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Does technical analysis work?

Blog-2 in our series of blogs on swing trading



Before we begin, let me ask you a question.

Will it rain today?


You will probably take out your mobile phone and check it on the weather app installed on your phone and you can get to know precipitation, wind speed and humidity etc. based on that you can say it might rain or it might not rain. It is easy peezy, right.

But did you think how these parameters have been collected, processed, derived, smoothened to provide you with the feed that shows you the probability of rain on that particular day? Massive quantitative data of the current state of atmosphere, land, sky and ocean is fed to computer-based algorithms which churn this data, recognize patterns based on the previous events that have happened in the past and provide the probability of that event happening on that particular day. The field of this study is called meteorology.


What will be the price of this stock?

Just like meteorology, technical analysis of stocks gives us the probability of stock moving on the upside or downside in coming days or weeks or months or years. But I want you to focus on the word probability this means just like predicting weather, stock price prediction also has a probability attached to it. It may dishearten you but it does not work 100% of the times. Technical analysis is a method to predict the probable future price movement of an investment instrument by analyzing the previous market data mainly price and volume. It is based upon a major assumption that collective buying or selling of market participants reflect all the relevant information in price and volume. Technical analysis is also used by fundamental analysts or investors to find the right opportunity to invest, and find the low risk and high reward entry point.


Let's understand it with examples.


Below is the technical chart of Reliance Industries on daily time frame. As you can see price has been in a range of 2236-2755 from Sep. 2021 to Oct. 2023. If someone has bought Reliance at 2236 in Sep. 2021 he would have generated 0% ROI in 2 years time frame.

Reliance Industries' stock price has been in a range from Sep. 2021 to Oct. 2023


Take another example of HDFC Bank, the price has been moving in a range of 1393-1690 for 2 years. If someone had invested in HDFC Bank in Oct. 2021, he might be sitting on negative return in Oct. 2023.

HDFC Bank's price has been in a range from Oct. 2021 to Oct. 2023

Instead, L&T has given a good ROI. If someone has invested in June 2022 and remained invested till Oct. 2023 he would have gained > 100% return on the investment.

L&T has given > 100% ROI from June 2022 to Oct. 2023

Another good example is of ITC, from Mar 2022 to Jul 2023 it has given ROI of 87% which was the up trending period for this stock.


The point that I would like to drive home with the above examples is that, along with fundamental analysis one must use technical analysis to find the right opportunity along with the low risk and high reward entry point while investing. Principles of technical analysis Charles Dow in late 19th century put forth some tenets which form the foundation of technical analysis in capital market.

Price discounts everything

As per this theorem, price fully reflects all the information that is out there that's why price is considered to be the most important parameter in technical analysis. After all, the market price of securities or derivatives reflect the sum of the knowledge of all the participants- investors, traders, fund managers, buy-side or sell-side analysts, fundamental analysts, promoters etc. It will be foolish to disregard the price which has been set by the wide range of participants who are much more smarter than an individual trader. Technical analysis captures this information provided by the price which can be used with other factors to predict the probability of price move in the future.


Price movements are not totally random

Many technicians believe that price moves in trends- up trend, down trend and sideways. Yet, there are times when this does not happen or when this theorem fails, we will discuss such a case in the upcoming section. Seeing the price chart of any stock you may observe that there are periods when stock price behaves randomly and then there will be periods when stock price will move in trends, the job of a technical analysts is to identify those periods and take advantage from the price move. That is the period when good ROI can be generated in the least amount of time.


Below chart of ITC on weekly time frame shows uptrend, downtrend and sideways phases. As a trader or an investor who is looking to generate returns on the investment, your job is to find the trending phase to take advantage of the price move.


Indices must confirm each other

Major indices like NIFTY and NIFTY BANK represent the average of stock market in India. Someone who wants to know the overall health of the capital market can just check these indices and gets to know it. For the beginning of a confirmed trend these two indices must move in tandem. If one index is showing a downtrend and another index is showing an uptrend, in that case it can not be assumed that an uptrend has begun. Both the indices must confirm it.


Below is the image of NIFTY 50 and NIFTY BANK on daily time frame, you can mark the uptrend, downtrend and sideways phases in both and compare, you will find them both moving in tandem.

NIFTY 50 and NIFTY BANK move in tandem

Volume must confirm the trend Always pay attention to the trading volume in uptrend and downtrend. If the trend is up but the volume is not high, it generally signifies that big money is not interested in that stock and often that trend fades away quickly. The uptrend has to be support by increase in volume. In addition, there has to be a low volume in the down trending or sideways phase which again confirms the strength of an uptrend. On the contrary, if the volume is high on down trending days as compared to up trending days it means that the big money is exiting from that stock and the trend can reverse in coming few days. Below is the example from Action Construction Equipment where you can see low volume in sideways phase and rise in volume on up trending days.

Low volume in sideways phase and rise in volume on up trending days


Market moves in cycles

As per the Dow theory, in a primary trend every market goes through 4 phases which repeat itself time and again. These phases are: accumulation phase, mark up phase, mark down phase and distribution phase. These phases are very important to understand because they help in identifying the trend and time the entry and exit.


Accumulation phase This phase starts after a heavy sell-off which can last for few months. Because of the steep fall in price no individual investor seems interested in the stock due to the fear of further sell off. Hence, the stock price plunges to rock bottom valuations and remains at a low level for a while until something fundamentally changes in the business of the company. This is when the institutions start accumulating the stock. Institutional investors place orders for large quantities, of worth hundreds or thousands of crores and they seek value on their investment. They generally invest with a long-term view. Since, they need the most value on their investment hence, they don't buy it in a single day, they acquire them regularly. This time period can last for few weeks to months. During this time period you will observe that the price will be oscillating in a range like a pendulum. The sellers who will be selling during this phase will match the buyers quickly, and therefore the prices don't drop further rather they keep on oscillating in a range. An important point to note here is, not all beaten down stocks will attract institutional buyers, the businesses which have fundamentally improved will attract institutional buying and often times this accumulation phase and improved business sentiment will coincide. This phenomenon creates the support level for the price.


Mark up phase

As the institutions keep on absorbing the supply of shares, the supply becomes scarce and during this time even a less demand will result in a sharp rise in price. That's the time when price breaks out of the range and a new up trend starts by making higher highs and higher lows. During this phase stock price rallies quickly and sharply. This phase may last for few months.


Distribution phase

When the stock price reaches to new highs during this time it will be gaining a lot of traction from individual investors, news reports will start mentioning about it, analysts will start talking all the good things about the company and its future growth. This is the time when an investor has to be cautious because someone has rightly said about the stock market, be greedy when everyone is fearful and be fearful when everyone is greedy. During this phase institutional investors will start booking the profits. They will slowly start offloading the shares and this process will continue for few few weeks. You will be seeing increase in volume and drop or no change in price on the upside. Accumulation and distribution phase may look alike but they have a fundamental difference, in accumulation phase with high volume price will go up but in distribution phase with high volume price will go down. Because now there are no strong buyers present to buy the shares only individual investors are absorbing the supply and they are not strong enough to absorb all the supply hence, supply will be way more than the demand, and you will see the price going lower and lower with each passing day. This phenomenon creates the resistance level for the stock price.


Mark down phase

Institutional investors have fully offloaded their holdings and there will be no bulk absorption of shares which will lead to the sharp fall in the share price.


These four phases will complete one cycle. After the mark down phase a fresh round of accumulation will start and the whole cycle will repeat. Completion of one cycle may take few months or in some cases few years.


"What" is more important than "why" Technical analysis is more focused on the price of a stock rather than its value. Instead, long-term investors who focus more on fundamental analysis are focused on the value of a stock rather than its price. Technical analysis focuses on two important things:

1. What is the current price?

2. What has been the history of the price movement?

Price of a security is the outcome of the battle between the demand and supply, that's why it is considered to be the most sacred thing in technical analysis. Closing price is the most important data point Out of open, high, low and close price points close is the most important data point. The closing price is calculated as the weighted average of all the price points at which the stock is trading in the last half an hour of the trading session, in India it is 03:00 PM to 3:30 PM. Let's understand it with an example. Consider the below data for any stock trading in the last half an hour of the trading session.

Closing price will be calculated as sum of the product of trading volume and trading price divided by the total quantity traded in the last 30 minutes. Here it comes out to be 48.59 as the closing price for the day. This price is tracked by traders and investors to formulate their strategies to enter and exit the stock on daily, weekly & monthly basis.


Trends in the market

Overall there are 3 trends in the stock market. Primary trend, secondary trend and minor trend.

Primary trend is the overall trend of the market over a period of several years. It tells the multi-year direction of the stock market. Long-term investors that stay invested for many years focus on the primary trend. Primary trend can be an up trend or down trend. This primary trend can have many secondary trends which are counter to the primary trend. In a bull market, they can be corrections or down trends or bounces in a bear market. This secondary trend can last from few weeks to months. Minor trends are the fluctuations happening in the market within a day(intraday). Some of the traders consider them as noise. As you might see these fluctuations are impulsive moves mainly driven by some sort of news.

NIFTY in Primary up trend since Apr. 2020 with many secondary down trends in between



What's is your opinion about the technical analysis? Do you think it works? ;) After you answer the above question, you might want to set your expectations right before becoming a trader. This blog can help you in doing so. Thank you for your time ! You can connect with me over LinkedIn and X(Twitter) I'm a student of life, so don't hesitate to send over your views or sources to refer to help me enlighten myself.

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3 Comments


Anurag Singhal
Anurag Singhal
Feb 20

Nicely explained. Can you also share most useful resources you use for your learning and research.

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raytraceventures
raytraceventures
Feb 22
Replying to

there is no one source that I refer, there are many. will be creating a dedicated blog for the same.

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Guest
Nov 27, 2023

Well explained , wasn't aware of this .

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