TECHNICAL ANALYSIS
STOCK EXCHANGES
DERIVATIVES MARKET
TRADING IN SECURITIES
INTRODUCTION TO MUTUAL FUNDS
INVESTING IN MUTUAL
TECHNICAL ANALYSIS
CHAPTER
LEARNING OUTCOMES
After reading this chapter you will be able to:
Explain the meaning and basic tenets of Technical analysis
Apply various trading rules to identify trading opportunities
Understand various types of charts and patterns
Use moving average analysis to identify buy and sell signals
Analyse securities using MACD technique
State the limitations of technical analysis
Learn the Do’s and Don’ts of investing
In previous chapter we discussed about Fundamental Analysis. In case of fundamental analysis we perform EIC analysis to make a forecast about expected earnings, dividends and growth rate of the company. On the basis of these forecasts we determine the intrinsic value of a share. As per fundamental analysis, the true value or fair price of a share is equal to its intrinsic value. Intrinsic value of a share is the present value of all expected future cash inflows from it. Hence under fundamental analysis we first calculate intrinsic value of a share and then compare it with market price in order to decide whether to buy or sell. Fundamental analysis is suitable for an investor who plans to invest in shares for a fairly long period of time. However there are many investors, especially speculators who do not want to invest for long. Their investment horizon is short term and hence they want to predict stock prices in relatively short term. This chapter deals with the second approach of security valuation- Technical analysis.
4.1 TECHNICAL ANALYSIS
Technical analysis is based on the premise that “history repeats itself” and hence movement in stock prices follow an established trend which can be gauged from past price and volume data. Technical analysis involves the study of various charts, ratios and patterns to predict future direction of stock prices. It helps in answering the questions like “Is it the right time to buy a share?” or “Is it the right time to sell a share?” Hence once it is decided to invest in the shares of a particular company, the right timing of investment can be decided on the basis of technical analysis.
4.2 BASIC TENETS (PROPOSITIONS) OF TECHNICAL ANALYSIS
Technical analysis is based on certain tenets, premises or propositions. Technicians does not consider value in the sense in which fundamentalists use it. The technicians believe that forces of demand and supply are reflected in the patterns of price and volume trading. By examination of these patterns he predicts whether prices will move up or down. Thus technicians believe that price fluctuations reflect logical and emotional forces. The basic tenets or premises of technical analysis are—
1. The price of a security is determined by the demand and supply forces operating in a market.
2. Prices tend to move in trends over long term. This long term trend sets the direction of market prices.
3. Price fluctuation reflect logical and emotional forces.
4. Price movements, whatever their cause, once in force persist for some period of time and can be detected.
5. The trends in security prices may reverse due to shift in demand and supply.
6. The changes in demand and supply can be predicted well in advance with the help of charts and technical tools. Hence the task of a Technical analyst is to:
i. Identify the trend and
ii. Recognize when one trend comes to an end and prices start moving in the opposite direction. For this, technical analyst uses a number of charts, patterns and technical indicators which are discussed below. It must be noted that Charts are the basic tools for technical analysis.
Tools of Technical Analysis
Technical analysis can be performed both at the market level and at individual company level using various types of charts, ratios, patterns or
indicators. Here we will examine market indicators and individual stock indicators separately.
4.3 TRADING RULES/THEORY (TECHNICAL INDICATORS)
4.3.1
Credit Balance Theory
According to Credit Balance Theory, the level of credit (cash) balance in investors’ trading or brokerage account is a good tool to forecast market trend. Investor with large cash balance in trading account is more likely to buy securities in near future. More and more investors sitting on positive credit (cash) balance will create demand for shares which would result in increase in share prices. Therefore, Credit Balance Theory proposes that high credit balance indicates a lurking bullish trend in future as cash represents potential purchasing power.
4.3.2 Barron’s Confidence Index
Confidence index as the name suggests, provides information as to how confident are investors about the market performance. Barron’s confidence index is calculated as the ratio of average yield on 10 top rated corporate bonds divided by average yield on 10 intermediate grade corporate bonds. Higher values of confidence index suggest bullish nature of the market. This ratio will always be below 1 because yield of top rated bonds cannot exceed those on low grade bonds.
Confidence Index = 10 10
Average Yield on Top rated bonds
Average Yield on intermediate rated bonds
4.3.3
Filter rules
A technical analyst sets trading rules based on the magnitude of percentage changes in market price of the share. For instance, he would buy a certain share if it falls by 2% on a trading day, while sell the other if it rises by say, 10%. Such set price parameters are called as filter rules. Filter rules are generally based on price momentum.
4.3.4 Market Breadth Analysis
Market breadth is the spread between the number of stocks that advance and decline in price. For example if on a particular day 300 stocks advance in prices while 200 stocks decline in prices, then market breadth will be 300 – 200 = 100. One can calculate cumulative breadth and if it is increasing, it signals a bullish market and vice versa. In Table 4.1 cumulative breadth is continuously rising and hence it suggests the presence of Bullish market in future as per Market breadth analysis.
4.1 : MARKET BREADTH ANALYSIS
4.3.5 Advance-Decline Ratio
Another way to analyse market breadth is calculating advance-decline ratio. It is computed by dividing the number of advancing shares by the number of declining shares. It compares the number of stocks that closed higher against the number of stocks that closed lower than their previous day’s closing prices.
Advance-Decline Ratio = . . Noofstocksadvancing Noofstocksdeclining
Advance decline ratio greater than 1 (Positive market breadth) denotes more stocks in the index have shown positive price movement whereas advance decline ratio less than 1 (Negative market breadth) implies more stocks had negative price movement in the index.
4.3.6 Relative strength
In relative strength analysis we compare a stock’s performance over a recent period to the market performance or other stocks in the same industry. Relative strength ratio is the stock price divided by market index. If the ratio increases overtime it shows relative strength of the stock and hence profitable investment opportunity.
4.3.7
Odd Lot Theory
Odd lot is trading in shares in smaller quantity than the market lot size. Small investors buy and sell shares in odd lots. As per odd lot theory, small investors are generally wrong especially before a change in the direction of market. It implies that small investors buy heavily just at the peak of the market and sell in huge quantities at the bottom of the market. Therefore contrarian view is that one should trade in the opposite direction of that of small investors. For this odd lot ratio is calculated as below :
Odd lot ratio = Oddlotpurchases
Oddlotsales
If the ratio is greater than 1 and continuously increasing then it implies that market will turn bearish in near future.
4.3.8
Volume indicators
All the chart patterns and indicators discussed so far, used only past price data for stocks. However stock’s past volume data also provides useful insights into its short term price movement and hence can be used in predicting stock prices. Researchers have observed that –
Rising volume in bullish market is further bullish.
Declining volume in bullish market suggests that market will turn bearish in near future.
Rising volume in bearish market further strengthens the bearish trend.
Declining volume in bearish market suggests that market will turn bullish in near future.
4.4
CHARTS
Charts are the basic tools for performing technical analysis. It provides a visual assistance to the technical analyst in detecting evolving and changing patterns of price behaviour. Charts may be of various types such as Line chart, Bar chart, Point and Figure chart and Candlestick chart. It must be noted that charts are useful both in the analysis of individual securities as well as market movement analysis. On a particular day, the price of a share varies many times. It is difficult to plot all the prices prevailing for a particular stock on a particular day. Therefore generally the following four prices are of interest to an investor- Open, High, Low and Close:
Open price: Open price is the price at which the trading on a share starts on a particular day.
High price: High price is the highest price at which the share has been traded on a particular day.
Low price: Low price is the lowest price at which the share has been traded on a particular day.
Close price: Close price is the price at which trading on a share closes on a particular day.
4.4.1 Types of Charts (Basic)
There are various types of charts which are used in technical analysis.
i. Line chart
ii. Bar chart
iii. Bar chart of prices with volume
iv. Point and figure chart
v. Candlestick chart
These charts are explained below:
i. Line Chart :
On a line chart X axis shows the time or number of days/week. On Y axis stock prices are shown. On a line chart only closing prices of a stock are shown. They are connected with each other successively with straight lines as shown in Fig. 4.1. The stock prices on five days are ` 14, 15, 14, 17 and 12.
FIG. 4.1 : LINE CHART
Although line chart is convenient to draw, it does not reveal anything about the intraday volatility of the stock price. It shows only the closing prices and not other prices such as high price, low price or open price.
ii. Bar Chart:
A ‘Bar chart’ shows high, low and closing prices of a stock every day. Open price of a day is generally equal to the close price of the previous day. Hence it is generally not shown on a bar chart. But if required one can also show open price of the share in a bar chart. On a bar chart, X axis shows time while Y axis shows stock prices. The length of the bar shows the range of price i.e. the highest price minus lowest price, in a particular day and hence if bar lengths increase overtime, it may be regarded as a signal of increasing stock volatility. One bar is placed every day and closing and opening prices may be depicted with some signs such as – or X. In Fig. 4.2 a bar chart is shown using the stock price data given in the following table.
iii. Point and Figure Chart:
It is a chart made up of X and O’s. X is placed for increase and O for decrease in stock price. A buy signal is implied when X lines are moving up after every O line. If O lines are going down after every X line then a sell signal is triggered. In this chart the axis do not represent time or price level, rather they just show the directional movement of prices irrespective of the quantity of change.
E.g. A stock’s price over the past 20 days is recorded as ` 20, 25, 28, 26, 30, 35, 37, 40, 38, 35, 31, 29, 30, 34, 38, 35, 37, 40, 42, 40.
The point and figure chart will appear as shown in Fig. 4.3.
It must be noted that whenever there is a change in price X or O are placed. The columns are changed when there is a change in direction i.e. from increasing prices if the price starts declining then we switched to second column and indicator O. After that the price starts increasing therefore we shifted to third column and put X signs for every increase.
FIG. 4.2 : BAR CHART
The main advantage of such a chart pattern is that it can compress large volumes of data in a small group which can be used in analysis.
iv. Candlesticks:
As the name suggests this chart type shows a candle for every day price movements. It is a chart pattern which shows four prices – open, close, high and low. If close price is lower than open price then the box is filled with black colour otherwise left empty. An increasingly dark candlesticks are bearish indicators. On × axis we measure time and on Y axis we measure stock prices. This chart pattern provides a bird’s eye view as to the movement of stock prices – both intraday and interday.
In Fig. 4.4, candlesticks are shown for the following 5 days.
FIG. 4.3: POINT AND FIGURE CHART
v. Price and Volume Chart:
Price –volume chart shows the high, low and close price of a share along with its volume in the same chart. The utility of this chart is that it provides information about the volume of trading regarding that share besides showing the relevant prices. Price and volume chart for the data given in the following table can be depicted as shown in Fig. 4.5.
FIG. 4.4 : CANDLESTICKS CHART PATTERN
4.4.2 Advanced Interactive Charts
Charts make use of historic prices to predict future price of a share. The basic chart is a tool to depict historical data of price and volume graphically. The visual representation makes it easier to identify technical patterns and formations which help take buy or sell decision. However, technical analysts would want to use multiple indicators to be assured about their trade decision. For instance, one may use moving averages to confirm breakout as suggested by head and shoulder pattern.
With regards to increasing complexity of trading environment, advanced interactive charts provide following benefits:
Multiple indicators like MACD, Bollinger bands, RSI, volume oscillator, regression line, etc. can be used simultaneously on the same chart using Advanced Interactive Charts.
Moreover, interactive charts are like drawing boards where analyst can mark values, dates, events, symbols, etc. using advanced chart tools.
Advanced interactive charts can be saved, captured as a picture or shared.
They also provide an option to change chart type (bar, line, candlestick, Renko, Heikin Ashi) as per analyst’s needs.
FIG. 4.5 : PRICE - VOLUME CHART
They are visually more appealing and attractive because multiple colors, symbols, patterns, etc. are used in them.
4.4.3 Technical analysis using charts
1. Dow Theory : Charles Dow, the grandfather of technical analysis, propounded what is popularly known as Dow theory now. Dow theory is based on the assumption that stock market does not move on random basis rather there are set trends which can detect the direction of market movement. According to this theory in any type of market; whether bullish or bearish, three trends are simultaneously at work - the primary trend, the intermediate trend and the minor trend:
i. Primary trend is the long term trend over a period lasting for more than one year. This trend sets the overall direction of the market. If primary trend is upward then bull market is in operation whereas if primary trend is downward then the market is bearish.
ii. Intermediate trend, on the other hand lasts for a few months and operate in the opposite direction of primary trend. If the primary trend is upward then intermediate trend will be downward movement and vice versa. Therefore intermediate trends are also known as “secondary corrections”.
iii. Tertiary or minor trends are day-to-day or intra-day fluctuations in stock market which do not last for long. These trends provide no meaningful conclusion regarding the overall market movement and hence are given least importance.
Bull Market : As per Dow theory a bull market is in operation when successive high points are higher than the previous high and successive low points are also higher than the previous low point. This can be understood with the help of Fig. 4.6.
As shown in Fig. 4.6 one can easily make out that the primary trend is upward moving. The intermediate trend is the period of decline in this bull market. Therefore during bull market, it is good time to buy during secondary corrections i.e. the periods of decline which do not last for long. By doing so the investor would be able to buy at low prices and in the long term he can expect increase in stock prices due to bull market. Minor trends are day to day fluctuations in stock market index and are of no use in deciding about the investment.
Bear Market : As per Dow theory a bull market is in operation when successive high points are lower than the previous lows and successive low points are also lower than the previous low point. This can be understood with the help of Fig. 4.7. Here, primary trend is downward sloping. The intermediate trend is the period of increase in this bear market. Here also it is termed as Secondary correction. Therefore in a bear market, the right time to sell is during the periods of intermediate corrections.
FIG. 4.6 : BULL MARKET (DOW THEORY)
FIG. 4.7: BEAR MARKET (DOW THEORY)
2. Elliott Wave theory:
A related theory is Elliott wave theory, which is a variant of Dow theory. As per Elliott wave theory stock prices can be described by a set of wave patterns – long term, short term and minor waves. Long term waves carry the entire market up or down while short term wave move in the opposite direction. Minor waves are daily fluctuations in the market and can be ignored by investors.
Elliott proposed that prices move in repetitive patterns, which he termed as “waves”. According to him, these waves are caused by investors’ reaction to external factors or predominant market psychology prevalent at the time. Moreover, prices move in sets of trends and corrections. Based on unique characteristics of the wave patterns, he identified:
1. Impulsive wave - A wave which goes with the main trend and always shows five waves in its pattern. It shows the main direction of prices.
2. Corrective wave - A wave which moves against the trend. It is the sideways movement in the prices.
The Elliott Wave Theory categorizes the waves from largest to smallest as follows:
Grand Supercycle, Supercycle, Cycle, Primary, Intermediate, Minor, Minute, Minuette, Sub-Minuette.
Key Points
Every action is followed by a reaction.
Five waves move in the direction of the main trend, followed by three corrective waves (a 5-3 move).
A 5-3 move completes a cycle.
This 5-3 move then becomes two sub-divisions of the next higher 5-3 wave.
The underlying 5-3 pattern remains constant, though the time span of each may vary.
Investing in Stock Markets
AUTHOR : VANITA TRIPATHI, NEETI PANWAR
PUBLISHER : TAXMANN
DATE OF PUBLICATION : JUNE 2024
EDITION : 8TH EDITION
ISBN NO : 9789357785754
NO. OF PAGES : 364
BINDING TYPE : PAPERBACK
Rs. 545 | USD 7
DESCRIPTION
This book provides readers with:
• A comprehensive understanding of the investment environment
• Insight into the investment decision process
• Knowledge of trading mechanisms in the stock market
This book focuses on investment in financial assets, primarily equity shares, with practical examples and illustrations to aid understanding.
It is designed for undergraduate students from the University of Delhi, Non-Collegiate Women’s Education Board, School of Open Learning, and various Central Universities across India.
The Present Publication is the 8th Edition, authored by Prof. (Dr) Vanita Tripathi & Neeti Panwar, with the following noteworthy features:
• [8th Edition Highlights]
o Updated Information: Latest data, facts, and stock market information
o Technical Analysis: Introduction to primary and secondary market segments
o Indian Securities Market: Coverage of clearing corporations and MSEI (Metropolitan Stock Exchange of India)
o Derivatives Market: EIC (Economy, Industry, Company) framework, call and put option payoffs
o Trading in Securities: Filter rules, Credit Balance Theory, MACD, advance-decline ratio, and interactive charts
• [Comprehensive Explanation] Clear and detailed investment concepts
• [Learning Outcomes] Goals set at the start of each chapter
• [Illustrations and Examples] Lucid explanations
• [Solved Problems] For better understanding and application
• [Summary Points] Recap key concepts at the end of chapters
• [Test Yourself] Assignments including True/False statements, theory questions, and numerical problems
• [Project Work] Real-life application opportunities
• [Previous Year’s Question Papers] Included for student reference