Why technical analysis works? Mechanism and logic behind technical analysis tools and prediction.

-Krishna Khatiwada

We used to hear that technical analysis is just simple mathematics represented in chart; it does not work in Nepal stock market very effectively. We deny this philosophy and will try to prove that it works with detail mechanism and logic.

First, what is technical analysis?

Technical analysis involves analysis of stock market using different combination of technical tools. Every tool involves price and volume movement.

We will understand some of the candlestick pattern and their prediction.

Dozi- When market open and fluctuates but at the end if it closed at opening price then dozi candle-stick pattern gets formed.

There are different kinds of dozi, but here we discuss about what it predicts and logic behind it. Dozi shows that there is indecisiveness in market; neither the buyers nor the sellers were able to dominate the game.

When it appears after the strong trend (uptrend/downtrend), it expresses that buyers/sellers who was dominating the game previously had slow down.  Consider one example, there is football match between Germany and Brazil, and Brazil consistently loosing against Germany but suddenly Brazil doesn’t letting Germany to win; when dozi formed similar kinds of emotion arises in the market. Now talking about the game, there could be numerous reason, may be Germany was not playing up to its level, less co-ordination among the players etc., however there is possibility that Brazil could be playing well against Germany. So when dozi appears technical analyst predict that this could be the early sign of the reversal of ongoing trend. The "weak trend investors" could be working hard to pull the trend on their side. Perfect dozi appear rarely, so near dozi candlestick can be considered dozi as well.

Let’s check whether it works in Nepal stock market or not. I have used Development bank index for proof.

I marked black circle, when it worked and red circle when it gave false signal, out of seven appearance of Dozi, it gave false signal only once. In this case Dozi accuracy is 85% but in general its accuracy is around 60%.

It works best when trend became very aggressive. In most of the cases, when it appears even in the sideways market the next day’s candle will be opposite to previous day’s candle in majority of the cases. But predicting market trend using only dozi pattern is not effective one. Candle stick or any other indicators give single information about the market and there is a plenty of room for the false prediction using only one information. So, to predict with more accuracy investors need to combine different information given by different technical indicators. Dozi appear frequently in Nepal stock market.

Now let’s check another pattern and its working principle.

Evening star: Evening star candle-stick pattern consist of three candles, the first one is bullish long candle stick, second one is small body candle with gap-up opening and third one has to be bearish candle that should open below the closed price of first day candle and closed below its mid-point. The second candle can be both bullish and bearish.

This pattern will be called an evening star only if it gets formed at the strong uptrend.

Again, finding a perfect evening star is hard especially in case of Nepal; here pre-open session is not regulated so the gap-up, gap-down candle doesn’t form regularly.

In case of Nepal, we could consider similar type of pattern without the requirement of gap-up/gap-down candle in the evening star pattern.

Evening star concept is similar to the concept of dozi, as we looked for candle with small body in the strong uptrend but in this case we react with the confirmation of reversal as we wait for bearish candle to form. Consider the example of above football game; in the case of evening star, we predict Brazil’s wins in future but only after their victory against Germany.

In case of dozi, we will exit the market without confirmation and in the case of evening star we exit, after the confirmation. The similar pattern with exactly opposite character is called the morning star which predicts uptrend in the the strong downtrend.

Let check whether it works in Nepal Stock Market or not.

In above NEPSE chart, the said candle stick pattern’s accuracy is more in comparison to dozi. In Nepal’s Market it doesn’t appear that frequently but when it appeared, predication accuracy increases.

I came across many investors who says, technical analysis doesn’t work as they were not getting the result, from their analysis. Technical analysis is an art which need consistent practice, you can’t be analyst overnight. The investors who failed in technical analysis are the one that don’t follow some core principle of technical analysis, like giving less importance to pattern in the sideways market, reacting on the pattern only at the strong trend, using decent number of indicator for prediction, being humble with analysis and lastly reacting on patterns which were genuinely present in charts. If you don’t use your medicines as prescribed then you shouldn’t blame medicine for not being effective.