Background

1.1 – Overview

The previous module set us on a good plane with a basic understanding of the stock markets. Taking cues from the previous module, we now know that developing a well-researched perspective is critical for stock market success. A good point of view should have a directional view and should also include information such as:

1. Price at which one should buy and sell stocks
2. Risk involved
3. Expected reward
4. Expected holding period

Technical Analysis (also abbreviated as TA) is a popular technique that allows you to do just that. It helps you develop a point of view on a particular stock or index and helps you define the trade, keeping in mind the entry, exit, and risk perspective.

Like all research techniques, Technical Analysis also comes with its own attributes, some of which can be highly complex. However, technology makes it easy to understand. We will discover these attributes as we proceed along with this module.

1.2 – Technical Analysis, what is it?

Consider this analogy.

Imagine you are vacationing in a foreign country where everything, including the language, culture, climate, and food is new to you. On day 1, you do the regular touristy activities, and by evening you are starving. You want to end your day by having a great dinner. You ask around for a good restaurant and you are told about a nice food street close by. You decide to give it a try.

To your surprise, many vendors are selling different varieties of food. Everything looks different and interesting. You are absolutely clueless as to what to eat for dinner. To add to your dilemma, you cannot ask around as you do not know the local language. So given all this, how will you decide on what to eat?

Well, you have two options to figure out what to eat.

Option 1: You visit a vendor, figure out what they are cooking/selling. Check on the ingredients used, cooking style, probably taste a bit and figure out if you actually like the food. You repeat this exercise across a few vendors, after which you would most likely end up eating at a place that satisfies you the most.

The advantage of this technique is that you know exactly what you are eating since you have researched it independently. However, on the flip side, the methodology you adopted is not really scalable. There could be about 100 odd vendors, and with limited time at your disposal, you can probably cover about 4 or 5 vendors.  Hence there is a high probability that you could have missed the best-tasting food on the street!

Option 2: You stand in a corner and observe all the vendors. You try and find a vendor who is attracting the maximum crowd. Once you find such a vendor you make a simple assumption -‘The vendor is attracting so many customers which means he must be making the best food!’ Based on your assumption and the crowd’s preference, you decide to go to that particular vendor for your dinner. The chances are that you could be eating the best tasting food available on the street.

The advantage of this method is the scalability. You need to spot the vendor with the maximum number of customers and bet that it is good based on the crowd’s preference. However, on the flip side, the crowd need not always be right.

If you could recognize, option 1 is very similar to Fundamental Analysis where you research a few companies thoroughly. We will explore the Fundamental Analysis in greater detail in the next module.

Option 2 is very similar to Technical Analysis, where one scans for opportunities based on the current trend, aka the market’s preference.

Technical Analysis is a research technique to identify trading opportunities in the market based on market participants’ actions. The actions of market participants can be visualized, utilizing a stock chart. Over time, patterns are formed within these charts, and each pattern conveys a certain message. The job of a technical analyst is to identify these patterns and develop a point of view.

Like any research technique, technical analysis stands on a bunch of assumptions. As a technical analysis practitioner, you need to trade the markets, keeping these assumptions in perspective. Of course, we will understand these assumptions in detail as we proceed along.

Also, at this point, it makes sense to throw some light on a matter concerning FA and TA. Often people get into an argument contending a particular research technique is a better approach to the market. However, in reality, there is no such thing as the best research approach. Every research method has its own merits and demerits. It would be futile to compare TA and FA to figure out which is a better approach.

Both techniques are different and not comparable. In fact, a prudent trader would spend time educating himself on both the techniques to identify great trading or investing opportunities.

1.3 – Setting expectations

Often market participants approach technical analysis as a quick and easy way to make a windfall gain in the markets. On the contrary, technical analysis is anything but quick and easy. Yes, if done right, a windfall gain is possible but to get to that stage, one must put in the required effort to learn the technique.

If you approach TA as a quick and easy way to make money in markets, trading catastrophe is bound to happen. When a trading debacle happens, more often than not, the blame is on technical analysis and not on the trader’s inability to efficiently apply Technical Analysis to markets. Hence before you start delving deeper into technical analysis, it is important to set expectations on what can and cannot be achieved with technical analysis.

1. Trades – TA is best used to identify short term trades. Do not use TA to identify long term investment opportunities. Long term investment opportunities are best identified using fundamental analysis. Also, If you are a fundamental analyst, use TA to calibrate the entry and exit points.
2. Return per trade – TA based trades are usually short term in nature. Do not expect huge returns within a short duration of time. The trick with TA being successful is to identify frequent short-term trading opportunities that can give you small but consistent profits.
3. Holding Period – Trades based on technical analysis can last anywhere between few minutes and few weeks, and usually not beyond that. We will explore this aspect when we discuss the topic of timeframes.
4. Risk ­– Often, traders initiate a trade for a certain reason; however, in case of an adverse movement in the stock, the trade starts making a loss. Usually, in such situations, traders hold on to their loss-making trade with a hope they can recover the loss. Remember, TA based trades are short term, in case the trade goes sour, do remember to cut the losses and move on to identify another opportunity.

Key takeaways from this chapter

1. Technical Analysis is a popular method to develop a point of view on markets. Besides, TA also helps in identifying entry and exit points.
2. Technical Analysis visualizes the actions of market participants in the form of stock charts.
3. Patterns are formed within the charts, and these patterns help a trader identify trading opportunities.
4. TA works best when we keep a few core assumptions in perspective.
5. TA is used best to identify short terms trades