Technical Analysis

Definition 1:
A method of evaluating future security prices and market directions based on statistical analysis of
variables such as trading volume, price changes etc., to identify patterns.

Definition 2:
Analysis applied to the price action of the market to develop trading decisions, irrespective of
fundamental factors.

Premises on Technical Analysis

¾ Market Action discounts everything.

Supply vs. Demand Factors
Fundamental, Political and Psychological factors

¾ Prices move in trends.

Identify new and existing trend.

¾ Prices move in trends - Trend in motion is more

Likely to continue than to reverse.

¾ History repeats itself.

Future is the repetition of the past.

Technical Vs. Fundamental

Fundamental:

9 Study the cause of market movement

9 Supply - demand factor
9 Government interventions

Technical:

9 Study the effect of movement

9 Charts, price, volume, trend

Theories Support Technical Analysis

¾ Dow Theory

Assumptions:
9 Averages discount everything
9 The market has three trends
9 Major trends have three phases
9 Volume must confirm the trend

¾ Elliot Wave Theory

Elliot Wave Theory, which State that the security prices are governed by cycles founded upon the
Fibonacci series (1-2-3- 5-8-13--21....)
Types of Charts

9 Line Charts
9 Candlestick Charts
9 Bar Charts
9 Point & Figure Charts

Candlestick charts have become very popular among all chartists.

Bar Charts

Candlestick Chart
Point & Figure Chart

What Are Moving Averages?

¾ An average of a number of specified historical time periods from the point on the chart.
Moving averages offer an indication of the clear direction and slope of the trend in the
market.

¾ The two most popular types of moving averages are the Simple Moving Average (SMA) and
the Exponential Moving Average (EMA).

¾ SMA is formed by computing the average (mean) price of a security over a specified no. of
periods. While it is possible to create moving averages from the Open, the High and the Low
data points, most moving averages are created using the Closing Price.

¾ Technicians often use EMAs in order to reduce the lag in SMAs (also called Exponentially
Weighted Moving Averages).

SMA & EMA Charts

Approaches of Technical Analysis
¾ Supports & Resistances
9 Pivot Analysis
9 Trend Channel Supports & Resistances

¾ Trend Line Theory

9 Fibonacci Method
9 GANN Theory
9 Bollinger Band

¾ Patterns
9 Continuation & Reversal

¾ Market Indicators
9 Volume Indicators
9 Momentum Indicators

Supports & Resistances

¾ Pivot Analysis Calculation:
Pivot Point = (H + L + C) / 3
Resistance Level 1 = (2 * PP) - L
Support Level 1 = (2 * PP) - H
Resistance Level 2 = (PP - S1) + R1
Support Level 2 = PP - (R1 - S1)
Resistance Level 3 = H + 2 * (PP - L)
Support Level 3 = L - 2 * (H - PP)

¾ Midpoint Calculation:
M1 = (S2 + S1) / 2
M2 = (S1 + PP) / 2
M3 = (R1 + PP) / 2
M4 = (R2 + R1) / 2

Trend Channel Supports & Resistances

Trend Line Theory
Fibonacci Theory:
The Fibonacci numbers are 0, 1, 1, 2, 3, 5, 8, 13, … (add the last two to get the next)

The series proceeds, any given number is 1.618 times the preceding number and 0.618% of the
next number.

(34/55 = 55/89 = 144/233 = 0.618) (55/34 = 89/55 = 233/144 = 1.618), and 1.618 = 1/0.618

The other Fibonacci numbers are 0.382 and 0.50 commonly used in technical analysis have a less
impressive background but are just as powerful in technical analysis.

0.382 = (1 - 0.618) = (0.618 * 0.618), and 0.5 is the mean of the two numbers.

Fibonacci numbers are commonly used in Technical Analysis with or without any knowledge of Elliot
Wave Analysis to determine potential support, resistance & price objectives.

GANN Theory
Features:

Price, Time & Range are the only three factors to consider.
The markets are cyclical in nature.

Based on these premises, GANN’s strategies revolved around three general areas of prediction:

Price Study: This uses support and resistance lines, pivot points and angles.

Time Study: This looks at historically recurring dates, derived by natural and social means.

Pattern Study: This looks at market swing using trend lines and reversal patterns.

GANN noted that there was a relationship between the extent of a price movement and the time the
price took to reach its new level. If a share price moves one unit of price per one unit of time this
results in a trend line of 450. GANN described this as 1 x 1 relationships or squaring of price and
time.
GANN reasoned that if the price breaks through the trend line the new trend line will have a
mathematical relationship with the original one. For example, it could be 2x, 3x or 4x the price or it
could be 1/2, 1/3 or 1/4 of the original.

A GANN chart uses a series of parallel horizontal lines which act as price targets together with a
series of trend lines which fan out at various GANN ratios from the start of a trend.

GANN Chart

GANN Angle
Bollinger Band
¾ Identify overbought and oversold markets

¾ Used in combination with oscillator for buy / sell signals

¾ With other indicators they can warn of impending price movers

¾ With other indicators they can signal potential tops and bottoms
 ¾ A simple moving average in the middle (sometimes omitted)

¾ An upper band (SMA plus 2 standard deviations)

¾ A lower band (SMA minus 2 standard deviations)

¾ Standard deviation is a statistical tool that provides a good indication of volatility. The bands
react quickly and reflect periods of high and low volatility.

¾ Closing prices are most often used to compute Bollinger Bands. Other variations, including
typical and weighted prices can also be used.

¾ Typical Price = (High + Low + Close) / 3

Weighted Price = (High + Low + Close + Close) / 4

¾ Bollinger recommends using a 20-day simple moving average for the center band and 2
standard deviations for the outer bands.

¾ The length of the moving average and no. of deviations can be adjusted to better
suit individual preferences and specific characteristics of an instrument.

¾ Double Bottom Buy: A double bottom buy signal is given when prices penetrate the lower
band and remain above the lower band after a subsequent low forms.

¾ Double Top Sell: A sell signal is given when prices peak above the upper band and a
subsequent peak fails to break above the upper band. The bearish setup is confirmed when
the prices decline below the middle band.

Patterns
¾ Identifying a chart pattern is simply a form of technical analysis.

¾ Research has proven that some chart patterns have high forecasting probabilities.

¾ There are two types of chart patterns:

9 Continuation
9 Reversal

Continuation Pattern
¾ Continuation pattern is nothing but continuation of the trend

9 Triangles
(Ascending, Descending and Symmetric)

9 Flags & Pennants

9 GAP Theory
Triangles
Ascending Triangle
Ascending triangles are generally considered bullish and are most reliable when found in an
uptrend.
The top part of the triangle appears flat while the bottom part of the triangle has an upward slant.

Descending Triangle
Descending triangle is generally considered to be bearish and is usually found in downtrends.
The top part of the triangle has a downward slant and the bottom is flat.

Symmetric Triangle
Symmetric triangles can be characterized as areas of indecision.
A market pauses and future direction is questioned.
Eventually this indecision is met with resolve and usually explodes out of this formation (often on
heavy volume)

Flags & Pennants

¾ Flags & Pennants can be categorized as continuation patterns.

¾ Usually represent only brief pauses in a dynamic market.

¾ They are typically seen after a gig, quick move.

¾ The market then usually takes off again in the same direction.

¾ Bullish flags are characterized by lower tops and lower bottoms, with the patterns slanting
 against the trend. But unlike wedges, their trend lines run parallel.

¾ Bearish flags are comprised of higher tops and higher bottoms. “Bear” flags also have a
tendency to slope against the trend.

¾ Pennants look very much like symmetrical triangles. But pennants are typically smaller in
size (volatility) and duration.

¾ Volume generally contracts during the pause with an increase on the breakout.

Charts

GAP Theory
¾ A Gap is an area on a price chart in which there were no trades.

¾ Normally this occurs after the close of the market on one day and the next day’s open.
Types of Gaps
Common Gaps
- A trading gap or an area gap. The common gap is usually uneventful.
- They appear in trading range or congestion area.

Breakaway Gaps
- Occur when the price action is breaking out of their trading range or congestion area. (price
range in which market has traded for some time.)

Runaway Gaps
- Increase interest in the security. Represents traders who failed to get into the security during
initial move.
Exhaustion Gaps
- Starts near the end of a good up or down trend.
- Signals the end of the move.

Reversal Patterns
¾ Double Top
- They appear on a chart in the shape of letter “M” and are quite common.
- Volume is important to confirm the formation. (Greater volume in the first peak than the secind
one.)
 ¾ Double Bottom
- This is opposite of Double Top and appears as letter “W” on a chart.
- Volume (greater volume in the second peak than the first)

¾ Triple Top / Bottom

- This is a reversal pattern made up of three equal highs followed by a break below support. In
contrast to Bottom.
 ¾ Rounding Tops / Bottom
- The rounding top reflects the market’s perception that the underlying fundaments driving the
prices are changing, but the turn is markedly slow.

¾ Head & Shoulder

9 A technical analysis term used to describe a chart formation in which:
1. Rises to a peak and subsequently declines.
2. Then the price rises above the former peak and again declines.
3. And finally rises again, but not to the second peak and declines once more.

9 The first and third peaks are shoulders, and the second peak forms the head.

9 The “Head - and - Shoulders” pattern is believed to be one of the most reliable
trend-reversal patterns.
Wedges
- Draw trend lines along both the bottom and top of a security price chart, you will sometimes get
a trend channel and you will sometimes get a wedge shape similar to the one below.

- If the wedge is pointing upwards, the security price will fall when the price line cuts across the
lower line of the wedge.

- If the wedge is pointing downwards (a falling wedge), the share price will rise when the price
line cuts across the upper line of the wedge.

- If the wedge is level, i.e., not pointing up or down, then this is a consolidation pattern and you
can expect the trends to continue. (i.e., n on reversal)

- Wedge formations take place over a period of 3 to 4 weeks. This is because they occur as
reversals of intermediate and minor trends.
Reversal Pattern Charts

Market Indicators
Volume Indicators

Volume Price Trend Indicator (VPT): A technical indicator consisting of a cumulative volume line that
adds or subtracts a multiple of percentage change in security prices trend and current volume,
depending upon their upward or downward movements.

This indicator is sued to determine a balance between a security’s demand and supply. The
percentage change in share price trend denotes the relative supply or demand of a particular
security, while volume indicates the actual size of the forces.

Momentum Indicators

Momentum is the changing velocity of a price when related to security analysis. Momentum
indicators are designed to track momentum in the price of a tradable to help identify the relative
enthusiasm of buyers and sellers involved in the price trend development.

Types of Momentum Indicators:

Relative Strength Index (RSI)

Moving Average Convergence & Divergence (MCAD)
Stochastic Oscillator

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.

100
Formula: RSI = 100 - ------------
1+RS
RS = Average of x days’ up closes / average of x days’ down closes.
The RSI ranges from 0 to 100. An asset is deemed to be overbought once the RSI approaches the
70 level, meaning that it may be getting overvalued and is a good candidate for a pullback. Likewise,
if the RSI approaches 30, it is an indication that the asset may be getting oversold and therefore
likely to become undervalued.

RSI Chart

MACD
¾ The most popular formula for the “standard” MACD is the difference between a security’s
26-day and 12-day exponential moving averages.

¾ Usually a 9-day EMA of MACD is plotted along side to act as a trigger line.

¾ A bullish crossover occurs when MACD moves above its 9-day EMA and a bearish
crossover occurs when MACD moves below its 9-day EMA.

MACD Chart
Stochastic Oscillator
This is a momentum indicator that shows the location of the current close relative to the high / low
range over a set number of periods. Closing levels that are consistently near the top of the range
indicate accumulation (buying pressure) and those near the bottom of the range indicate distribution
(selling pressure).

Three types of Stochastic: Fast (%K), Slow (%D) and Full.

Calculation:

Stochastic Chart

Elliot Wave Theory

Elliot Wave Theory interprets market action in terms of recurrent price structures. Basically, market
cycles are composed of two major types of waves: Impulse Wave and Corrective Wave. For every
impulse wave, it can be sub-divided into 5-wave structure (1-2-3-4-5), while for corrective wave, it
can be sub-divided into 3-wave structure (a-b-c).
“Practically all developments which result from (human) socio-economic processes follow a law that
causes them to repeat themselves in similar and constantly recurring serials of waves or impulses of
definite number and pattern...”
R. N. Elliot, Nature’s Law - The Secret of the Universe
By getting the wave count right, you are able to:

¾ Time the entry and catch the big move

¾ Project the end of the trend (accurately), take profits there and do a reverse trade

¾ Sometimes project more than one wave forward and with a built-in timing. A good stress
reliever.

¾ Remember every wave and where you are within the 5 or the 3 (especially useful for the
sales people)
Rule 1 – Wave 2 should not overlap the start of Wave 1

Rule 2 – Wave 3 should not be the shortest wave among waves 1, 3, & 5

Rule 3 – Wave 4 should not overlap Wave 1

References
¾ Above data is gist of Technical Analysis.

¾ Some charts are taken from various websites.

¾ John Murphy book.

Source: Karvy