Technical AnalysisTechnical Analysis

Module 3

Part B

Introduction

Technical analysis is the attempt to forecast stock prices on the basis of market-derived data.

Technicians (also known as quantitative analysts or chartists) usually look at price, volume and psychological indicators over time.

They are looking for trends and patterns in the data that indicate future price movements.

Dow Theory

This theory was first stated by Charles Dow in a series of columns in the WSJ between 1900 and 1902.

Dow (and later Hamilton and Rhea) believed that market trends forecast trends in the economy.

A change in the trend of the DJIA must be confirmed by a trend change in the DJTA in order to generate a valid signal.

Dow Theory Trends (1)

Primary Trend Called “the tide” by Dow, this is the trend that

defines the long-term direction (up to several years). Others have called this a “secular” bull or bear market.

Secondary Trend Called “the waves” by Dow, this is shorter-term

departures from the primary trend (weeks to months) Day to day fluctuations

Not significant in Dow Theory

Dow Theory Trends (2)

Dow Theory Phases

Three Phases Accumulation Followers Uptrend

The fall in the prices in the bull phase is a technical reaction

The rise in price in the bear phase is a technical ralley.

Uptrend period: The Volume will expand when prices rise and decrease when prices decline.

Downtrend Period: Volume expand when prices drop and contract when they start rising.

Agenda

Charting Stocks Bar Charts and Japanese Candlestick Charts Point and Figure Charts

Major Chart Patterns Price-based Indicators Volume-based Indicators Dow Theory Elliot Wave

Charting the Market

Chartists use bar charts, candlestick, or point and figure charts to look for patterns which may indicate future price movements.

They also analyze volume and other psychological indicators (breadth, % of bulls vs % of bears, etc.).

Strict chartists don’t care about fundamentals at all.

Drawing Bar (OHLC) Charts

Each bar is composed of 4 elements: Open High Low Close

Note that the candlestick body is empty (white) on up days, and filled (some color) on down days

Note: You should print the example charts (next two slides) to see them more clearly

Open

Close

High

Low

StandardBar Chart

JapaneseCandlestick

Open

Close

High

Low

StandardBar Chart

JapaneseCandlestick

Drawing Bar (OHLC) Charts

Drawing Bar (OHLC) Charts

Candle is comprised of two parts, the body and the shadows. The body encompasses the open and closing price for the period. The candle body is black if the security closed below the open, and White if the close was higher than the open for the period. The candlestick shadow encompasses the intraperiod high and low.(Note: In candlestick charting the following periods are often used; 5 min, 15 min, 1 hour, daily and weekly). Long shadows, show that the trading extended well beyond the opening and/or closing price, while short shadows, show that trading was confined closely to the open and/or closing price

Types of Charts: Japanese Candlesticks

This is a Japanese Candlestick (open, high, low, close) chart of AMAT from early July to mid October 2001

Types of Charts: Bar Charts

This is a bar (open, high, low, close or OHLC) chart of AMAT from early July to mid October 2001.

Drawing Point & Figure Charts

Point & Figure charts are independent of time.

An X represents an up move. An O represents a down

move. The Box Size is the number of

points needed to make an X or O.

The Reversal is the price change needed to recognize a change in direction.

XXXXX

OO

XXXX

OOOO

Drawing Point & Figure Charts Each chart has a setting called the Box Size that is

the amount that a stock needs to move above the top of the current column of X's

(or below the bottom of the current column of O's) before another X (or O) is added to that column.

Each chart has a second setting called the Reversal Amount that determines the amount that a stock needs to move in the opposite direction

(down if we are in a rising column of X's, up for a column of O's) before a reversal occurs.

Whenever this reversal threshold is crossed, a new column is started right next to the previous one, only moving in the opposite direction.

Chart Types: Point & Figure Charts

This is a Point & Figure chart of AMAT from early July to mid October 2001.

Basic Technical Tools

Trend Lines Moving Averages Price Patterns Indicators Cycles

Trend Lines

There are three basic kinds of trends: An Up trend where prices

are generally increasing. A Down trend where

prices are generally decreasing.

A Trading Range.

Uptrend Line

An uptrend line has a positive slope and is formed by connecting two of more low points.

The second low must be higher than the first for the line to have a positive slope.

Uptrend lines act as support and indicate that net-demand (demand less supply) is increasing even as the price rises.

A rising price combined with increasing demand is very bullish and shows a strong determination on the part of the buyers.

As long as prices remain above the trend line, the uptrend is considered solid and intact.

A break below the uptrend line indicates that net-demand has weakened and a change in trend could be imminent.

Downtrend line

A downtrend line has a negative slope and is formed by connecting two or more high points.

The second high must be lower than the first for the line to have a negative slope.

Downtrend lines act as resistance, and indicate that net-supply (supply less demand) is increasing even as the price declines.

A declining price combined with increasing supply is very bearish and shows the strong resolve of the sellers.

As long as prices remain below the downtrend line, the downtrend is considered solid and intact.

A break above the downtrend line indicates that net-supply is decreasing and a change of trend could be imminent.

Support & Resistance

Support and resistance lines indicate likely ends of trends.

Resistance results from the inability to surpass prior highs.

Support results from the inability to break below to prior lows.

What was support becomes resistance, and vice-versa.

Support Resistance

Breakout

SUPPORT = RESISTANCE

Moving Averages

Generally 7day , 10day, and 15day moving avgs are worked out . They are worked for both the scrip studied and the Index. The two graphs are compared and when the trends are similar the

scrip and index will show comparable avg. risks. When the avg line cuts the actual price line of the scrip or the index

from the bottom, it signal to sell shares When the avg line cuts the actual price line from above it is the

right time to buy shares. Generally , the closing prices of these scrips of the scrips are taken

for the moving avgs.

Price Patterns

Technicians look for many patterns in the time series of prices.

These patterns are reputed to provide information regarding the size and timing of subsequent price moves.

Head and Shoulders

This formation is characterized by two small peaks on either side of a larger peak.

This is a reversal pattern, meaning that it signifies a change in the trend.

Head

Head

Left Shoulder

Left Shoulder

Right Shoulder

Right Shoulder

Neckline

Neckline

H&S Top

H&S Bottom

Head & Shoulders Example

Head & Shoulders Example

Sell Signal

Minimum Target PriceBased on measurement rule

DOUBLE TOPS Example

Triangles

Triangles are continuation formations. Three flavors:

Ascending – BULLISH Descending - BEARISH Symmetrical - NEUTRAL

Typically, triangles should break out about half to three-quarters of the way through the formation.

TYPES

Ascending

Descending

Symmetrical

Symmetrical

EXAMPLE

DJIA Oct 2000 to Oct 2001 Example

What could you have known,and when could you have known it?

DJIA Oct 2000 to Oct 2001 Example

Double bottomGap, should getfilled

Nov to Mar Trading range

Descendingtriangles

Elliot Wave Principle (1)

R.N. Elliot formulated this idea in a series of articles in Financial World in 1939.

Elliot believed that the market has a rhythmic regularity that can be used to predict future prices.

The Elliot Wave Principle is based on a repeating 8-wave cycle, and each cycle is made up of similar shorter-term cycles (Big fleas have little fleas upon their backs to bite 'em - Little fleas have smaller fleas and so on ad infinitem).

The Elliot Wave Principle (2)

One complete cycle consists of waves made up of 2 distinct Phases – Bullish andBearish.Thus wave one is upward

The Elliot Wave Principle (2)

1

2

3

4

5

A

B

C

Does Elliot Wave Work?

Who knows? One of the biggest problems with Elliot Wave is that no two practitioners seem to agree on the wave count, and therefore on the prediction of what’s to come.

Robert Prechter (the most famous EW practitioner) made several astoundingly correct predictions in the 1980’s, but hasn’t been so prescient since (he no longer gets much press attention).

For example, in 1985 he predicted that the market would peak in 1987 (correct), but he thought it would peak at 3686 (± 100 points).

The DJIA actually peaked on 25 August 1987 at 2722.42, more than 960 points lower.

Oscillators (Rate Of Change)

Oscillators refer to the velocity of Price changes reflecting the market momentum which is measured by the rate of change in prices.

Short period 5 to 10 days or long periods of 3 to 6 mths.

Most oscillators would move in the same direction either positive or negative

Positive reflect overbought market and negative reflects oversold market.

They are plotted around zero line to reflect both +ve and –ve values.