Unit 3TECHNICAL ANALYSISThe Visual Clue

Outline What Is Technical Analysis Charting Techniques Technical Indicators Testing Technical Trading Rules Evaluation of Technical Analysis

What Is Technical AnalysisIn his book technical analysis explained, Martin J. Pring explains:The technical approach to investing is essentially a reflection of the idea that prices move in trends which are determined by the changing attitudes of investors toward a variety of economic, monetary, political and psychological forces. The art of technical analysis - for it is an art - is to identify trend changes at an early stage and to maintain an investment posture until the weight of the evidence indicates that the trend has been reversed.

Basic Premises Of Technical Analysis

Barring minor deviations, stock prices tend to move in fairly persistent trends.

Shifts in demand and supply bring about changes in trends.

Irrespective of why they occur, shifts in demand and supply can be detected in charts.

Technical Analysis Versus Fundamental Analysis

Technical Analysis Fundamental Analysis

Predicts short-term Establishes long-term values price movements

Focuses on internal market Focuses on fundamental data factors

Appeals to short-term traders Appeals to long-term investors

Charting Techniques

The Dow theory Bar and Line charts Point and figure chart Moving average analysis Relative strength analysis

Basic Concepts Underlying Chart Analysis

Prices move in persistent trends Volume and trend go hand in hand There are resistance and support levels

The Dow Theory

The market has three movements, all going at the same time:

Daily fluctuations : Random day-to-day wiggles Secondary movements : Corrections that last for a few weeks or months

Primary trends : Representing bull and bear phases of the market

The concept of Dow Theory

Bar And Line Charts

The bar chart depicts the daily price change along with the closing price.

A line chart shows the line connecting successive closing prices.

Technical analysts believe that certain formations or patterns observed on the bar chart or line chart have predictive value. For example, a head and shoulder pattern represents a bearish development.

Bar and Line Charts

Technical analysts believe that certain formations or patterns observed on the bar chart or line chart have predictive value. The more important formations and their indications are described below.Head and Shoulders Top (HST) PatternAs the name suggests, the HST formation has a left shoulder, a head, and a right shoulder, as shown in Exhibit 16.3A. The HST formation represents a bearish development. If the price falls below the neckline (the line drawn tangentially to the left and right shoulders), a price decline is expected. Hence, it is a signal to sell.Inverse Head and Shoulders Top (IHST) PatternAs the name indicates, the IHST formation is the inverse of the HST formation, as shown in Exhibit 16.3B. Hence, it reflects a bullish development. If the price rises above the neck line, a price rise is expected. Hence, it is a signal to buy.Triangle or Coil FormationThis is shown in Exhibit 16.3C. This formation represents a pattern of uncertainty. Hence, it is difficult to predict which way the price will break out.Flags and Pennants FormationThis is shown in Exhibit 16.3D. It typically signifies a pause after which the previous price trend is likely to continue.Double Top FormationThis is shown in Exhibit 16.3E. It represents a bearish development, signalling that the price is expected to fall.Double Bottom FormationThis is shown in 16.3F. It reflects a bullish development, signalling that the price is expected to rise.

Important Chart Formations

Point And Figure ChartMore complex than a bar chart, a point and figure chart (PFC) condenses the recording of price changes by eliminating the time scale and small changes.

More complex than a bar chart, a point and figure chart (PFC) has the following features.

1.On a PFC only significant price changes are recorded. For example, for a stock that has a price in the range of, say Rs 30 to Rs 50, price changes of one rupee or more only may be posted.

2.While the vertical scale on a PFC represents the price of the stock, the horizon scale does not represent the time scale in the usual sense.

3.Each column on the horizontal scale of a PFC represents a significant reversal of price movement and not a trading day.

Point and Figure Chart

Moving Average Analysis

A moving average is calculated by taking into account the most recent n observations.

A 5-day moving average of daily closing prices is calculated as follows:

Trading dayClosingSum of five mostMovingpricerecent closing pricesaverage125.0 226.0325.5424.5526.0 127.025.4626.0 128.025.6726.5 128.525.7826.5 129.529.9926.0 131.026.21027.0 132.026.4

Moving Average Analysis

To identify trends, technical analysts use moving averages analysis: a 200-day moving average of daily prices (or alternatively, 30-week moving average of weekly prices) may be used to identify a long-term trend; a 60-day moving average of daily prices may be used to discern an intermediate term trend; a 10-day moving average of daily prices may be used to detect a short-term trend.

Moving Average Analysis

The buy and sell signals provided by the moving average analysis are as follows:

Buy signalSell signalStock price line rises through the moving average line when the graph of the moving average line is flattening out. Stock price line falls below the moving average line which is rising.Stock price line, which is above the moving average line, falls but begins to rise again before reaching the moving average line.Stock price lines falls through the moving average line when the graph of the moving average line is flattening out.Stock price line rises above the moving average line which is falling. Stock price line, which is below the moving average line, rises but begins to fall again before reaching the moving average line.

MACD

A variation of the moving average is the moving average convergence divergence, or MACD. It involves comparing a short-term moving average, say a 50-day moving average, with a long-term moving average, say a 200-day moving average. If the short-term moving average is consistently higher than the long-term moving average, it is a bullish signal; if the short-term moving average is consistently lower than the long-term moving average, it is a bearish signal.

Relative Strength AnalysisTechnical analysts measure relative strength in different ways. A simple approach calculates rates of return and classifies securities that have earned superior historical returns as having relative strength. More commonly, technical analysts look at certain ratios to judge whether a security or, for that matter, an industry has relative strength. To illustrate how this is done, consider the price data of a hypothetical pharmaceutical company, Acme Limited, along with the price data for the pharmaceutical industry and the market as the whole, given in Exhibit 16.5.

Relative Strength Analysis

Exhibit 16.5Relative Strength Data for Acme Limited

YearAverage price of Acme PAAverage Price of pharmaceutical industry PPIAAverage price of the market PMAPA/PPIAPA/PMAPPIA/PMA20X140302001.330.200.1520x250322101.560.240.1520x365382301.710.280.1720x480452801.780.290.16

The Advance-Decline Line

The advance-decline line is also referred to as the breadth of the market. Its measurement involves two steps:Calculate the number of net advances/declines on a daily basis.Obtain the breadth of the market by cumulating daily net advances/declines.

Breadth of Market

An illustrative calculation of the breadth of the market is shown in Exhibit 16.7.

Exhibit 16.7Calculation of Breadth of Market

DayAdvancesDeclinesNet Advances or DeclinesBreadth of MarketTuesday630527103103Wednesday690475215318(103+215)Thrusday746424322640(318+322)Friday492630-138502(640-138)Monday366701-335167(502-335)Turesday404698-294-127(167-294)

Breadth of Market Analysis

How is the breadth of market analysis used? Typically, the breadth of market is compared with one or two market averages. Ordinarily, the breadth of market is expected to move in tandem with a market average. However, if there is a divergence between the two, the technical analysts believe that it signals something. More specifically, if the market average is moving upwards, whereas the breadth of market is moving downwards, it indicates that the market is likely to turn bearish. Likewise, if the market average is moving downwards but the breadth of market is moving upwards it signals that the market may turn bullish.

New Highs And LowsTechnical analysts consider the market as bullish when a significant number of stocks hit the 52-week high each day. On the other hand, if market indices rise but few stocks hit new highs, technical analysts view this as a sign of trouble.

VolumeVolume analysis is an important part of technical analysis. Other things being equal, a high trading volume is considered a bullish sign. If heavy volumes are accompanied by rising prices, it is considered even more bullish.

Short-Interest Ratio

The short interest ratio is defined as follows:

Total number of shares sold shortAverage daily trading volume

A technical analyst considers a high short-interest ratio as a sign of bullishness

Financial AstrologyFrom early 1990s a new breed of astrologers, call them financial astrologers if you will, has emerged in India. They try to predict market sentiments, share price movements, and even government policy on the basis of the movement of stars.Here is a sampling of what they say: The downtrend in share prices during the past fortnight is because of a debilitated mercury under the influence of saturn at a time when jupiter is retrograde.The market will stabilise by September 12 this year when jupiter enters the kanya rasi.According to them, nakshatras that are good for buying or selling are as follows:

BuyingSellingRevathiPurva phalguniSathabishaPurvashadaAshwiniKritikaShravanAshleshaBharani

Testing Technical Trading Rules

Does the trading rule produce excess return after adjusting for risk?

Does the trading rule produce excess returns after adjusting for transaction and other costs (like taxes)?

How consistent is the performance of the trading rule?

Is the trading rule valid outside the sample?

Evaluation of Technical Analysis

ProponentsUnder the influence of crowd psychology, trends persist for quite some time.Shifts in demand and supply are gradual rather than instantaneous. Fundamental information about a company is absorbed and assimilated by the market over a period of time.Charts provide a picture of what has happened in the past and hence give a sense of volatility that can be expected from the stock.

Evaluation of Technical Analysis

DetractorsEmpirical evidence in support of the random-walk hypothesis casts its shadow.Ultimately, technical analysis must be a self-defeating proposition. The numerous claims made for different chart patterns are simply untested assertions.There is a great deal of ambiguity in the identification of configurations and patterns.