As an approach to investment analysis, technical analysis is radically different from fundamental analysis. While the fundamental analyst believes that the market is 90 percent logical and 10 percent psychological the technical analyst assumes that it is 90 percent psychological and 10 percent logical. Technical analysts don’t evaluate a large number of fundamental factors relating to the company, the industry and the economy. Instead, they analyze internal market data with the help of charts and graphs. Subscribing to the castles-in-the-air approach, they view the investment game as an exercise in anticipating the behavior of market participants. They look at charts to understand what the market participants have been doing and believe that this provides a basis for predicting future behavior.
The technical approach is the oldest approach to equity investment, dating back to the late 19th century. It continues to flourish in modern times as well. As an investor, you will often encounter technical analysis because newspapers cover it, television programs routinely call technical experts for their comments and investments advisory services circulate technical reports. Thanks to its intuitive appeal, it is widely used. However, its validity has been severely challenged in recent decades
Although technical analysis can be applied to commodities, currencies, bonds, and equity stocks, our discussion is restricted to equity stocks.
What is technical Analysis?
Technical analysis involves a study of market generated data like prices and volumes to determine the future direction of price direction of price movement.
The technical approach to investing is essentially a reflection of the idea that prices move in trends which are determined by the changing attitudes of investors toward a variety of economic, monetary, political and psychological forces. The art of technical analysis for it is an art – is to identify trend changes at an early stage and to maintain an investment posture until the weight of the evidence indicates that the trend has been reversed.
The basic premises underlying technical analysis are as follows:
1. Market prices are determined by the interaction of supply and demand forces.
2. Supply and demand are influenced by a variety of factors, both rational and irrational. These include fundamental factors as well as psychological factors.
3. Barring minor deviations, stock prices tend to move in fairly persistent trends.
4. Shifts in demand and supply bring about changes in trends.
5. Irrespective of why they occur, shifts in demand and supply can be detected with the help of charts of market action.
6. Because of the persistence of trends and patterns analysis of past market data can be used to predict future price behavior.
Differences between Technical Analysis and Fundamental Analysis:
The key differences between technical analysis and fundamental analysis are as follows:
1. Technical analysis mainly seeks to predict short term price movements, whereas fundamental analysis tries to establish long term values.
2. The focus of technical analysis is mainly on internal market data, particularly price and volume data. The focus of fundamental analysis is on fundamental factors relating to the economy, the industry and the firm.
3. Technical analysis appeals mostly to short term traders, whereas fundamental analysis appeals primarily to long term investors.
Technical analysts use a variety of charting techniques. The most popular ones seem to be the Dow theory bar and line charts, the point and figure chart, the moving average line, and the relative strength line. We will examine these techniques in this section. However, as a prelude to that it is helpful to briefly explain the basic concepts underlying chart analysis.
Basic Concepts Underlying Chart Analysis:
The basic concepts underlying chart analysis are: (1) persistence of trends; (2) relationship between volume and trend and (3) resistance and support levels.
Trends: The key belief of the chart list is that stock prices tend to move in fairly persistence trends. Stock price behavior is characterized by inertia: the price movement continues along a certain path (up, down or sideways) until it meets an opposing force, arising out of an altered supply-demand relationship.
Relationship between Volume and Trends: Chartists believe that generally volume and trend go hand in hand. When a major upturn begins the volume of trading increase as the price advances and decreases as the price declines. In major downturn the opposite happens – the volume of trading increases as the prices declines and decreases as the price rallies.