The Hindu Business Line : Fundamentals of technical analysis

Meet Shanky, an engineer. And, Harry and Reena, students of finance. It has been a month since the trio had taken up new jobs after finishing their college. So, they decided to meet for coffee one evening to do some catching up. Shanky offered to pick up Harry and Reena from their offices in his swank new car.

As they settled down with their coffee, Shanky could not hold back his curiosity any longer. He addressed Harry, "I caught you staring at some weird looking graph in your office as if your life depended upon it. What exactly do you do?"

Harry: "I am specialising to be a technical analyst."

Shanky: "Sounds very hi-tech. Is it a new style of analysis invented by the tech whiz-kids?"

Harry: "Oh no. Technical analysis is an ancient science. It started in Japan in the 17th century. The Japanese used their technical tools (candlesticks) to trade in their rice exchanges and reap heaps of profit. We are lucky that we have computers to do technical analysis these days. In the pre-computer era, technical analysts used to spend hours each day updating their graphs on graph paper and then burning the midnight oil in interpreting these graphs."

Reena: "So, how does technical analysis help in investment decisions?"

Harry: "What we technical analysts actually do is study the past market action and use this information to predict where the price is heading. Study of market action is done primarily with the help of graphs. The term, market action, encompasses three principal sources of information — price, volume and open interest."

Reena: "But how can studying the past action of price help in predicting the direction in which the prices can move in future?"

Harry: "You have jumped to the very core of technical analysis. Stock markets worldwide are driven by men. The basic needs and emotions of men have not changed from primitive times. There is no way we can do without food or sleep. Similarly, human emotions such as love, greed, exuberance, depression, contentment, etc., will stay no matter how rapidly technology changes. Human behaviour, exposed to certain set of circumstances can be fairly constant and predictable.

"It is this predictability that gives rise to the famous adage `history repeats itself'. Let us take the example of our every day lives. The number of days we are joyous and exuberant are few. Similarly, extreme gloom or sadness does not last too long either. Most days are spent in more neutral moods of contentment or irritability. In stock markets too the peaks and bottoms generally pass at lightning speed. Most of the days are spent in exasperating sideways movement of the consolidation or distribution phase that is the bane of most stock market analysts.

"Stock market theories such as Dow and Elliott Wave are based primarily on the repetitiveness and predictability of human behaviour. The reason why technical tools such as supports, resistance, patterns, etc., work is because of the human element involved in stock market operations.

Enough about me guys. Reena, you tell us about your work?"

Reena: "Well my job is similar to yours. I too help others make investment decisions in equities. But I am a fundamental analyst."

Shanky: "Wow! That sounds profound. What exactly is this?"

Reena: "I study the underlying product or the company itself while Harry is content with study of the market action alone."

Harry: "Hey, you cannot dismiss technical analysis so easily. We technical analysts believe that market action reflects all the factors affecting the price — fundamental, political, psychological, economic and even manipulative action. A more arrogant way of putting it is `Technicals are what people think the fundamentals are'."

Shanky saw Reena's face turning red with anger. He tried to pacify, "If I understand you both right, I am sure fundamental analysis and technical analysis can co-exist in peace and complement each other. Since all the investors in the stock market want to make the maximum profits possible, they just cannot afford to ignore either fundamental or technical analysis."

That cooled down the tempers and the topic shifted to their other cronies in college and how they were progressing in the respective careers of their choice. They parted on a cordial note with promises to keep in touch, call every day, etc.

Shanky was however hugely fascinated by this technical analysis thing. So he landed up in Harry's office one evening.

Harry: "Hi buddy. Nice to see you."

Shanky: "Thought I would start learning some technical analysis myself to help in my personal investments. Where do I start?"

Harry: "That is a great decision. If you want to become a good technical analyst, the first step is to accept that the market is supreme. It is futile to outsmart or outguess it. We just have to flow with the market and try to amass a fortune in the process. This process can be stated as two steps — identify the trend and ride the trend till it reverses.

"Trend identification can be done with the help of simple technical tools called trend lines and trend channels. In a downtrend, trend lines should be drawn by joining the peaks and in an up-trend it is the bottoms that need to be joined to form a trend line. The point at which the price rises above the downtrend line or falls below the up-trend line is the point of entry or exit.

"Once an investor is fairly comfortable with trend lines, he can move on to identifying patterns in the charts.

Patterns can be reversal patterns (head and shoulder, double or triple tops and bottoms, rounding tops and bottoms, etc.) or continuation patterns (triangles, wedges, flags, pennants, etc.,). Right identification comes with constant practice. But once this skill is mastered, it will be easy to judge if the trend will continue or reverse.

"Other technical analysis tools that a beginner can look at are the oscillators. There are hundreds of oscillators currently in use. The most common ones are the ROC, RSI, MACD, Stochastic and Bollinger Band. As the name indicates, these are statistical tools that oscillate between overbought and oversold zones. They help to forewarn an investor when a trend is losing momentum and is likely to reverse. The trend, like a motorcar, cannot reverse while moving at top speed. It needs to slow down, stop and then reverse. If we can identify the slowing down phase in advance, we can be one step ahead of the actual reversal.

"Construction of these oscillators is fairly simple with the help of computer software available in the market. Buying a stock when the oscillator gives a buy signal and exiting when it signals a sell is a fairly simple and easy way to start using technical analysis in trading."

Shanky: "Whoa! That is quite a lesson. Thanks"

Harry: "No problem. In your quest for that first elusive million, every scrap of information, every bit of knowledge has to be treasured and utilised optimally. Welcome to a whole New World of knowledge that can only enhance your performance in the stocks arena."

Racy@TheHindu.co.in

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