technical analysis

Vipin k, Asst Prof. VJIM 1

Technical Analysis


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.


• 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.


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.



Difference between Fundamental & Technical Analysis



THEORIES OF TECHNICAL ANALYSIS

•Dow theory

• Elliot wave theory


Dow theory

• Charles .H. Dow

• Editor of wall street journal, in USA

• Popularly known as Theory of

Technical analysis


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”


• 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


• 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


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.


* 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.



Minor or Narrow movements/trend

Day today fluctuations in the market

Not significant & have no analytical

value

Very short duration


THREE MOVEMENTS

• Primary movements – Tides

• Secondary/ correction movements –

Waves

• Minor/ Narrow movements – Ripples


Trend

• Trend is the direction of movement.

• Share price can either increase, decrease or remain in flat.

• The three directions :


• 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.


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.


(1) Rising/up trend


(2) Falling/down trend


(3) Flat trend


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.


• 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.


Trend Reversal


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.


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)



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


Graph


Graph


Graph


• 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


• 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.


• 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.


Support and Resistance Level

• Support and resistance define natural boundaries for rising and falling prices.


Support and Resistance Level


Support Level

• Level that the technical analyst believes a stock price will not fall below. Some times called “Floor”.


Resistance Level

• Opposite of support level.• Technical analyst believe that stock

price will not exceed.


Breakout

• The security price moves out of the

previous trading range (breaching the

resistance or support level)


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.


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


Types of charts


Types of charts

• Line Chart

• Bar Charts

• Candlestick Charts


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.


Line Chart


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.


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).


Bar Charts


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


Candlestick Charts


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.


oscillators

• RSI (Relative Strength Index)

• ROC (Rate of Change Indicator)

• MACD (Moving Average

Convergence/Divergence)


RSI (Relative Strength Index)

RSI = 100 – 100 (1+RS)

RS = Average gain per day Average loss per day


• 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.


RSI Chart


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


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.


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





• 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


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)


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.


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.


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.


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”


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.


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


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

Economy & Finance

technical analysis