TECHNICAL ANALYSIS

Chasing Patterns
 DOW THEORY
 Charles H. Dow wrote editorials for Wall Street Journal.
The articles were based on averages and it was never
ever thought that the same could be used for
forecasting of the market. William Hamilton followed
the writings and organised them into a theory that is
now known as DOW THEORY.
 Securities from most established companies tended to
move together. Securities moving in the reverse
direction were few. Charles Dow expressed this general
trend in terms of averages. There were two such
averages devised. One average composed of 20
railroad stocks and the other of 10 (later increased to
20 in 1916 and to 30 in 1928) stocks consisted all other
industries.
 DOW THEORY - RULES
1. Averages discount everything; Since they
represent collective wisdom of millions of
investors, the averages can be said to reflect
all the known and discernible information.
Therefore, the averages represent all that is
already known to everybody.
2. There exist 3 trends; the Primary,
Secondary and Tertiary/Minor:
Primary: Broad overall up and down
movements usually lasting for more than a
year to several years.
 BULL & BEAR PHASES
 BULL P HASE: Successive peaks are
higher and higher and each successive
reaction also stops prior to the level
achieved by the previous reaction. Primary
trend is up and is called BULL Phase.
 BEAR P HASE: When successive tops
stop at level lower than the previous one,
while each correction goes lower than the
previous one, the trend is downwards and
is known as BEAR Phase.
 SECONDARY & TERTIARY
Secondary: These are reactions interrupting the
major trend going in the opposite direction to that
of the major trend. An uptrend is followed by
secondary reaction and a downtrend is followed
by intermediate rallies.
 Duration: The normal time frame associated with
secondary corrections is 3-4 weeks to 3-4 months.
 Extent: The corrections usually take place in the
range of 1/3rd to 2/3rd of the immediately preceding
rise or fall. This is referred to as 1/ 3 rd - 2/ 3 rd rule.
Minor/Tertiary: Small and rather insignificant
movement that lasts about 1 week. These
movements are of random nature.
 GRAPHICAL VIEW
Dow Theory
DOW THEORY - Bull & Bear Phase  Primary Bull Phase
from ‘a’ to ‘f’
f  Primary Bear Phase
from ‘f’ to ‘k’
 Fall ‘bc’ is between
h 1/3rd and 2/3rd of
the preceding gain
‘ab’
Index

g
d j  Same applies to ‘de’
 ‘fg’ breaks the 1/3rd
e I – 2/3rd rule
b  Rise of ‘gh’ is
between 1/3rd and
c
2/3rd of preceding
a k fall ‘fg’
Time  Same applies to ‘ij’.
 3 PHASES – BULL MARKET
Bull Market is characterised by 3 phases:
 Accumulation is the phase where the intelligent
investor makes the first move in hitherto dull market
comprising tired public with extremely low volumes.
These investors pick up all that is offered by distressed
sellers.
 In the second phase as corporate performance starts
corroborating the expectations more and more
investors join, volumes rise rapidly, and the rise is
faster than that of period of accumulation.
 In the third phase everyone joins the flock the rise
becomes spectacular. The rise is not supported by the
reality and sheer optimism drives the market.
 3 PHASES – BEAR MARKET
Bear Market is also characterised by three
phases.
 Intelligent and observant investors initiate first phase
of distribution. They foresee hectic activity as
excessive optimism rather than result of any
supportive fundamentals. These investors turn sellers
amid high volumes.
 This is followed by panic phase as the expectations
are belied. Sellers become desperate and almost a
vertical fall results.
 The market is gripped by pessimism and the third
phase of decline begins. This may or may not be as
steep as the panic phase.
 DOW THEORY - Rules
3. Two averages must confirm: The two averages
developed by Dow must exhibit the same behaviour.
If there is divergence the trends can not be said to
exist. This has stood the test of the time. This is
known as principle of confirmation.
4. Volume goes with the trend: Trading activity tends
to increase as prices move in the direction of primary
trend.
 In bull phase volume increases as the price rises and
decreases as price declines.
 Similarly, in the bear phase volume increases as the
price falls and does not pick up in secondary rallies.
 Generally volume leads the price.
 Non conformity of rule may indicate trend reversal. Should be
used as supportive evidence rather than conclusive.
 DOW THEORY - Rules

5. Price and only price is determinant of trend

reversal: There are many techniques used for the
forecast of the changes in the trend. Dow theory
suggests that while all other indicators may be
considered in determination of trend reversal, the
trend will be assumed to continue till such time
price exhibits the change of pattern.
 DOW THEORY - LIMITATIONS
 Sacrifices substantial gains: Dow theory suggests
action only upon confirmation of the trend. The rule of
1/3rd – 2/3rd delays action. An investor will enter only
when in a primary bull phase the gain has exceeded
1/3rd of the previous. Similarly, his exit is also delayed till
such time the prices fall by more than 1/3rd. An investor
can at best hope to gain about only 50% of the bull
phase.
 Does not talk of individual shares: The behavioural
patterns have been studied only for averages only. Will
the same hold good for individual stock?
 Ignores intermediate trends: The theory is mainly
concerned with primary bull and primary bear phase and
gives no warning of the intermediate trends thereby
missing on the opportunities offered by these trends.
 RICHARD DURANT STUDY
 $ 100 invested in DJIA on July 12, 1897 when primary
bull market was signaled by Dow Theory. Those stocks
were sold and repurchased when and only when Dow
Theory had definitely confirmed the change of trend.
This fund of $ 100 became $ 11,236 in 1956. There
were 15 sales and 15 purchases during this period.
 Alternatively, if the buy and hold strategy was adopted
by buying shares only once when the prices were
lowest and sold only once at the highest in the entire
span of 50 years, the fund of $ 100 could become only
$ 1,758.
 Therefore only by coincidence and not by
strategy the investor can outperform chartist.
 BREADTH OF THE MARKET
 Averages may behave contrary to the total
market.
 How disperse are the conditions are indicated
in the nos. of shares gaining (Advancing) and
nos. of shares losing (Declining).
 Breadth of the market is measured by
cumulative AD Line (Difference between nos.
of shares advanced and declined on a day)
 Generally,
 Averages and AD line will move in tandem.
 Divergence between the two signals trend
reversal.
 BREADTH OF THE MARKET
Day Adv. Dec. Cum A - D
Day 1 900 600 300
Day 2 700 800 200
Day 3 600 900 -100
 RULE: When there is divergence in Averages
and AD Line
AD line shows truer direction. Averages
can not defy the total sentiments for long
Breadth Index Signals
New Low At Peak Onset of Bear Phase
New High At Trough Onset of Bull Phase
 RULES OF VOLUME
 Price information is combined with the
data on Volume traded.
 Volume contains important clues.

 Belief: Volume tends to lead the price.

Normal Rule
 In Bull Market
 Volume increases with Price rise
 Volume decreases with Price fall
 In Bear Market
 Volume increases with Price fall
 Volume decreases with Price rise
 RULES OF VOLUME
 If Volume increases as Price drops: indicates drying
up of supply, Rise in price expected
 If Volume decreases as Price rises: indicates drying
up of demand, Fall in price expected
Charles Ying’s Empirical Study:
1. Small volume is accompanied with fall in price
2. Large volume is accompanied with rise in price.
3. Large increase in volume is accompanied by large increase
or large decrease in price.
4. Large volume is followed by rise in price.
5. Decline in volume for 5 consecutive days, leads to price
fall for next 4 days.
6. Rise in volume for 5 consecutive days, leads to price rise
for next 4 days.
 SUPPORT & RESISTANCE
 SUPPORT: The price below which enough
buying interest is generated. May be due to
the recognition of the fundamentals and/or
the intrinsic value of the share.
 Similarly, at certain other level a heavy selling
results where stock is considered overvalued,
known as RESISTANCE level.
 Forms a rectangle where the lines joining the
bottoms and the tops are almost parallel.
 It said to be a picture of conflict.
 It is a conflict of equally strong buyers and sellers.
Continues for some time until one group gives in.
 Who will give in is extremely difficult to predict.
 SUPPORT & RESISTANCE
 Trading inside the rectangle area is very
profitable as long as volumes do not draw much
attention. When information is limited trading
by few interested, knowledgeable and informed
operators is possible more readily.
 Volume: Generally diminishes as time elapses.
Volume generally declines in each successive cycle.
 Breakout: More of a consolidation pattern rather
than indicator of trend reversal. Apply 3% Filter rule.
 Measurement: Normally more frequent is the
touching of the support and resistance levels, larger
will be the break out. The quantum of change is
given by the width of the rectangle.
 Reliability: High
 MOVING AVERAGES
 Unpredictability of the stock market is
characterised by spikes. Sometimes signals do
not last long and mislead investors, who act on
such signals only to realise the mistake later on.
 Sharp increase in price with increased volume
may turn out to be flutter.
 The spike gives misleading signal of bullishness.
Price may pierce the resistance line briefly to
indicate onset of bull phase (Bull trap).
 Similarly, price may go below the support level
to signal bear phase only to return back to
normal trading range (Bear trap).
 MOVING AVERAGES - USES
 The reliability of the predictions must be
improved to eliminate stray incidents.
 The 3% filter rule attempts to eliminate the false
signals and whipsaws.
 Likewise, volume also helps confirmation and lends
credibility to prediction.
 Moving average is another tool that helps
improve the judgment and forecast.
 As the average itself is smoothing phenomena
the variations get evened out and therefore,
forecast based on average is more reliable.
 Better reliability of the moving average as it always
lags the price and therefore provides ample time
for false signals to vanish.
WHICH AVERAGE TO USE
 Long Term Moving Average
 Normally exceeding 150 days.
 Used for identifying the growth stocks, applies
well to cyclical stocks
 Intermediate Moving Average
 Between 51 – 150 days
 Closer to the price line than the LT MA Line.
 Recommended only for intermediate purposes.
 Short Term Moving Average
 Less than 50 days
 Closest to the price. Since the time to smooth
out is less the reliability of the ST MA is lesser.
 More meaningful to the speculator
 MA – Input Parameters
 WHICH PRICE TO USE
Only closing prices. More reliable.
 the willingness to carry forward position overnight,
 further flow of material information has ended,
 all available news of the day has been discounted.
 WHICH TIME SPAN OF MA TO USE
 MA lags the price. Choosing of the time period for
MA is a compromise between conflicting aspects of
elimination of whipsaws, and early prediction.
 5 d MA is volatile & may give false signals.
 48 m MA is too slow; mean sacrifice of gains.
 WHICH TYPE OF MA TO USE
Simple MA have out performed exponential and
weighted average MA.
 APPLYING MAs
 LT MA is pierced from below by price : BUY
 LT MA is pierced from top by price : SELL
 STMA is closer to the behaviour of the price while
behaviour of LTMA is that of smoothing the
fluctuations. What is applicable to the price line and
the average can be extended to STMA and LTMA.
 When STMA crosses LTMA from below
when LTMA is declining : BUY
 When STMA crosses LTMA from top
when LTMA is rising : SELL
 When STMA comes closer but does not pierce :
Price will follow the ST MA
 If STMA is declining price will continue to decline
 If STMA is rising the price will continue to rise
 OSCILLATORS
 The stock price has momentum of its own and
therefore it tends to oscillates around a point,
known as point of equilibrium.
 Identifies reversals much ahead of peaks and
troughs.
 Very useful when trends are difficult to identify.
 Helps identification of overbought and oversold
positions.
 Major oscillators are:
 Rate of Change (RoC)
 Momentum
 Relative Strength Index (RSI)
 Moving Average Convergence Divergence (MACD)
 RATE OF CHANGE (RoC)
 Rate of Change is the relationship of the current
price and that of the nth day preceding it. A 10–
day ROC is defined as ratio of current price to
the price 10 days back. This ratio will oscillate
around 1.0. Commonly used RoC are 12 days,
12 weeks, and 12 months for short term,
medium term and long term forecasts
respectively
 When oscillators achieves extreme values it
signifies that price movement has gone too far
to last and hence reversal must take place.
 RoC - Interpretation
 The rate of change as ratio of the current price to
price before, equal to 1.0 means no change in the
price.
 Ratio > 1 Rising price.
When demand outstrips supply. Farther the distance
from mean position of 1.0 greater demand is
assumed. A ratio of 1.3 would signify OVERBOUGHT
position.
 Ratio < 1 Falling price.
When supply outstrips demand. Farther the distance
from mean position of 1.0 greater supply is assumed.
A ratio of 0.7 would signify OVERSOLD position.
 Ratio between 0.3 to 0.7
Signifies normal trading area
 MOMENTUM
 13 day Momentum is calculated by subtracting
the price 13 day ago from the current price.
 Momentum rises/falls faster than the price and
and peaks/troughs before price does.
 3 ways to use:
 Identification of overbought and oversold
regions (Sell/Buy when reaches
Overbought/Oversold regions)
 Crossover of Zero line (Buy/Sell when momentum
crosses from below/top.)
 Divergence with the price line. (Price still rising
but Momentum falls “losing momentum”); follow
the oscillator
 RELATIVE STRENGTH INDEX
 Relative Strength Index (RSI) : Another oscillator
determines the relative strength or weakness.
 RSI is measured in terms of the ratio of amount of
gain to the amount of losses in the specified period.
Overcomes two major problems with other oscillators:
 Steadier than other oscillators like RoC & Momentum which
are based on single day price comparison.
 Other oscillators do not have specified range on vertical scale
 10 day RSI is calculated as
100 – {100/(1+R)} in %. where R = ratio of sum of
gains/sum of losses over the preceding 10 days
 RSI can be calculated for any number of days. Most
widely used RSI is 14 day RSI. Fluctuates between 0
and 100%
 Lesser the nos. of days more volatile is the oscillator.
 RSI - RULES
 Forms tops above 70 and bottoms below 30 before
price does so.
An RSI of 70% signals the
formation of the top : SELL
An RSI of 30% indicates the
formation of the bottom : BUY
 Whenever the RSI forms a top or a bottom it
provides an alert signal. A top would imply selling
of the scrip and a bottom would mean buying.
 In case of divergence with the price follow the RSI.
Price will follow the direction of RSI.
 MACD
 Moving Average Convergence/Divergence is
most widely used oscillator.
 Constructed by taking difference of two moving
average (Difference of 13 day EMA and 26 day
EMA). This oscillates around zero line.
 MACD is superimposed by 10 day moving
average of MACD (Signal/Trigger Line) itself.
 ST Moving Average works better when price
movement is sideways.
 LT Moving Average works better when there
exists a trend. A less sensitive average.
 + when ST MA > LT MA; - when STMA < LTMA
 MACD - RULES
 Same as for other oscillators.
 Identify crossovers:
 Buy/Sell when MACD crosses zero from below/top
 Buy/Sell when MACD crosses signal line from below/top
 Identify overbought and oversold conditions.
 (Normal is ± 30%, but is security specific)
 Identify divergence:
 Bearish Divergence: When MACD make new low while
price does not forms new low - Sell
 Bullish Divergence: When MACD make new high while
price does not forms new high - Buy
 Divergence is extremely significant when occurs close to
overbought/oversold regions.
 WHEN TO USE OSCILLATORS
 Oscillators are generally used
 As confirmation of trend reversal rather than leading
indicators
 In conjunction as predictions based on single
parameter is risky.
 More useful in horizontal trading zones.
 When trends are difficult to determine
 BUY Signals work better in BULLISH markets
and SELL signals work better in BEARISH
markets
 Patterns are more readily visible in oscillators
than in price charts.