There are two factions in market analysis. One being technical analysis and the other being fundamental analysis. Both the camps are extreme and contrast. They diverge in their view and the method of analysis but converge at one point- forecasting.
Technical Analysis is a technique to infer the supply and demand for an asset. The inference is made upon the studies of the historical price action and psychology of the investors.
It disregards the study of the intrinsic value of the asset and analyzing the politico-economic news.
Well, from the outset, it might seem ridiculous, but it isn’t.
Here’s an analogy for you. You want to buy an osteoporosis machine. If you’re pondering, “why on earth do I need?”. Well, for the sake of the universe, you want it, but you have no clue about it whatsoever. So, there are only two options in front of you now.
Option #1 – To research it thoroughly by visiting medical institutes, companies and get to know the best machine available in the industry.
Option #2 – The prevalent and straightforward practice is to go to amazon.com or any other online shopping site. Visit the reviews & rating section and order the one which you deem best.
Assuming you know nothing about the osteoporosis machine, you’re bound to choose the latter. Because if a handful of people like a product, then it is probably good. So rather than making a random choice and end up with regret, you have now given yourself an edge to get the best.
In this analogy, the former is the fundamental analysis and the latter is the technical analysis. The word to watch out for here is ‘probable’. Just because many people love a product, it doesn’t necessarily be the best. It could be a horrible product and people could be lame too.
However, the significant advantage of this method is that it is universally applicable. You can use it to buy any product on the market.
Likewise, the technical analysis applies to all types of market – stock, commodity and forex. The prerequisites being the asset is volatile and highly liquid so that the dynamics of supply and demand alter frequently.
Get to know the #9 critical differences that matter between Technical and Fundamental analysis here.
Basic Assumptions of Technical Analysis
The spirit of the technical analysis is to understand and interpret the psychology of investors, which corresponds to the trade decisions. Several factors – fundamental features, news, rumors, most of all emotions – amalgamate into a buy or sell order.
There are certain underlying assumptions of technical analysis which pave to overlooking these factors and make a trade decision without its influence.
The market discounts everything
The fundamental features, news and rumors are all absorbed by a price action already.
Hence, as a technician, you must disregard any new stimuli concerning fundamentals- news, rumors, even data.
And it is this assumption that repels many investors and to desist technical analysis. However, fundamental analysts conveniently forget that they do discount information labeling it as ‘already priced in’.
There is no dispute that this assumption raises many brows, but it is a tricky postulate made for the betterment of a technician.
The spirit of this theorization is to let the technician decide the fate of an asset by technical factors rather than fundamental analysis.
For instance, if a news surfaces in the market, say an upbeat GDP number, a technician should not pounce on it instantly. Instead, he/she must await a fresh impetus based on technical analysis — a shift in the dynamics of supply and demand — and then make a trade decision.
In most cases, the news would have been already factored into the price and it will not ado much. In some cases, where the entire market is caught off guard, it tends to overreact which has its say in technicals too.
A technician to solely rely on technical analysis — Is it a big ask?
Prices move in a trend
As said earlier, technical analysis performs well in short-term trading. For a fundamental investor, it seems irrational and meaningless. Whereas, for a technician, it is rational and exciting.
A technician believes a trend is set to continue rather than break. The supply and demand equation to stay the same than deviate. The investor psychology to prolong in the same state of mind than dissipate.
Most technical principles are based on this notion. Moreover, there are specific patterns which foretell a trend reversal. However, more often than not a technician must vote for a trend continuation.
History tends to repeat itself
This assumption is more likely a compliment or an extrapolation of assumption #2. It expands the purview of the trend to every aspect of technical analysis, say emotions and sentiment.
For instance, a stock runs off to the highs anticipating a good earnings report. And just two days prior to the report release, it cools off resulting in a short-term selling opportunity. The reason being investors wanting to lock their profits at higher levels and reduce their risk exposure in case a deviant report surfaces.
Next time when the same stock runs off to the highs before the release of the earnings report, a technician can anticipate the same behavior from investors. It is a history or trend of investor’s behavior. Likewise every aspect of technical analysis- support and resistance, patterns, indicators – repeat on and on.
What and how is more important than why
A technician should always ponder about what is going to happen and how it is about to happen. Instead of being intrigued why a big fish has bought a massive chunk of a stock, an analyst must delve into what the impact of it in price action — whether it has soared or plunged, and how it happened — whether it coincided with a volume surge.
The underlying assumptions are the basic primitives. One has to understand and absorb it in the right spirit to master the craft and devise a strategy.
Trend: The Buzz word in Technical Analysis
Prices move in trends. So, it is crucial a trader catches the trend and stays with it for an extended period. Always remember the saying, ‘The trend is your friend’.
But the trend identification part is slightly tricky as there are numerable ways.
When the price action forms a higher high continuously, it is an uptrend.
Likewise, if it forms subsequent lower lows, it is a downtrend.
Choose a moving average of your choice, say 50,100 or 200.
If the price is above the moving average, you can interpret it as uptrend. On the contrary, if it is below the moving average, it is a downtrend.
200 SMA and 100 SMA are the popular choices for defining trend for long-term and short term trading, respectively.
Connect the higher lows or the supports in an uptrend with a sloppy line to get a bullish trendline. In a downtrend, the bearish trendline connects the resistances.
If you want any success in the market, then anticipate a trendline to hold rather than break.
A break below the trendline is a rarity and when it does happen it usually result in a sell-off (in an uptrend).
When does a trend reverse as per technical analysis?
The market doesn’t provide a one-way ticket. So, what goes up, eventually comes down. And it is the role of support and resistance to denounce the trend and tender a reversal.
The past price action serves as a reference point for the reversals. If the price action has receded at a price point earlier, then it is deemed to render a reversal this time also.
So the points which tender reversal in an uptrend are the support and the points which render in downtrend are the resistance.
In the above chart, the currency pair rallies steeply indicating strong momentum. However, the rally was brought to a halt by the bears at the value 1.29000. It receded initially and tried to take it out again and again. But its efforts proved in vain and the point proved to be a tough nut to crack, which is the resistance. Finally, the price action the extended the correction extended further and the resistance stood vindicated.
The above chart is a classic example of static resistance. However, there is more to it. Know more about the dynamic support and resistance and the indicators used to identify it here.
Integral Components of Technical Analysis
Technical Analysis is an extensive study. Tools aplenty, techniques abundant, and the think-tanks apply it in preponderate ways. Yet, the community feels some components and mind hacks as basic amenities for their analyzation.
Chart reading is a vital aspect of technical analysis. Your eye must read the critical information and disregard the irrelevant, which the OHLC charts make viable.
OHLC means Open, High, Low and Close. These are the periods when the market is at its full potential- high volume, upbeat volatility, better liquidity and increased institutional presence. Hence the two charts — candlestick and bar chart — render better insights to a trader.
If an asset is volatile and liquid, then it is obviously going to have huge volume. Hence, technical analysis tends to perform better on assets which are highly traded.
Albeit the invention of sophisticated indicators to identify liquidity and volatility, the volume is still a widely used indicator.
Knowing the constraints of technical analysis
Since technical analysis is a game of probabilities, there is a fair chance to lose the trade as well. Hence, most technicians use a stop loss to limit their loss in case their analysis turns out to be a fallacy.
Supply and demand play an eminent role in short-term rather than long-term trading as it is subject to change sporadically.
Hence the impact of technical analysis tends to be more acute in short-term trading.
Technical and fundamental analysis are just different school of thoughts in the market. From the outside, the former seems inferior to the latter. But, as you work your way around it, you find its relevance. Fundamental analysts use the same set of tools in their study of Behavioral Economics. And of late, even the leading institutions, have braced technical analysis — employ fundamentals to know the intrinsic value of an asset but deploy technical principles to squeeze the maximum out of it.