What is technical analysis? Why technical analysis works? What is the theory behind technical analysis to work? What are principles of technical analysis? and lastly Why I think technical analysis may work for you as well?
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
- 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.
- 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.
- 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
- Why do you think technical analysis may work for me?
- What is the theory behind technical analysis to work?
- 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:
- A good result was expected and good results delivered
- A good result was expected and not so good results delivered
- A bad result was expected and good results delivered
- 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.
Kingfisher Airlines 2 Years
Kingfisher Airlines 6 Months
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.
Dear Shabbir,
I have started reading your e-book on technical analysis that I purchased yesterday.
I was always wanted some good read to understand charts by my self so that I can also see some gain in what I invest/trade. I guess, now I have finally found one in form of your ebook. Thanks a lot for writing this book.
I have a Query – As you said in one of your comments that you have some forever stocks. I wonder how to build such list? There are 100s or more fundamentally good stocks in market and I think it is not possible to technically analyse each one of those and choose best. I am interested in making some additional income time to time as well as creating wealth for long time. So can you pleas guide, how one should prepare list of stocks that latter could be followed/analysed regularly for short term trading as well as investing? Thanks in advance!!
You don’t need to analyze all stock but before you invest, you can analyze and you will find those good stocks.
I have explained the process of how I find forever stocks here – http://shabbir.in/forever-stocks/
Apart from that you can refer to the members area forum thread where many members have shared their best stock.
http://diytechnicalanalysis.com/members/showthread.php?t=34
Dear Sir,
I am of the view that one needs to learn learn technical analysis only for planning an exit strategy. I am holding fundamentally sound stocks but am unable to maximize my profit as I am unable to exit at the right time. Kindly advise me.
Appa Rao, I don’t think you need to know technicals for good exit strategy only but you also need to buy them back as well and so you even need to have good entry strategy as well. I do the same with my forever stocks and I have explained the same with Nestle India here.
Hi Sir, i have purchased e-book on technical analysis through online. It is very informative
and most practical book on tech.analysis, but in this book the topic MACD Is not included, could you give info reg this.
Thanks&Regards
K.Sruthi.
Hi Sruthi, thanks for the wonderful feedback and yes MACD is not part of my book because this book is more about trading pattern that I use and I don’t prefer too much of mathematical indicators but prefer more of price action indicators like support and resistance.
Hi sir, thank u for u r early reply. How do taxes are calculated on the income of trading.
can u pls clarify capital gains tax. Another query is about technical analysis softwares, are these really useful for trading.
Thanks & Regards
Sruti, tax calculation is based on the net profit you make out of trading after deducting all the expenses like brokerage and STT’s.
Regarding technical analysis software it would be too general statement to say everything work or don’t work but the most important part is to know how to make it work and we should know and understand how to make them work.
I never doubted why technical analysis work but now I know for sure why it works. Thanks for sharing.
Thanks Arjun for your feedback.