STOCK MARKET MOVEMENTS USING

TECHNICAL ANALYSIS

Dr.P.Karthikeyan,
School of Management Studies,
Kongu Engineering College
 Technical Analysis

• Technical analysis differs significantly from

fundamental analysis.

• Technical analysis is a controversial set of techniques for

predicting market direction based on
– Historical price and volume behavior
– Investor sentiment

• Technical analysts essentially search for bullish

(positive) and bearish (negative) signals about stock
prices or market direction.
8-3
 Dow Theory

• The Dow theory is a method that attempts to interpret

and signal changes in the stock market direction.

• Historically, quite popular.

• The Dow theory identifies three forces:

– a primary direction or trend,
– a secondary reaction or trend, and
– daily fluctuations

• Daily fluctuations are essentially noise and are of no real

importance.
 Dow Theory

Dow Jones Industrial Average,

January 2, 2001 to October 3, 2003
12,000

The primary direction is either bullish or bearish,

and reflects the long-run direction of the market.
11,000

10,000
Level

9,000

Secondary
trends,
temporary Corrections,
8,000 departures reversions to the
primary direction

7,000
01/01 04/01 07/01 10/01 01/02 04/02 07/02 10/02 01/03 04/03 07/03 10/03
Date
 Dow Theory

• Purpose: to signal changes in the primary direction.

• Must monitor two indexes:
– Dow Jones Industrial Average
– Dow Jones Transportation Average
• If ONE index departs from the primary direction, this is
not a signal.
• However, if a departure in one is followed by a
departure in the other, this is viewed is confirmation
that the trend has changed.

The trend is your friend…

 Charting, Relative Strength

• Relative strength charts measure the performance of

one investment relative to another.

• Comparing stock A to stock B, through relative strength.

Stock A Stock B Relative

Month (4 Shares) (2 Shares) Strength
1 100 100 1.00
2 96 96 1.00
3 88 90 0.98
4 88 80 1.10
5 80 78 1.03
6 76 76 1.00
 Charting, Moving Averages

• Moving average charts are average daily prices or index

levels, calculated using a fixed number of previous days’
prices or levels, updated each day.

• Because daily price fluctuations are “smoothed out,”

these charts are used to identify trends.

• Example: Suppose the technical trader calculates a 15-

day and a 50-day moving average of a stock price.
– If the 15-day crosses the 50-day from above, it is a bearish
signal—time to sell.
– If the 15-day crosses the 50-day from below, it is a bullish signal
—time to buy.
 Example: 15-Day and
50-Day Moving Averages
Dow Jones Industrial Average,
15-Day and 50-Day Moving Average
11,000

10,500

10,000
15-Day 50-Day
Index Level

9,500

9,000

8,500

8,000

7,500
1/2/02 3/6/02 5/7/02 7/9/02 9/9/02 11/7/02 1/10/03 3/14/03 5/15/03 7/17/03 9/17/03
Date

Note the "whipsaw" action—i.e., plenty of buying and selling signals.

This happens because 15 and 50 may be too "close" together in time.
Technical Analysis: Introduction
to Stock Charts
CHART BASICS
 Basic Terms

• Volatility
• Fluctuations
• 52-week high / low
• Price / trading range
• Open / closing price
Charts

• Maps price performance

• Sheds light on supply and

demand

• “investment roadmap”

• Price / volume
relationship important
 Chart Types - Line Charts

• Most basic of all charts

• Just a line that connects

the closing prices over a
time frame

• No trading range
 Chart Types – Bar Chart

• Vertical line represents highs/lows of the day

• Horizontal line represents closing price
• Red = down
• Blue/Black = up

Daily High
Closing Price
Daily Low Price Gap
 Chart Types – Candlestick Charts

• Vertical line represents the

trading range
• Wide bar represents open
and close
• White bar – Up and closes
above opening price
• Red Bar – down
• Black bar – up, but closes
below the opening price
Candlestick Making, Basics
Candlestick “Formations”
 Chart Basics – Time Scale

• Time Scale
– Dates along bottom of chart (varies
from seconds to decades)

– Common Types: intraday, daily, weekly,

monthly

– Subtle differences between different

time scales
 Point and Figure Charts
• Point-and-figure charts attempt to show only major price
moves and their direction.
– The point and figure chart maker decides what price move is major.
– That is, it could be Rs.2, Rs.5, or any other level.

• A major up-move is marked with an “X”

• A major down-move is marked with an “O”

• Start a new column when there is a direction change.

– Buy and sell signals are generated when new highs or new lows
are reached.
– Congestion area, the area between buy and sell signals—a time of
market indecision concerning its trend.
Point and Figure Charts
Point and Figure Charts
 Chart Formations

• Once a chart is drawn, technical analysts examine it for

various formations or pattern types in an attempt to
predict stock price or market direction.

• One example is the head-and-shoulders formation.

– When the stock price “pierces the neckline” after the right
shoulder is finished, it is time to sell.
Chart Formations, The Head and Shoulders
 Chart Basics – Time Scale

Daily Chart

Weekly Chart
Volume

• Amount of shares that trade

hands between seller and
buyers

• Price movements more

significant when volume is
above average
 Price and Volume

Average
Volume
 Trends

 The meaning of trend in finance isn't all that different from

the general definition of the term - a trend is really nothing
more than the general direction.

 A trend represents a consistent change in prices (i.e. a change

in investor’s expectations)

 A trendline is a simple charting technique that adds a line to a

chart to represent the trend in the market or a stock.
 Types of Trend
Uptrends
 Types of Trend
Downtrend
 Types of Trend
Sideways Trend
 Support and Resistance Levels

• A support level is a price or level below which a stock or

the market as a whole is unlikely to go, while a
• Resistance level is a price or level above which a stock
or the market as a whole is unlikely to rise.

• Resistance and support areas are usually viewed as

psychological barriers
– Bargain hunters help “support” the lower level.
– Profit takers “resist” the upper level.

• A “breakout” occurs when a stock (or the market) passes

through either a support or a resistance level.
 Support and Resistance

 Support level is a price level where the price tends to find

support as it is going down
 Support and Resistance
 Resistance Level is a price level where the price tends to
find resistance as it is going up
Importance of Support and Resistance
 Support and resistance analysis is an important part
of trends because it can be used to make trading
decisions and identify when a trend is reversing
 Aware: Support and Resistance levels

 Support and Resistance levels are highly

volatile

 Tradersshould not buy and sell directly at

these points as there may be breakout also
 Breakout
 The penetration of support and resistance level
is called breakout
 Trader’s Remorse
 Returning to the level of support or resistance
after a breakout is called trader’s remorse.
Trader’s Remorse
Resistance <-> Support
 Indicators

 A mathematical tool that can be applied on security’s

price giving a result that can be used to anticipate
trends, volatility and price

 Indicators are used in two main ways: to confirm

price movement and to form buy and sell signals
 Types of Indicator

 Lagging
This indicator simply tells you what prices are
doing, they don’t warn you of upcoming changes

 Leading
This indicators attempt to make investment calls on
securities prior to actual price confirmation
 Simple Moving Averages

• A moving average is simply the

MSFT Daily Prices with 10-day MA
average price (usually the 9/23/93 to 9/21/94

closing price) over the last N 60

periods. 55

• They are used to smooth out 50

fluctuations of less than N

periods.
45

Price
• This chart shows MSFT with a 40

10-day moving average. Note 35

how the moving average shows

much less volatility than the daily
30
1 21 41 61 81 101 121 141 161 181 201 221 241
Date
stock price.
 Moving Averages

• A simple moving average is calculated by taking

average of most recent closing prices of n time
period

• Exponential Moving average applies weighting

factors which decrease exponentially
Moving Averages
 Price Patterns

• Technicians look for many patterns in the historical time

series of prices.
• These patterns are reputed to provide information
regarding the size and timing of subsequent price
moves.
• But don’t forget that the EMH says these patterns are
illusions, and have no real meaning. In fact, they can be
seen in a randomly generated price series.
 Head and Shoulders

H&S Top
Head
• This formation is
characterized by two small
Left Shoulder Right Shoulder
peaks on either side of a
larger peak.
Neckline
• This is a reversal pattern,
meaning that it signifies a
H&S Bottom
change in the trend.
Neckline

Left Shoulder
Right Shoulder

Head
Head & Shoulders Example

Sell Signal

Minimum Target Price

Based on measurement rule
 Double Tops and Bottoms

Double Top
• These formations are
similar to the H&S
formations, but there is no
head.
• These are reversal patterns Target
with the same measuring Target

implications as the H&S.

Double Bottom
Double Bottom Example
 Triangles

• Triangles are
Ascending
continuation formations.
• Three flavors:
– Ascending
– Descending Symmetrical
– Symmetrical
• Typically, triangles
should break out about Symmetrical
half to three-quarters of
the way through the
formation.
Descending
 Rounded Tops & Bottoms

• Rounding formations are Rounding

Bottom
characterized by a slow
reversal of trend.

Rounding Top
Rounded Bottom Chart Example
 Broadening Formations

Broadening Bottoms
• These formations are
like reverse triangles.
• These formations
usually signal a reversal
of the trend.

Broadening Tops
 MACD

• MACD was developed by Gerald Appel as a way to

keep track of a moving average crossover system.
• Appel defined MACD as the difference between a 12-
day and 26-day moving average. A 9-day moving
average of this difference is used to generate signals.
• When this signal line goes from negative to positive, a
buy signal is generated.
• When the signal line goes from positive to negative, a
sell signal is generated.
• MACD is best used in choppy (trendless) markets, and
is subject to whipsaws (in and out rapidly with little or no
profit).
 Moving Averages Convergence Divergence

• MACD is calculated by subtracting 26 days moving

average from moving average of 12 days
 Trading using MACD
• A 9 day moving average of MACD is plotted along
with MACD
 Bollinger Bands
• Bollinger bands are the envelopes plotted at standard
deviations above and below the moving average

• Bollinger Bands can be used to measure the highness

or lowness of the price relative to previous trades
Bollinger Bands
Bollinger Bands
 Elliot Wave Theory
• Elliot stated that stock market moves in repetitive cycles
Impulse and Corrective Patterns

• The impulse pattern consists of five waves, the five

waves can be in either direction, up or down
• Corrective patterns can be grouped into two different
categories:
• Simple Correction( Zig-Zag )
• Complex correction (Flat, Irregular, Triangle)
 Fractal Structure

• The structures Elliott described meet the common

definition of a fractal ( self-similar patterns
appearing at every degree of trend)

• Elliott Wave patterns that show up on long term

charts are identical to, and will also show up on short
term charts
Fractal Structure
Fibonacci Retracement Patterns

• Stocks often pull back or retrace a percentage

of the previous move before reversing

• Retracement percentages follow a Fibonacci

ratio pattern, the key Fibonacci ratios are 23.6,
38.2, 50, 61.8
Fibonacci Retracement Patterns
 Linear Regression Lines

• When prices are below the Linear Regression Line, this

could be viewed as a good time to buy, and when prices
are above the Linear Regression Line, a trader might
sell
 Linear Regression Channel
• A Linear Regression trendline shows where equilibrium exists
but Linear Regression Channels show the range prices can be
expected to deviate from a trendline
 Relative Strength Index (RSI)
• RSI was developed by Welles Wilder as an
oscillator to gauge overbought/oversold levels.
• RSI is a rescaled measure of the ratio of average
price changes on up days to average price changes
on down days.
• The most important thing to understand about RSI
is that a level above 70 indicates a stock is
overbought, and a level below 30 indicates that it is
oversold (it can range from 0 to 100).
• Also, realize that stocks can remain overbought or
oversold for long periods of time, so RSI alone isn’t
always a great timing tool.
 RSI

• a technical analysis tool that is banded between two

extreme values and built with the results from a
trend indicator for discovering short term
overbought and over sold conditions. As the value
of the oscillator approach the upper extreme value
the asset is seem to be over brought and as it is
approaches to be lower extreme as it seems to be
over sold.
RSI Example Chart

Overbought Oversold
 Relative Strength Index
• It compares the magnitude of recent gains to recent losses in
an attempt to determine overbought and oversold conditions
of an asset
RSI= 100- 100/ (1+RS)

RS=EMA[U]/EMA[D] EMA- exponential moving

average

U= Sig (close (today)-close (yesterday))

D= Sig(close(yesterday)-close(today))
Relative Strength Index

Relative Strength Index

 Stochastic Oscillator
• Compares where a security’s price closed relative to its price
range over a given time period

Fast oscillator

Slow oscillator %D = SMA(%K, N)

 Stochastic Oscillator
• Buy when the Oscillator (either %K or %D) falls below a specific level
(e.g., 20) and then rises above that level. Sell when the Oscillator rises
above a specific level (e.g., 80) and then falls below that level;
• Buy when the %K line rises above the %D line and sell when the %K line
falls below the %D line
 Market Efficiency

• The Efficient Market Hypothesis (EMH) is a theory

that asserts: As a practical matter, the major financial
markets reflect all relevant information at a given time.

• Market efficiency research examines the relationship

between stock prices and available information.
– The important research question: Is it possible for investors to
“beat the market?”
– Prediction of the EMH theory: If a market is efficient, it is not
possible to “beat the market” (except by luck).
 What Does “Beat the Market” Mean?

• The excess return on an investment is the return

in excess of that earned by other investments that
have the same risk.

• “Beating the market” means consistently earning

a positive excess return.
 Forms of Market Efficiency,
(i.e., What Information is Used?)

• A Weak-form Efficient Market is one in which past prices and

volume figures are of no use in beating the market.
– If so, then technical analysis is of little use.

• A Semistrong-form Efficient Market is one in which publicly

available information is of no use in beating the market.
– If so, then fundamental analysis is of little use.

• A Strong-form Efficient Market is one in which information of any

kind, public or private, is of no use in beating the market.
– If so, then “inside information” is of little use.
 Why Would a Market be Efficient?

• The driving force toward market efficiency is simply

competition and the profit motive.

• Even a relatively small performance enhancement can

be worth a tremendous amount of money (when
multiplied by the dollar amount involved).

• This creates incentives to unearth relevant information

and use it.
 Are Financial Markets Efficient?

• Market efficiency is difficult to test.

• There are four basic reasons for this:
– The risk-adjustment problem
– The relevant information problem
– The dumb luck problem
– The data snooping problem.
 Are Financial Markets Efficient?

• Nevertheless, three generalities about market efficiency

can be made:

– Short-term stock price and market movements appear to be

difficult to predict with any accuracy.

– The market reacts quickly and sharply to new information, and

various studies find little or no evidence that such reactions can
be profitably exploited.

– If the stock market can be beaten, the way to do so is not

obvious.
 Some Implications if Markets are Efficient

• Security selection becomes less important, because

securities will be fairly priced.

• There will be a small role for professional money

managers.

• It makes little sense to time the market.

 Stock Price Behavior and Market Efficiency

The day-of-the-week effect refers to the tendency for

Monday to have a negative average return.