The markets have been rallying in the last few months and many a trader/investor is wondering if there is a method to the investment frenzy.
Technical analysis shows a way out to the serious player who is interested in optimising his returns on investments.
Every player who has some interest in stocks should have a working knowledge of technical analysis.
It is all about studying stock price graphs and a few 'momentum oscillators' derived thereof. It must be understood that technical studies are based entirely on prices and do not include balance sheets, P&L accounts (fundamental analysis), the assumption being that the markets are efficient and all possible price sensitive information is built into the price graph of a security/index.
Therefore, technical analysis supports the efficient market theory as against the random walk theory, which supports the belief that stocks can be bought/sold on random events like flipping a coin.
Technical analysis is more dynamic compared with fundamental analysis based on one simple argument -- fundamental analysts depend on corporate events like quarterly results and special announcements like earnings guidance and policy changes in operations to generate a buy/sell recommendation.
If fundamental analysis was the single most reliable indicator of trends, prices would predominantly fluctuate only 4-5 times a year, around the quarterly results and special announcements like mergers and acquisitions.
Why would prices fluctuate almost daily? If the prices fluctuate ever so often, is there a way to forecast them? Yes, according to technical analysis.
Technical analysis has evolved over a period of centuries and every geographical region has contributed it's flavour to the study. The west has given us the venerable Dow theory, which was advocated in the early 1900's and the Elliot Wave Theory advocated by R N Elliot.
While the Dow Theory (using typical bar charts and oscillators as we know them) remains the most basic and widely practiced due to it's simplicity, Elliot Wave Theory uses intra-day charts and bases it's computation on the principle that prices move in waves and that upmoves come in 5 waves and downmoves in 3 waves.
Oriental theories are as old as the hills as the Japanese Candlestick Theories formulated by the rice traders in Sakata province of Japan. They use bullish and bearish candles to determine the trends in the markets.
This theory uses life-like terminology like the morning star, hanging man, evening stars etc to denote chart patterns.
The Chinese have the Yin and Yang Theory, which is similar to the Japanese Candlestick patterns. The Dow Theory is more advocated, because of sheer simplicity.
Tricks of the trade
Technical analysis requires an efficient charting system. While it is almost mandatory to have a computer and a software that will generate charts based on periodic data updates available, some basic studies can be carried out with a simple graph paper being used as a charting board with a X & Y axis.
Most newspapers provide price updates with volumes, which should be sufficient to plot basic price graphs. If you have a PC and a software, you are already a few steps ahead.
In a complex looking charting screen, it must be remembered that the price graph is the meat and the oscillators the ketchup.
The mistake most novice technical analysts make is to give excessive emphasis to oscillators. Please remember that oscillators are derived from price graphs and not the other way round.
Some basic observation will tell us that some charts are more appealing than the others.
If a stock is making a rising bottom and top formation (higher highs and lows), the stock is displaying strength. Especially true if the prices are making new highs and that too with high volumes.
Volumes play a very large role in the projections as they signal participation or lack of it. If traded volumes are poor, it shows cynicism on the part of investors/traders in the prospects.
As long as the prices are rising, stick to the counter and let your profits run, remember the trend is your friend till it reverses and ends.
The stop-loss key
Technical analysis advocates a very dynamic system of financial/risk management. As a thumb rule, when you buy a share, a stop-loss on the day of entry (on the long side) should be the previous day's lows.
As the prices rise progressively, it is important that the stop-losses be modified too. This entails initiating "trailing stop-losses".
Suppose you buy a security ABC Ltd at Rs 100 and maintain a stop-loss at Rs 92. A week after you purchased it, the price escalates to Rs 120, you cannot maintain the same stop-loss.
A trailing stop-loss should raise the protective stop by at least 18 per cent (since the price appreciated 20 per cent) so that even if the prices reverse abruptly, even your notional gains are protected.
The smartest market players are not those who make lots of money on stray trades, but those who make money consistently. Therefore, risk management is as important as profiteering.
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