Unit I: Introduction to Technical Analysis

(Refer NCFM Technical Analysis Module)

What is Technical Analysis?

Technical Analysis can be defined as an art and science of forecasting
future prices based on an examination of the past price movements.
Technical analysis is not astrology for predicting prices. Technical
analysis is based on analyzing current demand-supply of commodities,
stocks, indices, futures, or any tradable instrument.

Technical analysis involves putting stock information like prices, volumes

and open interest on a chart and applying various patterns and indicators to
it in order to assess the future price movements. The time frame in which
technical analysis is applied may range from intraday (1-minute, 5-
minutes, 10-minutes, 15-minutes, 30-minutes or hourly), daily, weekly, or
monthly price data to many years.

There are essentially two methods of analyzing investment opportunities

in the security market viz fundamental analysis and technical analysis.
You can use fundamental information like financial and non-financial
aspects of the company or technical information which ignores
fundamentals and focuses on actual price movements.

Technical Analysis: The basic assumptions

The field of technical analysis is based on three assumptions:

1. The market discounts everything.

2. Price moves in trends.

3. History tends to repeat itself.

1. The market discounts everything

Technical analysis is criticized for considering only prices and ignoring

the fundamental analysis of the company, economy etc. Technical analysis
assumes that, at any given time, a stock’s price reflects everything that has
or could affect the
company - including fundamental factors. The market is driven by mass psychology and
pulses with the flow of human emotions. Emotions may respond rapidly to extreme events,
but normally change gradually over time. It is believed that the company’s fundamentals,
along with broader economic factors and market psychology, are all priced into the stock,
removing the need to consider these factors separately. This only leaves the analysis of price
movement, which technical theory views as a product of the supply and demand for a
particular stock in the market.
2. Price moves in trends
“Trade with the trend” is the basic logic behind technical analysis. Once a trend has been
established, the future price movement is more likely to be in the same direction as the trend
than to be against it. Technical analysts frame strategies based on this assumption only.

3. History tends to repeat itself.

People have been using charts and patterns for several decades to demonstrate patterns in
price movements that often repeat themselves. The repetitive nature of price movements
is attributed to market psychology; in other words, market participants tend to provide a
consistent reaction to similar market stimuli over time. Technical analysis uses chart
patterns to analyze market movements and understand trends.

Strengths and weakness of Technical Analysis

Importance of Technical Analysis

Not Just for stocks

Technical analysis has universal applicability. It can be applied to any financial

instrument - stocks, futures and commodities, fixed-income securities, forex, etc

Focus on price

Fundamental developments are followed by price movements. By focusing only on price

action, technicians focus on the future. The price pattern is considered as a leading
indicator and generally leads the economy by 6 to 9 months. To track the market, it
makes sense to look directly at the price movements. More often than not, change is a
subtle beast. Even though the market is prone to sudden unexpected reactions, hints
usually develop before significant movements. You should refer to periods of
accumulation as evidence of an impending advance and periods of distribution as
evidence of an impending decline.

Supply, demand, and price action

Technicians make use of high, low and closing prices to analyze the price action of a
stock. A good analysis can be made only when all the above information is present

Separately, these will not be able to tell much. However, taken together, the open, high,
low and close reflect forces of supply and demand.

Support and resistance

Charting is a technique used in analysis of support and resistance level. These are trading
range in which the prices move for an extended period of time, saying that forces of
demand and supply are deadlocked. When prices move out of the trading range, it signals
that either supply or demand has started to get the upper hand. If prices move above the
upper band of the trading range, then demand is winning. If prices move below the lower
band, then supply is winning.
Pictorial price history

A price chart offers most valuable information that facilitates reading historical account
of a security’s price movement over a period of time. Charts are much easier to read than
a table of numbers. On most stock charts, volume bars are displayed at the bottom. With
this historical picture, it is easy to identify the following:

● Market reactions before and after important events

● Past and present volatility

● Historical volume or trading levels

● Relative strength of the stock versus the index.

Assist with entry point

Technical analysis helps in tracking a proper entry point. Fundamental analysis is used to
decide what to buy and technical analysis is used to decide when to buy. Timings in this
context play a very important role in performance. Technical analysis can help spot
demand (support) and supply (resistance) levels as well as breakouts. Checking out for a
breakout above resistance or buying near support levels can improve returns.

First of all you should analyze stock’s price history. If a stock selected by you was great
for the last three years has traded flat for those three years, it would appear that market
has a different opinion. If a stock has already advanced significantly, it may be prudent to
wait for a pullback. Or, if the stock is trending lower, it might pay to wait for buying
interest and a trend reversal.

Weaknesses of Technical Analysis

Analyst bias

Technical analysis is not hard core science. It is subjective in nature and your personal
biases can be reflected in the analysis. It is important to be aware of these biases
when analyzing a chart. If the analyst is a perpetual bull, then a bullish bias will
overshadow the analysis. On the other hand, if the analyst is a disgruntled eternal bear,
then the analysis will probably have a bearish tilt.

Open to interpretation

Technical analysis is a combination of science and art and is always open to

interpretation. Even though there are standards, many times two technicians will look at
the same chart and paint two different scenarios or see different patterns. Both will be
able to come up with logical support and resistance levels as well as key breaks to justify
their position. Is the cup half-empty or half-full? It is in the eye of the beholder.

Too late
You can criticize the technical analysis for being too late. By the time the trend is
identified, a substantial move has already taken place. After such a large move, the
reward to risk ratio is not great. Lateness is a particular criticism of Dow Theory.
Always another level

Technical analysts always wait for another new level. Even after a new trend has been
identified, there is always another “important” level close at hand. Technicians have been
accused of sitting on the fence and never taking an unqualified stance. Even if they are
bullish, there is always some indicator or some level that will qualify their opinion.

Trader’s remorse

An array of pattern and indicators arises while studying technical analysis. Not all the
signals work. For instance: A sell signal is given when the neckline of a head and
shoulders pattern is broken. Even though this is a rule, it is not steadfast and can be
subject to other factors such as volume and momentum. In that same vein, what works for
one particular stock may not work for another. A 50-day moving average may work great
to identify support and resistance for Infosys, but a 70-day moving average may work
better for Reliance. Even though many principles of technical analysis are universal, each
security will have its own idiosyncrasies.

TA is also useful in controlling risk

It is Technical Analysis only that can provide you the discipline to get out when you’re
on the wrong side of a trade. The easiest thing in the world to do is to get on the wrong
side of a trade and to get stubborn. That is also potentially the worst thing you can do.
You think that if you ride it out you’ll be okay. However, there will also be occasions
when you won’t be okay. The stock will move against you in ways and to an extent that
you previously found virtually unimaginable.

It is more important to control risk than to maximize profits!

There is asymmetry between zero and infinity. What does that mean? Most of us have
very finite capital but infinite opportunities because of thousands of stocks. If we lose an
opportunity, we will have thousands more tomorrow. If we lose our capital, will we get
thousands more tomorrow? It is likely that we will not. We will also lose our
opportunities. Our capital holds more worth to us than our opportunities because we must
have capital in order to take advantage of tomorrow’s opportunities.

It is more important to control risk than to maximize profits! Technical Analysis, if

practiced with discipline, gives you specific parameters for managing risk. It’s simply
supply and demand. Waste what’s plentiful, preserve what’s scarce. Preserve your capital
because your capital is your opportunity. You can be right a thousand times, become very
wealthy and then get wiped out completely if you manage your risk poorly just once. One
last time: That is why it is more important to control risk than to maximize profits! You
can criticize the technical analysis for being too late. By the time the trend is identified, a
substantial move has already taken place. After such a large move, the reward to risk
ratio is not great. Lateness is a particular criticism of Dow Theory.
What Is Random Walk Theory?
Random walk theory suggests that changes in asset prices are random. This means that
stock prices move unpredictably, so that past prices cannot be used to accurately predict
future prices. Random walk theory also implies that the stock market is efficient and reflects
all available information.

A random walk challenges the idea that traders can time the market or use technical
analysis to identify and profit from patterns or trends in stock prices. Random walk has been
criticized by some traders and analysts who believe that stock prices can be predicted using
various Understanding Random Walk Theory

Economists had long argued that asset prices were essentially random and unpredictable—
and that past price action had little or no influence on future changes. This, indeed, was a
key assumption of the efficient market hypothesis (EMH). Random walk theory is based on
the idea that stock prices reflect all available information and adjust quickly to new
information, making it impossible to act on it.

Economist Burton Malkiel’s theory aligns with the semi-strong efficient hypothesis, which
also argues that it is impossible to consistently outperform the market. The theory thus has
important implications for investors, suggesting that buying and holding a diversified portfolio
may be the best long-term investment strategy.

Basic Assumptions of the Random Walk Theory:

1. The Random Walk Theory assumes that the price of each security in the stock market
follows a random walk.
2. The Random Walk Theory also assumes that the movement in the price of one
security is independent of the movement in the price of another security.
Implications of the Random Walk Theory
Since the Random Walk Theory posits that it is impossible to predict the movement of stock
prices, it is also impossible for a stock market investor to outperform or “beat” the market in
the long run. It implies that it is impossible for an investor to outperform the market without
taking on large amounts of additional risk.

As such, the best strategy available to an investor is to invest in the market portfolio, i.e., a
portfolio that bears a resemblance to the total stock market and whose price reflects
perfectly the movement of the prices of every security in the market.

A flurry of recent performance studies reiterating the failure of most money managers to
consistently outperform the overall market has indeed led to the creation of an ever-
increasing number of passive index funds.

Also, it appears that an increasing number of investors are firm believers in the wisdom of
index investing. According to data from Vanguard and Morningstar, 2016 saw an
unprecedented inflow of more than $235 billion into index funds.

Criticism of the Random Walk Theory

One of the main criticisms of the Random Walk Theory is that the stock market consists of a
large number of investors, and the amount of time each investor spends in the market is
different. Thus, it is possible for trends to emerge in the prices of securities in the short run,
and a savvy investor can outperform the market by strategically buying stocks when the
price is low and selling stocks when the price is high within a short time span.

Other critics argue that the entire basis of the Random Walk Theory is flawed and that stock
prices do follow patterns or trends, even over the long run. They argue that because the
price of a security is affected by an extremely large number of factors, it may be impossible
to discern the pattern or trend followed by the price of that security. However, just because a
pattern cannot be clearly identified, that doesn’t mean that a pattern does not exist.
A Non-Random Walk
In contrast to the Random Walk Theory is the contention of believers in technical analysis –
those who think that future price movements can be predicted based on trends, patterns,
and historical price action. The implication arising from this point of view is that traders with
superior market analysis and trading skills can significantly outperform the overall market
average.

Both sides can present evidence to support their position, so it’s up to each individual to
choose what they believe. However, there is one fact – perhaps a decisive one – which goes
against the random walk theory. This is the fact that there are some individual traders who
consistently outperform the market average for long periods of time.

According to the Random Walk Theory, a trader should only be able to outperform the
overall market average by chance or luck. It would allow for there to be some traders who, at
any given point in time, would – purely by chance – be outperforming the market average.

However, what are the odds that the same traders would be “lucky” year in and year out for
decades? Yet there are indeed such traders, people like Paul Tudor Jones, who have
managed to generate significantly above-average trading returns on a consistent basis over
a long span of time.

It’s important to note that even the most devout believers in technical analysis – those who
think that future price movements in the market can be predicted – don’t believe that there’s
any way to infallibly predict future price action. It is more accurate to say that probable
future price movement can be predicted by using technical analysis and that by trading
based on such probabilities, it is possible to generate higher returns on investment.
 FUNDAMENTAL VS TECHNICAL ANALYSIS

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THE CHARTS
What is a chart?

Charts are the working tools of technical analysts. They use charts to plot the price
movements of a stock over specific time frames. It’s a graphical method of showing
where stock prices have been in the past.

A chart gives us a complete picture of a stock’s price history over a period of an hour,
day, week, month or many years. It has an x-axis (horizontal) and a y-axis (vertical).
Typically, the x-axis represents time; the y-axis represents price. By plotting a stock’s
price over a period of time, we end up with a pictorial representation of any stock’s
trading history.
A chart can also depict the history of the volume of trading in a stock. That is, a chart can
illustrate the number of shares that change hands over a certain time period.

Types of price charts:

1. Line charts

“Line charts” are formed by connecting the closing prices of a specific stock or market
over a given period of time. Line chart is particularly useful for providing a clear visual
illustration of the trend of a stock’s price or a market’s movement. It is an extremely
valuable analytical tool which has been used by traders for past many years.

NIFTY (Daily) Line Chart

2. Bar chart

Bar chart is the most popular method traders use to see price action in a stock over a
given period of time. Such visual representation of price activity helps in spotting trends
and patterns.

Although daily bar charts are best known, bar charts can be created for any time period -
weekly and monthly, for example. A bar shows the high price for the period at the top
and the lowest price at the bottom of the bar. Small lines on either side of the vertical bar
serve to mark the opening and closing prices. The opening price is marked by a small tick
to the left of the bar; the closing price is shown by a similar tick to the right of the bar.
Many investors work with bar charts created over a matter of minutes during a day’s
trading.
NIFTY (Daily) Bar Chart

3. Candlesticks

Formation

Candlestick charts provide visual insight to current market psychology. A candlestick

displays the open, high, low, and closing prices in a format similar to a modern-day bar-
chart, but in a manner that extenuates the relationship between the opening and closing
prices. Candlesticks don’t involve any calculations. Each candlestick represents one
period (e.g., day) of data. The figure given below displays the elements of a candle.
A candlestick chart can be created using the data of high, low, open and closing prices for
each time period that you want to display. The hollow or filled portion of the candlestick
is called “the body” (also referred to as “the real body”). The long thin lines above and
below the body represent the high/low range and are called “shadows” (also referred to as
“wicks” and “tails”). The high is marked by the top of the upper shadow and the low by
the bottom of the lower shadow. If the stock closes higher than its opening price, a
hollow candlestick is drawn with the bottom of the body representing the opening price
and the top of the body representing the closing price. If the stock closes lower than its
opening price, a filled candlestick is drawn with the top of the body representing the
opening price and the bottom of the body representing the closing price.

Each candlestick provides an easy-to-decipher picture of price action. Immediately a

trader can see and compare the relationship between the open and close as well as the
high and low. The relationship between the open and close is considered vital information
and forms the essence of candlesticks. Hollow candlesticks, where the close is greater
than the open, indicate buying pressure. Filled candlesticks, where the close is less than
the open, indicate selling pressure. Thus, compared to traditional bar charts, many traders
consider candlestick charts more visually appealing and easier to interpret.
 NIFTY (Daily) Candlestick Chart

Why candlestick charts?

What does candlestick charting offer that typical Western high-low bar charts do not?
Instead of vertical line having horizontal ticks to identify open and close, candlesticks
represent two dimensional bodies to depict open to close range and shadows to mark
day’s high and low.

For several years, the Japanese traders have been using candlestick charts to track market
activity. Eastern analysts have identified a number of patterns to determine the
continuation and reversal of trend.

These patterns are the basis for Japanese candlestick chart analysis. This places
candlesticks rightly as a part of technical analysis. Japanese candlesticks offer a quick
picture into the psychology of short term trading, studying the effect, not the cause.
Applying candlesticks means that for short-term, an investor can make confident
decisions about buying, selling, or holding an investment.
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
6.1 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)

(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)

(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).

(Figure 3) illus-
trates primary
trend is rising and
A-B, C-D, E-F is
Primary Trend and
B-C, D-E is
Secondary Trend.
Here secondary
trend is correction
in the rising
market.
(Figure 3)
 (Figure 4) illustrates
primary trend is fall-
ing and G-H, I-J, K-L
is Primary Trend and
H-I, J-K is Secondary
Trend. Here secondary
trend is pull back in
the falling market.

(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)

(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

(a) 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.

(b) 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 wors, 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.
6.2 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.

6.3 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.