Technical Analysis

Prof Mahesh Kumar

Amity Business School
[email protected]
 Introduction
• Technical analysis is the oldest approach dating back to 19th
century.
• Technical analysis is different from fundamental analysis.
• Fundamental analyst believes that the market is 10%
psychological and 90% logical while technical analyst
assumes that it is 90% psychological and 10% logical.
• Technical analysis is essentially search of recurrent and
predictable patterns in stock prices.
• Technical analysis is frequently used as a supplement to
fundamental analysis rather than a substitute for it.
• Technical analysis involves a study of market generated data
like prices and volumes to determine the future direction of
the price movement.
 Basic Premise of Technical Analysis
1. Market prices are determined by the interaction of demand
and supply forces.
2. Supply and demand are influenced by number of factors
both rational and irrational-fundamental as well as
psychological.
3. Barring minor deviations, stock prices tend to move in fairly
persistent trends.
4. Shifts in demand and supply bring about changes in trends.
5. Irrespective of why they occur, shifts in demand and supply
can be detected with the help of charts of market action.
6. Because of the persistence of trends and patterns, analysis
of past market data can be used to predict future price
behavior.
 Difference between Technical Analysis
and Fundamental Analysis
• Technical analysis mainly seek to predict short term
price movements whereas fundamental analysis tries
to establish long term values.
• The focus of technical analysis is mainly on internal
market data, particularly price and volume data. The
focus of fundamental analysis is on fundamental
factors relating to the economy, the industry and the
firm.
• Technical analysis appeals mostly to short term
traders whereas fundamental analysis appeals
primarily to long term investors.
 Typical Stock Market Cycle
Stock Price
 Typical Stock Market Cycle
Stock
Price

Declining Peak
Trend
Channel Flat Trend Channel

Sell Point
Rising Trend
Channel Declining
Buy Point Trend Buy Point
Trough
Trough Channel
 Charting Techniques
• Technical analysis use a variety of charting
techniques.
• The most widely used are Dow Theory, bar and
line charts, the point and figure.
• The basic concept underlying chart analysis are:
1. Persistence of trend
2. Relationship between volume and trend
3. Resistance and support levels
 Trends
• The key belief of the chartist is that the stock prices
tend to move in fairly persistent trends. Stock price
is characterized by inertia: the price movement
continues along a certain path (up, down or
sideways) until it meets an opposing force, arising
out of an alternate supply-demand relationship.
 Relationship between Volume and
Trend
• Chartists believe that generally volume and trend go
hand in hand.
• Whenever a major upturn begins, the volume of
trading increases as the price advances and
decreases as the price declines.
• In a major downturn, the volume of the trading
increases as the price declines and decreases as
the price rallies.
 Support and Resistance Levels
• Chartists assume that it is difficult for the price of a
share to rise above a certain level called the
resistance level and fall below a certain level called
a support level.
• The level at which the declining share may evolve a
substantial increase in demand is called the support
level.
 Tools of Technical Analyst
• Technical analysts make use of number of tools or
indicators as indicated below to measure price-
volume, supply-demand relationships for the
overall market as well as for individual stocks.
Some of the tools used are:
1. Market indicators
2. Price indicators
3. Volume indicators
4. Other indicators
 Market Indicator-Dow Theory
• Dow Theory proposed in late nineteenth century by Charles H Dow, the
editor of ‘The Wall Street Journal’.
• According to this theory ‘the market is always considered as having three
movements, all going at the same time, that guides its general direction.’
• The Dow theory
1. Major trends are like tides in the ocean
2. Intermediate trends resemble waves
3. Short-run movements are like ripples
– Key is to identify the nature of a current price movement
• Proponents of Dow Theory classify these three movements as:
1. Daily fluctuations that are random day-to-day movements and have little
analytical value because of their short durations and variation in
amplitude.
2. Secondary movements or corrections that may last from few weeks to
some months. They tend to correct deviations from its general
boundaries.
3. Primary trends representing bull and bear phases of the market.
 Market Indicator-Dow Theory
• An upward primary trend represents a bull market
whereas a downward primary trend represents a bear
market.
• A major upward move is said to occur when the high
point of each rally is higher than the high point of the
preceding rally and the low point in each decline is
higher than the low point of the preceding decline.
• Likewise, a major downward move is said to occur when
the high point of each rally is lower than the high point of
the preceding rally and low point of each decline is lower
than the low point of the preceding decline.
 Price Indicators
• Technical analysts watch the behavior of prices
and volume of trading to make their prediction
about the group of stocks or individual stocks.
Some of the price indicators commonly used by
technician are:
a) Price advances versus declines
b) New highs versus lows
c) Price patterns of the ‘most active’ stocks.
 Price Indicators-Advances and
Decline
• Looking at BSE Sensex or NSE Nifty may be misleading.
• A relatively few stocks may be moving ahead while majority
stocks either are making no progress or are moving down.
The average may be behaving contrary to the larger
population of stocks.
• The basic idea behind the measurement of advances to
decline is to determine what the main body of stocks is
really doing.
• Comparison of advances and declines is means of
measuring the dispersion or breadth of a general price rise
or decline and is often referred as the ‘breadth of the
market’
 Price Indicators-Advances and
Decline
• The technician is interested in change in breadth rather than
in absolute value.
• The breadth of the market is compared with a market index
like Sensex or NSE Nifty.
• Normally, breadth and Sensex will move in unison. Any
divergence indicates a market sentiment.
• If the market average is moving upwards whereas the
breadth of the 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 the market is moving upwards it signals that
the market may turn bullish.
 Price Indicators-New Highs & Low
Highs
• As a part of stock market reporting, information is
provided on the 52-week high and low prices of
each stock.
• The theory is that a rising market will generally be
accompanied by an expanding number of stocks
attaining new highs and dwindling number of new
lows.
• The reverse is true for a declining market.
 Volume Indicators
• Importance of volume
– Ratio of upside-downside volume
– Price movements are not very important unless they are “confirmed”
by volume
• Volume is a function of the demand and supply of the stocks and
can signal turning points for the market as well as the individual
stocks.
• A Dow Theory tenet is that during the bull markets, the volume
increases with price advances and decreases with price declines.
• In a major downward price trend (bear run), the reverse will hold
true; volume will generally increase as prices decline and dwindle
on price rallies.
• Volume generally falls in advance of major declines in the stock
price averages and rise sharply during market bottoms.
• Forecasting price changes is the examination of the trend of price
changes as well as fluctuations in volume of transactions.
 Short Selling
• BSE & NSE make public the number of shares that have been
sold short.
• Short selling refers to shares that are not owned. The seller
has behaved in this way because he feels the stock will fall in
price. He hopes to purchase the shares at a later date (cover
his short position) below the selling price and reap a profit.
• Short selling is also referred as short interest.
• The theory is that short sellers must eventually cover their
positions. This buying activity increases the potential demand
for the stock resulting in buoying effect on prices.
 Short Selling
• Monthly short interest for the market can be related to
average daily volume for the preceding month. Thus
monthly short interest divided by average daily volume
gives a ratio which indicates how many days of trading it
would take to use up total short interest. Historically the
ratio has varied from one third of a day to four days.
• In general, when the ratio is less than 1, the market is
considered weak or weakening. It is common to say that
the market is ‘overbought’. A decline should follow sooner
or later. The zone between 1 to 1.5 is considered a
neutral indicator. Values above 1.5 indicate bullish
territory with 2 and above highly favorable. The market is
said to be ‘oversold’. The most bullish effect would occur
when the market is turning up and the short interest is
high.
 Odd Lot Trading
• The small investor more often than not buys fewer
than 100 shares of a given stock- an odd lot- and
such buyers and sellers are called odd lotters.
• Odd lotters try to do the right thing most of the time,
that is, they tend to buy stocks as the market
retreats and sell stocks as the market advances.
• However technician feel that the odd lotter is
inclined to do the wrong thing at critical turns in the
market.
 Other Market Indicators
• Mutual Fund Activity: Mutual Funds are one of the most potent
institutional forces in the market and their cash positions and
their net subscriptions are closely followed by the technicians.
• Mutual funds keep cash to take advantage of favorable
market opportunities and/or provide for redemption of shares
by holders.
• In theory a low cash ratio would indicate a reasonably fully
invested position, with the implication that not much reserve
buying power remains in the hand of funds as a group. Low
ratios (5-5.5%) are frequently equated with market highs.
Other Market Indicators-Mutual Fund
• At market bottoms, the cash ratio would be high to reflect
heavy redemptions, among other things. Such a build up of
cash ratio at market lows is an indication of potential
purchasing powers that can be injected into the market to
propel it upward.
• Another mutual fund indicator that is monitored quite closely is
net subscription (subscription to new shares less redemption
of existing shares). Like the odd-lot statistics, this indicator
measures public sentiment and the outlook for the stock
market. The trend to more or less buying moves in tandem
with the odd-lot purchase-to-sale ratio.
Other Market Indicators- Mutual Fund
• The sales-redemption differential narrows
considerably to market advances. In effect, market
advances are preceded by a relative shift towards
redemption. Shift towards relative buying (sales of
new shares) tend to precede market decline.
 Other Market Indicators
• Credit Balance Theory: Typically, investors receive credit
balances in their account at their brokerage houses when they
sell the stocks. Some feel that a build up in these cash
balances represent large reservoirs of potential buying power.
In effect, investors are leaving the credit balances in their
brokerage firm accounts because they anticipate a drop in
prices and thus a buying opportunity. Conversely drop in
credit balance suggests that prices will go up.
• However technicians feel that investor in general, as their
actions reflected in their credit balances are usually wrong.
The credit balance theory is a contrary opinion theory.
• In other words, technicians suggest that a wise investor will
buy stocks as credit balances are rising and sell stocks as
credit balances are dropping.
 Other Market Indicators
• Put/Call Theory: This is the indicator closely
monitored by contrarian technical analysts.
Speculators buy calls when they are bullish and buy
put when they are bearish. The put call ratio theory
is a contrary opinion theory.
• A rise in put/call ratio means that speculators are
pessimistic and for a contrarian technical analyst
this is a buy signal.
• Conversely if a put/call ratio falls, it means that the
speculators are optimistic. The technical analyst,
however regard this as a sell signal.
 Other Market Indicators
• According to great proponent of contrarian theory Templeton
‘To buy when others are despondently selling and to sell
when others are avidly buying requires the greatest fortitude
and pays the greatest ultimate reward.’ The same thoughts
have been echoed by Warren Buffet ‘Be fearful when others
are greedy and greedy when others are fearful.’
• ‘Bull markets are born on pessimism, grow on scepticism,
mature on optimism, and die on euphoria. The time of
maximum pessimism is the best time to buy, and the time of
maximum optimism is the best time to sell’ – Templeton
• People ask whether the outlook is positive, but that’s the
wrong question. The right question is : Is the outlook most
miserable.
 Other Market Indicators
• Trin Stastic: The number of advancing to declining issues
divided by the ratio of volume in advancing to declining issues
is called the trin stastics, that is
Trin= No of adv/ No. of Declining
Vol of adv/Vol of Declining
=Vol of decl/No of decl
Vol of adv/No of adv
 Trin measures the ratio of average volume in declining issues
to average volume in advancing issues.
 Generally, a trin of more than 1 is deemed bearish as it
means that the declining stocks have higher average volume
compared to advancing stocks, suggesting a net selling
pressure.
 Other Market Indicators
• Open Interest in F & O Segment: A rise in market
along with an increase in open interest confirms an
upward trend.
• A rise in market along with decrease in open interest
suggests that the market is weakening.
• A fall in market along with an increase in open
interest confirms a downward trend.
• A fall in market along with decrease in open interest
implies that the market is strengthening.
 Forecasting Individual Stock
Performance
• For forecasting individual stock performance there
are two broad category of tools:
1. Those looking only at price.
2. Those looking at price-volume relationship.
 Price Analysis Approach
• Charting represent a key activity for the technical analyst as they provide
visual assistance to him in detecting evolving and changing pattern of
price behavior. The most commonly used charts are:
• Line Charts:

The line chart connects the price over a time period and is more useful for
identifying long term trends. It has a line that connects the closing price
against time.
 Price Analysis Approach

• Bar Charts:

The bar chart gives the chartist information on

price changes at time. In this, the high, low, open,
close share price or index level is plotted against
time.
 Price Analysis Approach

• Point and Figure Chart:

The point and figure chart shows only the price changes. It
eliminates noise of detail, focusing only on trends. The two
distant marks of cross/round indicate respectively a rise/fall in a
price range.
 Point and Figure Charts
• There is no time on chart
• X use to plot up trending prices
• O use to plot down trending prices
• Only use daily high or low, close doesn’t
matter
• Buy/Sell signal generated when new
Higher/Lower X/O is plotted
 Price Analysis Approach

• Candlestick Chart:

Candlestick plot information is similar to bar charts but could

reveal an extra intuitive interpretation. Candlesticks are
shown as a vertical rectangle with wicks at both ends. When
the closing price is higher than the opening, the rectangle is
transparent and in the reverse case it is black.
 Price Analysis Approach
• Candlestick charts are said to have been developed
in the 18th century by legendary Japanese rice trader
Homma Munehisa. The charts gave Homma and
others an overview of open, high, low, and close
market prices over a certain period. This style of
charting is very popular due to the level of ease in
reading and understanding the graphs. The Japanese
rice traders also found that the resulting charts would
provide a fairly reliable tool to predict future demand.
• The method was picked up by Charles Dow around
1900 and remains in common use by today's traders of
financial instruments.
 Price Analysis Approach
• There are multiple forms of candlestick chart patterns,
with the simplest depicted at right. Here is a quick
overview of their names:
1. White candlestick - signals uptrend movement (those
occur in different lengths; the longer the body, the more
significant the price increase)
2. Black candlestick - signals downtrend movement
(those occur in different lengths; the longer the body,
the more significant the price decrease)
3. Long lower shadow - bullish signal (the lower wick
must be at least the body's size; the longer the lower
wick, the more reliable the signal)
 Price Analysis Approach
4. Long upper shadow - bearish signal (the upper wick must be at
least the body's size; the longer the upper wick, the more reliable
the signal)
5. Hammer - a bullish pattern during a downtrend (long lower wick
and small or no body); Shaven head - a bullish pattern during a
downtrend & a bearish pattern during an uptrend (no upper wick);
Hanging man - bearish pattern during an uptrend (long lower wick,
small or no body; wick has the multiple length of the body.
6. Inverted hammer - signals bottom reversal, however confirmation
must be obtained from next trade (may be either a white or black
body); Shaven bottom - signaling bottom reversal, however
confirmation must be obtained from next trade (no lower wick);
Shooting star - a bearish pattern during an uptrend (small body,
long upper wick, small or no lower wick)
 Price Analysis Approach
7. Spinning top white - neutral pattern, meaningful in combination
with other candlestick patterns
8. Spinning top black - neutral pattern, meaningful in combination
with other candlestick patterns
9. Doji - neutral pattern, meaningful in combination with other
candlestick patterns
10. Long legged doji - signals a top reversal
11. Dragonfly doji - signals trend reversal (no upper wick, long lower
wick)
12. Gravestone doji - signals trend reversal (no lower wick, long upper
wick)
13. Marubozu white - dominant bullish trades, continued bullish trend
(no upper, no lower wick)
14. Marubozu black - dominant bearish trades, continued bearish
trend (no upper, no lower wick)
 Price Analysis Approach
• Chartist are on the lookout for the formation of such patterns
in prices, so that the market players can take the desired
investment position. A vast majority of chart patterns may be
divided into two main groups:
1. Reversal
2. Continuation
 Reversal patterns indicate a change in the previous trend
occurring in the market. e.g. Head and Shoulders, Inverse
Head and Shoulders, Triple Tops, Triple Bottoms, Double
Tops, Double Bottoms.
 Continuation pattern confirms the movement of market in the
same direction as the previous trend. e.g. Symmetrical
triangles, Ascending Triangles, Descending Triangles, Flags,
Pennants, Gaps.
Double Top (triple top)
 Head and Shoulders
Head

Shoulder Shoulder

Neck line
 Key Reversal
• Higher high
• Lower low
• Close below prior day
close
– Sell signal

• Close above prior day

close
– Buy signal
Flag

Decline

Project =
Decline
 Triangle or Pennant
• Buy Signal if market
breaks out to the top
• Sell signal if market
breaks out to the
bottom
 Gaps

Break away

Measuring

Exhaustion

Common
 Moving Average Analysis

• A moving average is calculated by taking into

account the most recent observations.
• 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
long term trend; a 60 day moving average of daily
prices may be used to discern an intermediate
trend; a 10 day moving average of daily prices
may be used to identify a short term trend.
 Moving Average Analysis
Buy Signal Sell Signal
1. Stock price rise line rises 1. Stock price rise line falls
through the moving average through the moving average
line when the graph of the line when the graph of the
moving average is flattening
out. moving average is flattening
out.
2. Stock price line falls below
the moving average line 2. Stock price line rises below
which is rising. the moving average line
3. Stock price line which is which is falling.
above the moving average 3. Stock price line which is
line , falls but begins to rise below the moving average
again before reaching the line , rises but begins to fall
moving average line.
again before reaching the
moving average line.
 Price Volume Analysis Approach

• Resistance Support Charts: The purpose of these charts is to

detect resistance (areas of supply) as a stock prices goes up
and support (areas of demand) as a stock goes down

 The chart is constructed to show, in a series of horizontal lines,

the levels at which the stock in question has traded in the past.
The levels are determined regardless of the volume at which
the stock traded most often-the more often, the longer the
horizontal line.
 The hypothesis is that popular levels (longer lines) encountered
by the stock in an upward move present resistance; and
conversely popular lines (longer lines) encountered by the stock
in a downward move provide support.
 Price Volume Bar Charting

• Chartist following Dow Theory believe that volume goes

with the price trend. The basic tenets are:
• A volume increase with an upward move in prices is
good.
• A volume increase with a downward move in prices is
bad.
• If volume increases during a price drop, this is good
(drying up of supply)
• If volume decreases during a price rise, this is bad
(drying up of demand)
 Price Volume Bar Charting

• Ying has conducted an empirical study of price-volume

relationships. His results were as follows:
1. A small volume is usually accompanied by a fall in price.
2. A large volume is usually accompanied by a rise in price.
3. A large increase in volume is usually accompanied by a either a
large rise in price or a large fall in price.
4. If the volume has been decreasing consecutively for a period of
five trading days, then the price will tend to fall over the next
four trading days.
5. If the volume has been increasing consecutively for a period of
five trading days, then the price will tend to rise over the next
four trading days.
 Rationale for Technical Analysis

• As Bodie, Kane & Marcus put it “As prices unfold, each

trader infers the good news or bad news, nature of the
signals received by other traders and updates
assessments of the firms accordingly. Prices reveal as
well as reflect information and become useful data to
traders.”
• Hirson perhaps summarizes it best,” Whether it works or
not, Technical Analysis is no quick road to riches. Even
die-hard technical analysts say that the method works
best when accompanied by fundamental research-for
example, to time entry and exit point for a stock.”
 Technical Analysis
• To “non-believers,”
technical analysis can
sound like a lot of
focus-pocus!
Advantages of Technical Analysis
• Unlike fundamental analysis, technical analysis is
not heavily dependent on financial accounting
statements
– Problems with accounting statements:
• Lack information needed by security analysts
• GAAP allows firms to select reporting procedures,
resulting in difficulty comparing statements
between firms
• Many psychological and other non-quantifiable
factors do not show up in financial statements
 Advantages of Technical Analysis
• Fundamental analyst must process new
information and quickly determine a new intrinsic
value, but technical analyst merely has to
recognize a movement to a new equilibrium
• Technicians trade when a move to a new
equilibrium is underway but a fundamental
analyst finds undervalued securities that may not
adjust to “correct” prices as quickly
 Challenges to Technical Analysis
• Challenges to basic assumptions
– Empirical tests of Efficient Market Hypothesis (EMH)
show that prices do not move in trends
• Challenges to technical trading rules
– Rules that worked in the past may not be repeated
– Patterns may become self-fulfilling prophecies
– A successful rule will gain followers and become less
successful
– Rules all require subjective judgement