Importance of Technical Analysis in Stock Market

Posted by Saurabh Chaurasia on

Image of Technical Analysisi of Stock

If fundamental analysis was all about learning more about the market sentiments, technical analysis is about analyzing the company’s worth by mathematical methods inferred from statistical trends generated by trading activity, price movements, and volume. One of the most repeated terms in the study and practice of this technique is “The Law of Large Numbers” which in probability and statistics means that as sample size i.e. number of active traders in our case grow, its mean gets closer to average of the whole population. In other words, predicting the market movement is possible with various quantitative analysis techniques which are also part of technical analysis itself.

 

Technical analysis differs from fundamental analysis because the latter focuses on business centric metrics such as EBITDA, Valuation, Balance Sheets, etc and does not take into effect the stock side of the equation. Technical analysis on the other hand has a narrower focus and concerns itself with the stock prices only. That is why technical analysis is often used to solve short term trading problems only.

What is Technical Analysis?

The modern technical analysis practice dates back to the late 1800s and was introduced by Charles Dow as the famous Dow Theory. Over the course of years and contributions made to the theory, technical analysis has developed to include a multitude of patterns and signals. The basic assumption in the practice of technical analysis is that past trading activities and price changes of a financial instrument can be indicative of future price movements when passed through appropriate algorithmic trading functions. To reiterate, technical analysis aims to make sense of the market sentiment accompanying the price trends instead of analyzing the company’s fundamental attributes. To that extent, if we are to understand technical analysis we must take into account the following assumptions commonplace in the modern scenario.

 

Market Prices Are All Inclusive

Practitioners of technical analysis believe that all attributes of a company are priced into the stock value. This bears resemblance to the Efficient Markets Hypothesis which essentially states that share prices reflect all information and consistent alpha generation is impossible. The difference emanating from the fact that technical analysts view stocks as a commodity and thus apply demand and supply theories to its price movements.

 

Trends Dictate Price Movement

It is evident that the market moves with trends. All the market bubbles and crashes are a solid evidence for the existence of this point. This removes a certain chaos from the prediction of stock prices. A stock price is way more likely to move according to a past trend than erratically. A wonderful example of this can be seen with the emergence of demand for large-cap stocks in the wake of the pandemic, largely fueled by the general trend of low risk investments.

 

History Always Repeats Itself

One of the core tenets of technical analysis is historical records. It is visibly evident and ties down from point (2) that price movements are incredibly repetitive in nature. Technical analysts make use of these certain chart patterns to analyse the sentiments attached to a particular market trend. This quantification of market psychology has birthed an entirely new subfield of market analysis called ‘sentiment analyses 

 

Technical analysis in its vastness is generally viewed as essentially the study of supply and demand forces but reflected in the market price movements of the financial instrument. It most commonly applies to price changes but there are hundreds of patterns and signals developed by researchers over the years to support technical analysis and develop trading systems to help forecast the price movements. Commonly used technical indicators include trend lines, channels, momentum indicators etc. Apart from these, some of the commonly used indicators worth mentioning are price trends, chart patterns, volumetric and momentum indicators, oscillators, moving averages, support & resistance levels, to name a few.

 

It is however important to note that technical indicators have their limitations as well, more often than not technical analysis is considered to be a self-fulfilling prophecy riddled with false alarm potentials. Apart from that, modelling after historical trends is not always a good idea because even though history does tend to repeat itself, it does so differently. But with all that said, it must be acknowledged that technical analysis when combined with funda

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