How does Technical Analysis work?

“Analyzing charts really gives an impression of where the money lies.” Well, that's true to some extent; but this would garner mixed opinions. Indeed, Technical vs Fundamental has been one the most heated debates for years now.

There are investing sages who merely believe in capturing the fundamentals of a stock and promote the legacy of value investing; whereas on the contrary, there are traders who believe that price of the stock is the sole entity and that it captures all the fundamentals, trends and buzzing updates related to the stock within itself. Except for minuscule believers of both, you could say this debate has divided the investing community right through the middle!

We have delved into fundamental analysis in many of our blogs, but today you’re about to understand the nitty-gritty of technical analysis. In this blog, we shall decode 3 essential concepts of technical analysis and how traders use them for investment decision-making. But prior to that, here's a short snippet on technical analysis.

What is Technical Analysis?

Technical Analysis is an investment research methodology that involves using charts and other tools to predict or at least form an opinion about the probable future price movement based on the historical trend in price and volume. This is widely used in the case of stocks, derivatives, forex, etc. The time frame in which this method can be applied ranges from intraday, daily, weekly, or monthly to annually.

Now that you know what technical analysis is, here're the three most important elements of technical analysis.

Candlestick Patterns

This is the plinth of technical analysis. A Candlestick shows the movements in the price of a security in a day at one glance. Reading the pattern of candlestick charts is imperative to understanding all other stuff in technical analysis. Candlestick charts are like English alphabets, while trading strategies are like English grammar... if you are weak in grammar, you need to revisit your alphabets.

If you wish to know about Candlestick patterns in more detail, you can read our previous blog here.

Moving Averages

The most basic of moving averages is, as the name goes, a Simple Moving Average (SMA). SMA is simply the sum of the closing price of a stock for a period of time divided by the number of days. The formula would be:

SMA can be calculated for a day, a week, a month, or any other periodic basis. For the short term, the industry generally uses a 20 days SMA. A whipsaw is when a stock crosses over the moving average, giving a signal (buy or sell) and reverses the signal quickly. While using a 20-day SMA, an investor might get many whipsaws; hence many analysts prefer an intermediate (50-day SMA) or a long-term SMA (200-day SMA), which when compared to a 20-day SMA gives less number of whipsaws.

Though SMA is simple to calculate and use, it might use old data, which may not be relevant anymore. Hence short-term traders prefer Weighted Moving Average (WMA) or an Exponential Moving Average (EMA). Both of these moving averages consider recent data more relevant and assign it more weight, consequently reacting quickly to price changes and thereby improving decision making.

Barring the 3 moving averages discussed above, we have 3 more, namely DEMA, TEMA, and LSMA. DEMA stands for Double Exponential Moving Average. Investors that use MA theory for shorter tenure generally tend to use DEMA. It is usually preferred amongst swing traders and day traders.

To add an extra pair of hands to the modern-day analyst, the concepts of TEMA and LSMA were formed to fine-tune lags and predict volatility. TEMA’s formula uses a triple-smoothed EMA, which becomes the differentiating factor. On the other hand, the least-square moving average (LSMA) calculates the least-squares regression line for the preceding time periods; thus, it leads to future projections from the current period. The indicator predicts what could happen if the regression line is continued.

Moving Averages, as an indicator, is not a future prediction but the confirmation of trends and thus, they are a significantly used tool to carve out buy and sell calls based merely on historical trends. Therefore, traders that believe in the saying that “future is the past again entered through a different gate” use this indicator frequently for decision making. Moving Averages are vital to be tracked and at times act as Support and Resistance.

Let us now explore Support and Resistance in depth.

Support and Resistance

When it comes to money, almost all human beings in the world react similarly. We become cautious, our mind tells us to think twice before making a decision, but at the same time, mind battles with the opportunity cost too; what if I get late in making a decision and lose an opportunity where I can make money. All these factors contribute towards the formation of support and resistance lines in the chart. 

Investors understand that history and financial events may repeat themself; thus, they react cautiously at some events and aggressively at others based on their past perceptions and incidences. That is what makes support and resistance formation in stock prices and indices which is a widely prevalent and tracked matrix in technical analysis.

Support occurs when a downtrend is expected to pause and Resistance is formed when an uptrend is expected to pause.

We all have a habit of complicating easy stuff, and forming support and resistance levels is one such example of that. Just follow 2 simple steps, and you may end up discovering support and resistance levels yourself, very easily:

Step 1: Draw the most obvious levels on the charts using a straight line. These apparent levels should be one that you feel that can be support or resistance line level. Support is the level of trough in the bottom-most candle from where you think that the trend may change, and resistance is the peak of the candle from where you feel the downtrend may happen.

Step 2: Adjust your lines to be the best fitting lines, i.e., where it could touch the most number of candles or its wicks. This ensures reliability in finding the right and most appropriate levels for support and resistance.

The diagram below illustrates the steps mentioned above.

From the above chart, it is evident that bottom levels of 2017, i.e., when NIFTY 50 was priced at 7900, it acted as a strong support during the bloodbath that Covid 19 pandemic created in the indices. Similarly, 10880 acted as a resistance level multiple times.

Now you would be like, okay, we got the resistance and support levels. But now what? Well, here’s one instance of how these levels can prove to be very useful.

Let’s say you are a trader and have bought a stock for Rs 150 but are unsure where to exit. Based on extensive calculations and conviction, you find that its support level is at around Rs 100, which basically means most of the times when the stock’s price dropped to near 100, it re-bounced. That could mean that if the price breaches and falls below 100, it could be a further downtrend! So, you could set your stop loss or sell the stock as and when it breaches the 100 levels! That way, you can avoid further losses.

This is how support and resistance (in the opposite case) levels prove beneficial in many cases.

The Bottom Line

Just like a coin comes with 2 faces, Technical & Fundamental Analysis are basically two sides of the same coin. The key to success lies in finding a fundamentally sound stock and deciding the entry levels using the phenomenon of technical analysis.

The battle between technical and fundamental analysis seems to be never-ending. However, the winner could clearly be the one who can blend the flavor of both to make a perfect mocktail. So there you go!

To conclude, here’s a note on Technical Analysis from John Murphy - “Technical analysis is a skill that improves with experience and study. Always be a student and keep learning.”

So, what are you? A fundamental analysis person or a technical analysis person? Or a sweet spot between the two? Tell us the reason in the comments.