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Technical analysis - By Sohan Khatri

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An overview of technical analysis and its common techniques (Candlestick , MACD, Parabolic SAR, RSI, Bolinger Bands etc) - given to brokers and managers of Nepal Derivative Exchange (NDEX) by Mr. …

An overview of technical analysis and its common techniques (Candlestick , MACD, Parabolic SAR, RSI, Bolinger Bands etc) - given to brokers and managers of Nepal Derivative Exchange (NDEX) by Mr. Sohan Khatri (Resource person - Management Association of Nepal, Adjunct Faculty - Ace Institute of Management, Kathmandu College of Management)

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  • 1. Learn | Consult | Research Technical Analysis A peek into the world of psychology and charts By: Sohan Babu Khatri CEO- Three H Management Director- Grand Bank Nepal Ltd. Director – Strategic Center for Disaster Risk Reduction Adjuct Faculty - Ace Institute of Management Adjunct Faculty – Kathmandu College of Management Session Delivered For: Nepal Derivative Exchange (NDEX) Organized by: Management Association of Nepal (MAN)
  • 2. Types of Analysis Types of Analysis Fundamental Technical Random
  • 3. Fundamental Analysis • Find out the basics and fundamentals behind the value/price of the security • Fundamental analysis involves economic, industry, and company analysis that lead to valuation • Finding out intrinsic value on the basis of fundamentals • Comparing intrinsic value with the market value • Taking Buy/Sell/Hold decision on the basis of difference between intrinsic and market value.
  • 4. Technical Analysis • Method of evaluating securities by analyzing statistics generated by – Market activity – Past Prices – Volume • Technical analysis involves the development of trading rules based on past price and volume data for individual securities and the overall capital market. • Doesn’t attempt to measure intrinsic value • Instead look for patterns and indicators on charts to determine future performance
  • 5. ………. Technicians believe that securities move in very predictable trends and patterns Trends continue until something happens to change the trend Until that change takes place, price levels are predictable
  • 6. ………. • Most agree that technical analysis is much more effective when combined with fundamental analysis • Technical analysis is, perhaps, the oldest form of security analysis. It is believed that the first technical analysis occurred in 17th century Japan, where analysts used charts to plot price changes in rice. • Indeed, many present-day Japanese analysts still rely on technical analysis to forecast prices in their stock exchange, which is the second largest in the world. In the United States, technical analysis has been used for more than 100 years
  • 7. ……. • Technical analysis assumes that market psychology influences trading in a way that enables predicting when the price will rise or fall. • Technical analysis works best when market has some form of inefficiency.
  • 8. Assumptions of Tech. Analysis • The market value of any good or service is determined solely by the interaction of supply and demand. • Supply and demand are governed by numerous rational and irrational factors. Included in these factors are those economic variables relied on by the fundamental analyst as well as opinions, moods, and guesses. The market weighs all these factors continually and automatically. • Disregarding minor fluctuations, the prices for individual securities and the overall value of the market tend to move in trends, which persist for appreciable lengths of time. • Prevailing trends change in reaction to shifts in supply and demand relationships. These shifts, no matter why they occur, can be detected sooner or later in the action of the market itself
  • 9. Technical Analysis and Price Equilibrium Technical analysts look for the beginning of a movement from one equilibrium value to a new equilibrium value. Technical analysts do not attempt to predict the new equilibrium value. They look for the start of a change so that they can get on the bandwagon early and benefit from the move to the new equilibrium by buying if the trend is up or selling if the trend is down.
  • 10. Efficient Market • An efficient capital market is one in which security prices adjust rapidly to the arrival of new information and, therefore, the current prices of securities reflect all information about the security. • To be absolutely correct, this is referred to as an informationally efficient market.
  • 11. Efficient Market Hypothesis (EMH)
  • 12. MARKET EFFICIENCY AND SECURITY SELECTION LEVEL OF APPROACH TECHNICAL FUNDAMENTAL RANDOM EFFICIENCY ANALYSIS ANALYSIS SELECTION INEFFICIENCY BEST POOR POOR WEAK-FORM POOR BEST POOR EFFICIENCY SEMI-STRONG-FORM EFFICIENCY POOR GOOD FAIR STRONG-FORM EFFICIENCY POOR FAIR BEST
  • 13. Challenges of Technical Analysis • Challenges to basic assumptions – Empirical tests of Efficient Market Hypothesis (EMH) show that prices do not move in trends • Challenges to technical trading rules – Rules that worked in the past may not be repeated – Patterns may become self-fulfilling prophecies – A successful rule will gain followers and become less successful – Rules all require subjective judgment
  • 14. Advantages of Technical Analysis • Unlike fundamental analysis, technical analysis is not heavily dependent on financial accounting statements – Problems with accounting statements: • Lack information needed by security analysts • Many psychological and other non-quantifiable factors do not show up in financial statements • Fundamental analyst must process new information and quickly determine a new intrinsic value, but technical analyst merely has to recognize a movement to a new equilibrium • Technicians trade when a move to a new equilibrium is underway but a fundamental analyst finds undervalued securities that may not adjust to “correct” prices as quickly
  • 15. Indicators and Trading Rules
  • 16. Primary and Secondary Trend Primary Trend Called “the tide” by Dow, this is the trend that defines the long-term direction (up to several years). Others have called this a “secular” bull or bear market. Secondary Trend Called “the waves” by Dow, this is shorter-term departures from the primary trend (weeks to months)
  • 17. Trend Duration • Trend duration is also made up of three time periods; major, intermediate and minor. • The major trend will have a duration of six to eight months or longer and is best illustrated by weekly and monthly bar charts. • Within the major trend significant corrections or reversals of trend will be present; these would be intermediate and minor trends within the major trend. • The intermediate trend lasts from three weeks to three months, and the minor trend is anything less, from two to three weeks in duration.
  • 18. Price, Volume and Open Interest Price Volume Open Interest Interpretation Rising Rising Rising Market is Strong Rising Falling Falling Market is Weakening Falling Rising Rising Market is Weak Falling Falling Falling Market is Strengthening
  • 19. The Elliot Wave Principle 1 2 3 4 5 A B C Elliot believed that the market has a rhythmic regularity that can be used to predict future prices. The Elliot Wave Principle is based on a repeating 8-wave cycle, and each cycle is made up of similar shorter-term cycles (“Big fleas have little fleas upon their backs to bite 'em - little fleas have smaller fleas and so on ad infinitem”).
  • 20. Basic Types of Charts (OHLC) • Bar Chart • Line Chart • Candle Stick Chart • Point and Figure Chart
  • 21. Bar Chart Bar Charts A bar chart also shows closing prices, while simultaneously showing opening prices, as well as the highs and lows. Advantage is that it show the high, low, open and close for each day
  • 22. Drawing Point & Figure Charts • Point & Figure charts are independent of time. • An X represents an up move. • An O represents a down move. • The Box Size is the number of points needed to make an X or O. • The Reversal is the price change needed to recognize a change in direction. • Typically, P&F charts use a 1-point box and a 3-point reversal. X X X X X O O X X X X O O O O • Typically used for intraday charting • If used for multi-day study, only closing prices will be used
  • 23. Line Chart A simple line chart draws a line from one closing price to the next closing price.
  • 24. Support and Resistance • Support and resistance are tools used by technicians to help them identify and follow price trends. Horizontal lines are drawn on the bar chart to indicate areas of support and resistance. • The troughs or reaction lows on a price chart are identified as support. Support is an area on the chart where buying pressure overtakes selling pressure and the market reacts higher. • Usually support is identified by a previous reaction low or trough on the bar chart. • Resistance is an area on the chart where selling pressure overtakes buying pressure and the market reacts lower. A resistance level is identified by a previous price high or peak on the bar chart.
  • 25. Support and Resistance Support and resistance is one of the most widely used concepts in trading. Strangely enough, everyone seems to have their own idea on how you should measure support and resistance.
  • 26. Support and Resistance….. • Support and resistance lines indicate likely ends of trends. • Resistance results from the inability to surpass prior highs. • Support results from the inability to break below to prior lows. • What was support becomes resistance, and vice-versa. Support Resistance Breakout
  • 27. Simple Moving Averages • A moving average is simply the average price (usually the closing price) over the last N periods. • They are used to smooth out fluctuations of less than N periods. • This chart shows a 10-day moving average. Note how the moving average shows much less volatility than the daily stock price. 30 35 40 45 50 55 60 1 21 41 61 81 101 121 141 161 181 201 221 241 Price Date MSFT Daily Prices with 10-day MA 9/23/93 to 9/21/94
  • 28. Head and Shoulders • This formation is characterized by two small peaks on either side of a larger peak. • This is a reversal pattern, meaning that it signifies a change in the trend. Head Head Left Shoulder Left Shoulder Right Shoulder Right Shoulder Neckline Neckline H&S Top H&S Bottom
  • 29. Head & Shoulders Example Sell Signal Minimum Target Price Based on measurement rule
  • 30. Double Tops and Bottoms • These formations are similar to the H&S formations, but there is no head. • These are reversal patterns with the same measuring implications as the H&S. Target Double Top Double Bottom Target
  • 31. Double Bottom Example
  • 32. Triangles • Triangles are continuation formations. • Three flavors: – Ascending – Descending – Symmetrical • Typically, triangles should break out about half to three-quarters of the way through the formation. Ascending Descending Symmetrical Symmetrical
  • 33. Rounded Tops & Bottoms • Rounding formations are characterized by a slow reversal of trend. Rounding Top Rounding Bottom
  • 34. Rounded Bottom Chart Example
  • 35. Broadening Formations • These formations are like reverse triangles. • These formations usually signal a reversal of the trend. Broadening Tops Broadening Bottoms
  • 36. Example What could you have known, and when could you have known it?
  • 37. DJIA Oct 2000 to Oct 2001 Example Double bottom Gap, should get filled Nov to Mar Trading range Descending triangles
  • 38. Candlestick • Japanese Candlestick charting and analysis is one of the most effective methodologies in the universe of technical analysis. Japanese Candlestick analysis is a highly effective, but under-used investment decision-making technique. Yet few people understand the ramifications or significance of the signals that are clearly and reliably displayed. • Popularized by Sokuta Honma, Japanese Rice Trader during mid 1700s. • Developed over 400-year period • Steve Neson is credited with introducing them into the US markets
  • 39. The purpose of candlestick charting is strictly to serve as a visual aid. The advantages of candlestick charting are: • Candlesticks are easy to interpret, and are a good place for a beginner to start figuring out chart analysis. • Candlesticks are easy to use. • Candlesticks and candlestick patterns have cool names such as the shooting star, which helps you to remember what the pattern means. • Candlesticks are good at identifying marketing turning points – reversals from an uptrend to a downtrend or a downtrend to an uptrend.
  • 40. Formation of Candlestick There are two types of Candlestick, Bullish & Bearish • Bullish Candlestick formed when market close above the opening price. • Bearish Candlestick formed when market close below the opening price.
  • 41. A Long Day and Short Day A long day represents a large price move from open to close. Long represents the length of the candle body. Short days can be interpreted by the same analytical process of the long candles.
  • 42. Learn | Consult | Research Some Candlestick Patterns and Indicators
  • 43. Marubozu White Marubozu In Japanese, Marubozu means close cropped or close-cut. This is an extremely strong pattern. It opens on the low and immediately heads up. It continues upward until it closes, on its high. it is often the first part of a bullish continuation pattern. Black Marubozu It is often identified in a bearish continuation A long black candle could represent the final sell off, making it an "alert" to a bullish reversal.
  • 44. Closing Marubozu A Closing Marubozu has no shadow at it's closing end. A white body will not have a shadow at the top. A black body will not have a shadow at the bottom. In both cases, these are strong signals corresponding to the direction that they each represent. Opening Marubozu The Opening Marubozu has no shadows extending from the open price of the body. A white body would not have a shadow at the bottom end , the black candle would not have a shadow at it's top end. Though these are strong signals, they are not as strong as the Closing Marubozu.
  • 45. Spinning Top Spinning Tops are depicted with small bodies relative to the shadows. This demonstrates some indecision on the part of the bulls and the bears. Doji The Doji is one of the most important signals in candlestick analysis. It is formed when the open and the close are the same or very near the same. Interpretation is that the bulls and the bears are conflicting.
  • 46. Morning Star The Morning Star is a bottom reversal signal. Like the morning star, the planet Mercury, it foretells the sunrise, or the rising prices. The pattern consists of a three day signal. Evening Star The Evening Star is the exact opposite of the morning star. The evening star, the planet Venus, occurs just before the darkness sets in. The evening star is found at the end of the uptrend. Shooting Star A Shooting Star sends a warning that the top is near. It got its name by looking like a shooting star. The Shooting Star Formation, at the bottom of a trend, is a bullish signal. It is known as an inverted hammer. It is important to wait for the bullish verification.
  • 47. The hammer is a bullish reversal pattern that forms during a downtrend. It is named because the market is hammering out a bottom. When price is falling, hammers signal that the bottom is near and price will start rising again. The long lower shadow indicates that sellers pushed prices lower, but buyers were able to overcome this selling pressure and closed near the open. Hammer
  • 48. Leading VS. Lagging Indicators • A leading indicator gives a buy signal before the new trend or reversal occurs (oscillators are leading indicators.) Example: Stochastic, parabolic SAR, and the Relative Strength Index(RSI) • A lagging indicator gives a signal after the trend has started and basically informs you “ hey buddy”. Pay attention, the trend has started, you’re missing the boat.” (momentum indicators are lagging indicators also called Trend following Indicators) Example: Moving Average, MACD
  • 49. Relative Strength Index (RSI) • Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements. • RSI oscillates between zero and 100. Traditionally, and according to Wilder, RSI is considered overbought when above 70 and oversold when below 30. • Signals can also be generated by looking for divergences, failure swings and centerline crossovers. RSI can also be used to identify the general trend.
  • 50. RSI Relative Strength index ( RSI) identifies overbought and oversold conditions in the oscillator Is a price- following oscillator Scaled from 0 to 100- readings over indicate overbought and below indicates underbought Period-9 days and 14 days
  • 51. RSI Example Chart OversoldOverbought
  • 52. Parabolic SAR Parabolic Stop And Reversal (SAR) A Parabolic SAR places dots, or points, on a chart that indicate potential reversals in price movement Basically, when the dots are below the candles, it is a buy signal; and when the dots are above the candles, it is a sell signal. You DON’T want to use this tool in a choppy market where the price movement is sideways. It only gives bullish and bearish signals
  • 53. Stochastic Measures overbought and oversold conditions in the market. 2 lines are similar to the MACD lines in the sense that one line is scaled from 0 to 100 When the stochastic lines are above (The red dotted line in the chart above), then it means the market is overbought . When the stochastic lines are below ( the blue dotted line), then it means that the market is oversold.
  • 54. Bollinger Bands • Bollinger bands are used to measure a market’s volatility. • When the market is quiet, the bands squeez; and when the market is LOUD, the bands expand The Bollinger Bounce: • A strategy that relies on the notion that price tends to always return to the middle of the Bollinger Bands • You buy when the price hits the lower Bollinger band • You sell the price hits the upper Bollinger band • Best used in raging markets
  • 55. Bollinger Bands Example Chart Sell signal Buy signals Sometimes, the buy signals just keep coming and you can go broke!
  • 56. Moving Average • A “simple moving average (SMA) is calculated by adding the instrument prices for the most recent “n” time periods and then dividing by “n” • Crossover trading-two SMAs are plotted and the shorter period is used as the signal line. If is shorter period crosses over the longer period from below to above, then it is considered bullish and a buy opportunity. Conversely, if shorter period crosses over the longer period form above, then it is considered bearish and a sell opportunity. • Effective period are 5,10, 20,50 and for support and resistance 50,200
  • 57. MACD The MACD turns two trend-following indicators, moving averages, into a momentum oscillator by subtracting the longer moving average from the shorter moving average. As a result, the MACD offers the best of both worlds: trend following and momentum. The MACD fluctuates above and below the zero line as the moving averages converge, cross and diverge. Traders can look for signal line crossovers, centerline crossovers and divergences to generate signals. Because the MACD is unbounded, it is not particularly useful for identifying overbought and oversold levels.
  • 58. …….. Used to identify buy and sell signal. When MACD crosses above the signal line, it may be time for the longs to enter the market, whereas when a cross below the signal line occurs, it may be time for the shorts to enter the market. If you look at our original chart, you can see that as the two moving averages separate, the histogram, gets bigger. This is called divergence, because the faster moving average is diverging or moving away from the slower moving average. As the moving averages get closer to each other, the histogram gets smaller. This is called convergence because the faster moving average or getting closer to the slower moving average.
  • 59. ……… • The MACD Line oscillates above and below the zero line, which is also known as the centerline. These crossovers signal that the 12-day EMA has crossed the 26- day EMA. • The direction, of course, depends on the direction of the moving average cross. Positive MACD indicates that the 12-day EMA is above the 26-day EMA. • Positive values increase as the shorter EMA diverges further from the longer EMA. This means upside momentum is increasing. • Negative MACD values indicates that the 12-day EMA is below the 26-day EMA. Negative values increase as the shorter EMA diverges further below the longer EMA. This means downside momentum is increasing.
  • 60. MACD Example Chart
  • 61. Pivot Points • Pivot Points use the prior period's high, low and close to formulate future support and resistance. • In this regard, Pivot Points are predictive or leading indicators. • There are at least five different versions of Pivot Points. • Major ones are Standard Pivot Points, Demark Pivot Points and Fibonacci Pivot Points.
  • 62. …….. • At the beginning of the trading day, floor traders would look at the previous day's high, low and close to calculate a Pivot Point for the current trading day. • With this Pivot Point as the base, further calculations were used to set support 1, support 2, resistance 1 and resistance 2. • These levels would then be used to assist their trading throughout the day.
  • 63. ……… • Support and Resistance levels are areas at which the direction of price movement can possibly change. • Pivot points are especially useful to short- term trader who are looking to take advantages of small price movements.
  • 64. Standard Pivot Point
  • 65. Which Time Frame to Use Trading time frames are usually categorized into three types: • Long-term • Short-term or swing • Intraday or day-trading Which one is better? It depends on your personality!
  • 66. Time frame Description Advantages Disadvantages Long-term Long-term traders will usually refer to daily and weekly charts. The weekly charts will establish the longer term perspective and assist in placing entries in the shorter term daily. Trades usually from a few weeks to many months, sometimes years. Don’t have to watch markets intraday Fewer transactions means less paying of spreads Large swings which require large stops Usually 1 or 2 good trades a year so patience is required Bigger account needed to ride longer term swings Frequent losing months Short-term Short-term traders use hourly time frames and hold trades for several hours to a week. More opportunities for trades Less chance of losing months Less reliance on one or two trades a year to make money Transaction costs will be higher (more spreads to pay) Overnight risk becomes a factor Intraday Intraday traders use minute charts such as 1- minute or 5-minute. Trades are held intraday and exited by market close. Lots of trading opportunities Less chance of losing months No overnight risk Transaction costs will be much higher (more spreads to pay) Mentally more difficult due to frequency of trading Profits are limited by needing to exit at the end of the day.
  • 67. On Balance Volume • On Balance Volume was developed by Joseph Granville, one of the most famous technicians of the 1960’s and 1970’s. • OBV is calculated by adding volume on up days, and subtracting volume on down days. A running total is kept. • Granville believed that “volume leads price.” • To use OBV, you generally look for OBV to show a change in trend (a divergence from the price trend). • If the stock is in an uptrend, but OBV turns down, that is a signal that the price trend may soon reverse.
  • 68. OBV Example Chart Divergence, OBV failed OBV confirms trend change but doesn’t lead
  • 69. Reasons for several traders suffering from losses • No planning • No patience(investors’psychology) • Not following the trends • Hot news • Lack of time • Not using money management technique(investors’ psychology) • Not using stops(investors’psychology) • Overtrading (investors’psychology) • Continuous buy/sell
  • 70. • Buy and Sell on Confidence • Buy only Liquid Stocks and Liquid Markets • Don’t buy or sell on Hot Tips • Do not Dollar Cost Average • No one wins 100 % of the Time • Always use Stops • I don’t have Time • Be patient and let time be your Friend • Learn from your Mistakes • Know how to short Stocks • Follow the Rules
  • 71. Best guidelines for trading • Robert Deel’s 16 Rules of Investology (A successful trader, 20 years of experience ; He is an internationally recognized trading expert, and has trained groups of traders Throughout the U.S., Europe, Asia, and Canada. He is the author of Trading the Plan and The Strategic Electronic Day Trader. He is also the President and CEO of Tradingschool.com, a school that trains Individual and professional traders from all over the world. • Trade with a Plan • Screen your trade • Always Look at a Chart • Stay With a Trend • Use Money Management Techniques
  • 72. Learn | Consult | Research THE END