SAPM - Technical analysis

FinancialMarkets –TechnicalAnalysis

NJ Jaissy

Objective: (Module 4)Understand Technical Analysis

Chart PatternsMoving AveragesRSI / ROC /MACD

Learn of the Efficient Market Hypothesis andthe Random walk theory

References: SAPM texts byPunithavathy PandianPrassana Chandra

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Fundamental Vs. TechnicalAnalysis

Fundamental Analysis looks at analysis thestock’s ‘intrinsic value’ ( using valuationtechniques & EIC methodologies).

If intrinsic value < market price – BUY,If intrinsic > market price – SELL

Technical Analysis – Analysis only of thestock’s market price trends

BUY if the stock price shows an ‘upward’ trendSELL if the stock prices shows a downward trend

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Technical Analysis: IntroBased on the assumption that there aretrends in the market prices – upward trendshows market is on the rise & vice versa

Assumes that the markets pricesmovements incorporates all informationabout the stock and reflects sentiments ofinvestors ( hope & fear) – reflects supplyand demand of shares

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DOW Theory: AssumptionsFather of technical Analysis: Charles DowAnalyzed stock movement charts, computedmoving averages to develop the ‘DOWtheory’ ( now implemented using computers)1. Assumption 1: No single investor can influence

market trends ( only a stock trend if traded inlarge quantities)

2. Assumption 2: Market factors in everything –natural calamities, global recession etc

3. Assumption 3: Theory can only be used tounderstand market, not beat it

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Dow theoryTrend = direction of movementShare prices moves up & down in a zigzag;trend lines connect either 2 tops / bottomThere are 3 types of trends1. Primary ( upward / downward – 1 / 2 years)…

( like TIDES of the sea)2. Intermediary ( corrective movements – 1 – 3

months)…(like WAVES of the sea)3. Short term ( day to day oscillations)…RIPPLES

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Trend LinesRising trend line : BULL market

Falling Trend line : BEAR market

Prices rises, thenfalls then rises evenmore.. B2 > B1Indicates revival,growth in profitsB1

B2

Prices falls, thenrises, then falls evenmore & rises again..B2 < B1Indicates decline

B1B2

speculation

Distress selling

Decline in profit

Good profit

Loss of faith

Hope!

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Trends

Technical Analysis

Primary Trend

Intermediate / SecondaryTrend = correction ofprimary trend by 1/3 to 2/3of original gain

Bull

Bear

Minor Trends(intra day)

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Support & Resistance LevelsPrices will go up / down till there is ademand / supply correction at that priceSupport level – lowest price the stock willdrop to before rising againResistance level – highest price the stockwill rise before falling again

Resistance level

Support level

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Chart Patterns - 1Capture stock price movements over timeStock price is plotted over daysDistinct patterns based on the trend:1. V formation ( and inverted V)

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Chart Patterns - 2

2. Double top / double bottom formation

3. Head & Shoulder formation / invertedhead & shoulder

Neckline

Bear market

Bull market

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Chart Patterns - 34. Rounding bottom

5. Cup and handle

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Chart Patterns - 36. Triangles ( Symmetrical, Ascending,

Descending triangles)

Support level

Resistance level

Bull

Bear

Neutral

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INDICATORS & OSCILLATORSIndicator is a set of data points obtained byapplying a formula to the price data ( Open,close price, volume) of a stock / index.Technical indicators – used to find the overalldirection of the market.Oscillator – shows the stock price movementbetween two pointsOscillators show stock momentum &indication on a possible trend reversal

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Indicators: Volume of tradeindicates trend – bull or bear

Indicator 1: Volume; Volumes expand in a bullmarket & narrow in bear marketIndicator 2: Breadth of market : Diff betweenadvance & declines

Advances (# of shares that have risen in price)Declines (# of shares that have declined inprice) in volume

Indicator 3: Short sales ( in bear market) –selling shares that you don’t have hoping forfuture price decrease. # of short sales of amonths compared with avg daily volume forprevious month ( >1..oversold – bull trend)

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Indicator 4: Moving AveragesMoving averages = ( average of a bodyof data ( price) over time)Short term ( 10-30 days)/ medium term (50– 125 days) / long term ( 200 days) trendsof moving average studied to identifytrendsStock price moving avg. compared withindex moving avg. to identify trends

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Moving AveragesStock Price

Movingaverage

Sell

Buy

Cutting of the moving averagesSignals a trend reversal

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Types of moving averagesSimple moving average – equalweightage to each days priceExponential moving average – higherweightage to more recent prices.Moving averages are studied for ‘buy’and ‘sell’ signals.Rising moving average- rising trends anddeclining moving average -decliningtrend

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MACD ( Moving Averageconvergence & divergence

Oscillator 1: MACD= difference between 2exponential moving averagesMACD – difference between Short Term (SEMA - 12 days) & Long Term (LEMA - 26 days)exponential moving averagesMACD = SEMA - LEMA

Convergence = when the difference-> 0Divergence = when the difference-> highMACD: + = rising trendMACD: - = declining trend

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RSI- Relative Strength Index: Oscillator 2: RSI shows inherent strength or weaknessof a particular stock

RSI = 100 – 1001 + avg. daily gain

avg. daily loss

RSI avg. Gain / loss can be calculated for 9, 14 daysor more.. Higher the better.RSI >70 likely downturn – sell, RSI<30 likely upturn- buy

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ROC ( Rate of change)Oscillator 3: ROC measures rate of change betweencurrent price & price a number of days in past (could be 12days/ 12 weeks / 12 months)Used to indicate trend reversal

ROC = % change of current price vs. earlier price

ROC = Todays price * 100 - 100Price ‘n’ days ago

Current price – 210 and price 12 weeks ago – 230,ROC = 210/230 * 100 – 100= -8.69( negative sign meansdecline)

ROC plotted against time: highest peak – overboughtregion ( sell here) , lowest point – oversold region( buy here)

Overbought / oversold points indicate trend reversals

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Efficient Market TheoryIntroduced by Fama – Efficient market theorystates that stock price movements are randomand without any pattern ( unlike technical analysiswhich identifies chart patterns)This theory assumes that any information regardingthe stock will be factored into the stock prices.Higher the market efficiency, quicker will be theincorporation of future expectations / anyinformation into the stock price.Arbitrageurs look to make a quick profit in the timebefore the market prices adjust to newinformation; their actions cause the market toadjust.

Intense competition will ensure a fair price for securities in the market

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Efficient MarketsThis is a market in which market price of a securityis an unbiased estimate of its intrinsic valueThis means any deviation of market price fromintrinsic value is unbiased & random.What leads to efficient markets?

Investor rationality (investors respond rationally tonew information)Independent deviation from rationally ( even ifsome investors don’t behave rationally – this israndom & not correlated – will be net off finally)Arbitrage: Rational investors will try to exploit anyinefficiencies in the market – thereby correctingthe inefficiency.

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Random Walk TheoryIntroduced by Maurice Kendall, a statistician whostudied stock & commodity prices looking forregular cycles.He found that the security price movements arerandom and that the stock price movementsfollow a series of ‘random’ walks.At each point of time, the stock price isindependent of what it was before.The theory deals with successive changes in price(looks at absolute price delta for that security notrelative to other securities price delta)

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Random Walk & EfficientMarkets

Academicians state that the randomness ofstock prices is the result of the efficientmarket. i.e.:

All information is freely & quickly available to allmarket participantsKeen competition ensures that in time themarket prices will reflect ‘intrinsic values’Prices change only in response to newinformationNew information cannot be predicted so pricescannot be forecast & hence prices behave likea ‘random walk’

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Sem

Three forms of efficient markethypothesis

Efficient Market Hypothesis

Weak formefficiency

Semi strong form efficiency

Strong form efficiency

Security pricesfactor in all securitymarket info

Security prices factorin all public marketinfo as well as nonmarket info

Security prices factorin all available info –pubic & private

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Stock price factors in thefollowing info:

Weak Market HypothesisAll security market info: prices, trading volumes,rate of return, insider transactions, block trades,odd lot transactions

Semi Strong Market HypothesisAll public info– market & non market: macro-economic data, industry reports, corporateannouncements, P:E ratio, div yield

Strong Market HypothesisAll available info – public & private. Assumes thatno investor has monopolistic access to info thatwould lead to higher risk adjusted returns.

This means no one can getter returns than the market using info!

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Contradiction to concept of‘efficient markets’1. Over reactions of the market – Stock

prices decline dramatically after badresults - and take time to come to‘normal’ – during which time investorcan buy at low rates & sell at high ratesmaking abnormal profit – againstefficient market theory

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Contradiction to concept of‘efficient markets’2. Stock price will go back to ‘average’

return after low or high returns – therebygiving an investor a chance to ‘predict’price : against random walk theory

3. Delayed adjustment to new information:stock prices tend to continue to rise /decline for some time after corporateannouncements are positive / negative.

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Contradiction to concept of‘efficient markets’4. Small firm: A theory that says small firms give

better returns than large firms – confirmed bya study done on the NYSE

5. Weekend effect: Stock prices tend to rise allweek reaching a peak on Friday. So it makessense to buy on Monday and sell on Friday –the ‘weekend’ effect contradicts theefficient market hypothesis

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