Investment Analysis & Portfolio Management Technical Analysis

TECHNICAL ANALYSIS
INTRODUCTION:

The methods used to analyze securities and make investment decisions fall into two very broad categories:
fundamental analysis and technical analysis. Fundamental analysis involves analyzing the characteristics of a
company in order to estimate its value. Technical analysis takes a completely different approach; it doesn't
care one bit about the "value" of a company or a commodity. Technicians (sometimes called chartists) are
only interested in the price movements in the market.

Technical analysis really just studies supply and demand in a market in an attempt to determine what
direction, or trend, will continue in the future. In other words, technical analysis attempts to understand the
emotions in the market by studying the market itself, as opposed to its components. If you understand the
benefits and limitations of technical analysis, it can give you a new set of tools or skills that will enable you to
be a better trader or investor.

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.
DEFINITION:
“Technical analysis is a term used for predicting the trend (direction) of prices of a stock through the study of
past market data, primarily price and volume.”

Technical analysis can be applied to both an aggregate of prices (the market as a whole or industry averages)
and individual stocks. Technical analysis includes the use of graphs (charts) and technical indicators.

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Basic Assumptions of Technical Analysis:

The field of technical analysis is based on three assumptions:
1. The Market Discounts Everything: A major criticism of technical analysis is that it only considers price
movement, ignoring the fundamental factors of the company. However, technical analysis assumes that, at
any given time, a stock's price reflects everything that has or could affect the company - including
fundamental factors.
2. Price Moves in Trends: In technical analysis, price movements are believed to follow trends. This means
that after a trend has been established, the future price movement is more likely to be in the same direction.
3. History Tends To Repeat Itself: Another important idea in technical analysis is that history tends to repeat
itself, mainly in terms of price movement. 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.

TYPES/METHODS OF TECHNICAL ANALYSIS:

There are two types/methods to do technical analysis:
1. Stock Price and Volume Techniques
2. Technical indicators

STOCK PRICE AND VOLUME TECHNIQUES:

Stock price and volume techniques often referred to as charting. Price and volume are the primary tools of
the pure technical analyst, and the chart is the most important mechanism for displaying this information.
Technicians believe that the forces of supply and demand result in particular patterns of price behavior, the
most important of which is the trend or overall direction in price. Using a chart, the technician hopes to
identify trends and patterns in stock prices that provide trading signals.
Following are the stock price and volume techniques use to analyze the stocks.
 The dow theory
 Charts of price patterns
 Moving averages
 Relative strength

THE DOW THEORY:

The oldest and best known theory of technical analysis is the Dow theory, originally developed in the late
l800s by the editor of The Wall Street Journal, Charles H. Dow, who many regard as the father of technical
analysis. Although Dow developed the theory to describe past price movements, William Hamilton followed
up by using it to predict movements in the market. (It is not concerned with individual securities.) The Dow
Theory was very popular in the 1920s and 1930s, and articles offering support for it still appear periodically
in the literature. Several investment advisory services are based on the Dow Theory. The basic idea of Dow
Theory is that market price action reflects all available information and the market price movement is
comprised of three main trends.

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The Dow Theory is made up of six tenets, and all traders who decide to use technical analysis should know
these 6 principles, as they will help them to better understand how the markets work.

 The Averages Discount Everything

 The Market Has Three Trends
 Major Trends Have Three Phases
 The Averages Must Confirm Each Other
 Volume Must Confirm the Trend
 A Trend Is Assumed to Be Continuous Until Definite Signals of Its Reversal

THE AVERAGES DISCOUNT EVERYTHING:

Every single factor, information that is likely to have influence on both demand and supply is reflected in the
market price. For example, introduction of a new product etc.

THE MARKET HAS THREE TRENDS:

One of the most important concepts in technical analysis is that of trend. A trend is really nothing more than
the overall direction of a market or an asset's price.
There are three types of trend:
1. Uptrends: As the names imply, when each successive peak and trough is higher. It’s referred to as an
upward trend. It is also called bull/bullish trend.
2. Downtrends: If the peaks and troughs are getting lower, it's a downtrend. It is also called
bear/bearish trend.
3. Sideways/Horizontal Trends: When there is little movement up or down in the peaks and troughs,
it's a sideways or horizontal trend.

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Along with these three trend directions, there are three trend movement classifications. A trend of any
direction can be classified as
1. Primary trend (movement): The Primary trend is the largest trend, which lasts for more than a
year( 1 to 3 years) When there is a wave of rising prices, we have a rising (bull) market, when prices
are declining we have a falling (bear) market. So, the Primary trend can be either rising (bullish) or
falling (bearish).
2. Secondary trend (movement): Secondary (intermediate) trend, occurring within the primary moves,
which represent interruptions lasting several weeks or months (3 weeks to 3 months).
3. Minor trend (day to day movement): Minor trend is considered a short-term movement, and it
usually lasts less than three weeks. This trend is associated with the random movements in the
primary/secondary trend.

MAJOR TRENDS HAVE THREE PHASES:

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Dow states that there are three phases to every primary (major) trend, which is the most important trend to
be paid attention to.
The phases are:
1. Accumulation phase
2. Public participation phase
3. Distribution or panic phase
All of these phases occur in the uptrend and downtrend.
Accumulation phase: In the accumulation phase, investors buy or sell stocks. This accumulation happens
during the beginning of an uptrend or downtrend.
Public participation phase: In the public participation phase, the fundamental news starts to impact the
stock prices. In this phase, more investors participate. They drive the stock price higher in an uptrend and
lower in a downtrend. In this phase, there’s volatility in the stock prices. This phase happens in the middle of
an uptrend or downtrend.
Distribution phase: In the distribution phase, all of the prices have peaked or bottomed. During this phase,
more investors sell in an uptrend and buy in a downtrend. There’s consensus in the market that the stock
price is trading above or below its fundamental valuation.

THE AVERAGES MUST CONFIRM EACH OTHER:

Dow stated that for having a valid change of trend, the Industrial and Rail Averages must confirm each other.
Both averages must exceed the previous peak to confirm the inception or continuation of a bull market.
According to Dow, the signals did not have to occur simultaneously, but he believed that a shorter length of
time between the two signals provided stronger confirmation.

VOLUME MUST CONFIRM THE TREND:

Volume increases or diminishes according to whether the price is moving in direction of a trend or in
reverse. Dow considered volume a secondary indicator. His buy or sell signals were based on closing prices.
A TREND IS ASSUMED TO BE CONTINUOUS UNTIL DEFINITE SIGNALS OF ITS REVERSAL:

Dow believed that trends kept on existing regardless of the influencing factors known as “market noise.”
Markets might move in the direction opposite the trends for a short time, but they will soon return to prior
move. Dow in his turn believed that if the trend lasted longer, the probability of its change would be greater
and, of course, there are reversal signals to look for.

CHARTS OF PRICE PATTERNS:

To assess individual stock-price movements, technicians generally rely on charts or graphs of price
movements and on relative strength analysis. The charting of price patterns is one of the classic technical
analysis techniques. Technicians believe that stock prices move in trends, with price changes forming
patterns that can be recognized and categorized. By visually assessing the forces of supply and demand,
technicians hope to be able to predict the likely direction of future movements. The most basic measure of a
stock’s direction is the trendline, which simply shows the direction the stock is moving. If demand is
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increasing more rapidly than supply and the stock shows successively higher low points, it is in an uptrend.
Consistently lower highs indicate that supply is increasing more rapidly, and the stock is in a downtrend.
Technicians seek to identify certain signals in a chart of stock prices, and use certain terminology to describe
the events. These terminologies are Support level and resistance level.
Support level:
The level in which investors stop sailing their securities because securities rate too low. Securities their rates
correspond with support level are very cheap and their supply is higher than demand. Market that is
developing near support level is also known as an oversold and in short time is expected rising demand
about these cheap securities and growth of their prices. Bull Trend will transfer to Bear Trend.
Resistance level:
Resistance level Represents level where the growth of security rates are finished. Investors find out that
security rates are too high and securities are expensive. Demand is higher than supply. Market that is
developing near Resistance Level is known as a overbought and in short time is expected decline in demand.
Bull Trend is replaced by Bear Trend.

TYPES OF CHATRS:

A chart is simply a graphical representation of a series of prices over a set time frame. For example, a chart
may show a stock's price movement over a one-year period, where each point on the graph represents the
closing price (The closing price is the last price at which the stock traded during the regular trading day.) for
each day the stock is traded.
Following are the types of charts.
 Bar chart
 Line Chart
 Point and figure chart
Bar chart:

One of the most popular charts in technical analysis, bar charts are plotted with price on the vertical axis and
time on the horizontal axis. Bar charts show multiple price bars over time. Each bar shows how the price
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moved over a specified period of time. A daily bar chart shows a price bar for each day. Each bar typically
shows the open, high, low, and close (OHLC) prices for that period. This may be adjusted to only show the
high, low, and close (HLC). The bottom ofa bar chart usually shows the trading volume for each day,
permitting the simultaneousobservation of both price and volume activity.

Each bar has a vertical line that shows the highest price reached during the period, and the lowest price
reached during the period. The opening price is marked by a small horizontal line on the left of the vertical
line, and the closing price is marked by a small horizontal line on the right of the vertical line. If the close
price is above the open price, the bar may be colored black or green. If the close is below the open, the price
dropped during that period, so it could be colored red.

Line Chart:

A line chart is a graphical representation of an asset's historical price action that connects a series of data
points with a continuous line. This is the most basic type of chart used in finance and typically only depicts a
security's closing prices over time. Line charts can be used on any timeframe, but most often using day-to-
day price changes.

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Using a line chart helps traders clearly identify key support and resistance levels, trends and recognizable
chart patterns.

Point and figure chart:

Technicians also use point-and-figure charts. This type of chart is more complex in that it shows only
significant price changes, and volume is not shown at all.

When first looking at a point and figure chart, you will notice a series of Xs and Os. The Xs represent upward
price trends and the Os represent downward price trends. There are also numbers and letters in the chart;
these represent months, and give investors an idea of the date. Each box on the chart represents the price
scale, which adjusts depending on the price of the stock: the higher the stock's price the more each box
represents. On most charts where the price is between $20 and $100, a box represents $1, or 1 point for the
stock. The other critical point of a point and figure chart is the reversal criteria. This is usually set at three
but it can also be set according to the chartist's discretion. The reversal criteria set how much the price has
to move away from the high or low in the price trend to create a new trend or, in other words, how much
the price has to move in order for a column of Xs to become a column of Os, or vice versa. When the price
trend has moved from one trend to another, it shifts to the right, signaling a trend change.

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MOVING
AVERAGES:

A moving average of prices is a popular technique for analyzing both the overall market and individual stocks
and is used specifically to detect both the direction and the rate of change.

Some number of days of closing prices is chosen to calculate a moving average. After initially calculating the
average price, the new value for the moving average is calculated by dropping the earliest observation and
adding the latest one. This process is repeated daily (or weekly). The resulting moving average line
supposedly represents the basic trend of stock prices.

A comparison of the current market price to the moving average produces a buy or sell signal. The general
buy signal is generated when actual prices rise through the moving average on high volume, with the
opposite applying to a sell signal.

RELATIVE STRENGTH:

A well-known technique used for individual stocks (or industries) is relative strength analysis. The relative
strength for a given stock is calculated as the ratio of the stock’s price to a market index, or an industry
index, or the average price of the stock itself over some previous period. Relative strength could also be
calculated as the ratio of an industry average relative to the market. These ratios can be plotted to form a
graph of relative prices across time. In effect, the graph shows the strength of the stock relative to its
industry, the market, or whatever.

TECHNICAL INDICATORS
The chart remains the technician’s most important tool for making buy and sell decisions. However, in
addition to looking at the plot of stock prices, technicians also like to examine the overall situation by
analyzing such factors as breadth and market sentiment indicators.
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BREADTH INDICATORS:

Market Breadth Indicators are powerful technical analysis tools that gauge the direction of the market and
help traders determine if it's bullish, bearish or neutral.

TYPES OF BREADTH INDICATIORS:

The Advance-Decline Line:
Market breadth indicators analyze the number of stocks advancing relative to those that are declining in a
given index or on a stock exchange (such as the New York Stock Exchange or NASDAQ). Positive market
breadth occurs when more stocks are advancing than are declining. This suggests that the bulls are in control
of the market's momentum and helps confirm a price rise in the index. Conversely, a disproportional number
of declining securities is used to confirm bearish momentum and a downside move in the stock index.
52-week high and low:
A 52-week high/low is a technical indicator used by some traders and investors. The 52-week high/low is the
highest and lowest price at which a security, such as a stock, has traded during the time period that equates
to one year. The 52-week high/low is based on the daily closing price for the security.
The 52-week high serves as an indicator for potential investors. Investor’s will often reference the 52-week
high for a stock when looking at the current price. If the price is near or approaching the 52-week high, it
might not be a good time to buy, because the stock could be overvalued. Also, if a stock is near its 52 week
high, this may be a signal that it is a good time to sell and vice-versa.

SENTIMENT INDICATORS:

A sentiment indicator refers to a graphical or numerical indicator designed to show how a group feels about
the market or economy. A sentiment indicator seeks to quantify how current beliefs and positions affect
future behavior. Sentiment indicators show how bullish or bearish a group of people are, which may help
forecast this group's future behavior, often in a contrarian way. For example, when investors are extremely
bearish, that is often a contrary signal to sentiment indicator traders that market prices could start heading
higher soon.

Sentiment indicators are used to analyze trends, assets, and the economy from a perspective of the
participants involved, instead of just looking the asset, trend or economy itself. When a sentiment indicator
is moving in the same direction as what it is analyzing, that typically helps confirm that trend.

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