What is Technical Analysis – Why It Works?

What is technical analysis?

The definition of technical analysis in simple terms is

Technical analysis is the study of forecasting the direction of price movement through the study of past market data through charts.

There are 3 basic principles of technical analysis.

3 Basic 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 the market reacts to the news and stock price gives a clearer picture of the news that 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 aka bullish trend or downtrend aka bearish trend) it will continue to follow the trend unless trend reversal patterns are formed.
3. Pattern repeat itself – There are a 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 will repeat yet again when the same chain of events repeat.

Why technical analysis works?

It is often the first question in any discussion about the market with any of my blog readers. The question comes in many forms like

1. Why do you think technical analysis may work for me?
2. What is the theory behind technical analysis to work?
3. Is working on 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 the question from the above principles of technical analysis, we understand technical analysis is the study of the market participants and how they react to the certain type of news and events outcome. As an example, if a company is about to share its quarterly results, technical analysis isn’t focused on the results itself but it is more to do with how traders and investors react to the results of the company in each of the possible scenario like for example:

1. A good result was expected and good results delivered
2. A good result was expected and not so good results delivered
3. A bad result was expected and good results delivered
4. A bad result was expected and bad results delivered

So every such event can have multiple outcome and how each of the market participants (traders, investors, speculators) react to those news is captured by the studies of chart pattern and technical analysis.

So if one can define the exact set of events and possible outcome, technical analysis can predict the future price movement of the stock easily.

The market often discounts the news well ahead of time-based on its expectations and technical analysis catches that spot on more often than not. Let us see this as an example.

Examples

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 a 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.

Final thoughts

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.