UNIT – IV TECHNICAL ANALYSIS

Fundamental Analysis Vs Technical Analysis

Charting methods
Trend – Trend reversals
Patterns
Moving Average – Exponential moving Average
Market Indicators
Oscillators
Efficient Market theory
 Technical analysis is a study of historical Prices
and volume movements of securities in order to
determine the future direction of price movement.

 It is a forecasting Technique that utilise Historical

share price data.

 Technical analysis is mostly helpful for day trades

and short term investors who are interested in the
short term movement in stocks to make quick profit.
Long term investor considers fundamental (mainly) as
well as technical analysis for investment decision
making.
 Difference between TA and FA
1. Fundamental analysts, analyse the stock based on the goals of the
investors. They study the financial strength of corporate, growth of
sales, earnings and profitability. They also take into account the
general industry and economic conditions.
The technical analysts mainly focus attention on the history of prices.
Technical analysts choose to study two basic market Price data and
volume.

2.The fundamental analysts estimate the intrinsic value of the shares

and purchase them when they are undervalued. They dispose the
shares when they are over priced and earn profits. They try to find out
the long term value of shares.
3. Compared to fundamental analysts, technical analysts mainly
predict the short term price movement rather than long term
movement. They are not committed to buy and hold policy
4. Fundamentalists are of the opinion that supply and demand
for stocks depend on the underlying factors. The forecasts of
supply and demand depend on various factors.

Technicians opine that they can forecast supply and demand

by studying the prices and volume of trading.

In both the approaches supply and demand factors are

considered to be critical. Business, economic, social and
political concern affect the supply and demand for securities.
These underlying factors in the form of supply and demand
come together in the securities’ market to determine security
prices
Basic Assumptions of Technical analysis
1) The market value of a security is determined by the
demand and supply factors operating in the market.

2) There are both rational and irrational factors which

surround the supply and demand factors of a security.

3) The market always moves in the trends except for minor

deviations.

4) Trends in stock prices occur when there is a shift in the

demand and supply factors.

5) As the market always moves in trends, analysis of past

market data can be used to predict future price behavior.
Basic Technical Tools
 Dow Theory
 Price Charts
 Moving Averages
 Price Patterns
 Indicators
 Trend lines
 Fibonacci ratios
 Dow Theory
 Charles Dow formulated Dow theory
 According the theory the market has three
movements
Primary trend
Secondary trend
Minor movements
Primary Trend
• In a primary trend the security price trend may be either
increasing or decreasing.

• When the market shows an increasing trend, it is the Bull

market.

• The bull market has at least three peaks and three bottoms.
Each peak is higher than the previous peak. The bottoms are
also higher than the previous bottoms

• When the market show a declining trend it is Bear Market

• The bear market consists of lower bottoms and lower tops.

The secondary trend
The secondary trend moves against the primary trend and
leads to correction.

In the bull market, the secondary trend would result in the fall
of about 33-66% of the earlier rise.

In the bear market, the secondary trend carries the price

upward and corrects the main trend.

Minor trends
Minor trends are the daily price fluctuations. Minor trend tries
to correct the secondary trend movement
• Dow developed the theory on the basis of certain
hypotheses
• The first hypothesis is that, no single individual or
Institution can influence the prime trend of the market.
• The second hypothesis is that the market discounts
everything
• The third hypothesis is that the theory is not
infallible. It is not a tool to beat the market but
provides a way to understand it better.
Price Charts
Price Chart is the basic tool used by the Technical Analyst to
study the share price movement.

The prices are plotted on an XY graph , where the X axis

represents the trading days and y axis denotes the price.

It is the security prices that are charted.

A share consists of 4 Prices :

Opening Price
High Price
Low Price
Closing Price

Of these 4 prices the closing price is the most important

Types of Price Charts

Point & Figure Chart :

It is the oldest charting Procedure

Line Chart :
It is the simplest price chart.
In this chart the closing prices of a share are plotted on the
XY graph and are connected by a straight line which would
indicate the trend of the market.
Bar Chart:

In this chart a bar is formed by joining the highest price and the lowest
price of a security by a vertical line.

The top of the bar represents the highest price of the day and the bottom of
the bar represents the lowest price of the day and a small horizontal hash
on the right of the bar is used to represent the closing price of the day and
a hash on the left of the bar is used to represent the opening price of the
day.

Candlestick Chart:

These charts shows the stocks open, high & low and close price on a day
to day basis.

The highest and the lowest price are joined by a vertical bar. The opening
and closing price of the share would be represented by a rectangle so
that the price chart looks like a candle stick.
There are 3 types of candle stick

White , Black and Doji.

In the white candle stick the closing price of the security is higher
than the opening price.

In the black candle stick the closing price is lower than the opening
price.

Thus white candle stick indicates a bullish trend and black candle
stick indicates a bearish trend.

A Doji candle stick is the one where the opening price and the
closing price of the day are the same.
Trends and Trend Reversals
Trend is the direction of movement of share prices in the market.

When the price moves upward it is a rising trend.

When the price moves downwards it is a falling trend.

Also we have flat trend where the prices move within a narrow range.

The change in the direction of the trend is referred to as Trend

reversal. A share showing a rising trend may start to move narrowly or
fall.

A technical analyst tries to identify the trend reversals at an early stage

to trade profitably in the market.

During a flat trend the investor should stay away from the market.
Chart Patterns :
When price charts of several days are drawn close together
certain patterns emerge.
These patterns are used by Technical analysts to identify trend
reversal and predict the future price movement.
There are three types of patterns
• Reversal Pattern
• Continuation Pattern
• Support & Resistance Pattern
Reversal Pattern
Reversal patterns are chart formations that tend to signal a
change in direction of the earlier trend
1) Head and Shoulder Formation
2) Inverted Head and Shoulder Formation
3) Other formations : Double Top , Double Bottom
Head and Shoulder Formation
• It is the most popular reversal pattern which usually occurs near the end
of a bull phase.
• This pattern is an indication of reversal of trend.
• This formation resembles the head and two shoulders of a man and
hence the name Head and Shoulder Formation.
• The first hump , known as the left shoulder , is formed when the prices
reach the top due to strong buying.
• Then the trading volume becomes less and there is a short downward
swing.
• This is followed by another high volume advance which takes the price to
a higher top known as the Head.
• Them the trading volume decreases again which takes the price down to
the earlier bottom.
• A third rally now occurs taking the price to a height less then the head but
comparable to the left shoulder.
• A horizontal line joining the bottom of this formation is known as the neck
line.
• As the price penetrates the neck line , it is expected to decline sharply.
Inverted Head and Shoulder Formation
• This pattern is the reverse of the head and shoulder formation
• This pattern occurs at the end of a bear phase.
• The first bottom is the left shoulder , then comes a lower bottom which
form the head , followed by a third bottom which is the right shoulder.
• The neck line is drawn by joining the tops of the pattern.
• When the price rises above the neck line the price is expected to rise
sharply.
• In the formation of this pattern a large increase in volume is necessary.
Inverted Head & Shoulder
Double Top
In double top the stock rises to a certain level , falls rapidly again rises
almost to the same height and falls down.
Its pattern resembles the letter M.
The double top is an indication of a bear market.
The pattern should be confirmed with volume and trend.

Double Bottom
In double bottom , the price of a stock falls to a certain level , rises rapidly
, then again it falls almost to the same lower level and rises again.
Its pattern resembles the letter W.
The double top is an indication of bull market.
Double Top Double Bottom
Continuation Patterns
These patterns are formed during the side ways movement of share prices.

These patterns indicate a continuation of the trend prevailing before the

formation of the pattern.

Types of Continuation pattern :

 Triangles

 Flags & Pennants

Triangles
Triangles are the popular continuation patterns.
Triangles are formed when the price movements result in two or more
consecutive descending tops and bottoms.
When these consecutive tops and bottoms are joined by straight lines.
The triangle formation may occur either at a bull phase or bear phase.
In either case it would indicate a continuation of the trend.
Normally the volume reduces during the movement within the triangle
pattern.
The breakout form the pattern is usually accompanied by increased volume.
Flags
These patterns occur midway between a bullish trend or bearish trend.
The flag formation looks like a parallelogram with the two trend lines
forming two parallel lines.
The volume of trading is dull during the formation of the flag and again
pick up on breaking out from the pattern.

Pennants
The pennant formation looks like a symmetrical triangle.
The upper trend line connecting the tops taper downwards , while the
lower trend line connecting the bottoms rises upwards .
Pennant is formed midway between a bullish or bearish trend and
signals the continuation of the same trend.
The break out from the pattern is accompanied by increased volume.
Mathematical Indicators
1) Moving Averages :
Simple Moving Average
Exponential Moving Average
Moving Averages can be used alone or in combinations.
2) Oscillators – help to identify overbought & Oversold
conditions
ROC
Measures the rate of change
0 line , overbought / oversold
RSI :
RSI values above 70 denotes overbought condition , below 30 denotes
oversold condition.
When it crosses the 30 line from below – Buying Opportunity
When it crosses the 70 line from above – Selling Opportunity

MACD :
Measures the Convergence & Divergence between two EMA.
Popular combination – 12 , 26
The difference between short term ema and long term ema represents
MACD.
Crossing the zero line from above and below is used for trading.
Also an ema of the macd values is superimposed over the macd graph.
Then buy and sell signals are generated by the cross over of both the
lines.
Market Indicators
Indicators used by technical analysts to study the trend of the
market as a whole are known as market indicators. They are
as follows
 Breadth of the Market
 Short Interest
 Odd – Lot Index
 Mutual Fund Cash Ratio
Breadth of the Market
By comparing the number of shares which have advanced and declined
during a period , the trend of the market can be analyzed.
The daily net differences between the advances and declines is called the
Breadth of the market.
Each day’s difference between the advances and declines of shares is
added to the next day’s difference to form a continuous cumulative index.

Day Advances Declines Daily Breadth

Difference
Monday 620 350 + 270 + 270

Tuesday 470 510 - 40 + 230

Wednesday 360 610 -250 - 20

The breadth index is plotted as a line graph and compared with the market
index.
Normally breadth and market index move in unity.
When they diverge , it indicates a key signal.
During bull market , if the market index makes new highs but the breadth
index makes new lows it indicates the market may fall.
Similarly , during a bear market , when the market index falls and the
breadth index makes new highs it signals a rise in stock prices.
Short Interest
The Volume of short sales in the market can be used as a market indicator
often known as Short Interest.
Short interest has a significant effect on the market as a whole.
Monthly short selling volume is divided by average daily volume to give a
ratio which indicates how many days of trading would be needed to cover up
the total short sales.
When the ratio is less than 1 , the market is considered to be weakening or
Over bought and the market may turn bearish.
When the ratio is above 1.5 it indicates the market is Over sold and the
market may turn bullish.
Odd – Lot Index
Small investors normally buy smaller number of shares than the normal
trading lot.
These are known as odd lots and the buyers and sellers of odd lots are
called Odd lotters.
Technical analysts believe that odd lotters take wrong decisions at critical
turns in the market because of their lack of knowledge.
The odd – lot index is obtained by dividing the odd –lot purchases by odd –
lot sales.
An increase in the index suggests more buying activity by the odd lotters.
Normally near the peak of the bull market the odd – lot index rises
noticeably and near the end of a bear market the odd – lot index decreases
sharply.
Mutual fund Cash Ratio
Mutual funds are one of the important institutional forces in the market.
Mutual funds keep cash in hand to take advantage of favourable market
opportunities.
A Mutual fund’s cash as a percentage of their net assets on a daily or
weekly or monthly basis is considered as a popular market indicator.
A low mutual fund cash ratio indicates the peak of a bull market ( the market
is about to decline ) and a low ratio indicates the end of a bear market ( the
market is about to rise ).
Moving Averages
1) The market indices don’t rise or fall in straight line. The underlying
trends can be studied by smoothening the data. To smooth the data,
moving average is used
2) Moving averages are mathematical indicators of the underlying trend of
the price movement.
3) The closing prices of shares are generally used for the calculation of
moving averages.
4) Two Types of moving averages :
Simple Moving average
Exponential Moving average
Simple Moving Average
In a simple moving average , a set of share price averages are calculated
for a specific number of days , each average being calculated by including
a new price and excluding an old price.
The calculation of a 5 Day SMA is as follows ,

Day Closing Price Total of 5 most recent Five day MA

Closing Prices
1 25
2 26
3 25.5
4 24.5
5 26 127 25.4
6 26 128 25.6
7 26.5 128.5 25.7
8 26.5 129.5 29.9
9 26 131 26
10 27 132 26.4
Exponential Moving Average ( EMA )
EMA is calculated by using the formula :
EMA = ( Current closing price – Previous EMA ) * Factor + Previous EMA
Where
Factor = 2
n+1
n = number of days for which the average is to be calculated.
 Calculation of Five – Day EMA
Days Closing Price EMA
1 33 33
2 35 33.66
3 37.5 34.93
4 36 35.28
5 39 36.51
6 40 37.66
7 40.5 38.60
8 38.5 38.57
9 41 39.37
10 42 40.24

Factor = 2 = 2 = 2 = 0.33
n+1 5+1 6
The EMA for the first day is taken as the closing price of that day itself.

EMA for the second day is calculated as follows :

EMA = ( 35 – 33 ) * 0.33 + 33 = 33.66

EMA for the third day = ( 37.5 – 33.66 ) * 0.33 + 33.66 = 34.93

A moving average represents the underlying trend in the share price

movement.

The period of the average indicates the type of trend being identified.

For example , a 5 day or 10 day average would indicate the short term
trend , a 50 day average would indicate a medium term trend , a 200 day
average would represent the long term trend.
The moving averages are plotted on the price charts
When the price of the share moves above and below the moving average it
may be taken as the sign of trend reversal.
Some times , Two moving averages – one short term and the other long
term are used in combination.
When the short term MA crosses the long term MA from below it is taken
as a buy signal.
When the Short term MA crosses over the long term MA from above it is
taken as a sell signal.
Oscillators
Oscillators are mathematical indicators calculated with the help
of the closing price data.
They help to identify overbought and oversold conditions and
also the possibility of trend reversals.
Types of Oscillators :
 Rate of Change ( ROC )
 Relative Strength Index ( RSI)
 Moving Average Convergence and Divergence ( MACD)
Rate of Change
 It measures the rate of change of the current price as compared to the
price a certain number of days or weeks back.
 To calculate a 7 day rate of change , each day’s price is divided by the
price which prevailed 7 days ago and then 1 is subtracted from this price
ratio.
ROC = Current Price - 1
Price ‘n’ period ago
 The ROC Values may be Positive , Negative or Zero.
 In an ROC Chart X axis represents the time and Y axis represent the
values of the ROC.
 The ROC Values oscillate across the zero line .
 When the ROC crosses the zero line from below to above the zero line it
indicates a buying opportunity.
 When the Roc crosses the zero line from above to below the zero line it
indicates a selling opportunity.
 The overbought zone is above the zero line , the oversold zone is below
the zero line.
Calculation of 7 Day ROC :
Days Closing price Closing price 7 days ago Price ratio ROC = Ratio -1
1 70
2 72
3 73
4 70
5 74
6 76
7 77
8 75 70 1.07 0.07
9 78 72 1.08 0.08
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Relative Strength Index ( RSI )
 It signals buying and selling opportunities.
 RSI for a share is calculated by using the following formula
 RSI = 100 – { 100 / ( 1 + RS ) }
Where RS = Average gain per day / Average loss per day.
 The most commonly used time period for the calculation of RSI is 14
days.
 For calculating a 14 day RSI , The gain per day or loss per day is arrived
at by comparing the closing price of the day with that of the previous day
for a period of 14 days.
 The gains are added and divided by 14 to get the average gain per day.
 Also the losses are added and divided by 14 to get the average loss per
day.
 The RSI Values range from 0 to 100.
 These values are then plotted on an XY graph.
 RSI values above 70 are considered to be overbought condition and
values below 30 are considered to be oversold condition.
 When the RSI crosses the 30 line from below to above ,it signals a
buying opportunity.
 When the RSI crosses the 70 line from above to below , it signals a
selling opportunity.
Moving Average Convergence Divergence ( MACD ) :
• MACD is an Oscillator that measures the convergence and divergence between
two exponential moving average.
• The difference between the short term EMA and the long term EMA represents
MACD. Normally a 12 day EMA and a 48 day EMA combination is used.
• The MACD values are derived by deducting the long term EMA for each day from
the corresponding short term EMA for the day
• The MACD values are plotted on a XY graph. The MACD line would oscillate
across a Zero line .
• If the MACD line moves above the zero line from below it signals a buying
opportunity.
• If the MACD line crosses below the zero line from above it signals a selling
opportunity.
• Sometimes a moving average of the MACD values is used in the MACD graph.
• The buy and sell signals are generated by the cross over of the average line with
the MACD Line.
 MACD (-5.09279) 65
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Efficient Market Theory
Random Walk Theory
• According to this theory , The share piece movements are at random and
not orderly.

• Change occurs in the stock price only because of changes in the economy
, Industry or company.
• Information about these changes alter the stock prices immediately and the
stock moves to a new level either upwards or downwards depending on the
type of information.
• This rapid shift to new equilibrium whenever new information is received is
due to the fact that all information which is known is fully reflected in the
price of the stock.
• Further change in the price of the stock will occur only with some other new
information.
• Thus each price change is independent of other price changes.
• This theory is latter known as Efficient Market Hypothesis.
The Efficient Market Hypothesis :
 This hypothesis states that capital market is efficient in processing
information.
 An efficient market is one where security prices equal their intrinsic values
at all times , and where more securities are correctly priced.
 According to Eugene Fama , in an efficient market , prices fully reflect all
available information.
 Technical analysts believe that past price movements contain information
about future price movements.
 Fundamental analysts believe that through EIC analysis they can predict
under valued stock or over priced stock.
 But the efficient market theory states that as new information comes
prices adjust immediately and hence an investor cannot consistently earn
excess returns by undertaking fundamental or technical analysis.
Forms of Market Efficiency :
The capital market is considered to be efficient in three forms :
 Weak Form : It deals with past information
 Semi – Strong Form : It deals with publicly available information
 Strong Firm : It deals with both Public and Private information
The different forms of efficient market hypothesis have been tested
through empirical studies
Empirical Tests of Weak form Efficiency :
According to weak form of market efficiency the past prices are already
absorbed by the market and the present price movements are completely
random.
The new price movements are produced by new pieces of information and
are not dependent on past price information.
Serial Correlation Test :
 Randomness in stock prices can be tested by calculating correlation
between price changes in one period with another other period .
 Thus if correlation is close to zero , the price changes can be considered
to independent.
Filter Tests
 A filter rule is a trading rule regarding the actions to be taken when
shares rise or fall in value by x%. Filter rules should not work if markets are
weak form efficient.
Run Test :
 Run test is another test to test the randomness in stock price
movements.
 In this test only the direction of stock price change is considered.
 An increase in price is represented by + sign and a decrease in price is
represented by – sign. No change in price is represented by 0 .
 For ex the sequence +++ - - - has two runs , the sequence - - - + + 0 - -
- +++ has five runs.
 In a run test the actual number of runs observed in a series of stock
price movements is compared with the number of runs in a randomly
generated number series.
 If no significant differences are found , then the security price changes
are considered to be random in nature.
Empirical Tests of Semi Strong form Efficiency :
 Semi strong form efficiency states that security prices reflect all publicly
available Information about the company.
 Examples of publicly available information : Corporate annual reports ,
company announcements , press releases , announcements of forthcoming
dividend , bonus.
 In semi strong form the stock prices immediately adjust to the information
that is received.
 The implication of semi strong hypothesis is that fundamental analysts
cannot make superior gains by undertaking fundamental analysis.
 Semi strong form tests deal with whether or not security prices fully reflect
all publicly available information. These tests attempts to find whether share
prices react quickly to new information.
 The general methodology followed in these studies was to take an
economic event and measure its impact on the share price .
 The impact is measured by taking the difference between the actual
return and expected return of a security.
 The expected return is measured using Sharpe single index model.
The model is
Ri = ai + bi Rm + ei
Ri = Return on Security i , Rm = Return on a market index ,
ai and bi = constants , ei = Random error
This analysis is known as Residual analysis.
Tests of Strong Form Efficiency
• The strong form of efficient market hypothesis maintains that the current
security prices reflect all public and private information .
• This implies that no information , whether public or inside can be used to
earn superior returns consistently.
• The strong form efficiency involves two types of tests.
• The first type attempts to find whether those who have access to inside
information have been able to earn excess returns.
• The second type of tests examine the performance of mutual funds and
recommendations of investment analysis to check whether they have
achieved superior gains with the use of private information generated by
them.
• In the result it was found that insiders earned superior returns which
indicates markets are not efficient in the strong form.
• But mutual funds and investment analysts have not been able to earn
superior returns by using their private return.
EMH vs FA vs TA
Implications of EMH