In the previous chapter, we briefly understood technical analysis and the main difference between technical and fundamental analysis. In this chapter, we will dig a bit deeper and explore the assumptions technical analysis is based upon.
2.2 – Application on asset types
One of the greatest advantages of technical analysis is that 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 is the price information, 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 drive any car, whether a Mahindra XUV or a Maruti Swift. Likewise, you only need to learn technical analysis once. Once you do so, you can apply TA on any asset class – equities, commodities, foreign exchange, fixed income, etc.
The fact that TA can be applied to multiple assets is probably one of the biggest advantages of TA compared to the other stock market research techniques. For example, one has to study the profit and loss, balance sheet, and cash flow statements when it comes to the fundamental analysis of equity. However, the fundamental analysis of commodities is completely different.
When dealing with an agricultural commodity like Coffee or Pepper, the fundamental analysis includes analyzing rainfall, harvest, demand, supply, inventory etc. However, the fundamentals of metal commodities are different, so it is for energy commodities. So every time you choose a commodity, the fundamentals change.
On the other hand, 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 the same way on equity, commodity, or currency.
2.3 – Assumption in Technical Analysis
Unlike fundamental analysts, technical analysts don’t worry about the company’s valuation. The only thing that matters is the stock’s historical trading data (price and volume) and the insights the past data provides about the future movement in stock price.
Technical Analysis is based on a few key assumptions. You need to know these assumptions to ensure you use technical analysis effectively.
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, an insider could buy the company’s stock in large quantities in anticipation of a good quarterly earnings announcement. While the insider does this secretively, the price reacts, revealing to the technical analyst that something is about to happen in the stock price.
2) The ‘how’ is more important than the ‘why’ – This is an extension of the first assumption. Going with the same example discussed above – the technical analyst would not be interested in questioning why the insider bought the stock as long as the technical analyst knows how the price reacted to the insider’s action.
3) Price moves in trend – All major moves in the market are an outcome of a trend. The concept of trend is the foundation of technical analysis. For example, the recent upward movement in the NIFTY 50 Index to 18500 from 14750 did not happen overnight. This move happened in a phased manner in over 11 months. Another way to look at it is that 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 remarkably similar ways every time the price moves in a certain direction. For example, in an uptrend, market participants get greedy and want to buy irrespective of the high price. Likewise, market participants want to sell in a downtrend irrespective of the low and unattractive prices. This human reaction has been the same towards stock prices over time, ensuring that history repeats itself.
2.4 – The Trade Summary
The Indian stock market is open from 9:15 AM to 03:30 PM. During the 6 hours 15-minute market session, millions of trades occur. Think about an individual stock – every minute, a trade gets executed on the exchange. As market participants 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 many trades exist. Look at the picture below. Each point refers to a trade being executed at a particular time. If one manages to plot a graph that includes every second from 9:15 AM to 3:30 PM, the graph will be cluttered with many points. I’ve tried to represent this in the chart below –
The market opened at 9:15 AM and closed at 3:30 PM, during which there were many trades. It will be practically impossible to track all these different price points. One needs a summary of the trading action and not the details on all the different price points.
We can summarise the price action by tracking the Open, high, low, and close.
Open Price – When the markets open for trading, the first price a trade executes is called the opening price.
The High Price – This represents the highest price at which a trade occurred for the given day.
The Low Price – This represents the lowest price at which a trade occurred for the given day.
The Close Price – This is the most important price because it is the final price at which the market closes for the day. The close indicates the intraday strength and a reference price for the next day. If the close is higher than the open, 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, closing is more important than the opening, high or low prices.
The main data points from the technical analysis perspective are open, high, low, and close prices. Each of these prices has to be plotted on the chart and analyzed.
Key takeaways from this chapter
- Its scope does not bind to technical Analysis. The TA concepts can be applied across asset classes as long as it has time-series data.
- TA is based on a few core assumptions.
- Markets discount everything
- The how is more important than the why
- Price moves in trends
- History tends to repeat itself.
- A good way to summarize the daily trading action is by marking the open, high, low, and close prices, usually abbreviated as OHLC