An introduction to technical analysis

Investing in assets is similar to placing a bet except, unlike betting, investing is about developing a well-researched point of view, evaluating that critically and then following through with discipline. A good investment decision should have a directional view and should also include information such as:

  1. Price at which one should buy and sell
  2. Risk involved
  3. Expected reward
  4. Expected holding period

Technical Analysis (TA) is a popular technique that allows you to do just that. It not only helps you develop a point of view on a particular asset but also gives you structure to define the trade keeping in mind the entry, exit and risk perspective.

Fundamental vs Technical analysis

The goal of fundamental analysis is to understand the core intrinsic value of an asset and make the long-term investing decision based on it. Fundamental analysts examine financial information like earnings, dividends, assets, quality, ratio, new products, research and the like to predict cash flows and expected value and compare that with the current value to make decisions.

Technical analysts believe that the stock price already includes all relevant information regarding a company’s financial statements. Instead, the analyst focuses on analyzing the stock chart itself for hints into where the price may be headed in the short term based.

Technical analysts consider the market to be largely psychological and emotions in the short term whereas fundamental analysts believe it to be more rational and logical in the long term.

Price patterns and market trends represent the psychological aspects of financial markets and TA attempts to exploit those patterns using data and trading systems.

The Basics of Technical Analysis

Technical analysts look at chart data to try and predict price movements. There are a few key components to look at while charting:

Price

Price charts help traders visualize historical trading data which is a summary of what happened in that period. Price is represented in several different ways, depending on the type of chart you’re using. They are shown as bar charts, in which price is represented by a bar or as candlestick charts, in which price is represented by what resembles a candlestick and line charts, where price is nothing more than a line.


Bar and Candle for price movements

Volume

Volume represents the amount of the asset that changed hands that particular day. It is represented on a chart by a single bar directly below the price bar and helps traders validate the direction of movement.


Volume and price charts

Trends, supports and resistances

Technicians, traders and chartists look at a combination of price and volume to identify various trends in the price movement. Using trends they are able to make a point of view over the short-term direction of the asset. They then use indicators and other tools to find supports and resistances that help them manage risk and return expectations.


Trends, support and resistance

Price, volume and trends are the standard tools that all technical analysts have in their toolkit and then build their own systems on top.

Before you start

A lot of traders jump into TA assuming that it’s a quick and easy way to make money. On contrary, the truth is far from it. For such traders who get involved with TA assuming it’s straightforward and an easy way to make money in markets, trading catastrophe is bound to happen.

When a trading debacle happens, it is often the inability of a trader to understand and apply the technical analysis, than fault of TA itself. Hence before starting TA, one must internalize and set the expectations correctly for a few things below:

Trading time frames: Unlike fundamental analysis, trades that you make while doing TA are short-term, lasting from just a few minutes to a few weeks.

Returns per trade: The nature of the technical analysis is to identify and leverage market inefficiencies appearing in small durations as a result returns per trade are also relatively lower.

Trading frequency: To maximize your returns with TA you need to identify frequent short-term trading opportunities which can give you small but consistent profits.

Managing risk: All trades in TA are the result of a hypothesis for a short term trade. As a result, if the hypothesis is proven false early on, the trader might end up facing heavy losses. It is very important to monitor your trades and cut your losses and move on to identifying new opportunities.

TA is about having clear systems and rules that help you take advantage of market psychology in the short term. Technical Analysis is as much an art as it is a science. Mastering TA requires patience, perseverance and above all discipline and those who follow are bound to succeed.

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