Part 1: Introduction
Introduction to Technical Analysis
Technical Analysis is the study of market action through the use of charts in order to predict the future prices of the market. A trader or an analyst uses charts to analyze the behavior of the market and then applies some tools & techniques to make a future price prediction.
MARKET ACTION = PRICE + VOLUME + OPEN INTEREST
3 Arguments of Technical Analysis
There are 3 major principles on which Technical Analysis is based:-
1) Market Discounts Everything- Anything that can possibly affect the price fundamentally, politically, geographically, psychologically, etc. is reflected in the price of the market. The price action reflects the change in supply & demand. The shift in supply & demand can occur due to any of the above-mentioned factors. Hence, be it news, earnings, acquisitions, restructuring, etc., everything results in a shift in the supply & demand of the asset., which is ultimately shown in the price.
Therefore, it is argued that every chartist studies the fundamentals through the charts. The charts do not bring upon bull and bear markets themselves, it is the supply and demand forces that are the driving factors.
2) Price Moves in a Trend- Prices move in a trend. There are 3 major trends in the financial markets. Uptrend, downtrend & sideways trend. Either the prices will move higher, lower, or moves sideways. There are only 3 directions, the price can go. The whole purpose of charting is to identify the trends in their early stages.
Also, just like Newton's 1st law which states that an object tends to be in motion unless acted upon by an external force, the prices continue to be in a trend unless reversed.
3) History Repeats Itself- The patterns & trends work on human psychology which does not change with time. Hence the patterns that worked in the past are expected to work in the future too!
Fundamental Analysis Vs Technical Analysis
Technical Analysis focuses on the market action, while fundamental analysis gives importance to the forces of supply & demand that force the price to change. The fundamental approach determines the intrinsic value of the market. If the market price is above the intrinsic value, then the asset is overbought & if the market price is below the intrinsic value, then it is oversold.
Both approaches tend to predict the price of the market. The Fundamental approach studies the cause of market movement while the technical one studies the effect.
Market Prices tend to lead the fundamentals. How many times have you noticed, that there is a sudden drop in prices and then negative news starts popping up on TV & newspapers?
Criticism of Technical Analysis
It is often argued that Charts tell us about what has happened in the market but cannot tell us about what is going to happen. Also, studying charts is subjective in nature, my analysis can be different from your analysis. There are no hard and fast rules for a chartist to adhere to.
Can the past be used to predict the future?