## Assumptions of Technical Analysis

### Text version

Hello and welcome to the course.

## An introduction to technical analysis.

Let’s begin with flipping this coin. The first flip gets us, that’s a heads. Let’s do it again and this time we get, oh it’s a heads again. Third time we get a heads ...

Hello and welcome to the course.

## An introduction to technical analysis.

Let’s begin with flipping this coin. The first flip gets us, that’s a heads. Let’s do it again and this time we get, oh it’s a heads again. Third time we get a heads yet again. The fourth flip get us head again. Fifth time gets us head yet again. Surprised! You should be, because 5 heads in a row is very unlikely. Actually the chances of that happening are 3.125%. So, why we are flipping coins and what does it have to do with Technical Analysis? A lot more than you think.

Technical Analysis is about probability. It’s about raw numerical data crunching. It’s also about patterns and spotting that trend early. Now there are a lot of similarities between ‘flipping a coin’ and Technical Analysis. One is that you can make an objective decision without worrying about any subjective factors. So you know exactly the probability in advance. What I mean by this is that when I flip a coin, you know exactly what the probability is. It is 50/50% of it landing on either side. Technical analysis works there pretty much the same way. When you put on that trade, you are basing your decision on statistics, on pure math’s, on numbers. You know the probability in advance. Now there is one thing about technical analysis that is not accounted for in a conflict and that is Human Behavior. Think about it, what moves a stock. Mostly it is traders and investors basing in their perception and that the key word here. The perception of the investors, it could be greed it could be fair, it could be indecision which is reflecting in price. And what is technical analysis doing? It aims to quantify this behavior. Well now, I have a confession to make – I cheated. The coin that I was flipping was a weighted coin such that one side was heavier than the other meaning that there is an 80% probability of the coin landing on Heads. Knowing that information, what would you choose between heads and Tails? The answer is Heads.

Now let’s see how this concept can be applied to stocks. Now let’s suppose on the basis of historical data, you will find something fascinating in a stock. Every time this stock moved up 5% in the past, it was followed by a 3% fall. And this happenend again and again and again. Suppose you plotted its price movement on a chart and it looked something like this.

Now, I know what you’re thinking – in the real world, such a consistent pattern almost never appears. But nevertheless, patterns do emerge. See that red dot at the end; assume that point of time is now and you have the option of buy or sell. What would you do? The answer is obvious, you would buy. And that in the nutshell is an oversimplified way of explaining what Technical Analysis is.

You plot prices on a chart, spot the trend or pattern emerging again and again and making an objective decision to buy or sell which is based on human behavior, which is factored in that price.

The next lesson, we are going to focus only on trends. But in this lesson, we’re going to cover the 3 Big Assumptions of Technical Analysis.

– History repeats itself

When an event happens again and again, that is a pattern emerges. Now what the Technical Analysis does, it find these patterns throughout historical price data of stocks and indices and you can validate them through this process. This is probably one of the main reasons why traders are attracted to technical analysis too much, it removes any subjectivity, any guess work, and you are working on math probability. It’s a objective way to decide to buy and sell.

– All relevant information is already priced in

So what does that mean? Let’s take an actual example of Nifty that is the Index which is the average of the top 50 stocks on the NSE. This chart is of 2010

As you can see Nifty has appreciated 62% over 5 years. Since 2014, it has done very well. The overall trend is a positive one, but there’s been a slight dip in the recent past. That’s all fine and dandy. But now what? What do we look for to make the decision on whether to go long or short?

Let’s understand this with an example. Suppose the RBI is about to announce a rate change in the headline interest rate. Now we all know that the headline interest rate can change everything, from economy to sectors and companies in specific.

The fundamental analyst will try to figure out this complex web of information and here he will ask himself. Is the nifty over valued or undervalued after this decision? He will also try to find the intrinsic value of the Nifty.

The Technical Analyst, on the other hand does not look at that. He/she will try to figure out what is happening now. He will figure out if the information is relevant, it will reflect in price immediately. So if it is a positive announcement, prices are likely to go up and if it fixes his trading system, he will buy as per plan. If its bad news and he see sell signal according to his objective system, he will sell.

Now next time you will look at you TV and you find the analyst screaming buy or sell. Try to ask yourself, what are they basing their decisions on?

– The fundamentals of the company matter

We have fundamental analysis and Technical analysis.

Now what is funny is that every technical analyst usually discounts fundamentals completely and vice versa the fundamental guys will not look at charts at all.

To us as Trade Academy, that seems crazy; how you could do that. They both have strength and weaknesses. And you could use them both to your advantage.

For example

Look at DLF,

It was in a beautiful uptrend, the technical analyst would have dot, profited quite a bit but he would have to deal with this enormous crash. Now the average investor would find this a real mess and probably would lose money. However if you employed fundamental analysis first, you would have found that DLF is not that fundamentally sound. There were other candidates such as Colgate Palmolive, and much better on the books, financially it’s growing 15 % a year every year and has no debt. Now suppose you traded Colgate Palmolive using technical.

Look at the chart,

It’s a beautiful uptrend, making profit without having to worrying about crash. You see applying fundamentals and technicals, they compliment each other. And isn’t that a nicer way to invest you money.

So what have we learned so far? Well, for starters, we’ve learned that Technical Analysis allows you to make an objective decision on your trading. So without second guessing, you can make a trade based on probability, based on statistics. We also learned 3 assumptions i.e History repeats itself, all relevant information is reflected in price and fundamentals matter.

The next lesson is really interesting, we will introduce you to the concept of trends and it is beautiful because there is a relationship between the biggest investors, the economy and the Indian stock market. These concepts can be used worldwide and what is exciting is that we will be able to show you how to trade using these concepts.