Classroom | Understanding technical analysis

In Part 1 of Moneycontrol Classroom (Technical Analysis), Nooresh Merani breaks down the basics of technical analysis, how it is different from fundamental analysis and the skills required to become a technical analysis.

What is technical analysis?

Technical analysis is the forecasting of future financial price movements based on an examination of past price movements. Like weather forecasting, technical analysis does not result in absolute predictions about the future. Instead, technical analysis can help investors anticipate what is “likely” to happen to prices over time. Technical analysis uses a wide variety of charts that show price movements over time. It assumes that supply and demand determine the price of any security and prices of securities move in trends.

Technical analysis can be applied to stocks, indices, commodities, futures or any tradable instrument where the price is influenced by the forces of supply and demand. Price data refers to any combination of the open, high, low, close, volume, or open positions for a given security over a specific timeframe. The timeframe can be intraday (1-minute, 5-minutes, 10-minutes, 15-minutes, 30-minutes or hourly), daily, weekly or monthly price data and last a few hours or many years.

Technical analysis makes three assumptions

• History repeats itself.
• Prices move in trends
• Market Action discounts everything - Bhav Bhagwan che

Fundamental analysis aims to determine intrinsic value by looking at the strength of the business, a financial analysis and the operating environment including macroeconomic events.

Technical analysis analyzes past market performance by looking at the chart activity of price movements, volume, moving averages and the statistics of various outcomes.

Technical analysis ideally does not try to factor in fundamental data. That is not because they are irrelevant. Rather, it assumes that actions of buyers and sellers factor fundamental factors into the market price of a stock.

In a shopping mall, a fundamental analyst would go to each store, study the product that was being sold, and then decide whether to buy it or not. In contrast, a technical analyst would sit on a bench in the mall and watch people go into the stores. Disregarding the intrinsic value of the products in the store, the technical analyst's decision would be based on the patterns or activity of people going into each store.

Another difference is that a technical analyst prefers to have a defined stop loss.

Stop loss is a price at which you want to get out of a trade and stop making further losses

Simply put, he will exit a trade if some pre-set rules based on price and other parameters are triggered.

Can technical analysis be done in isolation? Don’t fundamental factors have a bigger bearing on stock prices?

Technical analysis in its original format is supposed to be done irrespective of fundamental factors. Technical analysis tries to understand the state and behaviour of market participants through price/volume data. It believes the market is supreme. Fundamental analysis, most of the time is trying to figure out if the market has mispriced a stock.

The market assigns a price to stocks differently under different conditions. In a bull market, the stocks trade at a huge premium to book value and high multiples and in a bear market, the same stock could be trading below book value, low multiples and even below cash on the books. Theoretically, only fundamental factors should have a bearing on the stock. But if that was indeed the case, stock prices should move only on events/data which alter the fundamentals. In a year there could be 4 results, 10 board meetings, 20 announcements and a few other events which affect the business. The prices still move up and down every day, every hour and every millisecond. This clearly suggests the price of a security is also governed by the demand/supply and sentiments of market participants.

To sum up, the stock price movements could be a combination of various factors affecting the fundamentals of the company, sector, country, the world and the demand/supply effects due to the same. Technical analysis is just another way at looking at the markets. An annual report is the picture of the balance sheet of the company on that particular day and historical annual reports are a biographical movie of the company which can give a lot of insights to the fundamental analysts. The same way, the technical chart is the state of the market and historical price behaviour gives insights to the technical analyst.

Technical analysis ideally should be used in isolation but over time, analysts have started using it in harmony with derivatives, fundamentals and other factors.

Does technical analysis work in illiquid stocks?

Illiquid stocks are those in which trading volumes are low. This does not necessarily mean the number of shares available to trade (free float) is low. There are times when a stock is illiquid because of the market cycle. We generally see lower volumes in small cap and midcap stocks in a bear market or when the market is moving in a narrow range.

One of the major principles and assumptions of technical analysis is that the primary trend cannot be manipulated. A stock, which has a larger number of shareholders with widely distributed holdings is generally difficult to manipulate. Some stocks that are illiquid today might have seen large volumes in previous market cycles and some others which are perpetually illiquid may have low floating stock (public holding) or low market cap and concentrated shareholding. Technical analysis should not work in illiquid stocks in the second case of concentrated shareholding. In the first case, technical analysis should work when the volumes and liquidity is back. The historical charts will give a good picture of whether the stock has always been illiquid or not.

Also, it is important to note that the definition of illiquid would be very different for different set of investors/traders. A fund manager running a Rs 20,000 crore portfolio would find a company with a market cap of Rs 500 crore illiquid even if a few lakh shares are traded. A thumb rule which is a little arbitrary is that a stock is illiquid for you if your volume participation exceeds 5 percent of the average traded volumes. So, if the daily average trading volume in a stock is 100 shares, and you are looking to buy 7 shares, then it could be illiquid for you.

What are the qualities required to become a good technical analyst?

A good technical analyst should have the following qualities:

• A clearly defined technical trading system/rules and ability to stick to their own rules
• A technical system works better when it is back-tested on various securities and on various time frames
• The trading system should match their personality/temperament
• A discretionary technical analyst needs to have a strong risk management and position sizing methodology.
• A few personality traits required are low emotional reactivity, detachment from the outcome, humility, decisiveness, confidence and lots of patience

Some basic books on technicals are :-

• NCFM Module on Techncial Analysis
• Timing the Market by Curtis M Arnold
• Technical Analysis from A to Z - Steven Achelis
• Technical Analysis Explained - Martin J Pring
• Getting Started in Technical Analysis by Jack Schwager
• How to Make Money in Stocks by William O’Neil

There are many analysts who write on technicals. However, a few famous names to follow are

• Peter Brandt - @PeterLBrandt
• J.C. Parets - @allstarcharts
• Ralph Acampora CMT - @Ralph_Acampora
• Mark Minervini - @markminervini
• Steve Burns - @SjosephBurns
• Martin Pring -  @martin_pring
• Ned Davis - @NDR_Research
• John Bollinger - @bbands

Yes, there are many training courses available for Technical Analysis.

NCFM has a certification module on Technical Analysis. Apart from NCFM, there are numerous private tutors providing paid courses on technical analysis. One can find them on Twitter or Google. Course content varies from basic to advanced technicals. One needs to read carefully about the course content before joining a training course. Training courses are available in both webinar and seminar format.

While many training courses may be available, one needs to practice what is taught. The markets are different every single day and the skill lies in identifying the type of market where the tools you have and learnt actually works.

It takes 10,000 hours to master something, and technical analysis is no different. It can't be broken down into easy-to-follow webinars/seminars with a guarantee to make you rich. Technical analysis trainings are merely a starting point of the long journey ahead.

Q: I haven’t heard of billionaire traders, other than George Soros. But there are plenty of billionaire value investors? Why is that?

There are a few hedge fund traders in the US who have made billions not being a value investor. Some of them are Steven Cohen, Paul Tudor Jones Jr., Ray Dalio, and James Simons etc.

The market in the US is huge in terms of liquidity and one can buy and sell large chunks of shares in that market. In India, barring a handful of stocks, liquidity is not adequate for trading large chunks of volumes. That is one of the reasons why there few billionaire traders in India. However, noted value investor Rakesh Jhunjhunwala has mentioned that trading helped him to create the capital, which he multiplied many times over through value investing.

Trading returns are lower as compared to investing. There a few aspects which put traders at a disadvantage.

Think of the chart trader as trading company and the value investor as an innovation/FMCG Company. For a trading company, the volume of goods traded are huge, but margins are thin. In an innovation/FMCG company, the focus is more on margins than volumes. In time, there could be some blockbuster products that could bring in windfall gains.

For example, a really long term investor can be lucky even though 9 stocks in his portfolio of 10 were losers. If one stock in the portfolio appreciates 100 times in value, it will more than compensate for the other losses, and the overall portfolio will deliver a return better than the benchmark indices.

Shorter the time frame, higher is the skillset and discipline needed, and lower the success ratio.

A trader may not necessarily keep his capital locked for long periods of time in the stocks that he trades in. Often, it may not be possible to do that, because he will need to deposit margins with stock exchanges, on his outstanding positions.

Also, sudden swings could trigger stop-loss limits and force a trader to exit his position in the short term.

Hypothetically even the best of traders may not end up making Rs 5000 crores if he cannot buy and sell Rs 500 crore of securities with a minimum impact on the price of that stock.