Is technical analysis another form of tea-leaf reading? No, say the experts. "Though technical analysis is not strictly a predictive tool, it is a pre-emptive weapon against the probable manner in which a stock, or any traded asset, is likely to behave," says Jamshed Desai, Head of Research at IL&FS Investsmart India, "It doubles up as an effective risk management tool as well."

Pre-emptive. Weapon. Risk management. It sounds too complicated to bother with. Then there are all these zigzag lines to decipher. Even with your best cryptologist instincts on high alert, you might be tempted to take the customary advice of financial advisors: 'stay off this stuff'.

They mean well, of course. By custom, these lines and charts are to be used discreetly, and rarely to be admitted so in public. So if anyone is around, lower your reading to a whisper. Psssst... is it addictive? The evidence on this is sketchy, but those who get it tend to stay with it.

So What Is It?

Broadly, the term 'technical analysis' applies to the study of historical asset price and volume data for the purpose of projecting its future behaviour. Unlike 'fundamental analysis', which looks at the company's financials to see what the stock is worth, technical analysis only looks at data generated by the stockmarket.

''Primary technical analysis is much better than using low levels of fundamental analysis'' C.K. Narayan/Consultant/ ICICI Securities

Now, investors can go by the 'fundamentals' or by the 'technicals', but the smart option perhaps is to use a combination of both, using the former to identify stocks, and the latter to figure out exactly when to buy and sell.

As Desai says, "Technical analysis is supplementary tool to fundamental analysis." Thankfully, it is quite easy to understand and practice---once you overcome the fear of those jagged lines.

According to C.K. Narayan, consultant at ICICI Securities, primary technical analysis is much better than using "low levels of fundamental analysis" (such as market hearsay or tips).

The broad idea is simple: you win by playing at the leading edge of the prevailing trend. That is, you buy a stock just as the price goes on an uptrend, and sell at the first signal of a downtrend. The trend, as they say, is your friend.

"Technical analysis," says Deepak Mohoni, a Pune-based technical analyst, "will help you find a trend when it starts." But how to identify the ups and downs? Compare spiky 'sensitive' data with generalised longer time-scale trends. Here are the tools:

Simple Moving Average

This is the simplest trend following technique. It smoothens the price chart's spikes and dips to present a trend of prices averaged out over several readings. For a fortnightly moving average, first take the average closing value of a stock (or Sensex) over the past fortnight (14 days' prices added up, divided by 14), and plot it against today's date. To make it 'move', you again plot the past fortnight's average tomorrow (with a new day's price added and the earliest day's dropped). Do this every day, and connect the dots to get a moving average line.

'''To mitigate the risk of false signals, go with the weight of technical evidence''' Mitesh Thacker/Associate VP/Kotak Securities

Of course, you could take an average of any period. The chart featured above is a 26-week moving average of the Sensex, ideal for long-term investors. The buy/sell rule here is simple: you buy when the quoted price goes above the moving average value, and sell when it falls below. By the chart above, a six-month horizon investor would have bought the Sensex on June 6, 2003, sold it on May 14, 2004, and made off with a tidy sum.

Note that a shorter-time moving average would have been of little help. "This is because the short term signals will be valid only for a short period," explains Manish Shah, Technical Analyst with KRC Research. You must pick a moving average to suit your investment time frame. Day traders use 30-minute moving averages, for instance. If you're investing on corporate research, a monthly, quarterly or six-monthly moving average would be far more appropriate.

Top-Bottom Trend Lines

You plot the stock's closing price every day, and get a sensitive price chart. Now look for peaks and valleys. A visibly high peak is a 'top', and a visibly sunken low is a 'bottom'. You draw a straight line through tops to connect peaks, or through bottoms to connect dips. Now, if both tops and bottoms keep going higher and higher, it's an obvious uptrend (and vice-versa).

But a single trend line will do. If just the tops keep getting lower and lower, you still have a downtrend. For a long-term trend, take the case of BHEL's stock price over several years (see chart below). The first top on July 31, 1997 is followed by two lower tops (January 29, 1998 and August 31, 1999). If you draw a straight line through the three top points, you get a downward sloping trend line.

TREND CATCHING

» Simple Moving Average offers a 'long view' of the price data (averaged over a length of time) to compare spiky sensitive prices with; if the live price overshoots the trend, buy. » Top-Bottom Trends tell you the generalised price story by joining the high (or low) points to see if it's going up or down; if the sensitive trading price goes above the line, buy » Momentum Indicators offer early-warnings on whether the price is gaining or losing momentum; if an MACD indicator overshoots its own moving average, buy.

Now, a buy/sell signal here is made by a so-called 'trend reversal'. How to identify one? If the price goes above the long downward trend, it's time to buy. For BHEL, this happens on February 28, 2003.

Likewise, an upward trend would be made by a straight line drawn through at least three successively higher bottoms. If the price falls below the trend, sell.

Momentum Indicators

Technical analysis gets slightly more complex if you want to catch an emerging uptrend even before its onset. It can be done-by watching trend momentum. Like a car, a trend typically slows down before turning around. Your speedometer is the momentum indicator, the most popular kind being the Moving Average Convergence Divergence (MACD) line. How to calculate it? Deduct a long-term moving average (usually 26 days) from a short-term one (usually 12 days), and plot the difference. This difference tells you what's happening. In an uptrend, the more recent averages are higher than the longer-span averages, so the MACD value is positive. If the trend is bearish, the MACD turns negative.

To get buy/sell signals, however, plot a separate 'trigger line'-typically a nine-day moving average of the MACD values. Now, if the the MACD zooms up ahead of its own smoothened average (cutting the trigger line from below on the chart), it means that things are getting zippy, so you buy. If the MACD line goes below the trigger line, sell (as on August 13, 2004, in the chart above). You must be cautious, however, to avoid picking up false signals. Slowing cars sometimes just shoot ahead again.

Yes, It Works

Admittedly, you risk a mishap or two, especially with momentum indicators. But don't let people tell you that all this is "too technical" for you. "Though it is used mostly by traders now," says Narayan, "it is not fair to call it an analysis only for traders."

True, false signals are a real problem. But there's a way to mitigate that risk. "Go with the weight of technical evidence," advises Mitesh Thacker of Kotak Securities. In other words, use several tools on the same asset, and act only if you get similar signals from most.

Used correctly, technical analysis is found to work. Prices, after all, are found to display visible patterns that occur over and over again-the result of the past behaviour of investors. It is reasonable to expect this collective behaviour to cause similar patterns in the future as well, be it a swing from over-optimism to excessive pessimism, or vice-versa. Greed and fear are what move markets, at times, and technical analysis does a good job of capturing the so-called 'sentiment'.

If that's not enough, technical analysis has the backing of market theory as well. The theory? The market, involving the dynamic interactions of myriad players, distills everything there is to know. "The price contains all information," as Manish Shah, Technical Analyst at KRC Research, puts it.

The condition: this market must always have diverse and numerous participants. So avoid illiquid stocks that could be rigged by a few rogues. Insure yourself against false signals: be discerning about what can and what cannot be manipulated.