A Brief Study on Technical Analysis and its Implications

Kushan Pratap Singh

5/24/2011

Bona Fide Certificate

This is to certify that the project entitled 'A Brief Study on Technical Analysis and its Implications' at SBICAP Securities Limited is a bona fide work carried out by KUSHAN PRATAP SINGH of St. Xavier's College for the purpose of independent summer training.

Acknowledgement
I would like to express my gratitude to all those who gave me the possibility to complete this project. I want to thank SBICAP Securities Limited for giving me permission to commence this project in the first instance, to do the necessary research work and to use departmental data. I have furthermore to thank Managing Director, SBICAP Securities Limited, Mrs. Swati Desai who gave and confirmed permission and encouraged for me to go ahead with the project. I am deeply indebted to my supervisors Mr. Ashu Bagri (Deputy Head Technical Analyst) and Mr. Amit Bagade (Technical Analyst) whose help, stimulating suggestions and encouragement helped me during my research and for writing of this project. I would also thank my friends and family for all their help, their wholehearted support, interest and valuable hints without which the completion of this project would not have been possible.

Table of Contents
Introduction ...................................................................................................................................... 5 Fundamental vs. Technical ............................................................................................................. 5 Assumptions .................................................................................................................................. 5 Volumes ........................................................................................................................................ 6 Types of Charts .................................................................................................................................. 7 Bar Chart ....................................................................................................................................... 7 Line Chart ...................................................................................................................................... 8 Candlestick Charts ......................................................................................................................... 9 Support, Resistance, Trendlines and Channels ................................................................................. 10 Support and Resistance................................................................................................................ 10 Trendlines .................................................................................................................................... 11 Channels ...................................................................................................................................... 12 Trends ............................................................................................................................................. 13 Uptrend ....................................................................................................................................... 13 Downtrend .................................................................................................................................. 14 Sideways...................................................................................................................................... 15 Patterns ........................................................................................................................................... 16 Triangles ...................................................................................................................................... 16 Flags ............................................................................................................................................ 19 Head and Shoulders ..................................................................................................................... 20 Rounded Bottom ......................................................................................................................... 21 Double Tops and Bottoms ............................................................................................................ 22 Triple Top and Bottoms................................................................................................................ 23 Gaps ............................................................................................................................................ 24 Indicators ........................................................................................................................................ 25 Moving Averages ......................................................................................................................... 25 Relative Strength Index (RSI) ........................................................................................................ 28 Stochastic Oscillator..................................................................................................................... 29 Average Directional Index (ADX) .................................................................................................. 30 Moving Average Convergence Divergence (MACD) ...................................................................... 31

A Brief Study on Technical Analysis

Introduction
What is technical analysis ?
Technical analysis is a method used to analyse securities and a more practical approach to making investment decisions. Its foundation is built on chart reading and usage of myriad indicators to trace certain trends and patterns occurring in the securities market and accrue profits using such techniques. It is a study of the market action by assessing charts and forecasting future movements. A necessary assumption to such an approach tells us that the market discounts itself. This suggests that all factors influencing the market price i.e., fundamental information, political events, natural disasters, and psychological factors( market behaviour) , are discounted in market activity.

Fundamental analysis vs. Technical Analysis

Fundamental analysis is based on the traditional study of the supply and demand factors that act directly on the market prices. Implicitly, a fundamental analyst would attempt to analyse a company's status in the financial markets by scrutinizing its financial statements, essentially looking at the revenues, expenses, assets and liabilities and keeping updated on any such news events that might have consequences, good or bad, for the business in question. It necessitates a mindful examination of both quantitative and qualitative facets so as to fairly evaluate its stability, future prospects and finally, make desirable investment decisions accordingly. It aims at estimating the intrinsic value of an asset in order to determine if it is overvalued or undervalued. Technical analysis, by contrast, is based on the study of the market action while fundamental analysis deals with the reasons to such price movements. Chart analysis is extremely useful in forecasting price. Charting can be used by itself, without any aid of fundamental inputs, or in conjunction with fundamental information

Assumptions for Technical Analysis

1. The market discounts everything 2. Price moves in trends 3. History repeats itself

A Brief Study on Technical Analysis

Importance of Volume
Chartists exercise a two-dimensional approach to analysing the securities market. It consists of a study of price and volume, among which price is clearly the more important factor. However, volumes provide a double-check on the price action of an asset and often even signal an advance warning of an impending shift in trend. Volume can be defined as the number of common shares being traded in a trading period. When used in combination with price action, volume tells us about the strength or weakness about the current price trend. It measures the pressure behind a given price move. As a general rule, heavier volume would strengthen the prevailing price trend. Volume also plays a vital part in the formation and resolution of price patterns such as the ones discussed later on in this project(pg. 16). Each pattern has its own volume pattern. As a rule, volume tends to diminish as price patterns form. The breakout following that confirms the pattern takes an added significance if the breakout is accompanied by a heavier volume.

Types of Charts

Types of Charts in Use

Many types of charts have been developed over the years for the purpose of analysis of market activity and observing the various trends .These charts are plotted along both, the horizontal and vertical axis. Price is assigned to the vertical axis while time variable is plotted along the horizontal axis. A common feature in these charts can be extended to any time dimension and be plotted against the price. Here is a visual aid describing two such distinct time dimensions against price of the security. A. Bar chart

In this analysis each bar summarizes data of the price action against the specified time period. For example, a daily chart would contain data relating to the high, low, open and close for that day. Open- that price at which a security starts being traded in the given time period. Close- the price at which the trading stops for the stock in the given time period. Low- the cheapest price at which the security is traded at in the given time period. High- the most expensive price the security assumes in a given time period.

Types of Charts

B. Line chart This chart is derived by simply connecting all the closing points in a bar chart and forming a line.

Most chartists and traders consider the closing price as the most important aspect of a security, be it currency, bonds, stocks etc., which is the reason for line charts being widely used and accepted. This arrangement aids easy viewing and it is graphically simple to use. It is considered especially advantageous while viewing multiple trading charts at once.

Types of Charts

C. Candlestick chart A candlestick chart is the similar to a bar chart where all details (high, low, open, close) are displayed but they offer a better visual display of the trading details. Also known as Japanese candle sticks since it originated from Japanese rice farmers.

Individual candlesticks have the same significance as that of each bar in a bar chart.

Support and Resistance, Trendlines and Channels

Support and Resistance

These two terms define the peaks and troughs in chart analysis. A previous trough usually forms a support level while a previous peak forms a resistance level. Support is a level below the market where buying pressure exceeds selling pressure and a decline is halted. Resistance is a level above which selling pressure surpasses buying pressure and a rally is halted. Support and resistance levels reverse roles once broken convincingly. A broken support level under the market becomes a resistance level above the market. A broken resistance level over the market functions as support below the market. The more recent the support or resistance, the more influential it is to impending market action. The rationale behind this being that many of the trades the caused the support and resistance have not been liquidated.

Support and Resistance, Trendlines and Channels

Trend Lines

A trend line is a perhaps the most straightforward and most valuable tool available to chartists. An uptrend line is a straight line drawn rising upward and connecting successive market bottoms. It is drawn so that all of the price action is above the trend line. A downtrend line is a straight line with a downward incline connecting consecutive market highs such that the price action is below the trend line. Even though two points are required to make the trend line, a third point is required to validate the effectiveness of it . Uses of Trend Lines y allow identification of support and resistance levels in order to initiate new positions in a trending market y the longer a trend line has been in effect and the more times it has been tested, the more significant it becomes y violation of a trend line is the best warning of a change in trend

11

Support and Resistance, Trendlines and Channels

Channels

Channel lines are straight lines drawn parallel to basic trend lines. Markets are often trend within these channels with the price action contained by the two trend lines running parallel to each other. Chartists tend to use this knowledge to their advantage by calculating the next possible support and resistance and where the security would likely change its course.

12

Trends

Trends
Trends are the general direction to which a security is headed. This is an implication to one of the pillars of technical analysis which states that price usually moves in trends. There are three types of trends in general.

a) Uptrend

y y y y

security price is seen on a continuous indefinite rise also known as a bullish trend market demand overtakes supply causing a hike in price successive crests and troughs are higher that previous one

Trends

b) Downtrend

y y y y

prices can be seen dropping indefinitely also known as bearish trend market supply overwhelms demand causing a situation of descending price successive peaks and troughs are said to be lower than preceding ones

14

Trends

c) Sideways

y y y

price moves horizontally suggesting a dead-lock between buyers and sellers demand and supply closely match each other creating an equilibrium like situation where the price level keeps steady for an indefinite phase before breaking out again regarded as a period of consolidation

15

Patterns

Patterns
1. Triangles
   one of the most common chart patterns observed also known as 'coils' as they usually result in a breakout might prolong for weeks or even months

Three types of triangle have been identified to crop up in the markets. these have been described as the following :i. Symmetrical triangles

 characterized by rising bottoms and falling tops pointing out to the declining confidence on the part of the bulls and bears  bulls taking short-term profits while bears covering their short positions quickly  breakout might occur in either direction once the consolidation has taken place

Patterns

ii.

Ascending Triangles

 distinguished by a horizontally moving upper trend line and an rising lower one  prices move higher from the pattern owing to the overwhelming demand caused by bulls motivated to buy at short term lows  indicates an upside breakout

17

Patterns

iii.

Descending Triangles

 recognized by a falling upper border and a flat bottom  points towards a downside breakout  bulls not as eager to start buying stock at short term lows as bears are to sell short term highs

18

Patterns

2. Flags

y y y

short term continuation pattern resembling a flag flying on a pole, usually occurring in the course of an uptrend spotted by a sharp upward movement followed by a generally sideways movement and concluded by a further advance in the uptrend The sideways movement occurs as some of the bulls prefer to book some profits at the current price. Since not all traders do this at the same time, the market displays a small counter trend lower as more of them take their profits. Subsequently, bulls take over again producing a break out in the original direction.

19

Patterns

3. Head and Shoulders

y y y y y y y

amongst the well known and most reliable reversal patterns security is likely to move in the opposite direction after incidence of the pattern characterized by three prominent market peaks with the middle peak, the head, being taller than the two surrounding peaks(shoulders) a trend line also known as the neckline(in this case), can be drawn below the two reaction lows a subsequent close below the neckline would demarcate the completion of the market reversal following the reversal confirmation, the new target for the market would roughly be the height from the top of head to the neckline an inverse head and shoulders is the same as the head and shoulders except that it is turned upside down

20

Patterns

4. Rounded Bottom

y y y y

long term reversal pattern also known as the saucer bottom signals a gradual transition in the trend from down to up infrequent but might persist on anywhere from several months to years another even more seldom seen pattern is the rounded top which is nothing but an upside down inversion of the rounded bottom

21

Patterns

5. Double top & bottom

y y y y y y

well known and dependable reversal pattern also called M's and W's owing to their shapes double top identified by two prominent peaks while the inability for the second peak to move above the first is a sign of weakness a close below the middle trough is an apparent sign of the pattern being completed the anticipated target after the downside breakout would be the height of the pattern double bottom is a mirror image of the double top

22

Patterns

6. Triple Top & Bottom

y y

another reversal pattern identical to the head and shoulders except that the three peaks or troughs rebound against roughly the same resistance or support respectively less frequent than the head and shoulders or the double top/bottom but functionality is analogous tests a support or resistance thrice after which a trend breaks out in the reverse direction

23

Patterns

7. Gaps

y y y y

areas on the bar chart where no trading has taken place and an evident gap is present between the close of one bar and the subsequent open of the following bar occurs due to large differences in the price in two successive trading periods found in bar charts and candlestick figures symbolizes that something of significance has taken place in the security such as a better than expected earnings announcement a more advanced study on gaps would delve into the types of gaps and their inferences

24

Indicators

Indicators
Indicators are simple instruments that make use of mathematical formulae by taking into account aspects like price, volume, velocity, etc., while they aim to gauge factors like momentum, rate of change, market sentiment, money flow and other such properties that help one understand and accurately forecast the prospects of a security.

1. Moving Averages
Moving average is an extremely popular tool among technicians. It is a simple indicator which is used to smoothen the price action in the market over a period of time for the purpose of catching on to underlying trends. Some trend signal are derived through interaction between two or more moving averages while some trends are spotted by observing the interplay between the price action and moving average. Moving averages are calculated by averaging the closing prices of several days. Hence, the shorter the average used, the closer it will trail the price action and vice versa. Most commonly used averages are the 50 day moving average and the 200 day moving average.

Indicators

I.

50 day Moving Average

      

uses data of past 50 days to plot the indicator bullish as long as price is above 50 day average bearish when price falls below the 50 day average buy and sell signals are given at crossovers buy signal when the average line crosses from above the price line sell signal when average line cuts from below the price line acts steady as both support and resistance line

26

Indicators

II.

200 day Moving Average

   

uses data pertaining to past 200 days to formulate chart bullish as long as price is above moving average and vice versa buy indication when average line cuts price from above and vice versa acts more steady as both support and resistance compared to 50 day average

27

Indicators

2. RSI (Relative Strength Index)

y y y y y y y

well recognized and popular among technicians momentum oscillator, measuring velocity and magnitude of directional price movement attempts to identify an overbought or oversold condition of an asset calculated on a scale of 0 to 100 with a 14 day time frame overbought- higher than 70 oversold- lower than 30 used to be attentive to any surges or plunges in the price of an asset

28

Indicators

3. Stochastic oscillator

y y y y y y y

momentum oscillator similar to the RSI but more volatile with wider bands scale of 0 to 100 with overbought and oversold levels at 80 and 20 respectively uses two lines- %K(fast line) and %D(slow line), where %K is a raw measure of the momentum and %D is a moving average of the former seeks to predict price movements by comparing current closing prices to its price range %D line is tracked more closely as it produces better outcomes typically used in a 14 day range buy signal when fast line crosses above slow line and vice versa

29

Indicators

4. Average Directional Index (ADX)

y y y

movement indicator used to quantify the strength of the existing trend it does not consider the direction of the movement, merely the strength, be it positive of negative ADX is a combination of two Directional Movement Indicators(positive and negative) and is plotted on the chart along with both these lines since ADX is a relationship of these DMI's mapped on a scale of 0 to 100 with values below 20 signalling a weak and above 40 indicating a strong trend

30

Indicators

5. MACD (Moving Average Convergence Divergence)

y y

y y y y y y

widely used and reliable technical analysis indicator employed to recognize transitions in direction, momentum, strength and duration of a trend a momentum oscillator that implements two exponentially moving averages(EMA), by plotting against time, the difference obtained by subtracting the longer moving average from the shorter one a moving average of the difference is also charted alongside plotted as a histogram(bar chart) that oscillates about the centreline(0 level) signals acquired by signal line crossovers, centreline crossovers and divergences common averages taken are 12 day and 26 day another moving average of 9 days utilized to smoothen the MACD and form a signal line since MACD is boundless, it does not signal overbought and oversold situation

31

THANK YOU