Stock Market: A Must Read Introduction To Technical Analysis

What is Technical Analysis and how it works in the stock market?

One of the definitions of technical analysis is the study of Market Action primarily through charts for the purpose of forecasting future price trends in the stock market.

There are other definitions of technical analysis present made by technicians which sounds correct and make justice to overall market behavior.

Stock-Market-A-Must-Read-Introduction-To-Technical-Analysis

Let’s see them listed below:


Forecasting price action before Time is the only purpose.


Deals in probabilities & never certainties.


The art of technical analysis, for it is an art, is to identify a trend reversal at a relatively early stage and ride on that trend until the weight of the evidence shows or proves that the trend has reversed.


Please re-read the above definitions again with concentration and it will make a lot of sense to you.


I will request you to go through the below points with full concentration. These points are the basis of understanding what technical analysis is built upon.


Technical Analysis is based on three premises, described below:

1. Market Action discounts everything.

It discounts everything except acts of God. You can treat the discount word as a digest here.


The technician believes that anything that can possibly affect the price-fundamentally, politically, psychologically, or otherwise is actually reflected in the price of that market.


This is why you hear few traders saying the market knows everything.


If demand exceeds supply, prices should rise. If supply exceeds demand, prices should fall. This is the basis of all economic and fundamental forecasting.

This means that the markets can only discount:

  1. Known information

  2. Expectations about known information

  3. Expectations about potential events

The market cannot discount:

  1. Unexpected events

  2. Unknown information

Unprecedented events like earthquakes, virus outbreaks (covid 19), tsunamis hamper the markets(making it fall/correct). Because markets can not discount those.

The stock market charts do not cause markets to go up or down; they simply reflect the bullish or bearish psychology of the marketplace.


2. Prices move in trends.


One of the essentials of price action is that it moves in trends. The price will keep on going upwards(Higher Highs & Higher Lows) unless and until the signs of reversal.


We will be studying those signs of reversal with the use of candlestick charts and patterns in future lessons of this stock market course.


Also the faster the market goes higher, the faster it will come downwards. It reflects Newton's one of the laws.


The stock markets will be trendless(range bound) 70% of the time and it will be trending 30%. The trend is your friend.


3. History repeats itself.


It's definitely attached to the study of human psychology. Just because some chart patterns have worked well in the past, it is assumed that they will continue to work well in the stock market future as well. It works well today itself, to be honest.


Technical analysts react to the particular chart pattern and it quickly spreads to all the traders and they all jump into the trade making it a cycle that keeps on repeating in the future. 


To put the above sentence in a different way, they say history repeats itself. The key to understanding the future lies in the study of the past or the future is the repetition of the past.


Please go through the illustration below. This is what happens in the stock market in order to have profit. DEMAND and SUPPLY is the key to operate for the overall market.


Stock-Market-A-Must-Read-Introduction-To-Technical-Analysis

Let's have a look at three main approaches to PRICE FORECASTING.

The only profitability rule in all of the approaches is knowing price ahead of time.

1. FUNDAMENTAL ANALYSIS(STOCK MARKET INVESTMENT)


Long-term holding is the mantra to follow here.


Stock-Market-A-Must-Read-Introduction-To-Technical-Analysis

Logic: Strongly performing companies will continue to perform strongly in the future as well.


Investors analyze the stocks to have in their portfolio based on P/E Ratio, EPS, Balance Sheet, Profit & Loss Statement, Cash Flow, Book Value, Order Book.


The reality is that investing is capital- and knowledge-intensive.


We will see all the above topics when we study Fundamental Analysis.


Points to observe:

  1. Stock market data can be manipulated to turn a poor-performing company into a good one.

  2. Actual price level forecasting.

  3. Investigations/Legal matters.

  4. Govt./RBI Interest Rate Cuts.

  5. News impact on Sector.

Buy and Hold Strategy. (Gauging Undervalued and leaving Overvalued)


Investors always look for INTRINSIC VALUE to identify if the stock is undervalued or overvalued. Let's have a look at it via the below explanation which is self-explanatory:


UNDERVALUED:


Stock-Market-A-Must-Read-Introduction-To-Technical-Analysis

OVERVALUED:


Stock-Market-A-Must-Read-Introduction-To-Technical-Analysis

2. TECHNICAL ANALYSIS(DAY TRADING/SHORT TERM TRADING)

Logic: Performance of stock based on live technical study. (OHLC data)


We will see OHLC data when we will study candlestick and how price action is derived from it.


Points to observe:

  1. Volatility

  2. Gods Acts

  3. News impact

Apart from the above the study of technical analysis also includes below very important points:

  1. Price action

  2. Volume action

  3. Open interest action

  4. Sentiment

  5. Market breadth

  6. Flow of funds

Technical Analysis can be further classified into four branches, namely:

  1. CLASSICAL TECHNICAL ANALYSIS(Chart Patterns, Oscillators, Indicators, Candlesticks)
  2. STATISTICAL ANALYSIS(Volatility Analysis)
  3. SENTIMENT ANALYSIS(Cash/Asset Ratio, PCR, Insider Trading, Margin Debt, Contrary Opinion)
  4. BEHAVIORAL ANALYSIS(Herd Behavior, Gambler's Fallacy, Anchoring Bias, Excitement)

3. INFORMATION ANALYSIS


Logic: Psychological actions


Points to observe:

  1. Reaction on news(Insider Trading)

Stock-Market-A-Must-Read-Introduction-To-Technical-Analysis


If you observe closely enough, those curves are where insider trading is happening and retail people accumulating(going long) and distributing (going short/squaring of) after that thing has already happened(PRIOR TO DATA RELEASE).


So some people already get access to the stock market data/information and being in advantage than retail people(like you and me), profits highly. 


Now you know why retail people are last to know the valuable information and profits less.

Well, let’s move ahead and see few assumptions to the application of technical analysis:

  1. Price will go on until there is a sign of Contrary.

  2. For every Bullish there is opposite Bearish.

  3. Extreme Bullishness is Bearish(vice versa)

It's always Price vs Value

In short, current price is the result of expectations about stock market future price and value.


Market Participants

Classified by Namings:

  1. Retail

  2. Institutional

  3. Speculator

  4. Supply Side

  5. Demand Side

  6. Professional

  7. Investor

  8. Novice

Classified by methods they use in the Market:

Scalpers:

Normally in and out of the markets within seconds or minutes. Very rapid long and short trades(usually buying at the bid and selling at the ask price).

Day Traders:

All trades completed within the same trading day(stock market open time and close time of that day). Intraday or buying and selling on the same day in any instrument/stock.


Swing Traders:

Capitalizing on technical reversal levels lasting a few days or a week. Attempting to catch trend and momentum and trailing the positions.


Position Traders:

Longer term view of the markets usually a few months to a year at most. Attempting to average against price until reverses types of traders can be added here.


Investors:

Buy and hold strategy.


Stock-Market-A-Must-Read-Introduction-To-Technical-Analysis

SELF-FULFILLING-PROPHECY


Basically, the process of being first in any stock market chart pattern-based trade will be more profitable in the cycle. People get to know about the particular pattern from each other and enter into the trade mostly impulsively because they don’t want to get left behind for claiming low profits, but by the time the last few thousand enters that trade, it already had been started to diminish. 


Hence those last few thousand people entered in a trade gets very little or no profit and people who entered trade early will always get more profit.


I hope you have got the idea here about what this prophecy tries to convey: early entrants get more profits than last entrants.


The effects of SFP may be advantageous and desirable to traders in the early stages but eventually, result in forcing traders into untenable positions.


Hence The logical answer would be to select only the most significantly clear and obvious technical signals and triggers.


All right readers, with that we will now have a look at few terms that we will use as we will be more familiar with our stock market trading journey.

Carefully re-read the below terms:

Go Long  = To buy to open a new position.

To Liquidate = To sell to close a position previously held.

Go Short = To sell to open a new position.

To Cover = To buy to close a position previously shorted.

To Enter = (i.e., to initiate) a new position

To Add to = (i.e., to scale into) a position

To Reduce the size of = (i.e., to scale out of) a position

To Exit = (i.e., to fully scale out of) a position

To Fully or Partially Hedge a Position = (i.e., to neutralize or diminish directional risk)

To Remain in Cash = (i.e., to refrain from holding any positions)


Book Alert:


New Trader Rich Trader: 2nd Edition: Revised and Updated

-BY STEVE BURNS AND HOLLY BURNS


KEY TAKEAWAYS:

  • DEMAND & SUPPLY is the key.
  • We must study both FUNDAMENTAL & TECHNICAL ANALYSIS
  • Keep a distance from SELF-FULFILLING-PROPHECY.


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