Technical Analysis Importance

TESTING OF TECHNICAL ANALYSIS
TOOLS AS A SIGNAL FOR ENTRY AND

EXIT OF STOCK MARKET
Submitted in partial Fulfillment of the requirements for the

award of MBA Degree of Bangalore University
Submitted By
Azime Adem Hassen
UNDER THE GUIDANCE OF
Dr. Nagesh S Malavalli
Register Number:
03XQCM6014
M.P. Birla Institute of Management

Associate Bharatiya Vidya Bhavan
Bangalore-560001
2003-2005
Testing of Technical Analysis Tools As A Signal For Entry & Exit of Stock Market 2
DECLARATION
I here by certify that this project report entitled “Testing

of technical analysis tools as signal for entry and exit
of stock market” has been prepared by me under the
able guidance and supervision of Dr. Nagesh S Malavalli,
Principal, M.P. Birla Institute of Management, Associate
Bhartiya Vidya Bhavan, Bangalore.
This project report was prepared by me in partial

fulfillment of the requirement for the award of MBA
Degree. I also declare that this project report has not been
submitted to any other University or Institution for the
award of any Diploma or Degree.
Date: 15/06/2005 Azime Adem Hassen

Place: Bangalore Reg. No.: 03XQCM6014
M.P. Birla Institute Of Management June, 2005

ACKNOWLEDGEMENT
This Project report has been made possible through the direct
and indirect cooperation of various people to whom I wish to
express my deep sense of Gratitude.
I am extremely grateful to my Guide Dr. Nagesh S Malavalli,

for his valuable advice and guidance throughout, which has
enabled me in the successful completion of this project and
whose constant backing and support made my project a
knowledgably and insightful experience.
I would also like to thank my friends and family members for

their continuous support and assistance they have given me.

Certificate
This is to certify that Project titled “Testing of technical

analysis tools as signal for entry and exit of stock
market” has been prepared by Mr. Azime Adem Hassen
bearing the registration number 03XQCM6014 under my
guidance.
Place: Bangalore
(Dr.Nagesh.S.Malavalli)
Date: 15th June 2005 Principal

Certificate
This is to certify that the project titled “ Testing of Technical

Analysis tools as a Signal for Entry and Exit of stock Market” , has
been prepared by Mr. Azime Adem Hassen bearing register number
03XQCM6014, under my guidance.
Date: June 15, 2005 (Dr. Nagesh.S.Malavalli)

Principal
Place: Bangalore

Contents
Declaration……………………………………………………………i
Certificates……………………………………………………………ii
Acknowledgement……………………………………………………iii
Abstract ………………………………………………………………iv
Chapter 1 1.1 Introduction …………………………………2
1.2 Purpose and objective of the study…………4
Chapter 2 Review of Literature…………………………….6
Technical Indicators…………………………7
2.1 Moving Averages ………………………..9
2.2 Relative Strength Index…………………12
2.3 Moving Average Convergence
& Divergence………………………18
Chapter 3 Data and Methodology………………………….24
Chapter 4 Results, Analysis and Discussion………………29
Chapter 5 Conclusion and Recommendations…………….62
5.1 Conclusion………………………………….62
5.2 Recommendations…………………………63
Bibliography

ABSTRACT
In this paper we assess whether different tools of technical analysis can

predict stock price movements in the New York Stock Exchange. To that
end, we use daily data for General Index of the New York stock
Exchange, covering for period from June 2004-June 2005.
Our results provide strong support for profitability of these technical
trading rules.

Chapter 1
Introduction

1.1 INTRODUCTION
Stock market prediction analyses can generally be classified as either

fundamental or technical. The former approach considers the cause of
market behaviour, whilst the latter studies the effect. Thus, technical
analysis is based only on quantifiable market data, whilst fundamental
analysis includes data related to the market situation, time of year,
company prospects and so forth. Technical analysis has attracted a large
following amongst trading practitioners but has been criticized in the past
by theoreticians. It should be noted, however, that more recent studies in
the literature have given some support to the technical approach. The
technique developed in this paper has focused solely on technical analysis.
However, it could easily be extended to cater for fundamental data types.
Technical stock analysis is based on three basic principles namely:

1. Market action discounts everything;
2. Prices move in trends;
3. History repeats itself.
Technical analysis is a forecasting method of price movements using past

prices, volume, and open interest. Pring (2002), a leading technical
analyst, provides a more specific definition:
“ The technical approach to investment is essentially a reflection of the

idea that prices move in trends that are determined by the changing
attitudes of investors toward a variety of economic, monetary, political,
and psychological forces. The art of technical analysis, for it is an art, is

to identify a trend reversal at a relatively early stage and ride on that trend
until the weight of the evidence shows or proves that the trend has
reversed.”
Technical analysis involves searching for recurrent and predictable
patterns in stock prices. This type of analysis has a long history and dates
back to the Japanese rice traders trading on the Dojima Rice Exchange in
Osaka as early as 1600s. It evolved into Chartism in the early 20th
century with mechanical trading rules to generate signals. This
development has since been aided by the introduction of electronics
which took the tedium out of complex mathematical manipulations. As
computers have become more powerful and its use more widespread,
analysts are found to combine fundamental economic data with the more
traditional price and volume data to produce new indicators. More
recently, concepts like chaos theory, fuzzy logic, artificial neural network,
genetic algorithms, and so on, have been applied to the financial markets.
This could well be the next stage of the evolution of technical analysis.
Since the seminal work of Friedman (1953) and Fama (1970), the role of
technical analysis as a forecasting mechanism continues to remain
controversial in the literature. As will be briefly discussed in the next
section, several influential studies conclude that technical analysis is not
useful. On the other hand, there is strong evidence that simple forms of
technical analysis contain significant forecasting power. In this paper, our
objective is to provide new evidence on this issue. NYSE data is used to
investigate whether the technical indicators do play any useful role in the
timing of stock market entry and exit. The focus is on the most
established of the trend followers, the Moving Average (MA), and the

most frequently used counter-trend indicator, the Relative Strength Index

(RSI).
1.2 Purpose and Objectives of the Study
The purpose of this study is to tests the performance the technical

analysis forecast applied on stock market by means of a specific indicator.
There is strong evidence that simple forms of technical analysis contain
significant forecasting power. In this paper, our objective is to provide
new evidence on this issue. We use NYSE data to investigate whether the
technical indicators do play any useful role in the timing of stock market
entry and exit.

Chapter 2
Review of Literature

Review of Literature
The use of market timing has long been the subject of much discussion.
Several researchers question the usefulness of such techniques, arguing
that such techniques usually cannot produce better returns than a buy-
and-hold (B-H) strategy. Although technicians recognize the value of
information on future economic prospects of the firm, their position is
that such information is not mandatory for a successful trading strategy.
The reason is that whatever the fundamental reason for a change in the
stock price, if the stock price is sluggish to adjust, the analyst should be
able to identify a trend that could be exploited during the adjustment
period. Consequently, the key to successful technical analysis is a lazy
response of stock prices to fundamental supply-and demand phenomena.
Note that this prerequisite is diametrically opposite to the notion of an
efficient market.
The guiding principle of technical analysis is to identify and go along

with the trend. When there is a trend, whether started by random or
fundamental factors, technical methods will tend to generate signals in
the same direction. This reinforces the original trend, especially when
many investors rely on the technical indicators. Thus, even if the original
trend were a random occurrence, the subsequent prediction made by the
technical indicator could be self-fulfilling. This self-fulfilling nature leads

to the formation of speculative bubbles (see, for example, Froot,

Sharfstein and Stein, 1992). Frankel and Froot (1990b) suggested that the
over-pricing of the U.S. dollar in the 1980s with respect to the underlying
economic fundamentals could be due to the influence of technical
analysis. Shiller (1984, 1987) found that irrational investor behaviour
resulted in excess bond and stock market volatility. He also suggested
that the October 1987 world-wide stock market crash could be due
largely to technical analysis.
Fama and French (1988) proposed a mean reverting model to explain
stock price movements. They also found that autocorrelation of returns
become strongly negative for a 3-5 year horizon. DeBondt and Thaler
(1985, 1987) found that stocks that were extreme losers over a 3-5 year
period tend to have strong returns relative to the market during the
following years. Conversely, extreme winners tend to have weaker
returns in subsequent years. Sy (1990) had argued against Sharpe’s
(1975) conclusion, saying that there was no need for the predictive
accuracy to be as high as 70 percent for the gains to be large. In addition,
he demonstrated that market timing would be increasingly rewarding
when the difference in returns between cash and stocks were narrowed
and when market volatility increased.
Technical Indicators
Practitioners’ reliance on technical analysis is well documented. Frankel

and Froot (1990a) noted that market professionals tend to include
technical analysis in forecasting the market. There is also a shift away
from the fundamentals to technical analysis in the 1980s, according to a
survey done by Euromoney (see Frankel and Froot, 1990a). On a market

level, the prevalence of technical analysis is demonstrated by the fact that

most real time financial information services, like Reuters and Telerate,
provide detailed, comprehensive and up-to-date technical analysis
information. It is obvious that the frequent upgrading of technical
analysis services is a response to the demand for technical analysis
services and competition among the financial information service
providers.
The guiding principle of technical analysis is to identify and go along

with the trend. When there is a trend, whether started by random or
fundamental factors, technical methods will tend to generate signals in
the same direction. This reinforces the original trend, especially when
many investors rely on the technical indicators. Thus, even if the original
trend were a random occurrence, the subsequent prediction made by the
technical indicator could be self-fulfilling. This self-fulfilling nature leads
to the formation of speculative bubbles (see, for example, Froot et al.,
1992). Conrad and Kaul (1988) found that weekly returns were positively
autocorrelated, particularly for portfolios of small stocks. Frankel and
Froot (1990b) suggested that the overpricing of the US dollar in the 1980s
with respect to the underlying economic fundamentals could be due to the
influence of technical analysis.
Shiller (1984, 1987) found that irrational investor behaviour resulted in

excess bond and stock market volatility. He also suggested that the
October 1987 world-wide stock market crash could be due largely to
technical analysis. Fama and French (1988) proposed a mean reverting
model to explain stock price movements. Conversely, extreme winners
tend to have weaker returns in subsequent years. Sy (1990) had argued

against Sharpe’ s (1975) conclusion, saying that there was no need for the
predictive accuracy to be as high as 70 percent for the gains to be large.
In addition, he demonstrated that market timing would be increasingly
rewarding when the difference in returns between cash and stocks were
narrowed and when market volatility increased.
There are several technical indicators in use by practitioners, but
generally, they can be classified into two major categories: trend
followers and counter-trend indicators. In this section, we discuss briefly
the most established of the trend followers, namely, the moving average,
and the most frequently used counter-trend indicator, known as the
relative strength index and Moving average convergence and divergence
(MACD)
2.1 Moving Averages (MA)

The most widely used moving average (MA) is the n-day simple MA
given by:
Where Mt,n is the simple n-day moving average at period t and Ci is the
closing price for period i. In the simple MA procedure, a buy signal is
generated when the closing price rises above the MA and a sell signal is
generated when the close falls below the MA. If there were a clear trend,
this method would work well. If, however, the market were moving
sideways or if there were excessive volatility, there could be a lot of
whipsaws (false signals).

Variants of moving averages include the dual moving average system, the
triple moving average system, and the t-ratio on moving averages. The
Dual Moving Average is the use of two moving averages while the Triple
Moving Average is the use of three moving averages. The T-Ratio of
Moving Average is the ratio of simple MA and its standard deviation
such that
Where Mt,n is the Simple Moving Average defined in (1) and
Dual Simple Moving Average Crossover is used to limit the amount of

false signals generated by the Simple Moving Average Price Crossover
The Dual SMA crossover generates far fever trading signals, then SMA
Price Crossover systems, and increases profitability of the trading system
used.
Typically, the Moving Averages used in the Dual Simple Moving

Average Crossover System are related on an 8 to 1 ratio. This means if
the first Simple Moving Average used is a 5 day SMA, then the second
should be a 40 day Simple Moving Average.
The buy and sell signals are generated when the faster Simple Moving
Average crosses a slower Simple Moving Average. The faster Simple
Moving Average is the one with a lower day period. The slower Simple

Moving Average is the one with a higher day period. For example, in the
trading system with 50 and 200 days Simple Moving Averages the Faster
simple moving averages is the 50 days SMA, and the slower simple
moving average is the 200 days SMA.
The BUY and SELL signal generation:
• When the faster Simple Moving Average has been below the
slower Simple Moving Average and crosses above the Slower
SMA, a BUY signal is generated;
• When the faster Simple Moving Average has been above the
slower Simple Moving Average and crosses below the Slower
SMA, a SELL signal is generated.
ABX, 5-40 day Dual Simple Moving Average Crossover Signals

2.2 Relative Strength Index

The Relative Strength Index, introduced by Wilder (1978), is one of the
most well-known momentum oscillator systems. Momentum oscillator
techniques derive their name from the fact that trading signals are
obtained from values which “ oscillate” above and below a neutral point,
usually given a zero value. In a simple form, the momentum oscillator
compares today’ s price with the price of n-days ago. Wilder (1978, p. 63)
explains the momentum oscillator as follows:
The momentum oscillator measures the velocity of directional price

movement. When the price moves up very rapidly, as some point it is
considered to be overbought; when it moves down very rapidly, at some

point it is considered to be oversold. In either case, a reaction or reversal

is imminent. Momentum values are similar to standard moving averages,
in that they can be regarded as smoothed price movements. However,
since the momentum values generally decrease before a reverse in trend
has taken place, momentum oscillators may identify a change in trend in
advance, while moving averages usually cannot. The Relative Strength
Index was designed to overcome two problems encountered in
developing meaningful momentum oscillators: (1) erroneous erratic
movement, and (2) the need for an objective scale for the amplitude of
oscillators.
The calculation of the at time t of period p uses only closing prices

and is the ratio of up-closes, U i, to down-closes, D I , over the time
period selected, expressed as an oscillator that has a range of 0 to 100.
The calculation start with defining an index set

followed by defining the up-closes and the down-closes such that
for any and C i is the closing price for period i. The next step is to
define

and thereafter the Relative Strength is given as follows:
The RSI at time t for period p is then defined as:
Readings of 100 implies that there are pure upward price movements,
while readings of 0 imply that there are pure downward price movements.
Hence a reading close to 100 indicates an overbought market, while a
reading around 0 indicates an oversold market. The time period for RSI is
found to be shorter for more volatile markets and longer for less volatile
markets. Generally, the longer the time period used the less frequent and
more stable are the trading signals. Shorter time periods tend to generate
more noise (erratic movements and false signals) than longer periods. For
example, using a time period of 14 days, the market tops and bottoms are
deemed to occur after the RSI goes above 70 or below 30. Using longer
time periods would mean setting less extreme levels for which the market
is considered to be overbought or oversold. Thus for a 20-day RSI, the

levels may be 60 and 40. Note that the RSI is an oscillator and a counter-
trend indicator. If used in a trending market, the RSI often becomes
entrenched near one end of the range for days, or even weeks, giving
false indications of a market top or bottom.
The Relative Strength Index (RSI) can provide an early warning of an
opportunity to buy or sell.
• The RSI is a momentum indicator, or oscillator, that measures the

relative internal strength of a market (not against another market or
index).
• As with all oscillators, RSI can provide early warning signals but
should be used in conjunction with other indicators.
• Divergences are the most important signal provided by RSI.
The Relative Strength Index (RSI) is a popular oscillator developed by

Welles Wilder. RSI measures the relative changes between higher and
lower closing prices, and provides an indication of overbought and
oversold conditions.
The term "Relative Strength" is slightly misleading and often causes

some confusion. Relative strength generally means a comparison between
two different markets or indices. RSI, on the other hand, looks at the
internal strength of a single market.

Interpretation
RSI is plotted on a vertical scale of 0 to 100. The 70% and 30% levels are
used as warning signals. An RSI above 70% is considered overbought
and below 30% is considered oversold. The 80% and 20% levels are
preferred by some traders. The significance depends upon the time frame
being considered. An overbought reading in a 9-day RSI is not nearly as
significant as an RSI for a 12-month period.
An overbought or oversold condition merely indicates that there is a high

probability of a counter reaction. It is an indication that there may be an
opportunity to buy or sell, but does not provide the final signal. RSI
signals should always be used in conjunction with trend-reversal signals
offered by the price itself.

RSI can be plotted for any time span. Wilder originally recommended
using a 14-day RSI. Since then, the 9, 10 and 25-day RSIs have also
become popular. The shorter the time period, the more sensitive the
oscillator becomes. If the user is trading short-term moves, the time
period can be shortened. Lengthening the time period makes the oscillator
smoother and narrower in amplitude.
In using RSI, a crossover above the 70% level is a warning signal to

prepare to sell and, conversely, when the RSI falls below 30% you have a
notice to prepare to buy. The actual buy and sell signals are given when
the RSI reverses (see below). RSI crossings through the 50% level are
also used as buy and sell signals by some traders.
Signals
Tops & Bottoms, Failure Swings, Divergence
Traders watch for double tops or what Wilder referred to as "failure

swings." If the RSI makes a double top formation, with the first top above
70% and the second top below the first, you get a sell signal when the
RSI falls below the level of the dip. Conversely, a double bottom at or
below 30% (with the first low below 30% and the second at or above the
same level) gives you a buy signal when the RSI breaks above the
previous peak.
These failure swings can lead to divergences between the price action and
the RSI. For example, a divergence occurs when a market makes a new
high or low, but the RSI fails to set a matching new high or low. A
divergence can be an indication of an impending reversal. In Wilder'
s
opinion, divergences are the most important signal provided by RSI.

Trendlines
RSI trendlines can provide good signals, particularly when used in

conjunction with price patterns. When both price and RSI trendlines are
violated within a short period you could have an important buy or sell
signal.
RSI is used in various forms including ‘Touch’ , ‘Peak’ , ‘Retracement’

and ‘50 Crossover’ methods. The ‘touch’ method generates a buy signal
when the RSI touches the lower bound (typically set at 30) which
indicates that the market is oversold and hence a time to buy. It generates
a sell signal when the RSI touches the upper bound (typically set at 70)
which indicates that the market is overbought and hence a time to sell.
The ‘peak’ method generates a buy signal when the RSI has crossed the
lower bound (typically set at 30) and turned back. It generates a sell
signal when the RSI has crossed the upper bound (typically set at 70) and
turned back. The ‘retracement’ method generates a buy signal when the

RSI has crossed the lower bound (typically set at 30) and retraced back to
the same lower bound or higher. It generates a sell signal when the RSI
has crossed the upper bound (typically set at 70) and retraced back to the
same upper bound or lower. The ’ 50 crossover’ method generates a buy
signal when the RSI rises above 50 and a sell signal when the RSI falls
below 50.
2.3 Moving Average Convergence Divergence

The Moving Average Convergence Divergence (MACD) statistic is a
simple difference between two moving averages -a short windowed one
and a longer windowed one. The traditional values are 12-day and 26-day.
Signals are generated in multiple ways. Since the MACD is an oscillator,

simple up crossings across the zero line are considered bullish;
correspondingly, down crossings are considered bearish. In addition, the
MACD statistic is often plotted against its own 9 day exponential moving
average. Up crossings of the MACD against its moving average are
considered bullish; down crossings are bearish.
MACD is a momentum indicator developed by Gerald Appel. It consists

of the indicator curve, the zero line, and a “ trigger line.” The indicator
curve depicts the vertical distance between two exponential moving
average curves covering time periods of differing widths (traditionally 12
and 26 periods). The trigger line is an exponentially smoothed curve of
the indicator curve (traditionally over 9 periods). The zero line indicates

where the short-term and long-term moving average curves would

intersect if plotted separately.
As prices move further away from the trend indicated by the longer-term
moving average, the MACD indicator line becomes more positive or
negative, depending upon the direction of price movement. As prices
move closer to the trend, the MACD indicator approaches zero. By first
smoothing the price volatility with the short-term moving average, then
smoothing the indicator with the trigger line, it is believed the MACD
provides very reliable trend reversal and confirmation signals.
An exponential moving average of MACD for t periods you specify is
plotted on top of the MACD as a “ trigger line.”
Interpretation: Buy (sell) when MACD crosses above (below) the trigger
line or zero line.
Look for divergence between price data and MACD curve.
The MACD proves most effective in trending markets rather than choppy,
sideways markets. There are two main sets of signals generated by the
MACD: crossovers and divergences.
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There are two main MACD crossover signals:
1. Signal Line Crossovers: MACD crosses above or below the signal

line
2. Zero Line Crossovers: MACD crosses above or below the zero line
Thomas Aspray found that MACD signals often lagged important market
moves, especially when applied to weekly charts. He first experimented
with changing the moving averages and found that shorter moving

averages did indeed speed up the signals. However, he was looking for a
means to anticipate MACD crossovers and came up with the MACD
Histogram.
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The MACD Histogram represents the difference between MACD and it'
s
signal line (usually the 9-day Exponential Moving Average (EMA) of the
MACD). Whenever MACD crosses the signal line, MACD-H crosses
the zero line.

• If the MACD line is above the signal line, the histogram is positive,
and the bars are drawn above the zero line.
• If the MACD line is below the signal line, histogram is negative,
and the bars are drawn below the zero line.
Sharp increases in the MACD-H indicate that MACD is rising faster than
its 9-day EMA and upward momentum is strengthening. Sharp declines
in the MACD-H indicate that MACD is falling faster than its moving
average and downward momentum is increasing.
Divergences between MACD and MACD-H are the main tool used to
anticipate crossovers. A positive divergence in the MACD-H indicates
that MACD is strengthening and could be on the verge of a bullish
moving average crossover. A negative divergence in the MACD-H
indicates that MACD is weakening and can act to foreshadow a bearish
moving average crossover in MACD.
Signals
The main signal generated by the MACD-Histogram is a divergence

from MACD followed by a zero-line crossover.
• A bullish signal is generated when a positive divergence forms

and there is an upward zero line crossover.
• A bearish signal is generated when there is a negative divergence
and a downward zero line crossover.
In Technical Analysis of the Financial Markets, John Murphy states that

the real value of the MACD-H is spotting when the spread between the
two lines is widening or narrowing. When the histogram is above its zero
line (positive) but starts to fall, the uptrend is weakening. Conversely,

when the histogram is below its zero line (negative) and starts to rise, the
downtrend is losing momentum. These turns of the histogram provide
early warnings that the current trend is losing momentum, and the buy or
sell signal is given when the histogram crosses the zero line.
Murphy also advocates a two-tiered approach in order to avoid making

trades against the major trend. The weekly MACD-H can be used to
generate long-term signals. Then only short-term signals that agree with
the major trend are used.
• If the long-term trend is up, only positive divergences with

upward zero line crossovers are considered valid for the MACD-H.
• If the long-term trend is down, only negative divergences with
downward zero line crossovers are considered valid.
Used this way, the weekly signals become trend filters for daily signals.
This prevents using daily signals to trade against the overall trend.
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The basic MACD trading rule is to buy when the MACD rises above its
signal line. Similarly, a sell signal occurs when the MACD crosses below
its signal line. The crossing of the MACD line above the signal line
can denote the beginning of a trend. An uptrend typically pauses or
stops when the MACD line crosses and falls below the signal line.
The location relative to the zero line is also important in indicating

how strong a trend might be. A crossover above the zero line is
considered more bullish than one below the zero line. The higher above

the zero line it crosses, the stronger the uptrend. If the crossover occurs
below the zero line, the uptrend is likely not very strong.
When the bullish crossover occurs above the zero line, the uptrend gains
more momentum, and the price rises with more intensity.
Bullish MACD crossovers are probably the most common signals and as
such can be less reliable. If not used in conjunction with other technical
analysis tools, these crossovers can lead to whipsaws and many false
signals.
One way to try and counteract false signals is to apply a price filter to the
crossover to see if a trend will hold. An example of a price filter would be
to buy if the MACD breaks above the signal line and remains above for
three days. The buy signal would then commence at the end of the third
day.

Chapter 3
Methodology
Data and Methodology
The data collected are daily historical stock price for one year of the New
York stock exchange. The period tested was from June 1, 2004 to June 10

2005. The daily close of the NYSE for the period of a year have been
used.
The following companies have been used in the analysis: PDF Solution,
The Coca-Cola Company, General Electric Company, General Motors
Corporation, ABX Air Inc, IBM International Business Machines, United
States Stl Corp New, AT&T Corp, Microsoft Corporation, and Ford
Motor Company. The companies selected have a minimum average daily
volume of a million shares and above.
Specifically, the following indicators are tested: 9-18day dual MAs,

MACD, and RSI. The closing prices of the NYSE are used to compute
the daily returns.
Stock prices (closes, opens, highs, and lows, the technical charts as well
as trading volume) were gathered from the Yahoo! Finance quote server
at http://finance.yahoo.com and http://www.bigcharts.com/
The indicator to be tested will provide us with the buy and sell signals as
follows:
i) Dual Moving average
In trading system with 9 days and 18 day Simple moving average the
faster SMA is the 9 days SMA, the slower SMA is 18 days SMA.
• When the faster simple moving average has below the slower
simple moving average and crosses above the slower
Simple moving average, a buy signal is generated.
• When the faster simple moving average has been above the
slower simple moving average and crosses below the slower
simple moving average, a sell signal is generated.

ii) MACD
The basic MACD trading rule is to sell when the MACD falls
Below its signal line and to buy when the MACD rises above its
Signal line.
iii) RSI
RSI is an oscillator, the indicator moves between two extremes 0% and
100%.
• A buy signal when RSI touches the lower bond (typically set at
25) which indicates the market is oversold and hence time to
buy.
• A sell signal when RSI touches the upper bound (typically set at
70) which indicates that the market is overbought and hence
time to sell.
iv) Buy and hold:
Buy at the beginning of the month of June 12004 and sell on
June 10 2005
Then we determine the action to be taken as well as the profit or loss
during the daily transaction after the signal to be tested. In these technical
trading systems transaction costs are totally ignored.
Data Analysis

The strategies common to all indicators were the discussed below. There
is a specific strategy for transforming the technical analysis indicators
into specific buy and sell signals according to trade rule.
• Comprehensive: Go (long, short) every stock whose indicator is
according to the trading rule.
• Buy and hold strategy. Buy at the beginning of June 2004 and sell
on June 10 2005.
More specifically, appropriate charts for each indictor are used to test
whether the buy and sell signals yield profit or loss.
There are four indicators which are used to analyze

Rule 1: Analyze the signal generated by using Dual Moving average as
follows:
• When the faster simple moving average has below the slower
simple moving average and crosses above the slower Simple
moving average, a buy signal is generated.
• When the faster simple moving average has been above the
slower simple moving average and crosses below the slower
simple moving average, a sell signal is generated.
Rule 2: Analyze the signal generated using the MACD
• The basic MACD trading rule is to sell when the MACD falls
Below its signal line and to buy when the MACD rises above its
Signal line.
Rule 3: Analyze the signal generate using RSI

• A buy signal when RSI touches the lower bond (typically set at
25) which indicates the market is oversold and hence time to
buy.
• A sell signal when RSI touches the upper bound (typically set at
75) which indicates that the market is overbought and hence
time to sell.
Rule 4: analyze the profitability of buy and holding strategy

Chapter 4
Results, analysis and

Discussion
Results

1) PDF Solution
Compan y Data
Compan y Name: PDF Solutions, Inc.
Dow Jones Industry: Software
Exchange: NYSE
Shares Outstanding: 25,868,000
Rule 1:
The signals, dates, price and profit (loss) for the 9- and 18-day moving
averages shown as follow:
Action Date Price ($) Profit

(Loss) ($)
Buy June-6 2004 9.77 N\A
Sell June-18 2004 8.71 (1.06)
Buy July-21 2004 7.95 N/A
Sell Nov-04 2004 13.07 5.12
Overall, the results for the buy signal as well as for the difference
between the buy and sell signals were reasonably good for the chartists

Rule 2:
Using the MACD method the following trading activity is shown as

follows:

(Loss) ($)
B uy 16- July 2004 7.85 N\A
Sell 27- Aug 2004 9.46 1.61
B uy 03- Sep 2004 9.66 N\A
Sell 11- Oct 2004 12.65 2.99
B uy 01- Dec 2004 13.65 N\A
Sell 30- Dec 2004 16.55 2.90
B uy 11- Feb 2005 13.74 NA
The above chart demonstrates the difficult in comparing MACD levels

over a long period of time Feb 2005 onwards.

Rule 3:
Using the RSI method the following trading activity and profit (loss) are
analyzed.
(Loss) ($)
Buy 24- June 2004 8.4 N\A
Sell 27- July 2004 9.06 .66
Buy 26- Oct 2004 12.2 N\A
Sell 17- Dec 2004 16.65 4.45

Buy 14- Jan 2005 14.9 N\A
between the buy and sell signals were reasonably good for the chartists.
Rule 4:
Buy and hold strategy:
If Buy and hold strategy is applied there is a loss of ($12.53-$8.87), $3.66

per share

2) The Coca-Cola Company
Compan y Data
Compan y Name: The Coca-Cola Company
Dow Jones Industry: Soft Drinks
Exchange: NYSE
Shares Outstanding: 2,407,773,952
Rule 1:
Action D at e Price ($) Profit
(Loss) ($)
Buy 19- Aug 2004 44.02 N\A
Sell 07- Sep 2004 45.65 1.63
Buy 07- Oct 2004 40.12 N\A
Sell 18- Nov 2004 40.28 0.16
Buy 07- Dec 2004 40.16 N\A
Sell 10- Mar 2005 43.07 2.91
Bu y 11- Apr 2004 41.87 N\A
Sell 07- June 2005 44.11 2.24

Rule 2:

follows:

(Loss) ($)
Bu y 11- Aug 2004 44.45 N\A
Sell 13- Sep 2004 42.80 (1.65)
Bu y 30- Sep 2004 40.05 N\A
Sell 16- Nov 2004 40.25 0.20
Bu y 01- Dec 2004 39.77 N\A
Sell 03- Jan 2004 41.54 1.77
Bu y 02- Feb 2005 41.92 N\A
Sell 07- Mar 2005 43.72 1. 8
Bu y 21- Apr 2005 41.98 N\A
Sell 27- May 2005 44.90 2.92

Rule 3:
analyzed.

(Loss) ($)
Bu y 29- July 2004 43.06 N\A
Sell 19- May 2005 45.25 2.19
Rule 4:

per share

3) General Electric Company
Compan y Data
Compan y Name: General Electric Company
Dow Jones Industry: Diversified Industrials
Exchange: NYSE
Rule 1:
(Loss) ($)
Buy 16-July 2004 33.09 N\A
Sell 03- Aug 2004 32.88 0.21
Buy 24- Aug 2004 32.63 N\A
Sell 29- Sep 2004 33.45 0.82
Buy 08- Oct 2004 33.74 N\A
Sell 19- Oct 2004 33.43 (0.31)
Bu y 02- Sep 2004 34.05 N\A
Sell 02- Dec 2004 35.94 1.89
Bu y 10- Dec 2004 36.69 N\A
Sell 31 Dec 2004 36.50 (0.19)
Bu y 02 Jan 2005 36.25 N\A

Sell 22 Jan 2005 35.35 (0.90)
Rule 2:
Using the MACD method the following trading activity is shown from
the above chart.
(Loss) ($)
Buy 14- June 2004 31.57 N\A
Sell 29- June 2004 32.33 0.76
Buy 14- July 2004 32.84 N\A
Sell 22- July 2004 32.88 0.04
Buy 18- Aug 2004 32.78 N\A
Sell 23- Sep 2004 33.42 0.64
Buy 10- Dec 2004 36.69 N\A
Sell 22- Dec 2004 36.84 0.15
Buy 27- Jan 2005 35.61 N\A
Sell 15- Feb 2005 36.39 0.78

Rule 3:
analyzed.

(Loss) ($)
Buy 5- Aug 2004 31.83 N\A
Sell 20- Sep 2004 34.21 2.38
Buy 25- Oct 2004 32.90 N\A
Sell 10- Nov 2004 35.32 2.42
Buy 5- Jan 2005 35.93 N\A
Sell 04- Feb 2005 36.25 0.32
Bu y 02- Mar 2005 35.6 N\A
Sell 18- May 2005 36.9 1. 3
Rule 4:
If Buy and hold strategy is applied there is a profit of ($36.63-$31.57),

$5.06 per share

4) General Motors Corporation
Compan y Data
Compan y Name: General Motors Corporation
Dow Jones Industry: Automobiles
Exchange: NYSE
Rule 1:

(Loss) ($)
Buy 01- Sep 2004 41.31 N\A
Sell 21- Sep 2004 42.05 0.74
Buy 04- Nov 2004 39.50 N\A
Sell 23- Nov 2004 39.56 0.06
Buy 14- Dec 2004 38.63 N\A
Sell 10- Jan 2005 38.49 (0.14)

Bu y 04- Feb 2005 37.22 N\A
Rule 2:
the above chart.
(Loss) ($)
Buy 28- June 2004 46.51 N\A
Sell 27- July 2004 43.46 (3.05)
Buy 01- Sep 2004 41.21 N\A
Sell 12- Oct 2004 41.80 0.59

Rule 3:
analyzed.

(Loss) ($)
Buy 25- Oct 2004 37.04 N\A
Sell 04- May 2004 32.8 (4.24)
Rule 4:
If Buy and hold strategy is applied there is a loss of ($34.51-$47.09),

$12.58 per share

5) ABX Air Inc
Compan y Data
Compan y Name: Abx Air Inc
Dow Jones Industry: Delivery Services
Exchange: NYSE
Rule 1:
(Loss) ($)
B uy 09- Aug 2004 6.27 N\A
Sell 25- Oct 2004 6.53 0.26
B uy 04- Nov 2004 6.86 N\A
Sell 11- Jan 2005 7.85 0.99
B uy 07- Feb 2005 8.30 N\A
Sell 17- Feb 2005 7.45 (0.85)

Rule 2:
the above chart.
(Loss) ($)
B uy 15- June 2004 4.50 N\A
Sell 15- July 2004 6.70 2.20
B uy 27- Aug 2004 5.77 N\A
Sell 15- Oct 2004 6.85 1.08
B uy 05- Nov 2004 6.99 N\A
Sell 22- Nov 2004 7.40 0.41
B uy 17- Dec 2004 8.10 N\A
Sell 04- Jan 2005 8.60 0.50
The signal after Jan 2005 was a difficulty to identify the exact signaling
action point. Overall, the results for the buy signal as well as for the
difference between the buy and sell signals were reasonably good for the
chartists.

Rule 3:
analyzed.

(Loss) ($)
Buy 13- Jan 2005 7.67 N\A
Sell 06- May 2005 8.29 0.62
Rule 4:
If Buy and hold strategy is applied there is a profit of ($7.65-$4.39), $3.26

per share

6) IBM International Business Machines
Compan y Data
Compan y Name: International Business Machines
Dow Jones Industry: Computer Services
Exchange: NYSE
Rule 1:
(Loss) ($)
Buy 23- July 2004 84.85 N\A
Sell 10- Aug 2004 84.99 0.14
Buy 30- Aug 2004 84.4 N\A
Sell 24- Sep 2004 84.43 0.03
Buy 10- Oct 2004 88.04 N\A

Sell 05- Jan 2005 96.5 8.46

Buy 25- May 2005 76.00 N\A
Rule 2:
the above chart

(Loss) ($)
Buy 19- July 2004 85.93 N\A
Sell 03- Jan 2005 97.75 11.82
Buy 29- Apr 2005 76.38 N\A

Rule 3:
analyzed.

(Loss) ($)
Buy 8- July 2004 83.65 N\A
Sell 15- Nov 2004 95.92 12.27
Buy 20- April 2005 72.01 N\A
Rule 4:

per share

7) AT&T Corp.
Compan y Data
Compan y Name: AT&T Corp.
Dow Jones Industry: Fixed Line Telecommunications
Exchange: NYSE
Rule 1:

(Loss) ($)
Bu y 15- July 2004 14.60 N\A
Sell 10- Aug 2004 14.09 (0.51)
Bu y 25- Aug 2004 14.78 N\A
Sell 28- Sep 2004 14.40 (0.38)
Bu y 11- Oct 2004 15.24 N\A
Sell 04- Jan 2005 18.33 3.09
Bu y 24- Jan 2005 18.51 N\A
Sell 23- Feb 2005 19.32 0.81

Rule 2:
follows:

(Loss) ($)
B uy 9- July 2004 14.37 N\A
Sell 6- Aug 2004 14.19 (0.18)
B uy 16- Aug 2004 14.21 N\A
Sell 21- Sep 2004 15.3 1.09
B uy 6- Oct 2004 15.2 N\A
Sell 22- Dec 2004 18.44 3.24
B uy 25- Jan 2005 18.54 N\A
Sell 18- Feb 2005 19.41 0.87
B uy 1- April 2005 18.66 N\A
Sell 14- April 2005 (18.46) 0.2

Rule 3:
analyzed.

(Loss) ($)
B uy 25- June 2004 14.86 N\A
Sell 12- Nov 2004 18.25 3.39
Rule 4:

$3.1 per share

8) United States Stl Corp New
Compan y Data
Compan y Name: United States Stl Corp New
Dow Jones Industry: Steel
Exchange: NYSE
Rule 1:
(Loss) ($)
B uy 5- Oct 2004 40.49 N\A
Sell 18- Oct 2004 34.73 (5.76)
B uy 1- Nov 2004 37.39 N\A
Sell 14- Dec 2004 49.31 11.92
B uy 21- Dec 2004 53.4 N\A
Sell 05- Jan 2005 48.84 (4.56)
B uy 24- Jan 2005 50.37 N\A

Sell 11- Mar 2005 56.55 6.18
Rule 2:
the above chart
(Loss) ($)
Buy 14- Jun 2004 28.9 N\A
Sell 21- July 2004 34.86 5.96
Buy 01- Sep 2004 36.59 N\A
Sell 17- Sep 2004 38.00 1.41
Buy 01- Oct 2004 38.36 N\A
Sell 11- Oct 2004 38.74 0.38
Buy 27- Oct 2004 37.18 N\A
Sell 06- Dec 2004 50.25 13.07
Buy 28- Jan 2005 50.97 N\A
Sell 07- Mar 2005 59.00 8.03
Buy 03- May 2005 43.61 N\A
Sell 12- May 2005 38.98 (4.63)
Buy 19- May 2005 40.41 N\A

Rule 3:
analyzed.

(Loss) ($)
Buy 19- Oct 2004 32.88 N\A
Sell 30- Dec 2004 52.36 19.48
Buy 15- Apr 2005 42.91 N\A
Rule 4:

$9.04 per share.

9) Microsoft Corporation
Compan y Data
Compan y Name: Microsoft Corporation
Dow Jones Industry: Software
Exchange: NYSE
Market Cap: 274.8 Billion
Rule 1:
(Loss) ($)
Buy 23- July 2004 28.03 N\A
Sell 06- Aug 2004 27.14 (0.86)
Buy 27- Aug 2004 27.46 N\A
Sell 01- Nov 2004 28.04 0.58
Buy 06- Apr 2005 24.67 N\A

Rule 2:
the above chart
(Loss) ($)
Buy 10- Jun 2004 26.77 N\A
Sell 06- Jul 2004 28.02 1.25
Buy 26- Aug 2004 27.44 N\A
Sell 22- Oct 2004 27.74 0.30
Buy 06- Dec 2004 27.33 N\A
Sell 14- Jan 2005 26.12 (1.21)
Buy 27- Jan 2005 26.11 N\A
Sell 17- Feb 2005 25.79 (0.32)

Rule 3:
analyzed.

(Loss) ($)
B uy 24- Jan 2005 25.67 N\A
Rule 4:

10) Ford Motor Company
Compan y Data
Compan y Name: Ford Motor Company
Dow Jones Industry: Automobiles
Exchange: NYSE
Rule 1:
(Loss) ($)
Buy 04- Nov 2004 13.78 N\A
Sell 11- Jan 2005 14.43 0.65
Buy 06- May 2005 9.76 N\A

Rule 2:
the above chart

(Loss) ($)
B uy 14- June 2004 15.22 N\A
Sell 29- June 2004 15.87 0. 65
B uy 26- Aug 2004 13.97 N\A
Sell 06- Oct 2004 14.18 0. 21
B uy 29- Oct 2004 13.03 N\A
Sell 03- Jan 2005 14.71 1. 68
If Buy and hold strategy is applied there is a loss of ($10.33- $15.22), $ 4.89.

Rule 3:
analyzed.

(Loss) ($)
Buy 04- Oct 2004 13.12 N\A
Sell 23- Dec 2004 14.8 1.68
Buy 21- Jan 2005 13.11 N\A
Rule 4:
If Buy and hold strategy is applied there is a loss of ($10.33- $15.22), $ 4.89.

Summar y of Profits made by various strategies
Using Technical Analysis Buy and

strategy Hold
Company MA MACD RSI Strategy
PDF Solution 4.06 -1.02 5.11 3.66

The Coca-Cola Company 6.94 3.27 2.19 -7.43
General Electric Company 1.52 2.37 6.42 5.06
General Motors Corporation 0.66 -2.46 -4.24 -12.58
ABX Air Inc 0.4 4.19 0.62 3.26
IBM International Business Machines
8.63 11.82 12.27 -15.3
United States Stl Corp New 3.01 5.22 3.39 3.1
AT&T Corp 7.78 24.22 19.48 9.04
Microsoft Corporation -0.28 0.02 0 -1.47
Ford Motor Company 0.65 2.54 1.68 -4.89
Total 33.37 50.17 46.92 -17.55

Chapter 5
Conclusions
and
Recommendation

Conclusions and Recommendation
5.1 Conclusions
In general, we can conclude from the results that the technical indicators
can play a useful role in the timing of stock market entry and exits. By
applying technical indicators, brokers or investors may enjoy substantial
profits.
The moving average Convergence and Divergence policy gives greater

total profit than the “ buy” and “ hold” Strategy. This study offers
predictive ability of technical trading rules without trading costs
environment in the market. The use of historical price information
together with the current prices allows extra returns to be generated.
The findings confirm the predictive ability of moving averages and
Convergence and the Relative Strength Index with out taking cost of
trading in to account.
Most survey studies indicate that technical analysis has been widely used
by market participants in futures markets and foreign exchange markets,
and that at least 30% to 40% of practitioners regard technical analysis as
an important factor in determining price movement at shorter time
horizons up to one year.
Despite positive evidence about profitability and improved procedures for
testing technical trading strategies, skepticism about technical trading
profits remains widespread among academics.

Technical analysis may be partially self-fulfilling and thus its

employment is likely to further increase its popularity. Thus it was
suggested that the usage of technical analysis would be likely to increase
volatility in stock markets.
This may show that there are potential negative impacts on society as a
whole of widespread usage of technical analysis, particularly through a
reduction in physical investment.
5.2 Recommendation
• We should buy stocks which demonstrate the potential for
explosive gains, while maintaining a highly disciplined trading
rules and exit strategy to manage risk.
• Focus on your potential risk and identifying your exit plan and
should your trade go against you, it is easy to keep emotions out of
the game allowing you to think clearly and stick to your trading
plan.
• You need to have a proven and consistent strategy that will allow
you to find winning stocks in any market environment.
• It is better to keep the application of technical analysis as simple as
possible using some of the indicators.
• For active trading in the short run this should be the better rather
than a long-term investors.

Bibliography
Brock, W., J. Lakonishock, and B. LeBaron. “ Simple Technical Trading
Rules and the Stochastic Properties of Stock Returns.” Journal of
Finance, 47(1992)
Frankel, J. and K. Froot, 1990b, Chartists, Fundamentalists and the .
Demand for Dollars, in Private Behavior and Government Policy in
Interdependent Economies, A.S. Courakis and M.P. Taylor (eds),
Oxford University Press
Froot, K.A., D.S. Scharfstein and J.C. Stein, 1992. Heard on the street :
information inefficiencies in a market with short-term speculators.
Journal of Finance 47
Fischer and Jordan. “ Security analysis and Portfolio management” sixth

edition
Lo, A.W., Mamaysky H. and Wang, J. 2000. Foundations of technical

analysis: computational algorithms, statistical inference, and
empirical implementation. Journal of Finance
Shiller, R.J., 1984, Stock Prices and Social Dynamics, Brookings Papers
on Economic Activity, 2, Brookings Institution,
Sy W., 1990, Market Timing: Is It a Folly? Journal of Portfolio

Management
‘’ Technical Analysis’ ’ , Capital Market Publisher, 2004

V.K Bhalla. “ Investment management” 11th edition
http://www.stockcharts.com
http://www.bigcharts.com
http://finance.yahoo.com


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TESTING OF TECHNICAL ANALYSIS

TOOLS AS A SIGNAL FOR ENTRY AND

Submitted in partial Fulfillment of the requirements for the

UNDER THE GUIDANCE OF

Dr. Nagesh S Malavalli

M.P. Birla Institute of Management

I here by certify that this project report entitled “Testing

This project report was prepared by me in partial

Date: 15/06/2005 Azime Adem Hassen

M.P. Birla Institute Of Management June, 2005

I am extremely grateful to my Guide Dr. Nagesh S Malavalli,

I would also like to thank my friends and family members for

M.P. Birla Institute Of Management June, 2005

This is to certify that Project titled “Testing of technical

Date: 15th June 2005 Principal

M.P. Birla Institute Of Management June, 2005

This is to certify that the project titled “ Testing of Technical

Date: June 15, 2005 (Dr. Nagesh.S.Malavalli)

M.P. Birla Institute Of Management June, 2005

Chapter 1 1.1 Introduction …………………………………2

1.2 Purpose and objective of the study…………4

Chapter 2 Review of Literature…………………………….6

2.1 Moving Averages ………………………..9

2.2 Relative Strength Index…………………12

2.3 Moving Average Convergence

Chapter 3 Data and Methodology………………………….24

Chapter 4 Results, Analysis and Discussion………………29

Chapter 5 Conclusion and Recommendations…………….62

M.P. Birla Institute Of Management June, 2005

In this paper we assess whether different tools of technical analysis can

M.P. Birla Institute Of Management June, 2005

M.P. Birla Institute Of Management June, 2005

Stock market prediction analyses can generally be classified as either

Technical stock analysis is based on three basic principles namely:

Technical analysis is a forecasting method of price movements using past

“ The technical approach to investment is essentially a reflection of the

M.P. Birla Institute Of Management June, 2005

M.P. Birla Institute Of Management June, 2005

most frequently used counter-trend indicator, the Relative Strength Index

1.2 Purpose and Objectives of the Study

The purpose of this study is to tests the performance the technical

M.P. Birla Institute Of Management June, 2005

M.P. Birla Institute Of Management June, 2005

The guiding principle of technical analysis is to identify and go along

M.P. Birla Institute Of Management June, 2005

to the formation of speculative bubbles (see, for example, Froot,

Practitioners’ reliance on technical analysis is well documented. Frankel

M.P. Birla Institute Of Management June, 2005

level, the prevalence of technical analysis is demonstrated by the fact that

The guiding principle of technical analysis is to identify and go along

Shiller (1984, 1987) found that irrational investor behaviour resulted in

M.P. Birla Institute Of Management June, 2005

2.1 Moving Averages (MA)

M.P. Birla Institute Of Management June, 2005

Where Mt,n is the Simple Moving Average defined in (1) and

Dual Simple Moving Average Crossover is used to limit the amount of

Typically, the Moving Averages used in the Dual Simple Moving

M.P. Birla Institute Of Management June, 2005

The BUY and SELL signal generation:

ABX, 5-40 day Dual Simple Moving Average Crossover Signals

M.P. Birla Institute Of Management June, 2005

2.2 Relative Strength Index

The momentum oscillator measures the velocity of directional price

M.P. Birla Institute Of Management June, 2005