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Chapter 1 Introduction to Technical Analysis

Technical Analysis

Technical Analysis is the art of forecasting future price movement based on past price action, volume on a chart and applying various studies and indicators to it. Technical Analysis works across all timeframes i.e. intraday – daily – weekly or even yearly data and is applicable to stocks, indices, commodities, futures or any tradable instrument where the price is governed by the forces of supply and demand.

Use of Technical Analysis

It is a very effective tool to time the markets, i.e. determine the entry levels, the stop-losses, as well as the target levels. It takes into account everything (barring the ACTS of GOD) that is likely to impact the prices, including fundamental reasons, stock specific news, results, events affecting same sector’s stocks, political happenings and so on.

Bases of Technical Analysis

The three most important bases of Technical Analysis are:

  • Price Discounts Everything

  • Price Moves in Trend

  • History Tends to Repeat Itself

Price Discounts Everything

Technical Analysis assumes 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.

Price Moves in Trend

“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 against it.

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.

Dow Theory

The Dow Theory is the oldest and by far the most publicized method of identifying major trends in the market. The goal of the theory is determine changes in the primary or major movement of the market. Once a trend has been established, it is assumed that it will exist until a reversal is proved. Dow Theory is concerned with the direction of a trend and has no forecasting value in terms of the trend’s ultimate direction or size.

Interpreting the Theory

The market discounts everything

The Dow Theory states that asset prices take into consideration all available information. Earnings potential, competitive advantage of a firm, management competence – all of these factors and more are priced into the market. The closing price reflects the aggregate judgment and emotions of all the market participants.

There are three kinds of market trends

Markets experience primary trends which last a year or more, such as a bull or bear market. Within these broader trends, markets experience secondary trends, often seen as a retracement against the primary trend, such as a pullback within a bull market or a rally within a bear market; these secondary trends last from three weeks to three months. Finally, there are minor trends that last less than three weeks, and are generally seen as noise.

Primary trends have three phases

A primary trend consists of three phases, according to the Dow Theory. In a bull market, these are the accumulation phase, the public participation phase and the excess phase. In a bear market, they are called the distribution phase, the public participation phase and the panic phase. 

Indices must confirm each other

In order to establish a trend, Dow Theory states that indices or market averages must confirm each other. Dow made use of two indices: the Dow Jones Industrial and Rail (now Transportation). A rise in Dow Jones Industrial would only be confirmed if the transportation average also confirmed the same, else there was no clear trend and we could witness a correction. The converse of this would also hold true.

Volume must confirm the trend

Volume should increase if price is moving in the direction of the primary trend, and should be light during a pullback. If volume picks up during a pullback, it could indicate trend reversal as more participants have turned bearish.

Trends persist until a clear reversal occurs.

Reversals in primary trends can be confused with secondary trends. Identifying whether a bull market is a reversal – the beginning of a bear market – or a short-lived correction to be followed by higher highs is difficult, and the Dow Theory advocates caution, insisting that reversal be confirmed.

Difference between technical and fundamental analysis

Fundamental Analysis is the method of evaluating a security by analyzing balance sheet, income statement, profit/loss, cash-flows and other financial/non-financial data about the company. Technical Analysis does not attempt to measure a security's intrinsic value, but instead uses charts and other tools to identify patterns that can suggest future price trend. It is a tool for timing the market i.e. entry and exit levels.

Technical or Fundamental

Techno fundamental approach is the one you should go by. It means you should use both.

  • Which security to trade – use Fundamental Analysis

  • When to trade – use Technical Analysis

Key Takeaways

  • Technical Analysis helps in identifying entry and exit points.

  • Technical Analysis basis a) Price Discounts Everything b) Price Moves in Trend c) History Tends to Repeat Itself.

  • Dow Theory is based on 6 basic tenants

  • Technical Analysis is best used to identify short terms trades

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