Technical Analysis - Meaning, Tools & Techniques, Objectives and Limitations

Technical Analysis of Companies
Unit 1 SAPM Notes 
Concept of Investments

Meaning of technical analysis

In fundamental analysis, a value of a stock is predicted with risk-return framework based on economic environment. An alternative approach to predict stock price behaviour is known as technical analysis. It is frequently used as a supplement rather than as a substitute to fundamental analysis. Technical analysis is based on notion that security prices are determined by the supply of and demand for securities. It uses historical financial data on charts to find meaningful patterns, and using the patterns to predict future prices.

In the words of Edwards and Magee: “Technical analysis is directed towards predicting the price of a security. The price at which a buyer and seller settle a deal is considered to be the one precise figure which synthesizes, weights and finally expresses all factors, rational and irrational quantifiable and non-quantifiable and is the only figure that counts”.

Tools of Technical Analysis:

Charting represents a key activity for a technical analyst during individual stock analysis. The probable future performance of a stock can be predicted and evolving and changing patterns of price behaviour can be detected based on historical price-volume information of the stock. Charts used to study the trend in prices, price index, and also volume of transactions. Technical analysis involves three basic types of charts. They are:

(a) Line charts,

(b) Bar charts, and

(3) Point and figure charts.

a)       A Line Chart connects successive trading day’s closing price/price indices or volume of trade as the case may. Each day’s price is recorded.

b)      A Bar Chart is made up by a series of vertical bars of lines, each bar of line representing; a particular day’s high and low prices. The closing price of a day is indicated by a small horizontal dash on the day’s bar. Each day’s price data are thus recorded.

c)       Point and figure charts are more complex than line and bar charts. Point and figure chart are not only used to detect reversals in a trend, but also used to forecasts the price, called price targets. The only significant price changes are posted to point and figure charts. Three or five point price changes as posted for high prices securities, only one point changes are posted follow prices securities. While line and bar charts have two dimensions with vertical column indicating trading day, point and figure chart represents each column as a significant reversals instead of a trading day. For example, for a share in the price hand of Rs. 1000-1500 or so, a price change exceeding, say, Rs. 15 may be taken as significant, whereas for a scrip in the price range of Rs. 100-150, a change in price of the order of Rs. 3 or more may be taken as significant. Upward significant moves are indicated by ‘x’ in the same column. Say for scrip of Rs. 3 change is taken as significant. Another ‘x’ in the same column, above the previous ‘x’ is put. The same day it moves to 107. One more ‘X’ is put. Next day price drifts by Rs. 2. No entry in price will he recorded in this column. If a significant increase in price takes place, next column of ‘x’ will be charted.

Theory of technical analysis - Dow Theory

The ideas of Charles H. Dow, the first editor of the Wall Street Journal, form the basis of technical analysis today. According to the hypothesis of Dow, the stock market does not perform on random basis but is influenced by three cyclical trends, namely, (a) Primary trend, (b) secondary or intermediate trend, and (3) Tertiary or minor trend. The general market direction can be predicted by following these trends. The primary trends are the long-term movement of prices, lasting from several months to several years. They are commonly called bear or bull markets. Secondary trends are caused by short-term deviations of prices from the underlying trend line. They last only a few months. The secondary trend acts as a restraining force on the primary trend, tending to correct deviations from its general boundaries. Minor trends are daily fluctuations in either directions (bull or bear) which are of little analytical value. In terms of bull and bear markets the trends are described as follows:

• The first phase of a bull market is the accumulation phase. This is when prices are depressed and financial reports don't look good. However, farsighted investors use this period of depressed prices to take advantage and buy shares.

• The second phase of the bull market is characterized by increased activity, rising prices, and better financial reports. This is the period where the large gains are made. At this point, the market becomes vulnerable to a reversal.

• The first phase of a bear market is the distribution phase. This is where farsighted investors see the uninformed investors scrambling to buy shares. The farsighted investors begin to sell shares. Oversupply leads to weakening prices and profits are harder to come by.

• The second phase of the bear market is characterized by near panic selling. Prices accelerate to the downside and more and more people begin to liquidate their holdings.

• The third phase of the bear market is characterized by further weakening and erosion of prices. Lesser quality issues erase the gains of the previous bull market. The news is full of bad market news.

The second part of the Dow Theory is that the Industrial Average and the Railroad Average must corroborate each other's direction for there to be a reliable market direction signal. Dow created the Industrial Average, of top blue chip stocks, and a second average of top railroad stocks (now the Transport Average). He believed that the behavior of the averages reflected the hopes and fears of the entire market. The behavior patterns that he observed apply to markets throughout the world.

According to Dow Theory, large active stocks will generally reflect the market averages. However, individual issues may deviate from the broad averages because of circumstances peculiar to them. The logic behind the makeup of the specific averages is that both the industrials and the transports are independent of each other. Yet, for the industrials to get their products to market, they must use the transports. When the industrials are doing well, the transports will do well. However, when one sector is doing substantially better than the other, a divergence is taking place. This demonstrates that one sector is much stronger than the other; and if it continues, without the other sector catching up, a major reversal in the market will take place.

Dow Theory also specifies that closing prices should only be used. This is because closing prices reflect the price level at which informed investors are willing to carry positions overnight. Thus, Dow Theory is used to indicate reversals and trends in the markets as well as individual security. The basic tenet of Dow Theory is that there is a positive relationship between trend and volume of shares traded.

Assumptions of technical analysis:

Edwards and Magee formulate the basic assumptions underlying technical analysis which are as follows:

1.       The market value of the scrip is determined by the interaction of demand and supply.

2.       Supply and demand is governed by numerous factors, both rational and irrational. These factors include economic variables relied by the fundamental analysis as well as opinions, moods and guesses.

3.       The market discounts everything. The price of the security quoted represents the hope, fears and inside information received by the market players. Insider information regarding the issuance of bonus shares and right issues may support the prices. The loss of earnings and information regarding the forthcoming labor problem may result in fall in price. These factors may cause a shift in demand and supply, changing the direction of trends.

4.       The market always moves in the trends except for minor deviations.

5.       It is known fact that history repeats itself. It is true to stock market also. In the rising market, investors’ psychology has upbeats and they purchase the shares in great volumes driving the prices higher. At the same time in the down trend, they may be very eager to get out of the market by selling them and thus plunging the share price further. The market technicians assume that past prices predict the future.

6.       As the market always moves in trends, analysis of past market data can be used to predict future price behavior.

7.       Shift in demand and supply, no matter when and why they occur, can be detected through charts prepared specially to show market action.

8.       Changes in trends in stock prices are caused whenever there is a shift in the demand and supply factors.

Advantages of technical analysis

1)      Simple and quick: Technical analysis is simple and quick method on forecasting behaviour of stock prices.

2)      Helps in identifying trend: Under the influence of crowd psychology, trends persist for quite some time. Tools of technical analysis that help in identifying these trends early are helpful in investment decision-making.

3)      Short term price prediction: Technical analysis try to predict short term market price which is useful for speculators who want to make quick money.

4)      Tracking shift in demand and supply: Shifts in demand and supply are gradual, not instant. Technical analysis helps in detecting these shifts rather early and hence provides clues to future price movements,

5)      Price movement analysis: Fundamental information about a company is absorbed and assimilated by the market over the period of time. Hence, the price movement tends to continue in more or less in the same direction till the information is fully assimilated in the market.

6)      Price prediction: Charts provide a picture of what has happened in the past and hence give a sense of volatility that can be expected from the stock. Further, the information on trading volume, which is ordinarily provided at the bottom of a bar chart, gives a fair idea of the extent of public interest in the stock.

7)      Superior than fundamental analysis: According to technical analysts, their method is far superior than the fundamental analysis, because fundamental analysis is based on financial statements which themselves are plagued by certain deficiencies like subjectivity, inadequate disclosure etc.

Limitations of technical analysis

1)      Past and historical data: Technical analysis is based on the past and historical data. Unexpected future is not taken into consideration by it.

2)      Analyst Bias: Just as with fundamental analysis, technical analysis is subjective and our personal biases can be reflected in the analysis.

3)      No explanation about the tools used: Most technical analysts are not able to offer convincing explanations for the tools employed by them.

4)      Chances of wrong decision: False signals can always occur in the stock markets. If the technical analysts act without confirmation, they would make mistakes and would suffer unnecessary expenses and losses.

5)      Limited use of technical analysis: Empirical evidence in support of the random walk hypothesis casts its shadow over the usefulness of technical analysis.

6)      Delay: By the time an up trend or downtrend may have been signaled by the technical analysis, may already have taken place.

7)      Commonly used system: Ultimately, technical analysis must be a self-defeating proposition. As more and more people employ it, the value of such analysis tends to decline.

8)      Different interpretation by different analyst: There is a great deal of ambiguity in the identification of configurations as well as trend lines and channels on the charts. The same chart can be interpreted differently.

Despite these limitations, technical analysis is very popular. It is only in the rational, efficient and well ordered market where technical analysis has no use. But given the imperfections, inefficiencies and irrationalities that characterize real markets, technical analysis can be helpful. Hence, it can be concluded that technical analysis may be used, albeit to a limited extent, in conjunction with fundamental analysis to guide investment decision-making, as it is supplementary to fundamental analysis rather than substitute for it.