If you have seen a trader or an analyst sitting and concentrating over a screen full of complex charts and trend lines then it is highly likely that the person is doing technical analysis. What exactly is technical analysis? It is the study of charts and patterns of price and volumes of stocks to extrapolate future trends. Technical analysis is based on 3 fundamental premises
- Everything that is to be known about the stock is already factored into the price and hence there is no great point in trying to identify undervalued stocks. Stock prices, according to technicals analysis, are just a random walk.
- Technical analysis believes that past patterns tend to repeat themselves in the future too since patterns are created by market psychology and that tends to remain constant over a period of time. Hence, one only needs to focus on these patterns.
- The third premise of technical is that all signals also have different types of confirmations and a trading call on a stock must be taken only when the trends and patterns are backed by adequate confirmations.
Understanding primary, secondary and tertiary trend
At the base of technical analysis is this classification of trends in the stock prices into 3 different time-based categories. They are called the primary trend, secondary trend and the tertiary trend. Your approach to trading will be based on whether the trend you are analyzing is a primary trend, secondary or tertiary trend. Let us understand what each of these trends mean?
A primary trend is normally called the inviolable trend. It lasts for a period of more than 1 year and can even last for a number of years in succession. It is primary trend that determines if the market is in a bull grip or in a bear grip. Within this primary trend there are secondary trends that last for a period of 3 weeks to 3 months. These could normally be opposite in direction of the primary trend. For example, within a bull market primary trend, there could be secondary trend in the form of a 3 month correction. Alternatively, there could be a 1 month bounce in a market where the underlying primary trend is bearish. Finally, we come to the tertiary trend. The tertiary trend is also called noise in technical analysis and can last from 1 day to a couple of weeks. Traders need to be careful about tertiary trends, especially if they are contrary to the primary trends.
Understanding the four pillars of technical analysis
If you open any text book on technical analysis, you will find a plethora of techniques and exotic names to describe trends. But if you were to condense all these ideas and compress them into a handful of pillars, there are broadly four of them. Understanding these four pillars of technical analysis is at the core of grasping technicals
- Point and Volume Charts: In fact these charts are the most commonly used charts in technical analysis and most technical packages will offer these point and figure charts. These point and figure charts are also called candlesticks and are important because they not only capture the closing price of the stock but also the opening price, closing price, high price and the low price. Thus the entire gamut of price movement is captured over a period of time. Additionally, the data on volumes is also captured to give a combination of price patterns and volume confirmation.
- Moving Averages: You often find technical analysts on business channels talking about 100 DMA and 200 DMA to justify their view on the market. What they are basically talking about is moving averages. Moving averages are used to adopt a time series approach to stock prices and smoothen out the rough edges that may be created by abnormal movement in stock prices. One can use simple moving averages (SMA) or Exponential Moving Averages (EMA). Normally, critical moving averages of 100 days and 200 days act as critical supports and resistances and that helps traders not only to time their purchase and sale but also to specifically pinpoint their stop loss levels.
- Supports and Resistances: Supports and resistances combine price trends with demand and supply scenarios. A support is typically a point where the demand volumes are strong enough to prevent the price from falling further. Technicals teach us to buy stocks around support levels and place stop losses below the support levels. Resistances, on the other hand, represent the level where the supply is strong enough to prevent the price from rising beyond that point. Traders typically sell around the resistance level and place their stop loss above the resistance level.
- Momentum Indicators: Momentum indicators are leading or lagging indicators of a price movement. Leading indicators are useful because they help you to get indication of a likely rise of fall in stock price. Traders can then position themselves accordingly. Lagging indicators are more like a confirmation of a trend.
Technical Analysis is incomplete without understanding Dow Theory
One of the biggest contributions of technicals has been the Dow Theory, which basically forms the foundation of technical analysis. The Dow Theory has been around for over 100 years and its contours have stood the test of time. Dow Theory is based on the premise that the market is in a bull run if one of its averages moves above a previous high and is followed up by similar such movement by other averages. Dow Theory also uses stock markets as a lead indicator of the overall economic conditions.
Many analysts and investors often look at fundamental analysis and technical analysis as two competing sciences of markets. That is incorrect. In fact, they are complementary. Fundamentals can identify value and technicals can help you time the market. The result of the combination will be a lot more refined!