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Unit 3

TECHNICAL ANALYSIS
The Visual Clue

Outline
What Is Technical Analysis
Charting Techniques
Technical Indicators
Testing Technical Trading Rules
Evaluation of Technical Analysis

What Is Technical Analysis


In his book technical analysis explained, Martin J. Pring explains:
The technical approach to investing is essentially a reflection of the
idea that prices move in trends which are determined by the
changing attitudes of investors toward a variety of economic,
monetary, political and psychological forces. The art of technical
analysis - for it is an art - is to identify trend changes at an early
stage and to maintain an investment posture until the weight of the
evidence indicates that the trend has been reversed.

Basic Premises Of Technical Analysis

Barring minor deviations, stock prices tend to move in fairly


persistent trends.

Shifts in demand and supply bring about changes in trends.

Irrespective of why they occur, shifts in demand and supply


can be detected in charts.

Technical Analysis Versus Fundamental


Analysis
Technical Analysis

Fundamental Analysis

Predicts short-term
price movements

Establishes long-term values

Focuses on internal market


data

Focuses on fundamental
factors

Appeals to short-term traders

Appeals to long-term
investors

Charting Techniques
The Dow theory
Bar and Line charts
Point and figure chart
Moving average analysis
Relative strength analysis

Basic Concepts Underlying Chart Analysis


Prices move in persistent trends
Volume and trend go hand in hand
There are resistance and support levels

The Dow Theory


The market has three movements, all going at the same time:
Daily fluctuations

: Random day-to-day wiggles

Secondary movements : Corrections that last for a few


weeks or months
Primary trends

: Representing bull and bear


phases of the market

The concept of Dow Theory

Bar And Line Charts

The bar chart depicts the daily price change along with the
closing price.

A line chart shows the line connecting successive closing


prices.

Technical analysts believe that certain formations or patterns


observed on the bar chart or line chart have predictive value.
For example, a head and shoulder pattern represents a
bearish development.

Bar and Line Charts

Technical analysts believe that certain formations or patterns observed on the


bar chart or line chart have predictive value. The more important formations
and their indications are described below.
Head and Shoulders Top (HST) Pattern As the name suggests, the HST formation
has a left shoulder, a head, and a right shoulder, as shown in Exhibit 16.3A. The
HST formation represents a bearish development. If the price falls below the
neckline (the line drawn tangentially to the left and right shoulders), a price
decline is expected. Hence, it is a signal to sell.
Inverse Head and Shoulders Top (IHST) Pattern As the name indicates, the IHST
formation is the inverse of the HST formation, as shown in Exhibit 16.3B. Hence,
it reflects a bullish development. If the price rises above the neck line, a price rise
is expected. Hence, it is a signal to buy.
Triangle or Coil Formation This is shown in Exhibit 16.3C. This formation
represents a pattern of uncertainty. Hence, it is difficult to predict which way the
price will break out.
Flags and Pennants Formation This is shown in Exhibit 16.3D. It typically
signifies a pause after which the previous price trend is likely to continue.
Double Top Formation This is shown in Exhibit 16.3E. It represents a bearish
development, signalling that the price is expected to fall.
Double Bottom Formation This is shown in 16.3F. It reflects a bullish
development, signalling that the price is expected to rise.

Important Chart Formations

Point And Figure Chart


More complex than a bar chart, a point and figure chart (PFC)
condenses the recording of price changes by eliminating the time
scale and small changes.

More complex than a bar chart, a point and figure chart (PFC) has
the following features.
1.

On a PFC only significant price changes are recorded.


For example, for a stock that has a price in the range
of, say Rs 30 to Rs 50, price changes of one rupee or
more only may be posted.

2.

While the vertical scale on a PFC represents the price


of the stock, the horizon scale does not represent the
time scale in the usual sense.

3.

Each column on the horizontal scale of a PFC


represents a significant reversal of price movement
and not a trading day.

Point and Figure Chart

Moving Average Analysis


A moving average is calculated by taking into account the most
recent n observations.
A 5-day moving average of daily closing prices is calculated as follows:
Trading day
1
2
3
4
5
6
7
8
9
10

Closing
price
25.0
26.0
25.5
24.5
26.0
26.0
26.5
26.5
26.0
27.0

Sum of five most


recent closing prices

127.0
128.0
128.5
129.5
131.0
132.0

Moving
average

25.4
25.6
25.7
29.9
26.2
26.4

Moving Average Analysis


To identify trends, technical analysts use moving averages
analysis: a 200-day moving average of daily prices (or alternatively,
30-week moving average of weekly prices) may be used to identify a
long-term trend; a 60-day moving average of daily prices may be
used to discern an intermediate term trend; a 10-day moving
average of daily prices may be used to detect a short-term trend.

Moving Average Analysis


The buy and sell signals provided by the moving average analysis are as follows:
Buy signal

Sell signal

Stock price line rises through the

Stock price lines falls through the

moving average line when the graph

moving average line when the graph

of the

of

moving average line is

flattening out.

Stock price line falls below the


Stock price line, which is above the

moving

average

line

is

flattening out.

moving average line which is rising.

the

Stock price line rises above the


moving average line which is falling.

Stock price line, which is below the

moving average line, falls but begins

moving average line, rises but begins

to

to fall again before reaching the

rise again before reaching the

moving average line.

moving average line.

MACD
A variation of the moving average is the moving average
convergence divergence, or MACD. It involves comparing a shortterm moving average, say a 50-day moving average, with a longterm moving average, say a 200-day moving average. If the shortterm moving average is consistently higher than the long-term
moving average, it is a bullish signal; if the short-term moving
average is consistently lower than the long-term moving average, it
is a bearish signal.

Relative Strength Analysis


Technical analysts measure relative strength in different ways. A
simple approach calculates rates of return and classifies securities
that have earned superior historical returns as having relative
strength. More commonly, technical analysts look at certain ratios to
judge whether a security or, for that matter, an industry has relative
strength. To illustrate how this is done, consider the price data of a
hypothetical pharmaceutical company, Acme Limited, along with the
price data for the pharmaceutical industry and the market as the
whole, given in Exhibit 16.5.

Relative Strength Analysis


Exhibit 16.5 Relative Strength Data for Acme Limited

Year

Average Average Price of Average


price of pharmaceutical price of the
Acme PA industry PPIA
market PMA

PA/PPIA

PA/PMA

PPIA/PMA

20X1

40

30

200

1.33

0.20

0.15

20x2

50

32

210

1.56

0.24

0.15

20x3

65

38

230

1.71

0.28

0.17

20x4

80

45

280

1.78

0.29

0.16

The Advance-Decline Line


The advance-decline line is also referred to as the breadth of the
market. Its measurement involves two steps:
1. Calculate the number of net advances/declines on a daily
basis.
2. Obtain the breadth of the market by cumulating daily net
advances/declines.

Breadth of Market
An illustrative calculation of the breadth of the market is shown in Exhibit 16.7.
Exhibit 16.7 Calculation of Breadth of Market
Day

Advances
Declines

Net
Breadth of
Advances or
Market
Declines
103
103

Tuesday

630

527

Wednesday

690

475

215

318(103+215)

Thrusday

746

424

322

640(318+322)

Friday

492

630

-138

502(640-138)

Monday

366

701

-335

167(502-335)

Turesday

404

698

-294

-127(167-294)

Breadth of Market Analysis


How is the breadth of market analysis used? Typically, the breadth
of market is compared with one or two market averages. Ordinarily,
the breadth of market is expected to move in tandem with a market
average. However, if there is a divergence between the two, the
technical analysts believe that it signals something. More specifically,
if the market average is moving upwards, whereas the breadth of
market is moving downwards, it indicates that the market is likely to
turn bearish. Likewise, if the market average is moving downwards
but the breadth of market is moving upwards it signals that the
market may turn bullish.

New Highs And Lows


Technical analysts consider the market as bullish when a significant
number of stocks hit the 52-week high each day. On the other hand,
if market indices rise but few stocks hit new highs, technical analysts
view this as a sign of trouble.

Volume
Volume analysis is an important part of technical analysis. Other
things being equal, a high trading volume is considered a bullish
sign. If heavy volumes are accompanied by rising prices, it is
considered even more bullish.

Short-Interest Ratio
The short interest ratio is defined as follows:

Total number of shares sold short


Average daily trading volume

A technical analyst considers a high short-interest ratio as a sign of


bullishness

Financial Astrology
From early 1990s a new breed of astrologers, call them financial astrologers
if you will, has emerged in India. They try to predict market sentiments,
share price movements, and even government policy on the basis of the
movement of stars.
Here is a sampling of what they say:
The downtrend in share prices during the past fortnight is because of a
debilitated mercury under the influence of saturn at a time when jupiter is
retrograde.
The market will stabilise by September 12 this year when jupiter enters the
kanya rasi.
According to them, nakshatras that are good for buying or selling are as
follows:

Buying
Revathi

Sathabisha
Ashwini
Shravan

Selling
Purva
phalguni
Purvashada
Kritika
Ashlesha
Bharani

Testing Technical Trading Rules


Does the trading rule produce excess return after adjusting
for risk?

Does the trading rule produce excess returns after adjusting


for transaction and other costs (like taxes)?

How consistent is the performance of the trading rule?

Is the trading rule valid outside the sample?

Evaluation of Technical Analysis


Proponents
1. Under the influence of crowd psychology, trends persist for
quite some time.
2. Shifts in demand and supply are gradual rather than
instantaneous.
3.

Fundamental information about a company is absorbed and


assimilated by the market over a period of time.

4. Charts provide a picture of what has happened in the past


and hence give a sense of volatility that can be expected from
the stock.

Evaluation of Technical Analysis


Detractors
1. Empirical evidence in support of the random-walk hypothesis
casts its shadow.
2. Ultimately, technical analysis must be a self-defeating
proposition.
3.

The numerous claims made for different chart patterns are


simply untested assertions.

4. There is a great deal of ambiguity in the identification of


configurations and patterns.