How to be a Smart Investor: Understanding Technical Analysis

Smart Investing: Understanding Technical AnalysisTechnical Analysis is the process of forecasting price movements based on a systematic study of past price actions through pictorial representations.


Technical analysis is effectively the indirect study of investor behavior and its effect on the subsequent price action based on the information they hold.


Why does Technical Analysis work?


Although in an ideal and rational world, all information must be publicly available and processed by market participants in a rational manner to be able to value an underlying asset or company. But markets are not always rational. 


Markets oscillate between panic and exuberance due to underlying emotions of Fear and Greed. Hence, technical analysis works as an effective tool to capture market trends created by human emotions. 


Warren Buffett makes an analogy for this by quoting stock market as an imaginary person - "Mr. Market is kind of a drunken psycho. Some days he gets very enthused, some days he gets very depressed."


Smart Investing: Understanding Technical Analysis


Foundation of Technical Analysis:


The basic foundation of Technical Analysis is similar to cause-effect principle in Physics.


Smart Investing: Understanding Technical Analysis


Similarly, any meaningful information in the market creates effect in terms of action by its market participant which thereby impacts price and volume of stocks. This can be further analyzed by Technical analysis for forecasting future price movements.


"Since all human actions obey laws, as fixed as those of geometry, psychology should be studied in geometrical form, and with mathematical objectivity..."  - Spinoza


Dow Theory and premises of Technical analysis:


Smart Investing: Understanding Technical Analysis


Although people know that Greed and Fear extremes are embedded in the stock market, history still repeats each time. Peter Bevelin in his book Seeking Wisdom - From Darwin to Munger writes "Fear is our most basic emotion. Fear has evolved to help us anticipate danger and avoid pain."


As science writer Rush Dozier in his book Fear Itself writes "Fear is fundamental because life is fundamental. If we die, everything else becomes irrelevant"


Pillars of Technical Analysis:


Any participant who wants to take advantage of information has to put money on the table to benefit from it. Any kind of information is thus reflected in the change in supply and demand. Key pillars that captures these changes are:

1. Trend
2. Price
3. Volume

Types of Charts used in Technical Analysis:


We would be learning below charts which captures price movements:
- Line charts
- Bar charts
- Candlestick charts

How can Technical Analysis complement with Fundamental Analysis?

Common dilemma in fundamental analysis:
- Selling too early; Not riding the trend
- Difficult to time entry and exit of cyclicals
- Valuations remaining expensive for prolonged period of time
- Information getting priced-in before news

Technical Analysis adds another dimension for buying and selling stocks through tools like trend lines, volume spurts, break-outs, resistance, supports, reversal patterns etc. When blended with Fundamental Analysis, this forms powerful combination. 

Technical Analysis for Long Term investing:

There is myth among people that Technical Analysis can only be used for intraday trading. This is not at all true. In reality, it can be used for medium and long term investing as well. 

I believe that both are highly complementary and should work together to tell you WHATto buy or sell and WHEN to buy or sell.


Link to complete presentation


Originally Published on TECHNOFUNDA