M2-Ch2-title

2.1– Overview

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 –

M2-Ch1-Chart1

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.

M2-Ch1-Chart2


Key takeaways from this chapter

  1. 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.
  2.  TA is based on a few core assumptions.
    1. Markets discount everything
    2. The how is more important than the 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



294 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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