Chapter – 9

Technical
Analysis
Introduction to technical analysis and assumptions

•The methods used to analyze securities and make

investment decisions fall into two very broad categories:

-fundamental analysis and

-technical analysis.

•In Fundamental analysis: Share prices are analyzed on

the basis of Economic, Industry & Company analysis.

•If share prices are lower than intrinsic value----Buy

•If share prices are higher than intrinsic value----Sell

What is Technical Analysis?
•Technical analysis is a method of evaluating
securities by analyzing the statistics generated by
market activity, such as past prices and volume.

• Technical analysts do not attempt to measure a

security's intrinsic value, but instead use charts and
other tools to identify patterns that can suggest
future activity.
•It formulates the buying & selling strategies.

•Using several indicators, investor analyzes the

relationship between price-volume and supply-demand
for overall market as well as individual stock.

•During upswing-----shares traded are greater

•During downswing-----shares traded are smaller

Basic Technical Assumptions

The basic and necessary assumptions regarding the

technical analysis:

1) Market Discounts Everything

2) Price Moves in Trends

3) History Tends To Repeat Itself

 Technical V/S Fundamental Analysis

Several ways the technician acts:

Technical analysis forecasts security prices by
studying patterns of supply and demand for
securities.
Technical analysts believe that behind the
fundamentals are important factors
 Technical analysts act on the what not the why
 Technical analysts are not committed to a buy-and-
hold policy
 Technical analysts act more quickly to make
commitments and to take profits and losses
 Technical analysts insist that the market always
repeats
 Technical analyst approaches a security from the
charts
 Technical analyst takes a relatively short-term
approach to analyzing the market
 Technical analysis is used for a trade
Distinctions between Fundamental and Technical
Analysis
Fundamental Technical
Perspective is long-term in nature Outlook is short-term oriented i.e.
i.e. conservative approach. aggressive.

Adopts a buy and hold policy. Believes in making a quick money.

Distinguishes between current Does not distinguish between

income and capital gains. current income and capital gains.
Interested in short-term profits.

Forecasts stock prices on the basis Forecasts security prices by

of economic, industry and studying patterns of supply and
company statistics. demand for securities.

Uses tools of financial analysis Uses mainly changes of financial

and statistical forecasting variables besides some quantitative
techniques tools.
Tools of Technical Analysis
A. Dow Theory
•Dow developed this theory to explain movements of
indices.
•Dow developed certain hypotheses:
1. No single individual or buyer can influence the
market’s primary trend. However, individual
investor can influence the daily prices by buying or
selling in large quantities.
2. Market discounts everything
3. The theory is not infallible
DOW THEORY: The Three-Trend Market

It consists of three types of market movements:

• The major primary trend- which can often last a year or

more;

•A secondary intermediate trend- which can move against

the primary trend for one to several months;

•Minor movements- lasting only for hours to a few days.

•The determination of the primary trend is the most

important decision for the Dow believer.
 Primary Trend

In anticipation of a recovery from the

recession, informed investors began to In a bear market, they are called the
accumulate stock during the First phase
distribution phase, the public
(box "A"). A steady stream of improved
earnings reports came in during the participation phase, and the panic (or
Second phase (box "B"), causing more despair) phase.
investors to buy stock. Euphoria set in
during the Third phase (box "C"), as the
general public began to aggressively buy
stock.
 Market Correction

A correction is referred to as a change in the stock price from its recent peak
state. Usually, a market correction occurs when there is a decline of 10% or
more in the price of security such as individual stocks, currency markets, indices
and any asset which can be traded on an exchange.
Assets, stock exchange indices, or the entire capital market itself may fall into a
correction for days, weeks, months or a longer sustained period. However,
market corrections are generally short-lived and last for about three to four
months as per the recent financial analysis.
 What is the difference between
bullish reversal and bearish reversal?
Reversals are patterns that tend to resolve in the opposite direction
to the prevailing trend: Bullish reversals are likely to resolve in an up-
trend; and. Bearish reversals are likely to resolve in a down-trend.
B. Support & Resistance Levels

• Support Level: price where considerable demand for

the stock is expected to prevent further fall in price
level.

•Resistance Level: supply of scrip is greater than

demand & a further rise in price is prevented.
Support Level
Resistance Level
Support & Resistance Level
C. Gaps
•Point at which scrips has not changed hands.
•They are formed in a rising or falling price level.

•If the prices are moving upwards & the high of any
day is lower than the next day’s low, a gap occurs
(Bullish gap)
•If the prices are moving downwards & the low of
any day is higher than the next day’s high, a gap
occurs (Bearish gap)
Gaps
Gaps
Gaps
D. Charts
Technical analysts use three basic types of charts.
 Line Charts

 Bar Charts

 Point and Figure Charts

Technical Analysis: Chart Patterns
A chart pattern is a distinct formation on a stock chart that creates a
trading signal, or a sign of future price movements. Chartists use
these patterns to identify current trends and trend reversals and to
trigger buy and sell signals.
 ‘V’ Formation
 Head and Shoulders & Inverted Head and Shoulders
 Cup and Handle
 Tops and Bottoms & Double Tops and Bottoms
 Flag and Pennant
 Triangles
 Wedge
 Rounding Bottom
 Candlesticks Chart
 ‘V’ Formation & Inverted ‘V’ Formation
 Head and Shoulders & Inverted Head and Shoulders
 Cup and Handle
 Tops and Bottoms & Double Tops and Bottoms
 Flag and Pennant
 Triangles
 Wedge
 Rounding Bottom
 Candlesticks Chart
E. Indicators and Oscillators
Indicators are calculations based on the price and the
volume of a security that measure such things as money
flow, trends, volatility and momentum.
Indicators are used as a secondary measure to the actual
price movements and add additional information to the
analysis of securities.
Indicators are used in two main ways: to confirm price
movement and the quality of chart patterns and to form
buy and sell signals.
Leading & Lagging indicators.
There are also two types of indicator
constructions:
 Those that fall in a bounded range called as
‘oscillators’.
 those that do not fall in a bounded range
known as ‘Non-bounded indicators’. They also
form buy and sell signals along with displaying
strength or weakness, but they vary in the way
they do this.
F. Volume of Trade
Technical Analysis see trading volumes as an excellent
method of confirming trends.
Large volume with rise in price indicates a Bull market.
Large volume with fall in price indicates a Bear market.
Significance of Volume:
Volume confirms trends
Confirms chart patterns
Lead to price movements
G. Breadth of Market
It refers to Advances & Declines that occur in the market.
Advances refers to the number of shares whose prices
have increased from the previous days trading.
Declines refers to the number of shares whose prices have
decreased from the previous days trading.
 The net difference between the number of stock advances
& declines during the same period is ‘Breadth of the Market’
A/D Ratio is calculated & compared with market index.
In a bull market, bearish signal is given when A/D line
slopes down while market index is rising & vice-versa.
H. Short Selling
Short selling refers to the selling of shares that you don’t have.
The short sellers are those who sell now in the hope of
purchasing at a lower price in the future to make a profit.
A short seller behaves in this way because he feels that the price
of the stock will fall.
And it is must for short sellers to cover their positions, i.e. the
purchase of shares.
This buying activity increases the potential demand for the stock.
Therefore, rising short sales foretell future demand for the
security and increase the future prices.
I. Moving Average
Market do not rise or fall in straight line.
Upward & downward movements are interrupted by trends.
These trend can be studied through ‘Moving Average’
‘Moving Average’ means the body of data moves forward
to include recent observations
Used to study the movement of market as well as individual
scrip price.
J. Elliott Wave Theory
Ralph Nelson Elliott developed the Elliott Wave Theory in
the late 1920s by discovering that stock markets, behave in
repetitive cycles.
Elliott discovered that these market cycles resulted from
investors' psychology of the masses at the time.
The same repetitive patterns, were then divided further into
patterns he termed "waves".
Elliott's theory is somewhat based on the Dow theory in
that stock prices move in waves.
 K. Relative Strength Index (RSI)
The Relative Strength Index (RSI) is a technical indicator that measures the
speed and magnitude of price changes in an asset, such as a stock, index, or
ETF. It's used to identify overbought and oversold conditions, and to help
traders assess momentum and potential trend reversals.
Here are some key things to know about the RSI:
How it works
The RSI is a momentum oscillator that produces a value between 0 and 100
based on the average gains and losses compared to previous periods. It's
usually calculated over a 14-day period.
What it indicates
RSI readings above 70 indicate that the asset is overvalued, while readings
below 30 indicate that it's undervalued. A reading of 50 indicates a balance
between bullish and bearish positions.
How it's used
RSI can be used to provide immediate signals for buying and selling. It can also
be used across different time frames for more accurate results.
Who created it
J. Welles Wilder Jr., a former Navy mechanic and mechanical engineer,
developed the RSI and introduced it in his 1978 book New Concepts in
Technical Trading Systems.
CRITICISMS OF TECHNICAL ANALYSIS
The various limitations of technical were pointed but by its critics
are as given under:

I. Difficult in interpretation

II. Frequent changes

III. Unpredictable changes
IV. Less precise tools
V. No one indicator is infallible