These two words can create many pictures in your mind like multicolored charts on computers, many horizontal & slanting lines, and curves on that charts, colorful bars going up and down and the name of your favorite stock that you recently trade. You will be dreaming about money that you could make if you knew how to read this chart.
But behind these charts, there is always a story of a particular stock. These charts speak in a different language that you may not understand and this language is known as technical analysis. Technical analysis is a chart reading skill. Technical analysis is the study of prices that involves the study of stock’s trading patterns, with the use of some indicators and tools, in order to predict the current and future market movement of the stock’s price that enables to identify different trading opportunities
Technical analysis is applicable to all tradable instruments including stocks, indices, commodities, futures etc where the price can be influenced by supply and demand.
Technical analysis is based on three assumptions:
1. Price discounts everything:
Technical analyst believes in charts and believes that market is always correct. Technical analysts study the price action of the market itself, rather than considering all the fundamental factors of the company because they believe that these factors are already factored into the demand and supply of the stock.
Technical analysis disregard all the factors which affect price including fundamental, political and psychological factors and studies only how the market is responding to these factors. Technical analyst analyzes the charts the same way, a doctor analyzes X rays.
2. Price moves in trend and price movements are not totally random:
Technical analysts believe that price movement is not random & if prices were always random it would be very difficult to make money with the study of Technical Analysis. Prices always move in a trend. Traders and investors hope to buy at the starting of an uptrend and sell when the trend ends at the high price. A technical analyst believes that it is possible to identify that trend, invest at the beginning, ride the trend and make money by selling as the trend unfolds. With the study of Technical Analysis, it is possible to identify the nature of the trend, whether it is an uptrend, downtrend or sideways trend.
- Price goes up when demand (buyer) is greater than supply(seller) and it is known as an uptrend.
- Price goes down when supply (seller) is more than demand (buyer) and it is known as a downtrend.
- Price moves sideways when demand (buyer) is equal to supply (seller) and it is known as a sideways or ranging market. By identifying these three trends one can make use of them to make money in the stock market
3. Chart patterns tend to repeat themselves:
Technical analyst assume that history repeats itself and market behave similarly to how it behaves in the past in similar circumstances. This similar behavior can be seen in patterns on the price chart. These patterns occur in different time frames with similar shapes and characteristics. A trader watching a 5-minute time frame chart will observe the same pattern on a monthly time frame chart at different intervals. Thus pattern analysis is universal and independent of time and technical analysis can be applied to any time frame from a one-minute chart to monthly chart. The analysis will be the same but the important difference is that the demand and supply are much larger in monthly charts than on 1-minute chart. A long-term investor will analyze the monthly chart and would never initiate a trade based on a five minute or a one minute chart pattern analysis but will initiate a trade when that same type of evidence is found on the monthly or weekly chart. Similarly, a trader watching on a 5-minute chart would not initiate any action based on the monthly or weekly chart but initiate a trade when that pattern occurs on 5 or 1-minute chart.
How does technical analysis help to make money: Several steps involved in a process to convert technical analysis into money.
- The first step is to identify a trend.
- The money can be made by jumping at the beginning of the trend and exiting at the end of the trend. It sounds simple but it is not so easy!
- The investor must be aware of the risk and protect himself against occurrence that causes losses.
- Different indicators and tools are to be used to determine the trend.
- The investor must choose when to exit the position if the price moves in the expected direction. He should know when to exit by taking profits and if Price moves in opposite direction he should know where to exit the position at a loss. It means the risk of loss must be determined right at the beginning of the investment.
- Money management should be applied to investment to lessen the chance of loss. Always enter the position only with that money that you can risk.
In sum, the Technical analysis is simply the identification of trend, entering a position at right time, playing the trend, controlling the capital risk of loss, exiting a position at profits and closing the position when an analysis is wrong. It is as simple as that…!