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Understanding the premises of technical analysis

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Understanding the premises of technical analysis


The success of any movie or novel is based on its premises. We consider technical analysis a study of charts but let’s understand its foundation first.

1. Studying the past price movement It is not something new. We have done this in every walk of our life. Experiences are a matter of the past, and decisions are a matter of the future. But every decision is born out of the experience . Putting it a different way, if the future is the lock, then the past is the key.

One needs to understand the history of price behaviour and extrapolate the same. One of the adages is apt in this context: ”The more we know about the past, the better we are prepared for the future.”

2) Technical analysis is about probabilities and not absoluteness Thinking in terms of probability for technical analysis is a required trait in traders.

How we think anchors our trading strategy. Adaptability to changing market scenarios is possible only when we are thinking in terms of probability.

Technical analysis is not a science where there is no second thought, nor is it as subjective as art. It lies in between the two extremes.

Technical analysis helps gauge the direction of trends, whereas risk management tool gives insight into where the trade setup is failing. Every trade has an element of risk, and one can embrace risk only when analysis and trades are imbibed with probability.

3) History repeats itself An alternate version of a popular phase can be “history repeats itself not exactly but rhymes around”. These premises are interlinked. If the history doesn’t repeat itself, there is no reason to study the past price behavior.

Trading technology, interface, and tools have evolved over time, but market psychology and reaction from the state of greed and fear tend to be very predictable.

4) Market discounts everything Let us understand this premise with an analogy. We all have experienced this.

Take the example of feeding fishes in a pond, the moment a person throws bread, the fishes consume it in a fraction of seconds. There are no leftovers.

The same thing happens in the stock market. The pond represents the market. A piece of bread is like a factor that affects the market, sector, or stock and investors.

The traders are the fishes. The moment any price-sensitive event occurs, all market participants act on that event and there is no leftover.

So, the market reacts immediately to any event which affects it. They can’t take any such news/factor in a leisurely manner.

These are key premises of technical analysis. In our next note, we will talk about studying past price movements.

(Kapil Shah is a Technical Analyst at Emkay Global Financial Services Limited & Trainer, FinLearn Academy) (Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of Economic Times)

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