Using charts to figure out the direction of stocks
Technical Analysis (TA) in the parlance of the markets is the study of charts to determine which way a security is headed. If you know the direction, then you can profit by trading in that direction.
At the core of TA is the belief that price discounts everything known to anybody in this world. If you know the price, then you don’t have to look at the fundamentals or listen to insiders, bankers, analysts, taxmen, weathermen and the regulators.
If you were to banish a technical analyst to one of the remote Andaman Islands, armed with a computer with a huge battery back-up and Net connection that would only feed his charts and not access any other site, he would perform as well, if not better, than a fundamental analyst who sits in the Jeejeebhoy Towers and has access to a Bloomberg terminal, a television, a pile of pink papers, high speed access to the Net and telephone to speak to his other colleagues and the benefit of a conference call with company managements.
While a fundamental analyst covering FMCG stocks may have close to no idea as to how an active hurricane season in the North Atlantic will effect the prices of West Texas Intermediate, a technical analyst can track all stocks, commodities and currencies with equal elan.
How is this possible? The answer lies in the belief that the price discounts everything, that the price moves in trends and history repeats itself. Patterns observed in the past will lead to similar conclusions whenever those patterns manifest themselves on the charts. A trend, unless broken, should be assumed to continue.
Technicals are of immense help when the fundamentalists have no explanation for the way the markets are behaving. When an early trend is emerging, it is the technical analyst who will sniff and call the direction, rather than the fundamentalists. Fundamental analysts are either too early or too late to announce the beginning of a bull or a bear market.
If someone can combine the fundamental knowledge with chart reading abilities and also have the learning to draw the right conclusions from the derivatives’ data, there is nothing to beat that combination. But till the time that you have mastered these separate skill sets, TA will give you better results on a standalone basis and with least resources.
While early chartists had to make their own charts on graph paper, software-enabled charting tools are now available, which make charting a pleasurable hobby. The abundance of historic data and the possibility of going back in the past and studying those patterns simulates a real-life environment for the analyst, without putting any money at risk.
In a typical chart, the dates will be found on the ‘X’ axis and the prices on the ‘Y’ axis. In a line chart, the closing price for a particular date is denoted by a dot and is plotted in the appropriate XY coordinate. These dots are then joined to make a line graph. Suddenly, things become visually appealing and it is easy to judge which way the stock is headed.
However, line charts do not tell you the whole story, as they only consider the closing prices. To capture the entire essence of trading, we will need to look at the opening, high and low prices of the day as well, apart from the closing prices. For that, we will have to opt for a bar chart or a candlestick chart. The subject matter of next week’s article.
The writer is director and head of research, Anagram Capital
