Technical Analysis is the science of predicting the movement of stock prices using chart patterns. These charts plot the stock prices against time. When a particular pattern is formed on the stock charts, it gives an indication to the technical analyst as to the direction in which the stock price is headed.
The rationale behind the science of forecasting stock price movements using technical analysis is that market movements are usually predicated by an activity in the stock by informed sources.
It is often observed by investors that the price of particular stock goes up without any apparent reason and when the price is ruling quite high, a positive development is released by the company in the press.
No development of a significant nature, whether it is a takeover, a merger, a large order or a setback in earnings, takes place overnight. Technical analysts believe that well before any major news gets released in the market, the stock is accumulated or sold, depending on the nature of the news by informed circles. It may be fundamental analysts who have got wind of some developments through their research or it may be company insiders.
Any activity of this nature follows three phases viz.
- Accumulation : Where large quantities of stock are bought without much influencing market prices.
- Marking up : Where sharp upward price movements are seen due to sellers having sold out and buyers still buying.
- Distribution : Where stock acquired at low prices are gradually sold out.
Bearish activity will similarly follow the phases of distribution, marking down and accumulation.
Such activity produces distinct patterns on stock charts. An experienced analyst can spot this pattern and use it to draw his conclusions as to the direction in which the stock should move.
Major patterns are classified into three categories as under:
1. Bullish patterns
- Inverted Head and shoulders
- Double bottom
- Rounding bottom
- Triangular bottom
- Head and shoulders
- Double top
- Rounding top
- Triangular top
- Flags
- Pennants
- Wedges
Volumes are an important consideration in the studying of patterns and no study can be considered complete unless due regard is given to significant changes in volumes.
Since chart patterns are far from infallible, the concept of stop loss is an important aspect of technical analysis.
When the decision to buy or sell is made a stop loss is also incorporated into the calculations. This gives the investor protection against greater losses should his trade go wrong.
Resistances are determined to indicate to what levels a stock is likely to move up before it meets selling pressure and supports indicate to what level a stock can move down before it encounters buying demand.
Technical analysis therefore relies upon the human element in trading. Its price patterns capture the relative balance between buying and selling as well as directed action by insiders or groups of operators.
