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PROJECT ON
TECHNICAL ANALYSIS OF EQUITIES
A PROJECT SUBMITTED IN PART COMPLETION OF
MASTERS IN FINANCIAL MANAGEMENT
DANIEL BABU P
MFM – SEM V, ROLL NO. 41
BATCH 2008 – 2011
UNDER THE GUIDANCE OF
PROF. A K PRADHAN
K J SOMAIYA OF MANAGEMENT STUDIES & RESEARCH
Vidyanagar,Vidyavihar(E). Mumbai - 400077.
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CERTIFICATE
This is to certify that the study presented by DANIEL BABU P to K J SOMAIYA
INSTITUTE OF MANAGEMENT STUDIES & RESEARCH in part
completion of MASTERS IN FINANCIAL MANAGEMENT on TECHNICAL
ANALYSIS OF EQUITIES has been done under my guidance in the year 2008 –
2011.
The Project is in the nature of Original Work that has not so far been submitted for
any other course in this Institute or any other Institute. Reference of work and relative
sources of information has been given at the end of the project.
Signature of the Candidate
(Daniel Babu P)
Forwarded through the Research Guide
Signature of the Guide
(Prof. AK Pradhan)
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DECLARATION
I Daniel Babu P, a Student of MFM SEM – V of University of Mumbai, 2008 – 2011
Batch at SIMSR do hereby declare that this project report entitled ―Technical
Analysis of Equities‖ has been carried out by me during this semester under the
guidance of Prof. A.K Pradhan as per the norms prescribed by university of
Mumbai & the same work has not been copied from any sources directly without
authenticating for the part / section that has been adopted from published / non
published work.
I further declare that the information presented in this project is true & original to the
best of my knowledge.
Date:
Place: Mumbai DANIEL BABU P
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ACKNOWLEDGEMENT
I wish to accord my sincere gratitude to the KJ Somaiya Institute of
Management Studies & Research for their Support and co–operation.
I thank Prof. AK Pradhan for his Support and Guidance, without whom the
Project would not have been possible.
Also, the support of my colleagues was indispensable as their points and
approach has helped me to achieve success in my project.
DANIEL BABU P
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Contents
EXECUTIVE SUMMARY ........................................................................................... 6
INTRODUCTION TO TECHNICAL ANALYSIS ....................................................... 7
BASICS OF TECHNICAL ANALYSIS ..................................................................... 11
CHARTS PATTERNS AND TRENDS. ..................................................................... 15
MOVING AVERAGES ............................................................................................... 25
INDICATORS AND OSCILLATORS ........................................................................ 30
OVERLAYS ................................................................................................................ 39
REAL LIFE PREDICTION AND OUTCOMES ........................................................ 44
SELECTION OF INDICATORS/OSCILLATORS/OVERLAYS .............................. 55
STEPS IN TECHNICAL ANALYSIS ........................................................................ 59
CONCLUSIONS .......................................................................................................... 62
BIBLIOGRAPHY OF REFERENCES ...................................................................... 62
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EXECUTIVE SUMMARY
The cornerstone of the technical analysis is the belief that all of the factors that
influence market price — fundamental information, political events, natural disasters,and psychological factors — are quickly discounted in market activity.
NEED FOR THE PROJECT:
Stock analysis today is a combination of both the fundamental analysis and the
technical or chart analysis. Fundamental analysis affects technical analysis. It is
important to time entry and exits, and use spreads to manage risk. In this context,
study and evaluation of various charting techniques is taken up with respect to its
application area.
OBJECTIVES :
Study of reversal and continuation chart patterns, trends, gaps, indicators,market profiling using Elliot wave theory, Fibonacci sequences etc.
Identifying the market condition and applying the appropriate indicatorand tools. Usage of multiple such tools to finalize the strategy.
Selection of tools (indicators and functions) for technical analysis. Survey and evaluation of various software tools for pointers, scaling etc,
platforms available for technical analysis.
Testing of historical charts of various companies in different sectors /segments.
METHODOLOGY :
Various indicators and functions for technical analysis were studied and suitable ones
were selected for selection of economic environment of investing (market, micro and
macro indicators). Next step involved selection of sectors and companies for
investing. For individual equity analysis Excel Add-In tool Analyzer XL was used.
For proving technical analysis Top 5 picks of the day appearing in Economic times
are taken and the tools and functions used are applied. The market movements are
followed and the success/failure reasons of the prediction are analyzed.
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INTRODUCTION TO TECHNICAL ANALYSIS
In finance, technical analysis is a security analysis discipline for forecasting the
direction of prices through the study of past market data, primarily price and volume.Technical analysis is a method of evaluating securities by analyzing the statistics
generated by market activity, such as past prices and volume. Technical analysts do
not attempt to measure a security's intrinsic value, but instead use charts and other
tools to identify patterns that can suggest future activity. Technical analysis can be
used on any security with historical trading data. This includes stocks, futures and
commodities, fixed-income securities, forex, etc. In fact, technical analysis is more
frequently associated with commodities and forex, where the participants are
predominantly traders.
Just as there are many investment styles on the fundamental side, there are also many
different types of technical traders. Some rely on chart patterns, others use technical
indicators and oscillators, and most use some combination of the two. In any case,
technical analysts' exclusive use of historical price and volume data is what separates
them from their fundamental counterparts. Unlike fundamental analysts, technical
analysts don't care whether a stock is undervalued - the only thing that matters is asecurity's past trading data and what information this data can provide about where
the security might move in the future.
The field of technical analysis is based on three assumptions:
1. The Market Discounts Everything
A major criticism of technical analysis is that it only considers price movement,
ignoring the fundamental factors of the company. However, technical analysisassumes that, at any given time, a stock's price reflects everything that has or could
affect the company - including fundamental factors. Technical analysts believe that
the company's fundamentals, along with broader economic factors and market
psychology, are all priced into the stock, removing the need to actually consider these
factors separately. This only leaves the analysis of price movement, which technical
theory views as a product of the supply and demand for a particular stock in the
market.
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2. Price Moves in Trends
In technical analysis, price movements are believed to follow trends. This means that
after a trend has been established, the future price movement is more likely to be in
the same direction as the trend than to be against it. Most technical trading strategies
are based on this assumption.
3. History Tends To Repeat Itself
Another important idea in technical analysis is that history tends to repeat itself,
mainly in terms of price movement. The repetitive nature of price movements is
attributed to market psychology; in other words, market participants tend to provide a
consistent reaction to similar market stimuli over time. Technical analysis uses
chart patterns to analyze market movements and understand trends. Although many of
these charts have been used for more than 100 years, they are still believed to be
relevant because they illustrate patterns in price movements that often repeat
themselves.
Technical analysis is a methodology to assist in deciding the timing of investments,
which is very vital to make wise investment decisions. Few of the most commonly
used technical analysis methods for capital market are Japanese Candlestick, Price
Curves, Trend Lines, High Low Charts and Moving averages
Need for technical Analysis.
A logical question is: What does technical analysis do? The answer is that the ability
to recognize when a stock has reached a support or resistance level, or a shift in
perceptions takes place, can help investors know whether to use the:
• buy low, sell high approach, or • buy high, sell higher approach, or
• whether to buy the stock at all.
The ability to apply this one aspect of chart reading will reveal the market to investors
with the same impact as understanding the colours of a traffic light. Once you know
that green means go and red means stop, you will know when it is safe to buy or not.
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We’ve touched upon some of the reasons to use technical analysis, such as the lack of
data revisions, estimates and subjectivity in its inputs. But as important as it is to
know when to buy a stock it is equally, if not more, important to know when not to
buy a stock, or when to sell a stock already held. Technical analysis is the only
investment decision-making discipline that lets you know when you are wrong
sooner, rather than later, to minimize losses.
When not to use it?
Since technical analysis is based on crowd psychology and actions of the masses, it
works best when there is a crowd to analyze. That means the best analysis occurs on
liquid stocks where there are plenty of bulls and bears at work and a critical mass of money value changes hands each day. What constitutes critical mass is subjective, but
many investors use a rule of thumb of stock price above Rs.20 and average daily
trading volume above 100,000 shares. Certainly we can tinker with these parameters
as we gain experience. Technical analysis also needs relatively normal market
conditions. War, terrorism, takeovers, legislation and litigation trump support and
resistance, although it does help during these unusual conditions to know where
investors found value in the past.
Everything supports price
A diagram resembling a table is used to stock prices. The price of the stock or
commodity is the top of the table. Indicators such as momentum, sentiment, volume
and anything else we can create, are the legs of the table. Everything is there to
support the price and as long as we keep this in mind we will be properly focused on
what we are doing. The stronger the ―legs‖ the better the ―table‖ (investment).
Price is the only thing that matters at the end of the day. It is what we say when
someone asks where a stock is today and it is the only way we judge our investing
success. Price rules and it is entirely possible to analyze a chart without any of the
other supporting indicators.
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Price
The stuff you put in the bank. Clearly, this is the most important component as we
measure our success in monetary terms. It only matters if we have more money after
investing than when we started and that is measured by price.
Other parameters help in understanding the problem.
• Volume
How much money is moving. If price tells us what is going on, volume tells us how
much is going on. Chart analysis depends on liquidity and crowd psychology, so the
more shares of stock that are traded, the more reliable the analysis can be.• Momentum
How fast it got there. It is important to know how eager the crowd is to buy and sell
because if it gets over enthused it will push prices out of equilibrium. Prices that move
too far, too fast are prone to snapbacks.
• Structure
The structure of the market refers to how it got to where it is now and we understand
that by studying trends and patterns. As stocks trade, their ups and downs form
patterns on the charts. Analysis of trends and patterns help us sort it all out and give
us clear guidelines to know when a trend changes to a pattern or a pattern changes
into a trend.
• Sentiment
How people feel about the market. Contrarianism is based on the idea that the crowd
gets it wrong when bull markets are changing to bear and vice versa. The masses
seem to pile into the market just at the wrong time, but we must look at it in reverse.
Just when everyone is buying, for example, is the wrong time to own stocks. Demand
becomes exhausted and without demand, prices must stop going up, if not fall. So,
when sentiment
indicators reach extreme optimism or pessimism, the prevailing trend is likely to be
nearing its end.
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BASICS OF TECHNICAL ANALYSIS
SUPPORT & RESISTANCE
Security prices are the result of a head-to-head battle between a bull (the buyer) and a
bear (the seller). The bulls push prices higher and the bears push prices lower. The
direction prices actually move reveals who is winning the battle.
Using this analogy, consider the price action of Phillip Morris in Figure below.
During the period shown, note how each time prices fell to the $45.50 level, the bulls
(i.e., the buyers) took control and prevented prices from falling further. That means
that at the price of $45.50, buyers felt that investing in Phillip Morris was worthwhile
(and sellers were not willing to sell for less than $45.50). This type of price action is
referred to as support, because buyers are supporting the price of $45.50.
Similar to support, a "resistance" level is the point at which sellers take control of
prices and prevent them from rising higher. Consider Figure in right. Note how each
time prices neared the level of $51.50, sellers outnumbered buyers and prevented the
price from rising.
The price at which a trade takes place is the price at which a bull and bear agree to do
business. It represents the consensus of their expectations. The bulls think prices will
move higher and the bears think prices will move lower.
Support levels indicate the price where the majority of investors believe that prices
will move higher, and resistance levels indicate the price at which a majority of
investors feel prices will move lower.
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But investor expectations change with time! For a long time investors did not expect
the Dow Industrials to rise above 1,000 (as shown by the heavy resistance at 1,000 in
Figure below). Yet only a few years later, investors were willing to trade with the
Dow near 2,500.
When investor expectations change, they often do so abruptly. Note how when prices
rose above the resistance level of Hasbro Inc. in Figure 9, they did so decisively. Note
too, that the breakout above the resistance level was accompanied with a significant
increase in volume.
Once investors accepted that Hasbro could trade above $20.00, more investors were
willing to buy it at higher levels (causing both prices and volume to increase).
Similarly, sellers who would previously have sold when prices approached $20.00
also began to expect prices to move higher and were no longer willing to sell.
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The development of support and resistance levels is probably the most noticeable and
reoccurring event on price charts. The penetration of support/resistance levels can be
triggered by fundamental changes that are above or below investor expectations (e.g.,
changes in earnings, management, competition, etc) or by self-fulfilling prophecy (
investors buy as they see prices rise). The cause is not as significant as the effect--new
expectations lead to new price levels.
Figure below in left shows a breakout caused by fundamental factors. The breakout
occurred when Snapple released a higher than expected earnings report. How do we
know it was higher than expectations? By the resulting change in prices following the
report!
Other support/resistance levels are more emotional. For example, the DJIA had a
tough time changing investor expectations when it neared 3,000 (see Figure above
right).
Supply and demand
There is nothing mysterious about support and resistance--it is classic supply and
demand. Remembering "Econ 101" class, supply/demand lines show what the supply
and demand will be at a given price.
The "supply" line shows the quantity (i.e., the number of shares) that sellers are
willing to supply at a given price. When prices increase, the quantity of sellers also
increases as more investors are willing to sell at these higher prices.
The "demand" line shows the number of shares that buyers are willing to buy at a
given price. When prices increase, the quantity of buyers decreases as fewer investors
are willing to buy at higher prices.
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At any given price, a supply/demand chart shows how many buyers and sellers there
are. For example, the following chart shows that, at the price of 42-1/2, there will be
10 buyers and 25 sellers.
Support occurs at the price where the supply line touches the left side of the chart
(e.g., 27-1/2 on the above chart). Prices can't fall below this amount, because no
sellers are willing to sell at these prices. Resistance occurs at the price where the
demand line touches the left side of the chart (e.g., 47-1/2). Prices can't rise above this
amount, because there are no buyers willing to buy at these prices.
In a free market these lines are continually changing. As investor expectations change,
so do the prices buyers and sellers feel are acceptable. A breakout above a resistancelevel is evidence of an upward shift in the demand line as more buyers become willing
to buy at higher prices. Similarly, the failure of a support level shows that the supply
line has shifted downward.
The foundation of most technical analysis tools is rooted in the concept of supply and
demand. Charts of security prices give us a superb view of these forces in action.
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CHARTS PATTERNS AND TRENDS.
CHARTS
The foundation of technical analysis is the chart. In this case, a picture truly is worth a
thousand words.
Line charts
A line chart is the simplest type of chart. As shown in the chart of General Motors in
Figure below, the single line represents the security's closing price on each day. Dates
are displayed along the bottom of the chart and prices are displayed on the side(s).
A line chart's strength comes from its simplicity. Line charts are typically displayed
using a security's closing prices.
Bar charts
A bar chart displays a security's open (if available), high, low, and closing prices. Bar
charts are the most popular type of security chart. As illustrated in the bar chart in
Figure below, the top of each vertical bar represents the highest price that the security
traded during the period, and the bottom of the bar represents the lowest price that it
traded. A closing "tick" is displayed on the right side of the bar to designate the last
price that the security traded. If opening prices are available, they are signified by a
tick on the left side of the bar.
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Volume bar chart
Volume is usually displayed as a bar graph at the bottom of the chart (see Figure
below). Most analysts only monitor the relative level of volume and as such, a volume
scale is often not displayed.
Figure on left displays "zero-based" volume. This means the bottom of each volume
bar represents the value of zero. However, most analysts prefer to see volume that is
"relative adjusted" rather than zero-based. This is done by subtracting the lowest
volume that occurred during the period displayed from all of the volume bars.
Relative adjusted volume bars make it easier to see trends in volume by ignoring the
minimum daily volume. Figure on right displays the same volume information as in
the previous chart, but this volume is relative adjusted.
OHLC "Bar Charts" —
Open-High-Low-Close charts, also known as bar charts, plot the span between the
high and low prices of a trading period as a vertical line segment at the trading time,
and the open and close prices with horizontal tick marks on the range line, usually a
tick to the left for the open price and a tick to the right for the closing price.
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Candlestick chart —
Of Japanese origin and similar to OHLC, candlesticks widen and fill the intervalbetween the open and close prices to emphasize the open/close relationship. In theWest, often black or red candle bodies represent a close lower than the open, whilewhite, green or blue candles represent a close higher than the open price.
Point and figure chart —
A chart type employing numerical filters with only passing references to time, andwhich ignores time entirely in its construction.
TRENDS
A trend is the market in motion, and a pattern is the market at rest, deciding if it wants
to continue its trend or change course.
A trend is really nothing more than a somewhat uniform change in price levels over
time. For a rising, or bull trend, prices start low and through a series of fits and starts,
advances and pullbacks, move to a higher level. Some trends are smooth and have
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small wiggles within. Others are choppy and are characterized by high volatility.
Some are flat with little net gain over time, and others are steep with a sharp increase
in relatively little time.
Support and resistance levels can be penetrated by a change in investor expectations
(which results in shifts of the supply/demand lines). This type of a change is often
abrupt and "news based."
A trend represents a consistent change in prices (i.e., a change in investor
expectations). Trends differ from support/resistance levels in that trends represent
change, whereas support/resistance levels represent barriers to change.As shown in Figure below, a rising trend is defined by successively higher low-prices.
A rising trend can be thought of as a rising support level--the bulls are in control and
are pushing prices higher.
Figure below shows a falling trend. A falling trend is defined by successively
lower high-prices. A falling trend can be thought of as a falling resistance
level--the bears are in control and are pushing prices lower.
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Just as prices penetrate support and resistance levels when expectations
change, prices can penetrate rising and falling trend lines. Figure below
shows the penetration of Merck's falling trend line as investors no longer
expected lower prices.
Note in Figure below how volume increased when the trend line was
penetrated. This is an important confirmation that the previous trend is no
longer intact.
Again, volume is the key to determining the significance of the penetration of
a trend. In the above example, volume increased when the trend was
penetrated, and was weak as the bulls tried to move prices back above the
trend line.
Indicator Alert Description
TrendLong Term UpwardSloping TradingChannel
A long term (6 months) upward sloping trading channel exists with thehighs and lows ->long term very bullish
TrendIntermediate TermUpward SlopingTrading Channel
A midterm (3 months) upward sloping trading channel exists with thehighs and lows -> midterm very bullish
TrendShort Term UpwardSloping TradingChannel
A short term (1 month) upward sloping trading channel exists with thehighs and lows ->short term very bullish
TrendLong TermDownward SlopingTrading Channel
A long term (6 months) downward sloping trading channel exists withthe highs and lows ->long term very bearish
TrendIntermediate TermDownward SlopingTrading Channel
A midterm (3 months) downward sloping trading channel exists withthe highs and lows -> midterm very bearish
TrendShort TermDownward SlopingTrading Channel
A short term (1 month) downward sloping trading channel exists withthe highs and lows ->short term very bearish
TrendLong Term BullishBreakout
A long term (6 months) downward trend in the highs has been broken->Long term bullish
Trend
Intermediate Term
Bullish Breakout
A midterm (3 months) downward trend in the highs has been broken-
>Midterm bullish
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TrendShort Term BullishBreakout
A midterm (1 month) downward trend in the highs has been broken->Short term bullish
TrendLong Term BearishBreakout
A long term (6 months) upward trend in the lows has been broken->Long term very bearish
TrendIntermediate TermBearish Breakout
A midterm (3 months) upward trend in the lows has been broken->Midterm very bearish
TrendShort Term BearishBreakout
A short term (1 month) upward trend in the lows has been broken->Short term very bearish
PATTERNS.
Rectangles (Trading Ranges)
Rectangle patterns contain the up and down wiggles of a sideways moving market.
All chart patterns are derivatives of this basic trading range. Some have steady
support levels but falling resistance levels over time. Others show support and
resistance levels converging, forming a pennant shape. But no matter what the shape,
all patterns are the same in that the stock is moving sideways rather than trending
higher or lower, and breakouts above or below these patterns tell us that either
demand or supply, respectively, has taken control.
The bottom line is that patterns and trends on charts yield clues as to the relationship
between bulls and bears and when that relationship changes. We do not have to know
why it changed other than it did change, and when we can identify it we can takeappropriate action – either buy, sell or hold.
Triangles
This type of continuation pattern has converging lines of support and resistance. Many
analysts refer to triangles as ―coils‖ because the trading action gets tighter and tighter,
storing energy until the market breaks out with great force. The breakout usually, but
not always, occurs in the direction of the original trend.
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A long-term chart of Google shows a very clear series of rising bottoms and falling
tops to create a triangle shape (see Chart above). Each swing higher and lower within
the pattern is marked with increased uncertainly as both bulls and bears lose
conviction. Bulls are taking short-term profits sooner and sooner on each rally and,
conversely, bears are covering their short positions sooner on each decline. The
market is waiting for something to unleash the energy building in this coiling action
and in September 2006, Google finally got that spark. The rally from the breakout
point was swift.
FlagsThe most common of the continuation patterns is called a flag because it resembles a
flag flying on a flagpole. When a market is trending higher, it is more common for it
to slowly give back some of those gains as the bulls take some profits. Since traders
do not all do this at the same time, the market displays a small counter trend lower as
more of them take their profits. When this is over, the market generally breaks out in
the direction of the original trend as the bulls take over again.
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Goldman Sachs was participating in the broad market rally that began in March 2003
(see Chart above). In late April, it settled into a corrective decline that was relatively
shallow and orderly. Lower highs and lower lows formed the pattern and when pricesmoved above the upper border, the rally resumed. The correction was over.
REVERSAL PATTERNS
The Head and Shoulders
The head and shoulders is the best known and probably the most reliable of the
reversal patterns. A head and shoulders top is characterized by three prominent market
peaks. The middle peak, or the head, is higher than the two surrounding peaks (the
shoulders). A trend line (the neckline) is drawn below the two intervening reaction
lows. A close below the neckline completes the pattern and signals an important
market reversal (See Figure below). Price objectives or targets can be determined by
measuring the shapes of the various price patterns. The measuring technique in a
topping pattern is to measure the vertical distance from the top of the head to the
neckline and to project the distance downward from the point where the neckline is
broken. The head and shoulders bottom is the same as the top except that it is turned
upside down.
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Double and Triple Tops and Bottoms
Another one of the reversal patterns, the triple top or bottom, is a variation of the head
and shoulders. The only difference is bottom is that the three peaks or troughs in this
pattern occur at about the same level.
Triple tops or bottoms and the head and shoulders reversal pattern are interpreted in
similar fashion and mean essentially the same thing. Double tops and bottoms (also
called M’s and W’s because of their shape) show two prominent peaks or troughs
instead of three. A double top is identified by two prominent peaks. The inability of
the second peak to move above the first peak is the first sign of weakness. When
prices then decline and move under the middle trough, the double top is completed.
The measuring technique for the double top is also based on the height of the pattern.
The height of the pattern is measured and projected downward from the point where
the trough is broken. The double bottom is the mirror image of the top
Saucers and Spikes
These two patterns aren’t as common, but are seen enough to warrant discussion. The
spike top (also called a V-reversal) pictures a sudden change in trend. What
distinguishes the spike from the other reversal patterns is the absence of a transition
period, which is sideways price action on the chart constituting topping or bottoming
activity. This type of pattern marks a dramatic change in trend with little or no
warning.
The saucer, by contrast, reveals an unusually slow shift in trend. Most often seen at
bottoms, the saucer pattern represents a slow and more gradual change in trend from
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down to up. The chart picture resembles a saucer or rounding bottom — hence its
name.
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MOVING AVERAGES
Moving averages are one of the oldest and most popular technical analysis tools. This
chapter describes the basic calculation and interpretation of moving averages. A
moving average is the average price of a security at a given time. When calculating a
moving average, you specify the time span to calculate the average price (e.g., 25
days).
A "simple" moving average is calculated by adding the security's prices for the most
recent "n" time periods and then dividing by "n." For example, adding the closingprices of a security for most recent 25 days and then dividing by 25. The result is the
security's average price over the last 25 days. This calculation is done for each period
in the chart.
Since the moving average in this chart is the average price of the security over the last
25 days, it represents the consensus of investor expectations over the last 25 days. If
the security's price is above its moving average, it means that investor's current
expectations (i.e., the current price) are higher than their average expectations over the
last 25 days, and that investors are becoming increasingly bullish on the security.
Conversely, if today's price is below its moving average, it shows that current
expectations are below average expectations over the last 25 days.
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The classic interpretation of a moving average is to use it to observe changes in
prices. Investors typically buy when a security's price rises above its moving average
and sell when the price falls below its moving average.
Time periods in moving averages
"Buy" arrows were drawn on the chart in Figure below when Aflac's price rose above
its 200-day moving average; "sell" arrows were drawn when Aflac's price fell below
its 200-day moving average.
Long-term trends are often isolated using a 200-day moving average. You can also
use computer software to automatically determine the optimum number of time
periods. Ignoring commissions, higher profits are usually found using shorter moving
averages.
Merits
The merit of this type of moving average system (i.e., buying and selling when prices
penetrate their moving average) is that you will always be on the "right" side of the
market--prices cannot rise very much without the price rising above its average price.
The disadvantage is that one will always buy and sell late. If the trend doesn't last for
a significant period of time, typically twice the length of the moving average, one will
lose money.
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There are five popular types of moving averages: simple (also referred to as
arithmetic), exponential, triangular, variable, and weighted. Moving averages can be
calculated on any data series including a security's open, high, low, close, volume, or
another indicator. A moving average of another moving average is also common.
The only significant difference between the various types of moving averages is the
weight assigned to the most recent data. Simple moving averages apply equal weight
to the prices. Exponential and weighted averages apply more weight to recent prices.
Triangular averages apply more weight to prices in the middle of the time period. And
variable moving averages change the weighting based on the volatility of prices.
Exponential Moving Average
An Exponential Moving Average (EMA) takes a percentage of today's price and adds
in the prior day's exponential moving average times 1 minus that percentage. For
instance, to calculate a 10% EMA, take today's price and multiply it by 10% then add
that figure to the prior day's EMA multiplied by the remaining percent:
(today's close * .10) + (yesterday's exponential moving average * (1-.10))
Because most people think in terms of days (time periods) versus percentages, the
following formula can be used to determine the percentage to be used in the
calculation:
Exponential Percentage = 2 /(Time Periods + 1).
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For a 20 period EMA you would use 9.52% (2/(20+1)) as your percentage for the
calculation. By nature of its calculation, the EMA gives more weight to the recent
periods.
Weighted Moving Average
The theory behind a weighted moving average (WMA) is that the recent data is more
relevant than past data. Therefore, it puts more "weight" on the recent data and less
weight on the older data. To calculate it, take the number of periods to analyze and
that becomes the weight for today's price. Yesterday's price would use today's weight
-1 and so on and so forth for the number of periods. Then divide the sum of the
weighted prices by the sum of the weights.
For example, suppose we took the last five "grades" we used in our first example and
calculated a 5-period WMA. The calculation would be as follows:
Calculation of a Weighted Moving Average. The number of periods (in
this case 5) becomes the "weight" for today. The weight for the
remaining days is reduced by 1 until the last day is found. Therefore,
the most recent period gets the highest weight and the oldest periodgets the smallest. The summed weighted prices are then divided by
the sum of the weights
Comparing the EMA,WMA and Simple Moving Averages
The simple moving average gives equal weight to all data points. By nature, it is the
"true" average. The exponential and weighted moving averages give the most recent
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data points the highest rankings or "weightings". Therefore, the simple moving
average tends to lag (by representing all data points equally) the exponential and
weighted moving averages during large price changes. However, during "normal" or
"flat" markets the differences become negligible. This is illustrated in figure below.
March 2000 Bonds with 50-day Simple, Exponential and Weighted Moving
Averages. Notice during "normal" or "flat" markets the averages tend to run
together (a). However, once the market begins to make sharp moves (b) and
(c) the EMA and WMA tends to catch up to price faster while the SimpleMoving Average tends to lag.
Which One to Use?
Deciding between the types of moving averages really becomes a matter of personal
preference. Normally when you hear talk of moving averages, in the media it
normally refers to simple moving averages. Therefore, due to widespread focus on
these numbers, it's important to give them consideration. The 50- and 200-day
(simple) moving averages are most commonly used here. As a trader, especially
during large price moves, you might consider experimenting with exponential or
weighted moving averages.
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INDICATORS AND OSCILLATORS
Indicators are calculations based on the price and the volume of a security that
measure such things as money flow, trends, volatility and momentum. Indicators areused as a secondary measure to the actual price movements and add additional
information to the analysis of securities. Indicators are used in two main ways: to
confirm price movement and the quality of chart patterns, and to form buy and sell
signals.
There are two main types of indicators: leading and lagging. A leading indicator
precedes price movements, giving them a predictive quality, while a lagging indicator
is a confirmation tool because it follows price movement. A leading indicator is
thought to be the strongest during periods of sideways or non-trending trading ranges,
while the lagging indicators are still useful during trending periods.
There are also two types of indicator constructions: those that fall in a bounded range
and those that do not. The ones that are bound within a range are called oscillators -
these are the most common type of indicators. Oscillator indicators have a range, for
example between zero and 100, and signal periods where the security is overbought
(near 100) or oversold (near zero). Non-bounded indicators form buy and sell signals
along with displaying strength or weakness, but they vary in the way they do this.
The two main ways that indicators are used to form buy and sell signals in technical
analysis is through crossovers and divergence. Crossovers are the most popular and
are reflected when either the price moves through the moving average, or when two
different moving averages cross over each other.
The second way indicators are used is through divergence, which happens when
the direction of the price trend and the direction of the indicator trend are moving
in the opposite direction. This signals to indicator users that the direction of the
price trend is weakening.
Indicators that are used in technical analysis provide an extremely useful source of
additional information. These indicators help identify momentum, trends,
volatility and various other aspects in a security to aid in the technical analysis of
trends. It is important to note that while some traders use a single indicator solely
for buy and sell signals, they are best used in conjunction with price movement,
chart patterns and other indicators.
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Indicators used in Technical Analysis
Accumulation/Distribution Line - Combines price and volume to show how money may be
flowing into or out of a stock.
Aroon - Shows whether a stock is trending or oscillating.
Average Directional Index (ADX) - Shows whether a stock is trending or oscillating.
Average True Range (ATR) - Measures a stock's volatility.
Bollinger Bands %B - Shows the relationship between price and Bollinger Bands.
Bollinger Bandwidth - Shows the distance between the upper band and the lower band. .
Commodity Channel Index (CCI) - Shows a stock's variation from its 'typical' price.
Chaikin Money Flow (CMF) - Combines price and volume to show how money may be
flowing into or out of a stock. Alternative to Accumulation/Distribution Line.
Chaikin Oscillator - Combines price and volume to show how money may be flowing into or
out of a stock. Based on Accumulation/Distribution Line.
Detrended Price Oscillator (DPO) - A price oscillator that uses a displaced moving average to
identify cycles.
Force Index - A simple price-and-volume oscillator.
MACD - A momentum oscillator based on the difference between two EMAs.
MACD-Histogram - A momentum oscillator that shows the difference between MACD and its
signal line.
Money Flow Index (MFI) - Combines a stock's 'typical' price with its volume to show how
money may be flowing into or out of the stock.
On Balance Volume (OBV) - Combines price and volume in a very simple way to show how
money may be flowing into or out of a stock.
Percentage Price Oscillator (PPO) - A percentage-based version of the MACD indicator.
Percentage Volume Oscillator (PVO) - The PPO indicator applied to volume instead of price.
Price Relative - Technical indicator that compares the performance of two stocks to each other
by dividing their price data.
Rabbitt Q-Rank - Paul Rabbit's proprietary indicator that rates a stock based on technical and
fundamental factors. Rate of Change (ROC) - Shows the speed at which a stock's price is changing.
Relative Strength Index (RSI) - Shows how strongly a stock is moving in its current direction.
Slope - Measures the rise-over-run for a linear regression.
Standard Deviation (Volatility) - A statistical measure of a stock's volatility.
Stochastic Oscillator - Shows how a stock's price is doing relative to past movements. Fast,
Slow and Full Stochastics are explained.
StochRSI - Combines Stochastics with the RSI indicator. Helps one see RSI changes more
clearly.
TRIX - A triple-smoothed moving average of price movements.
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Ultimate Oscillator - Combines long-term, mid-term and short-term moving averages into one
number.
Williams %R - Uses Stochastics to determine overbought and oversold levels.
Market Indicators
Arms Index (TRIN) - A breadth indicator derived from the AD Ratio and AD Volume Ratio.
Advance-Decline Line - A cumulative breadth indicator derived from Net Advances.
Advance-Decline Volume Line - A cumulative breadth indicator derived from Net Advancing
Volume.
Bullish Percent Index - A breadth indicator derived from the percentage of stocks on PnF buy
signals.
High-Low Index - A breadth indicator that shows new highs as a percentage of new highs plusnew lows.
McClellan Oscillator - A MACD type oscillator of Net Advances.
McClellan Summation Index - A cumulative indicator based on the McClellan Oscillator.
Net New Highs - A breadth indicator showing the difference between new highs and new
lows. Percentage, cumulative and smoothed versions can be used.
Percent Above Moving Average - A breadth oscillator that measure the percentage of stocks
above a specific moving average.
Put Call Ratio - A sentiment indicator found by dividing put volume by call volume.
Record High Percent - A 10-day moving average of the High-Low Index, which is a breadth
indicator.
Volatility Indices - Indicators of implied volatility designed to measure fear and complacency
for a range of indices and ETFs.
Important Indicators
Accumulation/Distribution Line
The accumulation/distribution line is one of the popular volume indicators that
measures money flows in a security. This indicator attempts to measure the ratio of
buying to selling by comparing the price movement of a period to the volume of that
period.
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Calculated as:
Acc/Dist = ((Close - Low) - (High - Close)) / (High - Low) * Period's Volume
This is a non-bounded indicator that simply keeps a running sum over the period of
the security. Traders look for trends in this indicator to gain insight on the amount of
purchasing compared to selling of a security. If a security has an
accumulation/distribution line that is trending upward, it is a sign that there is more
buying than selling.
Average Directional Index
The average directional index (ADX) is a trend indicator that is used to measure the
strength of a current trend. The indicator is seldom used to identify the direction of the
current trend, but can identify the momentum behind trends.
The ADX is a combination of two price movement measures: the positive directional
indicator (+DI) and the negative directional indicator (-DI). The ADX measures the
strength of a trend but not the direction. The +DI measures the strength of the upward
trend while the -DI measures the strength of the downward trend. These two measures
are also plotted along with the ADX line. Measured on a scale between zero and 100,
readings below 20 signal a weak trend while readings above 40 signal a strong trend.
Aroon
The Aroon indicator is a relatively new technical indicator that was created in 1995.
The Aroon is a trending indicator used to measure whether a security is in an uptrendor downtrend and the magnitude of that trend. The indicator is also used to predict
when a new trend is beginning.
The indicator is comprised of two lines, an "Aroon up" line (blue line) and an "Aroon
down" line (red dotted line). The Aroon up line measures the amount of time it has
been since the highest price during the time period. The Aroon down line, on the other
hand, measures the amount of time since the lowest price during the time period. The
number of periods that are used in the calculation is dependent on the time frame that
the user wants to analyze.
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Aroon Oscillator
An expansion of the Aroon is the Aroon oscillator, which simply plots the difference
between the Aroon up and down lines by subtracting the two lines. This line is then
plotted between a range of -100 and 100. The centerline at zero in the oscillator is
considered to be a major signal line determining the trend. The higher the value of the
oscillator from the centerline point, the more upward strength there is in the security;
the lower the oscillator's value is from the centerline, the more downward pressure. A
trend reversal is signaled when the oscillator crosses through the centerline. For
example, when the oscillator goes from positive to negative, a downward trend is
confirmed. Divergence is also used in the oscillator to predict trend reversals. A
reversal warning is formed when the oscillator and the price trend are moving in an
opposite direction.
The Aroon lines and Aroon oscillators are fairly simple concepts to understand but
yield powerful information about trends. This is another great indicator to add to any
technical trader's arsenal.
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Moving Average Convergence Divergence
The moving average convergence divergence (MACD) is one of the most well known
and used indicators in technical analysis. This indicator is comprised of two
exponential moving averages, which help to measure momentum in the security. The
MACD is simply the difference between these two moving averages plotted against a
centerline. The centerline is the point at which the two moving averages are equal.
Along with the MACD and the centerline, an exponential moving average of the
MACD itself is plotted on the chart. The idea behind this momentum indicator is to
measure short-term momentum compared to longer term momentum to help signal the
current direction of momentum.
MACD= shorter term moving average - longer term moving average
When the MACD is positive, it signals that the shorter term moving average is above
the longer term moving average and suggests upward momentum. The opposite holds
true when the MACD is negative - this signals that the shorter term is below the
longer and suggest downward momentum. When the MACD line crosses over the
centerline, it signals a crossing in the moving averages. The most common moving
average values used in the calculation are the 26-day and 12-day exponential moving
averages. The signal line is commonly created by using a nine-day exponential
moving average of the MACD values. These values can be adjusted to meet the needs
of the technician and the security. For more volatile securities, shorter term averages
are used while less volatile securities should have longer averages.
Another aspect to the MACD indicator that is often found on charts is the MACD
histogram. The histogram is plotted on the centerline and represented by bars. Each
bar is the difference between the MACD and the signal line or, in most cases, the
nine-day exponential moving average. The higher the bars are in either direction, the
more momentum behind the direction in which the bars point.
As you can see in Figure below, one of the most common buy signals is generated
when the MACD crosses above the signal line (blue dotted line), while sell signals
often occur when the MACD crosses below the signal.
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MACD Top Bearish DivergenceIncreasing highs but decreasing macds for last two tops->shortterm bearish
MACD top Bullish DivergenceDecreasing highs but increasing macds for last two tops->shortterm bullish
MACDBottom BullishDivergence
Decreasing lows but increasing macds for last two bottoms->shortterm bullish
MACDBottom Bearish
Divergence
Increasing lows but decreasing macds for last two bottoms->short
term bearish
MACDBullish MACD Crossoverat Center
The MACD fastline has crossed over the MACD smoothed line atcenter->short term very bullish
MACDBearish MACD Crossoverat Center
The MACD fastline has crossed below the MACD smoothed lineat center->short term very bearish
MACD Bullish MACD CrossoverThe MACD fastline has crossed over the MACD smoothed line ->short term bullish
MACDBearish MACD Crossoverat Center
The MACD fastline has crossed below the MACD smoothed line ->short term bearish
Relative Strength Index
The relative strength index (RSI) is another one of the most used and well-known
momentum indicators in technical analysis. RSI helps to signal overbought and
oversold conditions in a security. The indicator is plotted in a range between zero and
100. A reading above 70 is used to suggest that a security is overbought, while a
reading below 30 is used to suggest that it is oversold. This indicator helps traders to
identify whether a security’s price has been unreasonably pushed to current levels and
whether a reversal may be on the way.
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The standard calculation for RSI uses 14 trading days as the basis, which can be
adjusted to meet the needs of the user. If the trading period is adjusted to use fewer
days, the RSI will be more volatile and will be used for shorter term trades.
RSI RSI Bullish Crossover RSI has crossed over 50 ->short term bullish
RSI RSI Bearish Crossover RSI has crossed below 50->short term bearish
RSIRSI Over BoughtBuried
The RSI has been above 70 for a minimum of 3 trading sessions->shortterm bullish
RSI RSI Over Sold BuriedThe RSI has been below 30 for a minimum of 3 trading sessions->shortterm bearish
RSI RSI Over Sold The RSI is above 65 but not buried->short term bearish
RSI RSI Over Bought The RSI is below 25 but not buried->short term bullish
On-Balance Volume
The on-balance volume (OBV) indicator is a well-known technical indicator that
reflect movements in volume. It is also one of the simplest volume indicators to
compute and understand.
The OBV is calculated by taking the total volume for the trading period and assigning
it a positive or negative value depending on whether the price is up or down during
the trading period. When price is up during the trading period, the volume is assigned
a positive value, while a negative value is assigned when the price is down for the
period. The positive or negative volume total for the period is then added to a total
that is accumulated from the start of the measure.
It is important to focus on the trend in the OBV - this is more important than the
actual value of the OBV measure. This measure expands on the basic volume measure
by combining volume and price movement.
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Stochastic Oscillator
The stochastic oscillator is one of the most recognized momentum indicators used in
technical analysis. The idea behind this indicator is that in an uptrend, the price should
be closing near the highs of the trading range, signaling upward momentum in the
security. In downtrends should be closing near the lows of the trading range, signaling
downward momentum, the price
The stochastic oscillator is plotted within a range of zero and 100 and signals
overbought conditions above 80 and oversold conditions below 20. The stochastic
oscillator contains two lines. The first line is the %K, which is essentially the raw
measure used to formulate the idea of momentum behind the oscillator. The second
line is the %D, which is simply a moving average of the %K. The %D line isconsidered to be the more important of the two lines as it is seen to produce better
signals. The stochastic oscillator generally uses the past 14 trading periods in its
calculation but can be adjusted to meet the needs of the user.
StochStochastic Overbought
Buried
The fast stochastic is above 80 and has averaged above 80 for the past
5 trading sessions->short term bullish
StochStochastic OversoldBuried
The fast stochastic is below 20 and has averaged below 20 for the past5 trading sessions->short term bearish
StochStochastic OverboughtReversal
The stochastic has fallen below 80 after being buried ->short termbearish
StochStochastic OversoldReversal
The stochastic has crossed above 20 after being buried ->short termbullish
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OVERLAYS
Bollinger Bands - A chart overlay that shows the upper and lower limits of 'normal' price
movements based on the Standard Deviation of prices.
Ichimoku Clouds - A comprehensive indicator that defines support and resistance, identifies
trend direction, gauges momentum and provides trading signals.
Keltner Channels - A chart overlay that shows upper and lower limits for price movements
based on the Average True Range of prices.
Moving Averages - Chart overlays that show the 'average' value over time. Both Simple
Moving Averages (SMAs) and Exponential Moving Averages (EMAs) are explained.
Moving Average Envelopes - A chart overlay consisting of a channel formed from simple
moving averages.
Parabolic SAR - A chart overlay that shows reversal points below prices in an uptrend and
above prices in a downtrend.
Price Channels - A chart overlay that shows a channel made from the highest high and lowest
low for a given period of time.
Volume by Price - A chart overlay with a horizontal histogram showing the amount of activity
at various price levels.
Volume-weighted Average Price (VWAP) - An intraday indicator based on total dollar value of
all trades for the current day divided by the total trading volume for the current day.
ZigZag - A chart overlay that shows filtered price movements that are greater than a given
percentage.
Bollinger bands
Bollinger bands consist of a center line and two price channels (bands) above and
below it. The center line is an exponential moving average; the price channels are the
standard deviations of the stock being studied. The bands will expand and contract asthe price action of an issue becomes volatile (expansion) or becomes bound into a
tight trading pattern (contraction).
A stock may trade for long periods in a trend, albeit with some volatility from time to
time. To better see the trend, traders use the moving average to filter the price action.
This way, traders can gather important information about how the market is trading.
For example, after a sharp rise or fall in the trend, the market may consolidate, trading
in a narrow fashion and criss-crossing above and below the moving average. To better
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monitor this behavior, traders use the price channels, which encompass the trading
activity around the trend.
We know that markets trade erratically on a daily basis even though they are still
trading in an uptrend or downtrend. Technicians use moving averages with support
and resistance lines to anticipate the price action of a stock. Upper resistance and
lower support lines are first drawn and then extrapolated to form channels within
which the trader expects prices to be contained. Some traders draw straight lines
connecting either tops or bottoms of prices to identify the upper or lower price
extremes, respectively, and then add parallel lines to define the channel within which
the prices should move. As long as prices do not move out of this channel, the trader
can be reasonably confident that prices are moving as expected.
When stock prices continually touch the upper Bollinger band, the prices are thought
to be overbought; conversely, when they continually touch the lower band, prices are
thought to be oversold, triggering a buy signal.
When using Bollinger bands, designate the upper and lower bands as price targets. If
the price deflects off the lower band and crosses above the 20-day average (the middle
line), the upper band comes to represent the upper price target. In a strong uptrend,
prices usually fluctuate between the upper band and the 20-day moving average.
When that happens, a crossing below the 20-day moving average warns of a trend
reversal to the downside.
While every strategy has its drawbacks, Bollinger bands have become one of the most
useful and commonly used tools in spotlighting extreme short-term prices in a
security. Buying when stock prices cross below the lower Bollinger band often helps
traders take advantage of oversold conditions and profit when the stock price moves
back up toward the center moving-average line.
You can see in this chart of American Express (NYSE:AXP) from the start of 2008 that for the most part,the price action was touching the lower band and the stock price fell from the $60 level in the dead of
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winter to its March position of around $10. In a couple of instances, the price action cut through the centerline (March to May and again in July and August), but for many traders, this was certainly not a buy signalas the trend had not been broken
In the 2001 chart of Microsoft Corporation (Nasdaq:MSFT) (above), you can see the trend reversed to an uptrend in the early part of January,
but look how slow it was in showing the trend change. Before the price action crossed over the center line, the stock price had moved from $20
to $24 and then on to between $24 and $25 before some traders would have confirmation of this trend reversal.
Parabolic SAR (SAR - stop and reverse) is a method used to find trends in marketprices or securities. It may be used as a trailing stop loss based on prices tending to
stay within a parabolic curve during a strong trend.
The concept draws on the idea that time is the enemy (similar to option theory's
concept of time decay), and unless a security can continue to generate more profits
over time, it should be liquidated. The indicator generally works well in trending
markets, but provides "whipsaws" during non-trending, sideways phases; as such, it is
recommended establishing the strength and direction of the trend first through the use
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of things such as the Average Directional Index, and then using the Parabolic SAR to
trade that trend.
A parabola below the price is generally bullish, while a parabola above is generally
bearish.
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TECHNICAL ANALYSIS IN PRACTICE.
Above chart shows use of trends, indicators, overlays for technical analysis
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REAL LIFE PREDICTION AND OUTCOMES
Application of technical analysis in real life situation is taken up as follows.
Predictions by technical experts were taken up from Economic time archives e-paper. Relevant technical charts were prepared using tools in websites like
www.moneycontrol.com and www.in.finance.yahoo.com as well as using the
Microsoft Excel Add In analyzer Trend Analyzer XL.
Charts are plotted using these tools till the date or range of prediction. About 25
cases were studied. The success rate of predictions was seen to be less than 50%.
This is attributed to the abnormal market reactions. Technical analysis works on
past history. It cannot take care of government policy changes in interest rates,
taxation etc. International markets and commodities also cause sudden variation in
pricing. Unexpected financial results of companies also changes trends.
Trend Analyzer in Action
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Date 3rd July 2010
The Axis bank case is again taken after two months when the RSI and MACD startedturning positive. This was clear buy call and the ramp up in July shows that theanalysis was correct.
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Date 1st July 2010
From mid July onwards the scrip was trading way above 50 day EMA and this isstrong indication to buy. The ramp that followed led to nearly 33% growth.
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Date 3nd September 2010
High volumes along with sideways consolidation for long period was the indicationfor the ramp up which turned out to be correct
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Head and shoulder pattern formation is a good indicator which proved correct in thiscase.
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Here we see that the stochastic oscillator provided with good buy calls in the SBI
growth line. Also the stock kept trading at levels above 200 day EMA which showsgreater demand
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This is a 10 year chart. High volumes of SBI cause SBI shares to be overbought oroversold. This is why the RSI oscillators keep swinging above and below the 70% and30% line continuously. When the MACD rises dramatically - that is, the shortermoving average pulls away from the longer-term moving average - it is a signal thatthe security is overbought and will soon return to normal levels.
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In the six month period the strong reversal patters are brought out by MACD and RSIalong with spurts in volume.
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Again the huge volumes show the crowd behaviour and overbuying and selling in themarket in the 10 year period of reliance.
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Tools Used
AnalyzerXL is a library of 165 technical analysis functions, indicators and experts in
the form of Microsoft Excel formulas. The AnalyzerXL Wizard makes it easy to
implement a new function and simplifies the creation of trading systems. It is also
easy to create charts from functions with numeric outputs - just click the Chart icon
and select the type of chart one wish to create.
Types of Functions
An indicator is used to determine the trend of a market, the strength of the market
and the direction of the market. An expert is a stock market system such as Bill
Williams' Profitunity. Expert functions produce special outputs, such as Buy/Sell
signals, trend directions and more.
Types of Outputs
All functions are categorized by the type of output they produce. There are two types
of outputs: Formulas and Values. Formulas are automatically re-calculated when
one change input data, whereas Values remain the same. With Formulas, one do not
need to re-enter range references or function parameters when one update data.
Macros
For functions that output Values, AnalyzerXL provides a macro-building feature to
improve the updating process. These macros can easily be called when one update
oner data. There are two types of macros: Local and Global. Local macros can only
be called from the workbook in which they were created, whereas Global macros can
be called from any workbook.
Key features summary:
165 technical analysis functions, indicators, and experts
Built-in charts for more accurate analysis
Macro creation and management
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SELECTION OF INDICATORS/OSCILLATORS/OVERLAYS
A good rule of thumb is to restrict technical analysis to stocks that trade at least
100,000 shares per day so that there is a liquid market for the stock.
1) Objective: Every indicator has its own special feature and while choosing
which one to use, one should be very clear about the objective. Let’s For eg: to
identify whether the market is consolidating or trending, the Bollinger Bands is a
good choice as the width of the band will be able to tell one the answer.
But for an entry decision while scalping the market, one may need the help of
parabolic SAR. In short one need different tools for different strategy.
2) Variety: Some indicators like the Relative Strength Index (RSI), Stochastic and
Commodity Channel Index (CCI) are oscillating in nature. They are able to tell
whether the market is overbought or oversold. Therefore there is no point in
having a RSI and a CCI together in one chart as they are of the same nature.
A mix of indicators with different ability is used so that one can tell more things
from them when doing my analysis.
3) Quantity: Some traders tend to use a lot of indicators as they believe that it can
help them to have a better understanding of the market. In contrast, these traders
usually have difficulties in getting into a trade as it is very hard for all the
indicators to give them the same entry signal at the same time.
Therefore stick to a maximum of 3 indicators for trading if one is able to get the same
signal from them, one can enter my trade.
When technical tools are used judiciously, their value cannot be overstated. And every
time one apply a tool of technical analysis, one is calculating a consensus of
bullishness or bearishness among all market participants.
For example, the moving average convergence-divergence (MACD) is simply a tool
that measures shifts in consensus from bullishness to bearishness, and vice versa.
Extending the basic MACD to a deeper level, we find the MACD-histogram, which isactually a tool for determining the difference between long-term and short-term
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consensus of value. The measure tracks the difference between the fast MACD line
(short-term consensus) and the slow signal line (longer-term consensus).
The principles of market psychology underlie each and every technical indicator, so a
good understanding of crowd behavior is crucial to the understanding of the
fundamentals of particular technical indicators. How market psychology drives these
individual tools is described below.
The Directional System
The directional system (which one can read about in Directional Movement) was
developed by J. Welles Wilder, Jr., as a means of identifying trends that are strong
enough to be valid and useful indicators for traders. Directional lines are constructedto determine whether trends are bullish or bearish: when a positive directional line is
above the negative line, bullish traders possess greater strength (and a bullish signal is
given). The opposite situation indicates bearishness. More telling is the average
directional indicator (ADX), which rises when the spread between the positive and
negative lines increases. When the ADX rises, winners are getting ever stronger, and
losers are getting weaker; furthermore, the trend is likely to continue.
Momentum and Rate of Change (RoC)
Momentum indicators measure (which one can read about in Rate of Change) changes
in mass optimism or pessimism by comparing today's consensus of value (price) to an
earlier consensus of value. Momentum and RoC are specific measures against which
actual prices are compared: when prices rise but momentum or rate of change falls, a
top is likely near. If prices reach a new high but momentum or RoC reach a lower top,
a sell signal is realized. These rules also apply in the opposite situation, when prices
fall or new lows are reached.
Smoothed Rate of Change
The smoothed rate of change compares today's exponential moving average (average
consensus) to the average consensus of some point in the past. The smoothed rate of
change is simply an enhanced version of the RoC momentum indicator - it is intended
to alleviate the RoC's potential for errors in determining the market's attitude of
bullishness or bearishness.
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Williams %R (Wm%R)
Wm%R, a measure focusing on closing prices, compares each day's closing price to a
recent consensus range of value (range of closing prices). If, on a particular day, bulls
are able to push the market to the top of its recent range, Wm%R issues a bullish
signal; and a bearish signal is issued if bears are able to push the market to the bottom
of its range.
Stochastics
Similar to Wm%R, stochastics measure closing prices against a range. If bulls push
prices up during the day but cannot achieve a close near the top of the range,stochastic turns down and a sell signal is issued. The same also holds true if bears
push prices down but cannot achieve a close near the low, in which case a buy signal
is issued.
Relative Strength Index (RSI)
RSI measures market psychology also in a fundamentally similar way to that of
Wm%R. RSI is almost always measured with a computer, typically over a seven or
nine-day range, producing a numerical result between 0 to 100 that points to oversold
or overbought situations; the RSI therefore gives a bullish or bearish signals
respectively.
Volume
The total volume of shares traded is also an excellent way in which to ascertain the
psychology of the market. Volume is actually a measure of investors' emotional state:
while a burst of volume will cause sudden pain in losers and immediate elation in
winners, low volume will likely not result in a significant emotional response.
The longest lasting trends generally occur where emotion is the lowest. When volume
is moderate and both shorts and longs do not experience the roller coaster ride of
emotion, the trend can reasonably be expected to continue until the emotion of the
market changes. In a longer-term trend such as this, small price changes either up or
down do not precipitate much emotion, and even a series of small changes occurring
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day-after-day (enough to create a major, gradual trend) will generally not generate
severe emotional reactions. This is a classic example of how traders are lulled into a
feeling of complacency - small losses (even a series of small daily or weekly losses)
do not feel particularly devastating; but the series of small losses will, in a few weeks
or months, aggregate into one very large loss.
Volume can be interpreted to predict trend reversals. While moderate and steady
volume point to a sustained gradual trend due to the lack of emotion in the market,
falling volume may indicate that losers have finally thrown in the towel and that the
trend is near its top or bottom. Exceptionally high volume may demonstrate that a
great many losers have given up and are selling at any cost. This is true collectivepsychology at work: amateur traders and investors who are holding losing positions
typically reach their breaking point at roughly the same time. A huge burst of volume
in a declining market may indicate that even the most patient stalwarts have raised the
white flag, which is a classic signal that the bottom is high.
In the case of short selling, a market rally may serve to flush out those individuals
holding short positions, causing them to cover and subsequently push the market
higher. The same principle holds true on the flip side: when the longs give up and bail
out, the decline pulls more losers with it (even the most resilient loser reaches his
breaking point). At the most fundamental level of market volume, both short and long
losers who collectively exit their positions are the primary drivers behind significant
volume trends.
Believe it or not, the preceding indicators are only a few basic examples of how
market psychology is measured. There are a great number of additional indicators
used in trading rooms everywhere, not to mention a near-infinite selection of
variations and refinements possible.
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STEPS IN TECHNICAL ANALYSIS
Now that we have the theory and the tools, let’s look at the process of going from a
stock idea to an actual decision to buy or sell.1. Look at the trend
We want a rising trend or one that is just starting to do so.
2. Find nearby support and resistance levels
We are trying to find stocks where demand exceeds supply and new supply
is not likely to develop soon.
3. Determine if the current trend is healthy
We want prices to be above a relevant moving average, but not so far that
the stock is prone to a snapback decline as profit taking sets in.
4. Check volume and momentum indicators
We need to be sure that they are not fading as the stock price rises: A falling indicator
warns that there might be technical problems before price action sours.
5. Find out if the stock is leading a benchmark
Is the particular stock at least matching the performance of the market and its peers?
Find obvious patterns and trends
Check an indicator or two
Compare current condition to others
As has been said several times already, there are five major categories of tools in a
complete technical toolbox, and novice chartists need only to have a basic
understanding of what they do.
The three basic goals of the tools
1. Seeing where the stock is currently trading and figuring out how it got there
This is where we explore charting tools such as:
• stock trends,
•support levels (that point at which a stock is trading at which demand is thought to be
strong enough to prevent the price from declining further), and
•resistance levels (that price at which selling is thought to be strong enough to prevent
the price from rising further).
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We’ll also try to find a pattern or a trend to help.
2. Determining the power of a trend
This is also where we can find signs of an imminent end of a trend. For that, we will
look at important technical concepts such as trading volume and momentum.
3. Making comparisons of the stock to the market, its peers in its own industry and
even to its own history
This is where we look at relative performance and moving averages. We have not
covered relative performance of a stock to its industry group yet, but it is simpleenough to cover directly here.
If we know how fast a stock is moving, how much power is behind it and how it
stacks up to the market, then we’ll gain a huge advantage over other investors looking
only at the fundamentals (such as price-to-earnings ratios, return on equity, or
earnings growth).
A solid company with a solid chart is hard to beat.
Checklist for success
In looking at a stock, here is a checklist of key technical tools. Any potential
investment should meet most, but not necessarily all, of these criteria.
Price structure
Trends and trendlines
There is no secret to finding a trend. If prices are generally rising and making higher
highs as well as higher lows, then we have a rising trend. Most charting web sites also
offer the ability to draw trendlines on the chart to clearly define the trend more
objectively. Alternatively, the old-fashioned way of printing the chart and using a
ruler and pencil works just as well. We want stocks that are in rising trends.
Support and resistance
These are terms that simply tell us what price levels are likely to bring out the buyers
(demand) or the sellers (supply), respectively. What we want to see is a current price
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that has either just moved through resistance (demand overwhelmed supply) or one
that is far from the next resistance level.
Moving averages
Moving averages (or simply price averages) are just average prices over a user-
defined period of time, usually 50 or 200 days. They help us determine if a trend is
turning, as prices cross the averages. They also help us determine if an existing trend
is progressing in an orderly manner, or if it is accelerating in a frenzy. Clearly, we are
looking for prices to be above selected averages but not too far above them.
Relative performance
Relative performance charts simply divide the price of a stock by a relevant market
index or industry group. The theory is that we should buy strong stocks in strongsectors and this is how we find them. If the ratio is going up, then the stock is
outperforming the market or industry and is thus a strong candidate for further gains.
If the ratio is going down, then the stock is lagging and is often more vulnerable to
bad news. We are looking for stocks whose relative performance is increasing.
Volume
The number of shares traded and when those shares trade – either on days when prices
rise or when they fall – can confirm the health of a trend or warn of an impending
change. We are looking to see if buying is spreading to other investors and for
urgency for all to buy when prices start to rise. Fear of missing a good thing causes
these surges.
Momentum
We also want to know if days when the stock rises outnumber those when it falls. Are
the gains on these positive days greater than the losses on negative days? When the
losing days are bigger and more frequent than the winning days we can surmise that
the trend is weakening. We want to know if momentum is strong but not too euphoric.
Sentiment
We’ll just worry about obvious extremes in sentiment, as this portion of the analysis is
tricky even for the pros. Is everybody thinking the same thing? That’s the time to go
the other way. And as some traders will say, sometimes the best trades are the ones
that make you sick as you leave the comfort of the crowd. We want to know if
everyone is thinking the same thing.
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CONCLUSIONS
Technical analysis is based on evaluation of past prices and volume traded of the
stock. Followers of technical analysis are known as chartist as they look at the pastprices of the stock and identify patterns and trends. They do so to forecast through the
charts and prices what the stock will do in the future. The methodology involves
studying the supply and demand in the market to attempt what direction or trend will
continue in the future. There are many useful tools that have been developed to help
aid in this process. Most of them are automated and freely available for use.
Technical analysis can be a very valuable tool, but it is important to realize the
benefits as well as the limitations before diving in. Lot of subjectivity is there in
reading of patterns. It cannot take care of future events. However it can give a
scientific reason for the prediction based on current and past positions. There is no
definite answer about whether technical analysis should be used as a substitute to
fundamental analysis, but many agree that it has its merits when used as a compliment
to other investing strategies.
BIBLIOGRAPHY OF REFERENCES
Books:
1. The Technical analysis Course: Thomas A Meyers. Tata McGraw Hill
2. Technical Analysis Tools: March Tinghino, Bloomberg
Websites for data and analysis:
1. http://www.stockta.com
2. http://www.analyzerxl.com
3 http://in finance yahoo com