Unit-II: FUNDAMENTAL ANALYSIS AND TECHNICAL ANALYSIS

FUNDAMENTAL ANALYSIS:

Fundamental analysis is the study of economic factors, industrial environment and the factors
related to the company. The earnings of the company, the growth rate and the risk exposure of
the company have a direct bearing on the price of the share. These factors in turn rely on the
host of other factors like economic development in which they function, the industry belongs
to, and finally companies’ own performance. The fundamental school of thought appraised the
intrinsic value of shares through
• Economic Analysis
• Industry Analysis
• Company Analysis

ECONOMIC ANALYSIS:

The state of the economy determines the growth of gross domestic product and investment
opportunities. An economy with favorable savings, investments, stable prices, balance of
payments, and infrastructure facilities provides a best environment for common stock
investment. If the company grows rapidly, the industry can also be expected to show rapidly
growth and vice versa. When the level of economic activity is low, stock prices are low, and
when the level of economic activity is high, stock prices are high reflecting the prosperous
outlook for sales and profits of the firms. The analysis of macro economic environment is
essential to understand the behaviour of the stock prices.
The commonly analyzed macro economic factors are as follows:

 Gross domestic product (GDP):

GDP represents the aggregate value of goods and services produced in the economy. It consists
of personal consumption expenditure, gross private domestic investment and government
expenditure on goods & services and net export of goods & services. It indicates rate of growth
of economy. The estimate on GDP available on annual basis.

 Business Cycle:
Business cycles refer to cyclical movement in the economic activity in a country as a whole.
An economy marching towards prosperity passes through different phases, each known as a
component of a business cycle. These phases are:
a. Depression: Demand level in the economy is very low. Interest rates and Inflation rates are
high. These affect profitability and dividend pay out and reinvestment activities.
b. Recovery: Demand level starts picking up. Fresh investment by corporate firms shows
increasing trend.
c. Boom: After a consistent recovery for a number of years, the economy starts showing signs of
boom which is characterized by high level of economic activities such as demand, production
and profits.
d. Recession: The boom period is generally not able to sustain for a long period. It slows down
and results in the recession.

 Savings & investment:

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 The growth requires investment which in turn requires substantial amount of domestic savings.
Stock market is a channel through which the savings of investors are made available to the
corporate bodies. Savings are distributed over various assets like equity shares, deposits,
mutual fund unit, real estate and bullion. The saving and investment pattern of the public effect
the stock to great extent.

 Inflation:
The inflation is raise in price, where its rate increases, than the real rate of growth would be
very little. The demand is the consumer product industry is significantly affected. The industry
which comes under the government price control policy may lose the market. If the mild level
of inflation, it is good to the stock market but high rate of inflation is harmful to the stock
market.

 Interest rates:
The interest rate affects the cost of financing to the firms. Higher interest rates increase the cost
of funds and lower interest rates reduce the cost of funds resulting in higher profit. There are
several reasons for change in interest rates such as monetary policy, fiscal policy, inflation rate,
etc,

 Monetary Policy, Money supply and Liquidity:

The liquidity in the economy depends upon the money supply which is regulated by the
monetary policy of the government. RBI regulate the money supply and liquidity in the
economy. Business firms require funds for expansion projects. The capacity to raise funds
from the market is affected by the liquidity position in the economy. The monetary policy is
designed with an objective to maintain a balance in liquidity position. Neither the excess
liquidity nor the shortage are desirable. The shortage of liquidity will tend to increase the
interest rates while the excess will result in inflation.

 Budget:
The budget draft provides an elaborate account of the government revenues and expenditures.
A deficit budget may lead to high rate of inflation and adversely affect the cost of production.
Surplus budget may result in deflation. Hence, balanced budget is highly favourable to the
stock market.

 Tax structure:
Every year in March, the business community eagerly awaits the government’s announcement
regarding the tax policy. Concessions and incentives given to the certain industry encourage
investment in particular industry. Tax relief given to savings encourages savings. The minimum
alternative tax (MAT) levied by finance minister in 1996 adversely affected the stock market.
Ten years of tax holiday for all industries to be set up in the northeast is provided in the 1999
budget. The type of tax exemption has impact on the profitability of the industries.
 Monsoon and agriculture:
Agriculture is directly and indirectly linked with the industries. For example, sugar, cotton,
textile and food processing industries depend upon agriculture for raw material. Fertilizer and
insectide industries are supplying inputs to agriculture. A good monsoon leads to higher
demand for input and results in bumper crop. This would lead to buoyancy in the stock market.
When the monsoon is bad, agricultural and hydro power production would suffer. They cast a
shadow on a share market.

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 Infrastructure facilities:
Infrastructure facilities are essential for the growth of industrial and agricultural sector. A wide
network of communication system is a must for the growth of the economy. Good infrastructure
facilities affect the stock market favourably. The government are liberalized its policy
regarding the communication, transport and power sector.

 Demographic factors:
The Demographic data provides details about the population by age, occupation, literacy and
geographic location. This is needed to forecast the demand of customer goods. The population
by age indicates the availability of able work force.

 Economic forecasting:
To estimate the stock price changes, an analyst the macro economic environment and the factor
peculiar to industry concerned to it. The economic activities affect the corporate profits,
Investors, attitude and share prices.

 Economic indicators:
The economic indicators are factors that indicate the present status, progress or slow down of
the economy. They are capital investment, business profits, money supply, GNP, interest rate,
unemployment rate, etc. The economic indicators are grouped into leading, coincidental and
lagging indicators. The indicators are selected on the following criteria
Economic significance,
Statistical adequacy, Timing,
conformity.

 Diffusion index:
Diffusion index is a composite index or consensus index. The diffusion index consist of
leading, coincidental and lagging indicators. This type of index has been constructed by the
National Bureau of Economic Research in USA. But it is complex in nature to calculate and
the irregular movements that occur in individual indicators cannot be completely eliminated.

 Econometric model building:

For model building several economic variables are taken into consideration. The assumptions
underlying the analysis are specified. The relationship between the independent and dependent
variables is given mathematically. While using the model, the analyst has to think clearly all
inter-relationship between the variables. This model use simultaneous equations.

Other factors:
a. Industrial growth rate
b. Fiscal policy of the Government
c. Foreign exchange reserves
d. Growth of infrastructural facilities
e. Global economic scenario and confidence
f. Economic and political stability.

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 INDUSTRY ANALYSIS

An industry is a group of firms that have similar technological structure of production and
produce similar products. E.g.: food products, textiles, beverages and tobacco products, etc.
These industries can be classified on the business cycle i.e. classified according to their
relations to the different phases of the business cycle. They are classified into
 Growth industry
 Cyclical industry
 Defensive industry
 Cyclical Growth industry

 Growth industry:
The growth industry has special features of high rate of earnings and growth in expansion,
independent of the business cycle. The expansion of the expansion of the industry mainly depends
upon the technological change.
 Cyclical industry:
The growth and the profitability of industry move along with the business cycle. During the boom
period they enjoy the growth and during depression they suffer set back.
 Defensive industry:
Defensive industry defies the movement of business cycle. The stock of defensive industries can be
held by the investor for income earning purpose. They expand and earn income in the depression
period too, under the government’s of production and are counter-cyclical in nature.
 Cyclical Growth industry
This is a new type of industry that is cyclical and at the same time growing. The changes in
technology and introduction of new models help the automobile industry to resume their growth
path.

INDUSTRY LIFE CYCLE

The life cycle of the industry is separated into four well defined stages such as
o Pioneering stage
o Rapid growth stage
o Maturity and stabilization stage
o Declining stage

Fig.5

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Pioneering stage:
The prospective demand for the product is promising in this stage and the technology of the product
is low. The demand for the product attracts many producers to produce the particular product.
There would be severe competition and only fittest companies this stage. The producers try to
develop brand name, differentiate the product and create a product image. This would lead to non-
price competition too. The severe competition often leads to the change of position of the firms in
terms of market shares and profit. In this situation, it is difficult to select companies for investment
because the survival rate is unknown.
Rapid growth stage:
This stage starts with the appearance of surviving firms from the pioneering stage. The companies
that have withstood the competition grow strongly in market share and financial performance. The
technology of the production would have improved resulting in low cost of productions and good
quality products. The companies have stable growth rate in this stage and they declare dividend to
the share-holders. It is advisable to invest in the shares of these companies.
Maturity and stabilization stage:
In the stabilization stage, the growth rate tends to moderate and the rate of growth would be

more or less equal to the industrial growth rate or the gross domestic product growth rate.

Symptoms of obsolescence may appear in the technology. To keep going, technological

innovations in the production process and products should be introduced. The investors have

to closely monitor the events that take place in the maturity stage of the industry.

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 Declining stage:
In this stage, Demand for the particular product and the earnings of the companies in the industry
decline. The specific feature of the declining stage is that even in the boom period; the growth of
the industry would be low and decline at a higher rate during the recession. It is better to avoid
investing in the shares of the low growth industry even in the boom period. Investment in the shares
of these types of companies leads to erosion of capital.

KEY FACTORS IN INDUSTRY ANALYSIS:

1. The past performance of the industry.
2. The performance of the product and technology of the industry.
3. Role of government in the industry.
4. Labour conditions relating to the industry.
5. Competitive conditions in the market
6. Inter-linkages with other industries

DETERMINING THE SENSITIVITY OF THE INDUSTRY:

1. Sensitivity to sales.
2. Operating leverage
3. Financial leverage.

SWOT ANALYSIS FOR THE INDUSTRY

Strength: Strength of the industry refers to its capacity and comparative advantage in the
economy. For example, the existing research and development facilities and greater dependence
on allopathic drugs are two elements of strength to the pharmaceutical industry in India.
Weakness: Weakness refers to the restrictions and inherent limitations in the industry, which keep
the industry away from meeting its target. For example, Lack of infrastructure facility, rail-road
links, etc., are weakness of the tourism industry in India.
Opportunities: Opportunities refers to the expectation of favourable situation for an industry. For
example, with increase in purchasing power with the people, demand for pharmaceutical industry
will increase and likewise, changing preference from gold to diamond jewellary has brought a lot
of opportunities for the diamond industry.
Threats: Threat refers to an unfavourable situation that has a potential to endanger the existence
of an industry. For example, after liberalization of import policy in India, import of Chinese goods
has threatened many industries in India, such as toys, novelties, etc.
III. COMPANY ANALYSIS
Effect of a business cycle on an individual company may be different from one industry to

another. Here, the main point is the relationship between revenues and expenses of the firm

and the economic and industry changes. The basic objective of company analysis is to

identify better performing companies in an industry .These companies would be identified for

investment.

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 The processes that may be taken up to attain the objective are as follows:

a. Analysis of management of the company to evaluate its trust-worthiness, capacity and

efficiency.
b. Analyse the financial performance of the company to forecast its future expected earnings.
c. Evaluation of long-term vision and strategies of company in terms of organizational strength
and resources of company.
d. Analysis of key success factor for particular industry.

SOURCES OF INFORMATION:
Information and data required for analysis of earnings of a firm are primarily available in the annual
financial statements of the firm. It include,
 Balance sheet or Position statement
 Income statement or Profit & Loss account.
 Financial statement analysis (Ratio analysis)
 Cash flow statement, the statement of sources and uses of cash and also
 Top level management people in the company.
I.BALANCE SHEET (BS):
It is the most significant and basic financial statement of any firm. It is prepared by a firm to present
a summary of financial position at a given point of time, usually at the end of financial year. It
shows the state of affairs of the firm at a point of time. In fact, the total assets must be equal to the
total claim against the firm and this can be stated as,
Total assets =Total claim (Debt +Share holders)
=Liabilities +Share holders equity
The different items contained in BS can be grouped into,
1. Assets
2. Liabilities
3. Shareholder’s funds.
a. ASSETS: An asset of the firm represents the investments made by the firm in order to generate
earnings. It can be classified into (a).Fixed Asset (b).Current assets.
i. FIXED ASSET – Those which are intended to be for a longer period .These are permanent in
nature, relatively less liquid and are not easily converted into cash in short run. Fixed asset include,
plant & machinery, furniture & fixtures, buildings, etc. The value of fixed asset is known as book
value, which may be different from market value or replacement cost of the assets. The amount of
depreciation is anon-cash expense and does not involve cash out flow. It is taken as an expense
item and is included in the cost of goods sold or indirect expense.
ii.CURENT ASSET - It is the liquid asset of the firm and is convertible into cash within a period of
one year. It includes cash and bank balance, receivables, inventory (raw material, finished goods,
etc), prepaid expenses, loan, etc.
b. LIABILITIES: It is also called as debts. It is claimed by the outsiders against the assets of the
firm. The liabilities refer to the amount payable by the firm to the claim holders. The liabilities are
classified into long term and short term liabilities.
i. LONG TERM LIABILITIES: It is the debt incurred by the firm, which is not payable during the
period of next one year. It represents the long term borrowings of the firm.
ii.CURRENT LIABILITITES: It is the debt which the firm expects to pay within a period of one
year. It is related to the current assets of the firm in the sense that current liabilities are paid out of
the realization of current assets.
3. SHAREHOLDERS EQUITY (SE): It represents the ownership interest in the firm and reflects
the obligations of the firm towards its owners. It the direct contribution of the shareholders to the
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 firm.The retained earnings on the other hand reflects the accumulated effect of the firms earnings.
SE is also called as net worth. The liabilities and the SE must be equal to the total assets of the
firm.
II.INCOME STATEMENT OR PROFIT & LOSS ACCOUNT (IS):
It shows the result of the operations of the firm during a period. It gives detail sources of income
and expenses; Income statement is a flow report against the balance sheet which is a stock report
or status report. It helps in understanding the performance of the firm during the period under
consideration. It can be grouped into three classes. (i) Revenues (ii) Expenses & (iii) Net profit or
loss

REVENUES- It is the inflow of resources\cash that arise because of operation of the firm. The
revenue arises from the sale of goods and services to the customer and other non-operating
incomes. The firm may also get revenue from the use of its economic resources elsewhere. E.g. –
some of the funds might have been invested in some other firm. The income by way of interest or
dividend is also a revenue.
EXPENSES- The cost incurred in the earning the revenues is called the expenses. Expenses like,
salaries, general expenses, repairs, etc. It occurs when there is a decrease in assets or increase in
liabilities
III.CASH FLOW STATEMENT AND FUND FLOW STATEMENT:
The balance sheet and the income statement are the two common financial statements and are
also known as traditional financial statements. It is essential to know the movement of cash
during the period. It is a historical record of where the cash came from and how was it used.
IV. FINANCIAL STATEMENT ANALYSIS:
Financial statement analyses are ratio like:
a. Profitability ratios
b. Liquidity ratios
c. Solvency ratios

TECHNICAL ANALYSIS

It is a process of identifying trend reversal at earlier stages to formulate the buying and
selling strategy. With the help of various indicators they analyse the relationship between
price& volume, supply & demand, etc. An investor who does this analysis is called
technician.

ASSUMPTIONS:
1. The market value is determined by the interaction of supply and demand.
2. The market discounts everything. The information regarding the issuing of bonus shares and
right issues may support the prices. These are some of the factors which cause shift in demand
& supply and change in direction of trends.
3. The market always moves in trend, except for certain minor deviations. The trend may either be
increasing or decreasing. It may continue in same manner or reverse.
4. In the rising market, many purchase shares in greater volume. When the market moves down,
people are interested in selling it. The market technicians assume that past prices predict the
future.

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 THEORIES USED IN THIS ANALYSIS:

1. Dow theory
2. Elliot wave theory
DOW THEORY:
This theory was developed by Charles H Dow. He did research and published in journal in
1984 mainly for trend analysis. According to his theory, the price patterns do not move just
like that and it follows some trend. There are 3 types of trend.
• Primary trend – It is broad upward or downward movement which last for a year or two.
• Secondary trend or Correction trend – It last for 3 weeks to some months.
• Minor trend. –It refers to the day to day price. Its also knows as fluctuations

These 3 trends are compared to tide, waves and ripples of the sea. Diagrammatic
representations of these trends are depicted below:

Fig.6

PRIMARY TREND:
The security price may be either increasing or decresing.When market exhibits increasing
trend, its called bull market.The graph below show three clear cut peaks.

Fig.7
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Each peak is higher than the previous peak.The revival period encourages more and more
investors to buy scripts,their expectation about the future is high.In the next phase, increased
profits or corporate would result in further price rise.In the final phase,the price advance due
to inflation and speculation.

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Fig.8

the above graph depicts bear market.The contrary of bull market happens here .In the first phase
,the prices are coming down,this would result in lowering of profit in second phase.The final
phase is characrterised by distress sale of share.

SECONDARY TREND

Fig.9

In the bull market the secondary trend results in fall of about 33-66% of earlier rise. In bear
market, it carries the price upward and corrects the main trend. It provides breathing space to
market.
MINOR TREND :
Its also called as random wiggles. They are the daily price fluctuations. It tries to carry the
secondary trend movement. It’s better for the investors to carry primary or secondary than this
trend.

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 ELLIOT WAVE THEORY-

Fig.10

The above graph depicts bullish wave,

1,3,5 – impulsive waves
2,4 - correction waves
In starting wave, only few people invest and the waves keep moving high. It indicates the
prices of shares are moving high and hence they sell it. As they get more profit they will again
invest in the same company and there will be few more investors. This makes the wave to move
higher. Same process keeps going everyday. In the 5th wave investors will be more interested
in investing and to gain profit. Since people buy lot of shares here, it is called as buying wave.
After these five waves get over A,B,C waves or correction waves will occur. It these 8 waves
get over and if the same trend occur, again we may face bully’s wave or else we have beary’s
wave.
TYPES OF PRICES
1. The open price.
2. The close price.
3. The high price.
4. The low price.

TOOLS AND TECHNIQUES USED IN TECHNICAL ANLYSIS

CHARTS
What are stock charts

It is a graphical representation of how a stock’s price or trading volumes have changed over
time. This relationship can be presented in a number of ways, through the use of different types
of charts. It is your job, as a technical analyst, to identify the type that will bring out a hidden
trend most effectively.

Stock charts, like all other charts, have two axis—the vertical axis and the horizontal axis. The
horizontal axis represents the historical time periods for which a technical chart has been
constructed. The vertical axis displays the stock price or the trading volume corresponding to
each period.

There are many types of charts that are used for technical analysis. However, the four types
that are most common are—line chart, bar chart, point and figure chart and candlestick chart.
We will discuss these technical charts extensively later. However, we have illustrated three
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types of stock charts below. The bar chart looks a lot like the candlestick chart. All the charts
displayed below are stock price charts. The nature of the input may, however, have to be altered
when you move from one chart type to another.

Line charts: A line chart is the figure that, perhaps, automatically comes to mind when you
think of a chart. The line chart has the stock price or trading volume information on the vertical
or y-axis and the corresponding time period on the horizontal or x-axis). Trading volumes refer
to the number of stocks of a company that were bought and sold in the market on a particular
day. The closing stock price is commonly used for the construction of a line chart.

Once the two axes have been labelled, preparation of a line chart is a two-step process. In the
first step, you take a particular date and plot the closing stock price as on that date on the graph.
For this, you’ll put a dot on the chart in such a way that it is above the concerned date and
alongside the corresponding stock price.

Let’s suppose that the closing stock price on December 31, 2014 was Rs 120. For plotting it,
you’ll put a dot in such a way that it is simultaneously above the marking for that date on the
x-axis, and alongside the mark that says Rs 120 on the y-axis. You will do this for all dates. In
the second step, you will connect all the dots plotted with a line. That’s it! You have your line
chart below:

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 Fig. Line Chart
Fig.11

Point and figure charts:

A point and figure chart essentially displays the volatility in a stock’s price over a chosen period
of time. On the vertical axis, it displays the number of times stock prices rose or fell to a
particular extent. On the horizontal axis, it marks time intervals. Markings on the chart are
exclusively in the form of X’s and O’s. X’s represent the number of times the stock rose by the
specified limit, while O’s represent the number of times it fell by it. The specified amount used
is called box size. It is directly related to the difference between markings on the y-axis.

Fig. Point and Figure Chart

Fig.12
• Bar charts: A bar chart is similar to a line chart. However, it is much more informative. Instead
of a dot, each marking on a bar chart is in the shape of a vertical line with two horizontal lines
protruding out of it, on either side. The top end of each vertical line signifies the highest price
the stock traded at during a day while the bottom point signifies the lowest price at which it
traded at during a day. The horizontal line to the left signifies the price at which the stock
opened the trading day. The one on the right signifies the price at which it closed the trading
day. As such, each mark on a bar chart tells you four things. An illustration of the marks used
on a bar chart is given below:

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 A bar chart is more advantageous than a line chart because in addition to prices, it also reflects
price volatility. Charts that show what kind of trading happened that day are called Intraday
charts. The longer a line is, the higher is the difference between opening and closing prices.
This means higher volatility. You should be interested in knowing about volatility because high
volatility means high risk. After all, how comfortable would you be about investing in a stock
whose price changes frequently and sharply?

Fig. Bar Chart

Fig.13
• Candlestick charts: Candlestick charts give the same information as bar charts. They only
offer it in a better way. Like a bar chart is made up of different vertical lines, a candlestick chart
is made up of rectangular blocks with lines coming out of it on both sides. The line at the upper
end signifies the day’s highest trading price. The line at the lower end signifies the day’s lowest
trading price. The day’s trading can be shown in Intraday charts. As for the block itself (called
the body), the upper and the lower ends signify the day’s opening and closing price. The one
that is higher of the two, is at the top, while the other one is at the bottom of the body.

What makes candlestick charts an improvement over bar charts is that they give information
about volatility throughout the period under consideration. Bar charts only display volatility
that occurs within each trading day. Candles on a candlestick chart are of two shades-light and
dark. On days when the opening price was greater than the closing price, they are of a lighter
shade (normally white). On days when the closing price was higher than the opening price,
they are of a darker shade (normally black).A single day’s trading is represented by Intraday
charts. Higher the variation in colour, more volatile was the price during the period. The
appearance of candles on a candlestick chart is as follows:

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 Fig. Candle stick chart
Fig.14

PRICE PATTERNS

Price Patterns are formations which appear on stock with the help of charts which have shown
to have a certain degree of predictive value. Some of the most common patterns include: Head
& Shoulders (bearish), Inverse Head & Shoulders (bullish), Double Top (bearish), Double
Bottom (bullish), Triangles, Flags.

CONTINUATION PATTERNS

A price pattern that denotes a temporary interruption of an existing trend is known as a

continuation pattern. A continuation pattern can be thought of as a pause during a prevailing
trend – a time during which the bulls catch their breath during an uptrend, or when the bears
relax for a moment during a downtrend. While a price pattern is forming, there is no way to tell
if the trend will continue or reverse. As such, careful attention must be placed on the trendlines
used to draw the price pattern and whether price breaks above or below the continuation zone.
Technical analysts typically recommend assuming a trend will continue until it is confirmed
that it has reversed. In general, the longer the price pattern takes to develop, and the larger the
price movement within the pattern, the more significant the move once price breaks above or
below the area of continuation.
If price continues on its trend, the price pattern is known as a continuation pattern. Common
continuation patterns include:
• Pennants, constructed using two converging trendlines
• Flags, drawn with two parallel trendlines
• Wedges, constructed with two converging trendlines, where both are angled either up or down

FLAGS & PENNANTS

Flags and Pennants are short-term continuation patterns that represent a consolidation
following a sharp price movement before a continuation of the prevailing trend. Flag patterns
are characterized by a small rectangular pattern that slopes against the prevailing trend, while
pennants are small symmetrical triangles that look very similar.

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 Figure – Pennant Example – Source: StockCharts.com
Fig.15

The short-term price target for a flag or pennant pattern is simply the length of the ‘flagpole’
or the left vertical side of the pattern applied to the point of the breakout, as with the triangle
patterns. These patterns typically last no longer than a few weeks, since they would then be
classified as rectangle patterns or symmetrical triangle patterns.

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 Fig.16

TRIANGLES

Triangles are among the most popular chart patterns used in technical analysis since they occur
frequently compared to other patterns. The three most common types of triangles are
symmetrical triangles, ascending triangles, and descending triangles. These chart patterns can
last anywhere from a couple weeks to several months.

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 Figure Symmetrical Triangle Example – Source: StockCharts.com
Fig.17

Symmetrical triangles occur when two trend lines converge toward each other and signal only
that a breakout is likely to occur – not the direction. Ascending triangles are characterized by
a flat upper trend line and a rising lower trend line and suggest a breakout higher is likely, while
descending triangles have a flat lower trend line and a descending upper trend line that suggests
a breakdown is likely to occur. The magnitude of the breakouts or breakdowns is typically the
same as the height of the left vertical side of the triangle.

REVERSAL PATTERNS

A price pattern that signals a change in the prevailing trend is known as a reversal pattern.
These patterns signify periods where either the bulls or the bears have run out of steam. The
established trend will pause and then head in a new direction as new energy emerges from the
other side (bull or bear). For example, an uptrend supported by enthusiasm from the bulls can
pause, signifying even pressure from both the bulls and bears, then eventually giving way to
the bears. This results in a change in trend to the downside. Reversals that occur at market tops
are known as distribution patterns, where the trading instrument becomes more enthusiastically
sold than bought. Conversely, reversals that occur at market bottoms are known as
accumulation patterns, where the trading instrument becomes more actively bought than sold.
As with continuation patterns, the longer the pattern takes to develop and the larger the price
movement within the pattern, the larger the expected move once price breaks out.
When price reverses after a pause, the price pattern is known as a reversal pattern. Examples
of common reversal patterns include:
• Head and Shoulders, signaling two smaller price movements surrounding one larger
movement
• Double Tops, representing a short-term swing high, followed by a subsequent failed attempt
to break above the same resistance level
• Double Bottoms, showing a short-term swing low, followed by another failed attempt to
break below the same support level

HEAD AND SHOULDERS

The Head and Shoulders is a reversal chart pattern that indicates a likely reversal of the trend
once it’s completed. A Head and Shoulder Top is characterized by three peaks with the middle
peak being the highest peak (head) and the two others being lower and roughly equal
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(shoulders). The lows between these peaks are connected with a trend line (neckline) that
represents the key support level to watch for a breakdown and trend reversal. A Head and
Shoulder Bottom – or Inverse Head and Shoulders – is simply the inverse of the Head and
Shoulders Top with the neckline being a resistance level to watch for a breakout higher.

Figure Head and Shoulders – Source: StockCharts.com

Fig.18

DOUBLE TOPS AND BOTTOMS

The Double Top or Double Bottom pattern are both easy to recognize and one of the most
reliable chart patterns, making them a favorite for many technically-orientated traders. The
pattern is formed after a sustained trend when a price tests the same support or resistance level
twice without a breakthrough. The pattern signals the start of a trend reversal over the
intermediate- or long-term.

Figure – Double Top Example – Source: StockCharts.com

Fig.19

MARKET INDICATORS
Market indicators are a subset of technical indicators used to predict the direction of major
financial indexes or groups of securities. Most market indicators are created by analyzing the
number of companies that have reached new highs relative to the number that created new
lows, known as market breadth, since it shows where the overall trend is headed.

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• Market Breadth indicators compare the number of stocks moving in the same direction as a
larger trend. For example, the Advance-Decline Line looks at the number of advancing stocks
versus the number of declining stocks.

• Market Sentiment indicators compare price and volume to determine whether investors are
bullish or bearish on the overall market. For example, the Put Call Ratio looks at the number
of put options versus call options during a given period.

MOVING AVERAGES
Moving averages "smooth" price data by creating a single flowing line. The line represents the
average price over a period of time. Which moving average the trader decides to use is
determined by the time frame in which he or she trades. For investors and long-term trend
followers, the 200-day, 100-day and 50-day simple moving average are popular choices.
There are several ways to utilize the moving average. The first is to look at the angle of the
moving average. If it is mostly moving horizontally for an extended amount of time, then the
price isn't trending, it is ranging. If the moving average line is angled up, an uptrend is
underway. Moving averages don't predict though; they simply show what the price is doing, on
average, over a period of time.
Crossovers are another way to utilize moving averages. By plotting a 200-day and 50-day
moving average on your chart, a buy signal occurs when the 50-day crosses above the 200-day.
A sell signal occurs when the 50-day drops below the 200-day. The time frames can be altered
to suit your individual trading time frame.

Fig.20
When the price crosses above a moving average, it can also be used as a buy signal, and when
the price crosses below a moving average, it can be used as a sell signal. Since price is more
volatile than the moving average, this method is prone to more false signals, as the chart above
shows.
Moving averages can also provide support or resistance to the price. The chart below shows a
100-day moving average acting as support (i.e., price bounces off of it).

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Fig.21 PART – A

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