Basics of Technical Analysis in Stocks and Forex Trading

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Discussion Topic: Technical Analysis

Today, we will discuss few very basic lessons of technical analysis. Here, you will get to know that what is technical analysis in stocks and forex trading? How it is done? And what are the advantages and disadvantages of technical analysis?

What is Technical Analysis? – Definition

Technical Analysis (TA) is the technique used for forecasting future financial price movements based on the past price movements.

But remember that, TA does not make absolute predictions about the future. Rather, it just helps investors to anticipate what is “likely” to happen to price levels over time. Technical analysis analyzes a wide variety of charts and patterns that show price movements over time.

[See Also: Beginner's guide on How to Read Technical Charts]

You can apply technical analysis to trade stocks, indices, commodities, or any tradable instrument where the price is regulated by the forces of supply and demand. Here, the historical price data refers to any combination of the open, close, high, low, volume, or open interest for a given instrument over a specific timeframe. The timeframe can be based on intraday (i.e. - 1-minute, 3 minutes, 5-minutes, 10-minutes, 15-minutes, 30-minutes or hourly), daily, weekly, monthly, or even many years.

Key Assumptions of Technical Analysis

Technical analysis is applicable to all the tradable instruments where the price is only controlled by the demand and supply. TA doesn't work well when other external forces influence the price of the security.

Unlike fundamental analysis, technical analysis doesn’t consider the fact that whether the security is overvalued or undervalued. The only thing that matters is the historical price data (price and volume) and what information this data can provide about the future price movement.

In order to be successful, technical analysis makes few assumptions about the securities that are being analyzed. Those assumptions are as follows:

1) High Liquidity: Liquidity means the average transaction volume. Popular stocks allow investors to trade quickly and easily, without much affecting the stock price. Less-traded stocks are quite difficult to trade as there aren't many buyers or sellers at any given point of time, hence, buyers and sellers may have to change their entry price frequently to make a trade. As there are not much demand and supply forces, technical analysis is not much effective in analyzing those securities.

2) Market Discounts Everything: This assumption states that all known and unknown events of the public domain are reflected in the latest stock price. For example, there could be an institutional investment firm (FII  or DII) buying the company’s stock in large quantity in anticipation of a good quarterly result announcement. While they do this secretively, the price reacts according to their actions thus revealing to the technical analyst that this could be a good time to buy.

3) Answer of "How?" is more important than "Why?": This is an extension to the second assumption. Going with the same example as above - in time of the technical analysis, we would not try to know why that large investment firms are buying that security as long as we knows that how the price will react with that action.

4) No Artificial Price Changes: Stock Splits, Bonus issue, and dividends are the most common “reactors” for artificial price changes. Though there is no change in the value of the investment (holdings), artificial price changes can dramatically affect the historical price chart and makes it difficult to apply technical analysis.

5) History Repeats Itself: In the context of technical analysis, we assume that the price movement trend tends to repeat itself. This happens because traders consistently react to price movements in a remarkably similar way they have done in past. For example, in an uptrend, traders get greedy and want to buy irrespective of the high price which further increases the price. Similarly, in a downtrend, traders want to sell irrespective of the low prices which further draw-down the price.

6) Price Moves in Trend:  All major moves in the market is an outcome of a trend (up or down). The concept of the trend (or trending market) is the foundation of TA. It has been seen in the past that once a strong trend (up or down) is established, the price moves in the direction of the trend for a prolonged period of the time. If market is not in a trend then technical analysis will not work well.

7) No Extreme News: Last but not least, technical analysis cannot predict extreme events. For example, it can’t predict any political, economic, or business events. When the forces of “extreme news” are regulating the price, you have to wait with patience until the chart settles down and starts to reflect a “new trend” that results from such news. For example, by doing TA you can’t predict the price movement of crude oil on its inventory dates. That’s where the fundamental analysis comes into play.

Technical Analysis price chart

Key Expectations From Technical Analysis:

It has been observed that market participants often present technical analysis as a quick and easy way to take profit from the markets. Truly speaking, technical analysis is not that quick and easy. Yes, if done right, a high gain is possible but in order get to that stage you have to put in enormous effort to learn the whole technique. If you look at TA as a quick and easy way to make money in markets, then disaster is bound to happen.

Hence, before you start learning technical analysis it is important to have a clear understanding of what you can and cannot achieve with it.

Trades and Investment: Technical Analysis (TA) is more useful to identify short-term trades (1 day, 1 week, or 1 month). You can’t use TA to identify long-term investment opportunities (6 months or Years). For long-term investment analysis, you have to do a strong fundamental analysis. If you are doing fundamental analysis, you can use TA as an add-on to calibrate the entry and exit points.

Return per trade: You must not expect huge returns (per trade) as TA is used within a short duration of time. The trick to get a high return by doing technical analysis is to identify frequent short-term trading opportunities to get small but consistent profits.

Holding Period: Trades takes on the basis of technical analysis can continue anywhere between few minutes and few weeks, and usually not more than that. We will further explore this matter in our discussion about trading timeframes.

Risk: Often traders initiate a trade with a certain expectation in his/her mind, however in case of an opposite movement in the stock, the trade starts making a loss. Unremarkably, in such situations also, traders hold on to their position with a hope that they can recover the losses. Remember, TA based trades are short term, in case the trade goes wrong, cut the loss-making position and move on to identify another opportunity.

We hope that you have enjoyed the above article explaining what is meant by technical analysis. Be with us to explore forex trading, stocks trading, and other money-making opportunities.

Leave us some comments if you have any questions or doubts about any of the aspects of the TA, we will definitely try to help you.

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