Chapter Two

SECURITY ANALYSIS, ASSET VALUATION

AND SELECTION
2.1. Introduction
2.2. Fundamental Analysis
2.3. Technical analysis
2.4. Technical analysis VS Fundamental
analysis
2.5. Bond valuation
 2.1 Introduction

Security
 A security is a legal document that
represent contractual or ownership
claim.
 Portfolio ?
 Most investors invest their saving in
a group of securities rather than
single security.
 Security analysis involves the
analysis and valuation of particular
securities that might be included in
06/09/2024 2
 Cont.
 Large number of company’s shares and bonds, debentures,
government securities with different maturity period and
industry line are available in the market.
 Share of over 7000 companies were listed in Indian stock exchange market
in 2011
 Over 3000 company's share were listed in New York stock exchange in
2006

 Analysis that answer:

 Which security should I buy?
 which industry and company's security should I buy?
 At What price?
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This questions are at the heart of security analysis. 3
 Definition-Security Analysis
 It is the detail examination of risk and return
characteristics of individual security in the light of
different fundamental factors.

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 Definition-Security Analysis
 “the process of gathering and organizing information and then using
it to determine the intrinsic value or future price of a security
– Intrinsic Value – is estimated value of security
• The present value of the expected future cash flows discounted
at the decision maker’s required rate of return.
 To determine the intrinsic value:
1. Future Cash flows from security are forecasted
2. Determine required rate of return
 Intrinsic value is then compared with the security’s current
market price.
 If security is ‘underpriced’, a purchase is recommended
because it is perceived to be underpriced
 If security is ‘overpriced’, sell is recommended

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 The Role of Intrinsic Value in the Work
of the Analyst
• The essential point is that security analysis does not seek to
determine exactly what is the intrinsic value of a given security.
• It needs only to establish either that the value is adequate—e.g.,
to protect a bond or to justify a stock purchase—or else that the
value is considerably higher or considerably lower than the
market price.
• For such purposes an indefinite and approximate measure of the
intrinsic value may be sufficient.
• To use a homely simile, it is quite possible to decide by
inspection that a woman is old enough to vote without knowing
her age or that a man is heavier than he should be without
knowing his exact weight.
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 Approach to Security Analysis
Security analysis is one vital part of investment decision process
involving the analysis and valuation of individual securities.
Two basic approaches of security analysis

Security
Analysis

Fundamental
Technical
Analysis
Analysis

Economic Industry Company Past price

analysis Analysis analysis movement
06/09/2024 7
 2.2. Fundamental Analysis

• Fundamental analysis: The analysis of determinants

of firm value, such as prospects for earnings and
dividends.

• It can be defined as a systematic approach to estimate

future cash flow and determine intrinsic value of
securities through analyzing of fundamental factors
and then compares this intrinsic value with current
market value and make investment decision.
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• It is based on the assumption that the security price is
determined by the fundamental factors like economy,
industry and company.
– Fundamental analysis consists of detailed analysis of the
factors affecting the performance of company such as
Competition faced by company, Market share, EPS of the
company, Management quality, Technological changes,
Foreign exchange, Inflation, Raw material, etc
• It forecasts the security price on the basis of economic,
industry and company analysis.
– And so called E.I.C analysis (Economic, Industry and
Company analysis).
06/09/2024 9
 Security Analysis (cont.)

Top to down approach

of Fundamental analysis

Economy Industry Company

Financial and non financial

GDP
Supply of raw material
data
Inflation rate income statement
Industry life cycle stage
Exchange rate balance sheet
Competitive condition
Interest rate in the industry Ratio analysis
Infrastructure facility Government policy
Management quality
Employment rate Technological change

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 Economic Analysis
 The performance of the company is depend on the industry in which the
company is grouped and industry is depend on economic condition.

 If the economy grows rapidly, the industry can also be expected to show
rapid 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.

 Thus, The analysis of economic environment is essential to understand the

behavior of the stock prices.

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 Economic analysis
The key variables commonly used to describe the state of the
macro economy are :
1. Growth domestic product
2. Inflation rate
3. Level of employment rate
4. Foreign exchange rate
5. Interest rate
6. Infrastructure facility
In Ethiopia
NBE,
MOFED, and other like world bank are some
agencies/institutions publish yearly economic data.
06/09/2024 12
 Gross Domestic Product
• GDP is a measure of the total production of final goods and
services in the economy during a year.
• It is indicator of economic growth
• When the economy is growing faster,
 income rises,
 demand for goods increases,
 production and sales volume increase
 hence profit of industries and companies increase
which ultimately has favorable effect on security price

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 Inflation
• Inflation has considerable impact on the performance of the
companies.
• Higher rate of inflation:
– increase the cost of production which lead to increase price of goods
and services which in turn decrease demand of the product and sales
volume and then company profit and ultimately influence security
price negatively.
• Higher inflation rate increases uncertainty about future prices and
costs, and it harms firms that cannot pass their cost to consumers.
– industry under price control policy of the government may lose the
market, like sugar industry.

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 Interest rate
• Lower interest rate stimulates investment by making credit
available easily and cheaply.
• If there is Lower interest rate –
– cheap cost of finance for company
– lower cost of production
– Lower price and increase the demand
– increase production /investment and sales volume
– increase profitability of company and favorable impact on
stock prices
• Higher interest rate result in higher cost of production and higher
price of the product which may lead to lower demand and15
06/09/2024
 Exchange rate
• One of the determinants of import and export
oriented company.

• Depreciation of the birr improve the competitive

position of Ethiopian products in foreign market,
thereby stimulating exports.

• But it would also make import more expensive

– The performance of Import oriented Company are
affect adversely.
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 Infrastructural facilities
Infrastructure facilities play an important role in growth of
industry and agriculture sector.
– A wide network of communication system,
– regular supply of power,
– a well developed transportation system (railways, transportation,
road network, inland waterways, port facilities, air links) and
– telecommunication system improve the industrial production and
improves the growth of the economy.
• Thus, good infrastructure facilities have favorable effect on
stock market.
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 Industry analysis

• Investor ultimately invest their money in the

securities of two or more specific companies.
– “which industries have attractive investment
opportunity?
• This will lead to several industries, and industrial
analysis will lead us to choose financially sound
and strong industries.
• Security analyst has to study the fundamental factor
affecting the performance of different industry.

06/09/2024 18
 Step 2. Industry analysis

 The main purpose of industry analysis is to seek industry that

are expected to grow faster by considering industry
information on:
 trend of demand,
 competing units,
 capacity utilization,
 cost and availability of inputs,
 substitution products,
 government policy,
 technology changes
06/09/2024 19
 Industry analysis

Generally, Factors to be considered while

analyzing industry are:
1. Industry life cycle stage
2. Supply of raw material
3. Competitive condition in the industry
4. Government policy
5. Technological change , etc

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Industry life-cycle stages(product life cycle theory)
1. Pioneering stage (introduction)
• At Initial stage: industry is new and risks are very high, negative or
low profit while rapid growth of demand and sale

2. Expansion stage(growth)
 Profit, demand, sale are growing continuously
 Investors can get high return at low risk because demand
exceed supply in this stage
3. Stagnation stage (maturity)
 Increase in sale but at slower rate,
 investment opportunities with in the industry may
diminish and member firms may pay larger dividends and
may be deemed ‘cash caws’
4. Decay stage(decline)
 Decline in Profitability, demand,
 new product and technology have come to market
06/09/2024
demand for product is diminishing and investors avoid 21
 Nature of Competition
• Some of the questions to be answered are:
– What companies are in the industry?
– What are their market shares?
– Has the number of competitors been rising, fallen, or
remained stable?

• The numbers of the firms in the industry and the market

share of the top firms in the industry should be analyzed.
– If too many firms are present in the industry, the competition
would be severe. This will lead to a decline in price of the
product.

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 Raw Material
• Availability of raw material
• An industry which has a limited supply of raw
materials domestically and where imports are
restricted will have weak growth prospects.

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 Regulatory and Tax Conditions

– Some of the questions to be answered are:

• What are the current regulations that the
industry faces?
• Are there likely to be new regulations?
• Are the industry’s products subject to
special taxes (such as “sin taxes” on
alcohol and tobacco products )
• Are there special tax breaks offered to the
industry?
06/09/2024 24
 3.Company analysis

 Performance of firms differ within an industry.

 Which firm perform well with in the industry?
 It helps to select the profitable company by
analyzing
 Profitability,
 Efficiency,
 Capital structure & sales,
 Management quality.
06/09/2024 25
 Company analysis

Analysis that involve all factors that affecting the earning of

the particular company are considered
1. Financial indicator: quantitative Issues
• Financial statement analysis
Balance Sheet
Income Statement
Cash flow statement
Financial Ratio Analysis

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2. Non financial indicator :qualitative Issues
 Top Management quality
 Level of Diversification
 Future plan
 Research and Dev’t
 Listing

06/09/2024 27
 Categories of Financial Ratios
• Financial ratios are often divided into different categories
based on the information that they provide:
– Liquidity Ratios: describe the ability of a firm to meet its
current obligations.
– Current Ratio
– Cash Ratio
– Quick Ratio

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 – Leverage Ratios: amount of debt used by the company.
• the extent to which a firm relies on debt financing.
• A high and rapidly increasing debt-to-equity ratio, suggesting
problems with servicing debt in future
– debt to total asset ratio
– Debt to Equity
– Long-term Debt to Equity
– Profitability Ratios: the extent to which a firm is profitable.
• ROA=Net income/total asset
• ROE=Net income/total equity
• Net Profit Margin=net income over sale

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 Market Valuation Ratios

The Price/Earnings Ratio

P/E = Current Market Share Price / EPS

The Price/Book Ratio

P/B = Current stock Price / book value per share

06/09/2024 30
 Company Analysis: Qualitative Issues
 Top Management Quality
 Age and experience, qualification of top management
 Strategic planning
 Marketing strategy
 Effectiveness of board of directors
 Research and development
 Progressive companies spend substantial sum of money on
R & D to upgrade their existing products, introducing
new product and adopt new technology
 Listing
 Liquidity
 Sustainable Growth Rate

 It is the maximum rate of growth a firm can maintain without

increasing its financial leverage and using internal equity only.
 The value of sustainable growth can be calculated as

 Sustainable growth rate =ROE x Retention ratio

Example
 If ROE is 11.2 percent. The retention ratio is 1/2, so we can

calculate the sustainable growth rate as Sustainable growth

rate 11.2 (1/2) = 5.6%
 Composite Corporation can expand at a maximum rate of

5.6 percent per year with no external equity financing or

without increasing financial leverage.
 INTRINSIC VALUE
 Fundamental analyst make investment decision based on market price of share and
its intrinsic value.
 Market price and Intrinsic Value are Base for Investment decision process

Determine
required rate
of return
Economic Conditions
Compare
intrinsic value market price

Industry
Conditions Estimate Find I.V
Future of
Cash Flow Security

If Market Price
If market price < >Intrinsic Value,
Intrinsic Value , Buy sell and get profit
Firm Specific
Information Buy underpriced Sell overpriced
security security
Investor Decision to
buy/sell

06/09/2024 33
ESTIMATING INTRINSIC VALUE OF
SHARE
 There are two basic approaches for valuation of share
using fundamental analysis
A. Discounted Cash Flow Techniques
1. Discounted Cash Flow model
2. Dividend Discount Model
B. Relative valuation techniques
1. Price earnings ratio (P/E)=Share price/earning per
share
2. Price book value ratios (P/BV)=Market price/book
value per share
06/09/2024 34
 Discounted Cash Flow Techniques

• It is the present value of its expected future cash flow

stream
• The following applies to any financial asset:
S = Intrinsic value
Ct = Expected future cash flow in period (t)
Ct nrate of return
k = Investor’s required
V S C n
t

(11k )k )
t  1( t 1
t t

Note: When analyzing various securities (e.g., bonds,

stocks), the formula below is simply modified to fit the
particular
06/09/2024
kind of asset being evaluated. 35
 Estimating Intrinsic Value of share
Discounted Cash Flow Techniques
Intrinsic value of share -use share valuation modal

Present Value Models

Intrinsic Value = present value of expected future
benefits

Future benefits = Cash flow Future benefits = dividends

n CFt  Dt
S0   S0  
t 1 (1  K )
t
t 1 (1  K )
t

Discounted Cash Flow model Dividend Discount Model

 Intrinsic value of share
One year holding period or Single Holding Period
• The value of a stock today is the present value of future dividend
plus that of the selling price.
– The first step in valuing common stocks is to determine the cash
flows for a stock,
• Dividend payments
• Future selling price
• And then find the present values of these cash flows and adding them
together will give us the value
D1 S1
S0  
(1  k ) (1  k )
1 1

S0 = Intrinsic value of common stock

D1 = the amount of dividend expected to be received at the end of one year
S1 =Expected selling price at the end of one year
 Multiple -year holding Model
 The value of a stock today is in theory equal to the present
value of all future dividends plus that of the selling price.

D1 D2 D3 D4 Dn Sn
S0      .......... .  
1  k (1  k ) 2 (1  k ) 3 (1  k ) 4 (1  k ) n (1  k ) n
n
Dt Sn
 
t 1 (1  k ) t (1  k ) n

S0 = Intrinsic value of common stock

D1=The amount of dividend expected to be
received at the end of one year
Sn =Expected selling price at n period
k = Rate of return required by investor
06/09/2024 38
 Dividend Discount Model
 Dividend is the only cash flow
 Common stock has no maturity period – they may be expected to
bring a dividend stream of infinite duration.
D1 D2 D3 D4 D
S0      ........... 
(1  k ) (1  k ) 2 (1  k ) 3 (1  k ) 4 (1  k ) 
 Dt

t 1 (1  k )
t

Commonly used assumptions

To value common stock, you must make assumptions about the growth of future
dividends: constant dividend, constant growth

1. The dividend per share remains constant forever, implying that the growth rate is
nil (THE ZERO GROWTH MODEL)
2. The dividend per share grows at a constant rate per year forever (THE
CONSTANT GROWTH MODEL)

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 Zero Growth Model
 Investor anticipates to receive the same amount of dividend per year
forever.
 Zero growth model assumes a constant dividend, non-growing
dividend stream:
D1 = D2 = ... = D

 the valuation model becomes as that of the perpetual preference stock;

D D D D D
S0      ........... 
1  k (1  k ) (1  k ) (1  k )
2 3 4
(1  k ) 
 D D
 
t 1 (1  k )
t
k
Plugging constant value D into the common stock valuation
formula reduces to simple equation for a perpetuity: D/K
06/09/2024 40
 Constant Growth model
 Assumes that the dividend per share grows at a constant rate (g)
D0 (1  g ) D0 (1  g ) 2 D0 (1  g ) 3 D0 (1  g ) n
S0     ...........   .......
1 k (1  k ) 2
(1  k ) 3
(1  k ) n

 If dividends grow at a constant rate forever, you can value stock as a growing
perpetuity, denoting next year’s dividend as D1:
Where
D0 = Current Dividend (time period 0)
D1 =Dividend received after one year
D1 = D0 x (1+g)
or next year dividend.
D2 = D1 x (1+g) = D0 x (1+g)2 D1= D0 (1+g)
: D2 =Dividend received after two years
K=Estimate the required rate of return (k)
:
g=Estimated dividend growth rate (g)
Dt = D0 x (1+g)t S0 = the present value of the infinite series of
dividends
With a little algebra, this reduces to:
Assumptions

D 0 (1  g) D1 1. Dividends grow at a constant rate

S0   2. The constant growth rate will continue for
an infinite period
k -g k -g 3. The required rate of return (k) is greater
06/09/2024 41
Commonly called the Gordon Growth Model. than the infinite growth rate (g)
 2.3. Technical Analysis

Contents
• Basics & definitions
• Stock charts & chart types
• Moving Averages
• Trends / Channels
• Support & Resistance
• Volume

06/09/2024 42
 Fundamental and Technical Analysis
 Two techniques are commonly used to forecast prices.
 Technical analysis is the study of historical prices for the purpose of
predicting prices in the future.
 Technical analysts frequently utilize charts of past prices to identify
historical price patterns.
 These price patterns are then used to forecast prices in the future.
 A basic belief of technical analysts is that market prices themselves contain
useful and timely information
 Prices quickly reflect all available fundamental information, as well as
other information, such as traders’ expectations and the psychology of the
market
Role of Technical Analysis
 Identify and predict changes in direction of price trends
 Determine the timing of action – entry and exit decisions

06/09/2024 43
 Fundamental and Technical Analysis
 Technicians believe that market trends and patterns
repeat themselves and
 are somewhat predictable because human behaviour
tends to repeat itself and is somewhat predictable.
 The usefulness of technical analysis is diminished by any
constraints on the security being freely traded, by large
outside manipulation of the market, and in illiquid
markets.

06/09/2024 44
 There is two method of analyzing securities/value of
securities.
 Fundamental analyses-
 Estimate share prices on the basis of economic, industry and
company statistics.
 Technical analysis is an alternative method of security
analysis
 The technical analyst mainly studies the stock price
movement of the security market.
 If there is an up trend in the price
movement ,investor may purchase security.
 With down price trend, investor may sell it
 Technical analysis involves the examination of past market
data such as prices and the volume of trading, which leads to
 Technical analysis
• Technical Analysis is the forecasting of securities
future financial price movements by analysing
statistics generated about the past price movements by
market activity.
• Like weather forecasting, technical analysis does not
result in absolute predictions about the future.
• Instead, technical analysis can help investors anticipate
what is "likely" to happen to prices over time.
• Technical analysis is the study of historical prices for
the purpose of predicting prices in the future.
• Technical analysis is a security analysis technique that claims the
ability to forecast the future direction of prices through the study of
past market data, primarily price and volume.
• It is the process of identifying trend reversals at an earlier stage to
formulate the buying and selling strategy.
 With the help of several indicators they analyze the relationship
between price – volume and supply- demand for the overall market
and the individual stock.
 Volume: Amount of shares that trade hands between seller
and buyers .
 Volume is favorable on the upswing, i.e. the number of shares traded
is greater than before and on the downside the number of shares
traded dwindles.
 It is the other way round, trend reversals can be expected.
 2. Underlying Assumptions of Technical Analysis

1. The market value of any good or service is determined solely by the

interaction of supply and demand.

2. Supply and demand are governed by numerous factors, both rational

and irrational.

3. Disregarding minor fluctuations, the prices for individual securities and

the overall value of the market tend to move in trends(increasing or
decreasing), which persist for appreciable lengths of time and it
reverses.

4. Prevailing trends change in reaction to shifts in supply and demand

relationships and these shifts can be detected in the action of the market.
 Advantages of Technical Analysis
• Not heavily dependent on financial accounting statements

• Problems with accounting statements:

1. Lack of information needed by security analysts
2. GAAP/IFRS allows firms to select reporting procedures,
resulting in difficulty comparing statements from two
firms.
3. Non-quantifiable factors do not show up in financial
statements (psychological and other)
 Advantages of Technical Analysis
• Fundamental analysts must process new
information and quickly determine a new
intrinsic value.
• Technical analysts have to recognize movements
to new equilibrium
• Technicians trade when a move to a new
equilibrium is underway.
• Fundamental analysts find undervalued securities
that may not adjust their prices as quickly.
 Challenges to Technical Analysis
1. Assumptions of Technical Analysis
– Empirical tests of Efficient Market Hypothesis
(EMH) show that prices do not move in trends.
2. Technical Trading rules
– The past may not be repeated
– Patterns may become self-fulfilling predictions
– A successful rule will gain followers and become
less successful
– Rules require a great deal of subjective judgment
 History of Technical Analysis
• The technical analysis is based on the doctrine given by
Charles H. Dow in 1884, in the wall street journal.
• Technical analysts frequently utilize charts of past prices to
identify historical price patterns
• These price patterns are then used to forecast prices in the
future.
• A basic belief of technical analysts is that market prices
themselves contain useful and timely information.
– Prices quickly reflect all available fundamental
information, as well as other information, such as traders’
expectations and the psychology of the market
 Role of Technical Analysis

• Identify and predict changes in direction of

price trends
• Determine the timing of action – entry and exit
decisions
 6. Technical Tools
• Technical tools used by analysts include:
a. Dow theory
b. Volume of trading
c. Short selling
d. Odd lot trading
e. Moving averages
f. Chart Analysis
 a. DOW THEORY
• Dow developed his theory to explain the movement of the indices
of Dow Jones Averages.

• He developed the theory on the basis of certain hypotheses.

1. No single individual or buyer can influence the major trend

of the market.
 However, an individual investor can affect the daily price
movement by buying or selling huge quantum of particular
scrip(stock).
 The intermediate price movement also can be affected to a lesser
degree by an investor.
 DOW THEORY
2. MARKETS DISCOUNTS EVERYTHING.
The market returned back normality even natural
calamities.
3. The Theory is not infallible(perfect).
 It is not a tool to beat the market but provides a way to
understand it better.
THE THEORY
 According to DOW theory the trend is divided in to
primary, intermediate and short term trend.
 The primary trend may be the broad upward or
downward movement that may last for a year or two.
 THE THEORY
• The intermediate trends are corrective movement,
which may last for three weeks to three months.
• The primary trend may be interrupted by the intermediate
trend.
• The short term trend refers to the day to day price
movement.
• It is also known as oscillations or fluctuations.
• These three types of trends are compared to tide(rise and
fall of ocean), waves(large ripple on ocean) and ripples
of sea.
 Trend
• Is the direction of movement.
• The share prices can either increases or fall or remain flat.
• The three direction of share price movements are rising,
falling or flat trends.
• The share prices move in zigzag manner.
• The trend lines are straight lines drawn connecting either the
tops or bottoms of the share price movement.
 Trend Reversal
• The rise and fall in share price cannot go on forever.

• The share price movement may reverse in direction.

• Before the change of direction, certain pattern in price

movement emerges.
• The change in the direction of the trend is shown by violation
of the trend line.
• violation of the trend line means the saturation of the trend
line.
 Primary Trend
• The security price trend may be either increasing or decreasing.

• When the market exhibits the increasing trend, it is called bull market.

• The bull market shows three clear-cut peaks.

• Each peak is higher than the previous peak.

• The bottoms are also higher than the previous bottoms.

• The phases leading to three peaks are revival, improvement in

corporate profits and speculation.

 CONT….
• The reverse is true with the bear market.
• Here the first phase of fall starts with the
abandonment of hopes.
• The chances of prices moving back to the previous
high level seemed to be low.
• This would result in the sale of shares.
• In the second phase, companies are reporting lower
profits and dividends.
• This would lead to selling pressure.
• The final phase is characterized by the distress sale
of shares. Eg. Sale of shares below par.
 The Secondary Trend
• The secondary trend or the intermediate trend moves
against the main trend and leads to correction.

• In the bull market the secondary trend would result in the

fall of about 33 – 66% of the earlier rise.

• In the bear market, the secondary trend carries the price

upward and corrects the main trend. The correction would
be 33 – 66% of the earlier fall.

• Intermediate trend corrects the overbought and oversold

condition.
 Minor trends
• Also called tertiary moves are called random
wriggles.

• They are simply the daily price fluctuations.

• Minor trend tries to correct the secondary trend

movement.

• It is better for the investors to concentrate on the

primary or secondary trends than on minor trends.
 Technical Trading Rules and Indicators

• Stock cycles typically go through peaks and

troughs.
• Typical stock price cycles show a rising trend
channel, a flat trend channel, a declining trend
channel, and indications of when to trade
 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 Channel Buy Point
Trough
Trough
 Basic Techniques: Support Resistance and Basing

• Support is level at which a stock stops falling because supply no longer

exceeds demand. i.e, a support level exists at a price where
considerable demand for that stock is expected to prevent further
fall in the price level.

• Demand for the particular stock is expected(the price would be cheap

and investors would buy).
• Price at which BUYERS > SELLERS consistently.
• Resistance is the opposite of support. At this level supply is greater
than demand and the stock stops rising. The selling pressure is greater
and the increase in price is halted fro the time being or may result in
price reversal.
SELL if support “breaks down”, because it signifies that BUYERS no
longer overpower SELLERS.
Breakdowns are a BEARISH SELL signal.
 Cont.….
• Support and resistance usually occur whenever
the turnover of a large number of shares tend
to be concentrated at several price levels.
• Basing or congestion occurs when a stock
trades a narrow price range on low volumes.
Buyers and seller are evenly matched.
• This period is like a pause and
downward/upward movement resumes.
 b. Volume of trading

• Technical indicators are used to find out the direction of the

overall market.

• The overall market movements affect the individual share market.

• Aggregating forecasting is considered to be more reliable than the

individual forecasting.

• The indicators are price and volume of trade.

• Volume of trade is influenced by the behavior of price.

 Volume of trade

• Dow gave special emphasis on Volume.

• Volume expands along with the bull market and narrows

down in the bear market.

• If the volume falls with rise in price or vice versa., it is a

matter of concern for the investor and the trends may not
persist for a longer time.

• Technical analyst used volume as an excellent method of

confirming the trend.
 Volume of trade
• Large rise in price or large fall in price leads to large increase
in volume.

• Large volume with rise in price indicates bull market and Large
volume with fall in price indicates bear market.

• If volume indicates decline for five consecutive days, then it will

continue for another four and the same is true for increasing
volume.

• Using trading volumes to establish market direction

• Large volumes confirm support or resistance or breakout.

 Establishing market breadth

• The breadth of the market is the term often used to study

the advances and declines that have occurred in the stock
market.
• Advances mean the number of shares whose prices have
increased from the previous day’s trading and declines is
number of shares whose prices have fallen from the previous
day’s trading.
• Breadth is the extent at which all stocks participate in
market movement.
• The more companies participate the stronger and more valid the
move.
• A valid strategy for investing in funds or stocks that reflect the
broad market.
 Calculating market breadth

• Count the number of declining stocks

• Count the number of advancing stock

• Deduct number of declining stocks from advancing stocks

• Do this on a daily basis to obtain the trend line

• This is known as the advance and decline (A-D Line)

The A/D line is compared with the market index.

Generally, in a bull market, a bearish signal is given when the A/D
line slopes down while the market is rising.
 C. Short selling
• Short selling is a technical indicator known as
short interest.

• Short sales refers to the selling of shares that are

not owned.

• The bears are short sellers who sell now in the

hope of purchasing at a lower price in the future
to make profits.
 d. Odd lot trading
• Shares are generally sold in a lot of hundred.
• Shares sold in smaller lots, fewer than 100 are called odd lot.
• Such buyers and sellers are called odd lotters.
• Odd lot purchases to odd lot sales is the odd lot index.
• The increase in odd lot purchase results in an increase in the
index.
• Relatively more selling leads to fall in the index.
• Odd lot purchase is concentrated at the top of the market cycle
and selling at the bottom.
• High odd purchase forecasts fall in the market price and
low purchases/ sales ratios are presumed to occur toward
the end of bear market.
 e. Moving Average
The market indices do not rise and fall in straight line. The upward
and downward movements are interrupted by counter moves.

The underlying trend can be studied by smoothening of the

data.

To smooth the data moving average technique is used.

• Moving averages are used to determine price trends and trend
changes.
• A moving average is a statistical technique for smoothing price
movements in order to identify trends more easily.
 Moving Average
• A simple n-day moving average is the average of the
most recent n daily closing prices
– A 5-day moving average is the average of the last 5
daily closing prices.
– A 25-day moving average is the average of the last
25 daily closing prices.
• The number of days used to compute the average
determines the sensitivity of the average to new price
movements
– The more days that are used, the less sensitive is the
average
 Moving Average
• Weighted moving averages can also be constructed

– If greater weights are given to more recent prices,

the average becomes more sensitive to price
change
 Market Trend Analyses:
Simple Moving Averages (SMA)

Daily 5-Day 10-Day

Day Close SMA SMA
1 60.33
2 59.44
3 59.38
4 59.38
5 59.22 59.55
6 58.88 59.26
7 59.55 59.28
8 59.50 59.31
9 58.66 59.16
10 59.05 59.13 59.34
11 57.15 58.78 59.02
12 57.32 58.34 58.81
13 57.65 57.97 58.64
14 56.14 57.46 58.31
15 55.31 56.71 57.92
16 55.86 56.46 57.62
17 54.92 55.98 57.16
18 53.74 55.19 56.58
19 54.80 54.93 56.19
20 54.86 54.84 55.78
 Market Trend Analyses:
Simple Moving Averages (SMA)
 Market Trend Analyses:
Moving Averages: Trading strategy

• Sometimes traders use two moving averages to determine buy

and sell decisions.
• Using a slow moving average (more days) together with a fast
moving average (fewer days) generates the following trading
strategies:
– Buy when the faster moving average goes above (crosses)
the slower one (from below). Sell when the faster moving
average goes below (crosses) the slower one (from above).
– Buy when prices are above both the fast and slow moving
averages. Sell when prices are below both the fast and slow
moving averages.
• As with most tools of technical analysis,
moving averages should not be used on their
own, but in conjunction with other tools that
complement them.

• Using moving averages to confirm other

indicators and analysis can greatly enhance
technical analysis.
 Technical Analysis:
F. Chart Analysis
Chart Analysis - the basic tool of technical analysis
• A price chart is a sequence of prices plotted over a specific time
frame. In statistical terms, charts are referred to as time series plots.
• Chart analysts plots historical prices in a two-dimensional graph
in order to identify price patterns which can then be used to
predict the futures direction of prices
– The goal of any chart analyst is to find consistent, reliable, and logical
price patterns with which to predict future price movements.
• Chart analysts rely primarily on three bodies of data
– Prices (monthly, weekly, daily, and intra-day)
– Trading volumes, and
– Open interest
 Technical Analysis:
Chart Analysis
Price Pattern Recognition Charts
 The most commonly used price pattern recognition charts are: bar
charts, line charts, candlestick charts, and point-and-figure charts
 On these charts, the Y-axis (vertical axis) represents the price scale
and the X-axis (horizontal axis) represents the time scale. Prices are
plotted from left to right across the X-axis with the most recent plot
being the furthest right.
• Bar Charts:
 Bar charts mark trading activity of a specified trading period (e.g.,
day) by a single vertical line on the graph
 This line connects the high and low prices for the trading period

 The closing price is indicated by a horizontal bar

 Technical Analysis:
Chart Analysis – Bar Chart
 Technical Analysis:
Chart Analysis – Bar Chart

 Bar charts can also

be displayed using
the open, high, low
and close. The
only difference is
the addition of the
open price, which
is displayed as a
short horizontal
line extending to
the left of the bar.
 Technical Analysis:
Chart Analysis – Bar Charts

Bar Charts: One-Day Price Reversals

 Bar charts are frequently used to identify one-day price

reversals.
 A one-day price reversal occurs in a rising market when prices

make a new high for the current advance but then close lower
than the previous day’s close
 A one-day price reversal occurs in a falling market when prices

make a new low for the current decline but then close higher
than the previous day’s close
 Technical Analysis:
Chart Analysis – Line Charts

Line Charts:
 In a line chart, only
the closing prices are
plotted for each time
period.
 Some investors and
traders consider the
closing level to be
more important than
the open, high or low.
 By paying attention
to only the close,
intraday swings can
be ignored.
 Market Efficiency
•Efficient markets hypothesis (EMH) – states that
markets are efficient, with market prices reflecting
all available information at any given time
•Three common forms of market efficiency include:
–Weak form
–Semi-strong form
–Strong form
 Random Walk Hypothesis

•RWH argues that technical and fundamental

analysis are not accurate analyzing tools.

•RWH suggests that stock price movements

are unpredictable.
 Implications of the EMH

•For the investor the EMH implies:

1. Since all publicly available information is
reflected in current prices, there is no point
researching individual investments
2.Investment advisors advice of recommending
investments is of no value
3.Timing regarding when to buy or sell is
irrelevant.
 2.4. Technical analysis VS Fundamental
analysis
Fundamental analysis attempts to calculate the
intrinsic value of a stock using over all
economy, industry and company conditions.

While technical analysis looks at the price

movement of a security or stock price trends
to predict future price movements.
 Technical analysis VS Fundamental analysis

• Fundamental analysis takes a long-term approach to analyzing

the market, considering data over a number of years. So
fundamental analysis is more commonly used by long term
investors as it helps them select assets that will increase in value
over time

• Technical analysis takes a comparatively short-term approach to

analyzing the market, and is used on a timeframe of weeks, days
or even minutes. So it is more commonly used by day traders as
it aims to select assets that can be sold to someone else for a
higher price in the short term.
End of Chapter 2