6 Technical Analysis Mecklai

8/8/2019 6 Technical Analysis Mecklai

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TECHNICAL ANALYSIS


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DOW THEORY

In 1897, Charles Dow developed two broad market averages. The industrialAverage and the Rail Average. These are now known as the Dow Jones Industrial

Average and the Dow Jones Transportation Average. The Theory originally focused

on using general stock market trends as a barometer for general business

conditions. It was not originally intended to forecast stock prices. However,

subsequent work has focused almost exclusively on this use of the Theory.

Dow Theory is concerned with determining the direction of the primary trend of

the market, not the ultimate duration or size of the trend.


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Dow Theory and its six

assumptions The averages discount everything

The individual stocks price reflects

everything that is known about the security

The market comprises three trends

The P rimary, Secondary and Minor trends


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Assumptions continued

The Primary Trend has three phases

First phase backed by economic recovery,

followed by increasing corporate earnings in

the second phase and finally byrecord

corporate earnings in the third phase


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S&P Nifty

A

B

C

Three parts Of Primary Trends


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Assumptions continued

The averages must confirm each other

The industrials and transports must confirm

each other fora valid change of trend to

occur.

The volumes confirms the trend

A trend remains intact until it gives a

definite reversal again


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Summarizing.

The market discounts everything

Fundamental, Psychological, Political, Economic

etc

Prices move in trends - The markets move in

the path of least resistance.

History repeats itself

Mass psychology does not change. Markets overextend because of the herd instinct

leading to panic and euphoria time and again.


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Technical analysis- features

Identification of the current trend i.e. the

direction of price movement and spotting

any trend reversal as early as possible.

Applicable onlywhen prices fluctuate

freely in response to market forces of

demand and supply for the underlying

assets like commodities, stock marketindices, certain heavily traded stocks, etc.


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Technical analysis- featurescontd

More reliable in case of broad and very liquidmarkets than thin and shallow markets.

Helps to judge the emotional state of the market.

The market has its own collective consciousnessdistinct from the individual consciousness of theparticipants.

Historical price and volume data analyzed with

the help of charts.


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Contrast with Fundamental

Analysis Fundamental analysis is concerned with all thefundamental factors.

Technical analysis,on the otherhand, assumes that theprice at any given time is the result of not only thefundamental factors but also the markets collectiveresponse to all the factors.

Often, economists focus on certain fundamentals andprescribe how the market ought to behave when themarket behavior is linked to some other factors.


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CHARTS


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Line Chart

Line chart or the closing price chart is

constructed by plotting the closing prices

on hourly, daily,weeklyormonthly basis

and connecting the same.


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Barchart

Barchart comprises of a series of vertical

lines. Each vertical line represents the

price movement during that unit of time.

The high and low are connected and then

horizontal hashes are drawn on the left

and right torepresent the opening and

closing prices respectively.


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Candle Stick

Japanese candlestick chart differs from

barchart in that the range between the

open and the close is shown as a white or

black rectangle called the real body. The

ranges on eitherside of the real body are

called uppershadow and lowershadow.


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TRENDS


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Trend Lines

Direction of movement. Could be uptrend,downtrend and flat orneutral trend.

Prices move in a zigzag fashion

In an uptrend, the reaction is downwards while in adowntrend, the reaction is upwards.

Zigzag movement gives rise to a series oftops and bottoms or highs and lows.

The relative position of successive highs and lowsdetermine the trend at any given point of time.

Uptrend : series of higherhighs and higherlows.


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An up-trend is defined by a series of higher-highs and higher-lows.

In order for an up-trend to reverse, prices must have at least onelower high and one lower low (the reverse is true of a downtrend).


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Trend Lines

Trend lines are straight lines drawn by

connecting eitherthe highs or the lows.

In an uptrend, 2 ormore rising lows areconnected to denote an uptrend line.

In a downtrend, 2 ormore falling highs are

connected to denote a downtrend line.

A horizontal or flat trend line is drawn by

connecting eitherthe highs or the lows.


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Trend Lines

The importance of a trend line lies in its

ability to indicate the possibilityof a trend

reversal.

Reversal of uptrend signalled by the price

falling below the uptrend line.

Reversal of downtrend indicated by the

price rising above the downtrend line.


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Trend Lines- uptrend


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Trend Lines- downtrend


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Trend Lines- sideways


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Trend Lines- channel


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Trend Reversal


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Finerpoints in Trend Lines

Penetration of a trend line does not necessarily

imply a trend reversal but may indicate just a

temporary pause in the trend.

No fixed rule to judge whethersuch penetrationsignals a pause ora reversal. However,

important clues are often available.

Steepera trend line, greater is the possibilityof

its penetration signaling just a pause and not a

reversal.


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Finerpoints in Trend Lines

As to duration, the longera trend has been in

force, the more powerful is the violation of the

trend line.

Similarly, the more the numberof times a trendline is touched by the price, the stronger the

trend line and more powerful is its penetration.

Finally, trend line penetration accompanied by

rising volumes orbreakout from a reversal

pattern veryoften signals a trend reversal.


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SUPPORT & RESISTANCE


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Support-Resistance

Support is the price level where enough buying

pressure builds up to stop a decline at least

temporarily and prompt a recovery.

Resistance indicates a price level at whichselling pressure mounts to halt an ongoing rally

and start a decline.

Zigzag price movement gives rise to highs and

lows or tops and bottoms.

Tops offerresistance and bottoms offersupport.


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Support


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Resistance


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RETRACEMENT


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Fibonocci Retracement Analysis

Numbersequence - 1,1,2,3,5,8,13,21

Sum of any two consecutive numbers

equals the next highest. The ratioof any numberto its next higher

numberapproaches 0.618 afterthe first 4.

The ratioof any numberto its next lowernumber is 1.618or the reciprocal of 0.618.


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The ratioof alternate numbers approaches

2.618or its reciprocal 0.382.

The most common numbers inretracement analysis are 0.382,0.500 and

0.618


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REVERSALS


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Heads & Shoulders

Most powerful reversal pattern and resembles ahead and two shoulders.

In an uptrend, price declines from a peak to form

the left shoulder. Price then rallies to a new high, called the head

before falling again toornear the previous low.

Now the price rises once more but tops out

lower than the head and near the level of the leftshoulder. This third top is called the rightshoulder.


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Heads & Shoulders

The price then begins to fall and the

pattern is confirmed when the price breaks

and closes below the extended neckline

joining the previous two lows - first low

between the left shoulderand the head

and the second low between the head and

the right shoulder.


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Heads & Shoulders

The head and shoulders breakout is

followed by a sharp down move with

heavy volume before price rallies towards

the neckline on lowervolume. After this

return move, the downtrend usually

resumes.


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Heads & Shoulders


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Heads & Shoulders

Volume plays an important role in the formationof this pattern. Volume is rising when prices areapproaching the top of the left shoulderand dipson the first reaction.When price crosses over

the peak of left shoulder, increase in volume isnot prominent. After the head is formed, pricefalls below the top of the left shoulder indicatingpossibilityof trend change. Price usually findssupport near the previous low and rallies again

but forming a lower top with lowervolume.Finally,when price begins to fall again andbreaks the neckline it is on highervolume.


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Double top reversal pattern

Alsoreferred to as the "M" type reversal pattern.

Price rises to form a top with an increase in volume.

This is f ollowed by a price drop on lowervolume.

Next rally fails to cross the previous peak and endsthereabout forming a second top.

Double top reversal is confirmed when the price falls andcloses below the intervening low.

From this breakout point, the price target equals the

vertical distance between the double top and theintervening low.

Important point to note is that volume should be rising atthe breakout point else the pattern is suspect.


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Double Top


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Rectangle

This pattern aftera sharp up move ora downmove.

Market consolidates in a narrow sideways band

between two parallel lines, much similarto arectangle.

A break over the upperor the lowerchannel linewould result in a big move.

The target of such a move would be the heightof the rectangle (difference between the lowerand upperchannel lines.


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Rectangles


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Moving Averages

Zigzag movement of prices often makes it

difficult to judge the underlying trend. Trendlines

do help as we have already seen.

Anotherpopularway is to smooth the price datawith the help of moving averages.

Technical analysts use three different types of

moving averages - simple moving average,

exponential moving average and weighted

moving average.


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Moving Averages.

We will discuss only the simple moving

average because it is the easiest to

compute and interpret.

The moving average system of trading is

also known as the trend following system

because the traderwaits for the trend to

be established before initiating a trade


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Moving Averages


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Interpretation of MAs

A moving average smoothens the underlyingprice data and represents the trend fortheperiod used to calculate the average.

More importantly, it acts as a curved trendlineproviding support in an uptrend and resistancein a downtrend.

Since the moving average reflects the trend,intersection of the price with the moving averagesignals at least a pause in the trend bywayof acorrection and possibly a trend reversal.


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In an uptrend, both the price and the movingaverage are rising and price is above the movingaverage. If the price were now to move belowthe moving average while the moving average isstill rising, it would probably signal just acorrection.

Aftera while renewed buying usually pushes theprice again over the moving average. If the

moving average is still rising, such a crossoverof the price over the moving average indicatesresumption of the uptrend.


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Interpretation of MAs.

However, caution is indicated if the moving average hasbegun to move sideways. A trend reversal is now morelikely and is signalled when the price again crossesbelow the moving average.

Penetration of a very short term average such as the 5-day average occurs often in long lasting trends and oftensignals temporary pauses in the trend bywayofcorrection orconsolidation. This happens aftera sharpupmove ora downmove when profit-taking sets in a

countertrend move in the opposite direction. However,when prices retrace 50 to60% of the previous move,players who missed the earliermove usually enterleading toresumption of the underlying trend.


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On the otherhand, penetration of say 20-

day average accompanied by a change in

the direction of the moving average itself,

would usually confirm trend reversal or

prolonged and deep correction.


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BollingerBands

Empirical evidence shows that exchange rates

fluctuate around a moving average.

Ordinary bands such as moving average

envelopes are specified as a fixed percentagechannel around a moving average.

An alternate and popularmethod of constructing

bands is based on a moving standard deviation.

Such bands are known as Bollingerbands.


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BollingerBands


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BB-construction

Take a n-period moving average of the pricedata.

Foreach period, calculate the standard

deviation of the price around the movingaverage.

Choose a multiple of the standard deviation andcreate a band around the moving average.

A typical set up is a 20-day moving average withbands placed 2 standard deviations from themoving average.


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BB- Interpretation

The width of the band obviously varies with the volatilityi.e. the standard deviation of the prices.

In uptrends, the price usually moves between the 20-daymoving average and the upperbollingerband while in adowntrend, the price usually moves between the movingaverage and the lowerbollingerband.

Penetration of the upperbollingerband in an uptrend orthe lowerbollingerband in a downtrend usually suggestsan acceleration in the trend.

However, if the price quickly moves back into the band, a

trend reversal orat least a deep correction is likely. Sharp price movements accompanied byrange

expansion are often preceded by a contraction of theband due to a period ofreduced volatility.


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OSCILLATORS


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Types ofOscillators

Momentum

Rate of Change (ROC)

Relative Strength Index (RSI) Stochastics

Fast

Slow Money Flow Index


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Oscillators

Oscillators are price derivatives. Extremeoscillatorreadings indicate that the market isoverextended, that is,overbought oroversold;give advance warnings of an impending trend

reversal and alert the traderorhedger to booksome profits orto be on the lookout forothersigns of a reversal. Caution : Such warnings arenot a signal to take countertrend positions butonly to trim existing profitable positions or

protect them with tight stops.


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Momentum

Momentum denotes the speed at which

prices are rising or falling.

Momentum has to be related to some

period. Forexample, 10-day momentum

measures the size and direction of the

price change overthe last 10 days.


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Momentum- Calculation

Simplest way to calculate n-day

momentum at time is by the following

equation:

M(t) = P(t) - P(t-n) where M(t) is the

momentum at time t, P(t) is the price at

time t and P(t-n) is the price at time t-n.

The momentum line so plotted oscillatesaround the zero line.


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Momentum - Interpretation

Just as a carmoving at high speed slows down before coming to ahalt ormaking a U-turn, the momentum peaks out and reversesbefore reversal of the trend itself.

However, even afterreversal of momentum it is prudent towait forreversal of the price trend because quite often powerful trendsoverextend before finallyreversing. In such cases,we often seeprices making new highs or lows on lowermomentum indicating aweak technical position susceptible toreversal. Such a phenomenonof a new high or low in price without being confirmed by a new highor low in momentum, is called divergence.

Such a divergence is a red alert and a signal forbooking profits onexisting positions ratherthan a signal fortaking positions in theopposite directions.


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Momentum- Interpretation

On a stand alone basis, the best available confirmation of a trendreversal ortrend resumption aftera correction is the crossing of themomentum line above orbelow the zero line.

Overbought and oversold signals are given when the momentumoscillatorreaches extremely high or low values. Extremely highvalues point to an overbought condition i.e. the price has risen toofartoo fast and signal a correction while extremely low valuessuggest an oversold market and warns of a possible rally.

A disadvantage of the momentum oscillatoris that it is difficult topinpoint extreme values without comparative historical data. Lets

therefore examine 2 otheroscillators that are normalized and whosevalues always move between 0 and 100.


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Rate of Change (ROC)

ROC is classed as a price momentum

indicatorora velocity indicatoras it

measures the rate of change or the

strength of momentum of change

It is calculated as:

(Closing price today Closing price n

periods ago) / Closing price n periods ago

ROC greaterthan zero indicate an

increase in upward momentum and vice

versa.


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RSI

The RSI is an oscillator that always moves

between 0 and 100.

Necessary to specify a period for

calculation.Original designerproposed a

14-day period but 9-dayRSI has also

become popular.


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Relative Strength Index (RSI)


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RSI- Signals

For instance,reversal of the RSI from theoversold region can be taken as a buysignal and reversal from the overboughtregion as a sell signal.

However, in trending markets,RSIreversals opposite to the trend mayonlysignal a correction and these signals couldat the most be used forbooking profits ortrimming positions.On the otherhand,RSIreversal in the direction of the trendusually signals resumption of the trend.


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RSI Signals.contd

For indicating impending trend reversal,RSI divergence in the overbought oroversold zone is considered as a morereliable signal. Bearish RSI divergenceoccurs when the price makes a new highbut the RSI though overbought makes alowerhigh. Bullish RSI divergence occurswhen the price makes a new low but the

RSI makes a higher low in the oversoldzone.


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RSI Signals.contd

Even aftergetting RSI divergence, it is

prudent towait forsome reversal

indication in the price charts because it is

not uncommon forRSI divergences to getrepeated in powerful trends.


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Stochastics

This oscillator is based on the empiricalevidence that the price usually closes near thehigh of the dayorthe last few days in an uptrendand near the lowof the dayor the last few days

in a downtrend. The psychological reason is probably that as a

trend persists longerand longer, market playerstend to become less and less cautious and carrylargerovernight risks.

This is a complex indicatorand involvescalculation of3 statistical variables : %K, fast%D and slow %D.


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Stochastics- Construction

Choose a period for%K. Typical period is 5 days.

Identif y the highest intraday high (H) and the lowest intraday low (L)in the chosen period.

Calculate %K as follows:%K = 100 * (C - L)/ (H - L)

Calculate fast %D as a moving average, in this case,3-day movingaverage of %K values.

Also calculate slow %D as a 3-day moving average of fast %Dvalues.

Plot %K and fast %D to form the fast stochastic indicatororthe faststochastics. Similarly, plot fast %D and slow %D to form the slowstochastics.

Evidently, %K oscillates between 0 and 100 and so also do fast %Dand slow %D.


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Stochastics


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Stochastics - Signals

As with the RSI, there are overbought and oversoldzones. These are usually set as 80 and 20 or70 and 30.

With fast stochastics, a buy signal is given if %K crossesover fast %D in the oversold zone and is confirmed when

fast %D moves up into the neutral region. A sell signal isgiven if %K crosses below fast %D in the overboughtzone and is confirmed when fast %D moves down intothe neutral region. This may be suitable forshort-termtraders.

With slow stochastics, the signals are similarexcept thatthese are generated with the crossoverof fast %Doverorbelow slow %D. This seems preferable formedium-term traders and hedgers.

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