Technical analysis of a stock is about studying the patterns developing in stock market to predict the future. An analogy is to predicting the climate based on developments happening in the atmosphere. Before venturing into technical analysis, the first mental block to cross is whether one should believe it or not. At times there are random events, which take all the theories completely out of hook, or is it? Once one decides that technical analysis do have a grounding behind it, it becomes much easier to appreciate, understand and apply it. Till one remains a staunch believer of randomness, it becomes difficult to believe on technical analysis. Another mental block to overcome is that technical analysis is an exact science and can be easily mapped in terms of formulas and set patterns.It might be, but the field has not advanced yet to find the formula which can fit in itself the nature of movement. This is similar to trying to find the elusive formula in physics, which can tie micro and macro mechanics. A formula which can predict the movement of a photon and electron to the movement of large objects like stars. At the moment, technical analysis is more of an art than a science. Acceptance of this fact helps to apply it in a better way, including understanding its limitations.
Technical analysis is about studying the market action in terms of price, volume and open interest. The happenings in the above three variables helps in understanding the future price movements.
Technical analysis is based on two important premises:
- In price action, the market discounts everything. There might be moment of incongruence, but that is quickly covered up by market. This is very important to understand. If some news reaches to you, the chances are that it has already been discounted. One exception is insider information and that is illegal. Refrain from it.
- The price action follows certain patterns time and again. It's like saying, History repeats itself again and again. This premise should be understood more from the perspective of psychology. In fact, technical analysis is more about understanding the combined reaction of a crowd and it's the same crowd which was there in the last hour, yesterday, day before, year before, century before. What is important to understand that basic human nature has not changed a bit from the time of Neanderthels.
The other issue that is often raised is about technical analysis vs fundamental analysis. Both has there place under the sun. Fundamental analysis is the cause of price movement. In the longer term, the movement will happen based on fundamental factors. Here please understand that fundamentals does not mean just the fundamentals of the stock but of general economy. With respect to that, technical analysis is about studying the price pattern, the effect of it and than trying to predict the future as it is playing on the price action.
If you are of the "buy and forget" type than you can rely on the fundamental analysis. The two important criteria in this is the general outlook of underlying economy and the growth potential of the company. But if you are playing for short term, especially the derivatives market, than it's important to understand both the fundamental and technical aspect of the stock. In the fundamental side, the important thing to understand is the sentiments than anything else.