Technical analysis (2)

WHAT IS TECHNICAL ANALYSIS?
In finance, technical analysis is a securities analysis
methodology for forecasting the direction of prices
through study of past market data, primarily price
and volume. Behavioral economics and quantitative
analysis use many of the same tool of technical
analysis, which being an aspect of active
management, stands in contradiction to much of
modern portfolio theory. The efficacy of both
technical and fundamental analysis is disputed by the
efficient market hypothesis which state that stock
market price is essentially unpredictable.

ASSUMPTIONS
 ART OVER SCIENCE- many investment approaches
requires to perform a great deal of math to generate an
answer. Technical analysis does not. Looking at the same
chart many investors will derive different answers.
Therefore, reading charts evolves into an art from where
each analyst can provide a unique insight.
 NO NEED TO KNOW- as more information available,
people become obsessed with knowing why events occur.
In the market, we often never know. Instead of searching
for the next piece of data that magically unlock the
puzzles, technicians focus on the past and interpolate
how it will affect the future

 HISTORY REPEATS- A study of history shows that set
pattern repeat themselves over a long periods. By relying
on the past to predict the future we can take advantages
of that pattern.
 SELF FULFILLING PROPHECY- Enough people
seeing the same pattern will take actions that force the
prediction to occur. While this is a positive if you are on
the right side of the trade, it presents a major weakness
when everyone attempt to exit at the same time.
 MOMENTUM REVERSES- When a trade become very
crowded with everyone assuming the same position,
unexpected surprises can drive prices. If the exit become
crowded, what first looked promising quickly becomes a
nightmare

Basic Tenets And Premises Of TA
 Market price of security is related to and determined by
the interaction of demand and supply forces operating in
the stock market.
 Stock prices tend to move in trends for a long period,
nevertheless there may be a minor fluctuation in between.
This implies that the movement in prices is continuous in
a particular direction for some time.
 Reversal or shift in trend in prices may occur because of
change in demand and supply factor.
 The change in demand and supply factor can be detected
earlier with the help of charts and graphs.
 Price patterns projected by price movements in the market
tend to repeat themselves and can be used to forecast to
predict future price behavior

Fundamental Analysis And
Technical Analysis
 Fundamental analysis and technical analysis
are two type of security analysis. Technical
analysis is all about studying securities prices
and a few oscillators derived thereof, and not
taking any reference to the balance sheet and
income statement, the assumption being that
the market are efficient and all possible price
sensitive information is reflected in price
movements. These two differ in their
approaches, assumptions and method of
analysis.

SOURCE OF INFORMATION- fundamental analysis is based on the
information relating to economy industry and a particular company. This
information is generally available in the publication of the government, other
agencies and company itself. On the other hand the technical analysis is based on
the information relating to price and volume of traction and the capital market.
This information is analyzed by technical analysis to predict behavior. So the
fundamental analysis is based on information external to the market whereas the
technical analysis is based on the information internal to the market.
TYPE OF INFORMATION- in fundamental analysis, the data used are related
to sales growth earning etc., whereas the data used in technical analysis are related
to securities prices, volume of transactions, market index etc.
OBJECTIVES- in the fundamental analysis, the objective of analysis is to access
the intrinsic value of share based on expected performance of the company and
other related variables . However a technical analyst attempt to identify the trend
in prices and to indicate where there could be a reversal in the trend.

TYPES OF TECHNIQUES USED- the fundamental analysis is based on 1)
the accounting techniques of ratios, and 2) valuation model based on discounted
cash flow techniques produce an estimate of intrinsic value. On the other hand
technical analysis is based on charting techniques.
EMPHASIS- in the fundamental analysis, the emphasis is based on the cause of
price movements. If the earning are expected to grow, the prices will also increase.
However in technical analysis the emphasis is on what should be trend and
behavior of prices in the near future. Moreover in fundamental analysis the price
movement is performance based while in technical analysis the price is based on
the market forces of demand and supply.
BASIC PHILOSOPHY- the basic philosophy in fundamental analysis is that the
share has a real worth or would have a real worth in near future. An investor can
beat the market by taking an early decision. On the other hand, the basic
philosophy in technical analysis is that the share prices show identifiable trends
that can be exploited by investors by early identification of changes. The
fundamental analysis is designed to answer the question what to invest in?
whereas the technical analysis answer the question: when to invest in?

DOW THEORY
INTRODUCTION
Dow Theory is named after Charles H Dow, who is considered as the father of
Technical Analysis. Dow Theory is very basic and more than 100 years old but still
remains the foundation of Technical Analysis. Charles H Dow(1851-1902) ,however
neither wrote a book nor published his complete theory on the market, but several
followers and associates have published work based on his theory from 255 Wall Street
Journal editorials written by him. These editorials reflected his belief on
stock market behavior. Some of the most important contributors to Dow Theory are
a. Samuel A. Nelson- He is the first person to use the term Dow Theory and he
selected fifteen articles by Charles Dow for his book The ABC of Stock Speculation.
b. William P. Hamilton-He wrote a book titled The Stock Market Barometer which is
a comprehensive summary of the findings that Charles H Dow and Samuel A. Nelson
have gathered.
c. Robert Rhea- He wrote a book titled The Dow Theory.
d. Georg E Schaefer- He wrote a book titled How I Helped More than 10000
Investors to profi t in Stocks.
e. Richard Russell- He wrote a book titled The Dow Theory Today.

Principles of Dow Theory
The Dow Theory is made up of six basic principles. Let’s understand the principles of
Dow
Theory.
First Principle: The Stock Market Discounts All
Information
The first principle of Dow Theory suggests that stock price represents sum total of
hopes,
fears and expectation of all participants and stock prices discounts all information that
is
known about stock i.e. past, current and above all stock price discounts future in
advance i.e.
the stock market makes tops and bottoms ahead of the economy. It suggests stock
market discounts all information be it interest rate movement, macroeconomic data,
central bank decision, future earnings announcement by the company etc. The only
information which stock market does not discount is natural calamities like tsunami,
earthquake, cyclone etc.

Second Principle: The Stock Market Have
Three Trends
Dow Theory says stock market is made up of three trends
a. Primary Trend
b. Secondary trend
c. Minor Trend
Dow Theory says primary trend is the main trend and trader should trade in
direction of this trend. It says primary trend is trader’s best friend which
would never ditch trader in this volatile stock market. If primary trend is
rising then trend is considered rising (bullish) else trend is considered
falling (bearish). The primary trend is the largest trend lasting for more than
a year. The primary trend is considered rising if each peak in the rally is
higher than previous peak in the rally and each trough in the rally is higher
than previous trough in the rally. In other words as long as each successive
top is higher than previous top and each successive bottom is higher than
previous bottom, primary trend is considered rising and we say markets are
bullish. This would be clearer from (Figure 1)

(Figure 1) illustrates that each successive top that is D,
F, and H are higher than previous tops and each
successive bottom that is E and G are higher than
previous bottoms, hence primary trend is considered
rising.
The primary trend is considered falling if each peak in
the rally is lower than previous peak in the rally and
each trough in the rally is lower than previous trough in
the rally. In other words as long as each successive
bottom is lower than previous bottom and each
successive top is lower than previous top, primary
trend is considered falling and we say markets are
bearish. This would be clearer from (Figure 2)

(Figure 2) illustrates that each successive bottom that is D, F,
and H are lower than previous bottoms and each successive top
that is E and G are lower than previous tops, hence primary
trend is considered falling. Dow Theory says secondary trends
are found within the primary trend i.e. corrections when
primary trend is rising and pullback when primary trend is
falling. More precisely secondary trend is the move against the
direction of the primary trend .The secondary trend usually
lasts for three weeks to three months. This would be more
clearer from (Figure 3) & (Figure 4).

Dow Theory says that secondary trend consist of short term
price movements which is known as minor trends. The minor
trend is generally the corrective move within a secondary trend,
more precisely moves against the direction of the secondary
trend. The minor trend usually lasts for one day to three weeks.
The Dow Theory says minor trends are unimportant and needs
no attention. If too much focus is placed on minor trends, it
can lead to total loss of capital as trader gets trapped in short
term market volatility.

Third Principle: Primary Trend Have Three Phases
The Dow Theory says primary trend have three phases
a. Accumulation Phase
b. Participation Phase
c. Distribution Phase
The Dow Theory says that the accumulation phase is made up of buying by intelligent
investor who thinks stock is undervalued and expects economic recovery and long
term growth. During this phase environment is totally pessimistic and majority of
investors are against equities and above all nobody at this time believes that market
could rally from here. This is because accumulation phase comes after a significant
down move in the market and everything appears at its worst. Practically this is the
beginning of the new bull market. The participation phase is characterized by
improving fundamentals, rising corporate profits and improving public sentiment.
More and more trader participates in the market, sending prices higher. This is the
longest phase of the primary trend during which largest price movement takes place.

This is the best phase for the technical trader.
The distribution phase is characterized by too much optimism, robust fundamental
and above all nobody at this time believes that market could decline. The general
public now feels comfortable buying more and more in the market. It is during this
phase that those investors who bought during accumulation phase begin to sell in
anticipation of a decline in the market. This is time when Technical Analyst should
look for reversal in the trend to initiate sell side position in the stock market. Three
phases of primary trend would be clearer from (Figure 5)

(Figure 5) illustrates –
• Accumulation phase from April 2003 to June 2003 during which nobody believed that
markets could rally but intelligent investor took buy side positions in the stock market.
• Participation phase from July 2003 to January 2004 during which largest and longest
price movement occurred.
• Distribution phase from February 2004 to May 2004 during which smart money closed
buy side positions in the market

Fourth Principle: Stock Market Indexes Must Confirm
Each Other
Charles H Dow believed that stock market as a whole reflected the overall business
condition of the country. In other words stock market as a whole is a benchmark
indicator to measure the economic condition of the country. Dow first used basis of
his theory to create two indexes namely (i) Dow Jones Industrial Index and (ii) Dow
Jones Rail Index (now Transportation Index).Dow created these two indexes because
those days U.S was a growing industrial nation and urban centers and production
centers were apart. Factories have to transport their goods to urban centers by rail
road. Hence these two indexes covered two major economic segments i.e. Industrial
and transportation. Dow felt these two indexes would reflect true business condition
within the economy.

According to Dow
• Rise in these two indexes reflects that overall business condition of the economy
is good .The basic concept behind this is that if production is increasing then
transportation of goods to customer should also increase i.e. performance of
companies transporting goods to consumer should improve. According to Dow
Theory, two averages should move in the same direction and rising Industrial
Index is not sustainable as long as Transportation Index is not rising.
• The divergence in these two indexes is a warning signal. Under Dow Theory, a
reversal from a bull market to bear market or vice versa is not signaled until and
unless both indexes i.e. Industrial Index and Transportation Index confirm the
same. In simple words, if one index is confirming a new primary uptrend but
another index remains in a primary downtrend, then there is no clear trend.
Basically Dow Theory says that stock market will rise if business conditions are
good and stock market would decline if business conditions are poor.

Fifth Principle: Volume Must Confirm the Trend
Dow Theory says that trend should be confirmed by the volume. It says volume
should
increase in the direction of the primary trend i.e.
• If primary trend is down then volume should increase with the market decline.
• If primary trend is up then volume should increase with the market rally.
Basically volume is used as a secondary indicator to confirm the price trend and
once the trend is confirmed by volume, one should always remain in the direction of
the trend.
Sixth Principle: Trend Remains Intact Until and
Unless Clear Reversal Signals Occur
As we are dealing in stock market which is controlled by only one “M” i.e. Money
and this money flows very fast across borders. Hence stock prices do not move
smoothly in a single line, one day it’s up next day it might be down. Basically Dow
Theory suggests that one should never assume reversal of the trend until and unless
clear reversal signals are there and one should always trade in the direction of the
primary trend.

Significance of Dow Theory
It’s Dow Theory which gave birth to concept of higher top-higher bottom formations
and lower top-lower bottom formations which is the basic foundation of Technical
Analysis. This helps investors to improve their understanding on the market so that
they could succeed in their investment/trading decisions. Most of the technical analysts
follow this concept and if you go through any technical write up, you would definitely
find this concept.
Problems with Dow Theory
a. One misses the large gain due to conservative nature of a trend reversal signal i.e.
uptrend would reverse when stock prices make lower top-lower bottom formation
and downtrend would reverse when stock prices make higher top-higher bottom
formation.
b. Charles Dow considered only two indexes namely Industrial and Transportation
which is not major part of the economy today. Technology and financial services
i.e. banking constitutes major part of the economy today. We have seen in 1998-
1999, one sided rally in Nifty led by technology stocks. In this rally none of
industrial stock participated and if one waited for buy confirmation from
Industrial and Transportation indexes then one must have missed the classic bull
run of technology stocks.

CHARTS
BAR CHART
This technique, borrowed from statistical theory, is popular technique of showing the
price variation and accompanied volume on a particular day and then the comparative
presentation over a period of 1 month or half or so . In bar chart , each days price
boundaries( high and low) are shown as a bar. The closing price and opening price on
that day are shown as a horizontal tick on the high low bar. The volume of
transaction is also shown as vertical bars in the lower portion of the chart

LINE CHART
Line chart is another type of basic chart . The line chart is a simplest presentation
of movement in any variable. On the horizontal axis, time is taken and the variable
is taken on the vertical axis. The value of the variable for different dates are plotted
on the graph. All the points are then joined by a line. This line is known as the
variable line. The variable for line chart can be price of security, volume of security,
index number, total volume at the exchange, etc. line chart can be prepared even for
intra day fluctuation in a particular variable line chart In case of securities prices,
the line charts are drawn by taking the closing prices for different days. These
closing prices are joind by a line.

POINT AND FIGURE CHART
The technical analysts attempt to identify the future price behavior in term of past
data for pricing timing and volume. However, there are some analyst who consider
only the past prices and ignore the timing and volume. This is based on the
proposition that future prices behavior can be predicted on the basis of past price
only. The time dimension and volume are not useful. Rather significant price
changes and reversals should be noted to predict future price behavior. As the time
dimension is ignored, the preparation of point and figure chart is a bit different
than bar chart.
In order to prepare the point and figure chart, the analyst decide as to what is
significant price change or price reversal.

CANDLESTICKS CHART
Candlesticks chart can be considered as an extension of bar chart. In addition to the
price data, the candlesticks chart also show the trend in price for the day. In
candlesticks chart the price data for a day is shown by vertical candle with a vertical
line drawn through it. The candle may be shaded or clear. A clear candle shows a
increase in price during the day. A shaded candle show decrease in price during a day.
The top and bottom points of the line, passing through the candle, represent the high
low prices respectively for the day.

PATTERN ANALYSIS
 The price volume chart can be used to analyze the patterns of price
behavior. Dow theory and Elliot wave theory concentrated on the
analysis of price patterns. Identification of primary trend, secondary
trend and minor fluctuation was in fact the identification of price
patterns over a time period. The pattern analysis emphasizes the
tendency of price movement in a particular direction or to repeat the
same formation over and over again. These pattern can be categorised
to reflect the bullish and bearish trend over years. Based on the
formation of price movement or price patterns, the likely behavior of
price in future can be predicted. In general the share price do not
change overnight from being in the bullish phase to bearish phase or
vice versa. There are usually transitional phase in between. The price
pattern can give an advance idea of likely change in direction of prices.
These price pattern can be used to forecast:
1) End of bull and bearish phase
2) Reversal of trend prices
3) Direction of the new change
4) Confirmation of the new trend

TREND
Trend is the long term price pattern. Over a period of one
year to three year, the basic tendency of the prices can be
identified as increasing or decreasing trend.

HEAD AND SHOULDER
At the end of long term trend, a reversal may turn up. This
reversal can be signalled by head and shoulder formation. At the
end of the increasing trend a set of 3 humps may appear. A
neck line may be drawn to identify the base of the formation.
When the prices may fall below the neck line, a downward trend
is expected to occur. The three humps show the short term
rallies in price.
INVERTED HEAD AND SHOULDER
This pattern is reverse of head and shoulder pattern. It occur
at the end of a downward trend and is consisting of three
trough or humps. A neck line may drawn by joining the tops
of the inverted humps. When the price breach the neck line, it
indicates the start of a rising trend.

DOUBLE TOP AND BOTTOM
A double top appears when a share hits a high, comes lower, again pull back but fails
to hit the earlier high. So, price rise fails to breach the immediately prior high and
comes down. When the price comes below the lower level created by earlier move, a
downward trend starts. On the other hand, a double bottom appear at the end of
the bearish trend and indicate the start of bull phase. It is quite possible that there
may be small rally in price after first peak in double top or after first troughs in
double bottom. Similar to double top double bottom, there may be a triple top and
triple bottom also.
B
T
T
B

TRIANGLES
Out of the different continuation patterns, triangle are more popular. A triangle is
formed when a succeeding peak is lower than the preceding peak and each
succeeding bottom higher than the preceding bottom. The series of peak and
bottom are joined by a line which converges and form a shape of triangle. When the
prices break out the sides of the triangle, there may be a sharp reversal of prices.
The triangle formation may appear either during bull phase or bear phase. Triangle
may take different form and may be known as ascending, descending, symmetrical
and expending. In any case the upper line of the triangle is known as a resistance
line, as the price does not go beyond it and the lower line is known as support line as
the price does not go below it. Usually there are six points(three upper and three
lower) to form a triangle. There is a time limit for the end of the triangle pattern and
that is at point when the two lines meet. Before the end of the triangle or
immediately after the end, the price should break out the triangle in the direction of
earlier trend. The breakout from a triangle is usually accompanied by increasing
volumes.

FLAG
A flag formation appear when a bull rally or bear phase is interrupted by a
consolidation pattern appearing as a rectangle or a parallelogram. The consolidation
process appear only for a short period during volume may diminish drastically. As
the flag formation indicates a pause before continuation of trend earlier, the price
move in the same direction after the flag as before. At the start or just prior to the
formation of a flag pattern, the volume is very high. However, volumes taper off as
a formation is complete. So, the sufficient decrease in volume may be taken as
indicator of flag completion.

THE PENNANT
 The pennant forms what looks like a symmetrical triangle, where the
support and resistance trend lines converge towards each other. The
pennant pattern does not need to follow the same rules found in triangles,
where they should test each support or resistance line several times. Also,
the direction of the pennant is not as important as it is in the flag; however,
the pennant is generally flat.

THE WEDGE CHART PATTERNS
 The wedge chart pattern signals a reverse of the trend that is
currently formed within the wedge itself. Wedges are similar in
construction to a symmetrical triangle in that there are two trend
lines - support and resistance - which band the price of a security.
The wedge pattern differs in that it is generally a longer-term
pattern, usually lasting three to six months. It also has converging
trendlines that slant in an either upward or downward direction,
which differs from the more uniform trendlines of triangles.
There are two main types of wedges – falling and rising – which
differ on the overall slant of the pattern. A falling wedge slopes
downward, while a rising wedge slants upward.

Falling Wedge
 The falling wedge is a generally bullish pattern signaling that
one will likely see the price break upwards through the
wedge and move into an uptrend. The trend lines of this
pattern converge, with both being slanted in a downward
direction as the price is trading in a downtrend.

Rising Wedge
 Conversely, a rising wedge is a bearish
pattern that signals that the security is
likely to head in a downward direction.
The trendlines of this pattern converge,
with both trendlines slanted in an
upward direction.
 Again, the price movement is bounded
by the two converging trendlines. As the
price moves towards the apex of the
pattern, momentum is weakening. A
move below the lower support would be
viewed by traders as a reversal in the
upward trend.
As the strength of the buyers weakens
(exhibited by their inability to take the
price higher), the sellers start to gain
momentum. The pattern is complete,
with the sellers taking control of the
security, when the price falls below the
supporting trend line.

SUPPORT
A support is a horizontal floor where interest in buying a commodity is strong
enough to overcome the pressure to sell. Support level is the price level at which
sufficient demand exists to, at least temporarily, halt a downward movement in
prices. Logically as the price declines towards support and gets cheaper, buyers
become more inclined to buy and sellers become less inclined to sell. By the time
the price reaches the support level, it is believed that demand will overcome supply
and prevent the price from falling below support
Support does not always hold true and a break below support signals that the bulls
have lost over the bears. A fall below support level indicates more willingness to sell
and a lack of willingness to buy. A break in the levels of support indicates that the
expectations of sellers are reducing and they are ready to sell at even lower prices.
In addition, buyers could not be coerced into buying until prices declined below
support or below the previous low. Once support is broken, another support level
will have to be established at a lower level

RESISTANCE
A resistance is a horizontal ceiling where the pressure to sell is greater than the
pressure to buy. Thus a Resistance level is a price at which sufficient supply exists
to; at least temporarily, halt an upward movement. Logically as the price advances
towards resistance, sellers become more inclined to sell and buyers become less
inclined to buy. By the time the price reaches the resistance level, it is believed that
supply will overcome demand and prevent the price from
rising above resistance.
Resistance does not always hold true and a break above resistance signals that the
bears have lost over the bulls. A break in the resistance level shows more willingness
to buy or lack of incentive to sell. Resistance breaks and new highs indicate that
buyer’s expectations have increased and are ready to buy at even higher prices. In
addition, sellers could not be coerced into selling until prices rose above resistance
or above the previous high. Once resistance is broken, another resistance level will
have to be established at a higher level.

CONSOLIDATION
In technical analysis, the movement of an asset's price within a well-defined pattern or
barrier of trading levels. Consolidation is generally regarded as a period of indecision,
which ends when the price of the asset breaks beyond the restrictive barriers. Periods
of consolidation can be found in charts covering any time interval (i.e. hours, days,
etc.), and these periods can last for minutes, days, months or even years. Lengthy
periods of consolidation are often known as a base.
The levels of resistance and support within the consolidation are created through the
upper and lower bounds of the stock's price. Once the price of the asset breaks
through the identified areas of support or resistance, volatility quickly increases and so
does the opportunity for short-term traders to generate a profit.

RSI (RELATIVE STRENGTH INDEX)
A technical momentum indicator that compares the magnitude of recent gains to
recent losses in an attempt to determine overbought and oversold conditions of an
asset. It is calculated using the following formula:
RSI = 100 - 100/(1 + RS*)
*Where RS = Average of x days' up closes / Average of x days' down closes.

ROC (rate of change)
The speed at which a variable changes over a specific period of time. Rate of
change is often used when speaking about momentum, and it can generally be
expressed as a ratio between a change in one variable relative to a corresponding
change in another. Graphically, the rate of change is represented by the slope of a
line.
Rate of change is often illustrated by the Greek letter delta. Many traders pay close
attention to the speed at which one variable changes relative to another. For
example, option traders study the relationship between the rate of change in the
price of an option relative to a small change in the price of the underlying asset,
known as an options delta.

Technical analysis (2)

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