6 technical analysis mecklai
TRANSCRIPT
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TECHNICAL ANALYSIS
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DOW THEORY
In 1897, Charles Dow developed two broad market averages. The industrialAverage and the Rail Average. These are now known as the Dow Jones Industrial
Average and the Dow Jones Transportation Average. The Theory originally focused
on using general stock market trends as a barometer for general business
conditions. It was not originally intended to forecast stock prices. However,
subsequent work has focused almost exclusively on this use of the Theory.
Dow Theory is concerned with determining the direction of the primary trend of
the market, not the ultimate duration or size of the trend.
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Dow Theory and its six
assumptions The averages discount everything
The individual stocks price reflects
everything that is known about the security
The market comprises three trends
The P rimary, Secondary and Minor trends
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Assumptions continued
The Primary Trend has three phases
First phase backed by economic recovery,
followed by increasing corporate earnings in
the second phase and finally byrecord
corporate earnings in the third phase
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S&P Nifty
A
B
C
Three parts Of Primary Trends
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Assumptions continued
The averages must confirm each other
The industrials and transports must confirm
each other fora valid change of trend to
occur.
The volumes confirms the trend
A trend remains intact until it gives a
definite reversal again
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Summarizing.
The market discounts everything
Fundamental, Psychological, Political, Economic
etc
Prices move in trends - The markets move in
the path of least resistance.
History repeats itself
Mass psychology does not change. Markets overextend because of the herd instinct
leading to panic and euphoria time and again.
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Technical analysis- features
Identification of the current trend i.e. the
direction of price movement and spotting
any trend reversal as early as possible.
Applicable onlywhen prices fluctuate
freely in response to market forces of
demand and supply for the underlying
assets like commodities, stock marketindices, certain heavily traded stocks, etc.
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Technical analysis- featurescontd
More reliable in case of broad and very liquidmarkets than thin and shallow markets.
Helps to judge the emotional state of the market.
The market has its own collective consciousnessdistinct from the individual consciousness of theparticipants.
Historical price and volume data analyzed with
the help of charts.
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Contrast with Fundamental
Analysis Fundamental analysis is concerned with all thefundamental factors.
Technical analysis,on the otherhand, assumes that theprice at any given time is the result of not only thefundamental factors but also the markets collectiveresponse to all the factors.
Often, economists focus on certain fundamentals andprescribe how the market ought to behave when themarket behavior is linked to some other factors.
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CHARTS
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Line Chart
Line chart or the closing price chart is
constructed by plotting the closing prices
on hourly, daily,weeklyormonthly basis
and connecting the same.
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Barchart
Barchart comprises of a series of vertical
lines. Each vertical line represents the
price movement during that unit of time.
The high and low are connected and then
horizontal hashes are drawn on the left
and right torepresent the opening and
closing prices respectively.
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Candle Stick
Japanese candlestick chart differs from
barchart in that the range between the
open and the close is shown as a white or
black rectangle called the real body. The
ranges on eitherside of the real body are
called uppershadow and lowershadow.
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TRENDS
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Trend Lines
Direction of movement. Could be uptrend,downtrend and flat orneutral trend.
Prices move in a zigzag fashion
In an uptrend, the reaction is downwards while in adowntrend, the reaction is upwards.
Zigzag movement gives rise to a series oftops and bottoms or highs and lows.
The relative position of successive highs and lowsdetermine the trend at any given point of time.
Uptrend : series of higherhighs and higherlows.
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An up-trend is defined by a series of higher-highs and higher-lows.
In order for an up-trend to reverse, prices must have at least onelower high and one lower low (the reverse is true of a downtrend).
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Trend Lines
Trend lines are straight lines drawn by
connecting eitherthe highs or the lows.
In an uptrend, 2 ormore rising lows areconnected to denote an uptrend line.
In a downtrend, 2 ormore falling highs are
connected to denote a downtrend line.
A horizontal or flat trend line is drawn by
connecting eitherthe highs or the lows.
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Trend Lines
The importance of a trend line lies in its
ability to indicate the possibilityof a trend
reversal.
Reversal of uptrend signalled by the price
falling below the uptrend line.
Reversal of downtrend indicated by the
price rising above the downtrend line.
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Trend Lines- uptrend
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Trend Lines- downtrend
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Trend Lines- sideways
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Trend Lines- channel
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Trend Reversal
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Finerpoints in Trend Lines
Penetration of a trend line does not necessarily
imply a trend reversal but may indicate just a
temporary pause in the trend.
No fixed rule to judge whethersuch penetrationsignals a pause ora reversal. However,
important clues are often available.
Steepera trend line, greater is the possibilityof
its penetration signaling just a pause and not a
reversal.
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Finerpoints in Trend Lines
As to duration, the longera trend has been in
force, the more powerful is the violation of the
trend line.
Similarly, the more the numberof times a trendline is touched by the price, the stronger the
trend line and more powerful is its penetration.
Finally, trend line penetration accompanied by
rising volumes orbreakout from a reversal
pattern veryoften signals a trend reversal.
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SUPPORT & RESISTANCE
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Support-Resistance
Support is the price level where enough buying
pressure builds up to stop a decline at least
temporarily and prompt a recovery.
Resistance indicates a price level at whichselling pressure mounts to halt an ongoing rally
and start a decline.
Zigzag price movement gives rise to highs and
lows or tops and bottoms.
Tops offerresistance and bottoms offersupport.
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Support
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Resistance
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RETRACEMENT
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Fibonocci Retracement Analysis
Numbersequence - 1,1,2,3,5,8,13,21
Sum of any two consecutive numbers
equals the next highest. The ratioof any numberto its next higher
numberapproaches 0.618 afterthe first 4.
The ratioof any numberto its next lowernumber is 1.618or the reciprocal of 0.618.
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Fibonocci Retracement Analysis
The ratioof alternate numbers approaches
2.618or its reciprocal 0.382.
The most common numbers inretracement analysis are 0.382,0.500 and
0.618
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Fibonocci Retracement Analysis
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Fibonocci Retracement Analysis
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REVERSALS
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Heads & Shoulders
Most powerful reversal pattern and resembles ahead and two shoulders.
In an uptrend, price declines from a peak to form
the left shoulder. Price then rallies to a new high, called the head
before falling again toornear the previous low.
Now the price rises once more but tops out
lower than the head and near the level of the leftshoulder. This third top is called the rightshoulder.
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Heads & Shoulders
The price then begins to fall and the
pattern is confirmed when the price breaks
and closes below the extended neckline
joining the previous two lows - first low
between the left shoulderand the head
and the second low between the head and
the right shoulder.
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Heads & Shoulders
The head and shoulders breakout is
followed by a sharp down move with
heavy volume before price rallies towards
the neckline on lowervolume. After this
return move, the downtrend usually
resumes.
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Heads & Shoulders
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Heads & Shoulders
Volume plays an important role in the formationof this pattern. Volume is rising when prices areapproaching the top of the left shoulderand dipson the first reaction.When price crosses over
the peak of left shoulder, increase in volume isnot prominent. After the head is formed, pricefalls below the top of the left shoulder indicatingpossibilityof trend change. Price usually findssupport near the previous low and rallies again
but forming a lower top with lowervolume.Finally,when price begins to fall again andbreaks the neckline it is on highervolume.
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Double top reversal pattern
Alsoreferred to as the "M" type reversal pattern.
Price rises to form a top with an increase in volume.
This is f ollowed by a price drop on lowervolume.
Next rally fails to cross the previous peak and endsthereabout forming a second top.
Double top reversal is confirmed when the price falls andcloses below the intervening low.
From this breakout point, the price target equals the
vertical distance between the double top and theintervening low.
Important point to note is that volume should be rising atthe breakout point else the pattern is suspect.
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Double Top
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Rectangle
This pattern aftera sharp up move ora downmove.
Market consolidates in a narrow sideways band
between two parallel lines, much similarto arectangle.
A break over the upperor the lowerchannel linewould result in a big move.
The target of such a move would be the heightof the rectangle (difference between the lowerand upperchannel lines.
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Rectangles
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Moving Averages
Zigzag movement of prices often makes it
difficult to judge the underlying trend. Trendlines
do help as we have already seen.
Anotherpopularway is to smooth the price datawith the help of moving averages.
Technical analysts use three different types of
moving averages - simple moving average,
exponential moving average and weighted
moving average.
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Moving Averages.
We will discuss only the simple moving
average because it is the easiest to
compute and interpret.
The moving average system of trading is
also known as the trend following system
because the traderwaits for the trend to
be established before initiating a trade
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Moving Averages
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Interpretation of MAs
A moving average smoothens the underlyingprice data and represents the trend fortheperiod used to calculate the average.
More importantly, it acts as a curved trendlineproviding support in an uptrend and resistancein a downtrend.
Since the moving average reflects the trend,intersection of the price with the moving averagesignals at least a pause in the trend bywayof acorrection and possibly a trend reversal.
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Interpretation of MAs
In an uptrend, both the price and the movingaverage are rising and price is above the movingaverage. If the price were now to move belowthe moving average while the moving average isstill rising, it would probably signal just acorrection.
Aftera while renewed buying usually pushes theprice again over the moving average. If the
moving average is still rising, such a crossoverof the price over the moving average indicatesresumption of the uptrend.
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Interpretation of MAs.
However, caution is indicated if the moving average hasbegun to move sideways. A trend reversal is now morelikely and is signalled when the price again crossesbelow the moving average.
Penetration of a very short term average such as the 5-day average occurs often in long lasting trends and oftensignals temporary pauses in the trend bywayofcorrection orconsolidation. This happens aftera sharpupmove ora downmove when profit-taking sets in a
countertrend move in the opposite direction. However,when prices retrace 50 to60% of the previous move,players who missed the earliermove usually enterleading toresumption of the underlying trend.
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Interpretation of MAs
On the otherhand, penetration of say 20-
day average accompanied by a change in
the direction of the moving average itself,
would usually confirm trend reversal or
prolonged and deep correction.
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BollingerBands
Empirical evidence shows that exchange rates
fluctuate around a moving average.
Ordinary bands such as moving average
envelopes are specified as a fixed percentagechannel around a moving average.
An alternate and popularmethod of constructing
bands is based on a moving standard deviation.
Such bands are known as Bollingerbands.
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BollingerBands
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BB-construction
Take a n-period moving average of the pricedata.
Foreach period, calculate the standard
deviation of the price around the movingaverage.
Choose a multiple of the standard deviation andcreate a band around the moving average.
A typical set up is a 20-day moving average withbands placed 2 standard deviations from themoving average.
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BB- Interpretation
The width of the band obviously varies with the volatilityi.e. the standard deviation of the prices.
In uptrends, the price usually moves between the 20-daymoving average and the upperbollingerband while in adowntrend, the price usually moves between the movingaverage and the lowerbollingerband.
Penetration of the upperbollingerband in an uptrend orthe lowerbollingerband in a downtrend usually suggestsan acceleration in the trend.
However, if the price quickly moves back into the band, a
trend reversal orat least a deep correction is likely. Sharp price movements accompanied byrange
expansion are often preceded by a contraction of theband due to a period ofreduced volatility.
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OSCILLATORS
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Types ofOscillators
Momentum
Rate of Change (ROC)
Relative Strength Index (RSI) Stochastics
Fast
Slow Money Flow Index
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Oscillators
Oscillators are price derivatives. Extremeoscillatorreadings indicate that the market isoverextended, that is,overbought oroversold;give advance warnings of an impending trend
reversal and alert the traderorhedger to booksome profits orto be on the lookout forothersigns of a reversal. Caution : Such warnings arenot a signal to take countertrend positions butonly to trim existing profitable positions or
protect them with tight stops.
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Momentum
Momentum denotes the speed at which
prices are rising or falling.
Momentum has to be related to some
period. Forexample, 10-day momentum
measures the size and direction of the
price change overthe last 10 days.
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Momentum- Calculation
Simplest way to calculate n-day
momentum at time is by the following
equation:
M(t) = P(t) - P(t-n) where M(t) is the
momentum at time t, P(t) is the price at
time t and P(t-n) is the price at time t-n.
The momentum line so plotted oscillatesaround the zero line.
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Momentum - Interpretation
Just as a carmoving at high speed slows down before coming to ahalt ormaking a U-turn, the momentum peaks out and reversesbefore reversal of the trend itself.
However, even afterreversal of momentum it is prudent towait forreversal of the price trend because quite often powerful trendsoverextend before finallyreversing. In such cases,we often seeprices making new highs or lows on lowermomentum indicating aweak technical position susceptible toreversal. Such a phenomenonof a new high or low in price without being confirmed by a new highor low in momentum, is called divergence.
Such a divergence is a red alert and a signal forbooking profits onexisting positions ratherthan a signal fortaking positions in theopposite directions.
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Momentum- Interpretation
On a stand alone basis, the best available confirmation of a trendreversal ortrend resumption aftera correction is the crossing of themomentum line above orbelow the zero line.
Overbought and oversold signals are given when the momentumoscillatorreaches extremely high or low values. Extremely highvalues point to an overbought condition i.e. the price has risen toofartoo fast and signal a correction while extremely low valuessuggest an oversold market and warns of a possible rally.
A disadvantage of the momentum oscillatoris that it is difficult topinpoint extreme values without comparative historical data. Lets
therefore examine 2 otheroscillators that are normalized and whosevalues always move between 0 and 100.
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Rate of Change (ROC)
ROC is classed as a price momentum
indicatorora velocity indicatoras it
measures the rate of change or the
strength of momentum of change
It is calculated as:
(Closing price today Closing price n
periods ago) / Closing price n periods ago
ROC greaterthan zero indicate an
increase in upward momentum and vice
versa.
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RSI
The RSI is an oscillator that always moves
between 0 and 100.
Necessary to specify a period for
calculation.Original designerproposed a
14-day period but 9-dayRSI has also
become popular.
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Relative Strength Index (RSI)
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RSI- Signals
For instance,reversal of the RSI from theoversold region can be taken as a buysignal and reversal from the overboughtregion as a sell signal.
However, in trending markets,RSIreversals opposite to the trend mayonlysignal a correction and these signals couldat the most be used forbooking profits ortrimming positions.On the otherhand,RSIreversal in the direction of the trendusually signals resumption of the trend.
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RSI Signals.contd
For indicating impending trend reversal,RSI divergence in the overbought oroversold zone is considered as a morereliable signal. Bearish RSI divergenceoccurs when the price makes a new highbut the RSI though overbought makes alowerhigh. Bullish RSI divergence occurswhen the price makes a new low but the
RSI makes a higher low in the oversoldzone.
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RSI Signals.contd
Even aftergetting RSI divergence, it is
prudent towait forsome reversal
indication in the price charts because it is
not uncommon forRSI divergences to getrepeated in powerful trends.
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Stochastics
This oscillator is based on the empiricalevidence that the price usually closes near thehigh of the dayorthe last few days in an uptrendand near the lowof the dayor the last few days
in a downtrend. The psychological reason is probably that as a
trend persists longerand longer, market playerstend to become less and less cautious and carrylargerovernight risks.
This is a complex indicatorand involvescalculation of3 statistical variables : %K, fast%D and slow %D.
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Stochastics- Construction
Choose a period for%K. Typical period is 5 days.
Identif y the highest intraday high (H) and the lowest intraday low (L)in the chosen period.
Calculate %K as follows:%K = 100 * (C - L)/ (H - L)
Calculate fast %D as a moving average, in this case,3-day movingaverage of %K values.
Also calculate slow %D as a 3-day moving average of fast %Dvalues.
Plot %K and fast %D to form the fast stochastic indicatororthe faststochastics. Similarly, plot fast %D and slow %D to form the slowstochastics.
Evidently, %K oscillates between 0 and 100 and so also do fast %Dand slow %D.
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Stochastics
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Stochastics - Signals
As with the RSI, there are overbought and oversoldzones. These are usually set as 80 and 20 or70 and 30.
With fast stochastics, a buy signal is given if %K crossesover fast %D in the oversold zone and is confirmed when
fast %D moves up into the neutral region. A sell signal isgiven if %K crosses below fast %D in the overboughtzone and is confirmed when fast %D moves down intothe neutral region. This may be suitable forshort-termtraders.
With slow stochastics, the signals are similarexcept thatthese are generated with the crossoverof fast %Doverorbelow slow %D. This seems preferable formedium-term traders and hedgers.