Introduction to Technical Analysis in Stock Market

Stock prices change daily, in fact, almost constantly during trading hours. And as these stocks change hands, volume figures too, keep changing. These changes throw up some trends and patterns. By definition, the study of these trends and patterns is known as technical aalysis.
To put it in perspective, unlike fundamental analysis, which evaluates a stock’s intrinsic value based on various fundamentals like earnings and profitability, technical analysis focuses on statistical data from trading activity, such as price and volume.
In technical analysis, it is assumed that the historical price trends of stocks tend to repeat over time. Hence, it is seen as a valuable indicator of the stock’s future price movements. So, traders study these price trends and volume data, and try to look for possible future price direction of the stock.
Technical analysis also studies the demand and supply situation and tries to understand the emotions ruling the market.

Assumptions

Technical analysis is based on three assumptions — the market discounts everything, price moves in trends, and history tends to repeat itself.

Market discounts everything

Technical analysis assumes that everything that is of significance to the stock is discounted or priced in. That is, the price of a stock at any given point in time reflects every factor that could affect the company and the stock, including fundamental factors relevant to the company, macroeconomic factors, and market psychology. That leaves the analysts with just one factor that needs to be analysed closely – the price movement – says the theory of technical analysis.

Prices follow a trend

It is believed that the price movements of stocks follow trends. Technical strategies are based on assumptions that the future price movements of a stock are likely to be in the same direction as shown by the trend.

History tends to repeat itself

Another crucial assumption in technical analysis is that history tends to repeat itself with relation to stock price movements. It is believed that market psychology impacts stock price movements in a recurring or repetitive manner. This means a stock price reacts in a consistent manner over time due to similar market provocations. The historical price patterns are assumed to repeat themselves.
Technical analysts not only track price changes, but also other data such as trading volumes, and open interest or the total outstanding contracts that market participants hold at the end of every trading day. Technical analysts and researchers take the help of many such patterns and signals that have been developed over time to support the analysis and forecast the price movements.
Following are the broad types of indicators that technical analysts look at:

• Price trends
• Chart patterns
• Volume and momentum indicators
• Oscillators
• Moving averages
• Support and resistance levels
• Underlying Assumptions of Technical Analysis

Limitations

Technical analysis is not without its share of criticism. For one, critics say that history does not repeat itself exactly the way it panned out in the past. Hence, the study of price patterns is of questionable importance.
Technical analysis they believe works in some cases only because it constitutes a self-fulfilling prophecy. For example, if a large numbers of traders’ place stop-loss orders below the 200-Day Moving Average (DMA) of a stock and the stock hits this price, then there will be larger number of sell orders dragging down the stock further, confirming the movement anticipated by the traders.
Also, when this happens, other traders will also tend to liquidate their positions, further reinforcing the strength of the trend. However, this short-term selling will have little impact on the stock price in the long term. However, the short-term can be considered self-fulfilling.

Now, let’s quickly recap the key differences between technical and fundamental analyses: