J B GUPTA CLASSES

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Chapter 12
TECH ICAL A ALYSIS
Chapter Index
Charts Trend Chart Patterns/ Price Patterns Moving Average Momentum Analysis / Relative Strength Index (RSI) Bollinger Bands

Prices of the securities in the stock exchange keep on fluctuating. The investors and other operators are always interested in buying the shares at lower prices and selling them at higher prices to make profit. To achieve this objective, they analyze the share price behavior. There are two approaches in this regard: (a) Fundamental Analysis (b) Technical Analysis Fundamental analysis estimates the real worth of the share i.e. the fundamental analysis aims at finding the intrinsic value of the share based on the estimates of its future earnings. The share should be purchased if it is being traded in the market below its intrinsic value, it should be sold if it is traded in the market at a price above its intrinsic value. Suppose the intrinsic value of a share is Rs.200, the fundamental analyst suggests buying it if it is being traded in the market below Rs.200; sale is recommended if it is traded above Rs.200. Q. No. 1 Explain the beliefs and fundamental principals of Technical Analysis. Answer: Answer

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Technical analysis aims at estimating the future price trend with the help of past stock data, mainly prices data, primarily through the use of charts. According to Murphy, "Technical analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends. (The term market action here refers to three principle information price, volume and open interest). Technical analysis helps share market operators to anticipate: what is "likely" to happen to prices over time? This analysis ignores the intrinsic value for the purchase / sale decision. Purchase is recommended (even if the current price is more than intrinsic value) if the price trend is upward. Sale is recommended (even if the current price is less than intrinsic value) if the price trend is downward. Technical analysts believe that Trend is friend and that profit can be made by Trend following. Beliefs: (1) Prices move in trends: The movement in share prices in the stock exchange is not random; the prices move in trend i.e. the price movement has a direction for quite some time. (To make profit, (a) we should identify the trend and (b) the reverse in trend should immediately attract our attention.) A technical analyst believes that it is possible to identify a trend, invest or trade based on the trend and make money as the trend reverses. (2) History repeats itself. History gives us the lessons for the future. By studying the past share price behavior and drawing the lessons from the history, we can identify the trend and notice its reversal immediately

on its occurrence.
(3) What is more important than why. Technical analysts study the direction in which the prices are moving i.e. they interpret what the market is saying with the purpose of forming a view on the future, they do not try to find why the market is saying so. (4) Price discounts everything i.e. the technical analyst believes that anything that can possibly affect the price--fundamentally, politically, psychologically, or otherwise--is actually reflected in the price. In other words, the current price fully reflects all information (also fear and hopes). Hence, no information can be used to beat the market. The fundamental principles of Technical Analysis1 : (1) The market price of a security is determined at the intersection of its demand and supply. (2) The demand and supply are influenced by various factors, both fundamentals as well emotional.

Based on Schaum outlines on Investments.

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(3) The prices move in trend i.e. the price movement has a direction for quite some time. Prices seldom move in a straight line in any direction, rather the movement is in a series of ups and downs. The main direction of the prices is interrupted by short-term counter movements. These counter movements are referred as reactions. (4) Shift in the demand and supply results in reversal of the trend. (5) The price charts exhibit the trend in the price movements. The reversal of the trend is also exhibited by the charts. (6) The technical analysts are able to identify the trend and notice its reversal immediately on its occurrence. Technical Analysis helps in riding on the trend (i.e. to be on the side of the trend) until its reversal and identifying the trend reversal at a relatively early stage. Technical analysis is not perfect technique. It only increases the probability of making correct trading/investing decisions. It is not a perfect science. Sometimes the same chart is interpreted by the different technical analysts in different ways. The technique has an ever-evolving message there is need of continuous interpretation and reinterpretation2. If the knowledge of the history could make people rich, the richest persons would have been the historians. CHARTS Q. No. 2 Explain different types of Charts using for Technical Analysis. . Answer Charting is the very basis of the technical analysis. A chart is a graphical presentation of securitys price movements over a specific time frame. The time frame may be minutes, hours, days, weeks, months, quarters, or years (the most popular time framework is days). The chart is an easy to read historical account of a security's price movement over a period of time. Charts are much easier to read than a table of numbers. On the chart, the y-axis represents the prices and the x-axis represents the time frame work. Four types of prices are used for charting: opening price, closing price, highest price and lowest price. Closing price is given maximum importance for estimating the future trend.

Based on Dr. Melvin Pasternaks writings. ( streetauthority.com)

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There are three types of popularly used charts: (1) Line charts (2) Bar charts (3) Japanese candlestick charts LINE CHARTS: It is the simplest form of the three charts. This chart exhibits closing prices against the specific time frame work. (The most popular time frame is days). The closing prices are plotted by way of points against trading days. These points are joined to obtain the line chart.

BAR CHARTS:
It is the most popular form of the three charts. This chart exhibits all the four types of prices (opening, closing, highest and lowest) against the specific time frame work, generally the trading days. Highest and lowest prices are shown as a bar. Opening and closing prices are shown as small horizontal dashes on the bar. The opening price is shown by of a way a small horizontal dash towards left side. The closing price is shown by way of a small horizontal dash towards right hand side.

JAPANESE CANDLESTICK CHARTS:

The Japanese Candlestick consists of a body, an upper shadow and a lower shadow. In this type of charts, the opening and closing prices are shown as the body of the candle (a rectangular box). A vertical line is drawn from the level of highest price of the day to the upper side of the rectangular box. Another vertical line is drawn from the level of lowest price of the day to the lower side of the rectangular box. There are three types of Candlesticks from the point of view of technical analysis; (i) white (ii) black and (iii) Doji. The first type is drawn when closing price is more than opening price. The second type is drawn when the opening price is more than the closing price. The third type is drawn when the closing and the opening prices are the same.

TREND Q. No. 3 (a); What do you mean by Trend (with reference to Technical Analysis). Explain different types of trends. Answer The term trend refers to the general direction of the price movement. The price movement has a direction for quite some time. Prices seldom move in a straight line in any direction, rather the movement is in a series of ups and downs. The main direction of the prices is interrupted by short-term counter movements. These counter movements are referred as reactions. If the supply exceeds the demand, the prices have a downward bias. If the demand exceeds the supply, the prices have an upward bias.

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There are three types of trends : (a) Upward trend (b) Downward trend and (c) sideways or flat trend. Though moving in a zigzag form ( a series of ups and downs), a series of higher ups and higher downs is referred as upward trend and the series of lower ups and lower downs is referred as downward trend. In other words, in case of upward trend, each decline of price got a support at a level higher than the previous decline and in case of downward trend each decline of price got a support at a level lower than the previous decline. When there is little movement in the prices, the situation is referred as sideways or flat trend. Flat trend actually refers to absence of trend. Even in the case of a flat trend, the prices are seldom constant; they keep on moving in the narrow range. (The Flat trend is also referred as the range bound market). Buying is recommended in case of upward trend. Selling is recommended in case of downward trend. Staying away from the market is recommended in case of sideways trend.

Q. No.3 (b): Explain the reversal of trend (with reference to Technical Analysis). Answer

Reversal of trend can be divided into two types:

(1) When the upward trend moves downward (2) When the downward trend moves upward. If long position has been held during the upward trend, sale is recommended on the reversal of the upward trend. If short position has been held during the downward, squaring off of the transaction (purchase) is recommended on the reversal of the downward trend.

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Q. No. 4 Explain the terms Support level and Resistance Level With reference to Flat trend, two levels, support level and resistance level, need special mention. Support Level : If the supply exceeds the demand, the prices have a downward bias. With downward bias in the price movement, a stage ( i.e. a price level ) is reached when the market operators feel that the price is quite attractive for buying and more and more buyers come forward to buy; the outcome of this scenario is increase in demand ( i.e. the demand overtakes the supply) and upward bias in the prices . This price level is referred as Support level. The Support level is the price level, in case of sideways trend, which provides support to the falling prices i.e. this level prevents the prices from declining further.

Resistance Level : If the demand exceeds the supply, the prices have an upward
bias. With upward bias in the price movement, a stage (i.e. a price level ) is reached when the market operators feel that the price is quite attractive for selling and more and more sellers are there; the outcome of this scenario is increase in supply ( i.e. the supply overtakes the demand) and downward bias in the prices . This price level is referred as Resistance level. The Resistance level is the price level, in case of sideways trend, which prevents the prices from increasing further by increasing the supply i.e. this price level creates resistance

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in the way of upward bias; the outcome is that when this level is reached the price movement turns downwards. If the support level is broken i.e. if the prices fall below the support level, it is an indication of prices going down further i.e. a bearish trend. The old support level, which has been crossed by the falling prices, becomes new resistance level. If the resistance level is broken i.e. if the prices move above the resistance level, it is an indication of prices going up further i.e. a bullish trend. The old resistance level, which has been crossed by the rising prices, becomes new support level.

CHART PATTERNS / PRICE PATTERNS

Q. No. 5 Write a detailed note on Charts/Patterns. Answer When the prices are plotted against time frame work, certain patterns emerge i.e. some distinct formation is being exhibited. These patterns are referred as chart patterns/ price patterns. These patterns depict the on going battle between the bulls and bears. Chart patterns are defined as complex versions of trend lines.

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One of the fundamental beliefs of the Technical Analysis is that the history repeats itself. On completion of a particular pattern, whatever happened in the past, is likely to happen this time as well. Thus judging the pattern that has emerged and using the historical knowledge, the Technical Analyst can forecast the future movement of the prices. There are two important types of chart patterns (i) Reversal patterns (ii) continuation patterns.

Reversal Pattern
A Reversal pattern signals that the on-going trend is likely to reverse on the completion of the pattern. The most popular reversal pattern is Head and Shoulders Pattern. Head and Shoulders Pattern can be studied into two parts (i) Head and Shoulders Top and (ii) Head and Shoulders Bottom (also called as Head and Shoulders Reverse). In case of Head and Shoulders Top, there are three successive rallies; the second being highest. The pattern can be divided into four parts : (i) first a hump or small top is formed; reaching this level the prices start falling as the demand thins out but the falling prices support at the support level. (ii) At support level the prices attract buyers, the prices move upward and reach the level higher than the previous one; reaching this level the prices start falling as the demand thins out but the falling prices find support at the same support level. (iii) At the support level the prices attract buyers, the prices move upward and create a top equal to first one; reaching this level the prices start falling towards the support level, as the demand thins out. This time the support level is unable to provide the support i.e. the prices move downwards breaking the support level. This situation indicates the reversal of the upward trend to downward trend. (iv) All the three rallies have a common support level though after the third rally the support level is is unable to provide the support and the support level is broken. The completion of the Head and Shoulders Top is treated as the reversal of the upward trend i.e. the beginning of the down ward trend. The first and third rallies are like shoulders and the second one is like the head of a human being. The line joining the support points of various rallies looks like neckline. Thats why the pattern is referred as Head and Shoulder Top.

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The pattern of Head and Shoulder Bottom is just reverse of the Head and Shoulders Top. In this case, there three successive bottoms, the second one being the deepest one. The pattern can be divided into four parts : (i) first a small bottom is formed; reaching this level the prices start rising as the supply thins out but the rising prices face resistance at the resistance level. (ii) At resistance level the prices attract sellers, the prices move downward and reach the level lower than the previous one; reaching this level the prices start rising as the supply thins out but the rising prices face resistance at the same resistance level. (iii) At the resistance level the prices attract sellers, the prices move downwards and create a bottom equal to first one; reaching this level the prices start rising towards the resistance level, as the supply thins out. This time the resistance level is unable to put the resistance i.e. the prices move upwards breaking the resistance level. This situation indicates the reversal of the downtrend to uptrend. (iv) All the three bottoms have a common resistance level though after the third bottom when the prices start rising, the resistance level is unable to put the resistance and the resistance level is broken.

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The completion of the Head and Shoulders Bottom is treated as the reversal of the downward trend i.e. the beginning of the upward trend. The first and third bottoms are like shoulders and the second one is like the head of a human body viewed from bottom side (feet) to the up side (head). The line joining the resistance points of various bottoms looks like neckline. Thats why the pattern is referred as Head and Shoulder Bottom.

Continuation Patterns
A continuation pattern signals that the current trend, which may be either upwards or downwards, will continue after a brief pause. Triangle is the most popular continuation trend. In the case of declining trend, triangles are formed when there are at least two successive falling tops and at least two successive rising bottoms.( Extension of

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the two lines, one joining the tops and other joining the bottoms, form a triangle). The continuation pattern is further confirmed if the volumes decline during the formation of the Triangle.

In the case of increasing trend, triangles are formed when there are at least two successive rising tops and at least two successive falling bottoms.( Extension of the two lines, one joining the tops and other joining the bottoms, form a triangle). The continuation pattern is further confirmed if the volumes decline during the formation of the Triangle.

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MOVING AVERAGE Q. No. 6 : Explain the concept of Moving Average ( with reference to Technical Analysis) Answer: Answer Zigzag movement of prices often makes it difficult to judge the underlying trend. Moving averages are used to highlighten the trend. A moving average smoothens the underlying price data and represents the trend for the period used to calculate the average. For depicting short term-trend, 5 to 10 days moving average, for medium term-trend 50 days moving average and for long-term trend 200 days moving average may be used. 200 days moving average is quite popular among the technical analysts. For moving average, generally the closing prices are used. There are two types of moving averages: (i) Simple moving average and (ii) Exponential moving average. Simple Moving Average: The term moving average signifies that the average is computed for a moving body of data.

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For example, a 5-day average is calculated by adding the closing prices for the first five days and dividing the total by 5. The average so calculated represents moving average for the 5th day. At the end of 6th day, the average is taken for the closing prices for day 2 through day 6. The average so calculated represents moving average for the 6th day. And so

*Example: Calculation of 5 weeks moving average. Week 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Share price Index 7290 7380 7399 7379 7450 7513 7500 7565 7524 7597 7590 7586 7598 7624 7645 7656 7648 7642 7610 7563 5-week Moving average

7380 7424 7448 7481 7510 7540 7590 7652 7625 7657 7699 7647 7610 7595 7499 7466

18 Exponential Moving average =

[(Closing price Previous EMA) x EMA factor] + [Previous EMA] Where (i) (ii) EMA factor is 2/(n+1). For example, if 5 days EMA is to be calculated, the EMA factor is 2/(5+1) = 0.33 For the first period's exponential moving average, the simple moving average is used as the previous period's exponential moving average

Interpretation of Moving Averages:

The moving average is overlayed over a normal price chart. The moving average line is taken as the indicator of the trend (this particularly applies to 200 days moving average). Moving average smoothens the short-term fluctuations and depicts the long-term trend. (A) Since the moving average reflects the trend, intersection of the actual price with the moving average signals at least a pause in the trend by way of a correction and possibly a trend reversal. In an uptrend, both the price and the moving average are rising and price is above the moving average. If the price were now to move below the moving average while the moving average is still rising, it would probably signal just a correction.

After a while renewed buying usually pushes the price again over the moving average. If the moving average is still rising, such a crossover of the price over the moving average indicates resumption of the rising uptrend.

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However, if the moving average has begun to move sideways a trend reversal is more likely. It is signalled when the price again crosses below the moving average.

(B) Since the moving average reflects the trend, intersection of the actual price
with the moving average signals at least a pause in the trend by way of a correction and possibly a trend reversal.

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In a downtrend, both the price and the moving average are falling and price is below the moving average. If the price were now to move above the moving average while the moving average is still falling, it would probably signal just a correction.

After a while renewed selling usually pulls the price again below the moving average. If the moving average is still falling, such a crossover of the price over the moving average indicates resumption of the downtrend.

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However, if the moving average has begun to move sideways, a trend reversal is now more likely. It is signalled when the price again move above the moving average.

Q. NO.7: NO.7 Closing values of BSE Sensex from 6th to 17th January of the year 200X were as follows: Days 1 2 3 4 5 6 7 8 9 10 11 12 Date 6 7 8 9 10 11 12 13 14 15 16 17 Day THU FRI SAT SUN MON TUE WED THU FRI SAT SUN MON Sensex 14,522 14925 No Trading No Trading 15222 16000 16400 17000 No trading No trading No trading 18000

22 Compute EMA of the Sensex during the above period. The 30 days simple moving average of the sensex can be assumed as 15000. The value of exponent for 30 days EMA is 0.o62. (Nov. 2009) Answer Exponential Moving average =
[(Closing price Previous EMA) x EMA factor] + [Previous MA] Day 1 2 3 4 5 6 7 Closing price 14,522 14925 15222 16000 16400 17000 18000 EMA (14522-15000) x 0.062 + 15000 = 14,970 (14925-14970) x 0.062 + 14970 = 14967 (15222-14,967) x 0.062 + 14967 = 14983 (16000-14983) x 0.062 + 14983= 15046 (16400-15046) x 0.062 + 15046 = 15130 (17000-15130) x 0.062 + 15130 = 15246 (18000-15246) x 0.062 + 15246 = 15417

MOMENTUM ANALYSIS / Relative Strength Index (RSI) Q. No. 8 : Explain the concept of Momentum Analysis( with reference to Technical Analysis) Answer: Answer

MOMENTUM ANALYSIS / Relative Strength Index (RSI)

Momentum measures the rate of the rise or fall in stock prices. It is a useful indicator of strength or weakness in the share price. RSI is a technique of momentum analysis. This technique is quite popular as it is easy to calculate and easy to interpret. The technique was developed by Wilder and published in the magazine Commodities ( now called Futures) in 1978. The RSI measures the shares internal strength/ weakness by comparing todays prices to its previous days prices. It does not show the shares strength/weakness in comparison to other shares. RS = Average gain per day / average loss per day Wilder suggested to calculate RS on the basis of 14 price changes. (For 14 price changes, we require the price data for 15 days).

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*Calculation of 14 day RSI

Days Closing prices Change over previous day Gain 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Total Average RS = 2 / 0.714 = 2.80 RSI = [100] [(100)/ (1 + RS)] Values above 70 are considered overbought and values below 30, oversold. The RSI is best used as a valuable complement to other technical analysis. 20 22 20 25 27 24 26 30 30 32 29 31 35 33 38 2 5 2 2 4 2 2 4 5 28 28/14 = 2 Loss 2 3 3 2 10 10/14 = 0.714

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BOLLINGER BANDS

Q. No. 9 Write a not4 on Bollinger Bands. Answer Bollinger Bands, developed by John Bollinger in the 1980s, are used by
technical analysts for studying the volatility and share prices behaviour. Under this approach, the bands are overlayed over a normal price chart: the middle band exhibits the 20 days moving average of the prices the upper band exhibits the 20 days moving average of the prices + 2 SD Standard deviation the lower band exhibits the 20 days moving average of the prices 2 SD

SD is a measurement of volatility. Hence, narrower the bands (at a given time), lower the volatility and wider the bands (at a given time), greater the volatility. Chart Patterns: In up trends, the price usually moves between the 20-day moving average and the upper Bollinger band. In a downtrend, the price usually moves between the moving average and the lower Bollinger band. Penetration of the upper Bollinger band in an up trend usually suggests Continuation of the up trend. However, if the price quickly moves back into the band, a trend reversal or at least a deep correction is likely. Penetration of the lower Bollinger band in a downtrend usually suggests continuation of down trend. However, if the price quickly moves back into the band, a trend reversal or at least a strong temporary rally is likely.

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