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02 Apr 2007 | 17:04 The Mechanism Of Price Action.

The common perception of Technical Analysis is that it is a tool for traders. That one gets short-term signals and therefore its usage is restricted to short term trading, possibly, only intra day trading even. How did this perception emerge? And how does this persist to this day? This and a few other questions are what we shall attempt to answer in this write up.

The answer to the first question is a bit round about. Most people attempting trading know that the price moves change directions frequently and that fundamentals of a company cannot change with such frequency. Ergo, the moves of the stock, intra day or over a small time frame have therefore to be necessarily "technical" in nature. Since no one has quite bothered to explain cogently why prices do indeed move over the short term or within a day, the image of "technical" movements have persisted.

So what indeed is this "technical" movement of prices? Pause… And think of an answer. You may not really get one. That’s because the prices are, well, just there and happen all the time, don’t they? But what is the price, really? If we think of prices then we immediately think of supply- demand. All of us know that prices are a result of the supply-demand equation. Let us therefore go up one more level and see what produces supply or generates demand for stocks? Well, here again, the answers should be pretty quick. Our inkling of whether stocks are going cheap or expensive at the moment as compared with what they may do in the future.

This leads to the next question, then. How does one get an inkling of whether a stock is available at the right price or not? You would probably answer, depending on the "fundamentals" of the stock. So, what are the fundamentals of the stock? Ready answer, again. Sales, Profits, Products, Management, Earnings, Growth… and then you slow down, think a while, and come up with, Industry, Position within the industry, Competitors, Finished goods, Raw materials, inventory, cash flows… and then you think some more, and say, Economy, International competition (if applicable), political atmosphere, stability of Govt… By now, probably you have run out of items to list. Are you sure this is the full list of items, which affect the fundamentals? Probably, is your answer?

Ok, let’s take that as the list for now and examine it. Do you see a problem here? There are about a dozen factors, each of which comprise or is dependent on a dozen other factors. Many of these are themselves further interdependent. More. Many of these factors require collection of associated data before one can attempt to analyze them. So, in a nutshell, fundamental analysis faces two very important factors. One, collection all relevant material necessary for analysis, and secondly, that is more vital our ability to analyze the collected material.

Who can do a good job of it? Obviously, some large funds who have both the access to information (they can pay for it) and the ability to analyse (they can hire many analysts) and other larger players. What about small guys like you and me? Well, we try to do our best, don’t we? We read some magazines, try to get hold of a balance sheet or two, try our rudimentary knowledge of financials and come up with the best scenario that we can. Is this going to be correct? Who knows? We just hope that it is.

So what we have in the market is a collection of people who have all done some kind of analysis on stocks depending upon their access to material and their ability to analyze the material. All of this analysis leads to a perception of future value and this perception is then compared with the existing price to see whether or not a profit opportunity exists.

When you get into the realm of perceptions, you leave the comfort of rational numbers and enter into another domain, which is dominated by an entirely different set of factors. This is the domain of one’s own mind. Your perception of stock A would change from moment to moment, day to day or month to month... depending upon what your mindset is currently and what are the experiences you are undergoing at the moment. The mind waxes and wanes from moment to moment and therefore perceptions of value too change from time to time. So what was looking extremely attractive last week, suddenly is no longer so this week because you suffered a loss elsewhere. Or your sister is about to get married and you need the money. Or the government is shaky. Or there is a big drop at the Nasdaq. Or the FII selling is relentless. The list can go on and on. Therefore, you, who were on the demand side last week, are suddenly on the supply side this week.

Get the picture? There are so many reevaluations taking place in our own minds and there are so many of us out there in the markets - whether investors or traders or mutual funds or FIIs or hedge funds. All are trying to make valuations, develop perceptions and then, finally express those perceptions through the supply or demand mechanism. Is it any wonder that the prices keep on fluctuating back and forth as these multitudes of valuations keep being expressed? Remember, there is only one turf for all of us to express ourselves – the stock market. So starting from a big daddy FII right down to the ubiquitous Mr. Shah, we are all playing out our hopes and fears and greed and other associated emotions in the market.

And what do we all express it through? Off course the Price. This therefore is the one medium that unites one and all within the market place. Outside the market, we may be small and big, in terms of resources, access and ability. But within the market, our actions are pretty focused and are directed only through movements of price. The price of day is therefore the sum total of all the known news and all the known views up to that day. Think of it this way. If you knew something, which others did not, would you not be in the market, either demanding or supplying the stock? Would this volume not affect the prices? If you were bullish, you would be willing to pay a little premium so that you would not miss out on a good thing, so the prices would rise. If your news were bearish, you would be willing to offer a discount to the current rate so that you can get rid of the stuff fast before the rest of the market comes to know, so the prices would dip. Hence price is that equilibrium point where all known news and views – both bullish as well as bearish – have met and expressed themselves.

Price movements expressed over time are what define the Trend. The logic for the price moves however remains consistent over all time. Hence it is our own misconception that price moves over the long term are "fundamental" in nature while price moves over the short term are "technical" in nature. In reality, they are just price moves, nothing more. It is our own erroneous labeling which get us into all kinds of unnecessary imbroglios about the market. We will examine more such misconceptions later on in this series.