Technical Analysis

Why Technical Analysis?

The markets have been rallying in the last few months and many a trader / investor is wondering if
there is a method in the madness in the process of investing. Technical analysis shows a way out
to the serious player who is interested in optimising his returns on investments. I would advocate
every player who has some interest in stocks should have a working knowledge of technical
analysis. Going by the maxim of “knowledge is power”, technical studies provide handy tools akin
to the versatile Swiss army knife to all players.

Technical analysis is the examination of past price movements to forecast future price
movements. This theory is applicable to stocks, indices, or any tradable instrument where the
price is influenced by the forces of demand and supply.

What is technical analysis?

Technical analysis is all about studying stock price graphs and a few momentum oscillators
derived thereof. It must be understood that technical studies are based entirely on prices and do
not include balance sheets, P&L accounts ( fundamental analysis ), the assumption being that the
markets are efficient and all possible price sensitive information is built into the price graph of a
security / index. Therefore, technical analysis supports the efficient market theory as against the
"random walk theory" which supports the belief that stocks can be bought / sold on random events
like flipping a coin !!!, technical analysis is more dynamic as compared to fundamental analysis
based on one simple argument - fundamental analysts depend on corporate events like quarterly
results and special announcements like earnings guidance and policy changes in operations to
generate a buy / sell recommendation. If fundamental analysis was the single most reliable
indicator of trends, prices would predominantly fluctuate only 4 – 5 times a year - around quarterly
results and special announcements like mergers and acquisitions etc!! Why would prices fluctuate
almost daily? If the prices fluctuate ever so often, is there a way to forecast them? Yes according
to technical analysis!!

Features / Characteristics Of Technical Analysis

• Is a medley of Science & art. No algebraic / empirical formulae.

• Involves study of price charts and oscillators derived thereon.
• Study regards price as the ultimate factor, which factors in fundamental factors as well. Does not
subscribe to the random walk theory.
• Signals generated by market action on prices.
• Chances of multiple interpretations are higher.
• Will generate more signals, works for catching MOST price movements.
• Will generally generate signals in advance.
• Involves built-in capital / risk management techniques.
• Is a pure science form, involves pre-set parameters for investment decision support systems.
• Involves study of Balance Sheets, P & L accounts.
• Study regards price movements as a random phenomena, caused by market forces.
• Signals generated by corporate actions.
• Chances of multiple interpretations are lower.
• Will generate fewer signals, works better for catching major moves.
• Will generally generate delayed signals.
• Involves NO risk / capital management techniques.

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Schools of thought Technical analysis has evolved over a period of centuries and every
geographical region has contributed it's flavour to the study. The west has given us the venerable
Dow theory which was advocated in the early 1900's and the Elliot wave theory advocated by R.N.
Elliot. While the dow theory ( using typical bar charts and oscillators as we know them ) remains
the most basic and widely practiced due to it's simplicity, elliot theory uses intraday charts and
bases it's computation on the principle that prices move in waves and that upmoves come in 5
waves and downmoves in 3 waves. Oriental theories are as old as the hills as the japanese
candlestick theories formulated by the rice traders in Sakata province of Japan. They use bullish
and bearish candles to determine the trends in the markets. This theory uses life-like terminology
like the morning star, hanging man, evening stars etc to denote chart patterns. The Chinese have
the yin and yang theory which is similar to the Japanese candle-stick patterns. I would advocate
using the Dow theory based on the sheer simplicity of the same.

Objectives of technical analysis

The main objectives of technical analysis are as follows:

• Such an analysis aims to determine the appropriate time to enter and exit the stock market
by studying various technical indicators and charts. Hence, the main objective of technical
analysis is to study the market timing i.e. the question of ‘when’ to play in the market.
• Technical analysts believe that stock market movement is 10% logical and 90%
psychological in nature. Therefore, most of their tools are designed to read the psychology
of the market.

Assumption of technical analysis

The following are the basic assumptions underlying technical analysis are:

• Market value is determined mainly by the interaction of supply and demand

• Supply and demand are governed by numerous factors, both rational and irrational
• Stock prices tend to move in trends which persist for a considerable period of time
• Changes in trends are caused by shifts in supply and demand for the company’s stocks
• Changes in trends are depicted by means of different charts and graphs.

The New Approach of Technical Analysis

There are three major factors that affect stock prices, earnings, interest rate and investor's
psychology. In the long term, earnings may be the main driving force for stock prices. Short term,
however, investor's psychology or momentum plays a big role in moving stock prices. Technical
Analysis, therefore, is used to track the psychology. It does what no other market analysis
methodology can do. That is why serious traders and professional investors frequently look toward
technical analysis as a valuable trading tool.
Traditionally, charting is the main approach for technical analysis. However interpreting a chart or
an indicator is a subjective issue. Even you have the experience; your accuracy is still very limited
by looking at a chart, not to mention that the meaningful information is often swamped by the
random component of the prices.
In most of the time, stock market is a dynamically changing, stochastic and uncertain environment.
Mathematically, stock prices can be modeled as a time series with random components and serial
correlation information. Stock prices also have cross-correlation with other factors such as market
sentiment, industry strength, fundamental and economic data etc. The correlation information is
the scientific foundation of technical analysis.

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Now a day’s analyst uses neural networks to capture the correlation for individual stocks, and
makes predictions or decisions based on the nearest pattern match. Although such analysis is not
a guarantee to be accurate every time, it is truly objective and scientific, and maybe the best
possible that people can do when dealing with unpredictable stock markets.

Tools For Technical Analysis

Technical analysis requires an efficient charting system. While it is almost mandatory to have a
computer and software that will generate charts based on periodic data updates available, some
basic studies can be carried out with a simple graph paper being used as a charting board with a
X & Y axis. Most newspapers provide price updates with volumes which should be sufficient to plot
basic price graphs. If you have a PC and software you are already a few steps ahead.

Technicians and chartists use several tools to measure price and volume pattern. The following is
a brief description of some of the tools used in technical analysis.

• Moving Average Convergence Divergence (MACD): This is an oscillator, which is

obtained by dividing one moving average by another. For example, a weekly moving
average divided by a monthly moving average is plotted in a chart with a horizontal
equilibrium line. This line is used to give different signals (bullish and bearish). When two
moving averages cross below the equilibrium line, it denotes a bearish signal and when the
averages are above the equilibrium line it denotes a bullish signal. This measure can be
calculated for any number of time periods.

• Trend lines: Technical analysis is built on the assumption that prices trends/fluctuate. A
trend line is a straight line that connects two or more price points and then extends into the
future to act as a line of support or resistance. The trend of either the overall sensex or
individual stock prices can be either upward or downward. When prices break through a
rising or falling trend, the analysts expect the price to keep moving in the newly established
direction.

• Moving averages: This is a summary measure to smoothen share price fluctuations in a

chart and to get a clear indication of the share price trend. The analysts generally use three
types of moving averages. These are: simple moving average, weighted moving
average, and exponential moving average.

The simple moving average is calculated by adding the prices of shares for a number of
periods, and the sum is then divided by the number of periods. For instance, to construct
30-day simple moving average, the prices observed over the 30-day period is summed up
and divided by 30. Assigning weights to the share prices and summing the product of the
prices and weights, which is then divided by the sum total of the weights, calculates
weighted moving average. In exponential moving average, higher weights are assigned
to the most recent prices and lower weights are assigned to the older prices

• Rate of Change (ROC): This measures the rate at which prices rise or fall. It is based on
the principle that prices usually rise and fall at the fastest pace well ahead of their peak and
before their trough respectively.

• Momentum: This is a tool, which helps investors to take market enter-exit decisions in the
short run. This tool is useful at a time when the stock market is very volatile. This measures
the rate of change in share prices by calculating the price differences continuously for a
fixed time interval.

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 • Stochastic: This is an advanced technical tool used by short-term traders to sell at share
price peaks and buy at lower points. It is also useful to long- term investors for identifying
reversal at the end of a boom to exit from the scrip and also to locate the reversal at the
end of the bearish phase to take buying decisions. Stochastic analysis requires the
construction of two lines namely per cent K line and per cent D line. These lines emit
buying/selling signals useful to investors.

The nuts and bolts

In a complex looking charting screen, it must be remembered that the price graph is the meat and
the oscillators are the ketchup. The mistake most novice technical analysts make is to give an
excessive emphasis to oscillators. Please remember that oscillators are derived from price graphs
and not vice-a-versa!! Another aspect that I would stress emphatically is the fact that an objective
approach is needed to succeed using technicals. Try to see what the chart is telling you rather
than what you want to see in the chart.

How to Analyse / Read Charts

Patterns indicate three phases in the market movement – breakout ( beginning of a bull run ),
continuation patterns ( which confirm the ongoing up / down trend ) and exhaustion patterns
( indicate end of the trend ). Readers may note that charts in 2003 showed many breakout
patterns when the bull market began in earnest. Currently, we see a lot of continuation patterns as
bull markets unfold. Though we are yet to near the end of the bullish trend, I would still want
readers to know how to spot signals of trend exhaustion. Forewarned, as they say, is forearmed.

Breakout Patterns –
Gaps
Gaps are the first sign that the markets are attempting to break free from the lethargic sideways
/downward moves. Invariably, a gap up opening will be an early indicator of a bullish pattern
evolving. Traded volumes will show unusual activity as stock prices rally against gravity on buying
by informed circles. As momentum builds up, the rally advances with bigger moves. Gaps are of
three types – breakaway gaps ( beginning of the uptrend ), continuation gaps ( trend confirmation )
and exhaustion gaps ( stock prices making their final attempt to rally against gravity / profit taking.

Bar reversals
As the name suggests, it is a classic reversal pattern. The validity of the bar reversal can be
gauged from the duration of the trend prior to the bar reversal. If there is a reversal after a
prolonged fall, a long tern bearishness maybe ending and therefore a major upmove can be
anticipated. A bar reversal is signaled when the closing tick of the trading bar is against the main
trend. For example – a bear market is in progress and lower tops and bottoms are in formation.
Markets open near / below previous close and close even lower everyday. A bar reversal is
signaled when the intraday low is a new significant low point of the range and the closing is higher
than the opening. The higher the closing to the intraday high, the move valid is the pattern. Traded
volumes play an important part in bar reversals. The bulls and bears fight for domination and
bears attempt to beat down prices, bulls on the other hand refuse to give up and continue to buy.
A large churning can take place and traded volumes will spiral higher. Bar reversals are often early
signs of a bull / bear market emerging.

Inverted head & shoulders – as the name H & S suggests, the price movement resembles a
head flanked by shoulders along a neckline. The noticeable thing is that the pattern is inverted and
must be formed after a significant fall. As a reversal pattern, I would rate this indicator as the most
powerful indicator of all. Volumes play a very large part of a valid inverted H & Sand must rise with

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the prices to sustain the uptrend. One of the most dangerous mistakes that a trader can make is to
preempt a H & S formation and get caught on the wrong foot! Let the pattern evolve and initiate a
trade with confirmation of the neckline piercing is received.

Rounding bottoms / saucer formation –

This pattern resembles a semi circle / saucer and therefore the name – saucer formation. After a
prolonged fall, the chart shows a bottoming out and that too with lower volumes. Trader activity is
low and any concerted effort by bears to hammer prices lower will fail. During the down move of
the saucer, lower tops and bottoms will be seen, during the bottoming out, lateral movement
(probably with short term channels / rectangles) will be seen. On the right hand side (rising /
breakout formation, volumes will rise and the price will spurt past many weeks’ highs. A slight
pullback maybe seen as short term traders lock in profits, only to regret as the uptrend continues
with renewed vigour. It should be noted that many stocks currently display a saucer formation.

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Trendlines – These are the simplest indicator and a traders best friend. As the name itself
suggests, these are lines that are derived from connecting tops (to forecast resistance levels) and
bottoms (to forecast support levels). The most important thing to remember about trendlines is
their duration. The longer the duration of a trendline without it being violated, the more is it’s
validity. For example, a trendline drawn on daily charts and spanning a fortnight is not as affective
as a trendline drawn on a weekly chart and spans 8 weeks!! Once a trendline is drawn, it has room
for modification as the markets are not perfect and a proper trendline is the one which covers as
many tops / bottoms as possible. A trader should stick to his long / short position as long as a
trendline is not violated. In a breakout trendline for example, the lower tops and bottoms formation
will see a sudden reversal as prices breakout above the falling trend trendline. Traded volumes will
be higher and the upmove gathers momentum.

Channels – These are simple formations where two parallel lines can be drawn and within which
the scrip moves. As with a trendline, the longer the duration, the more significant is it’s validity. A
breakout above / below a channel with high volumes signals a breakout / breakdown in the
direction of the underlying security. A channel is useful for traders and investors alike. Traders can
buy at the lower trendline and sell near the upper trend, short at the higher end and go long again
at the lower trendline. Investors can buy once a breakout / breakdown as the case maybe. The
longer the duration of the channel, the higher will be the price swing in the security.

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Now that you have mastered some of these rudimentary yet effective techniques, discipline and
dedication is needed in avoiding temptations to pre-empt the pattern and act only after the pattern
is confirmed by a breakout / breakdown is achieved. Many a profitable trade has turned into a
disaster because the trader succumbed to the temptation of taking a short cut to profits. Then
again the wisdom of keeping stop losses cannot be emphasized enough.

Continuation And Reversal Patterns

These patterns will upgrade your skills on how to identify continuation of bullish patterns and
project the price targets. Forecasting will give a tremendous satisfaction cum profit as you can
plan your trades accordingly. Continuation patterns are for example are an excellent phase in the
markets, you can actually go out and watch movies and play golf as long as the long positions are
trending within identified chart patterns. No need to sit in front of a TV screen throughout the
session. Last but not the least, reversal patterns which will warn you of the bull markets
exhausting their uptrend.

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Continuation Patterns – Channels

Scrips can sometimes move within upward sloping channels for months. This is a bullish
continuation pattern, for as long as the channel bottom is not violated, the uptrend is intact. All a
savvy trader needs to do is to sit on a long position and wait till the channel is fractured. This
pattern helps you to let your profits run and take a laid back approach to investing / trading.

Flags and Pennants

For those who want the power to forecast prices in the future, flags and pennants are excellent
tools. Also known for their accurate price measuring capabilities, these formations are a traders
best friend. A flag formation consists of a pole, a flag ( parallelogram ) and a breakout formation.
The pole is an initial rally after which the scrip corrects downwards. The downward move is in a
channel and forms the flag. The traded volumes during the flag will shrink as traders await a
breakout / breakdown before taking a directional call. A flag formation is confirmed only after a
breakout upwards. As with all price patterns, pre-emptying a pattern can be a perilous affair. The
flag formation occurs typically at “half time” of an upmove. So the next time you see a flag on scrip
at 200 levels which started the upmove from 100, you know a similar rally of 100 points is yet to
unfold! A word of caution on flags – they should be of short duration as longer term flags show
heavy distribution / profit taking and weakens the rally. Pennants on the other hand are two
converging lines on short term charts which show a narrowing price pattern after a good run
upwards. The pattern must see lower traded volumes as traders wait and watch for a breakout /
breakdown. A breakout on atleast 50 % higher volumes is needed to make a valid pennant.

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Trendlines
Trendlines are the simplest form of trend continuation. Savvy and experienced traders have waited
for months as their long positions moved along a rising trendline and their capital multiplied. A stop
loss is placed a few percentage points below the trend line violation levels and the trade is allowed
to “run” its course.

Reversal patterns – Island reversal

This pattern is the first ominous sign of a trend reversal especially if the reversal comes after a
major uptrend. The bar will show a gap up opening, a new top and a sharply lower closing as the
higher levels are unsustainable. Traded volumes maybe higher but prices refuse to move higher
after a bar reversal. That should warn bulls to pare exposure on long positions.

Moving average crossover

A trend reversal will show up on the weekly charts as a price graph violating the short / medium
term moving averages. As long as the Bull Run is on, prices will rise faster than the averages.
Reversals will first show up on average crossover is no other pattern has been observed. Traders
would do well to cut their long positions and covert to cash atleast 50 % if not 100 %. A further
confirmation is when a short term moving average violates a medium / long term moving average
in a downward direction. Traded volumes need not be high on the downsides as hope prevents
bulls from selling scrips.

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Head and shoulder formation
A head and shoulder formation seen at the fag end of rally will mark a trend reversal. Prices will
refuse to move higher and this time the head is above the neckline. This formation is a measuring
move as the distance between the neckline and the head will be seen once the neckline is violated
lower. It is important that the head and shoulder pattern be confirmed by way of a neckline
violation. Pre empting a head & shoulder formation is the most expensive mistake a trader can
make.

Myths in Finance.

When you pass out with a finance degree what are the most important ideas on markets and
finance you get indoctrinated on? There are four key interconnected ideas that are supposed to
form the theoretical bedrock of investment, portfolio management and financial planning. These
are:
 Efficient Market Hypothesis
 Random Walk Theory
 Modern Portfolio Theory
 Capital Asset Pricing Model

For any finance professional worth his or her salt these theories are holy tenets, in the absence of
well-tested and well-developed investment science. Finance dominates everything but its theories
have been primitive compared to other disciplines. So, finance schools have embraced anything
that has the look of a robust theory -- so that it looks like they are teaching a solid body of
knowledge. What do these theories stand for and are they really robust? Not quite. All four
theories have too many exceptions making them, and whatever strategies are built on them, quite
suspect.

Efficient Market Hypothesis was coined by Eugene Fama who theorised that all financial prices
correctly reflect all public information at all times. In an article in Financial Analysts Journal in 1965
entitled "Random Walks in Stock Market Prices" he said:
"In an efficient market, competition among the many intelligent participants leads to a
situation where, at any point in time, actual prices of individual securities already reflect
the effects of information based both on events that have already occurred and on events
which, as of now, the market expects to take place in the future. In other words, in an
efficient market at any point in time the actual price of a security will be a good estimate of
its intrinsic value." This simply means that there is no mis-pricing and so you never under- or
overpay for a stock given what is publicly known at all times. Prices may appear to be too high or
too low at times, but it must be incorrect, only an illusion. According to Fama and followers, stock
picking, market timing, or any other strategy that assumes that any investor is more
knowledgeable than the market (which is the combined wisdom of all market players), is doomed
to fail over the long term. If Fama is right, the entire brokerage industry and the entire fund
management industry is built on shaky foundations at best and is a gigantic fraud on investors at
worst. Under EMH, one investor cannot make more money than another with the same amount of
invested funds since they will have the same information.

What is wrong with this theory? A lot. EMH does not recognise the many methods of analysing
and valuing stocks. EMH does not recognise that some investors may be looking for undervalued
market opportunities while others are looking for their growth potential. They will have different
views on fair market value. Who is actually thinking "efficiently" in an efficient market? However, in
real life everybody's returns are different. The assumption that there cannot be excess returns
waiting to be picked has given rise to an interesting joke. One day, a professor of EMH and his

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student were taking a stroll. The student noticed a Rs 100 note lying around and pointed to the
professor. The professor replied: it cannot be because the EMH theory says, it would have been
picked up long ago. We know from real life that markets do not work efficiently. Very often
speculative bubbles occur. Prices can remain overvalued or undervalued for prolonged periods
even after information becomes widely available. But finance textbooks often convey a sense of
orderly progression, markets that work with quiet efficiency without any disruption.

EMH says markets are efficient. Random Walk Theory says stock prices move in a random walk
fashion. Price changes are unpredictable and occur only in response to genuinely new
information, which by their nature are unpredictable. But if the markets were random and efficient,
prices would cluster around the mean with very few occurrences at the edge (called outliers). But
markets tend to have huge price swings that cannot be explained by randomness. For example,
on May 17th 2004, the markets crashed so badly within the first few minutes of trading that trading
had to be halted. The Sensex had fallen by 800 points or about 16% in a single day! On a random
basis, this ought to happen once in a thousand years.

The combined effect of EMH and Random Walk is to suggest that no investor should ever be able
to beat the average annual returns that all investors and funds are able to achieve collectively,
which is represented by various market averages. From this theory has arisen the whole concept
of passive investing: to put money in an index fund. Indeed, passive investing has been the
average of active investing in the US over long periods. However, there are many examples of
investors who have consistently beaten the market with completely distinctive styles - from Warren
Buffett to George Soros to John Henry to Victor Sperandeo. The record of these men proves that
markets are not random. There are not one but many different patterns in stock prices.

Modern Portfolio Theory developed in the 1960s with Harry Markowitz's work on portfolio
construction, which he pioneered in his paper "Portfolio Selection," published in 1952 by the
Journal of Finance. He made a remarkable discovery that would change investment theory and
practice. MPT holds that the more diversified a portfolio, the less the risk from each of its
components. It is one of the seminal ideas in finance. Some thirty-eight years later, he shared a
Nobel Prize with Merton Miller and William Sharpe for a broad theory for portfolio selection. Before
Markowitz's theory, investors focused on assessing the risks and rewards of individual securities.
Markowitz brought in the idea of diversification, proposing that investors should select portfolios
not individual securities.

He showed that risk is key to investment return and how investors can deal with uncertainty and
risk by constructing a portfolio through asset allocation. All Dr Markowitz did was to mathematically
prove the age-old adage:"Don't put all your eggs into one basket." The logic behind asset
allocation is that different asset classes have different financial characteristics. Stocks, bonds,
gold, real estate and cash all behave quite differently when it comes to risk and reward. For
instance, stocks may offer the highest returns among various asset classes, but they also carry
the highest risk of losses. The way to increase return is to seek a portfolio composition that
optimises the risk and return.

Capital Asset Pricing Model Formulated and published by William Sharpe in 1964, CAPM
decomposes a portfolio's risk into systematic and specific risk. Systematic risk is the risk of being
exposed to the market. As the market moves, each individual asset is affected. Specific risk is the
risk unique to an individual asset, uncorrelated with general market moves. According to CAPM,
the marketplace compensates investors for taking systematic risk but not for taking specific risk.
This is because specific risk can be diversified away through MPT. When an investor holds the
market portfolio, each individual asset in that portfolio entails specific risk, but through
diversification, the investor's net exposure is just the systematic risk. Systematic risk is expressed
as beta which is the variation of portfolio or asset vis-à-vis the market.
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The reason why these four pillars fail to hold in practice is that investing is more of an art and less
of a science. Investment decisions are made by human beings and are therefore prone to
subjective judgement and human error. As long as we do not have a universally agreed system of
pricing stocks, leaving room for subjective judgement, and as long as investments are made on
the basis of hope, fear and greed, returns will vary from one person to another and the market will
be highly inefficient. Three hundred years of irrational behaviour including Tulip mania, South
Seas bubbles, real estate and gold rushes, concept stocks, dotcoms and Asian Crises have
shown that investor psychology can move the market so violently that the four pillars of financial
theory can come crashing down any time.

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