Before we get into the success factors for technical analysis, it is essential to understand the underlying logic and assumption behind technical analysis. While fundamental analyst looks for value in the stock via cash flows and margins, the technical analyst purely looks at charts. Their logic goes something like this. In a reasonably matured market, most of the triggers pertaining to a stock are either known or factored in. That is because an army of analysts, traders, arbitrageurs and institutional investors will ensure that. Hence there is no point in trying to find value. Since stock prices are random pattern movements, there is only merit in reading charts which tell a story about the stock. Technical analysts also believe that such patterns tend to get repeated because human behaviour and their reaction to psychological factors like fear and greed remain the same. That means; under most conditions, technical analysis must work appreciably well. While there are no clear answers to this question, we can look at a series of factors that can be instrumental in answering the question.
Technicals as a counter-argument to fundamental approach
Technical analysis of stocks can be seen as a counterpoint to fundamental analysis. While fundamental analysis involves the use of macro factors, industry analysis and balance sheet analysis, they also consider qualitative factors. Technical analysis, on the other hand, is more to do with charts and chart patterns. The normal debate is; which works better? In reality, fundamental analysis and technical analysis are not exactly competing sciences but they are complementary approaches to the stock market. We need to understand the importance of technical analysis how it helps us fine tune and chisel investment decisions.
Actually, Jesse Livermore was right!
The legendary trader, Jesse Livermore underscored the fact that human beings are the same and therefore human behaviour is also the same over time. As a result, the way traders react to market highs and lows and also to bouts of panic and greed remains the same. This essentially implies that market chart patterns will tend to repeat over time. Therefore, understanding the market pattern is all about studying the past patterns, creating templates and extrapolating these templates to the future. Technical analysis is based on the basic premise stock prices will reflect all the known and unknown information and so prices are just random movements. By that definition, there can be a technical answer to every stock market problem.
Timing entry and exit with technicals: the real utility
Researching stocks is not only about identifying the stock but also about finding the right time to exit and enter the stock. Consider the example of two traders; one of them dwells at length on timing entry and exit while the other trader does not!
|Particulars||Price of Stock A||Quantity||Sale Price||Profit|
|Raju bought on Fundamentals||553||1000||665||Rs.1,12,000|
|Paresh bought on Technicals||541 (Support)||1000||679 (Resistance)||Rs.1,38,000|
In the above instance, Paresh is able to increase his profits by 23% just by buying closer to the support levels of the stock and selling closer to the resistance level of the stock. A word of caution here! Supports and resistances are not technical assurances; they are just an insurance against volatility. They tell us whether the trader can afford to wait for a lower price to buy or for a higher price to sell.
Trendy is eternal and short term profits are all about momentum
There are different types of trends in the market like an upward trend, downward trend, sideways trend, absence of trend etc. Technicals help you to capture the trend and trade accordingly. That is why technicals are the key to your strategy in the markets. How do you calibrate strategy in this case using charts? If the trend of the market is upward then you must use every dip to buy into the market or the stock. On the other hand, if the trend in the market is downward, then you must use each rise to sell the market. You identify this underlying trend with the help of momentum. When stocks break above the resistance or below the support in a decisive manner with volumes, then it is a sign of momentum. The second way to identify momentum is to gauge whether the uptrend is making higher tops and higher bottoms and whether the downtrend is making lower tops and lower bottoms. This is, once again a confirmation of the momentum. While technicals appear to make an unrealistic assumption that markets are perfect, the reality is that it has a key role to play in all kinds of markets.
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