analysis:
- Everything is discounted in the market.
- There is a pattern in price movement.
- Past trends repeat themselves.
Stock Price and Stock Volume
A share price refers to the price of a single share in a number of saleable stocks of a company. In layman’s terms, the stock price is the highest amount someone is willing to pay for the stock, or the lowest amount that it can be bought for. In simpler words, stock volume means the number of shares traded in a security or in the entire market at a particular period. Therefore, stock volume refers to the amount of stocks that are traded.
Stock volume is a measure of activity in the stock market. Information regarding stock volume is easily available in the market. However, it requires expertise to effectively use stock volume to increase profits and minimise risks. Let us understand the concept stock price and stock volume with the help of an example. Suppose a person purchases ten shares of ICICI bank Ltd. on 20th Dec, 2014 at the price of ₹357. For him, the stock price is ₹357. As the number of shares traded is 10, the stock volume is 10.
Price Charts
Price charts are very important components of technical analysis. A price chart graphically depicts the periodic movement of stock prices in the market. In technical analysis, the price chart is analysed to predict the future price movements of stocks. In other words, technical analysis use past price movements to predict future movements. Price charts have similarities with other types of visual charts.
In a price chart, the x-axis depcits time expressed in various units, such as hours, days, weeks, months, and years. On the other hand, price levels of stocks is plotted on the vertical axis of the chart. The general flow of a stock chart is from left to right: i.e, oldest information is presented in the left side whereas the latest information is posted in the right side of the chart.
There can be a number of different types of stock chart, such as:
Line Chart
This is the simplest of all price charts. In a line chart, the closing prices of stocks for a period of time are plotted. Next, the closing prices are connected to form a line. The line chart uses the closing price of stocks as the this price is considered to be the most significant data in stock prices in comparison with the intra-day high and low data. Figure shows a line chart:
Bar Charts
This is an extension of the line chart. A bar chart is prepared by including some information in the line chart. A bar chart consists of a set of verticle lines representing the data points. The verticle lines in the graph show the intra-day high and low along with the closing price. Figure shows a bar chart:
Candle Stick Chart
There is significant similarilty between a bar chart and a candle stick chart. The only difference is in the visual constructions of the charts. In the candle stick chart, a thin line shows the trading range of a period. Figure shows a candle stick chart:
What is Dow Theory?
This theory was developed from a series of editorials written by Charles Dow in The Wall Street Journal. The theory is based on stock price trends in the market. Market trend refers to the general tendency of the movement of stock prices. It has been empirically seen that the market tends to move in a general direction or trend.
The theory proposes that the overall market trend is determined by three types of trends:
- Primary Trend: The primary trend is a long-term secular trend that lasts for a period greater than 12 months. This trend tends to impact both secondary and minor trends.
- Secondary Trend: The secondary trend involves movement against the primary trend. It is an intermediate trend and it is observed for a period ranging from three weeks to three months.
- Minor Trend: The minor trend lasts for the shortest period of time as it varies along with the changing opinions. Minor trends generally last from hours to a month.
However, this trend is not a straight line. There may be periodic fluctuations in the market; however, it will move in a general direction. The theory proposes that the overall market trend is determined by three types of trends: primary trends, secondary trends, and minor trends. The primary trend is the long term secular trend that last for a period greater than 12 months. The secondary trend involves movement against the primary trend. It is an intermediate trend and it is observed for a period ranging from three weeks to three months.
Lastly, the minor trend lasts for the shortest period of time (generally, less than three weeks). Most investment analysts put maximum emphasis on primary and secondary trends as minor trends involve high amount of noise. Therefore, focusing too much on the minor trend can result in irrational trading as short-term market fluctuations can distract investors from looking at the bigger market picture.
In Dow Theory, market trends also consist of three phases:
- Accumulation Phase: In this period, buying/selling takes place in the market against a general opinion. During this phase, there is no impact on prices as demand is less than supply in the market. This compels trader to buy/sell large amount of stock.
- Absorption Phase: In this phase, accumulation of stock takes place due to increased participation in the market. The huge participation leads to speculation in the market.
- Distribution Phase: In this phase, judicious investors start distributing their holdings in the market due to the hype generated about the prices.
Dow Theory helps investors in determining and understanding facts. However, the theory is not considered as supportive for making forecasts against market conditions. The theory can be considered as an initial point for investors and traders to understand analysis guidelines.
Difference Between Fundamental Analysis and Technical Analysis
Fundamental analysis and technical analysis are different investment techniques based on different underlying premises. Fundamental analysis considers that the stock price of a company is a reflection of the financial performance of the company.
Therefore, analysis of the financial statement is critical to fundamental analysis. Fundamental analysis considers assets, liabilities, revenues, and expenses of a company to predict stock prices. In addition, fundamental analysis considers the propsect of the company, general market conditions, and the prospect of the industry to determine the intrinsic value of a stock.
Therefore, we can see that fundamental analysis is the analysis of the overall financial performance of a company to predict stock prices in the future. On the other hand, technical analysis takes a completely different approach of predicting the future performance of stocks.
This technique takes into account the statistical information of previous price movements of stocks of a company to find a pattern in past price movements and predict future stock price on the basis of this pattern. Therefore, the entire focus of technical analysis is on the trend of past stock prices rather than the financial condition of a company.
The main difference between fundamental analysis and technical analysis are shown in Table:
| Fundamental Analysis | Technical Analysis |
|---|---|
| It analyses securities by measuring the intrinsic value of a stock. | It analyses securities by studying statistics produced by market activities. |
| It takes into account the prospect of the company, general market conditions, and the prospect of the industry to determine the intrinsic value of a stock. | It takes into account the statistical information of previous price movements of stocks of a company to find a pattern in past price movements and predict future stock price. |
| It focus on the analysis of overall financial performance of a company to predict stock prices in the future. | It focuses on the analysis of the trend of past stock prices rather than the financial condition of a company |
| It is a long-term approach. | It is done for a short time. |
What is Technical Indicators?
Technical indicators are mathematical calculations or visual representations derived from historical price, volume, or open interest data of financial assets, such as stocks, currencies, commodities, or cryptocurrencies. These indicators are used by traders and analysts in technical analysis to gain insights into the potential future price movements of these assets. Technical indicators help traders make informed decisions about buying, selling, or holding positions.
Technical indicators are not related to the fundamentals of a business, such as revenue or profits. Active traders use these for studying shortterm price movements of stocks in the market. These are not generally used by long-term investors as they are used by short-term investors. However, long-term investors can use them for determining the right timings to purchase or sell stocks by looking at the long-term trend. There are various technical indicators used for technical analysis.
These indicators are as follows:
- Accumulation/Distribution Line: This indicates the flow of money into or out of stock with the help of stock price and stock volume.
- Average Directional Index (ADX): This indicates the trending or oscillating of a stock.
- Average True Range (ATR): It is a measure of the volatility of a stock.
- BandWidth: It reflects the difference of percentage between the upper and lower Bollinger Band.
- %B Indicator: It indicates how price and standard deviation of bands are related.
- Commodity Channel Index (CCI): It indicates how the price of a stock varies from a typical price.
- Coppock Curve: It works as an oscillator to measure the momentum of stocks.
- Correlation Coefficient: It indicates how the prices of two stocks correlate over a period of time.
- Detrended Price Oscillator (DPO): It helps in identifying cycles with the help of moving averages.
- Force Index: It is a simple price-and-volume oscillator
- Mass Index: It indicates reversals in case of widening of price ranges.
- Negative Volume Index (NVI): It helps in identifying trend reversals.
- Price Relative / Relative Strength: It is a technical indicator that divides the prices of two stocks for comparing their performance in the market.
- Rate of Change (ROC) and Momentum: It reflects the rate of change of stock price.
- Relative Strength Index (RSI): It indicates the strength of movement of a stock in the current direction.
- TRIX: It is a triple-smoothed moving average showing price movements.
- Slope: It measures the rise-over-run for a linear regression.
Breadth Indicators
A breadth indicator refers to the mathematic formula that helps in calculating the market participation. Breadth indicators evaluate the volume of stocks going up and down and the amount of trades placed by the investors to determine whether the overall market is bullish or bearish. A number of breadth indicators, such as force index, Chaikin Oscillator, up/down volume spread, on-balance volume and cumulative volume index are used by technical analysts.
For example, the most common breadth indicator that is used is the Arms index, which helps in assessing the relationship between various stocks (which include increasing and decreasing) and their trading volumes. It also enables investors to determine the nature of market, i.e., bearish, bullish or neutral.
Sentiment Indicators
A sentiment indicator refers to a graphical or numerical indicator that shows what perception a group of investors have in the market or the overall business environment. In other words, sentiment indicator takes into account various factors, such as inflation rate, political stability, GDP, economic condition, etc. to influence the future behaviour of the investors.
For example, a consumer sentiment index is used to display levels of pessimism which shows the unwillingness of consumers to spend. By using this indicator, companies can decide the amount of inventory to be stocked for trading.
