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Technical Analysis
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Meaning:
• Study of market generated data like price and
volume to determine the future direction of price
movement.
• A study of past or historical price and volume
movement so as to predict the future stocks
price behavior.
• Forecasting techniques that utilize historical share
price data.
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• Technical analysts believe that past patterns of market
action will recur in the future and that past patterns can
be used for predictive purposes.
• Some of the tools used by chartists to measure supply
and demand and to forecast security prices are the Dow
theory chart, odd-lot theory, confidence index,
breadth-of-market indicators, relative-strength
analysis, and trading-volume data.
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Assumptions/basic principles/premises of technical analysis
Market prices are determined by the interactions of
supply and demand forces.
Supply and demand are influenced by variety of
factors, both rational and irrational. Includes
fundamentals as well as psychological factors.
Shift in demand & supply bring about changes in
trends.
Shift in demand & supply detected with the help of
charts of market action.
Analysis of past market data can be used to predict
the future price behavior.
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Difference between Fundamental & Technical Analysis
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THEORIES OF TECHNICAL ANALYSIS
•Dow theory
• Elliot wave theory
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Dow theory
• Charles .H. Dow
• Editor of wall street journal, in USA
• Popularly known as Theory of
Technical analysis
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According to Charles .H. Dow
• “ The market is always considered as having
three movements, all going at the same time.
The first is the narrow movement from day to
day. The second is the short swing,
running from two weeks to a month or
more; the third is the main movement
covering at least four years in its
duration”
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• The Dow theory is used to indicate reversals and trends in the market as a whole or in individual securities.
• According to the theory, there are three movements going on in the markets at all times:
1. daily fluctuations (the narrow movement from day-to-day)
2. secondary movements (short-run movements over two weeks to a month or more)
3. primary trends, major movements covering at least four years in duration
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• Dow formulated a hypothesis is that the
stock market does not move on a
random basis but is influenced by three
distinctive cyclical trends that guides its
direction.
1)Primary / main movements
2)Secondary reaction / correction
movement
3)Minor / narrow movements
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According to Dow theory
• Price movements in the market can be
identified by means of line chart.
• In the line chart, closing price of shares or the closing value of the market index may be plotted against the corresponding trading day.
• The charts helps in identifying the primary,
secondary and minor movements.
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* Primary or main movements /trend
• Long range cycle that carries the entire market up
or down long term trend in the market.
* Secondary reaction or correction movement/trend
• These are the opposite direction to the primary
movements
• Only for a short period• Eg:- when the market is moving upward continuously,
this upward movement will be interrupted by downward movement of short duration.
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Minor or Narrow movements/trend
Day today fluctuations in the market
Not significant & have no analytical
value
Very short duration
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THREE MOVEMENTS
• Primary movements – Tides
• Secondary/ correction movements –
Waves
• Minor/ Narrow movements – Ripples
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Trend
• Trend is the direction of movement.
• Share price can either increase, decrease or remain in flat.
• The three directions :
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• Share price do not rise or fall in a straight
line.
• Every rise or fall in price experience a
counter moves
• Share price move in a zigzag manner.
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Trend lines
• Straight line drawn connecting either
the top or bottom of the price
movement
• To draw a trend line, the technical
analyst should have at lest two tops
or bottoms.
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(1) Rising/up trend
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(2) Falling/down trend
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(3) Flat trend
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Trend Reversal
• Changes in the direction of trend is referred to
as trend reversal.
• A share that exhibits a rising trend may start to
move narrowly or fall after some times, this change
in the direction of movement represent trend
reversal.
• Technical analyst tries to identify the trend reversal
at an early stage so as to trade profitably.
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• When the trend begins to rise the
technical analyst would recommend
purchase of the shares.
• When the trend begins to fall, sale is
indicated.
• During a flat trend the investor should stay
away from the market.
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Trend Reversal
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Elliot wave theory
• Ralph Elliot
• Theory was formulated in 1934
• After analyzing 75 years of stock market
price movements and charts.
• According to this theory – market movement
was quite orderly and followed a patter of
waves.
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According to this theory
• The market moves in waves
(A wave is a movement of the stock price from
one change in the direction to the next change in
the same direction. Depending on the demand &
supply pressure waves are generated)
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According to this theory
• A movement in a particular direction can be
represented by five distinctive waves.
• Of these five waves, three waves are in the
direction of the movement & are called impulse
waves.
• Two waves are against the direction of the
movement & are termed as corrective waves or
reaction waves
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Graph
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Graph
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Graph
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• Waves 1,3 & 5 are the impulsive waves
• 2 & 4 are the corrective waves
• The wave 1 is upwards and wave 2 correct
the wave 1.
• Waves 3 & 5 are impulsive and 4 corrects
wave 3
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• Correction involves correcting the earlier rise
• Wave 2 would correct the rise of wave 1
• Wave 4 would correct the rise of wave 3 & after
the completion of wave 5, there would come a
correction which would be labeled ABC
• This correction would be in three waves in
which the waves ‘A & C’ will be against
the trend and wave ‘B’ will be along the
trend.
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• The ABC correction following the fifth wave would correct the entire rise from the starting of wave 1 to the end of the fifth wave.
• One complete cycle consist of waves made up of two distinctive phases, bullish & bearish. One full cycle of waves is completed after the termination of 8 waves movement, there will be a fresh cycle started.
• The theory is used for predicting the future price changes & in deciding the timing of investment.
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Support and Resistance Level
• Support and resistance define natural boundaries for rising and falling prices.
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Support and Resistance Level
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Support Level
• Level that the technical analyst believes a stock price will not fall below. Some times called “Floor”.
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Resistance Level
• Opposite of support level.• Technical analyst believe that stock
price will not exceed.
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Breakout
• The security price moves out of the
previous trading range (breaching the
resistance or support level)
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BREADTH OF THE MARKET• Term used to study the advance and decline that
have occurred in the stock market.
• Advance means – Number of shares whose
prices have increased from the previous day’s
trading.
• Decline means – Number of shares whose prices
have fallen from the previous day’s trading.
• The net difference between the number of
stock advanced & declined during the same
period is the breadth of the market.
• A cumulative index of net differences measure
the market breadth.
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BREADTH OF THE MARKETDay advance decline Net Breadth
21-02-12 1486 774 712 712
22-02-12 1310 966 344 1056
23-02-12 898 1225 -327 729
24-02-12 1108 1091 17 746
25-02-12 931 1279 -348 398
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Types of charts
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Types of charts
• Line Chart
• Bar Charts
• Candlestick Charts
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Line Chart
The most basic of the four charts – because it represents only the
closing prices over a set period of time.
The line is formed by connecting the closing prices over the time
frame.
Do not provide visual information of the trading range for the
individual points such as the high, low and opening prices.
The closing price is often considered to be the most important price in
stock data compared to the high and low for the day and this is why it
is the only value used in line charts.
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Line Chart
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Bar Charts
• The chart is made up of a series of vertical lines
that represent each data point. This vertical line
represents the high and low for the trading period,
along with the closing price.
• The close and open are represented on the vertical
line by a horizontal dash.
• The opening price on a bar chart is illustrated by the
dash that is located on the left side of the vertical
bar.
• Conversely, the close is represented by the dash on
the right.
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Bar Charts
• Generally, if the left dash (open) is lower than the
right dash (close) then the bar will be shaded
black, representing an up period for the stock,
which means it has gained value.
• A bar that is colored red signals that the stock
has gone down in value over that period. When
this is the case, the dash on the right (close) is
lower than the dash on the left (open).
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Bar Charts
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Candlestick Charts
• Similar to a bar chart, but it differs in the way that it is visually constructed.
• The difference comes in the formation of a wide bar on the vertical line, which
illustrates the difference between the open and close. And, like bar charts,
candlesticks also rely heavily on the use of colors to explain what has happened
during the trading period.
• There are two color constructs for days up and one for days that the price falls.
• When the price of the stock is up and closes above the opening trade, the
candlestick will usually be white or clear.
• If the stock has traded down for the period, then the candlestick will usually be
red or black, depending on the site.
• If the stock's price has closed above the previous day's close but below the day's
open, the candlestick will be black or filled with the color that is used to indicate
an up day
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Candlestick Charts
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oscillators
• Mathematical indicators calculated with the help of the closing price data.
• Helps to identify overbought and over sold conditions of the scrip.
• Helps to identify possibility of trend
reversal.
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oscillators
• RSI (Relative Strength Index)
• ROC (Rate of Change Indicator)
• MACD (Moving Average
Convergence/Divergence)
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RSI (Relative Strength Index)
RSI = 100 – 100 (1+RS)
RS = Average gain per day Average loss per day
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• Most commonly used time period for the
calculation of RSI is 14 days.
• RSI value ranging from 0 – 100
• RSI value above 70 are considered to denote
overbought condition.
• RSI value below 30 considered to denote oversold
condition.
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RSI Chart
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ROC (Rate of Change Indicator)
• ROC measures the rate of change of the current price as compared to the price a certain number of days or weeks back.
• ROC = Current price - 1
price ‘n’ period ago
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ROC (Rate of Change Indicator)
• Value may be +ve,-ve or zero
• When the ROC line is above the zero
line, the price is rising & when it is
below zero line ,the price is falling.
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MACD (Moving Average Convergence Divergence)
• Short term & long term exponential
moving average are calculated with the
help of closing price data.
• A 12 day & 48 day exponential moving
average are popular combination
• Difference between short term & long term
EMA represent MACD
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MACD (Moving Average Convergence Divergence)
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MACD (Moving Average Convergence Divergence)
• MACD line (blue line): difference between the 12 and 26 days
EMAs
• signal (red line): 9 day EMA of the blue line
• histogram (bar graph): difference between the blue and red lines
Mathematically:
• MACD = [stockPrices,12]EMA - [stockPrices,26]EMA
• signal = [MACD,9]EMA
• histogram = MACD – signal
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ODD - LOT
• Shares are generally sold in a lot of hundreds
• Shares are sold in smaller lots fewer than 100 are called odd lot.
• Buyers & sellers of odd lots are called odd lotters.
• Odd lot purchases to odd lot sales ( purchase %) is the odd lot
index.
( Odd lot purchases divided by odd lot sales)
• Increases the odd lot purchases results in an increase in the index.
(selling leads to fall the index)
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Random walk theory
• Basic assumption of technical analyst is that price trends
occur in an orderly manner & not random.
• Random walk theory gained popularity in 1973 when
Burton Malkiel wrote "A Random Walk Down Wall
Street", a book that is now regarded as an investment
classic.
• Theory that states that the past movement or
direction of the price of a stock or overall market
cannot be used to predict its future movement.
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Random walk theory
• Random walk theory states that market price evolve at random and do
not follow any regular pattern.
• According to this theory future stock price
are completely independent of past stock
prices.
• The Random Walk Hypothesis is a financial theory stating that stock
market prices evolve according to a random walk and thus the prices of
the stock market cannot be predicted by analyzing the past stock prices.
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Assumption of Random walk theory
Market is supreme and no investor or group can influence
it.
Stock price discount all information quickly.
Markets are efficient and that the flow of information is
free and unbiased.
All investors have free access to the same information and
nobody has superior knowledge or expertise.
Market quickly adjusts itself to any deviations from
equilibrium level due to the operations of free forces of
demand and supply.
Nobody has better knowledge or insider information.
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Efficient market hypothesis
• Hypothesis states that the capital market is efficient in
processing information.
• Efficient capital market is one in which security prices equal
their intrinsic value at all time, and where most securities
are correctly priced.
• According to Elton and Gruber,” when some one refers to
efficient capital markets, they mean that securities prices
fully reflect all available information”
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Forms of market efficiency
• There are three forms of the efficient market hypothesis
• The "Weak" form asserts that all past market prices and data
are fully reflected in securities prices. In other words, technical
analysis is of no use.
• The "Semi strong" form asserts that all publicly available
information is fully reflected in securities prices. In other words,
fundamental analysis is of no use.
• The "Strong" form asserts that all information is fully
reflected in securities prices. In other words, even insider
information is of no use.
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The EMH Graphically• In this diagram, the circles
represent the amount of
information that each form of
the EMH includes.
• Note that the weak form
covers the least amount of
information, and the strong
form covers all information.
• Also note that each
successive form includes the
previous ones.
Strong Form
Semi-Strong
Weak Form
All information, public and private All public information
All historical prices and returns
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Assumptions Of Efficient Market Hypothesis
• Information is free and quick to flow
• All investors have the same access to information.
• Every investor has access to lending and borrowing at
the same rate.
• Market absorbs the information quickly and the market
responds to new technology, new trends, change the
tastes, etc efficiently and quickly.
• Investors are rational and behave in a cost effective
competitive manner for optimization of returns