Technical analysis is the process of evaluating various investment opportunities in the securities market by analyzing the volume and price of the respective securities such as shares and debentures.
Unlike the fundamental analysis, which uses the company’s performance in terms of revenue generation, profits earned, and various financial reports, the technical analysis aims to evaluate the security through its trading price and volume. In simple words, this tool uses the forces of market demand and supply to be able to understand the direction in which the future value of the security might be headed towards.
Technical analysis could be used in any market where there is a presence of historical data of price. Some of the most famous examples are the stock market, foreign exchange, futures, commodities, and other securities.
Technical analysis was first introduced by Charles Dow and in the Dow theory. The modern-day technical analysis has been created through researches and analysis conducted by lots of researchers and has been evolved using hundreds of patterns and signals developed through years of research.
The basic underlying assumption of technical analysis is that the past prices of a commodity or a security could be useful factors in determining the future movements of the value of that item. Various professional analysts have been using the tools of technical analysis paired with various other tools in order to predict the future value of a commodity with as high of an accuracy as possible.
Assumptions of Technical Analysis
In the modern theory of technical analysis, even though it is heavily based on Dow’s works, it has now three assumptions instead of the two introduced by him. Those assumptions are listed below:-
Price discounts everything
This assumption means that the current market price of the commodity explains all the relatively important information that the fundamental is trying to provide the qualitative and quantitative reasons for.
This means that the market can be heavily influenced by the investor’s perception of supply and demand.
Price moves in trends
Technical analysts go by the assumption that even in the most random movements of price in a particular market, it would still exhibit a moving pattern or a trend that could easily be read and understood to be able to predict the future trends of the price of the commodity or security.
In other words, the security is more likely to follow the previous trends instead of creating new paths which have not been seen for.
History tends to repeat itself over time
One of the most basic assumptions in technical analysis is that history tends to repeat itself over time, i.e., various patterns of price movements are very repetitive in nature, making them very predictable through various emotions such as fear or confidence amongst the market investors.
Limitations of Technical Analysis
One of the most common criticisms of technical analysis is that history does not tend to repeat itself exactly and some of the inferences taken using the past trends of prices of the security may not be accurate and might give false results leading to losses.
Another criticism of these tools is that sometimes they work only because lots and lots of investors are anticipating the same results because of the same data and same tools available to everyone else.
For example, if investors have calculated using the fifty day moving average that the stop loss on a stock order should be placed at rupees 500 per stock, all the investors might go for the same strategy and if the price of the stock reaches that mark, all of the sell orders will start getting placed.