Technical Analysis
Technical Analysis guides to pick a stock at right price and at right time. |
| Tecnical Analysis |
People advocating technical analysis hold that all factors influencing price that fundamental traders are using already is reflected in stock prices and that fundamental analysis therefore is not effective. Fundamental economic estimations of growth and profit margin are moreover far to uncertain. It is people that are buying and selling, and that is why the price will reflect human psyche, at least in the short run.
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| Technical Analysis |
Technical Analysis is an approach that uses information of past stock behavior in order to forecast future price movements. Within the technical analysis community there exists several schools with different techniques, but they all have in common that they use price and volume history. A basic thought is that it takes time before the market reacts upon new information and that pattern often occur in price behavior which makes forecasting possible.
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| Technical Analysis |
Rationale of technical analysis
1. The
market price of security is determined solely by supply and demand. Any shift
in the supply and demand relationship can be detected sooner or later in the
action of the market.
2. The
study of prices gives one a feel of direction of price movement.
3. Technical
analysis helps traders and investors alike to review their investment decisions
faster.
4. Technical
analysis brings to bear systematic and often disciplined approach to the
investment process.
5. Technical
analysis often gives an advance signal of an impending reversal in the markets.
Pitfalls of Technical Analysis
1.
Technical analysis is not an exact science. It is the
study of a dynamic situation and we must therefore continuously review your
decision in the light of Fresh price action.
2.
The Basis of technical analysis may be easy to learn
but the nuances are difficult to implement and master.
Charts:
1. On
the basis of time frame------
·
Daily charts: Shows day’s open, high, low and
closing prices.
·
Weekly charts: Shows week’s open, high, low and
closing prices.
·
Monthly charts: Shows month’s open, high, low
and closing prices.
2. On
the basis price depiction------
·
Line
chart: Only the closing price of each day is plotted.
·
Bar chart:
Only the open, high, low and closing prices are plotted.
·
Candle
stick: Only the open, high, low and closing prices are plotted in the form
of Japanese candle stick.
Trend:
A trend
indicates that there exists an inequality between the forces of supply and
demand.
·
If supply is more than demand, the trend will be
down..
·
If demand exceeds supply, the trend will be up.
·
If demand and supply are nearly equal , the
market will move side ways – what we call it as range.
A trend
may thus be considered as a phase in a markets movement when prices are going in
a particular direction.
Types of trends:
§ Rising
trend: Prices make higher highs and higher lows.
§ Falling
trend: Prices make lower highs and lower lows.
Correction:
The
term correction doesn’t necessarily mean falling prices. It simply means a
smaller price move which is counter, i.e. opposite to the prevailing trend.
Trend reversal:
When the
basic and necessary condition defining a trend is invalidated, it is a signal
of trend reversal.
·
When, after consistently making higher highs and
higher lows in an ongoing rising trend, the market index or a stock as the case
may be, makes a lower high and lower low formation, the uptrend is said to have
reversed direction into a down trend.
·
In rising trend, a traders strategy would be to buy
stocks on any price falls (corrections), and then wait for price to resume its
up trend.
·
Conversely, when the main trend is down, a
traders strategy would be to exit stocks on price rises (correction) and wait
for lower prices to re-enter ino the market.
Trend Lines:
·
To depict an uptrend, a trend line has to be
drawn on a price chart by joining the successive higher lows being formed.,
because higher lows being a condition of uptrend.
·
To depict a down trend, a trend line has to be
drawn by joining the successive a lower highs being formed, because lower highs
being a condition of a down trend.
ü Support line:
A trend line formed by joining
the higher lows of an uptrend is a supporting line.
Prices are likely to find
buying support in the vicinity or around, a support trend line.
ü Resistance line:
A trend
line formed by joining the lower highs of a down trend is a resistance line.
Prices are likely to find
selling pressure in the vicinity or around, a resistance line.
§ Price – Volume relationship:
Any price move supported
with higher or increasing volumes is a suggestive of a strong trend.
§ Rising
prices along with rising volumes is a bullish.
§ Rising
prices along with falling volumes is a bearish.
Any price move which is not supported by a volume expansion is
suggestive of a weak trend.
Rising
§ Rising
prices accompanied by falling volumes is a potentially bearish sign.
§ Falling
prices accompanied by falling volumes is a potentially bullish sign.
Line Chart of Closing prices
ü
Bar chart
is the most popular chart used where in the highest price, the lowest price and
the closing price of each day are plotted on a day to day basis. A bar is
formed by joining the highest price and lowest price of a particular day by a
vertical line. The top of the bar represents the highest price of the day, the
bottom of the bar represents the lowest price of the day and a small horizontal
hash on the right of the bar represents the closing price of the day. Some
times opening price of the day is marked as hash on the left side of the bar. A
price bar char is illustrated below:
Price bar chart
ü
Japanese
candlestick charts shows the highest price, the lowest price, the
opening price and the closing price of the shares on a day to day basis.
§
The highest price and the lowest price of a day
are joined by a vertical bar.
§
The opening price and closing price of the day
which would fall between the highest and the lowest prices would be represented
by a rectangle so that the price bar char looks like a candlestick.
There are mainly three types
of candlesticks:
-
The white candlestick used to represent the situation
where the closing price of the day is
higher than the opening price. It indicates a bullish trend.
-
The black candlestick is used when the closing price of
the day is lower than the opening price. It indicates the bearish trend.
-
The doji or neutral candlestick is one where the
opening price and the closing price of the day are same.
Japanese candle stick chart
is illustrated below:
Japanese
Candlesticks
Chart Patterns:
When the price bar charts of
several days are drawn close together certain patterns emerge. These patterns
are used by the technical analysts to identify trend reversal and predict the
future movement of prices. The chart patterns may be classified as
ü
Support and resistance patterns are price levels
at which the downtrend or uptrend in price movements is reversed.
ü
Support occurs when price is falling but
bounces back or reverses
direction
every time it reaches a particular level. When all these low points are
connected by a horizontal line, it forms the support line. In other words,
support level is the price level at which sufficient buying pressure
is exerted to halt the fall in prices.
ü
Resistance occurs when the share price
moves upwards and the price
may fall back every
time it reaches a particular level. A horizontal line joining these tops forms
the resistance level. Thus, resistance level is the price level where sufficient
selling pressure is exerted to halt the ongoing rise in the price of a
share.
The following figure illustrates support and
resistance level:
Support and
Resistance levels
If the scrip were to break the
support level and move downwards, it has bearish implications signaling the
possibility of a further fall in prices. Similarly, if the scrip were to
penetrate the resistance level it would be indicative of a bullish trend or
further rise in prices.
ü
Reversal
patterns are chart formations that tend to signal a change in direction of the
earlier trend. Price movements exhibit uptrends and down trends. The trends reverse direction
after a period of time. These reversals can be identified with the help of
certain chart formations that typically occur during these trend reversals.
§
Head and shoulder formation is the most popular
reversal pattern
which usually occurs at the end of long
uptrend. This formation
exhibits a hump or top followed by a still
higher top or peak and then
another hump or lower top. This formation
resembles the head and
the two shoulders of a man and hence the
name head and shoulder
formation.
ü
The first hump, known as left shoulder- when
the prices reach the top
under a strong buying impulse. Then
trading volume becomes less and
there is a short downward swing.
ü
This is followed be another high volume
advance, which takes the
price to a higher top known as
head. This is followed by another
reaction on less volume which takes the
price down to a bottom near
to the earlier downswing.
ü
A third rally now occurs taking the price to a
height less than the
head but comparable to the left shoulder
resulting in the formation
of right shoulder.
ü
A
horizontal line joining the bottoms of this formation known a the
neckline.
The head and shoulder formation
usually occurs at the end of a
bull phase and is indicative of reversal
trend. After breaking the
neckline, the price is expected to decline
sharply. Following figure
illustrates the head and shoulder
formation:
Head and shoulder
Formation
§
Inverse head and shoulder formation is the
reverse of head and shoulder formation and is really an inverted head and
shoulder pattern.
ü
The first bottom is the left shoulder
ü
Then comes a lower head
ü
Followed by a third bottom which is termed the
right shoulder?
ü
The neckline is drawn by joining the tops from
which the head and the right shoulder originate. When the price raises above
the neckline the formation of the pattern is completed.
This pattern occurs at the
end of a bear phase and indicative of
an oncoming bullish phase.
Inverse head and
shoulder pattern
§
Other reversal patterns are double top
formation, triple top formation,
double bottom
formation, triple bottom formation, etc.,
ü
Continuation patterns are formed during side
way movements of share
price because they indicate a continuation of
the trend prevailing
before the formation of the pattern.
§
Triangle formation is formed when the price
movements result in two or
more consecutive descending tops and two or
more consecutive ascending bottoms.
ü
The triangle becomes more apparent on the chart
when the consecutive
tops are joined
by a straight line and the consecutive bottoms are joined be another straight
line.
ü
The two straight lines are the upper trend and
the lower trend line
respectively.
The triangle formation may
occur during a bull phase or a bull phase. In
either case it would indicate
a continuation of the trend.
Triangle formation
ü
Flags formation looks like a parallelogram with
the two trend lines
Forming two
parallel lines. The volume of trading is expected to fall during the formation
of the flag and again pick up on breaking out from the pattern. It is
illustrated in the following graph:
Flag formation
§
Pennants formation looks like a symmetrical
triangle.
ü
The upper trend line formed by connecting the
tops stoops downwards.
ü
Whereas the lower trendline formed by connecting
the bottoms rises
Upwards.
Pennant formation
According to Dow Theory, the market
has three movements and these movements are simultaneous in nature. These movements
are:
ü
The primary movement is the long range cycle
that carries the entire market up or down and is the long term trend in the
market.
ü
The secondary reactions act as a restraining
force on the primary movement because these are in opposite direction to them
and last only for a short while. These are also called corrections
ü
The minor movements are the day-to-day
fluctuations in the market. These movements are not significant and have no
analytical value as they are of very short duration.
The price movements in the market can
be identified be means of a line chart in which the closing prices of shares or
the closing values of the market index may be plotted against the corresponding
trading days. The chart would help in identifying the primary and secondary
movements. This is illustrated in the following line chart:
Primary trend and
Secondary Reactions
From the above line chart it is clear that
the primary trend of the market is upwards, but the secondary reactions in the
opposite direction.
Bullish
trend:
ü
The First phase - the prices would advance with
the revival of
confidence in the future of business and
the future prospects of the
business would be perceived to be
promising which makes investors
to buy shares in the companies.
ü
The Second phase - the prices would advance due
to improvements in
corporate earnings.
ü
The Third
phase - the prices advance due to inflation and
speculation.
The three phases are shown in the
following graph:
Three phases in bull market
The line chart exhibits three
peaks. Each peak would be higher than the previous peak; each successive bottom
would be higher than the previous bottom. The formation of higher bottoms and
higher tops indicates a bullish trend.
Bearish
trend:
ü
The First phase
- the prices begin to fall due to abandonment of hopes. Investors begin to sell their shares.
ü
The Second phase - the prices fall due to
increased selling pressure.
ü
The Final phase - the prices fall still further due to
distress selling.
The three phases of a bear market
are shown in following line chart:
Three phases of bear market
A bearish market would
be indicated by the formation of lower tops and lower bottoms.
Further the Dow Theory
laid emphasis on volume of transactions. According to the theory volume should
expand along the main trend. This implies that if the main trend is bullish, the volume should increase with the rise in prices and
fall during the intermediate reactions. In a bearish market when prices are falling, the volume should increase with
the fall prices and be smaller during the intermediate reactions.
The theory also makes
certain assumptions referred to as the hypothesis of the theory:
ü
The first hypothesis states that the primary trend cannot be manipulated. It means that no single individual or institution
or group of individuals and institutions can exert influence on the major trend
of the market.
ü
The second hypothesis states that the averages discount everything. It means that
daily prices reflect the aggregate judgement and emotions of all stock
participants.
ü
The third hypothesis states that the theory is not infallible. The theory is
concerned with the trend of the market and has no forecasting value as regards
the duration or the likely price targets for the peak or bottom of the bull and
bear markets.
Market Indicators:
Technical analysis focuses
attention not only on individual stock price behaviour, but also on the general
trend of the market. Indicators used to study the trend of the market as whole
are known as market indicators. Some of them are as follows:
ü
Breadth of the market: by comparing the number
of shares which advanced the number of shares that declined during a period,
the trend of the market can be ascertained. Comparison of advances and declines
is a leans of measuring the dispersion or breadth of a general price rise or
decline. The difference between the advances
and declines is call Breadth of the
market.
ü
Short
interest: A speculator often resorts to short selling which is selling a
share that is not owned be the person. This is done when the speculator feels
that the price of the stock will fall in future. He hopes to purchase the share
at a later date below the selling price and reap a profit. The volume of short
sales in the market can be used as a market indicator. As a technical
indicator, short selling is called short
interest. The expectation is that short sellers must eventually
cover their positions, this buying activity increases the demand for stocks.
ü
Odd-lot
Index: Small investors are presumed to buy smaller number of shares than
the normal trading lot of 100 shares. These are known as odd lots and the
buyers and sellers of odd lots are called odd lotters. An odd-lot index can be
calculated by relating odd-lot purchases to odd-lot sales.
Odd-lot index =
Odd-lot purchases
Odd-lot sales
An
increase in index - suggests more buying activity.
A
decrease in index - suggests more selling activity.
Mathematical
Indicators:
Share prices
do rise or fall in straight lines. The movements
are erratic. This makes it
difficult for the analyst to gauge the underlying
trend. He can use the
mathematical tool of
Ø
Moving averages are the mathematical indicators
of the underlying trend
of the price
movement. Two types of moving average are commonly used by the analysts are as
follows:
ü
Simple Moving Average calculates a set of
averages for a specific number
of days, each
average being calculated be including a new price and excluding an old price.
ü
Exponential Moving Average(EMA) is calculated by
using the following
formula:
EMA = (Current closing price-Previous
EMA)* Factor+Previous EMA
Note: Factor =
2
n+1
Ø
Oscillators are calculated with the help of
closing price data which helps to identify overbought and oversold conditions
and also the possibility of trend reversals. These indicators are called
oscillators because they move across a reference point. They are of two types:
ü
Rate of Change
Indicator measures the rate of change of current price as compared to the price
a certain number of days or weeks back. To calculate a ‘n’ day rate of change:
ROC = Current
price - 1
Price ‘n’ period ago
ü
Relative Strength
Index is a powerful indicator that signals buying and selling
opportunities ahead of the market. RSI for a share is calculated by using the
following formula:
RSI =100-[100/ (1+RS)]
Note: RS = Avg. gain per day
Avg. loss per day
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