Technical Analysis

TECHNICAL ANALYSIS We all know that future price of stock is the central concern of the equity investment decision. The fundamentalists makes a judgment of the stock’s future price with a risk-return framework based upon economy, industry and company analyses. The principal decision variables take the form of earnings per share and dividend pay-out. Here we shall discuss an alternative approach to predicting stock price. This approach is called technical analysis or chartist approach. We will attempt answers to the following questions: What is the meaning of technical analysis? How does it differ from fundamental analysis? What is its origin? What are its tools and techniques? What are their limitations?

1

MEANING OF TECHINICAL ANALYSIS Technical Analysis is concerned with a critical study of the daily or weekly price and volume data of the Index comprising several shares, like Bombay Stock Exchange Sensitive Index (SENSEX), or of a particular stock, may be ‘Tata Steel’ etc. FUNDAMENTAL ANALYSIS VS TECHNICAL ANALYSIS The price of most the Indices and the stocks keep on varying in an erratic fashion, so much so that the difference between the high and the low during a year may exceed by a ratio of two or more, even though the fundamentals do not change much. For instance, in spite of the daily variation of price, the earnings of the company do not vary during the year, the book value, the loans, the profit margin, the taxes and other charges, depreciation, etc. may not change from one annual report to the other. Hence, the fundamentals dictate the price horizon of the shares of a company, but are not able to say what the price at a particular point of time would be. 2

Technical analysis incorporates techniques to determine when: o o o o

an equity is overbought, at which point of time it can be sold at a high price, or at which point of time it is oversold, at which point of time it may be bought at a low price.

A technical analyst believes that the price movements, whatever their cause, once in force persist for some period of time and form patterns which can be detected. He further believes that by critical study of these patterns of price and volume of trading, he can predict whether prices are moving higher or lower and even by how much. In sum and substance, technical analyst believes that the forces of supply and demand, guided by logical as well as emotional factors, reflect in the price and volume movements. And by carefully examining the pattern of these movements, future price of stock can be reliably predicted. And since the whole process involves much less time and data analysis, compared with fundamental analysis, it facilitates timely decision. Timing of Trade is the Important Thing Experts advise you to invest in a fundamentally strong company, one which has high reserves, large profits, low debt, and pays high dividends. But, if you buy such a share at the wrong time and then the price moves down, you lose, in spite of the strong fundamentals. 3

With technical analysis you can avoid this pitfall, because it tells you the most appropriate time to buy a share and the most appropriate time to sell the same.

Why is Technical Analysis Superior to Fundamental Analysis? Technical analysis analyses the buying and selling pressures which govern the price trend. It enables you to buy cheap and sell high regardless of the type of company you choose. The Insiders Versus the Crowd Surveys indicate that 85 per cent of the investors lose money in the stock market. The insiders, who comprise 15% of the total, win. They play a game. They spread rumours to mislead. They whisper to buy some shares because somebody is buying in huge lots and massive price rise is eminent. Some are tempted and buy, only to lose ultimately and blame their kismet instead. You would notice that on the eve of a new public issue, relatively unknown companies come into pre-eminence.

4

Big public campaigns are launched. Members of public are bombarded with mail. Hawkers thrust into your hands company prospectus and application forms. Magazines and newspapers splash the good news in big bold letters. The shares of companies which remained unheard of for a long time are traded actively on the stock market, at high prices. Many such companies go back into oblivion, after the public issue is over and leaves holes in many pockets. But the insiders know the real truth. They do exactly the opposite of what the crowd does. They buy when the crowd sells and they sell when the crowd buys. This is why the insider, the stock brokers, and the company directors become multi-millionaires. This is why the membership of Stock Exchange is coveted so much that the cost of a seat is astronomical, between Rs. 100 to 150 lakh or even more. The Broker The broker belongs to the insider club. He gets prior knowledge of the inside working of a company. He knows why a company share are going up, and the shares of another company are going down. 5

But, he may play against you in stock market. He makes money at the expense of gullible investors. What does Technical Analysis do? Price action of stock incorporates all the insider information. This includes manipulations within a company, the performance of the management, the hopes and the fears of the investors, the policies of the Government, the economic conditions, etc. Technical Analysis make meaningful studies of this price action. It brings order into a seemingly disorderly movement of prices. It highlights the hidden features in the price movements and lay bare the way the market is behaving and might behave in future. The technical indicators used in technical analysis are based on many different components of the price movement. This analysis of internal structure unfolds the insider action and brings to the fore the true picture. The cobwebs of rumours, differing opinions, and interested comments of the press are swept away. The investors are steered away from the crowd and are directed towards that strategy they should follow to win. We can say that technical analysis may be useful in timing a buy or sell order while fundamental analysis may help in identifying undervalued or overvalued stocks. 6

It is perhaps for this reason the technical analysis is frequently used as a supplement to fundamental analysis rather then as a substitute for it. The two approaches i.e., the fundamental analysis and Technical analysis however, differ in terms of their data bases and of focus analysis. While fundamental analysis focuses on macro and micro and qualitative and quantitative analyses. Technical analysis is focused on market and individual stocks and use quantitative analysis. The technician’s central problem is to distinguish between reversals within a trend and real changes in the trend itself while fundamentalist seeks to identify the impact of changes in the fundamental factors on the value of stock. Fundamentalist’s central problem is, thus, estimating the future value of stock as influenced by diverse macro and micro factors. The technician views price changes and their patterns mainly through price and volume statistics. His bag of tools comprise charts and other indicators. Fundamentalist analyst on the other hand uses detailed economy, industry and company data and information and makes use of accounting and statistical techniques.

7

We may here conclude by saying that fundamental analysis and technical analysis are two alternative approaches to predicting stock price behavior. It would be no surprise that the technical analysis can, and frequently does, confirm findings based on fundamental analysis. After all, if fundamental analysis seeks to guide price action, technical analysis seeks to analyse the price action. ORIGIN AND DEVELOPMENT OF TECHNICAL ANALYSIS Technical analysis evolved in 1900-1902 when Charles H. Dow presented the celebrated ‘Dow Theory’ in a series of editorials in Wall Street Journal in U.S. The classical technical analysis evolved gradually in the early part of 20 th century and deals with detailed study of price bar charts of the indices as well as of individual stocks. The Modern Technical Analysis was perfected in the later part of the century. It went deeper into internal structure of price movements like the difference between high and low of the day , weeks or hours of trading. Moving averages etc.

8

TECHNIQUES OF TECHNICAL ANALYSIS To understand the process of technical analysis we must know some of the things used like: What is a chart? A chart consists of a base line (horizontal) on which dates are marked. A perpendicular line at right angle to the base line is drawn and prices are marked on it. What is a Price bar Chart? A Bar is formed by joining the highest price and the lowest price of a particular share by a vertical line. The closing price of the day is marked by a horizontal mark on this vertical line.

Price Bar Chart 120 HIGH CLOSE

100

Price 100 90 LOW 80

Jan 5

6

7 8 9

10

What is a Moving Average? 9

An average is the sum of prices of a share over some weekly periods divided by the number of weeks. This point is marked on the latest date for which prices bar has been plotted. This process is repeated for the previous dates. The points thus obtained are connected together to give the Moving Average line. CALCULATION OF FIVE –WEEK MOVING AVERAGE Week

Closing Price

Total of price for five weeks

5-week average = Total /5

1

22

2

25

3

26

4

24

5

28.5

125.5

25.5

6

29

132.5

26.5

7

28

135.5

27.1

8

26.5

136

27.2

9

27.5

139.5

27.9

10

25

136

27.2

11

23.5

130.5

26.1 10

The points calculated in the last column of the above table are plotted in Chart of moving average. What is an Exponential Moving Average? In an Exponential Moving Average, more weight is given of the most recent data and less weight is given to the older data. What do the moving averages depict? Moving Averages smoothen out the apparent erratic movement of share prices and highlight the underlying trend. When the 10-week moving average line slopes up, the intermediate term trend is rising. When the 30-week moving average line slopes up, the long term trend of the market is positive, i.e, the market is bullish. Similarly, when the 10-week moving average line slopes down, the intermediate term is falling. When the 30-week moving average lines down, the log term trend of the market is negative, i.e., the market is bearish. What is an Oscillator? The values of the 10-week moving average are subtracted from the values of the 2-week moving average. These differences are plotted on a horizontal zero line. 2-week, 10 week Oscillator 11

3 2 1 0 -1 -2 1

2

3

4

5

6

7

8

9

10

-3

11

Week CALCULATION OF 2-WEEKS, 10-WEEK OSCLILLATOR Week 1

2-week moving average 19.5

10-week moving average 20

Oscillator = difference of the two -0.5

2

24

22

2

3

26.75

24

2.75

4

29

26

3

5

29.75

27

2.75

6

29.5

28

1.5

7

27.5

29

-1.5

8

28

30

-2

9

27

29

-2 12

10

27

28

-1

11

27.5

27

0.5

What help does an Oscillator give? An oscillator is an excellent indicator of overbought/oversold conditions. Values above the zero line indicates that buying is in progress. While values below the zero line indicates that selling is in progress. When the Oscillator moves from negative positive, it shows possible buying opportunity. When the Oscillator moves down from the positive towards the negative, it indicates that selling may be considered.

13

What is Rate-of-Change (Momentum) ? It indicates the rate of change of the price as compared to the prices a certain period back. To calculate a 7-week rate-of-Changes, today’s price is divided by the price 7 weeks ago, and this ratio is subtracts form 1. CALCULATION OF RATE–OF-CHANGE

Week

Closing Price

Price Seven weeks ago

Ratio of two prices

ROC = Ration less 1

1

49

2

50

3

52

4

54

5

55

6

56

7

56

49

1.14

0.14

8

55

50

1.1

0.1

9

54

52

1.04

0.04

10

48

54

0.89

-0.11 14

How does Rate-of-Change (ROC) help ? ROC depicts the speed of upward or downward movements of the price ahead of the price movement. When the ROC line is above the zero line, the price is rising and when it is below the zero line, the price is falling. Upside crossings (from below to above the zero line) indicate buying opportunities and down side crossings warn you to sell. What is Relative Strength Index? This index emphasizes market moves before they occur. When the price of stock advances, the closing price is higher than the closing price of the previous day. When the price of the stock declines, the closing price is lower than the closing price of the previous day. However, the rise of fall of a market is not smooth. During the rising phase, the price falls several times, while during the falling phase, the price falls several times. Relatives Strength Index tells us whether the net difference between the closing prices is increasing or decreasing. During the rising phase of the market, the prices move up fast, and the differences between the recent close and the previous close are large. 15

When the market reaches the top, these differences reduce. When the market declines, the difference again become large. The formula for 14 – week Cutler’s Relative Strength Index (RSI) i9s given Below: RSI = 100 – [ 100/( 1 + RS ) ] Average of 14 weeks up closing price Where RS = ------------------------------------------------Average of 14 weeks down closing price This is powerful indicator and pinpoints buying and selling opportunities ahead of the market. It ranges in value from to 0 to 100. Values above 70 are considered to denote overbought conditions, and values below 30 are considered to denote oversold conditions. If the RSI has crossed the 30 lines from below to above and is rising, a buying opportunity is indicated. If it has crossed the 70 lines from above to below indicates a selling opportunity.

What is Moving Average Convergence Divergence (MACD) Signal? 16

This indicator gives advance warning of buying and selling opportunities. A firm line and a dotted line are plotted above or below a zero line. The firm line represents the difference between a 12-week exponential moving average and a 6-week exponential moving average. The dotted line represent a 9-weeks exponential moving average of the differential. If the lines are below the zero line and the firm line crosses the dotted line from below to above, it indicates buying opportunities. If the lines are above the zero line and the firm line crosses the dotted line from above to below, it indicates selling opportunities. MARKET INDICATOR After discussing various techniques of technical analysis we understand that technical indicator help not only to predict individual stock price behavior but also the trend of the market. Some important Price, Volume and other indicators of market are highlighted below: Price Advance vs. Declines: By Comparing number of shares which advanced and those declined during a certain period of time, one may know what the market is really doing.

17

The difference between the advances and declines is called ‘breadth of the market’. The technician is generally more interested in change in breadth than in absolute level. Further, breadth may be compared with a stock market index. Normally, breadth and the stock market index will move in unison. However, when they diverge a key signal occurs. During a bull market if breadth declines to new lows while the stock market index makes new highs a peak in the average is suggested. The peak will be followed by major downturn in stock prices generally High-low Differential or Index: This be used as a supplementary measure to ‘breadth of the market’ to predict market. In theory, a rising market will generally be accompanied by an expanding number of stocks attaining new highs and a dwindling number of new lows. The reverse will hold true for a bearish market. The volume of short selling: This refers to selling shares that are not owned, can be useful indicator of the market as well as for individual stocks. 18

Short selling, or as it is called short interest also, can be related to average daily volume. The short interest for a period say a month, divided by average daily gives a ratio. This ratio indicates for many days of trading it would take to use up total short interest. Historically, on the New York Stock exchange (NYSE) and the American Stock Exchange (AMEX), the ratio has varied between onethird of a day and four days. In general when the ratio is less than 1.0, the market is considered weak or weakening. It is common to say that market is overbought. A decline should follow sooner or later. The zone between 1.0 and 1.5 is considered a neutral indicator. Values above 1.5 indicate bullish territory with 2.0 and above highly favorable. This market is said to be ‘oversold’. A rise should follow sooner or latter as ‘oversold’ state will lead to buying pressure (to cover short position) in the market.

19

Mutual-fund Cash as a percentage of net Assets on a daily or weekly or monthly basis has been a popular market indictor. The theory is that a low cash ratio, say about 5% would indicate a reasonably fully invested position leaving negligible buying power indicating that the market is due for climb down. High cash ratio indicates possibilities of market climb up. Indeed, the number of indicators technicians use to predict changes in the direction of the overall market is almost limitless.

DOW THEORY AND BASIC TENETS To start with Dow theory put forward six basic tenets as follows: 1.

Average discounts everything: The daily prices reflect the aggregate judgment and emotions of all stock market participants. This process discounts everything known and predictable that can affect the demand and supply.

2.

The market has three movements: Primary movements, secondary reactions and minor movements.

20

The primary movements is the long range cycle that carries the entire market up or down. The secondary reactions act as restraining force on the primary movement and tends to correct deviations from it. The secondary reactions usually last for several weeks to several months in length. The minor movements are day to day fluctuations in the market. The minor movements have little analytic value because of their short duration. 3. Price bar charts indicate movements 4. Price /Volume relationships provide background. 5. Price action determines the trend. 6. The averages must confirm The movement of two different market indices must confirm each other to confirm the trend.

21