Technical analysis

Why technicals ?

The markets have been rallying in the last few months and many a trader / investor is wondering

if there is a method in the madness in the process of investing. Technical analysis shows a way

out to the serious player who is interested in optimising his returns on investments. I would

advocate every player who has some interest in stocks should have a working knowledge of

technical analysis. Going by the maxim of " knowledge is power " , technical studies provide

handy tools akin to the versatile swiss army knife to all players. In this first piece in the series of

three articles, we take a step-by-step approach to understanding this subject.

What is technical analysis ?

Technical analysis is all about studying stock price graphs and a few momentum oscillators

derived thereof. It must be understood that technical studies are based entirely on prices and do

not include balance sheets, P&L accounts ( fundamental analysis ), the assumption being that the

markets are efficient and all possible price sensitive information is built into the price graph of a

security / index. Therefore, technical analysis supports the efficient market theory as against the

"random walk theory" which supports the belief that stocks can be bought / sold on random

events like flipping a coin !!! I believe that technical analysis is more dynamic as compared to

fundamental analysis based on one simple argument - fundamental analysts depend on

corporate events like quarterly results and special announcements like earnings guidance and

policy changes in operations to generate a buy / sell recommendation. If fundamental analysis

was the single most reliable indicator of trends, prices would predominantly fluctuate only 4 - 5

times a year - around quarterly results and special announcements like mergers and acquisitions

etc !! Why would prices fluctuate almost daily ? If the prices fluctuate ever so often, is there a way

to forecast them ? yes according to technical analysis !!

• Is a medley of Science & art. No algaebraic /

empirical formulae.

• Involves study of price charts and oscillators

derived thereon.

• Study regards price as the ultimate factor, which

factors in fundamental factors as well. Does not

subscribe to the random walk theory.

• Signals generated by market action on prices.

• Chances of multiple interpretations are higher.

• Will generate more signals, works for catching

MOST price movements.

• Will generally generate signals in advance.

• Involves built-in capital / risk management

techniques.

• Is a pure science form, involves pre-set

parameters for investment decision

support systems.

• Involves study of Balance Sheets, P & L

accounts.

• Study regards price movements as a

random phenomena, caused by market

forces.

• Signals generated by corporate

actions.

• Chances of multiple interpretations are

lower.

• Will generate fewer signals, works

better for catching major moves.

• Will generally generate delayed

signals.

• Involves NO risk / capital management

techniques.

Schools of thought

Technical analysis has evolved over a period of centuries and every geographical region has

contributed it's flavour to the study. The west has given us the venerable Dow theory which was

advocated in the early 1900's and the Elliot wave theory advocated by R.N. Elliot. While the dow

theory ( using typical bar charts and oscillators as we know them ) remains the most basic and

widely practiced due to it's simplicity, elliot theory uses intraday charts and bases it's computation

on the principle that prices move in waves and that upmoves come in 5 waves and downmoves in

3 waves. Oriental theories are as old as the hills as the japanese candlestick theories formulated

by the rice traders in Sakata province of Japan. They use bullish and bearish candles to

determine the trends in the markets. This theory uses life-like terminology like the morning star,

hanging man, evening stars etc to denote chart patterns. The Chinese have the yin and yang

theory which is similar to the Japanese candle-stick patterns. I would advocate using the Dow

theory based on the sheer simplicity of the same.

Tools of the trade / tricks of the trade

Technical analysis requires an efficient charting system. While it is almost mandatory to have a

computer and a software that will generate charts based on periodic data updates available,

some basic studies can be carried out with a simple graph paper being used as a charting board

with a X & Y axis. Most newspapers provide price updates with volumes which should be

sufficient to plot basic price graphs. If you have a PC and a software you are already a few steps

ahead.

The nuts and bolts

In a complex looking charting screen, it must be remembered that the price graph is the meat and

the oscillators are the ketchup. The mistake most novice technical analysts make is to give an

excessive emphasis to oscillators. Please remember that oscillators are derived from price

graphs and not vice-a-versa !! Another aspect that I would stress emphatically is the fact that an

objective approach is needed to succeed using technicals. Try to see what the chart is telling you

rather than what you want to see in the chart.