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A fundamental study on Technical Analysis


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A fundamental study on Technical Analysis

  1. 1. TECHNICAL ANALYSIS Present by Jayesh Sadhwani (IU 1252000038) Technical analysis is the examination of past price movements to the forecast future price movements. Technical analysts are sometimes referred to as chartists because they rely almost exclusively on charts for their analysis. Analysts believe that the historical performance of stocks and markets are indications of future performance. Technical analysis is applicable to stocks, indices, commodities, futures or any tradable instrument where the price is influenced by the forces of supply and demand. Price refers to any combination of the open, high, low or close for a given security over a specific timeframe. The time frame can be based on intraday (tick, 5-minute, 15-minute or hourly), daily, weekly or monthly price data and last a few hours or many years. In addition, some technical analysts include volume or open interest figures with their study of price action.
  2. 2. ASSUMPTIONS OF TECHNICAL ANALYSIS Three key assumptions on which technical analysis is based are:- The futures market discounts everything: - The technician believes that the price at any given time is the intrinsic value based upon the fundamental factors affecting the supply and demand of the product. Prices move in trends - Prices can move in one of three directions up, down or sideways. Once a trend in any of these directions is in effect, it usually will persist. The market trend is simply the direction of market prices, a concept which is absolutely essential to the success of technical analysis. History repeats itself - Technical analysis includes the psychology of the market place. Patterns of human behaviors have been identified and categorized for several hundred years and are found to be repetitive in nature. The repetitive nature of the market place is illustrated by specific chart patterns, from which one can forecast the next move for the prices. CHART PATTERN A chart pattern is a distinct formation on a stock chart that creates a trading signal, or a sign of future price movements. Chartists use these patterns to identify current trends and trend reversals and to trigger buy and sell signals. There are two types of patterns within this area of technical analysis, reversal and continuation. A reversal pattern signals that a prior trend will reverse upon completion of the pattern. A
  3. 3. continuation pattern, on the other hand, signals that a trend will continue once the pattern is complete. These patterns can be found over charts of any time frame. HEAD AND SHOULDERS This is one of the most popular and reliable chart patterns in technical analysis. Head and shoulders is a reversal chart pattern that when formed, signals that the security is likely to move against the previous trend. As you can see in Figure 1, there are two versions of the head and shoulders chart pattern. Head and shoulders top (shown on the left) is a chart pattern that is formed at the high of an upward movement and signals that the upward trend is about to end. Head and shoulders bottom, also known as inverse head and shoulders (shown on the right) is the lesser known of the two, but is used to signal a reversal in a downtrend. Both of these head and shoulders patterns are similar in that there are four main parts: two shoulders, a head and a neckline. Also, each individual head and shoulder is comprised of a high and a low. For example, in the head and shoulders top image shown on the left side in Figure 1, the left shoulder is made up of a high followed by a low. In this pattern, the neckline is a level of support or resistance. Remember that an upward trend is a period of successive rising highs
  4. 4. and rising lows. The head and shoulders chart pattern, therefore, illustrates a weakening in a trend by showing the deterioration in the successive movements of the highs and lows. CHART TYPES There are four main types of charts that are used by investors and traders depending on the information that they are seeking and their individual skill levels. The chart types are: the line chart, the bar chart, the candlestick chart and the point and figure chart. LINE CHART The most basic of the four charts is the line chart 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. Line charts do not provide visual information of the trading range for the individual points such as the high, low and opening prices. However, 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. Figure 1: A line chart
  5. 5. BAR CHART The bar chart expands on the line chart by adding several more key pieces of information to each data point. 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. Conversely, the close is represented by the dash on the right. 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. Figure 2: A bar chart CANDLESTICK CHART The candlestick chart is similar to a bar chart, but it differs in the way that it is visually constructed. Similar to the bar chart, the candlestick also has a thin vertical line showing the
  6. 6. period's trading range. 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. A major problem with the candlestick color configuration, however, is that different sites use different standards; therefore, it is important to understand the candlestick configuration used at the chart site you are working with. 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. Figure 3: A candlestick chart
  7. 7. POINT AND FOGURE CHART The point and figure chart is not well known or used by the average investor but it has had a long history of use dating back to the first technical traders. This type of chart reflects price movements and is not as concerned about time and volume in the formulation of the points. The point and figure chart removes the noise, or insignificant price movements, in the stock, which can distort traders' views of the price trends. These types of charts also try to neutralize the skewing effect that time has on chart analysis. Figure 4: A point and figure chart When first looking at a point and figure chart, you will notice a series of Xs and Os. The Xs represent upward price trends and the Os represent downward price trends. There are also numbers and letters in the chart; these represent months, and give investors an idea of the date. Each box on the chart represents the price scale, which adjusts depending on the price of the stock: the higher the stock's price the more each box represents.
  8. 8. Trends  The meaning of trend in finance isn't all that different from the general definition of the term - a trend is really nothing more than the general direction.  A trend represents a consistent change in prices (i.e. a change in investor’s expectations)  A trend line is a simple charting technique that adds a line to a chart to represent the trend in the market or a stock. Types of Trend Uptrends Describes the price movement of a financial asset when the overall direction is upward. A formal uptrend is when each successive peak and trough is higher than the ones found earlier in the trend.
  9. 9. Downtrend Describes the price movement of a financial asset when the overall direction is downward. A formal downtrend occurs when each successive peak and trough is lower than the ones found earlier in the trend.
  10. 10. Sideways Trend Describes the horizontal price movement that occurs when the forces of supply and demand are nearly equal. A sideways trend is often regarded as a period of consolidation before the price continues in the direction of the A sideways price trend is also commonly known as a "horizontal trend". previous move.
  11. 11. Support and Resistance Support level Support level is a price level where the price tends to find support as it is going down.
  12. 12. Resistance Level Resistance Level is a price level where the price tends to find resistance as it is going up.
  13. 13. Importance of Support and Resistance Support and resistance analysis is an important part of trends because it can be used to make trading decisions and identify when a trend is reversing. HOW TO USE TECHNICAL ANALYSIS? 1) Identify the trend of the market. 2) Measure the strength of the trend. 3) Look for the low risk entry into that trend. 4) Use Money Management to determine the size of any position. 5) Use an appropriate stop loss. 6) Keep following trend till market proves it has reversed. 7) Keep out of the market when the market is not showing significant trend one way or the other.
  14. 14. STRENGTHS OF TECHNICAL ANALYSIS Focus on Price: To predict the future price, technicians believe that one should focus on price movements. Price movements usually precede fundamental developments. By focusing on price action, technicians are automatically focusing on the future. Even though the market is prone to sudden knee-jerk reactions, hints usually develop before significant moves. A technician will refer to periods of accumulation as evidence of an impending advance and periods of distribution as evidence of an impending decline. Supply, Demand, and Price Action: Many technicians use the open, high, low and close when analyzing the price action of a commodity. Separately, these will not be able to tell much. However, taken together, the open, high, low and close reflect forces of supply and demand. Pictorial Price History: A price chart can offer plenty of valuable information. It is an easy to read historical account of a security's price movement over a period of time. Charts are much easier to read than a table of numbers. On most stock charts, volume bars are displayed at the bottom. With this historical picture, it is easy to identify the following: • Reactions prior to and after important events. • Past and present volatility. • Historical volume or trading levels. • Relative strength of a stock versus the overall market.
  15. 15. Assist with Entry Point: Technical analysis can help with timing a proper entry point. Some analysts use fundamental analysis to decide what to buy and technical analysis to decide when to buy. Technical analysis can help spot demand (support) and supply (resistance) levels as well as breakouts. Waiting for a breakout above resistance or buying near support levels can improve returns. WEAKNESS OF TECHNICAL ANALYSIS Analyst Bias: Just as with fundamental analysis, technical analysis is subjective and our personal biases can be reflected in the analysis. It is important to be aware of these biases when analyzing a chart. Open to Interpretation: Furthering the bias argument is the fact that technical analysis is open to interpretation. Even though there are standards, many times two technicians will look at the same chart and paint two different scenarios or see different patterns. Both will be able to come up with logical support and resistance levels as well as key breaks to justify their position. While this can be frustrating, it should be pointed out that technical analysis is more like an art than a science, somewhat like economics. Too Late: Technical analysis has been criticized for being too late. By the time the trend is identified, a substantial portion of the move has already taken place. After such a large move, the reward to risk ratio is not great. Lateness is a particular criticism of Dow Theory.
  16. 16. Trader's Remorse: Not all technical signals and patterns work. When you begin to study technical analysis, you will come across an array of patterns and indicators with rules to match. For instance: A sell signal is given when the neckline of a head and shoulders pattern is broken. Even though this is a rule, it is not steadfast and can be subject to other factors such as volume and momentum. In that same vein, what works for one particular commodity may not work for another. CRITICS OF TECHNICAL ANALYSIS SAY………………..  No one or group of trading rules seems to work consistently.  Some prices moves are self-fulfilling because so many chartist trades on breakouts–often are temporary.   Most of the trading rules require a great deal of subjective judgment. When price volatility goes down technical profits may also fall. Technical Analysis also happens to break one major jinx of fundamental analysis as it gives an exact price target and answers many questions like, • When to enter the market? • Whether to buy or sell? • If buy/ sell then at what prices? • How much should be the profit objective? • Where should one place a stop loss? Owing to all the above mentioned factors it could safely be concluded that Technical Analysis is one of the better tools for price forecasting. And in today’s rapidly changing world investors look for short time returns which could better be achieved only by a superior price forecasting system and in this case using Technical Analysis.
  17. 17. Conclusion Charts are one of the most fundamental aspects of technical analysis. It is important that you clearly understand what is being shown on a chart and the information that it provides. Now that we have an idea of how charts are constructed, we can move on to the different types of chart patterns.