The Study Of Stock Market Through Technical Analysis

Lesson -> Background Of Technical Analysis

1.1 - The Overview

We were able to get a good understanding of stock markets from the previous module. We now know from the previous module that a well-researched viewpoint is crucial for success in stock markets. A well-researched point of view should be directional and include information like:

  1. The price at which stocks can be purchased and sold
  2. Risk involved
  3. Expected rewards
  4. Expected holding period

Technical Analysis, also known as TA, is a popular method that allows you to do exactly that. This technique helps you to develop a view of a stock or index. It also helps you to define the trade keeping in mind the entry and exit points and the risk perspective.

Technical Analysis, like all research methods, has its own attributes. Some of these can be very complex. Technology makes it simple to understand. These attributes will be revealed as we move along this module.

1.2 - What is Technical Analysis?

This analogy is a good example.

Imagine that you are on vacation in a foreign country, where everything, including language, culture, and food, is completely new to you. You do your regular touristy activities on day one, but by the evening you are hungry. It is your goal to finish the day with a delicious dinner. Ask around for recommendations of a great restaurant. It is tempting to try it.

Many vendors sell different types of food, surprising you. Every item is unique and intriguing. It is difficult to decide what to eat for dinner. You are also unable to ask for help in the local language, which adds to your problem. How can you choose what to eat when all of this is considered?

You have two choices when it comes to choosing what to eat.

Option 1: Visit a vendor to find out what they're selling. You will need to look at the ingredients and the cooking style. Then you can taste the food and decide if it is something that you like. Repeat this process with several vendors until you find the one that you like best.

This technique has the advantage that you can know exactly what you eat because you have independently researched it. The downside is that the method you used is not very scalable. You could cover around 4 to 5 vendors with the time you have available. There is a good chance that you have missed some of the best street food.

Option 2: You take a seat in a corner to observe all the vendors. You look for the vendor that attracts the most customers. You make an assumption that the vendor attracts the most customers, and you decide to eat at the vendor. There are good chances that you will be enjoying the best street food.

This method has the advantage of scaling up. The trick is to find the vendor that has the most customers. You can then bet on its quality based on crowd preferences. Sometimes the crowd is not right.

Option 1 is very similar in concept to Fundamental Analysis, where you thoroughly research several companies. In the next module, we will be more in-depth about Fundamental Analysis.

Option 2 is similar to Technical Analysis. Here, one scans for potential opportunities based upon the current trend (aka the preference of the market).

Technical analysis is a technique that identifies trading opportunities in the market by studying market participants' actions. A stock chart can help visualize the actions of market participants. These charts can be used to create patterns over time. Each pattern communicates a specific message. Technical analysts are responsible for identifying these patterns and developing a point-of-view.

Technical analysis, like any other research technique, is based on a number of assumptions. Technical analysis practitioners must trade the markets keeping these assumptions in mind. These assumptions will be explained in more detail as we go along.

It is also sensible to shed some light on a topic concerning FA and TA. Many people argue that a certain research method is better than another. In reality, there is no best research method. Each research method has its merits and drawbacks. To compare FA and TA to determine which approach is better, it would be futile.

These techniques are not interchangeable. A prudent trader would invest time learning both techniques in order to find great investing or trading opportunities.

1.3 - The Setting of expectations

Market participants often view technical analysis as a quick way to make huge gains in the markets. Technical analysis is not quick and easy. It is possible to make a lot of money if you do it right. However, this requires that one put in the effort to learn the technique.

Trading catastrophes are inevitable if you view TA as a quick and easy method to make money in the markets. A lot of trading disasters are due to technical analysis, not the trader's inability or inability to apply Technical Analysis to markets. Before you dive deeper into technical analysis, it's important to establish expectations about what technical analysis can achieve.

  1. Trades- Short-term trades are best identified with TA. To identify long-term investment opportunities, do not use TA. Fundamental analysis is the best way to identify long-term investment opportunities. You can also use TA to calibrate entry and exit points if you are a fundamental analyst.
  2. Return per trade -Trades TA-based are often short-term in nature. Expect small returns over a short time. To make TA profitable, you must identify short-term trading opportunities that offer small but steady profits.
  3. Holding PeriodTechnical analysis trades can be executed in a matter of minutes to a few weeks. Usually, they are not extended beyond that. This aspect will be discussed when we talk about timeframes.
  4. Risk Trades are often initiated by traders for a specific reason. However, if the stock moves in an unfavorable direction, the trade will start making losses. In such cases, traders tend to hold onto their losing trades in the hope that they can recover the loss. Trades based on TA are usually short-term. If the trade turns sour, remember to reduce the losses and find another opportunity.

To Summerize

  1. Technical analysis is a popular way to get a market perspective. TA can also help identify entry and exit points.
  2. Technical Analysis depicts market participants' actions in stock charts.
  3. Charts contain patterns that help traders identify trading opportunities.
  4. TA works best when there are a few key assumptions.
  5. The best way to identify short term trades is with TA