Understanding technical analysis

In the current uncertainty and despite the surprising rally in the market, technical analysts continue to forecast specific target levels for stocks and indices. They determine the future levels by examining the past price movements and trading volumes of stocks and indices. Using price charts and trends, they predict which way a stock or an index is most likely to move.

However, their assumption that a stock will continue moving in the same way as it has done in the past is not always true. A stock's fundamentals and other factors also play a role in determining its future performance. Here is a brief introduction to technical analysis and a look at how it differs from fundamental analysis.

Technical Analysis versus Fundamental Analysis

Data: Technical analysis: Looks at the past price movements and trading patterns of a security to determine its future course.
Fundamental analysis: Examines the company's financials, its business model, profit growth and prospects to ascertain its future price.

Tenure: Technical analysis: The scope of the analysis can range from very short (daily or weekly) to midterm (monthly or quarterly).
Fundamental analysis: Typically takes a long-term perspective of at least one-two years while evaluating a security.

Assumptions: Technical analysis: Assumes that the stock price will move along an established trend and pattern as it has done in the past.
Fundamental analysis: Assumes that the stock price is determined by its intrinsic value and the future earning potential of the company.

Investor type: Technical analysis: Useful if you are a day trader, short-term investor or a hedger looking for quick gains from stocks.
Fundamental analysis: Useful for investors who want to create wealth over the long term by buying and holding securities.

Investments: Technical analysis: Can be used for any tradeable financial security-equity shares, commodities, forex, futures, bonds.
Fundamental analysis: Can be used only for a narrow range of instruments such as shares, stock indices and commodities.

Information flow: Technical analysis: Restricted to those who are conversant with the concept and have access to the required tools.
Fundamental analysis: Available to all investors through company's annual reports, stock exchange Websites, brokerages and media reports.

Charts Used For Analysing Trends

Some commonly used graphical representations of stock price movement that help in constructing future price levels.

Line chart: The most basic chart that represents only the closing price of a stock over a given time frame. It does not provide information such as the high, low and opening prices of stocks.

Bar chart: More advanced, this chart indicates the opening, high, low and closing prices of the stock. This information helps chartists determine if the stock is bullish or bearish.

Candlesticks: Also known as Japanese Candles, since they were first used in Japan to analyse the price of rice contracts. They are similar to bar charts but differ in the way they are drawn.

Indicators And Patterns

Technical analysis uses a wide range of indicators. Here are some of the common patterns that emerge and the tools used to analyse them.

Support and Resistance: Support or resistance levels are the prices that are difficult to breach for a stock or an index. A stock usually bounces back after falling to its support level. If it falls below the support, it can go into a free fall. Likewise, a stock finds it tough to cross the resistance. If it does, the resistance becomes the support level.

Head & Shoulders: This is actually a combination of four patterns. First, the left shoulder is formed when the price touches a high and then recedes. Then, a renewed surge takes it to a higher level, but it again falls, forming the head. In the third step, the right shoulder is formed. If the price falls below the neck line support level, there is heavy selling.

Double Top: This chart is formed at the peak of an upward trend when the price of a stock moves up to reach a resistance level, only to fall back. This forms the first top. The stock again moves up, but recedes after hitting the resistance. After two unsuccessful attempts at crossing the resistance level, the trend reverses and the price heads lower.

Double Bottom: This pattern is formed when a stock's price drops to the support level, but bounces back due to renewed buying. After the second bounce, there is a breakout and the stock price follows an upward trajectory. Double bottom patterns are generally seen at the end of a downtrend and are an early signal for a rally.

Moving Averages: These are average values of a stock over different time frames ranging from 20 days to 200 days. They help smoothen the daily fluctuation in stock prices to give a more realistic valuation. Analysts typically use the 20-day moving average (DMA) for a shorter trading horizon, 50 DMA for the mid-term and 200 DMA for a longer duration.

Trading Volumes: The volume of trading is very important in technical analysis. It validates the trend. Heavy volumes suggest bullishness because there is tremendous investor interest in the stock. Bleak volumes suggest bearishness, where there are few buyers and not much trading activity. The bars at the bottom of a chart denote the traded volume.

More On Technical Analysis

Want to learn more about technical analysis? These Websites and books can help.

www.tradersedgeindia.com
A useful Website that provides information on trading systems and advanced trading methods. Registered users also get a newsletter that gives trading tips based on technical analysis.

www.stockcharts.com
Though this is an American Website, the tools and information have universal application. However, expert opinions and support in technical analysis are useful only for traders in the US.

Technical Analysis Of Stock Trends
By Robert Edwards & John Magee
Considered the Bible of technical analysis. Used by experts because it explains advanced techniques.

Security Analysis And Portfolio Management
By D.E. Fisher & R.J. Jordan
Primarily for beginners, this book focuses on fundamental and technical analysis of stocks.