TECHNICAL ANALYSIS

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Technical analysis
Technical analysis is a form of security
analysis that uses price and volume data,
which is often graphically displayed, in
decision making.

Technical analysis is used on a wide range

of financial instruments, including equities,
bonds, commodity futures, and currency
futures
 Contd…
The underlying logic of technical analysis is
simple:

Supply and demand determine prices.

Changes in supply and demand cause
changes in prices.
Prices can be projected with charts and other
technical tools.
Existence of technical analysis
The first recorded use of technical analysis
was in Japan in the 1700s, where it was
used to analyze trading in the rice market.

Western use of technical analysis was

pioneered by Dow in the 1896s.
Difference between fundamental
and technical analysis
 A key distinction between technical analysis and
fundamental analysis is that the technician has more
concrete data, primarily price and volume data, to
work with.

 The financial statements analyzed by fundamental

analysts are not objective data but are the result of
numerous estimates and assumptions that have been
added together to arrive at the line items in the
financial statements.

 Financial statements are subject to restatements

because of such issues as changes in accounting
assumptions and even fraud.
Case-let: 1
A good example of when technical analysis is a
superior tool to fundamental analysis is in the case of
securities fraud, such as occurred at Enron
Corporation and WorldCom. These companies were
issuing fraudulent financial statements, but many
fundamental analysts continued to hold favorable
views of the companies’ equity securities even as the
share prices declined.

Simultaneously, a small group of investors came to

the opposite view and expressed this view through
high-volume sales of the securities. The result was
clearly negative chart patterns that could then be
discerned by technical analysis.
DOW Theory
Dow Theory is named after Charles H Dow,
who is considered as the father of Technical
Analysis.

This theory is based on the many editorials

Dow had written between the years of 1900-
1902. Following his death, William Hamilton
continued the work. In 1932, the writings of
these two men were collectively published
as the Dow Theory by Robert Rhea.
Principles of Dow Theory
First Principle: The Stock Market
Discounts All Information

Technical analysts believe that the current price

fully reflects all the possible material
information which could affect the price.

The market price reflects the sum knowledge of

all participants, including traders, investors,
portfolio managers, buy-side analysts, sell-side
analysts, market strategist, technical analysts,
fundamental analysts and many others.
 Contd…
Second Principle: The Stock Market
Have Three Trends

a. Primary Trend

b. Secondary trend
c. Minor Trend
Primary, Secondary & Minor Trends
 Contd…
Third Principle: Primary Trend Have
Three Phases

a. Accumulation Phase

b. Participation Phase
c. Distribution Phase
Accumulation Phase, Participation Phase and Distribution
Phase
 Contd…
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.
Create two indexes namely:-
(i) Dow Jones Industrial Index
(ii) Dow Jones Rail Index (now Transportation
Index)
 Contd…
According to Dow:-

Rise in these two indexes reflects that overall

business condition of the economy is good

The divergence in these two indexes is a

warning signal
 Contd…
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.
 Contd…
Trend weakness:
Rising prices and falling volume signal
trend weakness.
Falling prices and falling volume may signal
trend weakness.

Trend confirmation: Trend weakness:

Rising prices and rising volume Rising prices and falling volume
signal a healthy up-trend. signal trend weakness.
Falling prices and rising volume Falling prices and falling
signal a healthy down-trend. volume may signal trend
weakness.
 Contd…
Sixth Principle: Trend Remains Intact
Until and Unless Clear Reversal
Signals Occur

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
Elliott Wave
Elliott Wave theory (1938) is developed by
Ralph Nelson Elliott and is successfully
being used by market participants to
analyze stock market to forecast market
trends

Elliot Wave theory is based on the

hypothesis that stock prices move between
optimism and pessimism of all market
participants’
Fundamental Concept
Elliott Wave theory suggests that stock
prices move in clear trends:-
A. Dominant trend (Five wave pattern)
B. Corrective trend (Three wave pattern)
Dominant trend (Five wave
pattern)
Contd…
Characteristic of Dominant Trend
(when markets are rising)
Characteristic of Dominant Trend
(when markets are declining)
Corrective trend (Three wave
pattern)
Pattern Recognition
Elliot Wave Rules
Rule 1: Wave 2 cannot retrace more than
100% of Wave 1 i.e. in the rising market
Wave 2 would not break bottom of Wave 1
and similarly in declining market Wave 2
would not break top of Wave 1.
Rule 2: Wave 3 is never the shortest- This
means that Wave 3 is always longer than
other two waves i.e. Wave 1 or Wave 2.
Rule 3: Wave 4 can never overlap Wave 1 –
This means that end of wave 4 should not
trade below the peak of wave 1.
Moving average
A moving average is the average of the
closing price of a security over a specified
number of periods.
Moving averages smooth out short-term
price fluctuations, giving the technician a
clearer image of market trend.
Technicians commonly use a simple moving
average, which weights each price equally
in the calculation of the average price.
 Contd…
Some technicians prefer to use an exponential
moving average, which gives the greatest
weight to recent prices while giving
exponentially less weight to older prices.
The number of data points included in the
moving average depends on the intended use
of the moving average.
A 20-day moving average is commonly used
because a month contains roughly 20 trading
days. Also, 60 days is commonly used because
it represents a quarter year (three months) of
trading activity.
 Contd…
Moving averages can be used in
conjunction with a price trend or in
conjunction with one another.
 Contd…
Interpretations
Moving averages in conjunction with
price
A security that has been trending down in
price will trade below its moving average,
and a security that has been trending up will
trade above its moving average.
 Contd…
Moving averages (MA) in conjunction with
MA
Investors often use moving-average crossovers
as a buy or sell signal.
When a short-term moving average (i.e. 1 month)
crosses from underneath a longer-term average
(i.e. 3 months), this movement is considered
bullish and is termed a golden cross.
Conversely, when a short-term moving average
crosses from above a longer-term moving
average, this movement is considered bearish
and is called a death cross.
Moving average: Cipla Ltd.
 Cipla’s 50 day SMA (black) and a 50 day EMA (red) of closing prices.
Though both SMA and EMA are for a 50 day period, you can notice
that the EMA is more reactive to the prices and sticks closer to the
price.
Contd…
 EMA is quicker to react to the current market price because EMA gives
more importance to the most recent data points. This helps the trader to
take quicker trading decisions. Hence, for this reason, traders prefer the
use of the EMA over the SMA.
Moving average: Ambuja cement
 The black line on the price chart is the 50-day
exponential moving average.
Moving average: BPCL Ltd.
 Here is another example of BPCL, where the MA system
suggested multiple trades during the sideways market;
however, none of them was really profitable. However,
the last trade resulted in a 67% profit in about 5 months.
Daily Price Chart with 20-Day and 60-Day
Moving Averages: Gazprom EDR, November
2007–August 2009 (Price in Euros)
Bollinger Bands
John Bollinger combined his knowledge of
technical analysis with his knowledge of
statistics to create an indicator called
Bollinger Bands

Bollinger Bands consist of a MA plus a higher

line representing the MA plus a set number of
standard deviations from average price (for
the same number of periods as used to
calculate the MA) and a lower line that is a MA
minus the same number of standard
deviations
 Contd…
It consists of a 20 period simple moving
average with upper and lower bands.
The upper band is 2 standard deviation
above the moving average and
Similarly lower band is 2 standard deviation
below the moving average.
Bollinger Bands: Nifty
Bollinger Bands: BPCL Ltd.
Interpretation of Bollinger
Bands
Big move in price is witnessed on either side
when bands tightens/contracts as volatility
lessens.
The upper band act as area of resistance and
lower band act as area of support.
When prices move outside the band, it
signifies breakout, hence continuation of the
trend.
Bottoms and tops made outside the band,
followed by tops and bottoms made inside
the band suggests reversal of the trend.
William %R
W%R is also known as Williams percent
range

It is type momentum indicator that moves

between 0 and -100

It measures
overbought and oversold levels
Formula
%R = (Highest High - Close)/(Highest High -
Lowest Low) * -100
Lowest Low = lowest low for the look-back
period Highest High = highest high for the
look-back period
%R is multiplied by -100 correct the inversion
and move the decimal.
The default setting for Williams %R is 14
periods, which can be days, weeks, months
or an intraday timeframe.
Estimating W%R
Analysis of W%R
Moving Average
Convergence/Divergence (MACD)
The Moving Average
Convergence/Divergence indicator is a
momentum oscillator primarily used to
trade based on trends.

Although it is an oscillator, it is not typically

used to identify over bought or oversold
conditions. It appears on the chart as two
lines which oscillate without boundaries.
 Contd…
Step1. Calculate a 12 period exponential
moving average of the close price.
Step2. Calculate a 26 period exponential
moving average of the close price.
Step3. Subtract the 26 period moving
average from the 12 period moving
average. This is the fast MACD line.
Step4. Calculate a 9 period exponential
moving average of the fast MACD line
calculated above. This is the slow or signal
MACD line.
Fast line & Signal line
Analysis of MACD line
Moving average crossover:-

Go long when the fast line crosses

above the slow line.
Go short when the fast line crosses
below the slow line.
Moving average crossover
Bullish Divergence
Bearish Divergence
Divergence and Convergence

https://hmarkets.com/learn-to-trade/learning-hub/macd/
Relative strength analysis
Relative strength analysis is widely
used to compare the performance of a
particular asset, such as a common stock,
with that of some benchmark.

Such as, in the case of common stocks, the

Sensex, Nifty 50, FTSE 100, the Nikkei 225,
or the S&P 500 Index—or the performance
of another security.
 Contd...
The intent is to show over-or-under
performance of the individual security
relative to some other index or asset.

Typically, the analyst prepares a line chart

of the ratio of two prices, with the asset
under analysis as the numerator and with
the benchmark or other security as the
denominator.
 Contd...
A rising line shows the asset is performing
better than the index or other stock; a
declining line shows the opposite. A flat line
shows neutral performance.

Lets take an example of:

Amazon Inc. (AMZN) vis-a-vis S&P 500
Walmart Inc. (WMT) vis-a-vis S&P 500
Amazon Inc. (AMZN) vis-a-vis S&P
500
Walmart Inc. (WMT) vis-a-vis S&P
500
Relative Strength Index
A relative strength index (RSI) is
computed over a rolling time period. It
graphically compares a security’s gains with
its losses over the set period. The creator of
the RSI, Welles Wilder, suggested a 14- day
time period, and this period is generally the
period used in most technical analysis
software.

Short time periods (such as 14 days) provide

information about short-term price behavior.
Contd...
The RSI provides information on whether or
not an asset is overbought. The formula for
the RSI is not intuitive and is best
understood with an example. The formula
is:
Contd...
Contd...
The index construction forces the RSI to lie
within 0 and 100. A value above 70
represents an overbought situation. Values
below 30 suggest the asset is oversold.

Less volatile stocks (such as utilities) may

normally trade in a much narrower range.
More volatile stocks (such as small-
capitalization technology stocks) may trade
in a wider range.
Contd...
For example, in an uptrend, one might see
a range of 40–80 but in downtrends, a
range of 20–60.
Contd...
Candlesticks
Hammer and Hanging Man
Contd…
Bullish and Bearish Engulfing
Contd…
Contd…
Inter-market analysis
Inter-market analysis is a field within
technical analysis that combines analysis
of major categories of securities—namely,
equities, bonds, currencies, and commodities
—to identify market trends and possible
inflections in a trend.

Inter-market analysis also looks at industry

subsectors, and the relationships among the
major stock markets of countries with the
largest economies, such as the New York,
London, and Tokyo stock exchanges.
Contd...
Inter-market analysis relies heavily on the
field of economic analysis for its theoretical
underpinning. The field was pioneered by
John Murphy with his 1991 book Inter-
market Technical Analysis.

Murphy noted that all markets are inter-

related and that these relationships are
strengthening with the globalization of the
world economy.
Stock and Bond
Stock prices are affected by bond prices.
High bond prices are a positive for stock
prices since this means low interest rates.
Lower interest rates benefit companies with
lower borrowing costs and lead to higher
equity valuations in the calculation of
intrinsic value using discounted cash flow
analysis in fundamental analysis.
Thus rising bond prices are a positive for
stock prices, and declining bond prices are
a bearish indicator.
Bond and Commodity
Bond prices impact commodity prices.
Bond prices move inversely to interest
rates.
Interest rates move in proportion to
expectations to future prices of
commodities or inflation.
So declining bond prices are a signal of
possible rising commodity prices.
Currency and Commodity
Currencies impact commodity prices. Most
commodity trading is denominated in US
dollars and so prices are commonly quoted
in US dollars.
As a result, a strong dollar results in lower
commodity prices and vice versa.
Analysis
In inter-market analysis, technicians often
look for inflection points in one market as a
warning sign to start looking for a change
in trend in a related market. To identify
these inter-market relationships, a
commonly used tool is relative strength
analysis.
Contd...
Contd...
 Thank you!

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