Technical Analysis : Introduction

ITM, January 2011

The need for technical analysis
While fundamental analysis is helpful in stock selection,
technical analysis helps in deciding the timing of a stock
purchase/sale. Fundamental Analysis has certain
limitations:

1. It involves compilation and analysis of a huge amount of

data, and is therefore, complex and time consuming.
2. It relies on the financial statements which may be subject
to certain deficiencies like window dressing. This affects
the quality of the analysis.

Technical analysis uses information such as historic

prices, volume of trading etc. to predict future trends.
Frame work for Analysis

The four pillars of technical analysis are:

 Price

 Time: The longer it takes for a reversal in trend, the greater

the price change that would follow.

 Volume: A change in price accompanied by a low volume

implies that the change is not strong enough.

 Breadth: It is important to analyze if the change in trend is

concentrated in a few stocks or is spread across a large
number of sectors.
Relative Strength Analysis
The relative strength indicator (RSI) is an important
oscillator developed by Wells Wilder. The formula for
computation is:

RSI = 100 – (100/1+RS)

WHERE RS = average gain per day/ average loss per day

RSI can be calculated for 5, 7, 9 or 14 days.

RSI Interpretation
A graph is plotted using the RSI values. On this graph,
the overbought and oversold positions are drawn at 70
and 30 levels on a scale of 0 to 100.

1. If RSI crosses the level of 70 from above, this indicates

it may be time to buy the scrip. If it crosses 70 from
below, this is a sell signal.

2. If RSI crosses 30 from above, this is a signal to sell. If

the level of 30 is crossed from below, this is a buy
signal.
RSI Example
Date Price Gain Loss
-----------------------------------------------------------
Feb 4 300 - -
Feb 6 304 4 -
Feb 7 319 15 -
Feb 8 317 - 2
Feb 11 319 2 -
Feb 12 333 14 -
Feb 13 331 - 2
Feb 14 332 1 -
Feb 18 348 16 -
Feb 19 346 - 2

Average 52/9=5.78 6/9= 0.67

RS = 5.78/0.67 = 8.63
RSI = 100 – 100/9.63 = 89.61
Moving Averages
Analysts observe moving averages for crossovers to obtain
buy and sell signals. The following rules are important:
1. When the price line falls below a falling moving average, a
reversal in bullish trend is indicated.
2. When the price line crosses over a rising moving average, it
indicates end of a bear market.
3. A moving average may also act as a support/resistance line.
4. Multiple moving averages may also be used. If the short term
average intersects the long term average from below, while
the long term average is rising, this is a buy signal.