TECHNICAL ANALYSIS — PART 1
BACKGROUND
Consider this analogy, “You have a birthday coming up and you plan to throw a big party for your friends.”
You have two options:
Option 1 — You set out to do your own research before the party to find out which are the best clubs in the nearby locality which has great food and crowd. You personally visit these places and find it out on your own.
The advantage with this technique is that you know exactly what you are looking for since you have personally researched about it. However on the flipside, the methodology you adopted is not really scalable as there could be about 100 clubs, and with limited time at your disposal, you can probably cover about 4 or 5 clubs. Hence there is a high probability that you could have missed the best club for your party.
Option 2 — The second option is that you can have an impromptu and can visit the places on the day of your party and stand aside and notice all the people going to the different clubs. You can find there are some clubs that attract fewer crowd while some of them attract a huge crowd. You can figure out a club that is attracting the maximum crowd. The clubs attracting the maximum crowd may be assumed to be the best. Relying on the preferences of the crowd, you may decide to enter that club and chances are that you get to have the best birthday party with your friends.
The advantage of this method is the scalability. You just have to figure out the club with maximum crowd and bet on the same. The flipside of this method is that the decisions of the crowd can’t always be right and you can end up ruining your party.
If you could recognize,
Option 1 is very similar to Fundamental Analysis where you research about a few companies thoroughly. We will explore about Fundamental Analysis at a later stage.
Option 2 is very similar to Technical Analysis where one scans for opportunities based on the current trend aka the preference of the market.
WHAT IS TECHNICAL ANALYSIS?
Therefore, technical analysis is basically a security (stock, bonds, commodities & currencies) analysis for forecasting the direction of prices through the study of past market data. It primarily consists of price, volume and behavioural analysis.
This data can be visualised by means of a stock chart. Over time, patterns are formed within these charts and each pattern conveys a certain message. The job of a technical analyst is to identify these patterns and develop a point of view.
Like any research technique, technical analysis stands on a bunch of assumptions. As a practitioner of technical analysis, you need to trade the markets keeping these assumptions in perspective. Of course we will understand these assumptions in details as we proceed along.
COMPARISION WITH FUNDAMENTAL ANALYSIS
Also, at this point it makes sense to throw some light on a matter concerning Fundamental and Technical Analysis. Often people get into the argument contending a particular research technique is a better approach to the market.
However in reality there is no such thing as the best research approach. Every research method has its own merits and demerits. It would be futile to spend time comparing both these analysis in order to figure out which is a better approach. Both the techniques are different and not comparable.
Jus to give you a brief, in Fundamental Analysis, people usually consider analysing micro and macro-economic situations through use of Monetary Policy, Economic Data, Annual Report, Management Quality etc.
Whereas in Technical Analysis it is more about analysing the underlying chart history, through price development, volume development and general market dynamics.
In fact a prudent trader would spend time educating himself on both the techniques so that he can identify great trading or investing opportunities.
APPLICATION OF TECHNICAL ANALYSIS
Probably one of the greatest versatile features of technical analysis is the fact you can apply Technical Analysis on any asset class as long as the asset type has historical time series data. Time series data in technical analysis context is information pertaining to the price variables namely — open high, low, close, volume etc.
Here is an analogy that may help. Think about learning how to drive a car. Once you learn how to drive a car, you can literally drive any type of car.
Likewise, think about cooking, there are no set parameters for cooking, every dish you make requires different types of tasting and spices.
You only need to learn technical analysis once. Once you do so, you can apply the concept of TA on any asset class — equities, commodities, foreign exchange, fixed income etc (historical data available). This is also probably one of the biggest advantages of TA when compared to the other fields of study.
For fundamental analysis of equity, one has to study the profit and loss, balance sheet, and cash flow statements. However fundamental analysis for commodities is completely different. If you are dealing with agricultural commodity like Coffee or Pepper then the fundamental analysis includes analysing rainfall, harvest, demand, supply, inventory etc.
However the concept of technical analysis will remain the same irrespective of the asset you are studying.
SETTING UP EXPECTIONS
Often market participants approach technical analysis as a quick and easy way to make a windfall gain in the markets. If done with discipline, a windfall gain is possible but in order get to that stage one has to put in the required efforts to learn the technique.
One the contrary, trading catastrophe is bound to happen if you approach it as a quick and easy way to gain without discipline and adequate knowledge. Hence before you start delving deeper into technical analysis it is important to set expectations on what can and cannot be achieved with technical analysis.
Trades — TA is best used to identify short term trades. Do not use TA to identify long term investment opportunities. Long term investment opportunities are best identified using fundamental analysis.
Returns per trade — TA based trades are usually short term in nature. Do not expect huge returns within a short duration of time. The trick with being successful with TA is to identify frequent short term trading opportunities which can give you small but consistent profits.
Holding Period — Trades based on technical analysis can last anywhere between few minutes and few weeks, and usually few months and not beyond that. We will explore this aspect when we discuss the topic on timeframes.
Risk — Often traders initiate a trade for a certain reason, however in case of an adverse movement in the stock, the trade starts making a loss. Usually in such situations, traders hold on to their loss making trade with a hope they can recover the loss. Remember, TA based trades are short term, in case the trade goes sour, do remember to cut the losses and move on to identify another opportunity.
In the next lecture, will focus on the History of Technical Analysis, Different forms of Charts, Time Frames and Assumptions.
