Module 2   Technical AnalysisChapter 2

Introducing Technical Analysis

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M2-Ch2-title

2.1– Overview

In the previous chapter, we briefly understood what Technical Analysis was about. In this chapter, we will focus on the versatility and the assumptions of Technical Analysis.

2.2 – Application on asset types

Probably one of the greatest versatile features of technical analysis is the fact you can apply TA on any asset class as long as the asset type has historical time series data. Time series data in technical analysis context is information pertaining to the price variables namely – open high, low, close, volume, etc.

Here is an analogy that may help. Think about learning how to drive a car. Once you learn how to drive a car, you can literally drive any type of car. Likewise, you only need to learn technical analysis once. Once you do so, you can apply the concept of TA on any asset class – equities, commodities, foreign exchange, fixed income, etc.

This is also probably one of the biggest advantages of TA when compared to the other fields of study. For example when it comes to fundamental analysis of equity, one has to study the profit and loss, balance sheet, and cash flow statements. However fundamental analysis for commodities is completely different.

If you are dealing with an agricultural commodity like Coffee or Pepper then the fundamental analysis includes analyzing rainfall, harvest, demand, supply, inventory etc. However the fundamentals of metal commodities are different, so is for energy commodities. So every time you choose a commodity, the fundamentals change.

Anyhow, the concept of technical analysis will remain the same irrespective of the asset you are studying. For example, an indicator such as ‘Moving average convergence divergence’ (MACD) or ‘Relative strength index’ (RSI) is used exactly the same way on equity, commodity or currency.

2.3 – Assumption in Technical Analysis

Unlike fundamental analysts, technical analysts don’t care whether a stock is undervalued or overvalued. In fact, the only thing that matters is the stocks past trading data (price and volume) and what information this data can provide about the future movement in the security.

Technical Analysis is based on a few key assumptions. One needs to be aware of these assumptions to ensure the best results.

1) Markets discount everything – This assumption tells us that, all known and unknown information in the public domain is reflected in the latest stock price. For example, there could be an insider in the company buying the company’s stock in large quantity in anticipation of a good quarterly earnings announcement. While he does this secretively, the price reacts to his actions thus revealing to the technical analyst that this could be a good buy.

2) The ‘how’ is more important than ‘why’This is an extension to the first assumption. Going with the same example as discussed above – the technical analyst would not be interested in questioning why the insider bought the stock as long as he knows how the price reacted to the insider’s action.

3) Price moves in trend –  All major moves in the market is an outcome of a trend. The concept of trend is the foundation of technical analysis. For example, the recent upward movement in the NIFTY Index to 7700 from 6400 did not happen overnight. This move happened in a phased manner, in over 11 months. Another way to look at it is, once the trend is established, the price moves in the direction of the trend.

4) History tends to repeat itself – In the technical analysis context, the price trend tends to repeat itself. This happens because the market participants consistently react to price movements in a remarkably similar way, each and every time the price moves in a certain direction. For example in up trending markets, market participants get greedy and want to buy irrespective of the high price. Likewise in a downtrend, market participants want to sell irrespective of the low and unattractive prices. This human reaction ensures that the price history repeats itself.

2.4 – The Trade Summary

The Indian stock market is open from 9:15 AM to 15:30 PM. During the 6 hour 15 minute market session, there are millions of trades that take place. Think about an individual stock – every minute there is a trade that gets executed on the exchange. The question is, as a market participant, do we need to keep track of all the different price points at which a trade is executed?

To illustrate this further, let us consider this imaginary stock in which there are many trades. Look at the picture below. Each point refers to a trade being executed at a particular time. If one manages to plot a graph which includes every second from 9:15 AM to 15:30 PM, the graph will be cluttered with many points. Hence in the chart below, for ease of understating I’ve plotted a limited time scale period:

M2-Ch1-Chart1

The market opened at 9:15 AM and closed at 15:30 PM during which there were many trades. It will be practically impossible to track all these different price points. In fact, what one needs is a summary of the trading action and not really the details on all the different price points.

By tracking the Open, high, low and close we can draw a summary of the price action.

The open – When the markets open for trading, the first price at which a trade executes is called the opening price.

The high – This represents the highest price at which the market participants were willing to transact for the given day.

The Low – This represents the lowest level at which the market participants were willing to transact for the given day.

The close – The Close price is the most important price because it is the final price at which the market closed for a particular period of time. The close serves as an indicator for the intraday strength. If the close is higher than the open, then it is considered a positive day otherwise negative. Of course, we will deal with this in greater detail as we progress through the module.

The closing price also shows the market sentiment and serves as a reference point for the next day’s trading. For these reasons, the closing price is more important than the Open, High or Low prices.

The open, high, low, close prices are the main data points from the technical analysis perspective. Each of these prices has to be plotted on the chart and analyzed.

M2-Ch1-Chart2


Key takeaways from this chapter

  1. Technical Analysis is not bound by its scope. The concepts of TA can be applied across any asset classes as long as it has a time-series data.
  2.  TA is based on a few core assumptions.
    1. Markets discount everything
    2. The how is more important than why
    3. Price moves in trends
    4. History tends to repeat itself
  3. A good way to summarize the daily trading action is by marking the open, high, low and close prices usually abbreviated as OHLC

182 comments

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  1. Ravindranath says:

    I have an account with Zerodha and have started trading Nifty options. But I do not have any technical analysis tool. Currently I am using technical analysis on finance.yahoo.com, the problem with this is it is about 5 minutes behind market. I mean it does not show current price of Nifty but shows value which is 5 minutes before. Sometime back there was a pop-up in Zerodha about technical analysis software available for Zerodha members. I think around Deepavali there was a pop up mentioning that there is a discount for Zerodha traders if they want to use technical analysis software. I need information on which softwares to use for technical analysis which are display accurate values and up-to-date with market. If it is affordable, I am ready to pay for the services.

  2. HAWWA says:

    Dear sir,
    For analysing the movement of market , basically we need to know about the trend.
    I always do have confusions in knowing whether market is moving in uptrend or downtrend.
    For example, say Nifty previous closing is 8300, next day it had a gap up opening at 8374. Then it closed at 8310.
    So, if v compare it with previous closing, it is uptrend (8300-8310). if v compare it from open of the day to closing, it is down trend (8374-8310). So what is ur answer sir?. Pls explain.

    • Karthik Rangappa says:

      You need to see this movement in conjunction to the prior trend, that is when you will be in a position to form an opinion. Suggest you to go through the lesson on multiple candlestick patterns to get more clarity.

  3. Nitesh sharma says:

    Hi Karthik Wanted to Know the limitations or exclusions of Technical analysis in brief as an example wanted to ask are the bad news imbibed or taken care by the TA like recently the Supreme court Ruling on Coal Block and JSPL falling heavily or the Ruling on DLF and the share falling Hugely in the nest trading sessions are this taken care BY TA

    • Karthik Rangappa says:

      By and large most of the news such as – new product launch, new geographic expansion, M&A, management change, quarterly numbers etc is taken care by TA. The reason why I say this is such news (which is predetermined) somehow gets leaked and people (insiders) start taking positions and therefore the price and volume reacts.

      However things like court ruling may not be captured as its highly speculative in nature and till the last minute no one would know what would happen.

      • Manish says:

        Hi Karthik, My question is related to the assumption – Market discounts every news. Reading in one of your replies, I understand that the term “every news” means mostly the news related to the company as you mentioned. So do you agree that we should add another checklist item in the FINALE for news like election results, RBI or US Fed rate cut policy etc. I think such news can really have a great impact on the trend of a stock and might not go as we have calculated based on other checklist items. OR the other option would be to avoid trading on such a day or few following few days. Any other thought on how we should trade on such news driven days.

        • Karthik Rangappa says:

          You are right Manish, most of the news that is factored in is related to company news. Macros are not easy to factor in. It is best to avoid taking directional bets on such days..maybe you can explore delta neutral strategies.

  4. Janardhan Reddy says:

    Hi,

    My question is regarding close price. how exactly is close price determined. I have been observing the closing price of few stocks. few days it will be less than the last traded price of the day, few instances it was higher and few instances it was same as that of last traded price for the day. I googled on this and found that the closing price will be the average price for the last half an hour in the trading session.

    is it true?

    Thanks,
    Janardhan Reddy

  5. kishore says:

    Sir, Excellent chapters on FA and TA, simple and understable for investing and trading. I have a doubt on MACD and signal line cross overs. in some article/books it is stated that bullish signal occurs when MACD LINE CROSSES UPWARDS SIGNAL LINE. Where as it reverse in the above chapter. Thanks/Regards

    • Karthik Rangappa says:

      Signal line is a 9 day average line whereas the MACD takes the difference between 12 & 26 day average. Hence the signal line is more reactive to the daily price moves and therefore generates the trigger to either buy or sell.

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