Unit 3
TECHNICAL ANALYSIS
The Visual Clue
Outline
What Is Technical Analysis
Charting Techniques
Technical Indicators
Testing Technical Trading Rules
Evaluation of Technical Analysis
What Is Technical Analysis
In his book technical analysis explained, Martin J. Pring explains:
The technical approach to investing is essentially a reflection of the
idea that prices move in trends which are determined by the
changing attitudes of investors toward a variety of economic,
monetary, political and psychological forces. The art of technical
analysis - for it is an art - is to identify trend changes at an early
stage and to maintain an investment posture until the weight of the
evidence indicates that the trend has been reversed.
Basic Premises Of Technical Analysis
Barring minor deviations, stock prices tend to move in fairly
persistent trends.
Shifts in demand and supply bring about changes in trends.
Irrespective of why they occur, shifts in demand and supply
can be detected in charts.
Technical Analysis Versus Fundamental
Analysis
Technical Analysis
Fundamental Analysis
Predicts short-term
price movements
Establishes long-term values
Focuses on internal market
data
Focuses on fundamental
factors
Appeals to short-term traders
Appeals to long-term
investors
Charting Techniques
The Dow theory
Bar and Line charts
Point and figure chart
Moving average analysis
Relative strength analysis
Basic Concepts Underlying Chart Analysis
Prices move in persistent trends
Volume and trend go hand in hand
There are resistance and support levels
The Dow Theory
The market has three movements, all going at the same time:
Daily fluctuations
: Random day-to-day wiggles
Secondary movements : Corrections that last for a few
weeks or months
Primary trends
: Representing bull and bear
phases of the market
The concept of Dow Theory
Bar And Line Charts
The bar chart depicts the daily price change along with the
closing price.
A line chart shows the line connecting successive closing
prices.
Technical analysts believe that certain formations or patterns
observed on the bar chart or line chart have predictive value.
For example, a head and shoulder pattern represents a
bearish development.
Bar and Line Charts
Technical analysts believe that certain formations or patterns observed on the
bar chart or line chart have predictive value. The more important formations
and their indications are described below.
Head and Shoulders Top (HST) Pattern As the name suggests, the HST formation
has a left shoulder, a head, and a right shoulder, as shown in Exhibit 16.3A. The
HST formation represents a bearish development. If the price falls below the
neckline (the line drawn tangentially to the left and right shoulders), a price
decline is expected. Hence, it is a signal to sell.
Inverse Head and Shoulders Top (IHST) Pattern As the name indicates, the IHST
formation is the inverse of the HST formation, as shown in Exhibit 16.3B. Hence,
it reflects a bullish development. If the price rises above the neck line, a price rise
is expected. Hence, it is a signal to buy.
Triangle or Coil Formation This is shown in Exhibit 16.3C. This formation
represents a pattern of uncertainty. Hence, it is difficult to predict which way the
price will break out.
Flags and Pennants Formation This is shown in Exhibit 16.3D. It typically
signifies a pause after which the previous price trend is likely to continue.
Double Top Formation This is shown in Exhibit 16.3E. It represents a bearish
development, signalling that the price is expected to fall.
Double Bottom Formation This is shown in 16.3F. It reflects a bullish
development, signalling that the price is expected to rise.
Important Chart Formations
Point And Figure Chart
More complex than a bar chart, a point and figure chart (PFC)
condenses the recording of price changes by eliminating the time
scale and small changes.
More complex than a bar chart, a point and figure chart (PFC) has
the following features.
1.
On a PFC only significant price changes are recorded.
For example, for a stock that has a price in the range
of, say Rs 30 to Rs 50, price changes of one rupee or
more only may be posted.
2.
While the vertical scale on a PFC represents the price
of the stock, the horizon scale does not represent the
time scale in the usual sense.
3.
Each column on the horizontal scale of a PFC
represents a significant reversal of price movement
and not a trading day.
Point and Figure Chart
Moving Average Analysis
A moving average is calculated by taking into account the most
recent n observations.
A 5-day moving average of daily closing prices is calculated as follows:
Trading day
1
2
3
4
5
6
7
8
9
10
Closing
price
25.0
26.0
25.5
24.5
26.0
26.0
26.5
26.5
26.0
27.0
Sum of five most
recent closing prices
127.0
128.0
128.5
129.5
131.0
132.0
Moving
average
25.4
25.6
25.7
29.9
26.2
26.4
Moving Average Analysis
To identify trends, technical analysts use moving averages
analysis: a 200-day moving average of daily prices (or alternatively,
30-week moving average of weekly prices) may be used to identify a
long-term trend; a 60-day moving average of daily prices may be
used to discern an intermediate term trend; a 10-day moving
average of daily prices may be used to detect a short-term trend.
Moving Average Analysis
The buy and sell signals provided by the moving average analysis are as follows:
Buy signal
Sell signal
Stock price line rises through the
Stock price lines falls through the
moving average line when the graph
moving average line when the graph
of the
of
moving average line is
flattening out.
Stock price line falls below the
Stock price line, which is above the
moving
average
line
is
flattening out.
moving average line which is rising.
the
Stock price line rises above the
moving average line which is falling.
Stock price line, which is below the
moving average line, falls but begins
moving average line, rises but begins
to
to fall again before reaching the
rise again before reaching the
moving average line.
moving average line.
MACD
A variation of the moving average is the moving average
convergence divergence, or MACD. It involves comparing a shortterm moving average, say a 50-day moving average, with a longterm moving average, say a 200-day moving average. If the shortterm moving average is consistently higher than the long-term
moving average, it is a bullish signal; if the short-term moving
average is consistently lower than the long-term moving average, it
is a bearish signal.
Relative Strength Analysis
Technical analysts measure relative strength in different ways. A
simple approach calculates rates of return and classifies securities
that have earned superior historical returns as having relative
strength. More commonly, technical analysts look at certain ratios to
judge whether a security or, for that matter, an industry has relative
strength. To illustrate how this is done, consider the price data of a
hypothetical pharmaceutical company, Acme Limited, along with the
price data for the pharmaceutical industry and the market as the
whole, given in Exhibit 16.5.
Relative Strength Analysis
Exhibit 16.5 Relative Strength Data for Acme Limited
Year
Average Average Price of Average
price of pharmaceutical price of the
Acme PA industry PPIA
market PMA
PA/PPIA
PA/PMA
PPIA/PMA
20X1
40
30
200
1.33
0.20
0.15
20x2
50
32
210
1.56
0.24
0.15
20x3
65
38
230
1.71
0.28
0.17
20x4
80
45
280
1.78
0.29
0.16
The Advance-Decline Line
The advance-decline line is also referred to as the breadth of the
market. Its measurement involves two steps:
1. Calculate the number of net advances/declines on a daily
basis.
2. Obtain the breadth of the market by cumulating daily net
advances/declines.
Breadth of Market
An illustrative calculation of the breadth of the market is shown in Exhibit 16.7.
Exhibit 16.7 Calculation of Breadth of Market
Day
Advances
Declines
Net
Breadth of
Advances or
Market
Declines
103
103
Tuesday
630
527
Wednesday
690
475
215
318(103+215)
Thrusday
746
424
322
640(318+322)
Friday
492
630
-138
502(640-138)
Monday
366
701
-335
167(502-335)
Turesday
404
698
-294
-127(167-294)
Breadth of Market Analysis
How is the breadth of market analysis used? Typically, the breadth
of market is compared with one or two market averages. Ordinarily,
the breadth of market is expected to move in tandem with a market
average. However, if there is a divergence between the two, the
technical analysts believe that it signals something. More specifically,
if the market average is moving upwards, whereas the breadth of
market is moving downwards, it indicates that the market is likely to
turn bearish. Likewise, if the market average is moving downwards
but the breadth of market is moving upwards it signals that the
market may turn bullish.
New Highs And Lows
Technical analysts consider the market as bullish when a significant
number of stocks hit the 52-week high each day. On the other hand,
if market indices rise but few stocks hit new highs, technical analysts
view this as a sign of trouble.
Volume
Volume analysis is an important part of technical analysis. Other
things being equal, a high trading volume is considered a bullish
sign. If heavy volumes are accompanied by rising prices, it is
considered even more bullish.
Short-Interest Ratio
The short interest ratio is defined as follows:
Total number of shares sold short
Average daily trading volume
A technical analyst considers a high short-interest ratio as a sign of
bullishness
Financial Astrology
From early 1990s a new breed of astrologers, call them financial astrologers
if you will, has emerged in India. They try to predict market sentiments,
share price movements, and even government policy on the basis of the
movement of stars.
Here is a sampling of what they say:
The downtrend in share prices during the past fortnight is because of a
debilitated mercury under the influence of saturn at a time when jupiter is
retrograde.
The market will stabilise by September 12 this year when jupiter enters the
kanya rasi.
According to them, nakshatras that are good for buying or selling are as
follows:
Buying
Revathi
Sathabisha
Ashwini
Shravan
Selling
Purva
phalguni
Purvashada
Kritika
Ashlesha
Bharani
Testing Technical Trading Rules
Does the trading rule produce excess return after adjusting
for risk?
Does the trading rule produce excess returns after adjusting
for transaction and other costs (like taxes)?
How consistent is the performance of the trading rule?
Is the trading rule valid outside the sample?
Evaluation of Technical Analysis
Proponents
1. Under the influence of crowd psychology, trends persist for
quite some time.
2. Shifts in demand and supply are gradual rather than
instantaneous.
3.
Fundamental information about a company is absorbed and
assimilated by the market over a period of time.
4. Charts provide a picture of what has happened in the past
and hence give a sense of volatility that can be expected from
the stock.
Evaluation of Technical Analysis
Detractors
1. Empirical evidence in support of the random-walk hypothesis
casts its shadow.
2. Ultimately, technical analysis must be a self-defeating
proposition.
3.
The numerous claims made for different chart patterns are
simply untested assertions.
4. There is a great deal of ambiguity in the identification of
configurations and patterns.
