The two primary method to analyze securities in the stock market is through Fundamental Analysis and Technical Analysis. Fundamental analysis is studying the financial statement of the companies to determine the value of the company using various forecasting methods to conclude which is the right price to enter a particular stock. Technical analysis people assume that the fair value of the stock is already factored into the stock and it uses price movements on the chart to predict the future price of the stock.
Chartists believe that all the information regarding the company is publicly available and all the information available in the stock market are already factored in the stock price.
Technical analysis may look very hard on the outlook but in simple terms, it is a movement of price plotted on a time series chart. With the help of this one can understand historically how the stock price has moved over a period of time. Based on the past movement of the stock there are various methods, tools, indicators, and techniques one can predict the future price movement of the stock.
In simple words, technical analysis is the prediction of the future price of the stock studying the past prices movements.
It is always debatable if the Technical analysis is a Science or an Art.
The fundamentals of technical analysis are derived from a century-old financial data. Some of the techniques are as old as 17th Century.
Techniques like Candlestick study are even older and even today it still remains one of the most important aspects of technical analysis. Candlestick study is also one of the most popularly used tools for predicting the future stock market price.
Let’s dive deeper into the Technical Analysis. I would be taking you through everything that is required to understand technical analysis.
What is Technical Analysis?
Technical analysis is the study of the price movement on the chart which investors and traders use to predict the price movement in the market.
Simply said the price is plotted on a graph where time is on the X-Axis and Price point on the Y-Axis.
The graphical presentation of the price movement on the stock makes it easy to understand and predict the price movement in the stock market.
In short technical analysis helps you to learn how to catch trends in the stock market and how to make money from this trends. Catching a trend early is one of the main attributes of technical analysis.
The X-Axis which can also be called as Time Scale which is usually at the bottom of the screen or chart. The time scale varies based on the person who is studying the chart. The option of the time can be as low as 5 Seconds and can go up as high as 1 Year. Larger and broader prediction is made from higher time durations. Trader usually uses shorter period for predictions and intraday traders use lessor duration close to few minutes.
It totally depends on the Trader or Investor on his choice of time frame. These are the regularly used time frames minutes, hours, daily, weekly, monthly, and yearly.
Shorter time frame since they are used by short-term trader they have a lot of noise in them. The frequency of price movements is much higher when compared to higher time frames. This also reduces the probability of getting more correct predictions.
It is always important to know what suits you the most and then take the step to start investing and trading.
Now Y-Axis which is usually on the left side of the screen or chart denotes the price of the stock. They are plotted usually plotted based on the closing price. Certain investors and traders prefer average price over closing price. At the same time, a certain trader would want all the fact such as open price, high price, low price and closing price.
Assumption of Technical Analysis
Technical Analysis has a lot of premises based on which the technical analysis has been developed. It is very important that you first understand those premises to get the maximum of the technical analysis.
Technical analysis is the force between the demand and supply in the stock market.
By studying the stock market you are studying the effect over the cause for the price change to keep things simple.
An attempt to study the cause would eventually lead to confusion. Cause and the price movement could be very much different from each other. For example positive news with a fall in the stock market price and negative news with a rise in the stock market price.
1# Assumption. The stock market has all the information factored into the price. And all the market is freely available in the stock market. This is the foremost and the most important assumption. Anyone thinking that this is not true would find difficult to believe in the technical analysis.
2# Assumption Technical analysis work only in stocks with high volumes. Illiquid stock or stock with very less trading volumes cannot be predictable. This leads us to the stock selection of only liquid stock. Many first time investors and traders with technical analysis fall into this trap and conclude that the technical analysis doe not work.
3# Assumption Stocks which deal with price movement with only demand and supply: fear and greed can be prediction can be made. Stock with “Artifical Price Change” impact the stocks technical analysis and should not be considered for analysis. Especially when the situation arises from dividends, bonus, stock splits and distribution of the stock.
Failing to ignore this vital points would only lead to wrong stock predictions.
4# Assumption News which can have an extreme impact on the price of the stock should not be considered as a good opportunity for investment based on technical analysis. Any political news, natural disaster news, high impact news should be avoided to invest or trade. Technical analysis cannot predict such sudden change in the flow of information regarding the stocks and situations.
5# Assumption There has always been a discussion on technical analysis is an art or science. My question to those who think it is science is, if the technical analysis was since then robot or black box trading, machine learning would have been way successful than others. But this never happens.
#6 Assumption Technical analysts believe that history repeats itself. Recording of various stock prices have been done which has lead to the conclusion that price of the stock that goes up has to come down and then the stock consolidates. After every consolidation of a stock for a certain period of time, the stock usually breaks out to news highs forming a higher top and higher bottom.
#7 Assumption Market has all the information already factored into the stock price. Hence no other information is required or should be considered. This situation puzzles most of the traders into wrong decision making.
#8 Assumption Technical analysis does not study the intrinsic value of the company before doing the analysis.
How Technical Analysis is Used
Technical Analysis is used for an instrument whose price is changed based on demand and supply such as currency markets, bonds market, the stock market, commodities, etc. It is used to predict the future price of the stock based on the demand and supply in the stock market.
Price changes are mapped on the chart which in terms creates patterns, movements; over a period of time special indicators, tools, techniques, and methods have been developed to improve the accuracy of the prediction.
The ground rule of the technical analysis is that the larger the time period or trend better is the accuracy. Since technical analysts believe that the stock price moves in patterns. They are involved in understanding these patterns beforehand to ensure they are able to predict those patterns and take the right decision based on the historical patterns.
Predictions are usually made with probability ratio of success. A 60% success ratio of the stock market is a very good sign of success in technical analysis. If anyone says he would get sure shot 100% success ratio in the stock market he is only not aware of the truth or he is lying.
Arriving at a stock could be done in various methods. Many researchers combine technical analysis and fundamental analysis. After narrowing down the stock with fundamental analysis they conduct a technical analysis of the stock. For Fundamental Analysis, there are Fundamental Stock Screener tools available to narrow down your research on a particular stock.
Another method is using technical stock screener for analysis of the of patterns, breakouts, changes in trends etc.
Fundamental Analysis Versus Technical Analysis
Fundamental Analysis is the study of financial statements of the company such as cash flow, balance sheet, and profit & loss account. Future cash flows are predicted based on the current financials and intrinsic value of the company is derived. Based on the intrinsic value of the company if the current market price of the stock is lower than that of an intrinsic value of the stock. Then this stock is considered a good value investment opportunity.
Results of fundamental analysis the stock bought as expected to be bought at prices lesser than that of their value. In no way does fundamental analysis predict the price movement of the stock.
Whereas the technical analysts believe that all the past information is already factored into the stock prices and there is no need to study these documents since they are not much use to predict the stock market price. As per fundamental analysis even if the stock value is more than the stock price. It does not mean that stock price is going to move up immediately.
On the other hand, technical analysis is the study of price patterns plotted on the time series charts.
The future price movements are predicted based on the past price movements.
What is a Chart?
The chart is the pictorial presentation of the movement of the price on a time series graph.
Based on the preference of the user the stock timeline may vary from minutes, hours, days, weeks, or even months. The chart consists of X-Axis and Y-Axis wherein the X-Axis denotes the time period and Y-Axis denotes the price of the stock. The stock price cannot go negative in its lifetime and likewise, the time cannot go negative.
Based on the information that one needs to study the chart the complexity of the chart increases or reduces. If a chartist only requires the closing price point of the time frame let’s say daily basis. When the points are plotted of the daily closing price in the chart and joined together then it forms a Line Chart.
The line chart is the most basic form of charting. Stock market analysts have evolved the number of details that one should add in the chart and this gave rise to different types of chart.
The line chart has it’s own limitation because it has the only limited information such as the closing price of the stock. Technical analyst required other similar information for better decision making; the vital stats that were included over a period of time are volumes, opening prices, Day’s High, Day’s Low, and closing price. As more and more data was added to the charts this lead to different types of the chart in the stock market.
Types of Chart
There are four main types of charts that are most popularly used. We are going to discuss only those here in a brief way. Other types of charts we would discuss in a detailed manner in some other post.
The four major types of Chart are as follows:
Point and Figure Chart
They look different only because of the price that is factored into the chart from one to another change.
Line chart only things that are plotted on the chart is the closing price of the stock. This is one of the most basic forms of charting. They do not give much insight into the stock price. These types of stocks usually only give an idea about the trends in the stock market. While these types of chart do not portray the finer and smaller movement in the stock they are used only by Investor or traders who work on trends.
Bar Chart is little advance than the line chart and it has open, high, low and close. The chart is made up of a vertical line that represents the price range of one single day, the highest price it reached, lowest point it went and also closing price. Some software shows the falling in red color and rise in the price in blue.
Many Technical analysts found it very difficult to quickly find out the movement of the stock market in the short term. This lead to developing a chart which is called Candlestick Chart. They are originally called as Japanese Candlestick because its origins are dated 300 years back from Japan. Still, this remains the most popular and the useful tool for technical analysis.
I personally have been using this last decade for understanding price movements and pick up stocks. This is similar to the bar chart but the only difference is it shaded in the middle based on its movements. A negative movement is shaded in Red and Positive movement is shaded in Green.
Point and Figure chart are used by the beginners. In this chart, the price reflects without time and volume. It is believed that it removes the noise and show the actual progress in the price. Insignificant price movement is also eliminated in this process to give better results. But if you notice in the below software chart time is also mentioned. Over a period of time, there are some changes that have taken place in point and figure. But the original had all the characteristics which we have discussed above.
Candlestick chart is the most popular but to take the maximum advantage of the candlestick chart one has to understand how each candlestick works. This is classified into two types one is bullish e.i. when the opening price is lower than the closing price of the stock. And bearish e.i. when the opening price is higher than that of the closing price.
The Important Price Fields are as indicated below:
- Open (O)
- High (H)
- Low (L)
- Close (C)
From the above image, it is easy to understand when there are net buyers the stock price is Bullish likewise when there are net sellers the market is bearish.
Support & Resistance
In Stock Market Technical Analysis support and resistance is price levels or trend lines at which the price rebounds. If the stock is moving upwards and it rebounds to lowers level it is Resistance. Likewise, if the stock is moving downwards and rebounds upwards than that is a Support.
Understanding right support and resistance to the given stock can give you lot of opportunities to make money in stock market,
Their names are self-explanatory and self-derived for the purpose they are used. A support price level or trend line is that level where a falling stock price slows down and finds support or lot of buyers in other words.
A resistance price level or trend line is that level where a rising stock price slows down and resists and finds a lot of sellers in other words. The stock price will keep rising until it finds resistance.
Importance of Volumes
The Volumes of a particular chart is exactly the same time frame of a candlestick period. It is exactly placed at the bottom of the chart exactly below the candlestick. Volumes are exactly the total number of stock that have been exchanged for a specific time period.
Volumes play a very important role in understanding the value of trend. Change in trend with higher volumes confirms the trend. Likewise, change in trend with no change in volumes should not be considered as a change in trend.
Trading volumes confirm the momentum in the stock price and confirm the trend or change in trend. For example, if the stock price is reversing and forming higher tops and higher bottom with high volume this denotes a confirmation in a change in trend and gives confidence to the investor or trader that now there are more people buying the stock and it increases the chances of the stock price moving upward.
Contemporary charting tools not only show the volume of the stock but also the Volume Line Chart to easily find out the change in the volume. I have taken the Stock of ITC since the Index does not have volumes in it. The stock of ITC Limited has shown a large drop in the price along with high volumes.
This led the price to fall from the range of Rs 300 to as low as Rs. 250.