Technical Analysis

Chapter Objectives

To know the concept of technical analysis

To understand the Dow theory

To find out the support and resistance level To comprehend the indicators and oscillators To explain the chart form of price analysis

Technical Analysis

Technical analysts developed tools & techniques to study past patterns & predict future price. Unlike fundamental analysis, it is based purely on study of behavior of past price. While fundamental analysis is directed towards determining intrinsic value of a stock, it is directed towards predicting price of a security.

Assumptions

The market value of the scrip is determined by the interaction of supply and demand. Supply & demand are governed by numerous factors both rational & irrational. The market always moves in trend which persists for an appreciable length of time. History repeats itself. It is true in some chart pattern also.

Origin of Technical Analysis

Technical analysis is based on the doctrine given by Charles H. Dow in 1884, in the Wall Street Journal.

Dow theory only describes the direction of market trend and doest not attempt to forecast future movement.
A. J. Nelson, a close friend of Charles Dow formalized the Dow theory for economic forecasting. Analysts used charts of individual stocks and moving averages in the early 1920s.

Dow Theory

The theory is based on certain hypothesis:

The first hypothesis is that no single individual or buyer can influence the major trend of the market. The second hypothesis is that market discounts every thing. That means, the aggregate judgment of all stock market participants regarding current & potential changes in demandsupply relationship of stocks, is reflected in share price.

According to Dow theory the trend is divided into

Primary Intermediate/Secondary Short term/Minor

Primary Trend

It lasts from about a year to several years (long term movement in price). It can be either bull or bear trend. A primary bear market trend can be seen as a long decline, interrupted by some rallies. A rally is an increase in price that occurs after a falling trend in prices. A bull market trend is a broad upward movement, interrupted by some reversals. A reversal is a decrease in price that occurs after a rise in prices.

Bull Market

The bull market shows three clear-cut peaks. Each peak is higher than the previous peak. The bottoms are also higher than the previous bottoms.
Bull market Y T3 T2 P R I C E B2 Good corporate earnings Speculation phase

T1

Revival B1 of market confidence phase-1

X Days

Bear Market

The market exhibits falling trend. The peaks are lower than the previous peaks. The bottoms are also lower than the previous bottoms.
Y Bear market

Loss of hope (phase-1) P R I C E T1 Recession in business (phase-2) B1 T2 Distress selling (phase-3) B2 B3 Days X

The Secondary Trend

An important decline in bull market or advance in a bear market and lasts from 3 weeks to as many months. The correction would be 33% to 66% of the earlier fall or increase.

Minor Trends

Minor trends or tertiary moves form only a part of a primary or secondary trend. They are simply the daily price fluctuations.

Minor trend tries to correct the secondary trend movement.

Basic Technical Tools

Trend Lines Moving Averages Price Patterns Indicators Cycles

Trend Lines

The lines connect the peaks of rallies & bottom of reversals. There are three basic kinds of trends:

An Up trend where prices are generally increasing. A Down trend where prices are generally decreasing. A Trading Range.

Support and Resistance Level

In the support level, the fall in the price may be halted for the time being or it may result even in price reversal.

In this level, the demand for the particular scrip is expected.

In the resistance level, the supply of scrip would be greater than the demand.

Further rise in price is prevented. Selling pressure is greater and the increase in price is halted for the time being.

Moving Average

If the prices appear to move haphazardly & be very volatile, moving average can help. It reduces the distortions to a minimum by evening out fluctuations in share price. For identifying short-term trend, 10 to 30 days moving averages are used. In the case of medium-term trend 50 to 125 days are adopted. 300 days moving average is widely used by analysts.

Market Trend Analyses: Simple Moving Averages (SMA)

Da y 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Da ily Close 60.33 59.44 59.38 59.38 59.22 58.88 59.55 59.50 58.66 59.05 57.15 57.32 57.65 56.14 55.31 55.86 54.92 53.74 54.80 54.86 5-Da y SMA 10-Da y SMA

59.55 59.26 59.28 59.31 59.16 59.13 58.78 58.34 57.97 57.46 56.71 56.46 55.98 55.19 54.93 54.84

59.34 59.02 58.81 58.64 58.31 57.92 57.62 57.16 56.58 56.19 55.78

Market Trend Analyses: Simple Moving Averages (SMA)

Market Trend Analyses: Moving Averages: Trading strategy

Sometimes traders use two moving averages to determine buy and sell decisions. When moving average rises above the price line, a reversal in bullish trend is signaled. Using a slow moving average (more days) together with a fast moving average (fewer days) generates the following trading strategies:

Buy when the faster moving average goes above (crosses) the slower one (from below). Sell when the faster moving average goes below (crosses) the slower one (from above). Buy when prices are above both the fast and slow moving averages. Sell when prices are below both the fast and slow moving averages.

Relative Strength Index (RSI)

RSI was developed by Wells Wilder. It refers to the ability of an industry or stock to outperform the market indices
RSI =
100 100 1 Rs

Rs =

Average gain per day Average loss per day

If the share price is falling and RSI is rising, a divergence is said to have occurred. Divergence indicates the turning point of the market.

Days 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Price Change 0.5 0.2 -0.3 0.6 0.2 -0.7 -0.5 -1.1 -0.2 0.3 0.7 0.2 -0.3 -0.4 -0.5 0.1 0.3 -0.2 0.5 -0.3

Gain 0.5 0.2 0.6 0.2

Loss

Avg. Gain

Avg. Loss

RSI

0.3

0.7 0.5 1.1 0.2 0.3 0.7 0.2 0.3 0.4 0.5 0.1 0.3 0.2 0.5 0.3 0.19 0.18 0.17 0.18 0.17 0.19 0.18 0.25 0.27 0.25 0.23 0.23 0.21 0.22 43.55 40.07 41.08 44.14 42.55 47.61 45.05

Relative Strength Index (RSI)

Wilder recommended using 70 and 30 as overbought and oversold levels respectively.

RSI 70 => Stock is overbought Dont buy RSI 30 => Stock is oversold Dont sell

Generally, if the RSI rises above 30 it is considered bullish for the underlying stock. Conversely, if the RSI falls below 70, it is a bearish signal. The centerline for RSI is 50. A reading above 50 indicates that average gains are higher than average losses and a reading below 50 indicates that losses are winning the battle. Some traders look for a move above 50 to confirm bullish signals or a move below 50 to confirm bearish signals.

RSI Example Chart

Overbought Oversold

Head-and-Shoulders Tops or Bottoms

Head-and-Shoulders formations are among the most frequently used technical patterns for identifying a price reversal. Head-and-Shoulders formations consist of four phases:

The left shoulder The head The right shoulder The penetration of the neckline

A head-and-shoulder reversal pattern is complete only when the neckline is penetrated, either in an upward or downward direction.

Head-and-Shoulder top: The formation is complete when price penetrate the neckline from above indicating a reversal from a uptrend to a downtrend. Head-and-Shoulder bottom: The formation is complete when price penetrate the neckline from below indicating a reversal from a downtrend to an uptrend.

Head-and-Shoulders Top

Chart Analysis

The most commonly used price pattern recognition charts are: bar charts, line charts, candlestick charts, and point-and-figure charts Price Pattern Recognition Charts

On these charts, the Y-axis (vertical axis) represents the price scale and the X-axis (horizontal axis) represents the time scale. Prices are plotted from left to right across the X-axis with the most recent plot being the furthest right. Bar Charts: Bar charts mark trading activity of a specified trading period (e.g., day) by a single vertical line on the graph This line connects the high and low prices for the trading period The closing price is indicated by a horizontal bar

Chart Analysis Bar Chart

Technical Analysis: Chart Analysis Bar Chart

Bar charts can also be displayed using the open, high, low and close. The only difference is the addition of the open price, which is displayed as a short horizontal line extending to the left of the bar.

Chart Analysis Line Charts

Line Charts: In a line chart, only the closing prices are plotted for each time period. Some investors and traders consider the closing level to be more important than the open, high or low. By paying attention to only the close, intraday swings can be ignored.

Chart Analysis Candlestick Charts

Candlestick Charts: Originating in Japan over 300 years ago, candlestick charts have become quite popular in recent years. For a candlestick chart, the open, high, low and close are all required. Hollow (clear) candlesticks form when the close is higher than the open and Filled (solid) candlesticks form when the close is lower than the open. The white and black portion formed from the open and close is called the body (white body or black body). The lines above and below are called shadows and represent the high and low. A daily candlestick is based on the open price, the intraday high and low, and the close. A weekly candlestick is based on Monday's open, the weekly high-low range and Friday's close.

Charts
Charts are graphic presentations of the stock prices. These also have the following uses:

Spots the current trend for buying and selling Indicates the probable future action of the market by projection Shows the past historic movement Indicates the important areas of support and resistance

Point-and-Figure Charts
Point-and-Figure Charts:

Point-and-figure charts are constructed by filling in boxes with either a X or an O. A price increase or decrease is defined as a price change that exceeds a specified magnitude a price change less than that magnitude does not receive an X or O in the chart If prices are rising, the appropriate Xs are entered in a particular column. When prices begin to decline, a new column is started, and Os are entered in that column Each price reversal (a decline after previous increase or a rise after previous decline) results in the start of a new column

Point-and-Figure Charts

Point and Figure Charts

These charts are one-dimensional and there is no indication of time or volume. The price changes in relation to previous prices are shown. The change of price direction can be interpreted.
Some inherent disadvantages are: They do not show the intra-day price movement. Only whole numbers are taken into consideration, resulting in loss of information regarding minor fluctuations. Volume is not mentioned in the chart.

Indicators- Breadth of Market

Calculate the no. of net advances/decline on a daily basis. Deduct no. of shares decline on a day from no. of shares advances. Obtain breadth by cumulating daily net advances/declines.

Indicators- Breadth of Market

Day Tue Wed Thr Fri Mon Advances 630 690 746 492 366 Declines 527 475 424 630 701 Net Adv/Decl. 103 215 322 -138 -355 Breadth 103 318 640 502 167

Bar Charts

The bar chart is the simplest and most commonly used tool of a technical analyst. A dot is entered to represent the highest price at which the stock is traded on the day, week or month. Another dot is entered to indicate the lowest price on that particular date. A line is drawn to connect both the points. A horizontal nub is drawn to mark the closing price.

Chart Patterns
V Formation Double top and bottom Inverted head and shoulders

Tops and bottoms Head and shoulders

Oscillators
Oscillator shows the share price movement across a reference point from one extreme to another. The momentum indicates:

Overbought and oversold conditions of the scrip or the market. Signaling the possible trend reversal. Rise or decline in the momentum.

Indicators
Volume of Trade

Volume expands along with the bull market and narrows down in the bear market. Technical analyst use volume as an excellent method of confirming the trend. Heavy volumes accompanied with rising prices implies bullish trend. It refers to the selling of shares that are not owned. Short interest ratio= (Total no. of shares sold short)/ (Avg. daily trading volume) Investors sell short when they expect prices to fall. So when ratio is high it means that investors expect the prices to fall.

Short sales

Rate of Change (ROC)

ROC measures the rate of change between the current price and the price n number of days in the past. ROC helps to find out the overbought and oversold positions in a scrip. ROC can be calculated by two methods.

In the first method current closing price is expressed as a percentage of the 12 days or weeks in past.

In the second method, the percentage variation between the current price and the price 12 days in the past is calculated.

Triangles

The triangle formation is easy to identify and popular in technical analysis. The different triangles are:

Symmetrical
Ascending Descendinginverted

Technical Analysis and Fundamental Analysis

1.

Fundamental analysts analyses financial strength of corporate, growth of sales, earnings and profitability.

The technical analysts mainly focus the attention on the past history of prices.

2.

Fundamental analysts estimate the intrinsic value of the shares.

Technical analysts mainly predict the short term price movement.

3.

Fundamentalists are of the opinion that supply and demand for stocks depend on the underlying factors.

Technicians opine that they can forecast supply and demand by studying the prices and volume of trading.

Chapter Summary
By now, you should have:

Obtained knowledge of technical analysis Understood the various technical tools Understood the chart form of technical analysis