What is technical analysis?

Over the course of many previous chapters, we’ve touched upon technical analysis several times. Now, we’ll get into further details and see how versatile technical analysis can be, and we’ll see the primary assumptions that form the basis of technical analysis. But as always, let’s take another quick look at what technical analysis is before getting into the details.

What is technical analysis?

Technical analysis is an investment analysis technique that involves studying past price movements and trends in an asset in order to predict possible future trends in price. It uses past information to speculate about what is most likely to happen in the near future, so traders can take advantage of possible future trends to make potential profits.

As you can see, the main purpose of technical is to forecast future price trends by analysing historical price trends. This approach is vastly different from fundamental analysis, which focuses on evaluating an investment from various angles and on analysing the quantitative and qualitative factors that affect an asset. In fact, it’s this difference that makes technical analysis of stocks and othe assets so versatile.

Versatility in application

Let’s take two everyday activities – cooking and driving. Now, with cooking, the recipe for each dish is different. You cannot take one recipe and use it for another dish, hoping to get a different result. In other words, each time you cook a new dish, you need to use an entirely different set of ingredients and follow a different method.

Fundamental analysis is something like that. Since the fundamentals of each asset is entirely different, the process of analysing those fundamentals also changes for each possible investment option. For instance, we saw in an earlier module that to perform fundamental analysis for equity shares, you need to evaluate the industry, look into the company, and then study its financials to arrive at the value of a stock. Now you see, this approach will not work if you’re performing fundamental analysis for a different asset – say an agricultural commodity.

In that case, you’ll need to analyse a different set of metrics like the weather patterns, the crop cycle, the demand and supply for that commodity, and the details of its harvest. The fundamentals of a non-agricultural commodity are again different from what you’ll study for a crop.

But with technical analysis, it’s much simpler. The central concept of the analysis remains the same, no matter what kind of asset you’re evaluating. This is much like driving a bike. Once you learn to drive one kind of bike, you can practically take any bike for a ride. There may be minor changes, but the technique remains pretty much the same, isn’t it?

Just like this analogy, technical analysis, when you learn it once, can be applied to any kind of asset easily. The data points pretty much remain consistent across assets – the high price point, the low price point, the volume traded, and so on. This is why technical analysis is a versatile investment analysis technique that can be applied on various types of assets.

The fundamental assumptions of technical analysis

So, now you know that technical analysis is pretty straightforward when it comes to the metrics that need to be analysed. This technique only focuses on past price and trading volume of the asset, and using this information, future trends are speculated or predicted.

So, to make the connection between these past data points and the potential future trends, there need to be some assumptions in place, isn’t it? Here are the three main assumptions driving technical analysis.

The market discounts everything

Remember the Efficient Market Hypothesis, which theorised that the market factors in any all information, whether public, private or historical? Technical analysis of stocks and other assets also assumes something along these lines. This technique is based on the assumption that any information that is relevant to a particular asset is already factored into the price of that asset. In other words, the market already factors in all available and rumoured information into the price of the asset concerned. 

Technical analysts study how the price of a stock or any other asset reacts to all of this information. And based on the trends in the asset price, these analysts determine whether or not an asset makes for a good buy. 

Prices move in trends

These price trends that we’re always talking about with regard to technical analysis – they’re not random trends at all. Or so technical analysis assumes. According to this school of thought, price changes always follow a trend – whether it is bullish (moving upward) or bearish (moving downward) . There are patterns that are identifiable over time, and once a price trend is established, technical analysis of stocks and other assets assumes that the asset continues to move in that direction till a new trend comes into force.

These trends can be short-term, medium-term, or long-term in nature. And consequently, if you’re a short-term trader, you’ll need to look at short-term trend charts that plot hourly or minute-by-minute trends. On the other hand, if you’re a long-term trader, you’ll find weekly or monthly charts more useful. 

History tends to repeat itself

This is perhaps the most fundamental assumption that drives technical analysis. This technique assumes that price trends tend to repeat themselves over time, because human behaviour is quite predictable. For instance, when the market is bullish and the stock prices are on the rise, traders tend to buy despite the high prices, under the assumption that a further rise will bring in high profits. Similarly, in a bearish market, people tend to sell their assets despite the falling prices.

Because this is exactly how human behaviour plays out time and time again, the price trends also tend to be similar each time around. And based on this assumption, technical analysis focuses on studying past price patterns to predict how future trends will play out.

Types of Technical Analysis

When it comes to technical analysis of stocks, you have two approaches, namely the top-down approach and the bottom-up approach.

The Top-down approach

In the top-down approach, you start your analysis with a broader perspective. For instance, you start by analysing a particular sector or industry, and then work your way down to a particular stock within that industry. Or, you could start with a broad market index like Sensex or NIFTY, narrow it down to a sector, and then further down to a stock. This way, you can ensure that the stock you wish to invest in is technically a sound investment.

The Bottom-up Approach

The other approach is the bottom-up approach. Here, your technical analysis begins with a specific stock. Typically, experts take up undervalued stocks for technical analysis. Then, they work their way up to examine the technical and historical aspects of the sector that the stock belongs to, or any broad market index that the stock is a part of. This approach helps you determine entry points and exit points for your trade. 

Wrapping up

To study these price patterns, technical analysis makes use of different kinds of charts. These charts are essentially graphical representations of the price movements of stocks. The charts used in technical analysis include line charts, bar charts, candlestick charts, renko charts, point and figure charts and Heikin Ashi charts. 

If you’re eager to find out more about the types of charts and learn more about candlesticks – the most common kind of chart used for technical analysis –we’ve covered all of these concepts in the upcoming chapters.