Technical Analysis

Introduction

Technical analysis is one of the interesting subjects to learn. Technical analysis is a study of price movements of any asset, commodity or any other instruments that is priced and traded. It can be said that TA is a process of studying the human behaviour in relation to the pricing of the asset or commodity or any other thing. When we apply the technical analysis tools we will be astonished to see how perfectly it fulfills the rules in many cases. Please note that I have used the term “in many cases” and not “always”. This is because technical analysis tools also have their own limitations and any tool should be used along with others to arrive at a trading decision. Before moving on to TA in detail, let us first understand the difference between fundamental analysis and technical analysis.

Fundamental vs Technical Analysis

In previous module we discussed fundamental analysis in detail. What did we do in fundamental analysis? We tried to understand the business of the company, analyzed their financial statements and then arrived at the intrinsic value of the enterprise. Then, we calculated the present value of the intrinsic value to find out whether the market price of that company's stock is trading at premium or discount to its intrinsic value. Right! Fundamental analysis is a process of finding the intrinsic value of a business.

Whereas technical analysis is used to find out the right entry and exit points. To understand this let us take the example of Asian Paints stock. In the previous module on fundamental analysis we calculated future cash flows of Asian Paints and we arrived at an intrinsic value of Rs.567.80. And the stock was trading at Rs.1548.20 on that day which was a huge premium to its intrinsic value. An investor who just checks the intrinsic value under fundamental analysis approach is more likely to exit the stock at Rs.1548.20 on 16.09.19 on the basis that the stock is overvalued and it is due for a correction. But do you know what happened to the stock in next few days? It made a new high at Rs.1820 on 23.09.19. This you can find out from the chart below.

An investor or trader who uses technical analysis to decide on the entry and exit points, would have waited for the stock to give a sell signal in its chart. So does it mean fundamental analysis is not necessary? No! Both fundamental and technical analysis are necessary for successful investment. I personally pick up the stocks that are fundamentally strong and wait for the chart to give buy signal to invest in the stock. This is because I do not want to unnecessarily block the fund in a stock which is going to appreciate say after a year or so.

As against the fundamental analysis which is based on statistical data, technical analysis captures the emotions and moods of the investor/trader that is reflected in the market price of the stock. The culmination of all the combined emotions will trigger a reversal or fresh trend in the stock. This is the point at which the stock chart gives a buy or sell signal. We will learn about all these in this module.

Basis of Technical Analysis

Technical analysis is based on the primary assumption that history repeats itself. The previous price actions are studied to predict the future price of the security. The price movement in its due course will form some patterns and trends according to the emotions and moods and expectations of the market participants. Since how people respond to news and other factors is reflected in the price movements, the human reaction is expected to be the same in future also. Hence, technical analysts believe the price movements to be in the same patterns based on the psychology of the market participants.

Another assumption is that the price moves in a trend. Market price of a stock or any other security moves in a trend. It can be either a short term, medium term or long term trend. Generally, the trend is expected to be continued unless some triggers are factored in. The trend and trend reversals are dealt in a separate chapter.

Market discounts everything is an important assumption in technical analysis. It is believed that all information and all fundamental factors of the stock are factored in the market price of the stock. Hence, some argue that separate fundamental analysis is not required as the market price which captures everything from fundamentals to human psychology is sufficient to make investment or trading decisions.

Charts

Technical analysis is done by using the charting tools. The market price of a stock or any security is plotted graphically to find out the trend of the price movements. There are many forms of plotting of the price graphically. Before moving on to different types of charts, let us first understand how to capture the gist of the market price movement on a single trading day.

Multitude of trades takes place everyday during market time on a day. And trades are done at different prices. You may wonder how to plot all the prices that are traded at in a chart. If you are to plot all the traded price the chart will look like a cluster of stars. In the below GIF of trading screen you can watch the bids and offers that changes rapidly and guess the frequency of trades.

To capture the mood of the market, only the opening and closing traded price on a day and the highest and lowest price traded on a day are plotted. For example, let us assume that on 1st October 2019, stock of SBI started to trade at Rs.302 and closed the day at 307 and during the day it touched a high of Rs.310 and made a low of Rs.298. During the day, the stock would have traded at various price levels between the low of Rs.298 and high of Rs.310. But the chart is plotted only with the open, close, high and lowest price of the day.

When the prices traded on a day is plotted and chart is generated, it is called day chart. When a chart is generated with the open, high, low and closing prices of a week it is called weekly chart. And if the chart is generated with open, high, low and closing price of a month, it is called monthly chart.

Chart Types

We have seen that to capture the mood of the market the open, high, low and closing price is sufficient. With these 4 data we can construct a chart for technical analysis. The following types of charts are used in technical analysis.

• Line chart
• Bar chart
• Japanese Candlestick chart

Bar chart and Japanese candlestick charts are constructed with open, high, low and closing prices. While line chart is constructed only with closing prices.

Line charts

Line charts are constructed with only closing prices of a stock. In line charts a simple line is drawn joining the closing prices plotted as dots. For example if the closing price of SBI for last 5 days are 302, 305, 303, 307 and 310. Then the line chart will look like below:

Below is the line chart of Asian Paints.

Line charts helps us to know the trend. From the above Asian Paints chart we can see that the stock is in uptrend. But apart from the trend, a line chart will not reveal anything more. This makes the use of line chart less preferable among traders.

Bar chart

Bar chart is plotted with open, high, low and closing price of a stock. Let us understand how the 4 data is plotted in a bar chart. For example, if the open, high, low and closing price of SBI are:
Open - 310
High – 318
Low – 307
Close – 314

The bar chart of the above data will look like the below.

First draw a vertical line joining the high and low prices. Then draw a line at the left side of the vertical line to represent open price and draw a line at the right side of the vertical line to represent closing price.

Note that while plotting a bar chart, if the closing price is higher than the open price, the line drawn at the right side of the vertical line representing closing price will be above the open price line drawn at the left side of the vertical line representing open price. Let us assume in the above example, the closing price is 310 and open price is 314. In that case, the bar will look like the below.

The bar above is for a day. The chart comprising last 10 days data will include 10 such bars. In a weekly chart the open, high, low and close for 10 such weeks will be plotted. Similarly, in a monthly chart the open, high, low and close of 10 such months will be plotted.

Below is the daily bar chart of SBI.

Many technical analysts use bar charts as it helps to identify trends as well as patterns. It shows the trading range of the stock. The trading range is the difference between the high and low price of the stock.

Japanese Candlestick Charts

Japanese candlestick charts were developed by a rice merchant named Sokyu Homma in Japan during 18th century. Similar to bar chart, Japanese candlestick charts are also constructed with open, high, low and closing prices. The difference in construction of bar chart and Japanese candlestick chart is that the range between open price and closing price is depicted by a real body. And the range above and below the body are called shadows. Let us see the construction of candlestick bar with the same data of SBI.
Open - 310
High – 318
Low – 307
Close – 314

A candlestick bar will look like the one below.

Note that if the closing price is higher than the open price it indicates bullishness and if the closing price is lower than the open price, it indicates bearishness. In Japanese candlestick, the body of the candle is depicted in two different colours to indicate bullishness or bearishness. Generally, bullish candles are coloured in green or blue or it is left hollow and bearish candles are coloured in red or black.

In the case of closing price being lesser than open price it is bearishness and the candlestick bar will look like the below.

Below is the daily candlestick chart of SBI for a series of days.

In the above chart can you notice green and red candles? And can you see the difference in size of the candles and the shadows? Well, the size of the real body of the candle and shadows helps us to study the relationship between open, high, low and closing price.

Dow Theory

Charles H. Dow, the founder and first editor of “The Wall Street” journal laid the principles of the theory in his editorial during the 19th century. Later his successor William P Hamilton organized and formulated all the editorials and named it Dow Theory.

Basic tenets of Dow theory

Dow theory relies on the closing price rather than on open, high or low prices. Dow theory is based on a few basic hypothesis or tenets as usually called. There are six basic tenets.

Market discounts everything

According to this hypothesis, everything from known to unknown news and information are reflected in the market price. Market discounts all hopes and fears and expectations of market players and it is instantaneously reflected in the market price of the stock or index.

Market moves in a trend

The basic assumption as per Dow theory is the price of the stock or market moves in a trend. As per the theory, three trends exist. The trends are identified as “Primary or Major” trend, Secondary or Intermediary trend and Tertiary or minor trend.

Primary trend is the major trend which lasts for multiple years. As per the theory, as long as the prices moves up and makes a higher top than the previous one and as long as the corrections in between stops at a higher level than the previous correction, the trend is said to be primary up trend. Similarly, when the prices are making lower lows and in between short rallies stop at lower levels of previous short rallies, the trend is said to be primary down trend.

Secondary trend is the in between corrective trends that lasts between a few weeks to months. The corrective trend is the short counter trends to the primary trend.

Minor trends are the daily price movements which makes a small minor trend which usually lasts for 6 days to two or three weeks. This trend is usually a negligible trend.

All indices must confirm

According to Dow theory, all indices should confirm the trend. For example, if only Nifty 50 moves up and Nifty Midcap Index does not move up then it cannot be called a bull market. As per this theory all indices should move in the same direction to confirm a trend.

Trend should be confirmed with volumes

As per the theory, the trend should be confirmed by the volumes. In an uptrend the volume should increase when the price increases and it should decrease when the price falls. Similarly, in a down trend, the volume should increase when prices fall and it should decrease when prices rise.

Sideways movement substitute for secondaries

As per the theory, sideways movement that lasts for 2 or 3 weeks and for a few months can be called the secondary trend.

Relied on closing price

Dow theory considers only the closing price rather than the open, high or low prices recorded during the day.

Phases of market

According to Dow theory, typical major trend consists of three phases of intermediate trend in the direction of the major trend and two intermediate trend in the direction against the major trend.  This is shown in the below chart.

The three phases of intermediate trends are called accumulation phase, up move or public participation phase and distribution phase. In a bear market they are called distribution, down move or public phase and accumulation phase.

Accumulation phase is where informed investors who are usually institutional investors accumulate the stock upon finding the value in the stock. Accumulation phase is significant if it occurs at the end of the bear market.

The up move phase is where other investors and trend traders begin to participate and takes the prices higher. At this juncture more and more positive news starts flowing in.

Distribution phase is where more and more bullish stories comes in and everyone starts to talk about better economic conditions etc. This pulls the less informed speculators and investors to the market. It is at this phase the institutional investors who accumulated the stock during accumulation phase starts offloading them. During this phase the astute investors will sell on every rise of stock price thus creating selling pressure.

Once all the supply is absorbed by poor retail investors the stock price starts to fall. And this will be the start of a bearish trend. At the end of bear market fresh accumulation phase will come up thus repeating the whole cycle.

Conclusion

Dow theory is criticized for being too late and not being helpful in identifying the changes in intermediate trend. While long term investors are interested in major trend, short term traders are more concerned with intermediate trend. So, traders over a period of time developed many supplementary rules based on principles of Dow theory to trade intermediate trends. These will be dealt in a separate chapter “Chart Patterns”.

Key points to remember

• Technical analysis is used to find out the right entry and exit points
• Technical analysis captures the emotions and moods of the investor/trader that is reflected in the market price of the stock
• The culmination of all the combined emotions will trigger a reversal or fresh trend in the stock. This is the point at which the stock chart gives a buy or sell signal. We will learn about all these in this module.
• Technical analysis is based on the primary assumption that history repeats itself, price moves in a trend, and market discounts everything.
• Widely used chart types are bar chart and candlestick charts.
• Dow theory relies on the closing price rather than on open, high or low prices. Dow theory is based on a few basic hypothesis or tenets as usually called
• As per the Dow theory, three trends exist. The trends are identified as “Primary or Major” trend, Secondary or Intermediary trend and Tertiary or minor trend.
• According to Dow theory, typical major trend consists of three phases of intermediate trend in the direction of the major trend and two intermediate trend in the direction against the major trend.

Round Up

Technical analysis is used mostly by the short term traders to find out the right entry and exit points. However, long term investors can use the technical analysis to identify the entry point to avoid blocking the fund unnecessarily in a stock which is going to appreciate much later. Technical analysis involves the study of price patterns that is formed based on the emotions and moods of the traders and investors. The chart patterns as per Dow theory and candlestick chart patterns are dealt in the following chapters separately.

 

Suggested readings

“Technical Analysis of the Financial Markets" by John Murphy