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Technical Analysis is a powerful branch of study to analyze price movements and to take profitable Investment as well as Trading/speculative decisions, not only in stock markets but also in Commodities and Forex markets and or anything whose prices are determined by the forces of demand and supply in a free market economy. There is a famous Chinese proverb which says “ A picture speaks a thousand words”. Technical Analysis is studying the price movements with the help of a chart or a graphical presentation. WHY TO SYUDY TECHNICAL ANALYSIS ? To take profitable decisions consistently in Trading and/or Investments, it is necessary to develop special skills and knowledge of the working of Stock markets. One simple reason why many investors or traders do not make profit since they take decisions on the basis of current market scenario, while the stock market movements is based on Future Expectations. A company declares its operational results and though the numbers are impressive the price of the scrip falls, since the scrip has been rising in the past based on expectation and those smart guys who had bought earlier are booking profits on the declaration of results. This price movement may baffle an investor or trader who may wrongly think that the markets are stupid. It is well said that Buy on rumors and Sell on news. In order to take profitable decisions, one should be able to see the future and knowledge of technical Analysis helps one to do so. When a train is about to enter a dark tunnel, it is only the engine driver who will first come to know that the train is going to enter the dark tunnel i.e. the period of darkness. Similarly when the train is going to come out of the tunnel, the same engine driver will be able to see the light first. So one should be like the engine driver in the stock markets. WHAT IS TECHNICAL ANALYSIS ? Technical analysis is an organized and systematic study of market action through use of charts, of a particular scrip or index for the purpose of identifying trend changes at an early stage and to maintain an investment or speculative position until the weight of the evidence indicates that the trend has changed with the help of price and volume data of any share or index. Technical analysis is basically studying the price action or movements only. BASIC PRINCIPLES OF TECHNICAL ANALYSIS :
DOW THEORY : The Dow theory is the grandfather of all technical studies. Mr. Charles H. Dow is the inventor of technical analysis. Dow found that market movements have rhythm and it is not random, hence it can be predicted. Tenants of Dow Theory :- 1. The Market ( The Index ) Discounts Everything :-
2. The Three Trends : The “Market,” meaning the price of stocks in general, swings in trends, of which the most important are its Major or primary Trends. These are the phases of up or down trend which usually last for a year or more. Movements in the direction of the Primary trends are interrupted at intervals by Secondary correction in the opposite direction-- reactions or “corrections” which occur when the primary move has temporarily “ gotten ahead of itself.”. 3. The Primary Trend : These, as aforesaid, are the broad, overall up and down trends which usually (but not invariably) last for more than a year and may run for several years. So long as each successive rise (price advance) reaches a higher level than the one before it, and each secondary reaction stops (i.e. , the price trend reverses from down to up) at a higher level than the previous reaction, the Primary Trend is deemed to be Up. This is called a Bull Market. Conversely, when each intermediate decline carries prices to successively lower levels and each intervening rally fails to brings them back up to the top level of the preceding rally, the primary Trend is Down ,and that is called a Bear Market. 4. The Secondary Trend : These are the important reactions that interrupt the progress of prices in the Primary direction. They are the Intermediate declines or “corrections” which occur during Bull Markets or the intermediate rallies or “recoveries” which occur in the Bear Markets. Quite Often, they retrace the previous move from one-third to two-thirds of the gain (or loss , as the case may be ) in prices registered in the preceding swing in Primary direction. Note, however, that the one-third/two thirds rule is not an unbreakable law; it is simply a statement of probabilities. Most Secondaries are confined within these limits; many of them stop very close to the halfway mark, retracing 50% of the preceding Primary swing. 5. The Minor Trends :- These are the brief fluctuations which are so far as the Dow Theory is concerned meaningless in themselves, but which, in toto, make up the Intermediate trends. Usually, but not always, an Intermediate swing, whether a secondary or the segment of a primary between successive secondaries, is made up of a series of distinguishable Minor waves. Inferences drawn from these day-to-day fluctuations are quite apt to be misleading. The Minor trend is only one of the three trends which can be “ manipulated” (although it is, in fact, doubtful if under present conditions even that can be purposely manipulated to any important extent ). Primary trends cannot be manipulated; it would strain the resources of the Apex bank of any country . The Primary, Secondary and Minor trends are compared with the tidal waves. In a high tide every next wave reaches higher and higher points , this is the Primary trend , while one can see the tide receding during the high tide movements which is the secondary trend which is against the primary trend , and the minor trend can be compared with the small waves movements - the ripples. BSE 30 SENSEX CHART DEPICITNG TENENTS OF DOW THEORY.
Techniques and Tools OF Technical Analysis : Various techniques and tools are available to an analyst to interpret the markets. Some of them are listed hereunder. 1. Patterns or Formations When the price tends to reverse its direction from top to down or from down to top, a characteristic AREA or PATTERN takes shape on the chart. This shape is called as pattern or reversal formation. The formations of various patterns and the idea of interpreting its effect on the prices are developed on the basis of observation over a very long period of time. These patterns are repetitive in appearance. There are various types of such patterns or formations as listed hereunder. A breakout from the pattern indicates change of trend from Bull to Bear or vice-versa. Every pattern has its inverse.
Of all the above techniques I would like to discuss on Moving Averages which is one of the most powerful and simple technique in Technical Analysis. MOVING AVERAGES :- 1. ORIGIN : Wall Street old- timers claim that moving averages were brought to financial markets by antiaircraft gunners. They used moving averages to site guns on enemy planes during World War II and applied this method to prices. The two early experts on moving averages were Richard Donchian and J.M. Hurst. 2. DEFINITION AND FORMULA :- A moving average is a statistical device which smoothens out the erratic price fluctuations and gives us a smooth curve indicating the direction of the trend .A moving average (MA) shows the average value of data in its time window. A 5-day MA shows the average price for the past 5 days, a 20 day MA shows the average price for the past 20 days, and so on. When you connect each day’s MA values, you create a moving average line. P1 + P2 + ……… P n Simple MA= ______________________ N Where P is the price being averaged N is the number of days in the moving average (Selected by trader) The value of MA depends on two factors: values that are being averaged and the width of the MA time window, Suppose you want to calculate a 3 Day simple moving average of a stock. If it closes at 19,21 and 20 on three consecutive days, then a 3 day simple MA of closing prices is 20 (19+21+20 , divided by 3). Suppose that on the fourth day the stock closes at 22. It makes it 3-day MA rise to 21-the average of last three days (21+20+22), divided by 3. 3. TYPES OF MOVING AVERAGE :- There are three main types of moving averages: simple, exponential, and weighted, Many traders use simple MA‘s because they are easy to calculate, and Donchian and Hurst used them in precomputer days. 3.1: SIMPLE MOVING AVERAGE :- A simple MA changes twice in response to each piece of data. First, it changes when a new piece of data is added to the moving average. That is good -we want our MA to reflect changes in prices. The bad thing is that MA changes again when an old price is dropped off at the end of the moving average window. When a high price is dropped, a simple MA ticks down. When a low price is dropped, a simple MA rises. Those changes have nothing to do with current reality of the market. Imagine that a stock hovers between 80 and 90, and its 10 day simple MA stands at 85 but includes one day when the stock reached 105. When that high number is dropped at the end of the 10 day window, the MA dives, as if in a downtrend. That meaningless dive has nothing to do with the current reality of the market. When an old piece of data gets dropped off, a simple moving average jumps. A simple MA is like a guard dog that barks twice- once when someone walks away from it. You do not know when to believe that dog. Traders use simple MA s out inertia. A modern computerized trader is better off using exponential moving averages. 3.2 :Exponential Moving Averages :- An exponential moving average (EMA) is a better trend-following tool than a simple MA. It gives greater weight to the latest data and responds to changes faster than a simple MA. At the same time , an EMA does not jump in response to old data.This guard dog has better ears, and it barks only when someone approaches the house. EMA= P * K+EMA * (1-K) tod yest where K = 2 N+1 N= the number of days in the EMA (chosen by the trader) P = today’s price tod EMA = the EMA of yesterday yest Technical analysis software allows you to select the EMA length and calculate it a push of key.To do it by hand, follow these steps. 1. Choose the EMA length.Let us say, we want a 10 day EMA. 2. Calculate the coefficient K for that length. For example, if you want a 10 day EMA, k equals 2 divided 10+1. or 0.18. 3. Calculate a simple MA for the first 10 days -add closing prices and divide the sum by 10. 4. On the 11th day, multiply the closing price by K, multiply the previous day’s MA by (1-K), and add the two,The result is the 10 day EMA. 5. Keep repeating step 4 on each subsequent day to obtain the latest EMA . An EMA has two major advantages over a simple MA. First, it assigns greater weight to the last trading day. The latest mood of the crowd is more important. In a 10 day EMA, the last closing price is responsible for 18 percent of EMA value, while in a simple MA all days are equal. Second ,EMA does not drop old data the way a simple MA does.Old data slowly fades away, like a mood of the past lingering in a composite photo .
4. Choosing the length of a Moving Average : A relatively short EMA is more sensitive to price changes - it allows you to catch new trends sooner. It also changes its direction more often and produces more whipsaws. Awhipsaw is a rapid reversal of a trading signal. A relatively long EMA leads to fewer whipsaws but misses turning by a wider margin. When computers first became available, traders crunched numbers to find the “best” moving averages for different markets. They found which MA s worked in the past- but it did not help them trade because markets kept changing. Finally, traders can fall back on a simple rule of thumb: The longer the trend you are trying to catch, the longer the moving average you need. You need a bigger fishing rod to catch a bigger fish. A 200 days moving average works for long-term stock investors who want to ride major trends.
Most traders can use an EMA between 10 and 20 days A moving average should not be shorter than 8 days to avoid defeating its purpose as a trend following tool. 5. Market Psychology :- Each price is a snapshot of the current mass consensus of value .A single price does not tell you whether the crowd is bullish or bearish- just as a single photo does not tell you whether a person is an optimist or a pessimist. If, on the other hand, someone brings ten photos of a person to a lab and gets a composite picture, it will reveal that person’s typical features. If you update a composite photo each day, you can monitor trends in that person’s mood. A moving average is a composite photograph of the market- it combines prices for several days. The market consists of huge crowds, and a moving average indentifies the direction of mass movement. The most important message of a moving average is the direction of its slope. When it rises, it shows that the crowd is becoming more optimistic- bullish. When it falls it shows that the crowd is becoming more pessimistic- bearish. When the crowd is more bullish than before, prices rise above a moving average. When the crowd is more bearish than before, prices fall below a moving average. 6.:Trading Rules :- Moving averages help us to trade in the direction of the trend. The single most important message of a moving average is the direction of its slope. It shows the direction of the market’s inertia. 1. When an MA rises, trade that market from the long side. Buy when prices dip near or slightly below the moving average. The market gets support on a rising moving average. 2. When the MA falls, trade that market from the short side. Sell short when prices rally toward or slightly above the MA. The market faces resistance at falling moving average. 3. When the MA goes flat and only wiggle a little, it identifies an aimless, directionless and trendless market. A trader must accept that an EMA like any other trading tool, has good and bad sides. Moving averages help you identify and follow trends, but they lead to whipsaws to trading ranges. 7. More on Moving Averages :- Moving averages serve as support and resistance zones A rising MA tend to serve as a floor below prices, and a falling MA serves as a ceiling above them. That’s why it pays to buy near a rising MA, and sell short near a falling MA. Moving averages can be applied to indicators as well as prices. Some traders use a 5 day moving average of volume. When volume falls below its 5 day MA. it shows reduced public interest in the minor trend , which is likely to reverse. When volume overshoots its MA, it shows strong public interest and confirms the price trend. Moving averages can be based not only on closing prices but also on the mean between the high and the low,or on High or Low prices. An exponential moving average assigns greater weight to the latest day trading, but a weighted moving average (WMA) allows you to assign any weight to any day, depending on what you deem important. WMA s are so complicated that traders are better off using EMA s. CONCLUDING REMARKS: Knowledge of Technical Analysis can throw upon highly profitable opportunities in Trading or Investing in Stocks, Commodities, Forex and Interest Rate Derivatives markets, either on proprietary account or as a consultant or as a portfolio manager. It has global application since the rules of technical analysis are the same all over the world, whether it is BSE30 or Dow Jones or Gold or Currency. Technical Analysis is a complete theory in itself which may help one to take Investment decisions on a longer time frame and not only for the purpose of trading or speculating as is commonly misconstrued. In today’s dynamic and complex global markets wherein the all the markets anywhere in the world are interlinked, whether it be Stock Markets or Commodities or Forex Markets, knowledge of technical analysis would be one of the best technique to take profitable financial decisions. |
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