Technical Analysis (ii)
Let’s try to understand more about technical analysis in this post. In our first post on technical analysis, we introduced what technical analysis is and how it helps you make a good point of view about any trade/investment. Here we will be focusing on versatility of technical analysis and some assumptions which are used while applying technical analysis.
Consider an analogy. Think about learning how to swim. Once you learn swimming, you can literally swim anywhere. On the similar lines, Technical Analysis (TA) is the skill you need to learn just once and you can apply this across different asset classes. By asset classes, we mean stocks, bonds, currency, commodity etc. The underlying concept of Fundamental Analysis will keep on changing, depending on the asset class, whereas the basic concepts of Technical Analysis will remain same irrespective of the asset class.
Before going into how it works and how it should be applied, let us look at some of the assumptions used in the technical analysis
- One of the most important assumption of Technical Analysis (TA) is that price reflects everything. It means that price of a stock will contain all the information and if you are analyzing it, then you don’t need to analyze other factors. You must be thinking how this is possible, as there are many factors like profit, balance sheet, management which affects a company. But technical analysis assumes that just like you, other investors in the market also know these things and have already studied these factors. Thus, as others already know about these factors, the price has already changed to reflect it, assuming that they would have already acted upon this information.
- Technical analysis assumes that price movement follows a trend. Once a trend is established, it is expected that price will move in the same direction, unless trend changes. If using technical analysis you have concluded that a stock is in uptrend, then the price will keep on increasing unless the uptrend is reversed. We will be learning about finding and establishing these trends, in following articles.
- Technical Analysis believes that history repeats itself. This means that patterns in stock price will keep on repeating themselves. The rationale behind this assumption is that investors and traders behave in the same fashion, again and again, when they are exposed to similar situations. So if there was some pattern observed last time, when price of a particular stock crossed 52 week’s high, it is likely that same pattern will be observed again because all the investors will behave in the same fashion, as they did last time, to this information.
To establish trends and patterns, and analyze market movements, technical analysts use charts. In the chapters ahead, we will be covering different types of charts used by technical analysts and the process of identifying trends and pattern.