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What is technical analysis?

July 20, 2005 10:57 IST
First of a three-part series covering technical analysis, aimed at improving investor knowledge and market proficiency.

Why technicals ?
Technical analysis shows a way out to the serious player who is interested in optimising returns on investments. I would advocate every player who has some interest in stocks should have a working knowledge of technical analysis.

Going by the maxim of " knowledge is power" , technical studies provide handy tools akin to the versatile Swiss army knife to all players. In the first part, we take a step-by-step approach to understanding the subject.

What is technical analysis?
Technical analysis 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, profit and loss 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.

I believe that technical analysis is more dynamic compared with fundamental analysis based on one simple argument -- fundamental analysts depend on corporate events such as quarterly results and special announcements such as 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 four to five times a year -- around quarterly results and special announcements such as mergers and acquisitions.

Why would prices fluctuate almost daily? If prices fluctuate ever so often, is there a way to forecast them? Yes, according to technical analysis.

How they fare
Technical analysis versus fundamental analysis
1) Is a medley of Science & art. No algebraic / empirical
1) Is a pure science form, involves pre-set parameters for investment decision support systems.

.2) Involves study of price charts and oscillators derived thereon

2) Involves study of Balance Sheets, P & L accounts.
3) Study regards price as the ultimate factor, which factors in fundamental factors as well. Does not subscribe to the random walk theory.

3) Study regards price moves as a random phenomena, caused by market forces.

4) Signals generated by market action on prices.

4) Signals generated by corporate actions.

5) Chances of multiple interpretations are higher.

5) Chances of multiple interpretations are lower.

6) Will generate more signals, works for catching MOST price movements.

6) Will generate fewer signals, works better for catching major moves.

7) Will generally generate signals in advance.

7) Will generally generate delayed signals.

8) Involves built-in capital / risk management techniques.

8) Involves NO risk / capital management techniques.

School of thought
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 theory uses intra-day charts and bases its computation on the principle that prices move in waves and that upmoves come in five waves and downmoves in three 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 such as the morning star, hanging man, evening stars to denote chart patterns. The Chinese have the Yin and Yang theory which is similar to the Japanese candle-stick patterns. I would advocate using the Dow theory based on the sheer simplicity of the same.

Tools 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.

The nuts and bolts
In a complex looking charting screen, it must be remembered that the price graph is the meat and the oscillators are the ketchup.

The mistake most novice technical analysts make is to give an excessive emphasis to oscillators. Please remember that oscillators are derived from price graphs and not vice-a-versa.

Another aspect that I would stress emphatically is the fact that an objective approach is needed to succeed using technicals.

Try to see what the chart is telling you rather than what you want in the chart.

Vijay L Bhambwani is a Mumbai-based investment consultant

Vijay L Bhambwani