Unit 3 - TECHNICAL ANALYSIS

Technical Analysis
Martin J Pring define that, “The technical approach to investing is essentially a reflection of the idea that prices
move in trends which are determined by the changing attitudes of investors toward a variety of economic,
monetary, political and psychological forces”.
● Technical analysis involves a study of market generated data like prices and volumes to determine the
future direction of price movement.
● The art of technical analysis is to identify trend changes at an early stage and to maintain an
investment posture until the weight of the evidence indicates that the trend has been reversed.

Fundamental vs. Technical Analysis

● Technical analysis mainly seeks 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.

Dow Theory
● The Dow theory is a financial theory that says the market is in an upward trend if one of its averages
(i.e., industrials or transportation) advances above a previous important high and is accompanied or
followed by a similar advance in the other average.
● The Dow Theory is a technical framework that predicts the market is in an upward trend if one of its
averages advances above a previous important high, accompanied or followed by a similar advance in
the other average.
● The theory is predicated on the notion that the market discounts everything in a way consistent with the
efficient markets hypothesis.
● In such a paradigm, different market indices must confirm each other in terms of price action and
volume patterns until trends reverse.
● The Dow theory is an approach to trading developed by Charles H. Dow who, with Edward Jones and
Charles Bergstresser, founded Dow Jones & Company, Inc. and developed the Dow Jones Industrial
Average in 1896.

Components of Dow Theory

● The Market Discounts Everything
● 3 Primary Kinds of Market Trends – Primary, Secondary and Minor Trends
● Primary Trends have 3 Phases – Accumulation, Trending and Distribution
● Indices Must Confirm Each Other
● Volume Must Confirm the Trend
● Trends Persist Until a Clear Reversal Occurs
Charting Method
● Charts are the valuable and easiest tools in the technical analysis.
● The graphic presentation of the data helps the investor to find out the trend of the price without any
difficulty.
● The charts also have the following uses:
○ Spots the current trend for buying and selling.
○ Indicates the probable future action of the market by projection
○ Shows the past historic movement
○ Indicates the important areas of support and resistance.
● The charts do not lie but interpretation differs from analyst to analyst according to their skills and
experience.
● A leading technician, James Dines said, “Charts are like fire or electricity they are brilliant tools if
intelligently controlled and handled but dangerous to a novice (beginner)”.
Trend
● Trend is the direction of movement.
● The share prices can either increase or fall or remain flat.
● The three directions of the share price movements are called as rising, falling and flat trends.
● The point to be remembered is that share prices do not rise or fall in a straight line.
● Every rise or fall in price experiences a counter move.
● If a share price is increasing, the countermove will be a fall in price and vice-versa.
● 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.
● To draw a trend line, the technical analyst should have at least two tops or bottoms.
Trend Reversal
● The rise or fall in share price cannot go on forever.
● The share price movement may reverse its 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 penetration of the trend line.
● If a scrip price cuts the rising trend line from above, it is a violation of trend line and signals the
possibility of fall in price.
● Like – wise if the scrip pierces the trend line from below, this signal the rise in price.

Trend Patterns
● Primary Trend
● Secondary Trend
● Minor Trends

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 reactions following the peak used to halt before the previous bottoms.
● The phases leading to the three peaks are revival, improvement in corporate profit and speculation.
● The revival period encourages more and more investors to buy scrip’s their expectations about the
future being high.
● In the second phase, increased profits of corporate would result in further price rise.
● In the third phase, prices advance due to inflation and speculation.
● The figure gives the three phases of bull market.

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% to 66% of the earlier fall.
● Intermediate trend corrects the overbought and oversold condition.
● It provides the space to the market.
● Compared to the time taken for the primary trend, secondary trend is swift and quicker.
Minor Trend
● Minor trends or 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 the minor trends.
● The chartist plots the scrip’s price or the market index each day to trace the primary and secondary
trend.

Moving Average
● The market indices do not rise or 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.
● The word moving means that the body of data moves ahead to include the recent observation.

Aspects of Moving Average

● If it is five day moving average, on the sixth day the body of data moves to include the sixth day
observation eliminating the first day’s observation. Likewise it continues.
● In the moving average calculation, closing price of the stock is used.
● The moving averages are used to study the movement of the market as well as the individual scrip
price.
● The moving average indicates the underlying trend in the scrip.
● The period of average determines the period of the trend that is being identified.
● For identifying short-term trend, 10 day to 30 day moving averages are used.
● In the case of medium term trend 50 day to 125 day are adopted.
● 200 day moving average is used to identify long term trend.
Exponential Moving Average
● The exponential moving average (EMA) is a technical chart indicator that tracks the price of an
investment (like a stock or commodity) over time.
● The EMA is a type of weighted moving average (WMA) that gives more weighting or importance to
recent price data.

EMA Formula
Oscillators
● Oscillators indicate the market momentum or scrip momentum.
● Oscillator shows the share price movement across a reference point from one extreme to another.
● The momentum indicates:
○ Overbought and oversold conditions of the scrip or the market.
○ Signaling the possible trend reversal.
○ Rise or decline in the momentum.
● Generally, oscillators are analyzed along with the price chart.
● Oscillators indicate trend reversals that have to be confirmed with the price movement of the scrip.
● Changes in the price should be correlated to changes in the momentum, and then only buy and sell
signals can be generated.
● Actions have to be taken only when the price and momentum agree with each other.
● With the daily, weekly or monthly closing prices oscillators are built. For short term trading, daily price
oscillators are useful.

Market Indicators
● Market indicators are quantitative in nature and seek to interpret stock or financial index data in an
attempt to forecast market moves.
● Market indicators are a subset of technical indicators and are typically comprised of formulas and
ratios.
● They aid investors' investment/trading decisions.

Understanding Market Indicators

● Market indicators are similar to technical indicators in that both apply a statistical formula to a series of
data points to draw a conclusion.
● The difference is that market indicators use data points from multiple securities rather than just a single
security.
● Often times, market indicators are plotted on a separate chart rather than appearing above or below an
index price chart.

Most Common Market Indicators

● Market Breadth
○ Market Breadth indicators compare the number of stocks moving in the same direction as a
larger trend.
● Market Sentiment
○ Market Sentiment indicators compare price and volume to determine whether investors are
bullish or bearish on the overall market.

Popular Market Indicators

● Advance – Decline Issues
● New Highs – New Lows
● McClellan Oscillator
● Moving Averages
Relative Strength Index
● The relative strength index (RSI) is a momentum indicator used in technical analysis.
● RSI measures the speed and magnitude of a security’s recent price changes to evaluate overvalued or
undervalued conditions in the price of that security.
● The Relative Strength Index (RSI), developed by J. Welles Wilder, is a momentum oscillator that
measures the speed and change of price movements.
● The RSI oscillates between zero and 100.
● Traditionally the RSI is considered overbought when above 70 and oversold when below 30.
● Signals can be generated by looking for divergences and failure swings.
● RSI can also be used to identify the general trend.
● RSI also often forms chart patterns that may not show on the underlying price chart, such as double
tops and bottoms and trend lines.
● Also, look for support or resistance on the RSI.
Rate of Change
● The Rate-of-Change (ROC) indicator, which is also referred to as simply Momentum, is a pure
momentum oscillator.
● The ROC calculation compares the current price with the price "n" periods ago.
● The plot forms an oscillator that fluctuates above and below the zero line as the Rate-of-Change moves
from positive to negative.
● Like other momentum indicators, ROC has overbought and oversold zones that may be adjusted
according to market conditions.
● Remember, a security can become oversold / overbought and remain oversold / overbought for an
extended period.
● An upward surge in the Rate-of-Change reflects a sharp price advance.
● A downward plunge indicates a steep price decline.
● In general, prices are rising as long as the Rate-of-Change remains positive.
● Conversely, prices are falling when the Rate-of-Change is negative.
Moving Average Convergence / Divergence
● The MACD is one of the most potent technical tools in the arsenal of many traders.
● The indicator is used to check the strength and the direction of a trend as well as to define reversal
points.
● The MACD stands for the Moving Average Convergence Divergence and shows the relationship of the
price’s two Moving Averages.
● You don’t need to download it, because MACD is included in MetaTrader default indicator kit.
● Go to “Insert”, find “Indicators” and then “Oscillators” – and you will see the MACD.
● In a separate window below the price chart, the indicator will appear.
● The classic settings include 12 and 26 EMAs and a Signal Line (SMA) with a period of 9.
● You can choose other parameters depending on your trading style and goals.
● For example, the MACD (5,35,5) is more sensitive and might be better suited for weekly charts.

Efficient Market Theory

● The efficient market hypothesis is a central idea of a modern finance that has profound implications
(consequences).
● An understanding of the efficient market hypothesis will help to ask the right questions and save from a
lot of confusion that dominates popular thinking in finance.
● An efficient market is one in which the market price of a security is an unbiased estimate of its intrinsic
value (real worth).
● Note that market efficiency does not imply that the market price equals intrinsic value at every point in
time.
● A corollary (consequence) is that investors will also be less likely to discover great bargains and
thereby earn extraordinary high rates of return.

Requirements of Efficient Market

● Prices must be efficient so that new inventions and better products will cause a firm’s securities prices
to rise and motivate investors to supply capital to the firm
● Information must be discussed freely and quickly across the nations so all investors can react to new
information
● Transactions costs such as sales commissions on securities are ignored
● Taxes are assumed to have no noticeable effect on investment policy
● Every investor is allowed to borrow or lend at the same rate; and, finally,
● Investors must be rational and able to recognize efficient assets and that they will want to invest money
where it is needed most
Levels of Market Efficiency
● Weak Form Efficiency – Prices reflect all information found in the record of past and volumes.
● Semi-Strong Form Efficiency – Prices reflect not only all information found in the record of past prices
and volumes but also all other publicly available information.
● Strong Form Efficiency – Prices reflect all available information, public as well as private.

Market Efficiency
● Market efficiency refers to how well current prices reflect all available, relevant information about the
actual value of the underlying assets.
● A truly efficient market eliminates the possibility of beating the market, because any information
available to any trader is already incorporated into the market price.
● As the quality and amount of information increases, the market becomes more efficient reducing
opportunities for arbitrage (speculation) and above market returns.

Forms of Market Efficiency

● Weak Form Efficiency
● Semi-Strong Form Efficiency
● Strong Form Efficiency

Weak Form Efficiency

● Weak form efficiency, also known as the random walk theory, states that future securities' prices are
random and not influenced by past events.
● Advocates of weak form efficiency believe all current information is reflected in stock prices and past
information has no relationship with current market prices.
● The concept of weak form efficiency was pioneered by Princeton University economics professor
Burton G. Malkiel in his 1973 book, "A Random Walk Down Wall Street."

Semi-Strong Form Efficiency

● Semi-strong form efficiency is an aspect of the Efficient Market Hypothesis (EMH) that assumes that
current stock prices adjust rapidly to the release of all new public information.
● Semi-strong form efficiency contends that security prices have factored in publicly-available market and
that price changes to new equilibrium levels are reflections of that information.
● It is considered the most practical of all EMH hypotheses but is unable to explain the context for
material nonpublic information (MNPI).

Strong Form Efficiency

● Strong form efficiency refers to a market efficiency in which prices of stocks reflects all the information
in a market, be it private or public.
● In strong form efficiency, stock prices reflect public and private information about a market.
● Strong form efficiency is the strongest of the three forms of the efficient market hypothesis.
● According to the proponents of the strong form efficiency, the fact that private of insider information
about a market is revealed by the stock price does not give investors an edge in the market.
Empirical Tests of Market Efficiency
● Weak Form
● Simulation Test
● Serial Correlation Test
● Run Test
● Filter Test
● Relative Strength Method
● Semi-Strong Form
● Market Reaction Test
● Announcement Effects
● Strong Form
● Mutual Fund Performance

Applications
● Predictability of Stock Prices
● Volatility of Stock Prices
● Mutual Fund Performance
● Consumer Goods
● Industry Goods
● Imports
● Exports
● Public Distribution
● Airline Industry
● Textile Industry
● Cement Industry
● Chemical Industry
● Oil Industry
● Food Industry
● Steel Industry
● Agriculture Industry
● Construction Industry
● Education Industry, etc.