Stock analysis refers to the methodology of predicting the upward/downward movement of a stock price based on a study of its company financials, the market forces controlling the demand and supply of the stock, and a host of economic factors.
There are two types of analytical techniques used by investors and traders to identify stocks that have the potential to move either up or down. These are: Fundamental Analysis and Technical Analysis.
Fundamental analysis involves analyzing a stock based on its company’s financials, business model, the current standing and the future business prospects of the company. Investment decisions are based purely on the intrinsic value of the company, its current earnings, and financial projections. Thus, fundamental analysis is based on the “root cause” that affects a stock price, for example, company announcements, changes in a country’s financial policies, economic data, earnings reports and a host of other factors.
Technical analysis, on the other hand, leaves aside the financial and economic factors and makes use of the “price effect” factor – in terms of a stock’s price movement pattern – in order to predict the future price trends. Technical analysis studies the demand and supply of a stock by plotting its price and volume movements on a chart, and then predicting the future price movements based on some calculations – called technical indicators – made using a set of standard mathematical formulae.
To help you understand how a stock’s price movement is charted, here is a simple example of a company’s stock’s price chart over a 30-day period:
To you, this may look like an ordinary chart – but to a technical chartist, it is eye candy. He can apply several technical analysis methods to this price formation and conclude if the stock is worth buying or selling or leaving alone. There are many technical analysis methods adopted by chartists – these fall under the following two broad categories:
- Technical indicators
- Oscillators (strictly speaking, even oscillators are technical indicators, but are mentioned separately because their usage has grown considerably, especially amongst short-term traders)
People who are experts at reading such technical charts are referred to as Technical Chartists. Technical analysis is a vast area and involves many different techniques. Some technical traders swear by patterns made on the charts, some rely on technical indicators, some bank on oscillators, some on technical theories, and some use a combination of different technical indicators. So, the technical analyst market is a mixed bag – it is full of experts who rely on different techniques that may have maximized their profits in the past.
In fact, some technical analysis methods can be quite complex to work with. But for a beginner in the world of technical analysis, it will be sufficient to grasp simple technical methods that can help spot profitable trades. As you go along this topic, you will get clued on (in the forthcoming articles) how to spot profitable trades using simple technical indicators.
Principles governing technical analysis
There are three principles that are taken for granted by the technical analysts, these are:
1. Stock prices are purely governed by demand and supply
The basic concept of technical analysis assumes that fundamentals of any stock and the economic factors are always factored in its price, and so there is only one overall factor that can determine the future price movement of the stock – and this factor is the stock’s market price. Technical analysts believe that a stock’s market price will head towards a certain direction based purely on a stock’s demand and supply situation.
2. A stock’s future price movement is based on its current trend
Once a stock’s trend – upward or downward – is established, then, in the future, the stock’s price will always follow a similar trend for a certain period, and not go against it during that period. But remember that a technical trend cannot be permanent – it will always be based on a stock’s demand and supply situation.
3. Past patterns play a big role in determining the current price trends
Technical analysis has been around for over 100 years. Experts who are deep into technical analysis have observed that past stock price movements result in a variety of technical formations in the long run and these formations say a lot. For example, experts have noted that if a stock begins making a technical formation today that it has already made in the past (perhaps several times), then its price will move in the same direction like it did during the previous similar technical formation/s.
This was the ABC of technical analysis. The subject is vast, but once you get a handle on it, then you can make very good money in trading/investing stocks. You can be assured that by the time you are through with this entire section, you would have picked up enough technical analysis knowledge to identify profitable trades.
Stay tuned for the next feature.