Technical Analysis Meaning, Assumptions, Advantages and Disadvantages

In this Article, we are going to discuss about Technical Analysis Meaning, Assumptions, Advantages and Disadvantages. It is most common question for Investing in Stock Market Paper.

Technical Analysis Meaning

Fundamental analysis and technical analysis are two tools which are used while making investment in securities. In fundamental analysis, a value of a stock is predicted with risk-return framework based on economic environment.

An alternative approach to predict stock price behaviour is known as technical analysis. It is frequently used as a supplement rather than as a substitute to fundamental analysis. Technical analysis is based on notion that security prices are determined by the supply of and demand for securities. It uses historical financial data on charts to find meaningful patterns, and using the patterns to predict future prices.

In the words of Edwards and Magee: “Technical analysis is directed towards predicting the price of a security. The price at which a buyer and seller settle a deal is considered to be the one precise figure which synthesizes, weights and finally expresses all factors, rational and irrational quantifiable and non-quantifiable and is the only figure that counts”.

Technical Analysis Assumptions

Edwards and Magee formulate the basic assumptions underlying technical analysis which are as follows:

1. The market value of the scrip is determined by the interaction of demand and supply.

2. Supply and demand is governed by numerous factors, both rational and irrational. These factors include economic variables relied by the fundamental analysis as well as opinions, moods and guesses.

3. The market discounts everything. The price of the security quoted represents the hope, fears and inside information received by the market players. Insider information regarding the issuance of bonus shares and right issues may support the prices. The loss of earnings and information regarding the forthcoming labor problem may result in fall in price. These factors may cause a shift in demand and supply, changing the direction of trends.

4. The market always moves in the trends except for minor deviations.

5. It is known fact that history repeats itself. It is true to stock market also. In the rising market, investors’ psychology has upbeats and they purchase the shares in great volumes driving the prices higher. At the same time in the down trend, they may be very eager to get out of the market by selling them and thus plunging the share price further. The market technicians assume that past prices predict the future.

6. As the market always moves in trends, analysis of past market data can be used to predict future price behavior.

7. Shift in demand and supply, no matter when and why they occur, can be detected through charts prepared specially to show market action.

8. Changes in trends in stock prices are caused whenever there is a shift in the demand and supply factors.

Technical Analysis Advantages

1. Simple and quick: Technical analysis is simple and quick method on forecasting behaviour of stock prices.

2. Helps in identifying trend: Under the influence of crowd psychology, trends persist for quite some time. Tools of technical analysis that help in identifying these trends early are helpful in investment decision-making.

3. Short term price prediction: Technical analysis try to predict short term market price which is useful for speculators who want to make quick money.

4. Tracking shift in demand and supply: Shifts in demand and supply are gradual, not instant. Technical analysis helps in detecting these shifts rather early and hence provides clues to future price movements,

5. Price movement analysis: Fundamental information about a company is absorbed and assimilated by the market over the period of time. Hence, the price movement tends to continue in more or less in the same direction till the information is fully assimilated in the market.

6. Price prediction: Charts provide a picture of what has happened in the past and hence give a sense of volatility that can be expected from the stock. Further, the information on trading volume, which is ordinarily provided at the bottom of a bar chart, gives a fair idea of the extent of public interest in the stock.

7. Superior than fundamental analysis: According to technical analysts, their method is far superior than the fundamental analysis, because fundamental analysis is based on financial statements which themselves are plagued by certain deficiencies like subjectivity, inadequate disclosure etc.

Technical Analysis Disadvantages

1. Past and historical data: Technical analysis is based on the past and historical data. Unexpected future is not taken into consideration by it.

2. Analyst Bias: Just as with fundamental analysis, technical analysis is subjective and our personal biases can be reflected in the analysis.

3. No explanation about the tools used: Most technical analysts are not able to offer convincing explanations for the tools employed by them.

4. Chances of wrong decision: False signals can always occur in the stock markets. If the technical analysts act without confirmation, they would make mistakes and would suffer unnecessary expenses and losses.

5. Limited use of technical analysis: Empirical evidence in support of the random walk hypothesis casts its shadow over the usefulness of technical analysis.

6. Delay: By the time an uptrend or downtrend may have been signaled by the technical analysis, may already have taken place.

7. Commonly used system: Ultimately, technical analysis must be a self-defeating proposition. As more and more people employ it, the value of such analysis tends to decline.

8. Different interpretation by different analyst: There is a great deal of ambiguity in the identification of configurations as well as trend lines and channels on the charts. The same chart can be interpreted differently.

Despite these limitations, technical analysis is very popular. It is only in the rational, efficient and well-ordered market where technical analysis has no use. But given the imperfections, inefficiencies and irrationalities that characterize real markets, technical analysis can be helpful. Hence, it can be concluded that technical analysis may be used, albeit to a limited extent, in conjunction with fundamental analysis to guide investment decision-making, as it is supplementary to fundamental analysis rather than substitute for it.