INTRODUCTION TO TECHNICAL ANALYSIS
Technical Analysis can be defi ned as an art and science of forecasting future prices based on
an examination of the past price movements. Technical analysis is not astrology for predicting
prices. Technical analysis is based on analyzing current demand-supply of commodities,
stocks, indices, futures or any tradable instrument.
Technical analysis involve putting stock information like prices, volumes and open interest
on a chart and applying various patterns and indicators to it in order to assess the future
price movements. The time frame in which technical analysis is applied may range from
intraday (1-minute, 5-minutes, 10-minutes, 15-minutes, 30-minutes or hourly), daily, weekly
or monthly price data to many years.
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 fi nancial and non-fi nancial aspects of the company or technical information which ignores
fundamentals and focuses on actual price movements.
The basis of Technical Analysis
What makes Technical Analysis an effective tool to analyze price behavior is explained by
following theories given by Charles Dow:
• Price discounts everything
• Price movements are not totally random
• What is more important than why
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
Technical analysts believe that the current price fully refl ects all the possible material
information which could affect the price. The market price refl ects the sum knowledge of
all participants, including traders, investors, portfolio managers, buy-side analysts, sell-side
analysts, market strategist, technical analysts, fundamental analysts and many others. It
would be folly to disagree with the price set by such an impressive array of people with
impeccable credentials. Technical analysis looks at the price and what it has done in the past
and assumes it will perform similarly in future under similar circumstances. Technical analysis
looks at the price and assumes that it will perform in the same way as done in the past under
similar circumstances in future.
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 – prices move in trends. If prices were
always random, it would be extremely diffi cult to make money using technical analysis. A
technician believes that it is possible to identify a trend, invest or trade based on the trend
and make money as the trend unfolds. Because technical analysis can be applied to many
different time frames, it is possible to spot both short-term and long-term trends.
“What” is more important than “Why”
It is said that “A technical analyst knows the price of everything, but the value of nothing”.
Technical analysts are mainly concerned with two things:
1. The current price
2. The history of the price movement
All of you will agree that the value of any asset is only what someone is willing to pay for
it. Who needs to know why? By focusing just on price and nothing else, technical analysis
represents a direct approach. The price is the fi nal result of the fi ght between the forces of
supply and demand for any tradable instrument. The objective of analysis is to forecast the
direction of the future price. Fundamentalists are concerned with why the price is what it is.
For technicians, the why portion of the equation is too broad and many times the fundamental
reasons given are highly suspect. Technicians believe it is best to concentrate on what and
never mind why. Why did the price go up? It is simple, more buyers (demand) than sellers
The principles of technical analysis are universally applicable. The principles of support,
resistance, trend, trading range and other aspects can be applied to any chart. Technical
analysis can be used for any time horizon; for any marketable instrument like stocks, futures
and commodities, fi xed-income securities, forex, etc
Technical analysis uses top-down approach for investing. For each stock, an investor would
analyze long-term and short-term charts. First of all you will consider the overall market, most
probably the index. If the broader market were considered to be in bullish mode, analysis
would proceed to a selection of sector charts. Those sectors that show the most promise
would be selected for individual stock analysis. Once the sector list is narrowed to 3-5 industry
groups, individual stock selection can begin. With a selection of 10-20 stock charts from each
industry, a selection of 3-5 most promising stocks in each group can be made. How many
stocks or industry groups make the fi nal cut will depend on the strictness of the criteria set
forth. Under this scenario, we would be left with 9-12 stocks from which to choose. These
stocks could even be broken down further to fi nd 3-4 best amongst the rest in the lot.
Technical Analysis: The basic assumptions
The fi eld of technical analysis is based on three assumptions:
1. The market discounts everything.
2. Price moves in trends.
3. History tends to repeat itself.
1. The 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 refl ects everything that has or could affect the company – including fundamental factors.
The market is driven by mass psychology and pulses with the fl ow of human emotions.
Emotions may respond rapidly to extreme events, but normally change gradually over time.
It is believed that the company’s fundamentals, along with broader economic factors and
market psychology, are all priced into the stock, removing the need to actually consider these
factors separately. This only leaves the analysis of price movement, which technical theory
views as a product of the supply and demand for a particular stock in the market.
2. Price moves in trends
“Trade with the trend” is the basic logic behind 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 analysts 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 aconsistent reaction to similar market stimuli over time. Technical analysis uses chart patterns
to analyze market movements and understand trends.
Strengths and weakness of Technical Analysis
Importance of Technical Analysis
Not Just for stocks
Technical analysis has universal applicability. It can be applied to any fi nancial instrument –
stocks, futures and commodities, fi xed-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. The price pattern is considered as a leading indicator and
generally leads the economy by 6 to 9 months. To track the market, it makes sense to look
directly at the price movements. More often than not, change is a subtle beast. Even though
the market is prone to sudden unexpected reactions, hints usually develop before signifi cant
movements. You should refer to periods of accumulation as evidence of an impending advance
and periods of distribution as evidence of an impending decline.
Supply, demand, and price action
Technicians make use of high, low and closing prices to analyze the price action of a stock. A
good analysis can be made only when all the above information is present
Separately, these will not be able to tell much. However, taken together, the open, high, low
and close refl ect forces of supply and demand.
Support and resistance
Charting is a technique used in analysis of support and resistance level. These are trading
range in which the prices move for an extended period of time, saying that forces of demand
and supply are deadlocked. When prices move out of the trading range, it signals that either
supply or demand has started to get the upper hand. If prices move above the upper band of
the trading range, then demand is winning. If prices move below the lower band, then supply
Pictorial price history
A price chart offers most valuable information that facilitates reading historical account of
a security’s price movement over a period of time. Charts are much easier to read than a
table of numbers. On most stock charts, volume bars are displayed at the bottom. With this
historical picture, it is easy to identify the following:
• Past and present volatility
• Historical volume or trading levels
• Relative strength of the stock versus the index.
• Market reactions before and after important events
Assist with entry point
Technical analysis helps in tracking a proper entry point. Fundamental analysis is used to
decide what to buy and technical analysis is used to decide when to buy. Timings in this
context play a very important role in performance. Technical analysis can help spot demand
(support) and supply (resistance) levels as well as breakouts. Checking out for a breakout
above resistance or buying near support levels can improve returns.
First of all you should analyze stock’s price history. If a stock selected by you was great for
the last three years has traded fl at for those three years, it would appear that market has a
different opinion. If a stock has already advanced signifi cantly, it may be prudent to wait for a
pullback. Or, if the stock is trending lower, it might pay to wait for buying interest and a trend
Weaknesses of Technical Analysis
Technical analysis is not hard core science. It is subjective in nature and your personal biases
can be refl ected in the analysis. It is important to be aware of these biases when analyzing
a chart. If the analyst is a perpetual bull, then a bullish bias will overshadow the analysis.
On the other hand, if the analyst is a disgruntled eternal bear, then the analysis will probably
have a bearish tilt.
Open to interpretation
Technical analysis is a combination of science and art and 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. Both will be able to come up with
logical support and resistance levels as well as key breaks to justify their position. Is the cup
half-empty or half-full? It is in the eye of the beholder.
You can criticize the technical analysis for being too late. By the time the trend is identifi ed, 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.
Always another level
Technical analysts always wait for another new level. Even after a new trend has been identifi ed,
there is always another “important” level close at hand. Technicians have been accused of
sitting on the fence and never taking an unqualifi ed stance. Even if they are bullish, there is
always some indicator or some level that will qualify their opinion.
An array of pattern and indicators arises while studying technical analysis. Not all the signals
work. For instance: A sell signal is given when the neckline of a head and shoulders pattern is
broken. Even though this is a rule, it is not steadfast and can be subject to other factors such
as volume and momentum. In that same vein, what works for one particular stock may not
work for another. A 50-day moving average may work great to identify support and resistance
for Infosys, but a 70-day moving average may work better for Reliance. Even though many
principles of technical analysis are universal, each security will have its own idiosyncrasies.
TA is also useful in controlling risk
It is Technical Analysis only that can provide you the discipline to get out when you’re on the
wrong side of a trade. The easiest thing in the world to do is to get on the wrong side of a
trade and to get stubborn. That is also potentially the worst thing you can do. You think that
if you ride it out you’ll be okay. However, there will also be occasions when you won’t be okay.
The stock will move against you in ways and to an extent that you previously found virtually
It is more important to control risk than to maximize profits!
There is asymmetry between zero and infi nity. What does that mean? Most of us have very
fi nite capital but infi nite opportunities because of thousands of stocks. If we lose an opportunity,
we will have thousands more tomorrow. If we lose our capital, will we get thousands more
tomorrow? It is likely that we will not. We will also lose our opportunities. Our capital holds
more worth to us than our opportunities because we must have capital in order to take
advantage of tomorrow’s opportunities.
It is more important to control risk than to maximize profi ts! Technical Analysis, if practiced
with discipline, gives you specifi c parameters for managing risk. It’s simply supply and demand.
Waste what’s plentiful, preserve what’s scarce. Preserve your capital because your capital is
your opportunity. You can be right a thousand times, become very wealthy and then get wiped
out completely if you manage your risk poorly just once. One last time: That is why it is more
important to control risk than to maximize profits!
How to know what to look for? How to organize your thinking in a market of thousands of
stock trading millions of shares per day? How to learn your way around? Technical Analysis
answers all these questions.
Technical analysis works on Pareto principle. It considers the market to be 80% psychological
and 20% logical. Fundamental analysts consider the market to be 20% psychological and 80%
logical. Psychological or logical may be open for debate, but there is no questioning the current
price of a security. After all, it is available for all to see and nobody doubts its legitimacy. The
price set by the market refl ects the sum knowledge of all participants, and we are not dealing
with lightweights here. These participants have considered (discounted) everything under the
sun and settled on a price to buy or sell. These are the forces of supply and demand at work.
By examining price action to determine which force is prevailing, technical analysis focuses
directly on the bottom line: What is the price? Where has it been? Where is it going?
Even though some principles and rules of technical analysis are universally applicable, it must
be remembered that technical analysis is more an art form than a science. As an art form, it
is subject to interpretation. However, it is also fl exible in its approach and each investor should
use only that which suits his or her style. Developing a style takes time, effort and dedication,
but the rewards can be signifi cant.