Technical Analysis is an art or science of predicting future prices of a security or commodity based historical price movements. A technical analyst studies the price movements and tries to identify the patterns which are repeatedly formed while taking investment decisions.
There are several ways to do technical analysis: few analysts rely on chart patterns while others rely on technical indicators or oscillators. At any given point of time a technical analyst studies the historical price movements or volume traded for a particular security. Unlike fundamental analyst which tries to evaluate the price of a security based on studies of balance sheet or other financial statements or ratios, a technical analyst believe market price of a security reflects everything to be known about a security as prices adjust as per supply and demand.
Probably, the biggest advantage of technical analysis is the fact that any given analysis based on technical point of view applies to every security or commodity. That is certain pattern reflects bullish point of view then it applies to every security or commodity.
Whereas when it comes to fundamental analysis; analysis completed for security cannot be applied to analysis for commodities. While studying equity of a company we look into financial statements like balance sheet or profit and loss accounts which is not the case while studying commodity like gold or silver.
Even with commodity, fundamental analysis for gold and silver could be from agriculture based commodity where we also study rainfall or harvest.
Assumptions of Technical Analysis:
- Market discounts everything: Technical analysis is based on one basic assumption “Efficient Market Hypothesis” i.e. every known or unknown information for a given security or commodity is reflected in the price movement for security or commodity. Even if some kind of inside trading happens it would reflect in the price movement. Whereas fundamental analysis might not be able to capture inside trading on real time basis.
- History repeats itself: Whole technical analysis is based on the assumption that market repeats itself and by studying the historical patterns we could predict the future prices.
- Price moves in trend: All major stocks in the market follow the trend. Like in bullish market most of the stocks would go up where as in bearish market most of the stock prices fall.
- What is more important than Why: There is a famous saying “A technical analyst knows price of everything but the value of nothing”. A technical analysis is concerned about two things:
- What is the current price?
- What is the history of price movement?
So a technical analysis is concerned about what is the price movement whereas fundamental analysis would ask why the price movement.
- Price movements are not totally random: One of the main goals of a technical analyst is to identify the pattern even if market prices might face small random fluctuations.
Limitations of Technical Analysis:
- Trading Volume: Actively traded stocks allow investors to take better judgment of the price movements whereas prices of the shares which are not actively traded might not reflect the event based pattern i.e. prices of thinly traded shares might not be able to capture inside trading.
- Artificial price changes: Technical analysis of securities is greatly affected by stock split or dividends.
- Extreme News: Technical analysis cannot predict any extreme news like political events or terrorist act.
- Lagged information: The technical signals generated tend to have a lag, and by the time a clear signal is generated the price action could already be over.
- Random Walk: Random walk hypothesis casts its shadow over the validity of Technical Analysis.