The looking glass of technical analysis

Technical Analysis

At times technical analysis is looked upon at par with palm reading or star gazing to predict the future movement of the stocks. A technical analyst aims at predicting future price movements with the help of past data. While the technical analysis does carry some elements of prediction in it, they are especially useful to predict sudden price movements and help an investor from making large losses or grab an opportunity for larger profits. Like weather forecasting, technical analysis does not result in absolute predictions about the future. Instead, technical analysis can help investors anticipate what is “‘likely” to happen to prices over time. Technical analysis uses a wide variety of charts that show price movements over time.

Technical analysis requires a more hands on approach, where the investor regularly studies the movement of technical charts. For this reason it is used more by traders than investors. Investors rarely dedicate time on a daily basis to study their portfolio. Technical analysis helps traders and investors navigate the gap between intrinsic value and market price Technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume. Unlike fundamental analysts, who attempt to evaluate a security’s intrinsic value, technical analysts focus on patterns of price movements, trading signals and various other analytical charting tools to evaluate a security’s strength or weakness.

How does technical analysis work ?

All stocks have a price, which is normally studied in four highlighted points – the open, the high, the low and the close. These points are graphically represented through the analytical Software. You study and compare the current day’s price (or the previous day’s price) vis-à-vis the previous year and plot the price series on a graph over a period of time. Once this is done, you try to forecast it. This is a study of the market and share trend, and the forecast is based on the pattern that the study reveals. So, you can make money by riding the trend price. The basic premise of technical analysis is that the price discounts everything, fundamentals or otherwise. However, price is an effect of the fundamentals or the actual strengths of the company. Hence, technical analysis is nothing but an indirect way of studying the fundamentals.

The looking glass of Technical Analysis 

Watching financial markets reveals that there are trends, momentum and patterns that repeat over time. They may not be exactly the same, but would be quite similar. A chart is a mirror of the mood of the crowd and not of the fundamental factors. Thus, technical analysis is the analysis of human mass psychology. Therefore, it is also called as behavioral finance

Analyzing Charts with Different View Points 

Technical analysis is an art. We are looking at the same chart with different time frames. Someone may look at a chart with a five minutes perspective and some, with a four-day perspective or even with that of a month. So, the terms referred to by the chartists correspond to the time frame they are looking at. If somebody tells you to buy a particular stock because it is likely to rise, make sure you understand whether the dollar is expected to rise over a few days or a few months and if you should buy the stock with the intention to hold it for several days, several weeks or several months. For a day trader, the long-term horizon is entirely different from that of a retail investor. For a trader, long-term can mean several days, while for the investor, it can mean 1-3 years.

Popular Theories or Strategies of Technical Analysis 

The prominent strategies of technical analysis are the Dow Theory, The Elliot Wave, the Japanese Candlestick as well as Trend Lines, Oscillators and the Moving Average. We have made an attempt to explain each of these briefly. 

The Dow Theory

The root of today’s technical analysis dates back to the ideas of Charles Dow, the first editor of the Wall Street Journal. The six sound principles laid down by him in this theory are mentioned as below:

1. The market discounts everything, that is to say, that the market takes into account everything  except acts of God.
2. The market has three trends–Primary, Secondary and Minor
3. The primary trend is further divided into three categories-Accumulation, Run-up/ Run Down and Distribution,
4. The averages must confirm each other.
5. Volume must confirm the trend.
6. Trends exist until their reversals are confirmed.

Essentially, he believed that the market has three movements all going on at the same timeThe Narrow Movement: This spans the daily fluctuations from day to day. The Short Swing: This covers the secondary movements running from two weeks to a month. The Main Movement: Based on primary trends it covers at least four years in its duration. Dow Theory helps the investors to identify facts, not make assumptions or forecasts. It can be dangerous when investors and traders begin to assume things. Predicting the market is a difficult, if not an impossible, game, Hamilton admitted. While Dow Theory may be able to form the foundation for analysis, it is meant as a starting point for investors and traders to develop analysis guidelines that they are comfortable with and understand well. 

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