Technical Analysis : A tool with No edge?
August 19, 2022 by Ayush Anjana · 4 min read
Technical analysis , a method to understand the sentiment of the markets by observing the crowd behaviour. Working on the foundation of the famous saying “Price is God” - popularly known as “Bhav Bhagwan Che”. The Core principle of technical analysis is Stock price movement reflects the undue happenings related to the company and its business.
The need for technical Analysis:
Have you ever wondered what makes up the stock price of any company , it may be total market capitalization divided by total number of shares but it is also the PE ratio multiplied by earnings per share (EPS).Thus we can say that the stock price of any company is a function of its earnings (Fundamentals) and the prevailing market sentiment which is the PE multiple (technical analysis). So in simplest terms for understanding the PE multiple side of things , technical analysis is one of the relevant tools
Lets understand the “PE Ratio*EPS” Concept in detail:
A company for investors is a function of its Future earnings potential but that in isolation is an incomplete truth. Future earnings growth along with PE expansion is where the magic happens.
Case 1: when the EPS compounds @20% Cagr for next 3 years and no change in PE ratio
Say stock price 150 where EPS stands at 10 with a PE ratio of 15.
Case 2: when the EPS compounds @20% Cagr for next 3 years and PE ratio expands at 10% cagr.
Say the stock price 150 where EPS stands at 10 with a PE ratio of 15.
Note: With just the EPS compounding the stock price after three years ends up at 259.20 but with both EPS compounding and PE ratio expansion the same stock price ends up at 344.90. Hence for understanding where PE expansion may happen along with understanding the broader market sentiment ,technical analysis is needed
Reliance Industries during feb 2017, a classic example of PE ratio expansion
Technical analysis is nothing but a tool to find out good risk-reward setup with the help of price but majority of the beginners misunderstand technical analysis as a holy grail to mint money. Technical analysis in isolation has no edge but when combined with proper risk management ,right mindset it offers a positive expectancy in the long run.Technical analysis is just a medium to observe the mass behaviour , fund flows and rotations across sectors.Technical analysis offers clarity when it comes to when to buy and when to sell,which is the most important element as money is always made on the exits
As the famous 80-20 principle says 80 percent of the consequences come from 20 percent of the causes ,similarly 80% of the move in any stock will occur in 20% of the time. Rest followed by price consolidation.The same concept leads to the idea of “Trend following”
Trend following works on a similar line with Newton’s third law of motion for trading which is a stock showing strength will continue to go up until its trend bends. Now the question that arises in our mind is how to judge the beginning of a trend and its exhaustion?
The answer to this question is follow Dow theory!
Dow theory , a method developed by Charles Dow to assess the price structure and judge its trend whether being in an uptrend (going up) , downtrend (going down) or it be consolidation (be in a range).
Charles dow classified any stock to be in following state as:
- Uptrend - Stock making new higher highs and higher lows
- Downtrend - Stock making new lower highs and lower lows
- Consolidation - Stock trading between a well defined range of highs and lows
Stock price does not move in a linear fashion , but whether it goes up or down it moves like walking stairs.
A picture is worth a thousand words!
It’s not that only traders opt for technical analysis or the use of price action analysis but there are many investors who use charts with larger time frames such as weekly and monthly charts to assess their holding and keep a check on their exit rules.Technical analysis can be used to study the historic price movements and its pattern to observe good risk reward setup which is the first step to develop an idea for any system formation
Technical analysis in a nutshell:
- Way to understand the crowd behaviour and fund flow
- A way to observe the price movement and then react , rather than prediction of future price movements
- Technical analysis tells you the decisive levels around which you get high probability trades
- technical analysis in isolation has no edge , its when combined with risk management and right mindset (psychology)