The use of specific market-produced data for the analysis of both the overall stock prices (industry averages or market indices) and single stocks is called technical analysis. In other words the technical approach to investing indicate the fact that price move in trends which are set by the altering attitudes of the investors towards a variety of economic, political, psychological and monetary forces. In technical analysis trend changes are identified at early stage and to keep certain sort of investments until the reverse trend is indicated by the evidence.
Technical analysis is also called internal or market analysis because it is helpful in ascertaining the demand & supply of particular stock or entire market by using the records of the market itself. Hence technical analysis supports the fact that best data about the market is obtained from the market itself. In short the theory of technical analysis specifies that all the information about a security is covered in its price movements.
It is simple concept of economics that the interaction of demand and supply determine the prices. The technical analyst are although agree with this rule but points out that it is very difficult to ascertain all the factors that affect the demand and supply. The determining factor at any moment is the net demand for any stock based on how many investors are pessimistic or optimistic because all investors are agreed on certain price. This optimistic or pessimistic mood of the investors continues for some time and can be identified by different technical indicators.
Technical analysis is different from fundamental analysis in the sense that it depends on the published market data. On the other hand fundamental analysis is based on the factors such as sales, growth rates, earnings or government regulations. Price of a stock or market index and volume data in primarily included in market data. It is belief of many technical analysts that only such kind of market data is useful. For example the accounting data is opposed by technical analysts because of its certain limitations & ambiguity.
The fundamental analysts find out the estimated intrinsic value of the stock through Dividend Discount Model and finally compare that value with the market price. In fact it is belief of fundamentalists that the intrinsic value of a stock can be estimated through the proper evaluation of their data. On the other hand technicians think that estimation of intrinsic value of stock is very difficult and also the acquisition & analysis of the good information consistently is virtually impossible. In other words the value derived from the published financial statement analysis is considered as doubtful by the technicians. The technicians consider the market data which is the indicator of the demand & supply forces of a stock or market. It is another consideration of the technical analysts that there is gradual adjustment of price towards equilibrium or new price as the new information is available. The price of stock tends to move in a trend when the stock adjusts from its old equilibrium level to new level. The main concern is that the change is occurring at all. Technical analysts believe that investors exploit the identifiable trends that are shown by the stock prices. They try to point out the changes in the direction of the stock and buy or sell that stock so that the benefit of the trend can be taken.
Technical analysis is summarized in the following points.
- Technical analysis depends on the published market data and concentrates the internal factors by considering movements in the overall market, industry average or stock. On the other hand fundamental analysis considers the factors that are external to the market itself like economic and political factors.
- Technical analysis concentrates on the identification of the changes in the direction of stock prices which are reflected in the form of trends when the price of stock adjusts to new equilibrium level. The study of price movements & trading volume across time enables the analysts to analyze the trends as well as the changes occurring in these trends. The main focus is on the change of prices.
- Certain technical indicators are analyzed by technical analysts that assist in assessment of the overall situation concerning stocks like market sentiment, breath of market data, momentum and other indicators.
The bottom line of technical analysis is that prices of stock (either for the market or single stocks) try to move in a trend and certain time required unfolding these trends. Careful analysis is required to point out such trends and resultantly buying and selling is made accordingly.
Framework for Technical Analysis
Technical analysis can be used to both individual stocks as well as for aggregate of prices (entire market or industry averages). Technical indicators and graphs (charts) are used in the technical analysis.
The primary tools for pure technical analyst are price and volume and this information is displayed by the mechanism of charts. It is belief of technicians that the prices behave in a particular pattern as a result of interaction of demand & supply forces. Trend or overall direction is the most important pattern of price behavior. The identification of trends and patterns in the prices of stock are helpful in accessing trading signal when charts are used by the technicians.
In order to access the general trends in the market, volume data is used. It is definite fact that in technical analysis that rising prices of stock are mostly connected with rising volume. Similarly when stock pricing are declining, it represents declining trend in the volume. The technicians are skeptical about the upward trend when stock prices are rising but the volume is not increasing. Furthermore it is sign of bearishness when there the prices are falling but the volume is increasing.
The charting is the technique in which the stock price is viewed along with the volume. With the advancements in the field of technical analysis, there are some other indicators that are used to evaluate the market conditions & sentiments of the investors. Contrary analysis is also used in this regard.
Charts of Price Patterns
In order to ascertain the price movements of individual stock, charts & graphs are used by the technicians that relate to the price movements. The relative strength analysis is another tool to access the movements of particular stock price. According to technicians, the movements of stock prices are represented in the shape of trends and changes in prices create patterns that can be identified & recognized. They hope to forecast the future direction of movements by virtually accessing the forces of demand & supply. Trendline is the most basic measure of the direction towards which the stock is moving. The stock exhibits successively higher lower points when demand is enhancing more rapidly than supply, which is considered as uptrend. On the other hand consistently lower highs points exhibits that supply id more rapidly increasing than demand and this is downtrend of the stock. Investors try to sell in the downtrend and buy in the uptrend.
In a chart of stock prices, the technicians try to identify certain signals and use surely terminology to describe the events. The technicians expect significant increase in the demand for a stock at a support level of price (price range). Otherwise stated, the lower bound on price supports the price and stops further decline in price and it is expected that buyer will act accordingly. The technicians expect significant increase in the supply of stock at the resistance level of price. Otherwise stated, resistance is provided for further increase in the price by the upper bound on price where sellers are expected to act accordingly.
When an increase is followed by stock price as a reversal resulted by the profit taking which is due to development of support level; the support level is formed when those investor are willing to purchase at this price who did not buy earlier. After a stock declines from a higher level, resistance levels tend to develop. The investors wait for a particular recovery point at which they sell the stocks. The price will encounter the resistance moving beyond that particular level of price where significant increase in the supply occurs.
Trend is identified on a chart by the trendline. If trend shows resistance & support levels simultaneously that look to be properly defined, the trend lines are considered as channel lines, and the prices move between lower channel line & upper channel line. The speed with which prices change is indicated by momentum and there are certain momentum indicators that can used to measure momentum. Reversal in trend is occurred when change in direction is occurred for short term. When only partial retracing of the prior movement is included in the reversal, a correction occurs. Periods of consolidation may follow the correction with the initial trend resuming following the consolidation. There are certain charts that are primarily used by technicians like point bar charts, line charts and point & figure charts. There are also some additional charts too.