TECHNICAL ANALYSIS

DOW THEORY
In 1897, Charles Dow developed two broad market averages. The industrial Average 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.

Dow Theory and its six assumptions
‡ The averages discount everything
± The individual stock¶s price reflects everything that is known about the security

‡ The market comprises three trends
± The Primary, Secondary and Minor trends

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 by record corporate earnings in the third phase .

S&P Nifty C Three parts Of Primary Trends B A .

‡ The volumes confirms the trend ‡ A trend remains intact until it gives a definite reversal again .Assumptions continued« ‡ The averages must confirm each other ± The industrials and transports must confirm each other for a valid change of trend to occur.

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Political.The markets move in the path of least resistance. Psychological. Economic etc ‡ Prices move in trends . . ‡ History repeats itself ± ± Mass psychology does not change. ± Markets overextend because of the herd instinct leading to panic and euphoria time and again. ‡ The market discounts everything ± Fundamental.Summarizing«.

the direction of price movement and spotting any trend reversal as early as possible. certain heavily traded stocks.e.Technical analysis. etc. . stock market indices. ‡ Applicable only when prices fluctuate freely in response to market forces of demand and supply for the underlying assets like commodities.features ‡ Identification of the current trend i.

‡ Historical price and volume data analyzed with the help of charts.features«contd ‡ More reliable in case of broad and very liquid markets than thin and shallow markets. . ‡ Helps to judge the emotional state of the market.Technical analysis. The market has its own collective consciousness distinct from the individual consciousness of the participants.

assumes that the price at any given time is the result of not only the fundamental factors but also the market¶s collective response to all the factors. ‡ Technical analysis. .Contrast with Fundamental Analysis ‡ Fundamental analysis is concerned with all the fundamental factors. on the other hand. economists focus on certain fundamentals and µprescribe¶ how the market ought to behave when the market behavior is linked to some other factors. ‡ Often.

CHARTS .

. weekly or monthly basis and connecting the same. daily.Line Chart ‡ Line chart or the closing price chart is constructed by plotting the closing prices on hourly.

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Each vertical line represents the price movement during that unit of time.Bar chart ‡ Bar chart comprises of a series of vertical lines. . The high and low are connected and then horizontal hashes are drawn on the left and right to represent the opening and closing prices respectively.

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The ranges on either side of the real body are called upper shadow and lower shadow.Candle Stick ‡ Japanese candlestick chart differs from bar chart in that the range between the open and the close is shown as a white or black rectangle called the real body. .

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TRENDS .

Trend Lines ‡ Direction of movement. downtrend and flat or neutral trend. . ‡ Prices move in a zigzag fashion ± In an uptrend. ± The relative position of successive highs and lows determine the trend at any given point of time. ‡ Uptrend : series of higher highs and higher lows. the reaction is downwards while in a downtrend. ‡ Zigzag movement gives rise to a series of tops and bottoms or highs and lows. the reaction is upwards. Could be uptrend.

In order for an up-trend to reverse. . prices must have at least one lower high and one lower low (the reverse is true of a downtrend).An up-trend is defined by a series of higher-highs and higher-lows.

Trend Lines ‡ Trend lines are straight lines drawn by connecting either the highs or the lows. ‡ In an uptrend. 2 or more rising lows are connected to denote an uptrend line. . 2 or more falling highs are connected to denote a downtrend line. ‡ A horizontal or flat trend line is drawn by connecting either the highs or the lows. ‡ In a downtrend.

. ‡ Reversal of downtrend indicated by the price rising above the downtrend line. ‡ Reversal of uptrend signalled by the price falling below the uptrend line.Trend Lines ‡ The importance of a trend line lies in its ability to indicate the possibility of a trend reversal.

Trend Lines.uptrend .

Trend Lines.downtrend .

Trend Lines.sideways .

Trend Lines.channel .

Trend Reversal .

‡ No fixed rule to judge whether such penetration signals a pause or a reversal. important clues are often available. However.Finer points 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. ‡ Steeper a trend line. . greater is the possibility of its penetration signaling just a pause and not a reversal.

the stronger the trend line and more powerful is its penetration.Finer points in Trend Lines ‡ As to duration. trend line penetration accompanied by rising volumes or breakout from a reversal pattern very often signals a trend reversal. the longer a trend has been in force. the more the number of times a trend line is touched by the price. . ‡ Similarly. ‡ Finally. the more powerful is the violation of the trend line.

SUPPORT & RESISTANCE .

. ‡ Zigzag price movement gives rise to highs and lows or tops and bottoms.Support-Resistance ‡ Support is the price level where enough buying pressure builds up to stop a decline at least temporarily and prompt a recovery. ‡ Tops offer resistance and bottoms offer support. ‡ Resistance indicates a price level at which selling pressure mounts to halt an ongoing rally and start a decline.

Support .

Resistance .

RETRACEMENT .

1. ‡ The ratio of any number to its next lower number is 1.618 after the first 4.618 or the reciprocal of 0.3.5. .13.21 ‡ Sum of any two consecutive numbers equals the next highest.618.2.Fibonocci Retracement Analysis ‡ Number sequence . ‡ The ratio of any number to its next higher number approaches 0.8.1.

‡ The most common numbers in retracement analysis are 0.0.500 and 0.382.Fibonocci Retracement Analysis ‡ The ratio of alternate numbers approaches 2.618 or its reciprocal 0.618 .382.

Fibonocci Retracement Analysis .

Fibonocci Retracement Analysis .

REVERSALS .

‡ In an uptrend. price declines from a peak to form the left shoulder.Heads & Shoulders ‡ Most powerful reversal pattern and resembles a head and two shoulders. ‡ Price then rallies to a new high. called the head before falling again to or near the previous low. ‡ Now the price rises once more but tops out lower than the head and near the level of the left shoulder. This third top is called the right shoulder. .

.first low between the left shoulder and the head and the second low between the head and the right shoulder.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 .

.Heads & Shoulders ‡ The head and shoulders breakout is followed by a sharp down move with heavy volume before price rallies towards the neckline on lower volume. the downtrend usually resumes. After this return move.

Heads & Shoulders .

. Volume is rising when prices are approaching the top of the left shoulder and dips on the first reaction. After the head is formed. price falls below the top of the left shoulder indicating possibility of trend change. when price begins to fall again and breaks the neckline it is on higher volume. increase in volume is not prominent. Finally.Heads & Shoulders ‡ Volume plays an important role in the formation of this pattern. When price crosses over the peak of left shoulder. Price usually finds support near the previous low and rallies again but forming a lower top with lower volume.

‡ From this breakout point. Price rises to form a top with an increase in volume. ‡ Double top reversal is confirmed when the price falls and closes below the intervening low.Double top reversal pattern Also referred to as the "M" type reversal pattern. ‡ Important point to note is that volume should be rising at the breakout point else the pattern is suspect. the price target equals the vertical distance between the double top and the intervening low. Next rally fails to cross the previous peak and ends thereabout forming a second top. ‡ ‡ ‡ ‡ . This is followed by a price drop on lower volume.

Double Top .

‡ The target of such a move would be the height of the rectangle (difference between the lower and upper channel lines. ‡ A break over the upper or the lower channel line would result in a big move. .Rectangle ‡ This pattern after a sharp up move or a down move. much similar to a rectangle. ‡ Market consolidates in a narrow sideways band between two parallel lines.

Rectangles .

simple moving average. exponential moving average and weighted moving average.Moving Averages ‡ Zigzag movement of prices often makes it difficult to judge the underlying trend. . ‡ Another popular way is to smooth the price data with the help of moving averages. ‡ Technical analysts use three different types of moving averages . Trendlines do help as we have already seen.

‡ The moving average system of trading is also known as the trend following system because the trader waits for the trend to be established before initiating a trade . ‡ We will discuss only the simple moving average because it is the easiest to compute and interpret.Moving Averages«.

Moving Averages .

Interpretation of MAs ‡ A moving average smoothens the underlying price data and represents the trend for the period used to calculate the average. it acts as a curved trendline providing support in an uptrend and resistance in a downtrend. intersection of the price with the moving average signals at least a pause in the trend by way of a correction and possibly a trend reversal. ‡ More importantly. ‡ Since the moving average reflects the trend. .

both the price and the moving average are rising and price is above the moving average. If the moving average is still rising. ‡ After a while renewed buying usually pushes the price again over the moving average. such a crossover of the price over the moving average indicates resumption of the uptrend. . it would probably signal just a correction.Interpretation of MAs« ‡ In an uptrend. If the price were now to move below the moving average while the moving average is still rising.

. caution is indicated if the moving average has begun to move sideways. when prices retrace 50 to 60% of the previous move. However. ‡ However.Interpretation of MAs«. A trend reversal is now more likely and is signalled when the price again crosses below the moving average. ‡ Penetration of a very short term average such as the 5day average occurs often in long lasting trends and often signals temporary pauses in the trend by way of correction or consolidation. This happens after a sharp upmove or a downmove when profit-taking sets in a countertrend move in the opposite direction. players who missed the earlier move usually enter leading to resumption of the underlying trend.

Interpretation of MAs« ‡ On the other hand. penetration of say 20day average accompanied by a change in the direction of the moving average itself. would usually confirm trend reversal or prolonged and deep correction. .

‡ Ordinary bands such as moving average envelopes are specified as a fixed percentage channel around a moving average. ‡ An alternate and popular method of constructing bands is based on a moving standard deviation. . Such bands are known as Bollinger bands.Bollinger Bands ‡ Empirical evidence shows that exchange rates fluctuate around a moving average.

Bollinger Bands .

‡ A typical set up is a 20-day moving average with bands placed 2 standard deviations from the moving average. ‡ Choose a multiple of the standard deviation and create a band around the moving average. calculate the standard deviation of the price around the moving average. .BB-construction ‡ Take a n-period moving average of the price data. ‡ For each period.

. ‡ In uptrends.BB. a trend reversal or at least a deep correction is likely.e. the price usually moves between the moving average and the lower bollinger band. the price usually moves between the 20-day moving average and the upper bollinger band while in a downtrend. ‡ Sharp price movements accompanied by range expansion are often preceded by a contraction of the band due to a period of reduced volatility. if the price quickly moves back into the band. ‡ However. the standard deviation of the prices. ‡ Penetration of the upper bollinger band in an uptrend or the lower bollinger band in a downtrend usually suggests an acceleration in the trend.Interpretation ‡ The width of the band obviously varies with the volatility i.

OSCILLATORS .

Types of Oscillators ‡ ‡ ‡ ‡ Momentum Rate of Change (ROC) Relative Strength Index (RSI) Stochastics ± Fast ± Slow ‡ Money Flow Index .

. Caution : Such warnings are not a signal to take countertrend positions but only to trim existing profitable positions or protect them with tight stops.Oscillators ‡ Oscillators are price derivatives. Extreme oscillator readings indicate that the market is overextended. give advance warnings of an impending trend reversal and alert the trader or hedger to book some profits or to be on the lookout for other signs of a reversal. overbought or oversold. that is.

10-day momentum measures the size and direction of the price change over the last 10 days.Momentum ‡ Momentum denotes the speed at which prices are rising or falling. ‡ Momentum has to be related to some period. For example. .

‡ The momentum line so plotted oscillates around the zero line.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 µt¶. P(t) is the price at time µt¶ and P(t-n) is the price at time µt-n¶.Momentum.

Momentum .

is called divergence. . the momentum peaks out and reverses before reversal of the trend itself. we often see prices making new highs or lows on lower momentum indicating a weak technical position susceptible to reversal.Momentum . In such cases. ‡ However. Such a phenomenon of a new high or low in price without being confirmed by a new high or low in momentum. ‡ Such a divergence is a red alert and a signal for booking profits on existing positions rather than a signal for taking positions in the opposite directions. even after reversal of momentum it is prudent to wait for reversal of the price trend because quite often powerful trends overextend before finally reversing.Interpretation ‡ Just as a car moving at high speed slows down before coming to a halt or making a U-turn.

the price has risen too far too fast and signal a correction while extremely low values suggest an oversold market and warns of a possible rally.Momentum. . ‡ A disadvantage of the momentum oscillator is that it is difficult to pinpoint extreme values without comparative historical data.Interpretation ‡ On a stand alone basis. ‡ Overbought and oversold signals are given when the momentum oscillator reaches extremely high or low values. the best available confirmation of a trend reversal or trend resumption after a correction is the crossing of the momentum line above or below the zero line.e. Let¶s therefore examine 2 other oscillators that are normalized and whose values always move between 0 and 100. Extremely high values point to an overbought condition i.

Rate of Change (ROC) ‡ ROC is classed as a price momentum indicator or a velocity indicator as it measures the rate of change or the strength of momentum of change ‡ It is calculated as: ± (Closing price today ± Closing price µn¶ periods ago) / Closing price µn¶ periods ago ‡ ROC greater than zero indicate an increase in upward momentum and vice versa. .

RSI ‡ The RSI is an oscillator that always moves between 0 and 100. . Original designer proposed a 14-day period but 9-day RSI has also become popular. ‡ Necessary to specify a period for calculation.

RSI- Construction
‡ Choose a period for the RSI. Say we take it as 14 days. ‡ Tabulate the up closes and the down closes in the price over the 14-day period up to the given date. ‡ Divide the sum of the up closes by 14 to arrive at the average rise. ‡ Divide the sum of the down closes by 14 to arrive at the average fall. ‡ Calculate the relative strength (RS) as the ratio of the average rise to the average fall. ‡ Finally, calculate the RSI using the formula: RSI = 100 - [ 100/(1+ RS)]

Relative Strength Index (RSI)

RSI- overbought / oversold levels
‡ From the formula, one can see that if RS = 0, RSI = 0; if RS = 1, RSI = 50 and if RS = ¥ , RSI = 100. ‡ Normalization enables easier identification of overbought and oversold values. ‡ Typically, a market is said to be overbought, if RSI is above 70 and oversold if RSI is below 30.

RSI- Signals
‡ For instance, reversal of the RSI from the oversold region can be taken as a buy signal and reversal from the overbought region as a sell signal. ‡ However, in trending markets, RSI reversals opposite to the trend may only signal a correction and these signals could at the most be used for booking profits or trimming positions. On the other hand, RSI reversal in the direction of the trend usually signals resumption of the trend.

RSI divergence in the overbought or oversold zone is considered as a more reliable signal. . Bearish RSI divergence occurs when the price makes a new high but the RSI though overbought makes a lower high.RSI Signals«. Bullish RSI divergence occurs when the price makes a new low but the RSI makes a higher low in the oversold zone.contd ‡ For indicating impending trend reversal.

RSI Signals«. it is prudent to wait for some reversal indication in the price charts because it is not uncommon for RSI divergences to get repeated in powerful trends. .contd ‡ Even after getting RSI divergence.

market players tend to become less and less cautious and carry larger overnight risks.Stochastics ‡ This oscillator is based on the empirical evidence that the price usually closes near the high of the day or the last few days in an uptrend and near the low of the day or the last few days in a downtrend. ‡ The psychological reason is probably that as a trend persists longer and longer. ‡ This is a complex indicator and involves calculation of 3 statistical variables : %K. . fast %D and slow %D.

‡ Identify the highest intraday high (H) and the lowest intraday low (L) in the chosen period. 3-day moving average of %K values. %K oscillates between 0 and 100 and so also do fast %D and slow %D.Stochastics.Construction ‡ Choose a period for %K. . ‡ Evidently. plot fast %D and slow %D to form the slow stochastics. ‡ Plot %K and fast %D to form the fast stochastic indicator or the fast stochastics. Typical period is 5 days. Similarly.L) ‡ Calculate fast %D as a moving average. ‡ Also calculate slow %D as a 3-day moving average of fast %D values.L)/ (H . ‡ Calculate %K as follows: %K = 100 * (C . in this case.

Stochastics .

These are usually set as 80 and 20 or 70 and 30.Stochastics . the signals are similar except that these are generated with the crossover of fast %D over or below slow %D. ‡ With slow stochastics. a buy signal is given if %K crosses over fast %D in the oversold zone and is confirmed when fast %D moves up into the neutral region.Signals ‡ As with the RSI. . This seems preferable for mediumterm traders and hedgers. A sell signal is given if %K crosses below fast %D in the overbought zone and is confirmed when fast %D moves down into the neutral region. This may be suitable for short-term traders. ‡ With fast stochastics. there are overbought and oversold zones.