We all understand technical analysis of stocks as the counterpoint to fundamental analysis. While fundamental analysis involves the use of macro factors, industry analysis and balance sheet analysis, they also consider qualitative factors. Technical analysis, on the other hand, is more to do with charts and chart patterns. Often there is a debate on what works better: fundamental analysis or technical analysis. Actually, the very genesis of the debate is wrong. That is because fundamental analysis and technical analysis are not exactly competing sciences but they are complementary approaches to the stock market. We need to understand the importance of technical analysis and why is technical analysis needed? We also need to properly understand how to use stock technical analysis to fine tune and chisel our investment decisions.
Market patterns tend to repeat themselves
This is a fact that was pointed out by the legendary trader, Jesse Livermore. According to Livermore, human beings are the same and therefore human behaviour is also the same over time. The way individuals react to market highs and lows and also to bouts of panic and greed remains the same. Since the fundamental investor behaviour remains the same, the market chart patterns will also remain the same, or at least tend to repeat over time. As a result understanding the market pattern is all about studying the past patterns, creating templates and applying these templates to the future.
Technical analysis is based on the basic premise that the market reflects all the information that needs to be known. Hence there is no point in trying to identify underpriced and overpriced stocks. Stock prices are supposed reflect all the known and unknown information and so prices are just random movements and therefore the only way to analyse markets is to study past patterns and use these patterns to extrapolate the future
Proper entry and exit can make a lot of difference
Researching stocks is not just about identifying the stock but also about finding the right time to exit and enter the stock. Consider the example in the table below:
ParticularsPrice of Stock AQuantitySale PriceProfitXYZ bought on Fundamentals5531000665Rs.1,12,000XYZ bought on Technicals541 (Support)1000679 (Resistance)Rs.1,38,000
In the above instance, the trader is able to increase his profits by 23% just by buying closer to the support levels of the stock and selling closer to the resistance level of the stock. Supports and resistances are not technical assurances. On the other hand, they tell us whether the trader can afford to wait for a lower price to buy and for a higher price to sell. To that extent, this aspect of technical analysis actually complements the fundamental approach and helps enhance its performance.
Technicals capture trend and momentum best
There are different types of trends in the market. For example, there is an upward trend, downward trend, sideways trend, absence of trend etc. Technicals help you to capture the trend and trade accordingly. For example, if the trend of the market is upward then you must use every dip to buy into the market or the stock. On the other hand, if the trend in the market is downward, then you must use each rise to sell the market. But how do you determine whether the trend is positive or not? That is where momentum comes in handy.
The first way technicals enable us to identify a trend is by chasing a break out. When stocks break above the resistance or below the support in a decisive manner with volumes, then it is a sign of momentum. The second way to identify momentum is to gauge whether the uptrend is making higher tops and higher bottoms and whether the downtrend is making lower tops and lower bottoms. This is, once again a confirmation of the momentum. For traders, this momentum is very crucial as it is the basic task of a trader to stay on the right side of momentum.
Guides on the appropriate derivatives strategy
Above all, the technical charts enable to fine tune our derivatives strategy. When the momentum is positive, one can use long futures and calls to play a more decisive trend. On the other hand, when the momentum is negative, investors need to ensure that their long positions in the cash market are adequately hedged. When the market momentum points towards a volatile market with no clear direction, then the trader can use volatile strategies like straddles and strangles on the long side. A contrarian approach can be adopted when the market is likely to be range-bound. The market momentum and the supports and resistance levels are critical inputs in fine tuning the futures and options strategy that traders can adopt to make the best of the stock market trends.