Why technical analysis works?
It was the first question in my recent one on one consulting with one of my blog reader but similar questions are the starting point of discussions most of the time. Questions vary slightly like
- Why you think technical analysis may work for me?
- What is the theory behind technical analysis to work?
- Is working of technical analysis based on any principles or it works because it has worked in the past?
And the list of such questions continues … but the underlying question remains the same that is why technical analysis works in the Market?
To answer this question let me share with you 3 basic principles of technical analysis.
Principles of Technical Analysis
1. Stock Price reveals Everything – Anything upcoming – Good results, bad results, strategic decisions, management decisions, dividend, buybacks or anything else it will always be reflected in stock price. Technical analysts believe it is important to see how market reacts on the news and stock price gives clearer picture about the news than the news itself. Technical analysts don’t prefer digging into the news and trying to understand how it will affect the stock price but they try to understand the news based on the stock price movement.
2. Stock price move in trends – If a stock is following a trend (uptrend or downtrend or bullish or bearish trend) it would continue to follow the trend (unless trend reversal patterns are formed) for some more time.
3. Pattern repeat itself – There are certain set of events that occur on a regular basis in the market and if a pattern is formed with those set of events, the price pattern would repeat yet again when those chain of evens repeat.
Understanding the principles of technical analysis clearly suggests why it is more likely that technical analysis will work but still let us take an example to understand them in a better way.
Let us try to understand the principles of technical analysis with an example of Kingfisher Airlines. It is one of those stocks, which is in the news lately and so let us look at the 2 years and 6 months charts of Kingfisher Airline at ChartInk.
I don’t track Kingfisher Airlines from trading or investing point of view and so I will not be able to comment on the exact dates of news outcome but from my traveling habits I know it is in news for last few months.
Looking at the above charts, we clearly see that stock has not done much when it is in the news but has done lot of things ahead of the news and such a big fall in the stock price revealed everything (even well ahead of time).
To see how chart patterns repeats itself read this.
I hope I have managed to clarify why technical analysis has more probability of working in the market but if you have any questions about anything please share them in comments.