10 Fundamentals of Technical Analysis

  • Ayush Singh Rawat
  • Mar 24, 2021
  • Financial Analytics
10 Fundamentals of Technical Analysis title banner

Introduction

 

In today’s world, investing has become a powerful term. Money investment has taken over the financial world and is one of the most likeable exercises of the people. But to calculate how to become optimal for profits, one needs to carry out proper and effective technical analysis. 

 

The analysis proves to be an excellent way for people to check if the investment done by them would bear fruitful rewards or would go down the drain. It also reduces the risk that comes pre-applied with the stock market. If the analysis is done skeptically, then its efficacy would also be very high making loss-incussing opportunities become minimal.

 

Let's dig deeper and find out how one can carry out technical analysis.

 

 

History of Technical Analysis

 

The technical analysis of stocks and the different trends have been used for hundreds of years to predict profit incurring techniques. In the 17th century, Joseph de la Vega adopted early technical analysis techniques to predict Dutch markets. Charles Dow, William P. Hamilton, Robert Rhea, Edson Gould, and Nicolas Darvas are considered to be the pioneers of modern techniques.

 

These people represented a market with a new perspective in which a tide that is best measured in highs and lows on a chart rather than by discussing the particulars of the underlying company. 

 

The diverse collection of theories from early technical analysts were brought together and formalized by Robert D. Edwards and John Magee in 1948 in their book ‘Technical Analysis of Stock Trends’. (From)


 

What is Technical Analysis?

 

Technical Analysis is the forecasting of future financial fluctuations based on an analysis of past price movements. Like weather forecasting, technical analysis helps the investors in predicting what is likely to occur and does not result in absolute predictions about the future. 

 

So it can be a great tool at your disposal but we have to be careful as the market is very volatile and technical analysis can only help you in studying the market but predicting the market is no possible task for any tool.

 

Technical analysis is the overall study of historical market data, using insights for market psychology, behavioural economics and quantitative analysis. Traders use these techniques of Technical analysis and apply it to charts in order to identify entry and exit points for potential traders.  


 

Fundamentals of Technical Analysis

 

Charles Henry Dow’s theory, who is the founder and co-founder of the wall street journal laid down some rules which are essential in determining the trends in the stock market. 

 

Technical analysts gain immense help from the three investment theories carved out by Charles Dow. Some of the fundamentals addresses by him are:


Displaying some fundamentals required to carry out effective technical analysis, namely, predicting the price movement , repetition of history, short-term focus, usage of charts and graphs, trade volume any many more.

10 Fundamentals of Technical Analysis


  1. The Stock market reflects all known information

 

The ‘known information’ here referred is the information which is disclosed and is publicly available. In addition, technical analysts do not approve financial information as accountable for analysis.

 

All entities like Return on equity ratio, price-to-earning ratio(P/E) and shareholder equity are not considered as they come under the fundamental analysis.

 

 

  1. Predicting the Price movement

 

As it is known that price never stays static and has a tendency to move randomly without any fixed pattern but one theory proves that movement of price can be predicted and charted as price movement tends to repeat itself sometimes or move in a known trend. 

 

Once you learn to understand trends, money-making becomes quite easy. When the tough part becomes easy, it becomes a child’s play to get good at it and become profitable after some time.

 

 

  1. Repetition of History

 

This theory reveals that the history is bound to be repeated and the condition holds true for the stock market too. This property makes the investors and market players react in the same manner as they reacted in the past because of re-occurrence of the events.

 

So, Technical analysts gain from these reactions from the investors to understand the effect of the reaction on the market last time around and use it when the event re-occurs.

 

 

  1. Short-term focus

 

Technical analysis of stocks focuses on a short period of time ranging from a month to a minute also. Fundamental analysis focuses on long-term investment but technical analysis relies on short-term investment.

 

Technical analysis proves best for people who look for making profits in a small amount of time or who constantly buy and sell stocks.

 

 

  1. Usage of charts and graphs

 

Technical analysis of stocks uses charts and graphs to read spot price trends. A chart is especially used to know about the trend of price movement.

 

Prediction of the current price of a stock and its near future becomes easy to study with the help of graphs. Trends can also be defined and classified according to their duration and types.

 

 

  1. Uptrends

 

The upward movement is known as uptrend. This is to be learnt that this upward movement to its high is not an all-time high but the high of the previous day, week or month.

 

The steady high and low price indicates the market's positivity about the stock. It is a clear indication that the stock is on upward trend and is optimal for buying. So, everytime a stock falls investors don't take a chance and let it fall further instead they take a chance and buy it immediately.

 

 

  1. Downtrends

 

When the stock prices continue to fall, it is regarded as a downtrend. Peaks and troughs both tend to take a hit during this phase. 

 

It means that the analysts consider that the stocks can go down further so it is advised to investors to wait for some time and let the stock recover and as the prices start rising, then sell the stocks.

 

For a short-term investor this is a bad time to invest but for a long-term investor it is optimal moreover we could wait more for the prices to go further down.


 

 

  1. Horizontal trends

 

A horizontal trend does not have a fixed trend; only the peaks and troughs remain constant. 

 

Traders can profit from horizontal trends in several ways, from looking for major signs of a breakout or breakdown to using stock options to placing stop-loss orders when the price nears resistance levels.

  

 

  1. Support and Resistance

 

Support and Resistance are two concepts of price movement involved in the technical analysis of stocks. 

 

Support is a price level where a downward trend of price movement is expected to halt. At this point, the price of the falls and the demand of the increases which forms a pattern.

 

Resistance refers to the highest price of a stock it reaches and traders start selling the stocks after which prices start to fall again.

 

Once the field of support and resistance is identified, trading becomes an easy task to carry forward. When the price reaches any of these two points, there are 2 possibilities. First, it may cross the levels and may go upward or downward. Second, bounce back after touching either of the two levels.

  

 

  1. Trade volume

 

Volume of trades is an important factor to be considered when performing the technical analysis of stocks. Important information about the market can be accessed through trading volume.

 

If the volume increases simultaneously with the increase in the price of the stock, the trend is probably valid. And, if the volume of trade grows slightly, probably it is due to the reverse trend that is in motion.

 

(Must check: 5 Keys Elements of Financial Analysis)

 

 

Indicators of Technical Analysis

 

Based on these guidelines, you can use three important technical indicators to identify market trends and predict future stock prices. 


3 important technical indicators of Technical Analysis,

3 important technical indicators of Technical Analysis, Source


  • Charts

 

Price and volume graphs and charts are the most typical tools that are used as technical indicators for technical analysis. A volume chart is used to depict the number of shares of a company that were bought and sold in the market during a single day.

 

For technical analysis, you can choose one of the traditional line or bar charts, or alternatively, use a candlestick chart. A candlestick chart is a special kind of chart that is the most appropriate for technical analysis and is in the form of a series of consecutive candles.

 

 

  • Moving Averages

 

Moving averages are calculated to remove sharp, frequent fluctuations that take place in a stock chart. Sometimes, stock prices can move very sharply in a small period of time making it difficult to spot a trend.

 

To remove this impact, and make a trend more prominent, an average of a few days price is calculated. 

 

For example, if a five day pattern of a stock’s price is Rs.50, 52, 48, 46 and 51, it is difficult to tell the movement of prices. However, if we can calculate the average of these prices and compare them with the average of the previous five days and the next five days, we can ascertain a broad trend.

 

This kind of moving average is known as a Simple moving average (SMA). It may be noted though, that moving averages are calculated for longer durations like Ten days or a month.

 

 

  • Momentum indicators

 

Momentum indicators are statistical figures that are churned out based on price and volume data of stocks. They act as supporting tools to charts and moving averages in carrying out the technical analysis.

 

Once you are through with forming an opinion about a stock based on charts and moving averages, you can use these indicators to confirm your views. Some momentum indicators act as signs that foretell the price move you. They confirm whether the price is going to move as you had thought.

 

These are known as leading indicators. Other signs come after the stock has started moving in a particular direction which are called lagging indicators. They confirm that the stock will continue moving in a particular direction. Indicators are also used in collaboration with moving averages.

 

 

Conclusion

 

At the end, we can conclude that Technical analysis of the stock market is an essential part of investing. If the proper analysis does not take place, it can lead up to wrong predictions and assumptions, ending up with people mis-judging the investing period and hence losing money. 

 

The above points also prove if investing is done using the indicators and assumptions in mind, it can also lead to rich dividends.

 

(Recommend blog: Top 10 Data Visualization Techniques)

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