Introduction to Technical Analysis - Handbook for a layman

Hi all, today we are going to study about basics and usage of technical analysis. I have prepared this wholesome post so that you guys are able to understand what technical analysis is all about. I have shortened the sentences to readable points, hence, don't mind the grammar.

Learning objectives:

After studying this post the student should be able to understand:
1. The basis of technical analysis
2. Top-down analysis in TA
3. Assumptions on which TA is based on

What is Technical Analysis?

1. Art and science of forecasting future prices based on an examination of the past price movements.
2. Based on analyzing demand-supply in any tradable instrument.
3. Analyze prices, volumes, open interest, various patterns, and indicators to it in order to assess the future price movements.
4. It can be applied to any time frame.
5. TA ignores fundamentals (like financial and non-financial aspects of the company) and focuses on actual price movements.
6. TA is not astrology for predicting futures prices.

The Basis of Technical Analysis
What makes the Technical Analysis an effective tool to analyse the price behaviour, is explained by following theories given by Charles Dow:

1. Price discounts everything

• “Each price represents a momentary consensus of value of all market participants – large commercial interests and small speculators, fundamental researchers, technicians and gamblers- at the moment of transaction” – Dr Alexander Elder
  
• The current price fully reflects all the possible material information which could affect the price.
  
• The market price reflects the sum knowledge of all participants, including traders, investors, portfolio managers, buy-side analysts, sell-side analysts, market strategist, technical analysts, fundamental analysts and many others.
  
• Technical analysis looks at the price and what it has done in the past and assumes it will perform similarly in future under similar circumstances.
  

2. Price movements are not totally random

• If prices were always random, it would be extremely difficult to make money using technical analysis.
  
• Technical analysis is a trend following system. Most technicians acknowledge that hundreds of years of price charts have shown us one basic truth – prices move in trends.
  
  
  
  
  
• A technician believes that it is possible to identify a trend, invest or trade based on the trend and make money as the trend unfolds.
  
• TA can be applied to many different time frames, and so it is possible to spot both short-term and long-term trends.

3. What is more important than why

• “A technical analyst knows the price of everything, but the value of nothing”.
  
• Technical analysts are mainly concerned with two things:
  1. The current price
  2. The history of the price movement
  
  
• All of you will agree that the value of any asset is only what someone is willing to pay for it. Who needs to know why? By focusing just on price and nothing else, technical analysis represents a direct approach.
  
• The price is the final result of the fight between the forces of supply and demand.
  
• The objective of analysis is to forecast the direction of the future price.
  
• Fundamentalists are concerned with “why the price is what it is”. Technicians believe it is best to concentrate on what and never mind why. Why did the price go up? Simple, more buyers (demand) than sellers (supply).
  
  
  
  
  
• The principles of technical analysis are universally applicable. The principles of support, resistance, trend, trading range and other aspects can be applied to any chart.
  
• TA can be used for any time horizon; for any marketable instrument like stocks, futures and commodities, fixed-income securities, forex, etc.

Top-down analysis in Technical analysis

• Consider the overall market, most probably the index. If the broader market were considered to be in bullish mode, analysis would proceed to a selection of sector charts.
  
• Those sectors that show the most promise would be selected for individual stock analysis.
  
• Once the sector list is narrowed to 3-5 industry groups, individual stock selection can begin.
  
• With a selection of 10-20 stock charts from each industry, a selection of 3-5 most promising stocks in each group can be made.
  After the stock selection, start with higher time frame charts and move down to the lower time frames.

Technical Analysis: The basic assumptions

The field of technical analysis is based on three assumptions:
1. The market discounts everything.
2. Price moves in trends.
3. History tends to repeat itself.

The market discounts everything

• Technical analysis is criticised for considering only prices and ignoring the fundamental analysis of the company, economy etc.
  
• TA assumes that, at any given time, a stock’s price reflects everything that has or could affect the company - including fundamental factors.
  
• The market is driven by mass psychology and fluctuates with human emotions. Emotions may respond rapidly to extreme events, but normally change gradually over time.
  
• It is believed that the company’s fundamentals, along with broader economic factors and market psychology, are all priced into the stock, removing the need to actually consider these factors separately.
  
• This only leaves the analysis of price movement, which technical theory views as a product of the supply and demand for a particular stock in the market.

Price move in trends

• “Trade with the trend” is the basic logic behind TA.
  
• Once a trend has been established, the future price movement is more likely to be in the same direction as the trend than to be against it. Analysts frame strategies based on this assumption only.
  
• Trend is your friend. Don’t betray your friend.
  
  History tends to repeat itself
  
  
• People have been using charts and patterns for several decades to demonstrate patterns in price movements that often repeat themselves.
  
• The repetitive nature of price movements is attributed to market psychology.
  
• Market participants tend to provide a consistent reaction to similar market stimuli over time. Big Green candle = Buy, Big Red candle = Sell.
  
  
  
  
  So, this is it for this post. It should clear all the basic doubts about TA. If it doesn't, post the queries in the comments and I will try to help you out.
  
  I spend a lot of time creating these educational posts, illustrations, charts, and PDFs. Please be appreciative of that and leave a like and comment if you found these helpful. It will help me to know that people are actually reading these posts. Also, if you need a PDF of this post with all the charts and illustrations, check out the links below this post.
  
  Disclaimer: This is NOT investment advice. This post is meant for learning purposes only. Invest your capital at your own risk.
  
  Happy learning. Cheers!
  Rajat Kumar Singh (@johntradingwick)
  NSE Certified Technical & Fundamental Analyst