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An introduction to Technical Analysis

We keep hearing technical analysts on TV, predicting the movement of the market. They talk confidently about these predictions based on their analysis of the past movements of the market.

But how reliable are these predictions? Can technical analysis be trusted? Is it reliable? Is it even relevant?

If you have been investing in the stock market for some time, or even if you have just been monitoring the equity market for some time, surely you would have heard terms like:

  • Oversold
  • Overbought
  • Double bottom
  • Bottom out
  • Candle sticks
  • Breakout
  • Daily Moving Average (DMA)
  • Simple Moving Average (SMA)
  • Trend reversal
  • Shooting star
  • Trigger line

All these terms (and there are many more) come from the field of technical analysis. Technical analysts use these terms to convey certain type of market conditions, and predict the future of the market movement based on it.

But what exactly is technical analysis? What is its definition?

What is Technical Analysis

Technical analysis (also called Tech Analysis at time) means analysis of the past movements of a given indicator, and predicting its future movement based on this analysis.

The indicator that is studied and analyzed can be an index (which means the study is for the entire market), or the stock price of an individual company.

Often, apart from the index value or price of the stock, the related volumes are also used during technical analysis.

Since the analysis deals with historic data, charts and chart analysis software is also extensively used.

The principle or belief behind Technical Analysis

The basic principle behind technical analysis is that the future movements of an index or a security can be predicted by their past movements.

If an index or a security has behaved in a certain way in the past, it would repeat the behaviour in the future as well. This forms the basis for prediction of the future price movement.

This also implies that unlike fundamental analysis, technical analysis does not attempt to find the intrinsic or true value of a stock – thus, it doesn’t help in determining if the prevailing stock price is more (less) than the intrinsic value, and therefore, if the stock should be sold (bought) or not.

The aim of technical analysis is to predict the future price movement, and the decision to buy or sell is taken purely based on that: If it is predicted that the stock (or index) would move up (irrespective of the reasons), it should be bought, and if it is predicted to go down, it should be sold.

Relevance of Technical Analysis

What does the price of a stock reflect?

The stock price is a reflection of the future growth prospects of the company. If a company is expected to grow in the future, and thus produce more profits, the price of the stock increases.

Similarly, if the growth of the company is expected to slow down, it would mean that the company would make less profit in the future. Therefore, people would be willing to pay less for the company, and the share price will go down.

Thus, the sole determinant of the price of a stock is the future growth prospect of the company. That is what determines the demand for the stock, and would influence the price.

And what does the future growth of a company depend on?

It depends on many factors: the condition and growth rate of the economy, the condition and growth rate of the sector in which the company operates, the competition that the company faces, profitability of the company, future expansion plans, etc.

Thus, any meaningful analysis of a stock, and any prediction about its future price movement, should involve a study of these factors.

Does technical analysis pass this test?

As mentioned before, the only factor that technical analysis considers is the historic price movements of a stock. And at times, the accompanying volumes.

It does not consider the fundamental factors mentioned before: the economy, the sector in which the company operates, the competition that the company faces, profitability of the company, future expansion plans, etc.

How comfortable should you feel about a measure that doesn’t take into account the most fundamental factors that affect a company and its growth?

Not comfortable at all!

Therefore, focus on the study of the factors that affect the growth (and therefore, the profitability) of the company. The study of such factors and their impact on a stock’s price is called Fundamental Analysis. (Please read “An Introduction to Fundamental Analysis” to know more about it.)

The bottom line: Stay away from technical analysis, and the predictions of technical analysts.

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