Technical Analysis

Meaning, Assumptions, and Difference Between Technical and Fundamental Analysis

Core Concept: Technical analysis is a method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. It aims to forecast the future direction of prices based on historical data.

1. Meaning of Technical Analysis

• Definition: Technical analysis is the study of historical market data, including price and volume, to identify patterns and trends that can be used to predict future price movements.
• Focus: Technical analysts, often called "chartists," primarily focus on:
  • Price Charts: Visual representations of price movements over time.
  • Patterns: Recurring formations on price charts that suggest potential future price direction.
  • Indicators: Mathematical calculations based on price and volume data that provide signals about market conditions.
• Goal: The goal of technical analysis is to identify entry and exit points for trades based on anticipated price movements.

2. Assumptions of Technical Analysis

Technical analysis is based on several key assumptions:

• a) The Market Discounts Everything:

  • Explanation: This assumption implies that all known information, including economic, political, and psychological factors, is already reflected in the price of a security. Therefore, studying price movements alone can provide insights into market sentiment and future price direction.
  • Implication: Technical analysts do not need to analyze financial statements or economic data directly. They believe that the market price already reflects all relevant information.

• b) Prices Move in Trends:

  • Explanation: This assumption suggests that prices tend to move in patterns or trends that persist for a certain period. These trends can be upward (uptrend), downward (downtrend), or sideways (consolidation).
  • Implication: Technical analysts attempt to identify these trends and trade in the direction of the trend.

• c) History Repeats Itself:

  • Explanation: This assumption is based on the idea that market participants tend to react in predictable ways to certain market conditions, leading to recurring patterns in price movements. These patterns can be identified and used to forecast future price direction.
  • Implication: Technical analysts study historical price charts to identify patterns and trends that have been successful in the past and are likely to repeat in the future.

3. Difference Between Technical and Fundamental Analysis

Detailed Breakdown of the Key Differences:

• Focus:
  • Technical Analysis: Technical analysts are primarily concerned with the "what" – what is happening with the price of a security. They study price charts and use technical indicators to identify patterns and trends.
  • Fundamental Analysis: Fundamental analysts are concerned with the "why" – why a security is trading at a certain price. They analyze financial statements, economic data, and industry trends to determine the intrinsic value of a company.
• Data Source:
  • Technical Analysis: Technical analysts rely on historical price and volume data. This data is readily available and can be easily visualized on price charts.
  • Fundamental Analysis: Fundamental analysts use financial reports (balance sheets, income statements, cash flow statements), economic indicators (GDP, inflation, unemployment), and industry reports.
• Assumptions:
  • Technical Analysis: Technical analysis is based on the assumption that the market discounts everything, prices move in trends, and history repeats itself.
  • Fundamental Analysis: Fundamental analysis assumes that the market may misprice securities in the short term but will eventually reflect their intrinsic value.
• Time Horizon:
  • Technical Analysis: Technical analysis is typically used for short-term to medium-term trading strategies, with a time horizon of days, weeks, or months.
  • Fundamental Analysis: Fundamental analysis is primarily used for long-term investment strategies, with a time horizon of years.
• Primary Users:
  • Technical Analysis: Technical analysis is commonly used by traders, chartists, and market technicians.
  • Fundamental Analysis: Fundamental analysis is used by investors, analysts, and portfolio managers.
• Decision Making:
  • Technical Analysis: Technical analysts make decisions based on technical indicators and chart patterns. They look for signals that suggest potential price movements.
  • Fundamental Analysis: Fundamental analysts make decisions based on a company's financial health, growth prospects, and competitive position. They attempt to determine whether a security is undervalued or overvalued relative to its intrinsic value.
• View of Market:
  • Technical Analysis: Technical analysts believe that the market is driven by emotions and psychology. They believe that market participants tend to react in predictable ways to certain market conditions.
  • Fundamental Analysis: Fundamental analysts believe that the market is rational and will eventually reflect the intrinsic value of a security.

Conclusion:

Technical analysis and fundamental analysis are two distinct approaches to evaluating securities. Technical analysis focuses on price and volume data to identify short-term trading opportunities, while fundamental analysis focuses on a company's underlying financials and economic conditions to determine its long-term intrinsic value. Both approaches have their strengths and weaknesses, and many investors use a combination of both to make informed investment decisions.