LOS A requires us to:
explain principles of technical analysis, its applications, and its underlying assumptions
What is Technical Analysis?
a. Technical analysis is a form of market analysis that studies the demand and supply for securities and commodities based on trading volume and price studies.
b. Technical analysts make use of charts and modeling techniques and attempt to identify the price trends in a market.
c. Technical analysis is not based on a strong conceptual framework but depends fully on the use of historical trends to predict future prices.
d. Though technical and fundamental analysis provide diagonally opposite approaches to valuation, in practice, a judicious blend of the two approaches is attempted to arrive at better results.
e. Technical analysis can be conducted for all the assets operating in a free market. In a free market, the willing buyers and sellers can interact freely without being subjected to government restrictions or any other constraints.
Assumptions Inherent in Technical Analysis
Following are the main assumptions and principles behind the technical analysis:
1. Markets are not efficient
a. This is the basic assumption about the market in the case of technical analysis is that they are not efficient; which means that the investors are not rational and behave on the basis of emotional impulses as well.
b. These markets have consistently biased understated and overstated securities.
c. Since these markets are based on the behaviors of their participants, which are usually patterned, the price movements in the markets are also patterned.
2. Prices reflect all the available information and sentiments
This means that the prices at which the securities are trading reflect all the information related to the stocks along with the market sentiments affecting the prices. Therefore, there is not much use doing the fundamental analysis, as the market prices do not only get affected by the important information but the investors’ and traders’ sentiments also affect it.
3. Price/volume lead fundamental information
It is assumed that it is the trends in prices that affect the movements in the prices of the securities rather than the information as provided by the fundamental analysis.
Technical Analysis Vs. Fundamental Analysis
a. Technical analysis, as discussed above, is based on the behavioral pattern of trading volume and prices.
b. Fundamental analysis, on the other hand, is a more conservative technique. It involves a detailed study of the information provided in the recorded financial statement. It aims at measuring the intrinsic value of security to ascertain whether it is undervalued or overvalued.
Limitations of Technical Analysis
Some of the biggest limitations of the technical analysis are:
a. The trends and patterns, based on which the technical analysis is conducted, are only obvious after they are formed.
b. Fundamental analysis has always proved to be a better tool for analysis in comparison to technical analysis.
c. There is no academic support for the technical analysis.
Applications of Technical Analysis
a. There are assets that do not provide cash flows in the form of dividends, interests, etc. Technical analysis is a good way of pricing such assets.
b. Sometimes financial statements may be unreliable, fraudulent, or even manipulative. In such cases, fundamental analysis is relatively difficult. One may use technical analysis in such cases.
c. Technical analysis is done using the historical data and is done graphically and displayed in form of charts. It can also be performed using various software. So it is easy to conduct and understand in comparison to fundamental analysis. However, its reliability and accuracy may be questioned sometimes.