Technical Analysis

Technical analysis involves a study of market generated data like prices and volumes to determine the future direction of price movement.

A technical analyst believes that share prices are determined by the demand and supply forces operating in the market.

Basic Premises of Technical Analysis

Market prices are determined by the interaction of supply and demand forces.

Supply and demand are influenced by a variety of factors. These include fundamental factors as well as psychological factors.

Barring minor deviations, stocks prices tend to move in fairly persistent trends.

Basic Premises of Technical Analysis

Shifts in demand and supply bring about changes in trends.

Irrespective of why they occur, shifts in demand and supply can be detected with the help of charts of market action.

Because of the persistent of trends and patterns, analysis of past market data can be used to predict future price behaviour.

Technical Analysis Vs Fundamental Analysis

Technical Analysis Fundamental Analysis

1. Technical analysis mainly seeks to predict short-term price movements.

2. The focus of the technical analysis is mainly on internal market data, particularly price and volume data.

3. Technical analysis appeals mostly to short-term traders.

Fundamental analysis tries to establish long-term values.

The focus of fundamental analysis is on fundamental factors relating to economy, the industry, and the firm.Fundamental analysis appeals primarily to long-term investors.

Charting Techniques

Technical analysts use a variety of charting techniques.

The most popular ones seem to be the Dow theory, bar and line charts, the point and figure chart, the moving average line, and the relative strength line.

Basic concepts underlying chart analysis

Trends: The key belief of the chartists is that stock prices tend to move in fairly persistent trends.

Stock price behaviour is characterized by inertia: the price movement continues along a certain path (up, down, or sideways)until it meets an opposing force, arising out of an altered supply-demand relationship.

Basic concepts underlying chart analysis

Relationship between volume and trends: Chartists believe that generally volume and trend go hand in hand.

When a major upturn begins, the volume of trading increases as the price advances and decreases as the price declines.

In a major downturn, the opposite happens: the volume of trading increases as the price declines and decreases as the price rallies.

Basic concepts underlying chart analysis

Support and Resistance Levels: Chartists assume that it is difficult for the price of a share to rise above certain level called the resistance level and fall below a certain level called a support level.

Resistance and Support

Resistance

Support

Resistance/Support

Dow Theory

Originally proposed in the late nineteenth century by Charles H.Dow, the editor of the The Wall Street Journal, the Dow theory is perhaps the oldest and best known theory of technical analysis.

Charles Dow formulated a hypothesis that the stock market does not move on a random basis but is influenced by three distinct cyclical trends that guide its direction.

Dow Theory

According to Dow theory , the market has three movements and these three movements are simultaneous in nature.

These movements are the1. The primary movements2. Secondary reactions3. Minor movements

Dow Theory

Primary Movement: The primary movement is the long range cycle that carries the entire market up or down. This is long-term trend in the market.

Secondary reactions: The secondary reactions act as a restraining force on the primary movement.

These are in the opposite direction to the primary movement. These are also known as corrections.

For Example: When the market is moving upwards continuously, this upward movement will be interrupted by downward movements of short durations. These are secondary reactions.

Dow Theory

Minor movement: The third movement in the market is the minor movements which are the day-to-day fluctuations in the market.

The minor movements are not significant and have no analytical value as they are of very short duration.

Dow Theory

According to Dow theory, the price movements in the market can be identified by means of a line chart.

In this chart, the closing prices of shares or the closing values of the market index may be plotted against the corresponding trading days.

The chart would help in identifying the primary and secondary movements.

Bullish Trend

During a bull market (upward moving market), in the first phase the prices would advance with the revival of confidence in the future business.

During the second phase, prices would advance due to the improvements in the corporate earning.

In the third phase, prices advance due to inflation and speculation

Bullish Trend

During the bull market, the line chart would exhibit the formation of three peaks.

Each peak would be followed by a bottom formed by the secondary reaction.

Each peak would be higher than the previous peak, and each successive bottom would be higher than the previous bottom.

According to Dow theory, the formation of higher bottoms and higher tops indicates a bullish trend.

Bearish Trend

The bear market is also characterized by three phases.

In the first phase, prices begin to fall due to abandonment of hopes. Investors begin to sell their shares.

In the second phase, companies start reporting lower profits and lower dividends. This causes further fall in prices due to increased selling pressure.

In the final phase, prices fall still further due to distress selling.

A bearish market would be indicated by the formation of lower tops and lower bottoms.

Efficient Market Theory

Efficient market theory states that the share price fluctuations are random and do not follow any regular pattern.

Efficient Market Theory – Basic Concepts

Market Efficiency: The expectations of the investors regarding the future cash flows are translated or reflected on the share prices.

The accuracy and the quickness in which the market translates the expectation into prices are termed as market efficiency.

Operational efficiency: At stock exchange operational efficiency is measured by factors like time taken to execute the order and the number of bad deliveries.

Efficient Market Theory – Basic Concepts

Informational efficiency: It is a measure of the swiftness or the market’s reaction to new information.

New information in the form of economic reports, company analysis, political statements and announcement of new industrial policy is received by the market frequently.

The Random Walk Theory

Stock price behaviour is explained by the theory in the following manner.

A change occurs in the price of a stock only because of certain changes in the economy, industry or company.

Information about these changes alters the stock prices immediately and the stock moves to a new level, either upwards or downwards, depending on the type of information.

The Random Walk Theory

According to this theory, changes in stock prices show independent behaviour and are dependent on the new pieces of information that are received.

The basic premise in random walk theory is that the information on changes in the economy, industry and company performances is immediately and fully spread so that all investors have full knowledge of the information.

The Random Walk Theory

The current stock price fully reflects all available information on the stock.

The random walk theory presupposes that the stock markets are so efficient and competitive that there is immediate price adjustment.

The random walk theory is based on the hypothesis that the stock markets are efficient.

This theory later came to be known as the efficient market hypothesis (EMH) or efficient market model.

Efficient Market Hypothesis

This hypothesis states that the capital market is efficient in processing information.

An efficient capital market is one in which security prices equal their intrinsic values at all times, and where most securities are correctly priced.

The efficient market model is actually concerned with the speed with which information is incorporated into security prices.

Efficient Market Hypothesis

The technicians believe that past price sequence contains information about the future price movements because they believe that information is slowly incorporated in security prices.

Fundamentalists believe that it may take several days or weeks before investors can fully assess the impact of new information.

This provides an opportunity to the analyst who has superior analytical skills to earn excess returns.