CHAPTER - 4

Meaning of Technical Analysis

Technical analysis involves a study of market-generated data like prices and

volumes to determine the future direction of price movement. It is a process of
identifying trend reversal at an earlier stage to formulate the buying and selling
strategy. With the help of several indicators, the relationship between price –
volume and supply-demand is analyzed for the overall market and individual
stocks.

The basic premises, on which technical analysis is formulated, are as

follows:

1. The market value of the scrip is determined by the interaction of demand and
supply.

2. Supply and demand is governed by numerous factors, both rational and

irrational. These factors include economic variables relied by the fundamental
analysis as well as opinions, moods and guesses.

3. The market discounts everything. The price of the security quoted represents the
hope, fears and inside information received by the market players. Insider
information regarding the issuance of bonus shares and right issues may support
the prices. The loss of earnings and information regarding the forthcoming labor
problem may result in fall in price. These factors may cause a shift in demand and
supply, changing the direction of trends.

4. The market always moves in the trends except for minor deviations.

5. It is known fact that history repeats itself. It is true to stock market also. In the
rising market, investors’ psychology has upbeats and they purchase the shares in
great volumes driving the prices higher. At the same time in the down trend, they
may be very eager to get out of the market by selling them and thus plunging the
share price further. The market technicians assume that past prices predict the
future.

Tools of Technical Analysis

Techical analysis is the attempt to forecast stock prices on the basis of market-
derived data. Technicians (also known as quantitative analysts or chartists)
usually look at price, volume and psychological indicators over time. They are
looking for trends and patterns in the data that indicate future price movements.

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 1. BAR CHARTS

In technical analysis, a bar chart is a way for a trader to monitor the price
movement of an asset and spot trends in order to make trading decisions. A
bar chart shows the opening, high, low, and closing prices of an asset on a
trading day.

2. LINE CHART

A line chart graphically represents an asset's price over time by connecting a

series of data points with a line. This is the most basic type of chart used in
finance, and it typically only depicts a security's closing prices. Line charts
can be used for any time frame but most often have day-to-day price
changes.

3. Candle stick Chart

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A candlestick's shape varies based on the relationship between the day's high, low,
opening and closing prices. Candlesticks reflect the impact of investor sentiment on
security prices and are used by technical analysts to determine when to enter and
exit trades.

4. Point & Figure Chart

Point-and-figure charts often provide technical analysts with different trade and
trend signals, relative to traditional candlestick or bar charts. While some analysts
rely more heavily on the point-and-figure charts, others use these charts to confirm
signals provided by traditional charts in an effort to avoid false breakouts.

The key to point-and-figure charting is the box size, or the amount of price
movement that determines whether a new X or O is added to the chart.

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 5. Support and Resistant level

Support' and 'resistance' are terms for two respective levels on a price chart
that appear to limit the market's range of movement. The support level is
where the price regularly stops falling and bounces back up, while the
resistance level is where the price normally stops rising and dips back down.

6. Head and Shoulders

A head and shoulders pattern is used in technical analysis. It is a specific chart

formation that predicts a bullish-to-bearish trend reversal. The pattern appears as
a baseline with three peaks, where the outside two are close in height, and the
middle is highest.

The head and shoulders pattern forms when a stock's price rises to a peak and then
declines back to the base of the prior up-move. Then, the price rises above the
previous peak to form the "head" and then declines back to the original base.
Finally, the stock price peaks again at about the level of the first peak of the
formation before falling back down.

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 7. Moving Average Analysis

A moving average is a technical indicator that investors and traders use to

determine the trend direction of securities. It is calculated by adding up all
the data points during a specific period and dividing the sum by the
number of time periods. Moving averages help technical traders to
generate trading signals

8. Moving Average Convergence and Divergence

MACD was developed by Gerald Appel as a way to keep track of a moving

average crossover system. Appel defined MACD as the difference between
a 12- day and 26-day moving average. A 9-day moving average of this
difference is used to generate signals. When this signal line goes from
negative to positive, a buy signal is generated. When the signal line goes
from positive to negative, a sell signal is generated. MACD is best used in
choppy (trendless) markets, and is subject to whipsaws (in and out rapidly
with little or no profit).

9. Relative Strength Index

RSI was developed by Welles Wilder as an oscillator to gauge

overbought/oversold levels. RSI is a rescaled measure of the ratio of average
price changes on up days to average price changes on down days. The most
important thing to understand about RSI is that a level above 70 indicates a
stock is overbought, and a level below 30 indicates that it is oversold (it can
range from 0 to 100). Also, realize that stocks can remain overbought or
oversold for long periods of time, so RSI alone isn’t always a great timing tool.

10. Market Breath Analysis

Market breadth looks at the relative change of advancing to declining

securities in a market. Market breadth indicators may forewarn of
reversals and uncover strength or weakness in the movements of an index
that are not visible simply by looking at a chart of the index.

11. The Price Rate of Change (ROC) is a momentum-based technical

indicator that measures the percentage change in price between the current
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 price and the price a certain number of periods ago. The ROC indicator is
plotted against zero, with the indicator moving upwards into positive
territory if price changes are to the upsidse, and moving into negative
territory if price changes are to the downside.

The indicator can be used to spot divergences, overbought and oversold

conditions, and centerline crossovers.

DOW THEORY

Originally proposed in the late nineteenth century by Charles H Dow, the editor
of Wall Street Journal, the Dow theory is perhaps the oldest and best-known
theory of technical analysis. The theory explains how the stock market can be
used by investors to understand the health of the business environment. It was
the first theory to explain that the market moves in trends. While a lot has
changed in the stock markets over the years, the basic tenets of Dow Theory still
remain valid.

Dow developed this theory on the basis of certain hypothesis, which are as follows:

Assumption

 No single individual or buyer or buyer can influence the major trends in the
market. However, an individual investor can affect the daily price
movement by buying or selling huge quantum of particular scrip.

 The market discounts everything. Even natural calamities such as earth

quake, plague and fire also get quickly discounted in the market. The world
trade center blast affected the share market for a short while and then the
market returned back to normalcy.

 The theory is not infallible and it is not a tool to beat the market but
provides a way to understand the market. Explanation of the Theory Dow
described stock prices as moving in trends analogous to the movement of
water.

The market has three trends

1. PRIMARY
2. SECONDARY
3. MINOR

Primary Trends have 3 Phases PRIMARY TREND TYPES

 UPTREND -DOWNTREND
 Phases of Primary uptrend ACCUMULATION, PUBLIC PARTICIPATION
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 and EXCESS PHASE
 Phases of Primary Downtrend DISTRIBUTION, PUBLIC PARTICIPATION
and PANIC PHASE

Primary Trend

 Largest trend-lasting more than a year

 Affects the movements in stock prices
 Generally lasts between 1-3 years but could vary in some instances
 Regardless of trend length, it remains in effect until there is confirmed
reversal.
 Eg: If in an Uptrend, the price closes below the low of a previously
established Trough, it could be a sign that the market is headed lower and
not higher.
 It is important to identify the direction of this trend and trade with it,
until evidence of reversal is received.

SECONDARY TREND

 Intermediate trend lasting 3 weeks – 3 months, usually associated with

movement against primary trend It is a correction to the primary trend
 Eg: Upward Primary Trend will be composed of Secondary Downtrends ie;
movement from a consecutively Higher High to a consecutively Lower
High. In a Primary Downtrend, Secondary trend will be an upward move
or rally ie; movement from consecutively Lower Low to consecutively
Lower Low
 Traders would use this to confirm the validity of the correction within a
Primary trend if the short-term highs fail to create successively higher
peaks (suggesting that a short-term Downtrend is present)

MINOR TREND

 Lasts less than 3 weeks and is associated with movements in the

secondary trend/ intermediate trend
 Goes against the direction of Secondary trend

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  Due to its short-term nature and long-term focus of Dow Theory, this
trend is not of major focus to Dow Theory followers
 Traders will get distracted by short-term volatility and lose sight of bigger
picture

Technical Analysis is the Financial Analysis that uses patterns in market data to
identify trends and make predictions.

 It is used to evaluate investments and identify trading opportunities in

price trends and patterns seen on charts.

 Technical analysts believe past trading activity and price changes of a

security can be valuable indicators of the security's future price
movements.

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Elliott Wave Theory
The Elliott Wave Theory in technical analysis describes price movements in the
financial market.

Elliott wave theory is used to predict price variations primarily in the stock market;
the creator of Elliott wave theory is Ralph Nelson Elliott, an American accountant,
and author; hence the theory is named after him. He introduced it in 1930.
Typically, the wave theory suggests that the price movements are repetitive and
historic, and when looked at from a broader perspective, they look like ocean waves
in long patterns.

It is essential to identify where one wave segment finishes and another starts and
analyze whether a significant correction is the completion of a wave or merely a
deviation from the general trend. As a result, it is one of the most popular forms
of technical analysis used by many portfolio managers globally.

How Elliott Waves Work

Some technical analysts profit from wave patterns in the stock market using the
Elliott Wave Theory. The theory assumes that stock price movements can be
predicted because they move in repeating up-and-down patterns called waves
created by investor psychology or sentiment.

The theory is subjective and identifies two different types of waves: motive or
impulse waves, and corrective waves.

Impulse Waves
Impulse waves consist of five sub-waves that make net movement in the same
direction as the trend of the next-largest degree. This pattern is the most common
motive wave and the easiest to spot in a market. It consists of five sub-waves, three
of which are motive waves. Two are corrective waves.

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  Wave 2 can’t retrace more than the beginning of Wave 1
 Wave 3 cannot be the shortest wave of the three impulse waves,
1, 3, and 5
 Wave 4 does not overlap with the price territory of Wave 1
 Wave 5 needs to end with momentum divergence2

If one rule is violated, the structure is not an impulse wave. The trader
would need to re-label the suspected impulse wave.

Corrective Waves
Corrective waves, called diagonal waves, consist of three, or a
combination of three sub-waves that make net movement in the direction
opposite to the trend of the next-largest degree. Its goal is to move the
market in the direction of the trend.

 The corrective wave consists of 5 sub-waves.

 The diagonal looks like either an expanding or contracting wedge.
 The sub-waves of the diagonal may not have a count of five,
depending on what type of diagonal is being observed.
 Each sub-wave of the diagonal never fully retraces the previous sub-
wave, and sub-wave 3 of the diagonal may not be the shortest wave.

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What are the Elliot Wave Theory Rules and Guidelines

Elliott wave theory’s rules and guidelines ease the identification of waves
for a trader. Elliott wave theory consists of 5 simple rules and guidelines
–

1. Motive waves or impulse waves are a five-wave pattern. It should

always have 5 waves that are known as Wave 1, 2, 3, 4, and 5
respectively.
2. Corrective wave is a three-wave pattern. It should always have 3
waves that are also known as Wave A, B, and C.
3. In a five-wave structure, Wave 2 should never go below the low of
Wave 1. The pattern is considered to be incorrect if wave 2 violates
the bottom of wave 1.
4. In motive waves, wave 3 can never be shorter than wave 1 and wave
5.
5. In a five-wave structure, wave 4 cannot go below the low of wave 3.

Advantages

Elliott wave theory has been a subject of controversy for a long time but it does have
its advantages. Following are the 3 major advantages of the Elliot wave theory –

1. Universal adaptation –
Motive and corrective waves can be seen on every stock, commodity, currency price
chart. The Elliott wave theory offers many opportunities across all types of markets.

2. Identifies the main trend –

Elliott wave theory helps a trader in identifying the main trend of the market.
Elliott wave theory can help a trader in predicting a pending correction in the
market as well. This helps a trader in taking his trading related decisions.

3. Enhances a trader’s edge when used with other indicators –

Elliott wave theory can be used with other technical indicators. Traders use
indicators like RSI and Fibonacci to effectively predict the potential support and
resistance on a price chart.

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The limitations of Elliott wave theory are the main reason why it faces much
criticism. Following are the 3 limitations of the Elliot wave theory –

1. Elliott wave theory is highly subjective –

Elliott wave theory requires a trader to mark the waves according to his own
individual perception about the current market data. This can result in confusion as
other traders can interpret the same data differently and mark the waves in a
completely different way.

2. Elliott wave theory is difficult to understand –

As a beginner trader, identifying and marking Elliot waves correctly can get very
difficult. This results in faulty analysis of the price chart.

3. Elliott wave theory believes that market moves can be predicted –

The stock market is constantly changing and is affected by various other factors
constantly. Sometimes, prices can move drastically because of the latest news in the
market and it may not move according to its past market data.

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