The first question that arises in our minds is that why should we spend time and energy technical analysis when we all know that that there is absolutely no way of predicting future stock prices. When it comes to predicting the future of stock market trends, experts and analysts are relentlessly waging a war to find out an effective means of solving the problem and accurately predict the stock price behavior. Technical analysis has however a very important role to play in their attempt to predict the future of stock prices.
It works on the theme of predicting future financial price movements by drawing data based on a thorough examination of past price movements. It can never be a full-proof method or guidance to investors as to where to put in their money and when to put in. But it is only an approximate report showing how the markets are likely to behave in the future. Technical analysis uses various kinds of charts that show price ranges of different stocks over time. Data can be pulled as and when required. Technical analysis is applicable to stocks as the prices are influenced by the forces of demand and supply. The prices are applicable to securities over a specific time frame which in turn might span intra day of about a minute, 5 minutes, 15 minutes, 30 minutes or even an hour.
The foundation for tech analysis was laid down by Dow, which later took the shape of the more sophisticated and modern version of technical analysis. Of the many theories put forth by Dow, three stand out exceptionally well: price discounts everything, price movements are not totally random and in technical analysis ‘what’ is more important than ‘why’.
It is based on the idea that the current market price reflects all information that can be had from the market because price itself is a fair value and should form the basis of analysis. The market price reflects the sum of knowledge of all market players comprising traders, investors, portfolio managers, analysts, strategists and so on. Another theory is that prices are not always random but it can be opined that there are extended periods of random fluctuation that are interspersed with shorter periods of non-random behavior. The role of the analysts is to identify those periods and plot charts. Technical analysis can be applied to many different time frames and it is possible to identify these long-term and short-term market trends. The third theory as to ‘what’ is important than ‘why’ preaches that it is more important to know what is the current price and what has been the history of prices rather than finding out answers to questions such as why did the price go down or why did it go up. They believe that price is the end result of the forces of demand and supply and we should only stay focused as to what the end price would be.
Technical analysis covers certain broad spectra such as broad market analysis, sector analysis and individual stock analysis. The first step of technical analysis would be to identify the overall trend. Areas of congestion or previous highs and lows mark support levels. A break below support would be considered bearish and above support would be considered bullish. The final step of technical analysis would be to ascertain the strength of the current trend, maturity of the current trend and potential entry level for new long positions. After a careful study of 10 to 20 stock charts of a particular industry an investor can conveniently shortlist 3 to 4 promising stocks to invest in.
But technical analysis has its own drawbacks. Just like any other analysis technical analysis is also subject to human errors and biases. Moreover, every chart or every analysis is open to varied arguments and interpretations. Ironically, no two technical analysts would agree on same conclusions after studying a single chart. It is possible that both analysts come up with logical support and resistance levels as well key breaks to justify their arguments.
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