Hi Guys,
A rainy Saturday it is and I find it hard to chalk out any plans of venturing outdoors. Saturdays for me are normally full of fun, a break from the routine life I have at office and a way to look at life beyond numbers, returns and rates. But my rocket crashed even before taking off thanks to Indra for blessing Mumbai with stupendous rainfall.
Jokes apart. I have always faced problems understanding the validity of technical analysis in the markets, more so in the initial days of my career as an equity analyst. Although fundamental analysts are known to be not in very good terms with chartists but off late I have fallen in love with the art of reading historical prices and trading volumes and predicting market movements. Let's have a quick look at how it works.
Technical Analysis is a study of the stock market considering factors related to the supply and demand of stocks. Technical Analysis doesn't look at underlying earnings potential of a company while evaluating stocks.The idea is to identify a trend using charts and computer programs to study the stock’s trading volume and price movement. An underlying assumption is that Technical Analysis assumes that the market is efficient and the price has already taken into consideration fundamental factors related to the company and the industry. It therefore hypothesizes that all the fundamental factors such as earnings, growth rate, company disclosures etc. are already priced in. Having discounted these, the only factors affecting the stock price would be supply and demand of the stock (that's where volumes come into play).
As explained above, Technical Analysis is done by identifying the trend from past movements and then using it as a tool to predict future price movements of the stock. Popular methods are:
- Moving Averages—This method is used to predict the trend and specify various support and resistance levels in the short and long term period. Most commonly used moving averages are 30 DMAs and 200 DMAs. Where DMA means Days Moving Average.
- Charts—This method mainly concerns finding patterns in the historical price chart of a stock. Some patterns that are of interest to technical analysts are:
- Double Top
- Double Bottom
- Head and Shoulders
- Upper triangle
- Lower triangle
The list of methods goes on and truly speaking there are hundreds of methods used everywhere. Let's end it here as far as the methods are concerned and focus on a very important things without which technical analysis isn't complete:
Volume
Volume plays a key role in deciding about the kind of future movement in stock. If a stock breaks it's trend with an increase in price one must look at the volumes to decide if it's a trend reversal or not. If the volumes are increasing it generally is an indication that there is a trend reversal and it is a sustainable one. If the volumes are not high one should believe that there is no trend reversal and the increase in price is an illusion in itself. To read more about volumes click here.
Alternatively, whenever there is a sudden rise in the volume of the stock and if it is not followed by a price fall, the price may rise in near future. Smart investors uses technical analysis to judge the rise in volume and take early positions in the stock during breakthroughs.
Well, I think we've seen enough. By now most of you would have figured out if technical analysis is your cup of tea. If you like to read more about it you can read it here.
For me it's time for a drink. Have a great weekend!
